1 Chapter 23 Mutual Fund Operations © 2001 South-Western College Publishing Company

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Chapter 23

Mutual Fund Operations

© 2001 South-Western College Publishing Company

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Background on Mutual Funds

Mutual funds offer a way for small investors to diversify when they could not do so on their own with the purchases of individual stocks

Comparison to depository institutionsLike depository institutions, mutual funds

repackage proceeds from individuals to make investments

Bank deposits are a form of credit but a mutual fund represents partial ownership

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Mutual funds adhere to a variety of federal and state regulations Securities and Exchange Commission (SEC) regulates -

SEC Act 1993 Disclosure since 1993 of manager’s name and length of

time employed in that position Funds must register and provide a prospectus to

investors Investment Company Act of 1940 contains restrictions to

prevent conflicts of interest between investors and mangers

Exempt from tax if fund distributes 90 percent of taxable income

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Information contained in a prospectusThe minimum amount of investment requiredThe investment objective of the fundThe return on the fund over the past year, the

past three years and the the past five yearsThe exposure of the fund to various types of

riskServices the fund offersThe fees incurred and passed on to investors

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Distributions to shareholders or returns to stockholders can take three formsPass on any earned income from dividend or

coupon payments as a dividendDistribute the capital gains from the sale of

securities in the fundMutual fund price appreciation

• As market price goes up, NAV increase

• Shareholders benefit if they sell shares

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Mutual fund classifications depend on the type of securities the fund invests in and can includeStock or equity mutual fundsBond mutual fundsMoney market mutual funds

Many investment companies offer a family of funds to meet the needs of diverse customer preferences

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Management of mutual fundsManagers invest in a portfolio of securities to

meet the needs of investorsCover management costs with fees which are

typically less than one percent of total assets per year

Managers adjust the composition of their portfolios in response to market and economic conditions

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ExpensesFees include management plus record-

keeping and clerical feesPassed on to investors since NAV is reduced

by feesCompare expense ratios

A fund’s emphasis on marketing in order to attract more investors may not enhance performance because fees increase

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Corporate control by mutual fundsMutual funds are large shareholders in

companies whose stock they holdManagers may serve on the board of

directors of companies in which the fund invests

Companies try to satisfy mutual fund managers in order to keep them from selling their stake in the firm

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Stock Mutual Fund Categories

Growth funds for investors who want high returns with moderate risk Invest in companies that expect to grow at a

higher than average rateGenerate an increase in investment value

rather than steady income Capital appreciation or aggressive growth funds

High but unproven growth potential stocksHigher risk

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Growth and income funds try to offer growth but with some stability of income

International and global funds allow investment in foreign securities without the costs involved in purchasing and monitoring individual stocksReturns affected by stock pricesReturns also affected by foreign exchange rates

A global mutual fund invests in some U.S. stocks

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Internet funds focus on investments in Internet companies

Specialty funds focus on a group of companies sharing a particular characteristic

Index funds are designed to simply match the performance of an existing stock index

Multifund funds invest in a portfolio of different mutual fundsMore diversified Involves higher expenses

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Bond Fund Investment Objectives

Risks in bond funds Interest rate riskCredit risk

Tax implications of bond fund investments Income funds vary in terms their exposure to credit

risk and focus on periodic coupon payments and attract investors who are Interested in periodic income since prices are

volatilePlan to hold the fund long term

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Tax-free funds for high tax bracket investors High-yield or junk bond funds invest in bonds

with a high risk of default International and global bond funds

International bond funds contain bonds issued by governments or corporations from other countries

Global funds may contain both U.S. and foreign bonds

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Maturity classifications Interest rate sensitivity depends on the

maturity of bondsFunds are typically segmented based on

maturity

• Intermediate-term funds invest in bonds with 5 to 10 years remaining to maturity

• Long-term funds invest in maturities of 15 to 30 years

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Asset allocation fundsFunds that contain a variety of investmentsComposition among stocks, bonds and

money market securities is based on manager’s expectations

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Performance of Mutual Funds

Investors should diversify among different kinds of funds to reduce volatility

Research on stock mutual fund performanceUsing return only is not valid Mutual funds typically do not outperform the

market Include risk and expenses

Research on bond mutual funds

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Money Market Funds

Money market funds are portfolios of short-term assetsCan include check-writing privileges for

investorsNumber of checks per month may be

restrictedShareholders get periodic statementsLiquid

Documents

1 Chapter 23 Mutual Fund Operations © 2001 South-Western College Publishing Company