Chapter 4: Mutual Funds Overview

Chapter 4: Mutual Funds and Other Investment Companies

• Mutual funds are a way to pool investor funds for investment
• In 1980, 5 million Americans owned mutual funds
• By 2019, an estimated 99.5 million Americans in 56 million households owned mutual funds.
• In 2018, investors withdrew $191 billion from mutual funds.
• Mutual fund assets totaled $18 trillion by the end of 2018
• Mutual funds act as financial intermediaries like commercial banks and life insurance companies
• The buy and sell decisions for a pool of investor funds are made by a fund manager
• Mutual funds offer diversification, reducing risk
• Professional money managers handle security selection in mutual funds
• Minimum initial purchase amounts in mutual funds can range from 2,500to2,500 to 2,500to250, with subsequent purchases sometimes as low as $50.
• Mutual fund values may decrease, losing value from initial investment
• No government or private agency guarantees mutual fund value
• Investing in mutual funds involves fees and expenses
• Taxes are paid on mutual fund distributions (dividends and capital gains), and profits from sale of mutual fund shares
• Investment companies pool investor funds for investments.
• Open-end funds can buy or sell shares at any time
• Closed-end funds have a fixed number of shares and trading only occurs on open market.
• Types of mutual funds include money market funds, long-term funds, stock funds, bond funds, and blended funds.
• Net Asset Value (NAV) is the value of a mutual fund's assets divided by the number of shares.
• Open-end fund shares are worth their NAV.
• Closed-end fund share prices can differ from their NAV.
• Mutual funds are corporations owned by shareholders electing a board of directors.
• Investment advisory firms often create and manage mutual funds
• SEC "regulated investment companies" do not pay taxes on investment income
• Qualified investment companies hold majority assets in securities like stocks and bonds.
• Limit asset allocation to a single security to no more than 5%
• Distributors of realized investment income are fund shareholders
• Mutual funds are required to provide a prospectus to investors wishing to buy shares.
• Mutual funds provide annual reports to their shareholders.
• Sales charges, or loads, are levied on purchases (front-end loads) and redemptions (back-end loads).
• 12b-1 fees allow funds to spend up to 1% of assets annually on distribution and marketing, though .25% is most common.
• Management fees typically range from .25% to 1.50% of assets
• Trading costs are reported as "turnover," reflecting trading activity; high turnover signifies higher costs.
• Shareholder transaction expenses include loads, deferred sales charges.

Investment Companies and Fund Types

• Investment companies pool funds from individual investors
• Open-end funds can buy/sell shares at any time
• Closed-end funds trade in the open market with fixed shares
• Fund types include money market, long-term, stock, bond, and blended funds
• NAV is the value of assets divided by shares

Mutual Funds: Operations and Creation

• Mutual funds are corporations.
• Ownership is by shareholders who elect a board of directors
• Investment advisory firms and brokerage firms with investment advice operations create and manage mutual funds

Mutual Fund Costs and Fees

• Sales charges or loads and 12b1 fees cover distribution and marketing costs
• Annual management fees typically range from .25% to 1.50% of assets
• Trading costs reported as turnover.

Short-term Funds

• Short-term funds (money market funds) specialize in money market instruments.
• Aim to provide low risk, highly liquid investments
• Net asset value (NAV) maintained at $1.00
• Not all money market funds are suitable
• FDIC insurance is an option for money market deposit accounts

Long-Term Funds

• Many fund types exist, classified historically as stock, bond, or balanced. Today, investment objectives are the major differentiating factor
• Common classifications based on asset allocation (stock funds, bond funds, blended funds)

Stock Funds

• Stock funds can seek out capital appreciation or dividends
• Categories by company size (small-cap, mid-cap, large-cap)
• Sector or thematic (biotechnology, internet, energy) funds
• Index funds reflect market indices (i.e., S&P 500)

Bond Funds

• Bond funds can be classified by maturity, credit quality, taxability, and issuing country.
• Different types of underlying bonds include short-term, intermediate-term, general, high-yield, mortgage, world, insured, and single-state municipal.

Stock and Bond Funds (Blended)

• Some funds mix stocks and bonds in various combinations, based on investment objectives and expected returns
• Target-date funds shift portfolio allocations based on a target retirement date

Mutual Fund Objectives: Recent Developments

• Mutual fund style boxes place funds in a visual grid arrangement based on size (large, medium, small) and style (value, blend, growth).
• Recent trends in classifying objectives based on actual holdings (e.g., Wall Street Journal categorizes by market capitalization and growth/value stock investments)

Mutual Fund Performance

• Mutual fund performance is closely watched by several organizations
• Financial publications provide data on a regular basis
• Sources like the Wall Street Journal provide timely print reports, and online resources like morningstar.com offer further information

Closed-End Funds

• Closed-end funds have a fixed number of shares, traded on exchanges.
• There are approximately 600 closed-end funds listed on US exchanges and 8,000 open-end funds.
• Closed-end funds frequently trade a discount compared to their NAV.
• Reasons for a firm's choice to close a fund include the expectation that the income stream exceeds the fund's investment potential

Exchange Traded Funds (ETFs)

• ETFs are essentially index funds that trade like closed-end funds (without discount phenomenon).
• They offer specialized indexes and are a frequently used instrument.
• Well-known examples like SPDR (mimics the S&P 500) and Diamond (mimics the Dow Jones) are examples
• Trading occurs on major stock exchanges.

Leveraged ETFs

• Leveraged ETFs are designed to provide returns in multiples of underlying indexes
• Leverage works both ways; losses/gains are amplified
• Performance results over longer periods often deviate from expectations

Hedge Funds

• Hedge funds are pools of money from investors.
• Unlike mutual funds, they are not required to maintain specific diversification or liquidity levels.
• They give managers significant freedom in investment strategy
• Investors should be accredited or qualified investors for investment considerations
• Hedge fund fee structures commonly include a 2/20 model
• Managers of the hedge fund incur hurdles to prevent manipulation, with "high water mark" being a common example

Chapter Review

• Summarizes key concepts for exam preparation.