CHAPTER 8 Investment Products and Markets:

Mutual fund (investment company)

Corporation that uses it’s capital to purchase investment vehicles instead of plant and equipment.

Suitability (who are they best for?)

Best return ; minimizing risksLimited amount of money

How do you make money?

Dividends or interest from within portfolioCapital gains from within the portfolioCapital gains from the shares of the portfolio

MUTUAL FUND BASICS

What is the difference between an open-end and a closed-end mutual fund?

Open ClosedUnlimited shares Limited sharesAlways primary market trade on an exchangeReflects the value of the portfolio supply and demand also impact value

What are the three primary advantages of a mutual fund?

DiversificationProfessional money mgtliquidity

TYPES OF MUTUAL FUNDS (objectives)

Aggressive Growth

Growth

International/Global

International should only have investments outside the US

Global could include US investments

Growth and Income

Fixed Income

Balanced/Equity Income

Specialty/Sector

Asset Allocation

Money Market

Index

Loads

Commissions

Front-end - pay up front

Redemption – pay to redeem

Contingent deferred sales charges – pay a decreasing commission if sell within a certain period of time (CDSC)

FEES AND EXPENSES

Management Fees and Operating Expenses

12b-1 Fees

Trustee Fees

Expense Ratio

Ratio of expenses to NAV

Higher the ratio, better the manager must perform to generate a desired return.

The more expensive it is to own the investment

Higher returns could offset higher expenses (or not)

Mutual Fund Basics

The People

Investment Advisor

Day to day investment decisionsMoney manager

Custodian / Transfer Agent

BookkeeperSafekeeping securities and cash

Analysis of Mutual Funds

Three basic areas

1) first you select funds that match investment objectives.

2) next rank funds by statistical performance measures

This can be done manually or via software

Morningstar has a filter that can assist

The premium filter allows ranking by different statistics

3) non-statistical measures

Really not a ranking tool

Most mutual funds either by law or necessity provide the same services

That is not to say that customer service quality is the same!!

Prospectus

READING MUTUAL FUND PROSPECTUS

INVESTMENT OBJECTIVES AND POLICIES

RISK FACTORS

INVESTMENT RESTRICTIONS

PAST PERFORMANCE

FUND INFORMATION

COSTS AND FEES

MISCELLANEOUS INFORMATION

A document provided by mutual fund that describes in some detail the characteristics of this mutual fund.

The components are mandated by law

A mutual fund is always a primary market transaction; unlike stocks

This requires a prospectus be provided at or before the sale of any mutual fund.

A prospectus has a life of 13 months

Classes of Shares

What is meant by share class?

No distinction between portfoliosMarketing of the loads and expenses

Class A shares

Front load; lower fees; no redemption load

Class B

CDSC condition al deferred sales charge

No front load; only a redemption load if sold within a certain time frame; higher initial fees higher than “A” but then they are lowered after time

Class C

No load; usually higher fees

These fees never reduce

Misc other classes

Institutional shares have a variety of combinations of fees and loads

• How to choose between Class A and B

– Class A shares have a front load

• they also have a declining load schedule as investment increases

– Class B shares are CDSC; but have higher initial expenses

• As holding period increases, potential redemption load decreases

• Eventually become Class A

• If have large sum or will be investing over time, Class A may be more expensive

• If do not have a large sum to invest, the choice is really about when to pay the load. (up front or over time)

• Not a clear choice all the time. Regulation has dictated how and when some classes can be

Mutual Funds Restrictions

a list of restricted investment vehicles and strategies will be listed in the prospectus.

Potential list

No margin or short sales

No underwriting except their own shares

No investment in commodities

No private placement

No controlling interest

No more 5% value of total assets

No more 10% voting stock

No borrowing except for emergencies and only from a bank.

Diversified Investment Companies

The 5% and 10% rule actual applies to 75% of the mutual funds cash

The remaining 25% of cash can be invested in any security or company.

Prices

NAV (Net Asset Value)

Equivalent of share price

Represents the current value of one share of the investment portfolio

POP (public offering price)

Incorporates the load

NAV = $12 with a 5.75% load

What is the POP of a mutual fund with a NAV of 37.25, and a 4.5% front load?

POP=37 .251−.045

=39.005

Who gets the extra 1.755?

Break Point Qualification

NAV= Assets - Liabilities# of shares

POP= NAV1−load%

POP=121−.0575

=12.73

How can you “beat” break points?

Large Sum purchaseLetter of intent Can back date 90 days Have 13 months to break the point Not a contractual arrangementAccumulated funds

Redemption of shares

How do you “sell” the shares

In the stock market shares are sold back through the brokerage. They are purchased by another investor.

With mutual funds the process is different. The mutual fund company by law must “redeem” the shares within 7 days of a request. It is the mutual fund that buys the shares from the old shareholder.

Remember these shares are retired and never sold to another investor.

Services

Reinvestment Privilege

Current income and capital gains are automatically reinvested (buy more shares)

No load charged

You must request distribution in cash if you want it.

Conversion Privilege

Can move share between same fund family funds at no load.

Taxable though unless in a retirement account

Systematic Withdrawals (investments)

Can request to have funds automatically deposited to or withdrawn from an account

MUTUAL FUND RATING SERVICES

MORNINGSTAR

Industry’s best resource for comprehensive, unbiased and accurate mutual fund information

LIPPER

Leading global mutual fund information company analyzing fund companies and financial intermediaries

STANDARD & POOR’S

Leading global provider for mutual fund information and analysis

THOMAS FINANCIAL

Global provider of data, analysis, and information tools

TRADITIONAL INDEX FUNDS

Index funds hold shares in all the companies that make up an index like S&P 500

NOT true. They rarely hold the shares of all. They attempt to create a “clone”

ADVANTAGES

Fewer Capital Gains

Keeping Pace with Selected Index

Painless Strategy

Lower Cost

PITFALLS OF INDEX FUNDS

Downside Risk

Skewed Weighting Systems

Do they actually copy the index?

Divergence Between Index Funds

How can different index funds have different returns?

Narrow Focus

Lose the Value Added by Money Managers

Increased Volatility