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Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Background on mutual funds Stock mutual fund categories Bond fund categories Growth and size of mutual funds Performance of mutual funds Mutual fund scandals
Mutual funds:
Serve as a financial intermediary by pooling investments by individual investors and using the funds to accommodate financing needs by governments and corporations in the primary market Frequently invest in securities in the secondary market Provide an important service for individuals who wish to invest funds and diversify Offer liquidity if they are willing to repurchase an investors shares upon request Offer various different services, such as transfers between funds and check-writing privileges
A mutual fund hires portfolio managers to invest in a portfolio of securities that satisfies the desires of investors
The portfolio composition is adjusted in response to changing economic conditions Monitors management Establishes procedures Ensures that the fund is properly serving its shareholders
Types of funds
Open-end
funds:
Are open to investment from investors at any time Allow investors to purchase or redeem shares at any time Have a constantly changing number of shares Maintain some cash in case redemptions exceed investments Consist of many different categories to satisfy investors investment needs
funds:
Do not repurchase shares they sell Require investors to sell the shares on a stock exchange Have a constant number of outstanding shares Have an asset size that is about 1/40th of the asset size of open-end funds Focus primarily on bonds and other debt securities
They require a much larger initial investment They may not always accept additional investments or accommodate redemption They are unregulated and provide very limited information to prospective investors They invest in a wide variety of investments to achieve high returns
Mutual funds repackage the proceeds from individuals to make various types of investments Investing in mutual funds represents partial ownership
Mutual funds must register with the SEC and provide a prospectus Mutual funds are regulated by state laws If a mutual fund distributes 90 percent or more of its taxable income to shareholders, it is exempt from taxes on dividends, interest, and capital gains
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minimum amount of investment required The investment objective The return on the fund over the past year, the past three years, and the past five years The exposure of the fund to various types of risk The services offered by the fund The fees incurred by the find that are passed on to investors
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net asset value (NAV) of a mutual fund indicates the value per share
Estimated each day by determining the market value of all securities comprising the fund, adding interest or dividends, and subtracting expenses, then dividing by the number of shares outstanding
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Distributions to shareholders
Mutual
mutual funds, bond mutual funds, or money market mutual funds (see next slide)
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17% 6% 50%
27%
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funds pass their expenses on to their shareholders Expenses can be compared among mutual funds by comparing the expense ratio
Equal to annual expenses per share divided by the NAV The higher the expense ratio, the lower the return for a given level of performance Mutual funds with lower expense ratios tend to outperform others with similar objectives
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include:
Compensation to the portfolio managers and other employees Record-keeping and clerical fees Marketing fees 12b-1 fees cover advertising expenses or compensate brokerage firms that advised their clients to invest in that fund
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Sales load
Load
Promoted by brokerage firms who earn a sales charge between 3 and 8.5 percent Investors pay the sales charge through the difference between the bid and ask prices of the load fund Front-end load versus back-end load
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12b-1 fees:
Were
allowed in 1980 as distribution fees Have sometimes been used by funds to pay a commission to a broker whose clients invested in the fund May be charged instead or in addition to loads Are subject to much controversy because many funds do not specify how they use the money received
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mutual funds can exert control over the management of firms because they are commonly a firms largest shareholders
Portfolio
managers of many funds serve on the board of directors of various firms Many firms discuss any major policy changes with analysts and portfolio managers of funds to convince them that the change will have a favorable effect
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Growth funds are composed of stocks of maturing companies that are expected to grow at a high rate
Capital appreciation funds are composed of stocks that have high growth potential but may be unproven
Growth and income funds provide potential for capital appreciation with some stability in income
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funds invest in foreign securities Returns on international funds are affected by the foreign companies stock prices and the movements of the currencies that denominate the stocks Global funds include some U.S. stocks
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energy or banking
Index funds are designed to match the performance of an existing stock index
e.g.,
Vanguard 500
Multifund funds invest in a portfolio of different mutual funds to achieve more diversification
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Income funds are composed of bonds that offer periodic coupon payments and vary in exposure to risk
Corporate bonds are subject to credit risk, Treasury bonds are not Bonds backed by government agencies are less risky than corporate bonds Allows investors in high tax-brackets to avoid taxes while maintaining a low degree of credit risk
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High-yield (junk) bond funds consist of at least twothirds of bonds rated below Baa by Moodys or BBB by S&P International and global bond funds
International funds contain bonds issued by corporations or governments based in other countries Global bond funds contain U.S. as well as foreign bonds Foreign bonds are subject to credit risk, interest rate risk, and exchange rate risk
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Maturity classifications
Bond funds are commonly segmented according to the maturities of the bonds they contain Intermediate-term bonds invest in bonds with 5 to 10 years remaining to maturity Long-term bond funds contain bonds with 15 to 30 years until maturity
Asset allocation funds contain a variety of investments such as stocks, bonds, and money market securities
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The number of stock and bond funds is substantially larger today than it was during the 1980s Growth funds, income funds, international and global funds, and long-term municipal bond funds are the most popular types of bonds (see next slide)
Growth and income funds are the most popular when measured according to total assets Common stocks are clearly the dominant asset maintained by mutual funds
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9% 5% 9% 6%
Liquid Assets Common and Preferred Stock Municipal Bond Treasury Bonds
71%
Corporate Bonds
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end funds The performance of closed-end stock funds is also affected by a change in the premium or discount
If a funds premium increases relative to its NAV, the return to shareholders is increased A strong demand for closed-end fund shares can push the market price of the shares above the NAV
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Change in the risk-free rate Bond prices are inversely related to changes in the risk-free interest rate Bond funds focused on longer maturities are more exposed to interest rate changes
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Bond prices decline in response to an increase in the risk premium Poor economic conditions tend to increase the risk premium
Change
in management abilities
The performance of specific bond classifications varies due to differences in managers abilities An efficient fund has low expenses and high returns
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Driven by the same factors as open-end bond funds Closed-end bond funds are also affected by a change in their premium or discount The performance of any given mutual fund may be primarily driven by a single economic factor
e.g., growth funds are highly dependent on the stock markets performance
Diversification across different mutual funds reduces susceptibility to any particular type of risk
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performance should be compared to a market index and risk should be considered Most studies find that mutual funds do not outperform the market, especially when accounting for the type of securities that the fund invests in
Even when returns are adjusted for risk, mutual funds fail to outperform the market
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general, bond funds underperform bond indexes Generally, bond mutual funds with higher expense ratios generate lower returns Past performance does generally not serve as a useful indicator for future performance
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In 2003, some funds were allowing their large clients to buy or sell the funds shares after the 4 p.m. closing but at the 4 p.m. prices
Late trading involves engaging in a trade on stale prices Violates 1968 SEC laws Investigated mutual funds once this problem was publicized Heavily fined some mutual funds Is attempting to restore investor confidence in mutual funds by prosecuting mutual fund managers
The SEC:
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investment company owners are different than the shareholders on the fund Some managers employed by mutual funds invest in the investment company rather than the mutual funds it manages
Each
portfolios of money market instruments constructed and managed by investment companies Allow investors to participate for as little as $1,000 Usually allow check-writing privileges Send periodic account statements to their shareholders Send shareholders periodic updates on any changes in the asset portfolio composition Sell some of their assets when redemptions exceed sales
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paper dominates, followed by Treasury and other U.S. securities (see next slide) During recessionary periods, the proportion of Treasury bills normally increases Each individual MMF is concentrated in whatever assets reflect its objectives
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Commercial Paper Other U.S. Securities U.S. Treasury Securities Other Repurchase Agreements CDs
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19% 8%
19%
average maturity is determined by individual asset maturities, weighted according to their relative value In the mid-1970s, the average maturity was relatively long By the late 1970s, average maturity had declined to less than half During the 1980s, the average maturity was about 40 days The average maturity has generally increased since the 1980s
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risk is low, with the exception of commercial paper defaults Money market securities are not too sensitive to movements in market interest rates Expected returns on MMFs are low because of:
Low credit risk Low interest rate risk Consistently positive returns
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MMF portfolio manager maintains an asset portfolio that satisfies the underlying objective of the fund
Managers may change the asset composition if economic conditions change Managers may influence performance by changing the maturities of the securities in which they invest
Some
MMFs have little flexibility to change their portfolio composition because of their stated objectives
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Securities Act of 1933 requires sponsoring companies to provide full information on any MMFs they offer and a prospectus that describes the funds investment policies and objectives The Investment Company Act of 1940 contains numerous restrictions that prevent a conflict of interest by the funds managers If a fund distributes at least 90 percent of its income, the fund itself is exempt from federal taxation
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Hedge Funds
Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Have historically been unregulated but are not allowed to advertise Are usually organized as limited partnerships May allow investors to withdraw their investments but require advance notice of 30 days or more Often invest in derivative securities, sell short, or use borrowed funds along with equity investments Strive for high returns but also have a very high degree of risk
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fees usually range from 1 to 2 percent of the investment per year Incentive fees (usually 20 percent) are based on the return of the fund
Regulation
Hedge
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a closed-end mutual fund that invests in real estate or mortgages Allows small investors to participate with a low minimum investment Generates income by passing through rents on real estate or interest payments on mortgages Can typically be sold on a stock exchange Can be either classified as an equity REIT, a mortgage REIT, or a hybrid
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Finance companies
Securities firms
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Pension funds
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Mortgage markets
International and global mutual funds have facilitated international capital flows and helped create a global securities market
Can reduce excessive transaction costs Increase the degree of integration among stock markets
European countries have recently agreed to allow their respective mutual fund shares to be sold across their borders Due to NAFTA, qualified companies are allowed to sell mutual fund shares in Mexico
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