Chapter 4

Mutual Funds and Other

Investment Companies

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 Mutual Funds and Other Investment Companies

“Take calculated risks. That is quite different from being rash.”

– George S. Patton

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 Learning Objectives

You are probably going to be a mutual fund investor very

soon, so you should definitely know the following:

1. The different types of mutual funds.

2. How mutual funds operate.

3. How to find information about how mutual funds have performed.

4. The workings of Exchange Traded Funds (ETFs) and hedge funds.

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 Mutual Funds: Overview

• Our goal in this chapter is to understand the different types of

mutual funds, their risks, and their returns.

• Around 1980, 5 million Americans owned mutual funds.

• However, by mid-2012, 90.4 million Americans in 52.3 million

households owned mutual funds.

• In 2011 investors added $24 billion in net new funds to mutual

funds.

• In 2011, mutual fund assets totaled $11.6 trillion.

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 Mutual Funds: Overview, Cont.

• 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.

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 Advantages of Mutual Fund Investing

• Diversification
―A mutual fund is a portfolio, or basket, of securities.
―As you will learn later, holding a diversified portfolio helps you reduce risk.
―Diversification does not eliminate risk.

• Professional Management
―Professional money managers make decision of when to add or remove particular securities
from the mutual fund.
―This means that you, as the investor, do not have to make these crucial decisions.

• Minimum Initial Investment

―Most mutual funds have a minimum initial purchase of $2,500, but some are as low as
$1,000 or even $250 in some cases.
―After your initial purchase, subsequent purchases are sometimes as low as $50.
―Of course, these amounts vary from fund to fund.
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 Drawbacks of Mutual Fund Investing

• Risk
― Mutual fund values, unlike a bank deposit, can fall and be worth less than your initial
investment.
― No government or private agency guarantees the value of a mutual fund.

• Costs
― investing in mutual funds entails fees and expenses that do not usually accrue when
purchasing individual securities directly.
― We detail most of these costs later in the chapter.

• Taxes
― You will pay taxes on distributions (dividends and capital gains) from the mutual fund.
― You will pay taxes on profits you make when you sell mutual fund shares.
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 Investment Companies and Fund Types, I.

• An Investment company is business that specializes in pooling funds from

individual investors and making investments.

• An Open-end fund is an investment company that stands ready to buy and sell
shares in itself to investors, at any time.

• A Closed-end fund is an investment company with a fixed number of shares

that are bought and sold by investors, only in the open market.

• Sometimes, if an open-end fund gets too big, it will not take in new investors.
― It will, however, take more money from its current investors.
― Of course, current investors can withdraw money from the fund.

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Investment Companies and Fund Types, II.

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 Investment Companies and Fund Types, III.

• Net asset value (NAV) is the value of the assets held by a mutual
fund, divided by the number of shares.

• Shares in an open-end fund are worth their NAV, because the

fund stands ready to redeem their shares at any time.

• In contrast, share value of closed-end funds may differ from their

NAV.

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 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 (say

Fidelity Investments) or brokerage firms with investment advisory
operations (say Merrill Lynch).

• Investment advisory firms earn fees for managing mutual funds.

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 Mutual Fund Operations
Taxation of Investment Companies

• A “regulated investment company” does not have to

pay taxes on its investment income.

• To qualify, an investment company must:

― Hold almost all its assets as investments in stocks, bonds, and other
securities
― Use no more than 5% of its assets when acquiring a particular security
― Pass through all realized investment income to fund shareholders

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 Mutual Fund Operations
The Fund Prospectus and Annual Report

• Mutual funds are required by law to supply a prospectus

to any investor who wishes to purchase shares.

• Mutual funds must also provide an annual report to

their shareholders.

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 Mutual Fund Costs and Fees
Types of Expenses and Fees

• Sales charges or “loads”

― Front-end loads are charges levied on purchases.
― 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. 0.25% is most common

• Management fees:
― Usually range from 0.25% to 1.50% of the funds total assets each year.
― Are usually based on fund size and/or performance.

• Trading costs
― Not reported directly
― Funds must report "turnover," which is related to the amount of trading.
― The higher the turnover, the more trading has occurred in the fund.
― The more trading, the higher the trading costs.
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 Mutual Fund Costs and Fees
Expense Reporting

• Mutual funds are required to report expenses in a fairly

standardized way in their prospectus.
―Shareholder transaction expenses - loads and deferred sales
charges.
―Fund operating expenses - management and 12b-1 fees, legal,
accounting, and reporting costs, director fees.

• Funds report a hypothetical example showing total

expenses paid by investors per $10,000 invested.

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Example: Fee Table

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 Mutual Fund Costs and Fees
Why Pay Loads and Fees?

• After all, many good no-load funds exist.

• But, you may want a fund run by a particular manager.

All such funds are load funds.

• Or, you may want a specialized type of fund.

― Perhaps one that specialized in Italian companies
― Loads and fees for specialized funds tend to be higher, because there is little
competition among them.

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 Short-Term Funds, I.

• Short-term funds are collectively known as money market mutual

funds.

• Money market mutual funds (MMMFs) are mutual funds

specializing in money market instruments.
―MMMFs maintain a $1.00 net asset value to make them resemble bank
accounts.

―There is no guarantee that the net asset value will be $1.00 or more.
o A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.”
o Following the Crash of 2008, a few MMMF “broke the buck.”

―Depending on the type of securities purchased, MMMFs can be either

taxable or tax-exempt.
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 Short-Term Funds, II.

• 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.

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 Long-Term Funds
• There are many different types of long-term funds, i.e.,
funds that invest in long-term securities.

• Historically, mutual funds were classified as stock funds,

bond funds, or balanced funds.

• Today, the investment objective of the fund is the major

determinant of the fund type.

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 Stock Funds, I.
• Some stock funds trade off capital appreciation and dividend income.
―Capital appreciation
―Growth
―Growth and Income
―Equity income

• Some stock funds focus on companies in a particular size range.

―Small company
―Mid-cap
―Large-cap

• Some stock fund invest internationally.

―Global
―International
―Region
―Country
―Emerging markets
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 Stock Funds, II.

• Sector funds specialize in specific sectors of the economy:

― Biotechnology
― Internet
― Energy

• Other fund types include:

― Index funds
― Social conscience, or “green,” funds
― “Sin” funds (i.e., tobacco, liquor, gaming)
― Tax-managed funds

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 Bond Funds

• Bond funds may be distinguished by their

― Maturity range
― Credit quality
― Taxability
― Bond type
― Issuing country

• Bond fund types include:

― Short-term and intermediate-term funds
― General funds
― High-yield funds
― Mortgage funds
― World funds
― Insured funds
― Single-state municipal funds
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 Stock and Bond Funds
• Funds that do not invest exclusively in either stocks or bonds are often
called “blended” or “hybrid” funds.

• Examples include:
―Balanced funds
―Asset allocation funds
―Convertible funds
―Income funds

• Target Date Funds (also known as Lifecycle Funds)

―The asset allocation chosen by target date funds is based on the anticipated retirement
date of the investors holding the fund.
―If a company offers a Target Date 2040 Fund, the fund is for people planning to retire in
about 2040.
o In 2014, say, this fund would have a large equity exposure.
o In 2039, say, this fund would have a large bond exposure.
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 Mutual Fund Objectives:
Recent Developments, I.

• A mutual fund “style” box visually represents a fund’s investment

focus by placing the fund into one of nine boxes:

Style
Value Blend Growth
Large
Size

Medium
Small

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 Mutual Fund Objectives:
Recent Developments, II.

• In recent years, there has been a trend toward classifying a mutual

fund’s objective based on its actual holdings.

• For example, the Wall Street Journal classifies most general purpose
funds based on
― the market “cap” of the stocks they hold
―whether the fund tends to invest in “growth” or “value” stocks (or both).

• Growth stocks are those considered more likely to grow their

businesses.

• Value stocks are those that look to be relatively undervalued.

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Mutual Fund Objectives

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 Mutual Fund Performance

• Mutual fund performance is very closely tracked by a

number of organizations.

• Financial publications of all types periodically provide

mutual fund data.

• The Wall Street Journal is particularly timely print source.

• [Link] has a “Fund Selector” that

provides performance information.
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 Mutual Fund Selection
([Link])

Our Screen: domestic stock fund;

small-cap growth; low expenses;
no loads

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Mutual Fund Perfaormance: Yardsticks

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 Mutual Fund Performance:
Online Version of The Wall Street Journal, I.

Note the fund

with symbol: FBGRX
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 Mutual Fund Performance:
Online Version of The Wall Street Journal, II.

Result by clicking on “BluCh”

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 Mutual Fund Performance: Cautions

• 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 debate.

• Some of the poorest-performing funds are those with

very high costs.

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 Closed Funds
• Sometimes a fund will choose to close.

• Choosing to close means that the fund will no longer sell shares to
new investors.
• The use of the word “close” here should not be confused with
“closed-end.”
• The number of shares in a closed fund can still fluctuate as
existing owners buy and sell.
• Why would a fund choose to close?
―When a fund grows rapidly, the fund manager might feel that the
incoming cash is more than the fund can invest profitably.
―Funds that close often reopen at a later date.
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 Closed-End Funds

• A closed-end fund has a fixed number of shares.

• These shares are traded on stock exchanges.

―There are about 600 closed-end funds that have their shares
listed on U.S. Stock Exchanges.
―There are about 8,000 long-term open-end mutual funds.

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Mutual Fund Performance:
Closed-End Funds

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 The Closed-End Funds Discount

• Most closed-end funds sell at a discount relative to their

net asset values.
― The discount is sometimes substantial.
― The typical discount fluctuates over time.

• Despite a great deal of academic research, the closed-

end fund discount phenomenon remains largely
unexplained.

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 Exchange Traded Funds, ETFs
• An exchange traded fund, or ETF,
―Is basically an index fund.
―Trades like a closed-end fund (without the discount phenomenon).

• An area where ETFs seem to have an edge over the more traditional index
funds is the more specialized indexes.

• A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR.

―This ETF mimics the S&P 500 index.
―It is commonly called “spider."

• Another well-known ETF mimics the Dow Jones—it is called "Diamond."

• A list of ETFs can be found at [Link].

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Exchange Traded Funds, Performance

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 Leveraged ETFs, I.

• A particularly interesting, but potentially dangerous, ETF growth area is

in leveraged ETFs.
― The fund managers of a leveraged ETF create a portfolio designed to provide a
return that tracks the underlying index.
― But, by also using derivative contracts, the managers can magnify, or leverage, the
return on the underlying.
― The Fund Manager can also use derivatives to generate returns opposite, or
inverse, of the index return.

• Leveraged funds are designed to have twice the return on an index, say
the S&P 500.
― In other words, if the S&P 500 return on a given day is one percent, the leveraged
fund should provide a return of two percent.
― The danger is that leverage works both ways. Losses are also magnified by two.
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 Leveraged ETFs, II.
• Levered ETFs seem to track their underlying indexes on a short-term basis, i.e., day by
day.

• Over longer periods of time, however, their performance is probably not what you
would expect.

• For example, trading in leveraged ETFs offered by Rydex, a reputable firm, began on
November 7, 2007.
― The Long Fund (RSU) was designed to earn twice the S&P 500 index return.
― The Inverse Fund (RSW) was designed to earn the opposite of twice the S&P 500 Index return.

• Over the next two years, the S&P 500 lost -22.4 percent.
― Given its objective, the RSU fund should have lost -44.8 percent.
― The inverse fund, RSW, should have gained 44.8 percent.
― Over this two-year period, however, the RSU lost -56.5 percent, and the inverse fund, the RSW, lost -7.3%.

• How is such a result possible?

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 Leveraged ETFs, III.
• The answer lies in average versus geometric returns (and not with Rydex).
― Recall that geometric returns are lower than arithmetic returns
― Volatility fuels the difference.
― Both Rydex leveraged funds add extra volatility to the series of S&P 500 index returns.
― As a result, returns from any leveraged funds will be less than expected.

• Example: Consider a week during which the S&P500 earns daily returns of 1, -2, 2, 1,
and 3 percent, respectively.
― The arithmetic average is 1%.
― The geometric average is just slightly less, 0.986%.
― This difference seems trivial.

• Consider the returns, however, for a twice-leveraged fund.

― The arithmetic average is exactly double, 2%.
― The geometric average, however, is [(1.02)(0.96)(1.04)(1.02)(1.06)](1/5) – 1 = .0194, or 1.94%.
― Six basis points tracking error in one week.

• The longer the holding period and/or the more volatile the underlying index, the less
accurate a leveraged fund will be in tracking its stated objective.
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 Exchange Traded Notes, ETNs

• Introduced in mid-2006 by Barclays Bank.

• To investors, ETNs look like ETFs.

• However, ETNs are unsecured debt—so, unlike holders of ETFs,

holders of ETNs do have default risk.

• ETNs provide investors with exposure to commodities, but

without the leveraged risk of futures contracts.

• Handy web source: [Link]

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 Hedge Funds, Overview

• Like mutual funds, hedge funds collect pools of money from investors.

• Like mutual funds, hedge funds are generally required to register with
the SEC. But:
― Hedge funds are not required to maintain any particular degree of diversification or
liquidity.
― Hedge fund managers have considerably more freedom to follow various investment
strategies, or styles.

• Investing in hedge funds is not suitable for the all investors.

― Hedge funds accept only “qualified” (or accredited) investors.
― To be considered a qualified investor, you need to fulfill one of these conditions:
1. You must be an institution or an individual investor with a net worth of about $1 million.
2. You must have a recurring annual income of over $200,000.

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 Hedge Fund Fees
• Most common fee structure is 2/20, but many others exist.
― A short way to say that the manager charges an annual 2% management fee and retains 20% of
the hedge fund profits.

• To prevent the fund from being manipulated by its managers,

many fee structures include hurdles for the manager to meet.
― A common example is called a “high-water mark.”
― When a hedge fund fee structure includes a high-water mark, the manager will receive
performance fees only when the fund value is higher than its previous highest value.

• Why do hedge fund investors willingly pay high fees?

― Obvious answer: returns earned are high enough to provide a reasonable return.
― Some experts opine that hedge fund returns net of fees are about the same as the overall stock
market return.
― If these experts are correct, why would anyone invest in a hedge fund instead of a market index
fund? The answer lies in the principle of diversification.
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Some Common Hedge Fund Investment Styles, I.
• Market Neutral. Goal: offset risk with opposite positions in pairs of
securities.
― These hedge funds are also called long-short funds.
― Properly constructed, the resulting portfolio makes money regardless of how the overall market performs.
― Hence the name “market neutral.”
― Expected Volatility: Low.

• Arbitrage. Goal: identify a mispricing in relationships between securities

that theoretically should not exist.
― These hedge fund managers look at pricing relationships for securities offered by the same company, or for
investments across time or countries.
― Expected Volatility: Low.

• Distressed Securities. Goal: Buy securities that are being offered at deep
discounts resulting from company-specific or sector-wide distress.
― For example, a manager of distressed securities fund might buy securities of firms facing bankruptcy.
― Expected Volatility: Low to moderate.

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 Some Common Hedge Fund Investment Styles, II.

• Macro. Goal: These hedge fund managers attempt to profit from changes in global
economies brought about by governmental policies that affect interest rates
interest rates, currencies, or commodity prices.
― Macro fund managers often use leverage and derivative securities to increase the impact of market
moves.
― Expected Volatility: High.

• Short Selling. Goal: Managers of a pure short hedge fund only short sell.
― In addition, these managers use leverage through the use of margin.
― Expected Volatility: High

• Market Timing. Goal: Managers of these hedge funds attempt to identify trends in
particular sectors or overall global markets.
― These managers often take concentrated positions and generally use leverage to increase the fund’s
exposure to predicted movements.
― Expected Volatility: High
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 Hedge Funds, Conclusion

• As you can see, hedge fund managers employ many approaches,

and each has its own risk level.

• The lesson?
― Suppose you make your millions and become a qualified hedge fund investor
― You still have your work cut out trying to identify the best hedge fund for your
portfolio.

• Suppose you just cannot decide?

― You might want to use a “Fund of Funds.”
― These investment companies invest in hedge funds.
― Note: There is an additional, and significant, layer of fees heaped onto the already
hefty hedge fund fees.
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 Useful Internet Sites
• [Link] (mutual fund facts and figures)
• [Link] (example of a major fund family website)
• [Link] (website of largest investment advisory firm in US)
• [Link] (information on thousands of funds)
• [Link] (one of the best mutual fund sites)
• [Link] (more “social conscience” funds)
• [Link]/vicefund (“vice” funds)
• [Link] (more on exchange traded funds)
• [Link] (all about ETNs)
• [Link] (hedge fund information)
• [Link] (more hedge fund information)
• [Link] (want to start your own hedge fund?)
• [Link] (reference for recent financial information)

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 Chapter Review, I.
• Investment Companies and Fund Types
― Open-End versus Closed-End Funds
― Net Asset Value

• Mutual Fund Operations

― Mutual Fund Organization and Creation
― Taxation of Investment Companies
― The Fund Prospectus and Annual Report

• Mutual Fund Costs and Fees

― Types of Expenses and Fees
― Expense Reporting
― Why Pay Loads and Fees?

• Short-Term Funds
― Money Market Mutual Funds
― Money Market Deposit Accounts
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 Chapter Review, II.
• Long-Term Funds
― Stock Funds
― Taxable and Municipal Bond Funds
― Stock and Bond Funds
― Mutual Fund Objectives: Recent Developments

• Mutual Fund Performance

― Mutual Fund Performance Information
― How Useful are Fund Performance Ratings?

• Closed-End Funds, Exchange Traded Funds, and Hedge Funds

― Closed-End Funds Performance Information
― The Closed-End Fund Discount Mystery
― Exchange Traded Funds
― Leveraged Funds
― Exchange Traded Notes
― Hedge Funds and their Investment Styles
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