A Presentation on Mutual Funds

Questions to start with

• What is a mutual fund?
• How does one compute the net asset value
(NAV)?
• What expenses and charges might a mutual
fund investor face?
• What does research on mutual fund
performance tell about fund expenses,
portfolio turnover, and returns?
 Questions to start with
• 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 between mutual
funds and some other managed
investments?
Mutual Fund Growth
• Mutual funds have
become very popular
investment vehicles.
• Nearly $7 trillion in
total assets in 2000 vs
$13 trillion in NYSE
in 2002.
• Total assets have
grown 600% since
1990.
 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.
 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
NAV1=NAV0+All Incomes-All Distributed
Example: NAV0=Rs.100, Distributed 1) Net
Realized Gains=Rs.2 and 2) Net Investment
Income=Re.1.
NAV1= Rs.100-Rs.2-Re.1=Rs.97
 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.
 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
 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
 Mutual Fund Drawbacks
• Active trading contributes to high costs
which lower fund returns
• 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
 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 (∆NAV)
– From unrealized gains/losses from assets
 Mutual Fund Returns
Return = (ID + CGD –Payments + ∆
NAV)/Beg.NAV
• Ex. NAV0=Rs.35,NAV1=Rs.35.2, Net Realized
Gain Rs.2, Net Investment Income =Rs..5.
Return= (2+.5+35.2-35)/35=7.714%
• Most mutual funds allow investors to either
receive distributions in cash or to reinvest in
additional shares.
 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
 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
 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
Municipal Bond Funds
• Provide investors with
income exempt from
Federal taxation
• Often concentrate on
single states to avoid
state income taxation
as well
 Stock and Bond Funds
• Seek to provide a combination of income and
value appreciation.
• Different names
– Balanced funds (60% equity+40% of debt securities)
Goal: to conserve principal, by maintaining a
balanced portfolio of both stocks and bonds
– Blended funds: Mutipurpose funds(e.g., balanced
target maturity, convertible securities that invest in
both stocks and bonds
– Flexible funds: Flexible income, flexible portfolio,
global flexible and income funds, that invest in both
stocks and bonds
 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 Re.1; income either paid out
or reinvested daily
• Provide an alternative to bank deposits, but
not FDIC insured
 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
 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
 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 plus
the load (while no-load funds are sold at their NAV)
– Ex. 4% load with NAV Rs.96, buy at Rs.100
– Load range from around 3% (low-load) to 8.5%
• 12b-1 Fees: pay to the distributor (.25%-.75% )+
.25% servicing charge in some cases)
– Fees deducted from the asset value of the fund to cover
marketing expenses
– An alternative to loads
• Offering Price= NAV/(1-load %).
– Investing Rs.1,000 in a load MF with 7% and
expected return of 10%,
– Rs.value=1000(1-.07)(1.10)=1023 (2.3%
growth)
– Investing Rs.1,000 no load MF with 8% return
and 2% redemption fee,
– Rs.value=1000(1-0)(1.08)(1-.02)= 1058.4
(5.84% growth)
– Rs.35.4 Difference
 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
 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
 *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
 Holding Period for a Portfolio
• Portfolio Turnover
• Holding Period = 12 months/(Portfolio
Turnover%)
• Ex Turnover 125%=>12/1.25=9.6 month
 Mutual Fund Return and Risk
Performance
Return Performance
• On a risk-adjusted basis, the average stock fund
under-performs market averages
• While portfolio managers seem to out-perform the
market before expenses, 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
 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
 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 may be 30-40% less than pre-tax
 •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.
 •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.
 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.