CHAPTER 4 FUNDAMENTALS OF INVESTMENT MANAGEMENT

CHAPTER 4 FUNDAMENTALS OF INVESTMENT MANAGEMENT

Zoubida SAMLAL - MBA , CFA Member, PHD candidate for HBS

program

MUTUAL FUNDS

Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns.

Investors added $363 billion in net new funds to mutual funds in 1999, and by the end of the year, mutual fund assets totaled $6.85 trillion. These were estimated to be 83 million Americans.

MUTUAL FUNDS

• Mutual funds are simply a means of combining or pooling the funds of a large group of investors.

• The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided.

• Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.

INVESTMENT COMPANIES AND FUND TYPES

Investment companyA business that specializes in pooling funds from individual investors and investing them.

Closed-end fundAn investment company with a fixed number of shares that are bought and sold only in the open stock market.

Open-end fundAn investment company that stands ready to buy and sell shares at any time.

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INVESTMENT COMPANIES AND FUND TYPES

• Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.

• In contrast, the shares of closed-end funds may or may not be equal to their NAV.

Net asset valueThe value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.

INVESTMENT COMPANIES AND FUND TYPES

WORK THE WEB

For mutual fund facts and figures, visit:http://www.ici.org

MUTUAL FUND OPERATIONS

Organization and Creation• A mutual fund is simply a corporation. It is owned

by shareholders, who elect a board of directors.• Most mutual funds are created by investment

advisory firms (such as Fidelity Investments), or brokerage firms with investment advisory operations (such as Merrill Lynch).

• These firms wish to manage the funds to earn fees.

WORK THE WEB

All the major fund families have websites. Try, for example:

http://www.vanguard.com

MUTUAL FUND OPERATIONS

Taxation of Investment Companies• An investment company that

holds almost all its assets as investments in stocks, bonds, and other securities,

uses no more than 5% of its assets when acquiring a particular security, and

passes through all realized investment income to fund shareholders,

is treated as a “regulated investment company” for tax purposes and does not need to pay taxes on its investment income.

The Fund Prospectus and Annual Report• Mutual funds are required by law to supply a

prospectus to any investor who wishes to purchase shares.

• Mutual funds must also provide an annual report to their shareholders.

MUTUAL FUND OPERATIONS

MUTUAL FUND COSTS AND FEES

Types of Expenses and Fees Sales charges or “loads.” Front-end loads are

charges levied on purchases, while back-end loads are charges levied on redemptions.

12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.

Management fees. Usually based on fund size, performance, etc.

Types of Expenses and Fees …continued Trading costs. This is related to the fund’s turnover.

MUTUAL FUND COSTS AND FEES

WORK THE WEB

Prospectuses are increasingly available online. To see some examples, visit:

http://www.fidelity.comTo see a fund that really discloses information, try:

http://www.ipsfunds.comCheck out the “plain language” risk disclosure!

MUTUAL FUND COSTS AND FEES

Why Pay Loads and Fees?• You may want a fund run by a particular

manager, and all such funds are load funds.• You want a specialized type of fund. Loads and

fees for such funds tend to be higher as there is little competition among them.

SHORT-TERM FUNDS

• Short-term funds are collectively known as money market mutual funds, or MMMFs.

• MMMFs always maintain a $1 net asset value to make them resemble bank accounts.

• Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt.

Money market mutual fundA mutual fund specializing in money market instruments.

SHORT-TERM FUNDS

• Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.

• The distinction is that a bank money market account is a bank deposit and offers FDIC protection.

WORK THE WEB

For information on thousands of funds, including MMMFs, visit:

http://www.mfea.com

LONG-TERM FUNDS

• A fund’s objective is the major determinant of the fund type.

• Historically, mutual funds were classified as stock, bond, or income funds. However, it is becoming increasingly difficult to do so.

STOCK FUNDS

• Some stock funds trade off capital appreciation and dividend income.– Capital appreciation, growth, growth and income,

equity income.• Some stock funds focus on companies in a

particular size range.– Small company, midcap.

• Some fund groups invest internationally.– Global, international, region, country, emerging

markets.

STOCK FUNDS

• Sector funds specialize in specific sectors of the economy.

• Other fund types include index funds, social conscience funds, and tax-managed funds.

BOND FUNDS

• Bond funds may be distinguished by their maturity range , credit quality, taxability, bond type, and issuing country.

• Bond fund types include short-term and intermediate-term funds, general funds, high-yield funds, mortgage funds, world funds, insured funds, single-state municipal funds.

STOCK AND BOND FUNDS

• Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.

• Examples include balanced funds, asset allocation funds, convertible funds, income funds.

MUTUAL FUND OBJECTIVES: RECENT DEVELOPMENTS

• In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings.

• For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold, and also on whether the fund tends to invest in “growth” or “value” stocks (or both).

MUTUAL FUND PERFORMANCE

• Mutual fund performance is very closely tracked by a number of organizations.

Mutual Fund Performance4 - 26

Mutual Fund Performance4 - 27

MUTUAL FUND PERFORMANCE

• While looking at historical returns, the riskiness of the various fund categories should also be considered.

• Whether historical performance is useful in predicting future performance is a subject of ongoing debate.

• Some of the poorest-performing funds are those with very high costs.

CLOSED-END FUNDS & EXCHANGE TRADED FUNDS

• Most closed-end funds sell at a discount relative to their net asset values, and the discount is sometimes substantial. The typical discount also fluctuates over time

• Despite a great deal of research, the closed-end fund discount phenomenon remains largely unexplained.

• An exchange traded fund, or ETF, is basically an index fund, except that it trades like a closed-end fund (without the discount phenomenon).

• An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes.

CLOSED-END FUNDS & EXCHANGE TRADED FUNDS

CHAPTER REVIEW

• Investment Companies and Fund Types– Open-End versus Closed-End Funds– Net Asset Value

• Mutual Fund Operations– Mutual Fund Organization and Creation– Taxation of Investment Companies– The Fund Prospectus and Annual Report

CHAPTER REVIEW

• Mutual Fund Costs and Fees– Types of Expenses and Fees– Expense Reporting– Why Pay Loads and Fees?

• Short-Term Funds– Money Market Mutual Funds– Money Market Deposit Accounts

CHAPTER REVIEW

• Long-Term Funds– Stock Funds– Taxable and Municipal Bond Funds– Stock and Bond Funds– Mutual Fund Objectives: Recent Developments

• Mutual Fund Performance– Mutual Fund Performance Information– How Useful are Fund Performance Ratings?

CHAPTER REVIEW

• Closed-End Funds and Exchange Traded Funds– Closed-End Funds Performance Information– The Closed-End Fund Discount Mystery– Exchange Traded Funds