4 4 C h a p t e r Mutual FundsMutual Funds second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 2 Mutual Funds Our goal in this chapter is to understand the different types of mutual funds, their risks, and returns. Goal 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 owned by 83 million Americans. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 3 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. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 4 Investment Companies and Fund Types Investment company A business that specializes in pooling funds from individual investors and investing them. Closed-end fund An investment company with a fixed number of shares that are bought and sold only in the open stock market. Open-end fund An investment company that stands ready to buy and sell shares at any time. Investment Companies and Fund Types 4 - 5 @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 6 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 value The value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 7 Work the Web For mutual fund facts and figures, visit: http://www.ici.org © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 8 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. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 9 Work the Web All the major fund families have websites. Try, for example: http://www.vanguard.com © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 10 Mutual Fund Operations Taxation of Investment Companies An investment company that c holds almost all its assets as investments in stocks, bonds, and other securities, d uses no more than 5% of its assets when acquiring a particular security, and e 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. [...]... predicting future performance is a subject of ongoing debate Some of the poorest-performing funds are those with very high costs McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 34 Closed-End Funds & Exchange Traded Funds McGraw Hill / Irwin 4 - 35 Closed-End Funds & Exchange Traded Funds Most closed-end funds sell at a discount relative to their net asset values,... number of organizations McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 31 Mutual Fund Performance 4 - 32 Mutual Fund Performance 4 - 33 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... Inc All rights reserved 4 - 19 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 20 Work the Web For information on thousands of funds, including MMMFs,... specific sectors of the economy Other fund types include index funds, social conscience funds, and tax-managed funds McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 24 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... © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 27 Mutual Fund Objectives: Recent Developments 4 - 28 Mutual Fund Objectives: Recent Developments A mutual fund “style” box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes: Value Style Blend Growth Size Large Medium Small McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc... 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 13 Mutual Fund... 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 21 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, bond, or income? McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 22 Stock Funds Some... deferred sales charges Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees Hypothetical example showing the total expense you would pay over time per $10,000 invested McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 15 Mutual Fund Costs & Fees McGraw Hill / Irwin 4 - 16 Work the Web Prospectuses are increasingly... McGraw-Hill Companies, Inc All rights reserved 4 - 17 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 18... also fluctuates over time Despite a great deal of research, the closed-end fund discount phenomenon remains largely unexplained McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 4 - 36 Closed-End Funds & Exchange Traded Funds 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 . 4 4 C h a p t e r Mutual FundsMutual Funds second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien . Fund Types 4 - 5 @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 4 - 6 Investment. Inc. All rights reserved. McGraw Hill / Irwin 4 - 3 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