Mutual Funds Chapter 1 Final (1) PDF

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

Faculty of Economics and International Trade Module Name: Mutual Funds Management & Valuation Module Code: FIN-E04 Level IV Finance Department Course Leader: Ihab Raouf Petro Head of Finance Department (Acting) Course Assistants: Celine Nabil Teaching Assistant (Finance Department) Youmna Ahmed Teaching Assistant (Finance Department) 2024 Chapter 1: Understanding Mutual Funds Introduction It is usually advised that an investor with limited savings should not invest them in securities. Given the possibility that those savings may not be sufficient to purchase a variety of those securities, which would reduce the level of risk his savings might be exposed to. The small size of savings is not the only reason for investors' reluctance to invest directly in securities. There are investors who have abundant financial resources that enable them to purchase a suitable portfolio of securities, but they refrain from doing so either due to a lack of expertise and knowledge to manage such a portfolio, or due to a lack of sufficient time. To meet the needs of these investors, specialized companies were established to build and manage public portfolio formations or investment funds named “Mutual Funds”. A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates. 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 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-end) and (open-end). 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-end 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-end 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-How Mutual Funds are structured? A mutual fund is usually either a corporation or a business trust (which is like a corporation). Like any corporation, a mutual fund is owned by its shareholders. Virtually all mutual funds are externally managed; they do not have employees of their own. Instead, their operations are conducted by affiliated organizations and independent contractors. The illustration below shows the business structure of a typical mutual fund. Figure 1.1: Mutual Fund Structure 1.3-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. 1.4-Who invests in funds? Most collective investment funds are designed to attract ordinary people to invest and are commonly known as ‘publicly offered’ or more rarely ‘non-specialized’ or ‘diversified’ funds. However, these funds may also attract institutional investors, such as pension funds or insurance or other collective investment funds that may wish to use funds for many of the same reasons as individuals do: to achieve diversification; or to lower the costs of portfolio management; or to utilize professional management they may lack the expertise to invest in specialist areas so choose to attain this exposure through a fund instead. However, whoever or whatever the investor may be, a collective investment fund performs the same function: gathering sums of money from a variety of investors, pooling it together, and using a professional management company to invest the money in a spread of investments which will, in turn, hopefully achieve capital growth or bring in an income, in the form of dividends from companies or interest from bonds or deposits (or more rarely rental on real estate), (Figure 1.3). These returns (capital gain, income) belong to fund investors. Figure 1.3: The function of a collective investment fund. 1.5-Collective Investment Funds Broadly, a ‘fund’ is a pool of money contributed by a range of investors who may be individuals or companies or other organizations, which is managed and invested as a whole, on behalf of those investors. Generically such funds are sometimes known as ‘collective investments’ since they collect people’s money together. Traditionally, most collective investments fell into one of three main categories: -Pension Funds: that is, funds into which people save during their working life, which can only normally be accessed upon their retirement, in order to receive a pension (in some countries provident funds fulfil a similar role). -Insurance Funds: that is, funds into which people save whereby the fund agrees to pay them a specific sum upon the occurrence of certain events (such as the inappropriately named life insurance which pays out on death, to the deceased’s nominated beneficiaries). -Investment Funds: into which people save, but where money can be put into and taken out of the fund at any time and where payouts are not specifically related to any one event occurring. This book is about this last category– known as collective investment funds. 1.6-Key Differences between Collective Investment Fund and Mutual Fund Although both offer a variety of investment options and consist of a basket of assets. CIFs differ from mutual funds in several meaningful ways. The below clearly outlines the differences between mutual funds and collective investment funds. Pros Diversified portfolio Lower management and distribution costs Held to bank fiduciary standard Tax-exempt earnings Cons Available only through employer retirement plans Performance difficult to track Less transparent operations Fewer investment options -Perhaps most notably, CIF tends to have lower operating costs than mutual funds, since they don’t have to meet Securities and Exchange Commission (SEC) reporting requirements. -CIFs are also offered only by banks and trust companies for retirement plans and not available to the public, unlike mutual funds, which investors can purchase directly or through a financial intermediary, such as a broker. -The oversight of CIFs is usually delivered by managers employed by the trustee, whereas mutual funds are led either by a mutual fund manager or group of managers as approved by a board of directors. 1.7-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 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.