Mutual Funds Booklet Fall 2024 PDF

Faculty of Economics and International Trade Module Name: Mutual Funds Management & Valuation Module Code: FIN-E04 Level IV Finance Department Final Booklet Course Leader: Ihab Raouf...

Faculty of Economics and International Trade Module Name: Mutual Funds Management & Valuation Module Code: FIN-E04 Level IV Finance Department Final Booklet Course Leader: Ihab Raouf Petro Head of Finance Department Course Assistants: Celine Nabil Teaching Assistant (Finance Department) Youmna Ahmed Teaching Assistant (Finance Department) 2024 1.1-What is Mutual fund (Investment Company)? Mutual Funds (Investment companies) are financial (Investment) intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets. Pooling of assets is the key idea behind investment companies. Each investor has a claim to the portfolio established by the investment company in proportion to the amount invested. These companies thus provide a mechanism for small investors to “team up” to obtain the benefits of large-scale investing. In other words, Mutual funds are a major intermediary between savers and borrowers, gathering savings out of bank deposits and investing these savings into money market instruments, bonds, and equities issued by governments and corporates. While all mutual funds pool the assets of individual investors, they also need to divide claims to those assets among those investors. Investors buy shares in investment companies, and ownership is proportional to the number of shares purchased. 1.1.1-Investment Companies Importance Investment companies provide a mechanism for small investors to “team up” to obtain the benefits of large-scale investing. Investment companies perform several important functions for their investors: 1-Record keeping and administration: Investment companies issue periodic status reports, keeping track of capital gains distributions, dividends, investments, and redemptions, and they may reinvest dividend and interest income for shareholders. 2-Diversification and divisibility: By pooling their money, investment companies enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot. 3-Professional management: Investment companies can support full-time staffs of security analysts and portfolio managers who attempt to achieve superior investment results for their investors. 4-Lower transaction costs: Because they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees and commissions. 5-Flexibility: Investment companies can buy and sell on any business day, so it is easy to invest and disinvest. Further, they meet a wide variety of different needs: for capital preservation; for capital growth, income, or a mixture of both; for a stable or a rising income; for exposure only to domestic markets or worldwide; for those with ethical, religious or environmental concerns etc.: the list is almost endless. 1.1.2- Net Asset Value (NAV) While all investment companies pool the assets of individual investors, they also need to divide claims to those assets among those investors. Investors buy shares in mutual funds (investment companies), and ownership is proportional to the number of shares purchased. The value of each share is called the net asset value, or NAV. Net asset value (NAV) is the current market value of all the fund’s assets, minus liabilities, divided by the total number of outstanding shares. NAV = [Market value in $ of a fund’s assets (including income and other earnings) – Fund’s liabilities (including fees and expenses)] ÷ number of shares outstanding Example 1: If a mutual fund’s total market value is $6 million, fund’s liabilities amount to $60 thousand, and number of shares outstanding are 500 thousand. The net asset value (NAV) is? Therefore, NAV = (6,000,000 – 60,000) ÷ 500,000 = $11.88 1.1.3- Types of Investment Companies (Classification) In the United States, investment companies are classified by the Investment Company Act of 1940 as either unit investment trusts or managed investment companies. The portfolios of unit investment trusts are essentially fixed and thus are called “unmanaged.” In contrast, managed companies are so named because securities in their investment portfolios continually are bought and sold: The portfolios are managed. Managed companies are further classified as either (Closed- end) or (Open-end). Open-end companies are what we commonly call mutual funds. 1-Unit Investment Trusts (Unmanaged Companies) Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfolio of securities which are deposited into a trust. It then sells to the public shares, or “units,” in the trust, called redeemable trust certificates. All income and payments of principal from the portfolio are paid out by the fund’s trustees (a bank or trust company) to the shareholders. There is little active management of a unit investment trust because once established, the portfolio composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to invest in relatively uniform types of assets; for example, one trust may invest in municipal bonds, another in corporate bonds. The uniformity of the portfolio is consistent with the lack of active management. The trusts provide investors with a vehicle to purchase a pool of one particular type of asset, which can be included in an overall portfolio as desired. The lack of active management of the portfolio implies that management fees can be lower than those of managed funds. 2-Managed Investment Companies There are two types of managed companies: (closed-ended) and (open-ended). In both cases, the fund’s board of directors, which is elected by shareholders, hires a management company to manage the portfolio for an annual fee that typically ranges from 0.2% to 1.5% of assets. In many cases the management company is the firm that organized the fund. In other cases, a mutual fund will hire an outside portfolio manager. Most management companies have contracts to manage several funds. -Open-ended funds stand ready to redeem or issue shares at their net asset value (although both purchases and redemptions may involve sales charges). When investors in open-end funds wish to “cash out” their shares, they sell them back to the fund at NAV. -Closed-ended funds do not redeem or issue shares. Investors in closed-end funds who wish to cash out must sell their shares to other investors. Shares of closed-end funds are traded on organized exchanges and can be purchased through brokers just like other common stock; their prices therefore can differ from NAV. Unlike closed-end funds, open-end mutual funds do not trade on organized exchanges. Instead, investors simply buy shares from and liquidate through the investment company at net asset value. Thus, the number of outstanding shares of these funds changes daily. 3-Other Investment Organizations Some intermediaries are not formally organized or regulated as investment companies but nevertheless serve similar functions. Among the more important are commingled funds, real estate investment trusts, and hedge funds. -Commingled Funds are partnerships of investors that pool funds. The management firm that organizes the partnership, for example, a bank or insurance company, manages the funds for a fee. Typical partners in a commingled fund might be trust or retirement accounts that have portfolios much larger than those of most individual investors but are still too small to warrant managing on a separate basis. Commingled funds are similar in form to open-end mutual funds. Instead of shares, though, the fund offers units, which are bought and sold at net asset value. A bank or insurance company may offer an array of different commingled funds, for example, a money market fund, a bond fund, and a common stock fund. -Real Estate Investment Trusts (REITs) is similar to a closed-end fund. REITs invest in real estate or loans secured by real estate. Besides issuing shares, they raise capital by borrowing from banks and issuing bonds or mortgages. Most of them are highly leveraged, with a typical debt ratio of 70%. There are two principal kinds of REITs. Equity trusts invest in real estate directly, whereas mortgage trusts invest primarily in mortgage and construction loans. REITs generally are established by banks, insurance companies, or mortgage companies, which then serve as investment managers to earn a fee. -Hedge Funds: Like mutual funds, hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager. Unlike mutual funds, however, hedge funds are commonly structured as private partnerships and thus are not subject to many SEC regulations. Typically, they are open only to wealthy or institutional investors. Many require investors to agree to initial “lock-ups,” that is, periods as long as several years in which investments cannot be withdrawn. Lock-ups allow hedge funds to invest in illiquid assets without worrying about meeting demands for redemption of funds. Moreover, since hedge funds are only lightly regulated, their managers can pursue other investment strategies that are not open to mutual fund managers, for example, heavy use of derivatives, short sales, and leverage. Hedge funds by design are empowered to invest in a wide range of investments, with various funds focusing on derivatives, distressed firms, currency speculation, convertible bonds, emerging markets, merger arbitrage, and so on. Other funds may jump from one asset class to another as perceived investment opportunities shift. 1.2-Why Governments encourage developments of funds? Both governments and companies need to be able to borrow money in order to finance their current and future operations: this is why both companies and governments issue bonds (whereby generally they agree to repay the amount borrowed upon a certain date, and pay a stated level of interest over the period of the life of the bond), which represent fixed-term borrowing; and why companies issue shares (also known as equities since they broadly represent equal proportions of ownership or rights of ownership of a company), which represent indefinite or permanent borrowing, since the shares will remain in existence for ever unless the company is shut down. Companies try to incentivize people to buy and hold their shares by growing the company and its profits, resulting in the payment of rising dividends to holders, which in turn should increase demand for their shares, and thus achieve a rising share price: holders can then make capital gains from selling these shares at a higher price than they bought them for. If smaller savers keep their money under the mattress, this money is clearly not available to finance government or commerce and thus the development of an economy; and if they keep it on term deposit it will generally only be available to fund bank lending over a stated term, which often will be relatively short. Therefore, the money available to fund borrowing for the longer term could be restricted. However, if smaller savers invest through funds, their money will become available to finance longer term borrowing through purchase of bonds and shares and thus help to develop countries’ economies and this is a key reason why governments encourage collective investment (and indeed insurance and pension) funds: they ‘mobilize capital’. Insurance, pension and collective investment funds are often characterized as ‘non-bank financial institutions’7 since they provide non-banking finance. This role of collective investment funds, that of standing between the investor with spare cash and the entity (the government or company) that wants to borrow it is known as ‘intermediation’ and is illustrated in Figure ( 1.2). Figure 1.2: Investment fund intermediate The other reason that governments wish to stimulate the development of collective investment funds is to encourage people to save, thus reducing the likelihood of future dependency on the state and consequent drain on state budgets: particularly in relation to retirement. 1.3-Practical Case In an Open-end fund the outstanding shares is 100,000 shares. Balance sheet of Investment Company (Amounts in ,000 EGP) The Market Value of Securities in the Fund 5,400 Cash 400 Notes Receivables 800 The Total Values of Fund Assets 6,600 Current Liabilities 1,600 The Market Value of Fund Equity 5,000 Total Market Values of Liabilities 6,600 From the mentioned data above: 1-Calculate the Net Asset Value per share. NAV = (Total Values of Assets – Current Liabilities) ÷ Number of Shares NAV = (6,600 – 1,600) ÷ 100 = 5000 ÷ 100 = EGP 50. In case of issuing new shares of 8000 shares. 2-The market value of new shares. Market Value of new shares = NAV × Number of new shares = EGP 50 × 8000 = EGP 400,000. In the case the Market Value of Securities in the Fund declined to EGP 5,000. 3-the Net Asset Value per share will be? NAV = (Total Values of Assets – Current Liabilities) ÷ Number of Shares NAV = [(5000 + 400 + 800) – 1600] ÷ 100 NAV = (6200 – 1600) ÷ 100 = EGP 46. Types of Mutual Funds (Investment Policies) Introduction Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market, while bond funds hold fixed-income securities. Some funds have even more narrowly defined mandates. For example, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed securities. A mutual fund can be created around any portfolio of assets. However, mutual funds tend to exist for only the more liquid asset classes, such as stocks and bonds. There are four broad fund objective categories recognized by the Investment Company Institute: common stock funds, bond funds, hybrid funds, and money market funds. Equity funds invest almost exclusively in common stocks. Within that broad mission, however, substantial differences can be found, including funds that focus on specific industries (e.g., Chemical Fund, Oceanography Fund), a collection of industries (e.g., Technology Fund), security characteristics (e.g., Growth Fund, Large-Cap Fund), or even geographic areas (e.g., Global Funds, Northeast Fund). With several thousand to choose from, any investor should find an existing equity fund that matches his or her desired investment strategy. Thus, the important thing that an investor must do is to decide what that preferred strategy happens to be. Bond funds concentrate on various types of bonds to generate high current income with minimal risk. They are similar to common stock funds; however, their investment policies differ. Some funds concentrate on U.S. government or high-grade corporate bonds, others hold a mixture of investment-grade bonds, and some concentrate on high-yield (junk) bonds. Management strategies also can differ, ranging from buy and hold to extensive trading of the portfolio bonds. In addition to government, mortgage, and corporate bond funds, a change in the tax law in 1976 caused the creation of numerous municipal bond funds. These funds provide investors with monthly interest payments that are exempt from federal income taxes. Some municipal bond funds concentrate on bonds from specific states, such as the New York Municipal Bond Fund, which allows New York residents to avoid most state taxes on the interest income. Balanced funds diversify outside a single market by combining common stock with fixed-income securities, including government bonds, corporate bonds, convertible bonds, or preferred stock. The ratio of stocks to fixed-income securities will vary by fund, as stated in each fund’s prospectus. Flexible portfolio (or asset allocation) funds seek high total returns by investing in a mix of stocks, bonds, and money-market securities. Target date (or life cycle) funds adjust the asset allocation weights in the portfolio to match the needs of an investor who is aging toward retirement. Money market funds were initiated during 1973 when short-term interest rates were at record levels. These funds attempt to provide current income, safety of principal, and liquidity by investing in diversified portfolios of short-term securities, such as Treasury bills, banker certificates of deposit, bank acceptances, and commercial paper. 2.1-Mutual Funds Classifications and Objectives 2.1.1-Stock Funds: -Aggressive growth funds: invest primarily in common stock of small, growth companies with potential for capital appreciation. -Emerging market equity funds: invest primarily in equity securities of companies based in less- developed regions of the world. -Global equity funds: invest primarily in worldwide equity securities, including those of U.S. companies. -Growth and income funds: attempt to combine long-term capital growth with steady income dividends. These funds pursue this goal by investing primarily in common stocks of established companies with the potential for both growth and good dividends. -Growth funds: invest primarily in common stocks of well-established companies with the potential for capital appreciation. These funds’ primary aim is to increase the value of their investments (capital gain) rather than generate a flow of dividends. -Income equity funds: seek income by investing primarily in equity securities of companies with good dividends. Capital appreciation is not an objective. -International equity funds: invest at least 80 percent of their portfolios in equity securities of companies located outside the United States. -Regional equity funds: invest in equity securities of companies based in specific world regions, such as Europe, Latin America, the Pacific Region, or individual countries. -Sector equity funds: seek capital appreciation by investing in companies in related fields or specific industries, such as financial services, health care, natural resources, technology, or utilities. 2.1.2- Bond Funds: -Corporate bond-general funds: seek a high level of income by investing 80 percent or more in their portfolios in corporate bonds and have no explicit restrictions on average maturity. -Corporate bond–intermediate-term funds: seek a high level of income with 80 percent or more of their portfolios always invested in corporate bonds. Their average maturity is five to ten years. -Corporate bond-short-term funds: seek a high level of current income with 80 percent or more of their portfolios always invested in corporate bonds. Their average maturity is one to five years. -Global bond-general funds: invest in worldwide debt securities and have no stated average maturity or an average maturity of more than five years. Up to 25 percent of their portfolios’ securities (not including cash) may be invested in companies located in the United States. -Global bond-short-term funds: invest in worldwide debt securities and have an average maturity of one to five years. Up to 25 percent of their portfolios’ securities (not including cash) may be invested in companies located in the United States. -Government bond-general funds: invest at least 80 percent of their portfolios in U.S. government securities and have no stated average maturity. -Government bond-intermediate-term funds: invest at least 80 percent of their portfolios in U.S. government securities and have an average maturity of five to ten years. -Government bond-short-term funds: invest at least 80 percent of their portfolios in U.S. government securities and have an average maturity of one to five years. -High-yield funds: seek a high level of current income by investing at least 80 percent of their portfolios in lower-rated corporate bonds (Baa or lower by Moody’s and BBB or lower by Standard & Poor’s rating services). -Mortgage-backed funds: invest at least 80 percent of their portfolios in pooled mortgage-backed securities. 2.1.3- Hybrid Funds: -Asset allocation funds: seek high total return by investing in a mix of equities, fixed-income securities, and money market instruments. Unlike flexible portfolio funds (defined below), these funds are required to strictly maintain a precise weighting in asset classes. -Balanced funds: invest in a specific mix of equity securities and bonds with the three-part objective of conserving principal, providing income, and achieving long-term growth of both principal and income. -Flexible portfolio funds: seek high total return by investing in common stock, bonds and other debt securities, and money market securities. Portfolios may hold up to 100 percent of any one of these types of securities and may easily change, depending on market conditions. Target date (or lifecycle) funds are an example of these portfolios. -Income mixed funds: seek a high level of current income by investing in a variety of income- producing securities, including equities and fixed-income securities. Capital appreciation is not a primary objective. 2.1.4- Money Market Funds -National tax-exempt money market funds: seek income not taxed by the federal government by investing in municipal securities with relatively short maturities. -State tax-exempt money market funds: invest predominantly in short-term municipal obligations of a single state, which are exempt from federal and state income taxes for residents of that state. -Taxable money market-government funds: invest principally in short-term U.S. Treasury obligations and other short-term financial instruments issued or guaranteed by the U.S. government, its agencies, or its instrumentalities. -Taxable money market-nongovernment funds: invest in a variety of money market instruments, including certificates of deposit of large banks, commercial paper, and banker’s acceptances. 2.1.5-Other Classification of Funds -Index funds: An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to the security’s representation in that index. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy, that is, to invest without engaging in security analysis. 2.2-Mutual Funds Objectives It is best if the manager can focus on a shorter list of objectives that appear most attractive. 2.2.1-Growth Funds Funds in this category are generally less volatile. As the name implies, growth portfolios hold stocks of companies whose earnings are expected to rise at an above-average rate. Companies tend to be larger, well-established. The portfolio managers emphasize capital appreciation rather than dividend income. 2.2.2-Growth-and-Income Funds Capital appreciation, dividend income, and even growth in future dividends are the features that appeal to growth-and-income managers. Typically, however, they concentrate on the appreciation potential. These investments make sense for people who want somewhat more income and perhaps less volatility than provided by a growth fund. The portfolios consist of both growth companies and income stocks with good dividend-paying-records. 2.2.3-Income Funds The income strategy is a special kind of value investing. These managers focus primarily on dividends yields. They seek yields significantly higher than that of an overall market yardstick such as the S&P 500. Income funds should be less volatile than the overall market. They represent one of the lowest-risk approaches to investing in stocks. But by no means are they risk-free. High-yielding stocks tend to be especially sensitive to interest rates, as long-term bonds are. When rates rise, the prices of dividend stocks fall so that their yields can remain competitive with fixed-income securities. Though income portfolios are the least risky of the general stock funds, some have delivered outstanding performances over long stretches. Mutual Funds Key functions and roles 3.1-Key Operational Functions The fundamental purpose of funds is to make money for their investors. This will be done through: -Creating and promoting the fund so it attracts money, making sales, keeping investors informed (known as marketing). -Receiving subscriptions and paying out proceeds, recording transactions, valuing, and pricing the fund and reporting to investors (known as administration or customer servicing). -Investing subscribers’ money in assets that align with the investment objective of the fund and which it is anticipated will give a good return and adjusting that portfolio as necessary (known as investment management). These functions must be conducted in order for funds to operate. However, regulation also requires three other key functions to be undertaken. 3.1.1-Additional Functions required by Regulation -The first precaution is to prevent fund management companies or directors stealing fund assets is known as a ‘custodian’. A custodian is required by law and regulation to be at least operationally independent of the management company or independent from it. The net outcome of this requirement for a custodian is that while the management company takes the investment decisions, it cannot carry out those decisions without the co-operation of the custodian, which must release money or securities to complete a purchase or sale transaction. Equally, the custodian cannot initiate a transaction with fund assets upon the instructions of the management company. -The second precaution is the regulatory requirement for a fund to be audited by a qualified professional auditor who is independent of the management company of the fund. The auditor’s task is to check that the financial statements made about any one fund accurately reflect its real financial position, and to undertake random tests to validate this. They may also be required to report any irregularities they find to the regulator. -The third precaution is not always the norm but is increasingly so: that a management company (and a custodian) are required by law and regulation to have a compliance function in place. The responsibility of this function is to ensure that the company concerned is operating in compliance with law and regulation and that its systems and procedures are designed in such a way that it remains in compliance on a continuing basis. To summarize – while investment funds operate in different ways in different countries, they all need the following functions to be undertaken in order for them to work effectively: -Marketing -Administration -Investment Management -Custody -Audit -Compliance 3.2-Role of the Fund Management Company Essentially the term ‘fund management companies are used for the entity that usually causes a fund to be created (to add to revenues) and operates the fund. The functions that are carried out by the fund management company will vary from quite narrow (such as fund initiation and marketing only) to very wide (all tasks except audit and custody) and will depend upon the structure of the fund being formed as well as the commercial choices made about its operation. For the purposes of clarity, the functions listed under the sub-headings below are those that, at the maximum, are carried out by the fund management company. In theory anyone can start a fund management firm – though some regulatory regimes may be more restrictive. 3.2.1-Investment management Investment management will generally cover the following activities: -Defining investment objectives and styles -research -Investment Analysis -Portfolio Selection and Management. Some or all these activities may be subcontracted. 3.2.2-Administration Administration includes two different areas of activity: the first being outward facing, which is servicing the fund’s investors; the second, being inward facing, which is administration and accounting for the fund’s investments. At a maximum, these cover: 1st: Outward facing: -Administering the flow of money into and out of a fund. -Creating and maintaining individual accounts for fund investors. -Confirming contractual details. -Creating and maintaining fund registers. -Recording all payments to and from investors. -Paying dividends to investors. 2nd: Inward facing: -Fund valuation and pricing. -Advising fund managers of money available (or not available) for investment. -Recording fund portfolio transactions. -Operating the accounts of the fund including income received and gains or losses realized. -Liaison with the custodian and auditor. A management company may, however, sub-contract these activities to another party. 3.3.3-Marketing This is a broad title, which at its most extensive, covers the following activities: -Market research. -Branding. -Product development – design of funds and related services. -Promotion of funds to potential and existing investors, including general information provision. -Sales of funds to investors. -Communications with investors. Again, some or all these functions may be subcontracted to other entities. 3.3-Role of the Custodian The role and responsibilities of the entity that fulfils the role of custodian to a fund will vary according to the legal structure of the fund (company, a trust or a contractual pool). It will also vary according to the duties placed upon the function of governing law and regulation. - ‘Trustee’: is used only to refer to the capacity of a single trustee whose responsibilities under a trust deed of a fund are to protect the interests of beneficiaries under that deed. It has both: -Safekeeping and -Supervisory Functions. 1st: Safekeeping of assets Regulation makes a custodian, trustee or depositary responsible for the safekeeping of all the assets of a fund, whether cash or near cash, securities, title to real estate or other assets. 2nd: Supervision of the conduct of business of the fund Supervision of the compliance of the management company’s conduct of business of a fund with its founding documents and with regulation is a duty that is imposed upon a depositary or a trustee of contractual or trust (or ICVC) form funds, in addition to safekeeping of assets. This supervisory role is not imposed on custodians, however, since the funds for which they act have directors who are responsible for such supervision. Table 3.1-Summary of safekeeping and supervisory roles by fund legal structure Fund Type Safekeeping role Supervisory role Corporate fund Undertaken by a custodian Undertaken by fund directors Trust fund Undertaken by a trustee, trustee can Undertaken by a trustee subcontract role to a custodian Contractual fund Undertaken by a depositary Undertaken by a depositary Analyzing a fund performance Introduction Although individual investment objectives may be different, all fund investors ideally want to get the highest possible return on their investment either in the form of capital, or income or a combination of both. All other things being equal, an investment that returns more is more attractive. But how can a return be measured in relative terms so as to make comparisons possible? Performance of open-ended and closed-ended funds is expressed as a percentage change – rise or fall – in a fund unit or share’s net asset value (NAV) over a certain period. Fund performance is usually expressed as the “total return”, which takes account of both increase or decrease of the net asset value of the fund’s shares or units and of distributions. The principal formula for performance calculation, based only on the percentage increase or decrease in the NAV of shares or units over a given period (Excluding the effect of dividends distribution) is as follows: P = [(B – A) ÷ A] × 100 Where: P = Performance in percentage terms B = The net asset value per share or unit on the last day of the period over which it is wished to calculate the performance A = the net asset value per share or unit on the first day of the period. Table 4.1 Fund performance over the period 01.01.22-30.06.22 Fund NAV 01.01.22 NAV 30.06.22 Performance Fund D 125 136 +8.8% Fund E 150 136 -9.3% Fund F 324 398 +22.8% Table 4.1 illustrates a typical use of such figures, showing that fund D has risen by 8.8%, while fund E has fallen by 9.3% and fund F has done best with a rise of 22.8%. The figure above shows historic performance (Indicator). In the future the performance of the investment may follow a different pattern from the past, and it is very difficult to predict how it is going to change. In general funds do not guarantee any amount of regular income payments or repayment of the principal; and the share or unitholder accepts the full market risk. Therefore, past performance: -Should not be expected to be repeated in the future. -It is not a reliable guide to future performance. -Must only be based on actual performance. 4.1-Common Measurements of Funds Performance 4.1.1-Total Return The simple performance calculation in table 4.1 assumed that none of the funds made any distributions (Paid out income). However, if a fund had paid out any income during the specified period, fund investors would have two different sources of return – distribution of income and capital gains – both should be considered when performance is measured. The total return is the comparisons which encompass both changes in NAV resulting from appreciation or depreciation of the underlying portfolio (capital gain/loss) and the payment of any distribution of income. Table 4.2 Comparative NAV Performance Fund NAV 01.01.22 NAV 30.06.22 Performance Fund D 12.5 13.6 +8.8% Fund G 32.4 35.4 +9.3% According to table 4.2 fund G performed better. However, how would the two funds be judged if fund D had made a distribution of 0.4 per share on 31.03.22 and fund G had not made a distribution at all? The result for fund D has been reduced by the value of distribution paid out and if it had not been paid out, the outcome would have been different. In order to calculate total return, it is assumed that any dividend that has been paid out to investors during the performance measurement period is theoretically reinvested in shares or units of the fund. The investor therefore ends up owing more shares in fund D at the end of the period. To calculate how many more shares the investor obtains, it is necessary to know the price of the shares of the fund that has paid dividend on the day after the dividend has been declared. The calculation for fund D would be as in table 4.3. Table 4.3 Calculating total return for fund D (assuming no market movement between 31.03.22 and 01.04.22 and no tax payable on distribution) Date Number of Price per Distribution Value Increase/decrease shares share amount in value 01.01.22 1000 12.5 12500 31.03.22 1000 14.7 14700 31.03.22 400 Distribution (0.4 per share) 01.04.22 1027.97 14.3 30.06.22 1027.97 13.6 13980 11.8% total return New number of shares = 1000 + (400 ÷ 14.3) = 1027.97 shares on 01.04.22 Total return = [(value in 30.06.22 - value in 01.01.22) ÷ value in 01.01.22] × 100 Total return = [(13980 – 12500) ÷ 12500] × 100 = 11.8%. 4.1.2- Presentation of Yield Total return is a key indicator of performance of any investment fund, in particular performance of funds investing in shares naturally is compared with performance of shares, which usually both pay out dividends and generate capital gain. However, investment funds investing in bonds and comparing their performance with the performance of bonds may require presenting their yields separately. Therefore, in the case of bond funds two forms of yield are quoted: -Running (or current) yield: This is an estimation of the income an investor in a particular fund is likely to receive in a year, divided by the current price of the fund share. Estimation of what will happen to income in that year is possible since coupons on bonds will be paid at a known rate of interest and on a known date so is more certain than future dividends. The yield figure also may be quoted gross or net of tax and the basis clearly stated. -Redemption yield: This is an estimation of the total return of a fund, usually over a 10- year period, taking into account predicted income and any potential reduction in gain in capital, in addition to charges. This may be quoted gross of tax or net, which should be stated. 4.2- Treatment of Entry and Exit Fees The net asset value (NAV) or offer to bid basis, should consider the entry and exit costs (fees) in calculating fund performance. Table 4.4 illustrates how the selected method may make an impact on performance. Table 4.4 NAV basis versus offer to bid basis 01.01.22 NAV 500 Offer price 525 Bid price 475 30.12.22 NAV 1000 Offer price 1050 Bid price 950 It is clear that on the basis of comparison of NAVs the return is as follows: = [(1000 – 500) ÷ 500] × 100 = 100%. On the basis of offer to bid return is as follows: = [(925 – 525) ÷ 525] × 100 = 81%. The basis of NAV per share and offer to bid price depends on: -The objective of performance measurement: - To investors the key concern is what money they would have made if they bought at the beginning of the period and sold at the end of it. Thus, they would compare the offer price at the beginning, which they would pay to enter the fund, with the bid price at the end because this is what they would get if they redeemed from the fund. - However, to judge the success of investment management activity the key measure is the rise and fall in NAV in the period. - The nature of the benchmark with the fund is being compared: for instance, if fund offer to bid prices are used for comparison, these include charges for entering and exiting the fund as well as other costs paid by the fund in the relevant period. Comparing this figure with an index will no be fair because an index does not include costs of entry and exit.  - The type of fund, investors in closed-ended funds, where funds shares are traded on a stock market, can only buy and sell their investments at a market price. They would compare market offer price and bid prices for fund shares over the period because they reflect the costs of their investment period in the fund; though they will also look at NAV to see how fund share prices relate to these. If fund performance is quoted “offer to offer, “bid to bid” or “NAV to NAV” charges will not have been included in the calculation. 4.3-Time Periods 4.3.1-Diffrernt returns over different time periods Returns over different time periods are very likely to be different. A long period of time through which the performance was, in aggregate, excellent might include shorter periods of worse and even negative returns. 4.3.2-Mispricing performance A fund management company wishing to show itself in the best light may present only performance calculated for the periods when it was at its best and ignore periods of poor performance. It may wish to quote the longer rather than the shorter period to hide volatility, or it may only wish to quote the shorter period if that shows the best performance. Figure 4.1 Volatility From figure 4.1, fund C publishes its performance which shows that its share price from mid-2001 until mid-2002 rose from 5 to 30, an increase of 500%. On the other hand, fund A rose in the same period from 20 to 25, an increase of only 25%. It can be concluded that fund A has increased steadily over a long period, while fund C has been extremely volatile. (Investors in fund C who bought in mid-1999 LOST half of their money by mid-2001) Distortions of performance caused by misapplication of time periods may send the wrong signal to investors and make it impossible for them to make fair comparisons between funds. 4.4-Benchmarks A benchmark is a reference point against which measurement is made. 4.4.1-Making comparisons While knowing the performance of their investment is clearly of interest, investors will wish also to compare it with the performance of other financial products or the performance of other funds, i.e. a benchmark. In comparing an investment with a benchmark investor will wish to assess: -Whether the investment objective is being achieved and whether it would have been achieved better elsewhere. -Whether added value has been provided by the investment manager of a portfolio as opposed to the market. 4.4.2-Comparing a fund to other funds 1-Comparing one fund to another fund The more similar the investment objectives of the funds with which comparisons are made, the more visible the difference in the impact of investment management and the effect of fees and charges. To make comparisons relevant, performance figures must be calculated on a similar basis: the same formula, the same treatment of fees and charges, the same time periods, etc. Comparison between two funds can be made not only through direct comparison of respective performances, but also through comparing the respective performances with another benchmark (e.g. a sector or a more general index). 2-Comparing a fund with an industry average Performance of a fund can be compared with an average (depending on the construction principle – arithmetic or geometric, simple or weighted) of performance of all funds or a group of funds sharing the same features (‘in the same sector’), for instance funds investing only in domestic corporate bonds or only in European ‘blue chip’4 equities. Availability of prices of all funds for a period makes it possible to construct an index showing the average performance of all funds. Then the performance of an individual fund can be compared with the relevant fund index. 3-Comparing funds with other financial products While it is natural to compare a money market fund to a bank deposit, since they both aim to pay back the sum originally invested, performance of equity or bond funds is also often compared with bank deposits since banks commonly compete with funds to attract money. Also, since people may be taking money off deposits to invest in such funds, they want to know if this is likely to prove worthwhile by comparing their performance. 4-Comparing funds with the market Investors also may be interested to see how well or badly their fund investment has done in comparison with the market. In fact, this means a comparison of a fund’s performance with the change in an average price of a particular market sector over a certain period of time. Such a comparison is best made by comparing fund performance with the change in the market index. Of course, it is important that the chosen index is a fair benchmark against which to judge the performance of the fund: comparing a sector specialist fund with the relevant sector index for example. 5-Comparing with economic indicators-Inflation indices Investors may also be interested to see whether their investment in a fund provides a real rate of return (i.e. over and above inflation) – that is, effectively preserves the buying power of their money over time. The comparison of fund performance with inflation indicators is particularly important for investors in countries with high rates of inflation (it is important that such countries take inflation into account when taxing capital gains). Methods of evaluating the performance of investment funds Introduction The performance of investment funds can be evaluated through the following simple models and methods: -Total Return on Fund’s invested capital. -Treynor Model. -Sharpe Model. -Ratios and indicators. 1st Treynor Model It is one of the well-known models used in evaluating the performance of investment funds, which takes into account both the return and the risk factors together. The fund that achieves a higher return than similar funds may be associated with a higher level of risk. The Treynor model focused on evaluating the fund’s performance on the systematic risk that’s affect all the market units, the following equation will be applied to show the fund’s efficiency. Treynor Model = (RMF – RF) ÷ β. Where: RMF = Return on funds invested capital RMF = Risk-Free Rate β = Beta Coefficient, Systematic risk measure Example 1: Below is the data of three mutual funds for one year ending 31/12/2023 Fund A Fund B Fund C Return on Invested 12% 13% 14% Capital Risk-Free Rate 10% 10% 10% Beta Coefficient 0.90 0.9 0.9 Therefore, by applying Treynor Model’: Fund A = (12% - 10%) / 0.90 = 0.022 Fund B = (13% - 10%) / 0.90 = 0.03 Fund D = (14% - 10%) / 0.90 = 0.04 It can be concluded that Fund C is performing better. 2nd Sharpe Model The Sharpe model, when evaluating the performance of investment funds, relies on the capital asset pricing model (CAPM). Therefore, Sharpe model rely on measuring the risk on total risk (σ) not systematic risk. Sharpe Model = (RMF – RF) ÷ σ. Where: RMF = Return on funds invested capital RMF = Risk-Free Rate σ = Standard deviation, risk measure Example 2: Below are the data of two mutual funds for one year ending 31/12/2023 Fund A: σ = 2.1 Fund B: σ = 3.4 Fund A Return = 14% Fund B Return = 16% Risk-Free Rate = 10% By applying for the Sharpe Model Equation: Fund A = (14% - 10%) ÷ 2.1 = 0.019 Fund B = (16% - 10%) ÷ 3.4 = 0.017 It can be concluded that Fund A is better than Fund B. 3rd Measuring Fund’s performance by using financial ratios and indicators In this section the financial analysis of fund’s performance can be applied by using financial ratios and indicators to measure several areas: liquidity measures - debt measures - profitability measures – Investment fund activities analysis. 4th Evaluating Fund Performance Using Financial Ratios Methods of Evaluation: 1st: Comparing Fund’s performance in two different fiscal years. 2nd: Comparing Fund’s performance with other fund’s performance (Growth) same fiscal year. 3rd: Comparing Fund’s performance with other fund’s performance (Income) same fiscal year. 1st: Comparing Fund’s performance in two different fiscal years: Balance Sheet of Fund (X) (Periodic Income) in 31/12/2023 In (000) EGP 31/12/2023 31/12/2022 Assets Cash & Deposits in Banks 42360 5892 T-Bills and CDs in CBE 0 2999 Common Stocks (Local) 104405 97787 Government Securities (Bonds) 10081 17581 Other Securities 4515 5436 Mutual Funds Certificates 39860 12820 Others 619 770 Total Current Assets 201840 143285 Total Current Liabilities (15437) (2606) Fund’s Total Asset Value 186403 140679 No of Outstanding Shares 4035 78 NAV 46.2 18.8 Income Statement as of 31/12/2023 In (000) EGP 31/12/2023 31/12/2022 Return of Invested Securities 7408 7196 Interests Revenues (Banks) 708 228 Budgeting of Price Fluctuations 1695 250 Actual Increase in Securities market value 19091 Actual Increase in invested CDs (Market Value) 3375 1021 Net Income from Selling Securities 24145 3705 Foreign Exchange-Value Differences (580) (80) Other Revenues 407 317 Total Revenues 56249 12637 Expenses Marketing Expenses 317 284 Administrative Expenses 1827 1680 Actual decrease in securities market value 4047 Total Expenses 2144 6011 Net Income 54105 6626 1- Fund’s invested capital turnover = (Total Revenues ÷ Fund’s capital” Total Current Assets”) × 100 In 2023 = 56249 ÷ 201840 = 27.87% = 0.279 times In 2022 = 12637 ÷ 143285 = 8.82% = 0.088 times 2- The ratio of returns on securities investments to the fund's total revenues = Net Income from Selling Securities ÷ Fund’s Total Revenues) × 100 In 2023 = 24145 ÷ 56249 = 42.93% In 2022 = 3705 ÷ 12637 = 29.32% 3- Ratio of securities invested capital to Fund’s capital = Fund’s financial securities ÷ Fund’s capital) × 100 In 2023 = (104405+10081+4515+39860) ÷ 201840 = 78.71% In 2022 = (2999+97787+17581+5436+12820) ÷ 143285 = 95.35% 4- Debt Ratio = (Fund’s Liabilities ÷ Fund’s Assets) × 100 In 2023 = 15437 ÷ 201840 = 7.65% In 2022 = 2606 ÷ 143285 = 1.82% 5- Ratio of T-Bills Invested = (T-Bills invested ÷ Fund’s Assets) × 100 In 2023 = Zero ÷ 201840 = Zero In 2022 = 2999 ÷ 143285 = 2.09% 6- Ratio of Bonds Invested = (Bonds invested ÷ Fund’s Assets) × 100 In 2023 = 10081 ÷ 201840 = 4.99% In 2022 = 17581 ÷ 143285 = 12.27% 7- Gain/Loss of Invested financial securities = (Gain/Loss of Invested financial securities ÷ Fund’s Total Revenues) × 100 In 2023 = 54105 ÷ 56249 = 96.19% In 2022 = 6626 ÷ 12637 = 52.43% 8- Ratio of investment in local Shares = Local Shares ÷ Fund’s Assets) × 100 In 2023 = 104405 ÷ 201840 = 51.73% In 2022 = 97787 ÷ 143285 = 68.25% Summary of Results 30/12/2023 30/12/2022 Fund’s invested capital turnover 27.87% 8.82% The ratio of returns on securities investments to the 42.93% 29.32% fund's total revenues Ratio of securities invested capital to Fund’s capital 78.71% 95.35% Debt Ratio 7.65% 1.82% Ratio of T-Bills Invested Zero 2.09% Ratio of Bonds Invested 4.99% 12.27% Gain/Loss of Invested financial securities 96.19% 52.43% Ratio of investment in local Shares 51.73% 68.25% 2nd: Comparing Fund’s performance with other fund’s performance (Growth) same fiscal year. Balance Sheet of Fund (X) (Periodic Income) in 31/12/2023 In (000) EGP Fund A Fund B Assets Cash & Deposits in Banks 249681 14116 T-Bills and CDs in CBE 79457 Zero Common Stocks (Local) 578871 278917 Certificates of CBE Zero 218104 Other Securities Zero Zero Mutual Funds Certificates Zero 6990 Others 692 300 Total Current Assets 908701 518427 Total Current Liabilities 68422 24560 Fund’s Total Asset Value 840279 493867 No of Outstanding Shares 6127 4470 NAV 137.14 110.5 Par-Value of Fund’s Share 100 100 Income Statement as of 31/12/2023 In (000) EGP Fund A Fund B Return of Invested Securities 17360 27730 Interests Revenues (Banks) 8145 1033 Budgeting of Price Fluctuations Zero Zero Actual Increase in Securities market value 157702 47837 Actual Increase in invested CDs (Market Value) Zero 762 Net Income from Selling Securities 44094 3732 Extra Ordinary Revenues Zero Zero Other Revenues Zero Zero Total Revenues 227301 81094 Expenses Marketing Expenses 9605 6360 Administrative Expenses 15383 5576 Actual decrease in securities market value 6120 7601 Budgeting of Price Fluctuations 4277 15621 Distributed Profits 64347 23864 Total Expenses 99732 59022 Net Income 127569 22072 Required is the Evaluation of Fund A and Fund B (From Tutorial) Cost of investing in Mutual Funds Introduction In this chapter, the focus will be on the following main topic dealing with mutual funds: - Cost of investing in mutual funds. 6.1- Cost of investing in mutual funds Fee Structure An individual investor choosing a mutual fund should consider not only the fund’s stated investment policy and past performance, but also its management fees and other expenses. Investors should be aware of four general classes of fees. 6.1.1- Operating expenses Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, may range from 0.2% to 2%. Shareholders do not receive an explicit bill for these operating expenses; however, the expenses periodically are deducted from the assets of the fund. Shareholders pay for these expenses through the reduced value of the portfolio. So, the average expense ratio weighted by assets under management is considerably smaller. In addition to operating expenses, most funds assess fees to pay for marketing and distribution costs. These charges are used primarily to pay the brokers or financial advisers who sell the funds to the public. Investors can avoid these expenses by buying shares directly from the fund sponsor, but many investors are willing to incur these distribution fees in return for the advice they may receive from their broker. 6.1.2- Front-end load A front-end load is a commission or sales charge paid when you purchase the shares. These charges, which are used primarily to pay the brokers who sell the funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds have loads that range up to 3% of the funds invested. No-load funds have no front-end sales charges. About half of all funds today (measured by assets) are no load. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with a 6% load results in a sales charge of $60 and fund investment of only $940. You need cumulative returns of 6.4% of your net investment (60/940 =.064) just to break even. 6.1.3- Back-end load A back-end load is a redemption, or “exit,” fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce them by one percentage point for every year the funds are left invested. Thus, an exit fee that starts at 6% would fall to 4% by the start of your third year. These charges are known more formally as “contingent deferred sales charges.” 6.1.4- 12b-1 charges The Securities and Exchange Commission allows the managers of so-called 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. The 12b-1 fees are limited to 1% of a fund’s average net assets per year. 6.2- Fees and Mutual Fund Returns The rate of return on an investment in a mutual fund is measured as the increase or decrease in net asset value plus income distributions such as dividends or distributions of capital gains expressed as a fraction of net asset value at the beginning of the investment period. If we denote the net asset value at the start and end of the period as NAV0 and NAV1, respectively, then Rate of return = (NAV1 - NAV0 + Income and capital gain distributions) ÷ NAV0 For example, if a fund has an initial NAV of $20 at the start of the month, makes income distributions of $.15 and capital gain distributions of $.05, and ends the month with NAV of $20.10, the monthly rate of return is computed as: Rate of return = ($20.10 - $20.00 + $.15 + $.05) ÷ $20.00 =.015, or 1.5%. Notice that this measure of the rate of return ignores any commissions such as front-end loads paid to purchase the fund. On the other hand, the rate of return is affected by the funds’ expenses and 12b-1 fees. This is because such charges are periodically deducted from the portfolio, which reduces net asset value. Thus, the rate of return on the fund equals the gross return on the underlying portfolio minus the total expense ratio. To see how expenses can affect the rate of return, consider a fund with $100 million in assets at the start of the year and with 10 million shares outstanding. The fund invests in a portfolio of stocks that provides no income but increases in value by 10%. The expense ratio, including 12b-1 fees, is 1%. What is the rate of return for an investor in the fund? The initial NAV equals $100 million/10 million shares = $10 per share. In the absence of expenses, fund assets would grow to $110 million, and NAV would grow to $11 per share, for a 10% rate of return. However, the expense ratio of the fund is 1%. Therefore, $1 million will be deducted from the fund to pay these fees, leaving the portfolio worth only $109 million, and NAV equal to $10.90. The rate of return on the fund is only 9%, which equals the gross return on the underlying portfolio minus the total expense ratio. Fees can have a big effect on performance. Table 6.1 considers an investor who starts with $10,000 and can choose between three funds that all earn an annual 12% return on investment before fees but have different fee structures. The table shows the cumulative amount in each fund after several investment horizons. Fund A has total operating expenses of.5%, no load, and no 12b-1 charges. This might represent a low-cost producer like Vanguard. Fund B has no load but has 1% management expenses and.5% in 12b-1 fees. This level of charge is typical of actively managed equity funds. Finally, Fund C has 1% in management expenses, has no 12b-1 charges, but assesses an 8% front-end load on purchases. Note the substantial return advantage of low-cost Fund A. Moreover, that differential is greater for longer investment horizons. Table 6.1 Impact of costs on investment performance Cumulative Proceeds (all dividends reinvested) Fund A Fund B Fund C Initial Investment* $10,000 $10,000 $9,200 5 years 17,234 16,474 15,502 10 years 26,699 27,141 26,123 15 years 51,183 44,713 44,018 20 years 88,206 73,662 74,173 Notes: Fund A is no-load with a 0.5% expense ratio, Fund B is no-load with 1.5% total expense ratio, and Fund C has an 8% load on purchases and a 1% expense ratio. Gross return on all funds is 12% per year before expenses. * After front-end load, if any.