Ch. 4 Mutual funds and other investment companies

4.1 investment companies• Functions performed by investment companies:• - record keeping and administration• - diversification and divisibility• - professional management• - lower transaction costs

• Investors buy shares in investment companies. The share value is called Net Asset Value (NAV)

NVA = Market value of assets minus liabilities / shares outstandinge.g) a mutual funds managing a portfolio of securities worth $120

million. The fund owes $4million to its investment advisers and owes another $1 million for rent. The fund has 5 million shares

NAV = (120 – 4 - 1)/5 =$23 per share

4.2. Types of investment companies (Investment Company Act in 1940)

• 1) Unit investment trusts: money pooled from many investors that is invested in a portfolio fixed for the life of the fund.

• - A sponsor (e.g. brokerage firm) buys a portfolio of securities which is deposited into a trust. It then sells to the public shares or units, called redeemable trust certificates. All incomes and principals of the portfolio is paid out by the fund’s trustees (e.g. bank or trust company) to shareholders.

• - investors may sell the shares back to the trustee to liquidate their holdings.

• - fee is lower than that of managed funds.

• 2) Managed investment companies• Two types: closed-end and open-end. • (1) Open end funds: funds stand ready to redeem or

issue shares at their net asset value. Price = NAV. But price will exceed NAV if the fund carries a load that is a sale commission charged on a mutual fund. Shares are not traded at organized exchanges but at investment companies.

• (2) Closed end funds: funds do not redeem or issue shares. Investors in closed end funds must sell their shares to other investors in order to cash out. Price can differ from NAV. Shares of closed end funds are traded on organized exchanges and can be purchased through brokers.

• Figure 4.1. PREM/DISC = (Price –NAV)/NAV; 52WEEK RETURN % means percentage change in price + dividend income during the last 52 weeks.

• (3) Puzzle 1: closed end fund shows the divergence of price from NAV. At a discount, the profitability seems to persist for a long period time.

• (4) Puzzle 2: while many closed end funds sell at a discount, the Issue price of NAV tends to be higher than original NAV.

• In contrast to closed end fund, the price of open end funds can not be below NAV because it redeems at NAV.

• 2) Other Investment Organization: intermediaries not formally organized or regulated as investment companies.

• (1) Commingled funds: partnerships of investors that pool their funds. For example, a bank or insurance firm manage the funds for a fee. This fund is similar to open end funds and offer units which is bought and sold at NAV.

• (2) Real Estate Investment Trusts (REITs)• It invests in real estate or loans secured by real estate

and is similar to closed end fund. Most of them are highly leveraged (debt ratio of 70%).

• (3) Hedge funds: a private investment pool, open to wealthy or institutional investors. It is exempt from SEC regulation and can therefore pursue more speculative investment policy. And hedge funds often require lock-up periods.

4.3 Mutual funds• It is the common name of an open end investment company.• 1) Investment Policies• Each mutual fund has a specific investment policy described in the

fund’s prospectus. E.g) money market mutual funds, bond funds, etc

• Management companies manage a family or “complex” of mutual funds. E.g) Fidelity, Vanguard, Putnam, Dreyfus, etc

• (1) Money market funds: invest in money market securities such as commercial paper, repurchase agreements, certificate of deposit

• - maturity: a little bit more than a month• - NAV: $1 and no tax implication from capital gain or loss.

• (2) Equity funds: invest primarily stocks in management discretion.• - hold 5% of total asset in money market securities to deal with

potential redemption. • - income funds (high dividend yield) vs growth fund (capital gains)

• (3) Specialized sector funds: investing in specific industry.

• (4) Bonds funds: • - investing in corporate bonds, treasury bonds,

mortgage-backed securities, muni-bonds• - specialized in maturity or credit risk• (5) International funds• - global funds: invest in securities worldwide• - international funds: invest in securities of firms located

outside the U.S.• - regional funds: invest in a particular area such as

emerging market.• (6) Balanced funds: investing equities and bonds in

relatively stable proportions.• - life cycle funds: asset mix can range from aggressive to

conservative.

• (7) Asset allocation and flexible funds• Funds varying the proportions allocated to each

market in accord with the portfolio managers’ forecast of the relative performance of each sector.

• - market timing• (8) Index funds: funds matching the performance

of a broad market index. • - buying shares in securities included in a

particular index in proportion to the security’s representation in that index. E.g) Vanguard’s Windsor and Wellington fund

• 2) how funds are sold• Most mutual funds have an underwriter that has an

exclusive right to distribute shares to investors.• Mutual funds are marketed directly by the underwriter or

indirectly by brokers on behalf of the underwriter.• Revenue sharing: a fund company pay brokerage firms

for preferential treatment when making investment recommendation for the fund. It causes a potential conflict of interests.

• - not illegal as long as an investor is informed about revenue sharing arrangement and potential conflict of interest.

• - SEC requires brokerage firms to reveal any compensation and incentives they receive to sell a particular fund.

• Financial Supermarket (e.g. Charles Schwab & Co.)

4.4. Cost of investing in mutual funds

• CDA/Wiesenberger or Morningstar’s mutual fund sourcebook has performance and fee information.

• 1) Fee Structure• (1) Operating expenses: costs incurred by the mutual funds in

operating the portfolio, including administration expenses, advisory fees.

• - expressed as a percentage of total assets• - ranged between 0.2% to 2%.• - periodically deducted from the asset fund• In addition to operating expenses, most funds assess fees to pay

marketing and distribution costs.

• 2) Front-end load: commission or sales charge.• - primarily paid to broker• -not exceed 8.5%, practically rarely higher than 6%.

• -low load funds: up to 3% of invested funds• - no load funds: no front end sales charge• E.g) each $1000 paid for a fund with 6%load. Your break even

return = 60/(1000-60)=6.4%

• 3) Back-end load (contingent deferred sales charges): redemption or exit fee incurred when you sell your shares.

• - 5% or 6%, typically reduced by 1% every year

• 4) 12b-1 charges: SEC allows the managers of 12b-1 funds to use fund assets to pay for distribution cost such as advertising, annual reports, prospectuses, commission to brokers

• - annually deducted from the asset fund• - should be added to operating expenses to estimate true annual

expense ratio.• - limited to 1% of a fund’s average net assets per year.• - required to show a consolidated expense table.

• Many funds provide “classes” with different combination of fees. Example 4.1 at page 92.

• Depending a holding period, investors have different preference for fees. Loads are paid once when purchased but 12b-1 fee is paid annually.

• Pure no-load no-fee funds distributed directly by the mutual fund group are the cheapest alternative to knowledgeable investors.

• Fee-only financial managers who charge directly for service not for commission. They help to find low or no load funds for investors. Recently personal financial planner becomes an important distribution channel.

• 2) Fees and Mutual Fund Return

• (1) rate of return • = (NAV1-NAV0+ Income and capital gain

distribution) / NAV0

• = gross return on the underlying portfolio – total expense ratio

• Here total expense ratio = total expenses of a fund / total asset in the fund

• E.g) fee structure and its impact on the performance of annual 12% return

Fund A Fund B Fund C

Operating Exp 0.5%

MGMT Exp 1% 1%

Front-end Load 8%

12b-1 0.5%

Expense ratio 0.5% 1.5% 1%

Initial investment 10,000 10,000 9,200

5 years 17234 16474 15502

10 years 29699 27141 26123

Here 17234 = 10000*(1+0.12-0.005)^5; 16474 = 10000*(1+0.12-0.015)^5;

15502 = 9200*(1+0.12-0.01)^5

• (2) soft dollar: payment made by mutual fund (portfolio managers) to service provider for database, computer, etc. The payment generates an additional fee to a trade for that fund. Brokerage firms transmit this additional fee to service provider.

• - This soft dollar is not included in expense ratio of the fund, artificially lowering expense ratio to the public.

• - SEC allows soft dollar arrangements as long as the proceed is used for research beneficial to mutual fund shareholders.

4.5 Taxation of mutual funds• “Pass-through status” under U.S. tax code. It means

that taxes are paid only by investors in the mutual funds not by the fund itself as long as the funds meet several requirements. E.g) funds are sufficiently diversified and virtually all income is distributed to shareholders.

• This pass-through limits investors to engage in tax management – can not time to realize gains and loss for tax purpose.

• Turnover: ratio of the trading activity of the portfolio to the assets of the portfolio. It measures the fraction of the portfolio that is replaced. The high turn over means often realization of capital gains or losses. Equity fund on average has around 60% whereas index fund has around 2%.

• SEC requires funds to disclose the tax impact of portfolio – after tax return.

4.6 Exchange traded funds (ETFs)• ETFs: offshoots of mutual funds that allows investors to trade index portfolio

just like a share of stock. Mutual fund is traded at the end of day with NAV whereas ETFs can be traded during the day and be sold and purchased on margin.

• Types of ETFs: Spider (S&P 500), Diamond (DJIA,, ticker: DIA), Qubes (NASDAQ 100, ticker: QQQQ), WEBS (foreign stock market index), Table 4.3 at page of 96. Also other variations are available (e.g. leveraged ETFs – daily returns that are a targeted multiple of the index return, inverse ETFs – moves in opposite direction of an index, etc)

• Barclay’s Global Investors is the market leader in the ETFs. After merged with Blackrock, (www.iShares,com) is operated under Blackrock.

• ETFs’ advantages:- Tax advantage over mutual funds. Large number of shareholders’ redemption

in mutual funds triggers sales of securities and tax for remaining shareholders.

- Cheaper than Mutual funds. Saved management fee. (An expense ratio of Total Stock Market Mutual fund is 0.18% but that of Total Stock Market EFTs is 0.07%)

- But ETFs price can depart from index (mutual) fund, especially in a stressed market.

- ETFs trade costs a brokerage fee in buying and selling whereas mutual funds with no load has no expense on purchase.

- Assets in ETFs in 2011: recently, on the top of US broad index, bond, commodities and Global/Int’l equity started to take an increasing portion. (Figure 4.2)

- Investment Company Assets under Management in 2011: Mutual funds (Largest), ETFs (Second largest). (Figure 4.3)

4.7 mutual fund investment performance.

• One of issue is to select a proper benchmark.• Text book uses Wilshire 5000 index value

weighting 6000 firms.• During 1971 to 2008, the average return of

diversified equity funds was below the average return of Wilshire 5000.

• It is not clear whether ,on average, managers have a skill to outperform the market. But the bad performance is more likely to persist than good performance.

4.8 information on mutual funds

• Prospectus: investment objectives, policies and risk, advisers and managers, service charges, operating expenses, management fees, 12b-1, etc

• Statement Additional Information (SAI): Part B of the prospectus. List of securities.

• Wiesenberger’s Investment Companies and Morningstar’s Mutual Fund Sourcebook

• www.morningstar.com and finance.yahoo.com• Figure 4.5.

• Under “Performance” • - quarterly performance after expenses (but not sales

charge- front or back end load) is introduced.• - Trailing is for comparison• - %rank means % of funds beat the fund.

Under “Historical Profile”- Performance Quartile: If shaded band is to the top of

box, it means the fund is one of top quartile performers in that year.

Under “ Rating and Risk”- Load adj Return = total return – all loads and back-end fee

“Portfolio Analysis” presents the largest 20 holdings of the portfolio

Fee information is at the bottom.