2. Chapter 4 Questions
• What is a mutual fund?
• How is the net asset value (NAV) computed?
• What expenses and changes might a mutual
fund investor face?
• What does research on mutual fund
performance reveal about fund expenses,
portfolio turnover, and returns?
3. Chapter 4 Questions
• What is a good procedure for
determining which mutual funds to
purchase?
• When might it be appropriate to sell
shares in a mutual fund?
• What are the similarities and
differences between mutual funds and
other managed investments?
4. Mutual Fund Growth
• Mutual funds have
become very
popular investment
vehicles.
• Nearly $7.5 trillion in
total assets in 2004.
• Total assets have
grown 600% since
1990.
5. What is a mutual fund?
• Mutual funds are open-end investment
companies.
• The fund sells shares to the public and
invests the proceeds in a pool of funds,
which are jointly owned by the fund’s
investors.
6. Computing Net Asset Value
• For investors, the performance of their
investment depends on what happens
to the fund’s per share value, or net
asset value (NAV).
NAV= Market Value of Assets – Liabilities
Number of Shares Outstanding
7. Mutual Fund Management
• Most funds are started by investment
management companies who hire the fund
manager to make investment decisions.
– Fidelity, Vanguard, etc.
• Usually offer many different funds and allow
investors to switch between funds.
• Funds (open-end) sell additional shares to
those who want to invest, redeem shares at
the NAV (less any fees) to those who want to
sell their shares.
8. Why invest with mutual
funds?
• Liquidity
– Funds buy and sell their own shares quickly, even
if fund investments are illiquid
• Diversification
– Small minimum investment buys a typically well-
diversified investment
• Professional management and record-
keeping
– Expertise and services
9. Why invest with mutual
funds?
• Choice and flexibility
– Families of funds offer a variety of
investments to match investor needs
• Indexing
– Some funds track a broad market index
which insures that investors will earn the
“market return”
– Increasingly popular mutual fund
alternative
10. Mutual Fund Drawbacks
• Active trading contributes to high costs
which lower fund returns (Turnover)
• Tax consequences can be a
disadvantage
– Tax impacts of asset trading are passed
through to investors
– Tax bill can be large even when the NAV
falls
11. Mutual Fund Returns
Three sources of return:
• Income distributions (ID)
– Bond interest, stock dividends
• Capital gain distributions (CGD)
– Realized gains/losses from selling assets
• Changes in NAV (ΔNAV)
– From unrealized gains/losses from assets
12. Mutual Fund Returns
Return = (ID + CGD + ΔNAV)/Beg.NAV
• By dividing the sum of the three
components of dollar returns by the
beginning NAV, we have the mutual
fund’s holding period return.
• Most mutual funds allow investors to
either receive distributions in cash or to
reinvest in additional shares.
13. Types of Mutual Funds
• Funds can be classified according to
the type of security in which they invest
– Stock Funds
– Taxable Bond Funds
– Municipal Bond Funds
– Stock and Bond Funds
– Money Market Funds
14. Common Stock Funds
• Most popular type of fund
• Wide variety with different objectives
and levels of risk
– Growth
– Industry or sector funds
– Geographic areas
– International or Global
– Equity Index funds
15. Taxable Bond Funds
• Generally seek to generate current income
with limited risk
• Can vary by maturity
– Short-term, Intermediate-term, Long-term
• Can vary by type of bond
– Government
– Corporate
– Mortgage-backed
– International/Global
– Bond Index funds
16. Municipal Bond Funds
• Provide investors
with income exempt
from Federal
taxation
• Often concentrate
on single states to
avoid state income
taxation as well
17. Stock and Bond Funds
• Seek to provide a combination of
income and value appreciation.
• Different names
– Balanced funds
– Blended funds
– Flexible funds
18. Money Market Funds
• Provide safe, current income with high
liquidity
• Invest in money market securities
– T-bills, Bank CD’s, Commercial paper, etc.
• NAV stays at $1; income either paid out
or reinvested daily
• Provide an alternative to bank deposits,
but not FDIC insured
19. Mutual Fund Innovations
• Life-stage funds
– Offer different mixes of securities based on
the age of the investor
• Supermarket funds
– Offer a wide variety of funds with “one-
stop” fund shopping
– Transfer services between funds
– Expenses/fees can be high
20. Mutual Fund Prospectus
• Must be available to investors and should be
review by investors.
• Contains:
– Fund’s investment objective
– Investment strategy
– Principal risks faced by investors
– Recent investment performance
– Expenses and fees
– Lots of other detailed information
21. Mutual Fund Expenses and
Considerations
• Loads
– Commission to the broker to financial advisor who
sold the fund to the investor
– For load funds, the offer price is the fund’s NAV
less the load (while no-load funds are sold at their
NAV)
– Load range from around 3% (low-load) to 8.5%
• 12b-1 Fees
– Fees deducted from the asset value of the fund to
cover marketing expenses
– An alternative to loads
22. Mutual Fund Expenses and
Considerations
• Deferred Sales Loads
– Redemption charges when fund shares are sold
(rather than when purchased)
– Often high (5-7%) if shares are sold within the first
year, but then fall over time, perhaps even
disappearing eventually
• Share Classes
– Many funds offer several different classes of
shares (A-B-C) with different fee structures
– Best choice usually depends of investment
horizon
23. Mutual Fund Expenses and
Considerations
• Management Fees
– Fees deducted from the fund’s asset value
to compensate the fund managers
– Some adjust fees according to the fund’s
performance
• Expense ratio
– Adding all fees and calculating expenses
as a percentage of the fund’s asset
24. Mutual Fund Expenses and
Considerations
• Portfolio Turnover
– Not an explicit cost, but very important
determinant of shareholder returns
– Trading costs rise with turnover
– In order for high turnover to pay off, fund
managers must be successful in their active
trading strategies
• Sources of Information
– Wall Street Journal, Business Week
– Morningstar
• Fund history, tax efficiency, risk analysis
25. Mutual Fund Return and Risk
Performance
Return Performance
• On a risk-adjusted basis, portfolio managers
seem to out-perform the market before
expenses, but net returns are below the
market index
• Some above-average performers over short
time horizons, but such performance is not
generally sustained (just luck?)
• These results help to explain the growing
popularity of index funds
26. Mutual Fund Return and Risk
Performance
Risk Performance
• While returns are not consistent, risk is
• Objectives lead to strategies that lead to
varying degrees of investment risks
• Return is positively related to the level of risk
• Risk is therefore an important consideration
Style Consistency
• Style-shifting funds earn less on average
27. Mutual Fund Return and Risk
Performance
Fees and expenses: Do higher fees pay off?
• Investment performance is no better (and
perhaps worse) for load funds vs. no-load
• Expenses lower returns in predictable ways –
lower expense funds give better returns
• Turnover affects returns in several ways,
including taxes – high turnover means more
short-term realized gains
• Tax efficiency is an important consideration –
after-tax returns tend to be less for high
turnover funds
28. •Mutual Fund Investment
Strategies
• Choose in funds consistent with your
objectives, constraints, and tax situation.
• Consider index funds for a large portion of
your fund portfolio.
• When possible, invest in no-load funds with
below-average expense and turnover
ratios.
• Invest at least 10-20% in international or
global funds.
• Own funds in different asset classes and
consider life-cycle investing.
29. •Mutual Fund Investment
Strategies
• If you actively manage your portfolio,
consider the past year’s “hot funds.”
• Do not attempt to time the market; timing
strategies add little except costs and risk.
• Use dollar cost averaging by investing a set
dollar amount each month.
• Avoid investing money shortly before the
capital gain distribution dates (prospectus).
• Do not own too many funds. You will get
average returns with high expenses.
30. When should you sell a
mutual fund?
• Personal considerations
– Portfolio rebalancing points due to life cycle
considerations
• Be aware of the quick trigger, selling on the first dip in
NAV; think long-term
• Be aware of capital gains with selling fund shares
• Fund considerations
– Change in portfolio manager
– Change in investment style
– Fund is growing “too large” or “too fast”
– Persistent bad performance
31. Mutual Fund Scandals
• Market timing, late trading,
miscalculating load fees, soft dollar
commissions
• Benefit fund managers, hurt long-term
shareholders
• Rule changes to combat abuses
initiated by the SEC
32. Other Managed Investments
Closed-end investment companies
• Shares trade like stock rather than
being bought and sold from the fund
• Number of shares are fixed
• Often sell at a discount from NAV (a
puzzle for modern finance)
• Often a means of investing in a pool of
assets from a foreign country
33. Other Managed Investments
Exchange-traded funds (EFTs)
• Relatively new, yet very popular
• Like closed-end funds, they trade like
individual stocks
• Passively managed to mirror a market index,
both broad and narrow
• Low expenses, but do involve brokerage
commissions
• Tax and liquidity concerns
34. Other Managed Investments
Variable Annuities
• Many offered by insurance companies
• Offers investors with choices of investments
with tax-deferred growth
• Insurance product: payment in the case of
death or else retirement income stream
• Expenses for both fund management and to
pay for insurance, so fees tend to be much
higher than with mutual funds
• Income stream taxed as regular income
