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CHAPTER 8 Investment Products and Markets:
Mutual fund (investment company)
Corporation that uses it’s capital to purchase investment vehicles instead of plant and equipment.
Suitability (who are they best for?)
Best return ; minimizing risksLimited amount of money
How do you make money?
Dividends or interest from within portfolioCapital gains from within the portfolioCapital gains from the shares of the portfolio
MUTUAL FUND BASICS
What is the difference between an open-end and a closed-end mutual fund?
Open ClosedUnlimited shares Limited sharesAlways primary market trade on an exchangeReflects the value of the portfolio supply and demand also impact value
What are the three primary advantages of a mutual fund?
DiversificationProfessional money mgtliquidity
TYPES OF MUTUAL FUNDS (objectives)
Aggressive Growth
Growth
International/Global
International should only have investments outside the US
Global could include US investments
Growth and Income
Fixed Income
Balanced/Equity Income
Specialty/Sector
Asset Allocation
Money Market
Index
Loads
Commissions
Front-end - pay up front
Redemption – pay to redeem
Contingent deferred sales charges – pay a decreasing commission if sell within a certain period of time (CDSC)
FEES AND EXPENSES
Management Fees and Operating Expenses
12b-1 Fees
Trustee Fees
Expense Ratio
Ratio of expenses to NAV
Higher the ratio, better the manager must perform to generate a desired return.
The more expensive it is to own the investment
Higher returns could offset higher expenses (or not)
Mutual Fund Basics
The People
Investment Advisor
Day to day investment decisionsMoney manager
Custodian / Transfer Agent
BookkeeperSafekeeping securities and cash
Analysis of Mutual Funds
Three basic areas
1) first you select funds that match investment objectives.
2) next rank funds by statistical performance measures
This can be done manually or via software
Morningstar has a filter that can assist
The premium filter allows ranking by different statistics
3) non-statistical measures
Really not a ranking tool
Most mutual funds either by law or necessity provide the same services
That is not to say that customer service quality is the same!!
Prospectus
READING MUTUAL FUND PROSPECTUS
INVESTMENT OBJECTIVES AND POLICIES
RISK FACTORS
INVESTMENT RESTRICTIONS
PAST PERFORMANCE
FUND INFORMATION
COSTS AND FEES
MISCELLANEOUS INFORMATION
A document provided by mutual fund that describes in some detail the characteristics of this mutual fund.
The components are mandated by law
A mutual fund is always a primary market transaction; unlike stocks
This requires a prospectus be provided at or before the sale of any mutual fund.
A prospectus has a life of 13 months
Classes of Shares
What is meant by share class?
No distinction between portfoliosMarketing of the loads and expenses
Class A shares
Front load; lower fees; no redemption load
Class B
CDSC condition al deferred sales charge
No front load; only a redemption load if sold within a certain time frame; higher initial fees higher than “A” but then they are lowered after time
Class C
No load; usually higher fees
These fees never reduce
Misc other classes
Institutional shares have a variety of combinations of fees and loads
• How to choose between Class A and B
– Class A shares have a front load
• they also have a declining load schedule as investment increases
– Class B shares are CDSC; but have higher initial expenses
• As holding period increases, potential redemption load decreases
• Eventually become Class A
• If have large sum or will be investing over time, Class A may be more expensive
• If do not have a large sum to invest, the choice is really about when to pay the load. (up front or over time)
• Not a clear choice all the time. Regulation has dictated how and when some classes can be
Mutual Funds Restrictions
a list of restricted investment vehicles and strategies will be listed in the prospectus.
Potential list
No margin or short sales
No underwriting except their own shares
No investment in commodities
No private placement
No controlling interest
No more 5% value of total assets
No more 10% voting stock
No borrowing except for emergencies and only from a bank.
Diversified Investment Companies
The 5% and 10% rule actual applies to 75% of the mutual funds cash
The remaining 25% of cash can be invested in any security or company.
Prices
NAV (Net Asset Value)
Equivalent of share price
Represents the current value of one share of the investment portfolio
POP (public offering price)
Incorporates the load
NAV = $12 with a 5.75% load
What is the POP of a mutual fund with a NAV of 37.25, and a 4.5% front load?
POP=37 .251−.045
=39.005
Who gets the extra 1.755?
Break Point Qualification
NAV= Assets - Liabilities# of shares
POP= NAV1−load%
POP=121−.0575
=12.73
How can you “beat” break points?
Large Sum purchaseLetter of intent Can back date 90 days Have 13 months to break the point Not a contractual arrangementAccumulated funds
Redemption of shares
How do you “sell” the shares
In the stock market shares are sold back through the brokerage. They are purchased by another investor.
With mutual funds the process is different. The mutual fund company by law must “redeem” the shares within 7 days of a request. It is the mutual fund that buys the shares from the old shareholder.
Remember these shares are retired and never sold to another investor.
Services
Reinvestment Privilege
Current income and capital gains are automatically reinvested (buy more shares)
No load charged
You must request distribution in cash if you want it.
Conversion Privilege
Can move share between same fund family funds at no load.
Taxable though unless in a retirement account
Systematic Withdrawals (investments)
Can request to have funds automatically deposited to or withdrawn from an account
MUTUAL FUND RATING SERVICES
MORNINGSTAR
Industry’s best resource for comprehensive, unbiased and accurate mutual fund information
LIPPER
Leading global mutual fund information company analyzing fund companies and financial intermediaries
STANDARD & POOR’S
Leading global provider for mutual fund information and analysis
THOMAS FINANCIAL
Global provider of data, analysis, and information tools
TRADITIONAL INDEX FUNDS
Index funds hold shares in all the companies that make up an index like S&P 500
NOT true. They rarely hold the shares of all. They attempt to create a “clone”
ADVANTAGES
Fewer Capital Gains
Keeping Pace with Selected Index
Painless Strategy
Lower Cost
PITFALLS OF INDEX FUNDS
Downside Risk
Skewed Weighting Systems
Do they actually copy the index?
Divergence Between Index Funds
How can different index funds have different returns?
Narrow Focus
Lose the Value Added by Money Managers
Increased Volatility