Chapter 23 Mutual Fund Operations 1 Chapter Outline Background on mutual funds Stock mutual fund categories Bond fund categories Growth and size of mutual funds Performance of mutual funds Mutual fund scandals 2 Chapter Outline cont d Money market funds Hedge funds Real estate investment trusts Interaction with other financial institutions Use of financial markets Globalization through mutual funds 3 Background on Mutual Funds Mutual funds Serve as a financial intermediary by pooling investments by individual investors and using the funds to accommodate financing needs by governments and corporations in the primary market Frequently invest in securities in the secondary market Provide an important service for individuals who wish to invest Offer liquidity if they are willing to repurchase an investor s funds and diversify shares upon request Offer various different services such as transfers between funds and check writing privileges 4 Background on Mutual Funds cont d A mutual fund hires portfolio managers to invest in a portfolio of securities that satisfies the desires of investors The portfolio composition is adjusted in response to changing economic conditions The board of directors Monitors management Establishes procedures Ensures that the fund is properly serving its shareholders Under new SEC rules a majority of board members must be outsiders 5 Background on Mutual Funds cont d Types of funds Open end funds Are open to investment from investors at any time Allow investors to purchase or redeem shares at any time Have a constantly changing number of shares Maintain some cash in case redemptions exceed Consist of many different categories to satisfy investors investments investment needs 6 Background on Mutual Funds cont d Types of funds cont d Closed end funds Do not repurchase shares they sell Require investors to sell the shares on a stock exchange Have a constant number of outstanding shares Have an asset size that is about 1 40th of the asset size of open end funds Focus primarily on bonds and other debt securities 7 Background on Mutual Funds cont d Types of funds cont d Exchange traded funds Are designed to mimic particular stock indexes and are traded on a stock exchange Differ from open end funds in that their shares are traded on an exchange and their share price changes throughout the day Consist of a fixed number of shares Are not actively managed Have become very popular in recent years Typically do not have capital gains and losses that must be distributed to shareholders 8 Background on Mutual Funds cont d Types of funds cont d Hedge funds Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Differ from open end funds because They require a much larger initial investment They may not always accept additional investments or accommodate redemption They are unregulated and provide very limited information to They invest in a wide variety of investments to achieve high prospective investors returns 9 Background on Mutual Funds cont d Comparison to depository institutions Mutual funds repackage the proceeds from individuals to make various types of investments Investing in mutual funds represents partial ownership Investors share the gains or losses generated by the fund 10 Background on Mutual Funds cont d Information contained in a prospectus The minimum amount of investment required The investment objective The return on the fund over the past year the past three years and the past five years The exposure of the fund to various types of risk The services offered by the fund The fees incurred by the find that are passed on to investors 11 Background on Mutual Funds cont d Estimating the net asset value The net asset value NAV of a mutual fund indicates the value per share Estimated each day by determining the market value of all securities comprising the fund adding interest or dividends and subtracting expenses then dividing by the number of shares outstanding 12 Computing the NAV Philly Mutual Fund has 50 million shares issued to its investors It used the proceeds to buy stock in 100 different firms These shares have a market value of 100 million In addition Philly incurred 7 000 in expenses today and collected interest and dividends totaling 5 000 What is the net asset value per share Net asset value Market value of fund numbe of r shares 100 000 99 998 00 2 00 000 5 000 0 50 000 0 00 7 000 50 000 000 13 Background on Mutual Funds cont d Distributions to shareholders Mutual funds generate returns to shareholders in three ways They pass on earned income as dividend payments They distribute capital gains resulting from the sale of securities within the fund Mutual fund share price appreciation Mutual fund classifications Stock mutual funds bond mutual funds or money market mutual funds see next slide 14 Background on Mutual Funds cont d Distribution of Investment in Mutual Funds 17 6 27 50 Stock Funds Money Market Funds Hybrid Funds Bond Funds 15 Background on Mutual Funds cont d Expenses incurred by shareholders Mutual funds pass their expenses on to their shareholders Expenses can be compared among mutual funds by comparing the expense ratio Equal to annual expenses per share divided by the NAV The higher the expense ratio the lower the return for a given level of performance Mutual funds with lower expense ratios tend to outperform others with similar objectives 16 Background on Mutual Funds cont d Expenses incurred by shareholders cont d Expenses include Compensation to the portfolio managers and other employees Record keeping and clerical fees Marketing fees 17 Background on Mutual Funds cont d Sales load Load funds have a sales charge Promoted by brokerage firms who earn a sales charge between 3 and 8 5 percent Investors pay the sales charge through the difference between the bid and ask prices of the load fund Front end load versus back end load 18 Background on Mutual Funds cont d Sales load cont d fund of concern investment decisions No load funds are promoted strictly by the mutual Preferred by investors who feel capable of making their own Recently some small no load funds have become load funds because they could not attract sufficient investors 19 Background on Mutual Funds cont d Corporate control by mutual funds Large mutual funds can exert control over the management of firms because they are commonly a firm s largest shareholders e g Fidelity is the largest shareholder of more than 700