Chapter

4
Mutual Funds

Fundamentals
of Investments
Valuation & Management
second edition

Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

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Mutual Funds
Our goal in this chapter is to
Goal understand the different types of
mutual funds, their risks, and returns.
 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.

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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.
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Investment Companies and Fund Types

Investment company
A business that specializes in pooling funds
from individual investors and investing them.
Open-end fund
An investment company that stands ready to
buy and sell shares at any time.
Closed-end fund
An investment company with a fixed
number of shares that are bought and sold
only in the open stock market.
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Investment Companies and Fund Types

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Investment Companies and Fund Types

Net asset value

The value of the assets held by a mutual
fund, divided by the number of shares.
Abbreviated NAV.
 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.
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Work the Web

 For mutual fund facts and figures,

visit:
http://www.ici.org

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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 (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.
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Work the Web

 All the major fund families have

websites. Try, for example:
http://www.vanguard.com

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Mutual Fund Operations

Taxation of Investment Companies
 An investment company that
 holds almost all its assets as investments in stocks,
bonds, and other securities,
 uses no more than 5% of its assets when acquiring
a particular security, and
 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.
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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, 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.
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Mutual Fund Costs and Fees

Types of Expenses and Fees …continued
 Trading costs. This is related to the fund’s turnover.

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Mutual Fund Costs and Fees

Expense Reporting
 Mutual funds are required to report expenses
in a fairly standardized way in the prospectus.
 Shareholder transaction expenses - loads and
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.

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Mutual Fund
Costs & Fees

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Work the Web

 Prospectuses are increasingly available
online. To see some examples, visit:
http://www.fidelity.com

 To see a fund that really discloses

information, try:
http://www.ipsfunds.com
Check out the “plain language” risk
disclosure!

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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.

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Short-Term Funds
Money market mutual fund
A mutual fund specializing in money market
instruments.
 Short-term funds are collectively known as
money market mutual funds, or MMMFs.
 MMMFs always maintain a $1 net asset value
to make them resemble bank accounts.
 Depending on the type of securities purchased,
MMMFs can be either taxable or tax-exempt.
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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.

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Work the Web

 For information on thousands of

funds, including MMMFs, visit:
http://www.mfea.com

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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?

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Stock Funds
 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, midcap.
 Some fund groups invest internationally.
 Global, international, region, country, emerging
markets.
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Stock Funds
 Sector funds specialize in specific sectors of
the economy.
 Other fund types include index funds, social
conscience funds, and tax-managed funds.

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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 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.

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Mutual Fund Objectives: Recent Developments

 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, and also
on whether the fund tends to invest in
“growth” or “value” stocks (or both).

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Mutual Fund Objectives: Recent Developments

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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:
Style
Value Blend Growth
Large
Size

Medium
Small

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Work the Web

 One of the best mutual fund sites is:
http://www.morningstar.com
Try picking some funds using their
“Fund Selector.”
 To learn more about “social
conscience” funds, visit:
http://www.socialinvest.org
http://www.domini.com

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Mutual Fund Performance

 Mutual fund performance is very closely
tracked by a number of organizations.

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Mutual Fund Performance

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Mutual Fund Performance

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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 debate.
 Some of the poorest-performing funds are
those with very high costs.

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Closed-End Funds
& Exchange
Traded Funds

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Closed-End Funds & Exchange Traded Funds

 Most closed-end funds sell at a discount
relative to their net asset values, and the
discount is sometimes substantial. The typical
discount also fluctuates over time
 Despite a great deal of research, the closed-end
fund discount phenomenon remains largely
unexplained.

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

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Chapter Review
 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

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Chapter Review
 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
 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?

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Chapter Review
 Closed-End Funds and Exchange Traded
Funds
 Closed-End Funds Performance Information
 The Closed-End Fund Discount Mystery

 Exchange Traded Funds

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