Charles J. Corrado_Fundamentals of Investments - Chapter 4 pot

CHAPTER 4 Mutual Funds More than 8,000 different mutual funds are available to United States investors. Incredibly, this is about the number of different stocks traded on the Nasdaq and the New York Stock Exchange combined. There are funds for aggressive investors and conservative investors, short-term investors and long-term investors. There are bond funds, stock funds, international funds, you-name-it funds. Is there a right fund for you? Let’s see! As we discussed in an earlier chapter, if you do not wish to actively buy and sell individual securities on your own, you can invest in stocks, bonds, or other financial assets through a mutual fund. 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. Since mutual funds provide indirect access to financial markets for individual investors, they are a form of financial intermediary. In fact, mutual funds are now the second largest type of intermediary in the United States. Only commercial banks are larger. Mutual funds have become so important that we will devote this entire chapter to them. The number of funds and the different fund types available have grown tremendously in recent years. Indeed, 37 percent of U.S. households held mutual fund assets in 1997, which is up markedly from only 6 percent of U.S. households in 1980. One of the reasons for the proliferation of mutual funds and fund types is that mutual funds have become, on a very basic level, consumer products. They are created and marketed to the public in ways that are intended to promote buyer appeal. As every 2 CHAPTER 4 Figure 4.1 about here business student knows, product differentiation is a basic marketing tactic, and in recent years mutual funds have become increasingly adept at practicing this common marketing technique. 4.1 Investment Companies and Fund Types At the most basic level, a company that pools funds obtained from individual investors and invests them is called an investment company. In other words, an investment company is a business that specializes in managing financial assets for individual investors. All mutual funds are, in fact, investment companies. As we will see, however, not all investment companies are mutual funds. (marg. def. investment company A business that specializes in pooling funds from individual investors and investing them.) In the sections that follow, we will be discussing various aspects of mutual funds and related entities. Figure 4.1 is a big picture overview of some of the different types of funds and how they are classified. It will serve as a guide for the next several sections. We will define the various terms that appear as we go along. Open-end versus Closed-End Funds As Figure 4.1 shows, there are two fundamental types of investment companies, open-end funds and closed-end funds. The difference is very important. Whenever you invest in a mutual fund, you do so by buying shares in the fund. However, how shares are bought and sold depends on which type of fund you are considering. MUTUAL FUNDS 3 With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem (i.e., buy back) shares from anyone wishing to sell. When an investor wishes to buy open-end fund shares, the fund simply issues them and then invests the money received. When someone wishes to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result, with an open-end fund, the number of shares outstanding fluctuates through time. (marg. def. open-end fund An investment company that stands ready to buy and sell shares at any time.) With a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares, you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must sell them to another investor. (marg. def. closed-end fund An investment company with a fixed number of shares that are bought and sold only in the open stock market.) Thus, the key difference between an open-end fund and a closed-end fund is that, with a closed-end fund, the fund itself does not buy or sell shares. In fact, as we discuss below, shares in closed-end funds are listed on stock exchanges just like ordinary shares of stock, where their shares are bought and sold in the same way. Open-end funds are more popular among individual investors than closed-end funds. Strictly speaking, the term “mutual fund” actually refers only to an open-end investment company. Thus, the phrase “closed-end fund” is a bit of an oxymoron, kind of like military intelligence, and the phrase “open-end mutual fund” is a redundancy, an unnecessary repetition or restatement. Nonetheless, particularly in recent years, the term “investment company” has all but disappeared from common use, and investment companies are now generically called mutual funds. We will stick with this common terminology whenever it won't lead to confusion. 4 CHAPTER 4 Net Asset Value A mutual fund's net asset value is an important consideration. Net asset value is calculated by taking the total value of the assets held by the fund and dividing by the number of outstanding shares. For example, suppose a mutual fund has $100 million in assets based on current market values and a total of 5 million shares outstanding. Based on the value of the assets held by the fund, $100 million, each share has a value of $100 million/5 million = $20. This $20 is the fund's net asset value, often abbreviated as NAV. (marg. def. net asset value The value of the assets held by a mutual fund, divided by the number of shares. Abbreviated NAV.) Example 4.1: Net Asset Value. The Fidelity Magellan Fund is the largest mutual fund in the United States with about $88 billion invested (as of early1999). It has about 680 million shares outstanding. What is its net asset value? The net asset value is simply the asset value per share, or $88 billion/ 680 million = $1129. With one important exception, the net asset value of a mutual fund will change essentially every day simply because the value of the assets held by the fund fluctuates. The one exception concerns money market mutual funds, which we discuss in a later section. As we noted, an open-end fund will generally redeem or buy back shares at any time. The price you receive for shares you sell is the net asset value. Thus, in our example just above, you could sell your shares back to the fund and receive $66 each. Because the fund stands ready to redeem shares at any time, shares in an open-end fund are always worth their net asset value. In contrast, because the shares of closed-end funds are bought and sold in the stock markets, their share prices at any point in time may or may not be equal to their net asset values. We examine this issue in more detail in a later section. MUTUAL FUNDS 5 CHECK THIS 4.1a What is an investment company? 4.1b What is the difference between an open-end fund and a closed-end fund? 4.2 Mutual Fund Operations In this section, we discuss some essentials of mutual fund operations. We focus on how mutual funds are created, marketed, regulated, and taxed. Our discussion here deals primarily with open-end funds, but much of it applies to closed-end funds as well. Further details on closed-end funds are provided in a later section. Mutual Fund Organization and Creation A mutual fund is simply a corporation. Like a corporation, a mutual fund is owned by its shareholders. The shareholders elect a board of directors; the board of directors is responsible for hiring a manager to oversee the fund's operations. Although mutual funds often belong to a larger “family” of funds, every fund is a separate company owned by its shareholders. Most mutual funds are created by investment advisory firms, which are businesses that specialize in managing mutual funds. Investment advisory firms are also called mutual fund companies. Increasingly, such firms have additional operations such as discount brokerages and other financial services. There are hundreds of investment advisory firms in the United States. The largest, and probably best known, is Fidelity Investments, with over 220 mutual funds, $500 billion in assets under management, and 36 million shareholder accounts. Dreyfus, Franklin, and Vanguard are some other 6 CHAPTER 4 1 Fidelity would probably come up with a better name. well-known examples. Many brokerage firms, such as Merrill Lynch and Charles Schwab, also have large investment advisory operations. Investment advisory firms create mutual funds simply because they wish to manage them to earn fees. A typical management fee might be .75 percent of the total assets in the fund per year. A fund with $200 million in assets would not be especially large but could nonetheless generate management fees of about $1.5 million per year. Thus, there is a significant economic incentive to create funds and attract investors to them. For example, a company like Fidelity might one day decide that there is a demand for a fund that buys stock in companies that grow and process citrus fruits. Fidelity could form a mutual fund that specializes in such companies and call it something like the Fidelity Lemon Fund. 1 A fund manager would be appointed, and shares in the fund would be offered to the public. As shares are sold, the money received is invested. If the fund is a success, a large amount of money will be attracted and Fidelity would benefit from the fees it earns. If the fund is not a success, the board can vote to liquidate it and return shareholders' money or merge it with another fund. As our hypothetical example illustrates, an investment advisory firm such as Fidelity can (and often will) create new funds from time to time. Through time, this process leads to a family of funds all managed by the same advisory firm. Each fund in the family will have its own fund manager, but the advisory firm will generally handle the record keeping, marketing, and much of the research that underlies the fund's investment decisions. In principle, the directors of a mutual fund in a particular family, acting on behalf of the fund shareholders, could vote to fire the investment advisory firm and hire a different one. As a practical MUTUAL FUNDS 7 matter, this rarely, if ever, occurs. At least part of the reason is that the directors are originally appointed by the fund’s founder, and they are routinely reelected. Unhappy shareholders generally “vote with their feet” — that is, sell their shares and invest elsewhere. Taxation of Investment Companies As long as an investment company meets certain rules set by the Internal Revenue Service, it is treated as a “regulated investment company” for tax purposes. This is important because a regulated investment company does not pay taxes on its investment income. Instead, the fund passes through all realized investment income to fund shareholders who then pay taxes on these distributions as though they owned the securities directly. Essentially, the fund simply acts as a conduit, funneling gains and losses to fund owners. To qualify as a regulated investment company, the fund must follow three basic rules. The first rule is that it must in fact be an investment company holding almost all of its assets as investments in stocks, bonds, and other securities. The second rule limits the fund to using no more than five percent of its assets when acquiring a particular security. This is a diversification rule. The third rule is that the fund must pass through all realized investment income to fund shareholders as soon as it is realized. The Fund Prospectus and Annual Report Mutual funds are required by law to produce a document known as a prospectus. The prospectus must be supplied to any investor wishing to purchase shares. Mutual funds must also provide an annual report to their shareholders. The annual report and the prospectus, which are 8 CHAPTER 4 sometimes combined, contain financial statements along with specific information concerning the fund's expenses, gains and losses, holdings, objectives, and management. We discuss many of these items in the next few sections. CHECK THIS 4.2a How do mutual funds usually get started? 4.2b How are mutual funds taxed? 4.3 Mutual Fund Costs and Fees All mutual funds have various expenses that are paid by the fund's shareholders. These expenses can vary considerably from fund to fund, however, and one of the most important considerations in evaluating a fund is its expense structure. All else the same, lower expenses are preferred, of course, but, as we discuss, matters are not quite that cut and dried. Types of Expenses and Fees There are basically four types of expenses or fees associated with buying and owning mutual fund shares: 1. Sales charges or “loads.” 2. 12b-1 fees. 3. Management fees. 4. Trading costs. We discuss each of these in turn. MUTUAL FUNDS 9 SALES CHARGES Many mutual funds charge a fee whenever shares are purchased. These fees are generally called front-end loads. Funds that charge loads are called load funds. Funds that have no such charges are called no-load funds. (marg. def. front-end load A sales charge levied on purchases of shares in some mutual funds.) When you purchase shares in a load fund, you pay a price in excess of the net asset value, called the offering price. The difference between the offering price and the net asset value is the load. Shares in no-load funds are sold at net asset value. Front-end loads can range as high as 8.5 percent, but 5 percent or so would be more typical. Some funds, with front-end loads in the 2 percent to 3 percent range, are described as low-load funds. Front-end loads are expressed as a percentage of the offering price, not the net asset value. For example, suppose a load fund has an offering price of $100 and a net asset value of $98. The front-end load is $2, which, as a percentage of the $100 offering price is $2/$100 = 2 percent. The way front-end loads are calculated understates the load slightly. In our example here, you are paying $100 for something only worth $98, so the load is really $2/$98 = 2.04 percent. Example 4.2: Front-end Loads. On January 20, 1995, according to the Wall Street Journal, the Common Sense Growth fund had a net asset value of $13.91. The offering price was $15.20. Is this a load fund? What is the front-end load? Since the offering price, which is the price you must pay to purchase shares, exceeds the net asset value, this is definitely a load fund. The load can be calculated by taking the difference between the offering price and the net asset value, $1.29, and dividing by the $15.20 offering price. The result is a hefty front-end load of 8.5 percent. Some funds have “back-end” loads, which are charges levied on redemptions. These loads are often called contingent deferred sales charges and abbreviated CDSC. The CDSC usually declines 10 CHAPTER 4 through time. It might start out at 6 percent for shares held less than one year, then drop to 3 percent for shares held for two years, and disappear altogether on shares held for three or more years. 12B-1 FEES So-called 12b-1 fees are named for the Securities and Exchange Commission rule that permits them. Mutual funds are allowed to use a portion of the fund’s assets to cover distribution and marketing costs. Funds that market directly to the public may use 12b-1 fees to pay for advertising and direct mailing costs. Funds that rely on brokers and other sales force personnel often use 12b-1 fees to provide compensation for their services. The total amount of these fees could be .75 percent to 1.0 percent of the fund's assets per year. (marg. def. 12b-1 fees Named for SEC Rule 12b-1, which allows funds to spend up to 1 percent of fund assets annually to cover distribution and marketing costs.) Frequently, 12b-1 fees are used in conjunction with a CDSC. Such funds will often have no front-end load, but they effectively make it up through these other costs. Such funds may look like no-load funds, but they are really disguised load funds. Mutual funds with no front-end or back-end loads and no or minimal 12b-1 fees are often called “pure” no-load funds to distinguish them from the “not-so-pure” funds that may have no loads but still charge hefty 12b-1 fees. MANAGEMENT FEES We briefly discussed management fees in an earlier section. Fees are usually based first on the size of the fund. Beyond this, there is often an incentive provision that increases the fee if the fund outperforms some benchmark, often the S&P 500 (this index is discussed in Chapter 1). Management fees generally range from .25 percent to 1.0 percent of total funds assets every year. [...]... closed-end funds are generally very poor investments CHECK THIS 4. 7a What is the closed-end fund puzzle? 4. 7b Why are newly offered closed-end funds often a poor investment? 32 CHAPTER 4 4.8 Summary and Conclusions We have covered many aspects of mutual fund investing in this chapter We have seen that there are thousands of mutual funds and dozens of types A few of the more important distinctions we made... are calculated in Chapter 9 MUTUAL FUNDS 17 paying only 4. 6% × (1 - 40 ) = 2.76% on an after tax basis, so you're slightly better off with the taxexempt fund Example 4. 4: Taxes and Money Market Fund Yields In our discussion just above, suppose you were in a 25 percent bracket Which type of fund is more attractive? On an after tax basis, the taxable fund is offering 4. 6% × (1 - 25) = 3 .45 %, so the taxable... generally offer SIPC protection, but this is not a perfect substitute Confusingly, some banks offer both money market accounts and, through a separate, affiliated entity, money market funds CHECK THIS 4. 4a What is a money market mutual fund? What are the two types? 4. 4b How do money market funds maintain a constant net asset value? 18 CHAPTER 4 4.5 Long-Term Funds There are many different types of long-term... coupon income on its investments, so it would hold a variety of dividend-paying common and preferred stocks and bonds of various maturities CHECK THIS 4. 5a What are the three major types of long-term fund? Give several examples of each and describe their investment policies 4. 5b What do single-state municipal funds, single-country stock funds, and sector stock funds have in common? 4. 5c What are the distinguishing... library Of course, a mutual fund's prospectus and annual report contain a great deal of information as well 28 CHAPTER 4 as of the close of trading Here we see that Blue Chip closed at a price of $42 .76 Next we have the change in the NAV from the previous day, revealing that the Blue Chip Fund gained 50 cents per share Finally, the last column reports the fund’s year-to-date performance, up 14. 4 percent... higher CHECK THIS 4. 3a What is the difference between a load fund and a no-load fund? 4. 3b What are 12b-1 fees? 4. 4 Short-Term Funds Mutual funds are usually divided into two major groups, short-term funds and long-term funds Short-term funds are collectively known as money market mutual funds Long-term funds essentially include everything that is not a money market fund We discuss long-term funds in... Answers to Self-Test Problems 1 You will pay 100 times the offering price Since the load is computed as a percentage of the offering price, we can compute the offering price as follows: Net asset value = (1 - Front-end load) × Offering price In other words, the NAV is 97 percent of the offering price Since the NAV is $50, the offering price is $50/0.97 = $51.55 You will pay $5,155 in all, of which $155... $4, 000 in KDSAX shares You submit this order as “sell $4, 000 KDSAX.” MUTUAL FUNDS 35 STOCK-TRAK EXERCISES 1 Look up stock ticker symbols for these mutual funds: Templeton Foreign Equity Fund, Strong Growth Fund, T Rowe Price Blue Chip Growth Fund 36 CHAPTER 4 Chapter 4 Mutual Funds Questions and problems Review Problems and Self-Test 1 Front-end loads The Madura HiGro Fund has a net asset value of. .. are some of the problems with comparing historical performance numbers? 4. 7 Closed-End Funds It is probably fitting that we close our mutual fund chapter with a discussion of closed-end funds As we will see, such funds have some unusual aspects Closed-End Funds Performance Information As we described above, the major difference between a closed-end fund and an open-end fund is that closed-end funds... Some funds are open-end and some are closed-end Open-end funds stand ready to buy or sell shares Closed-end funds do not; instead, their shares trade on the stock exchanges 2 Some open-end funds have front-end loads, meaning that there is a fee tacked on to the fund's net asset value when you buy Other funds are no-load Various costs and fees exist, including back-end loads and 12b-1 fees 3 Funds have . higher. CHECK THIS 4. 3a What is the difference between a load fund and a no-load fund? 4. 3b What are 12b-1 fees? 4. 4 Short-Term Funds Mutual funds are usually divided into two major groups, short-term funds. front-end or back-end loads and no or minimal 12b-1 fees are often called “pure” no-load funds to distinguish them from the “not-so-pure” funds that may have no loads but still charge hefty 12b-1. 17 paying only 4. 6% × (1 - .40 ) = 2.76% on an after tax basis, so you're slightly better off with the tax- exempt fund. Example 4. 4: Taxes and Money Market Fund Yields. In our discussion just above,