Textbook Questions
The Mutual Fund Concept
1. LG 1
2. LG 2
Questions of which stock or bond to select, how best to build a diversified portfolio, and how to manage the costs of building a portfolio have challenged investors for as long as there have been organized securities markets. These concerns lie at the very heart of the mutual fund concept and in large part explain the growth that mutual funds have experienced. Many investors lack the know-how, time, or commitment to manage their own portfolios. Furthermore, many investors do not have sufficient funds to create a well-diversified portfolio, so instead they turn to professional money managers and allow them to decide which securities to buy and sell. More often than not, when investors look for professional help, they look to mutual funds.
Basically, a mutual fund (also called an investment company) is a type of financial services organization that receives money from a group of investors and then uses those funds to purchase a portfolio of securities. When investors send money to a mutual fund, they receive shares in the fund and become part owners of a portfolio of securities. That is, the investment company builds and manages a portfolio of securities and sells ownership interests—shares—in that portfolio through a vehicle known as a mutual fund.
An Advisor’s Perspective
Catherine Censullo Founder, CMC Wealth Management
“Mutual funds are pools of assets.”
MyFinanceLab
Portfolio management deals with both asset allocation and security selection decisions. By investing in mutual funds, investors delegate some, if not all, of the security selection decisions to professional money managers. As a result, investors can concentrate on key asset allocation decisions—which, of course, play a vital role in determining long-term portfolio returns. Indeed, it’s for this reason that many investors consider mutual funds the ultimate asset allocation vehicle. All that investors have to do is decide in which fund they want to invest—and then let the professional money managers at the mutual funds do the rest.
An Overview of Mutual Funds
Mutual funds have been a part of the investment landscape in the United States for 91 years. The first one started in Boston in 1924 and is still in business. By 1940 the number of mutual funds had grown to 68, and by 2015 there were more than 9,300 of them. To put that number in perspective, there are more mutual funds in existence today than there are stocks listed on all the major U.S. stock exchanges combined. As the number of fund offerings has increased, so have the assets managed by these funds, rising from about $135 billion in 1980 to $15.8 trillion by the end of 2014. Compared to less than 6% in 1980, 43% of U.S. households (90 million people) owned mutual funds in 2014. The mutual fund industry has grown so much, in fact, that it is now the largest financial intermediary in this country—even ahead of banks.
Mutual funds are big business in the United States and, indeed, all over the world. Worldwide there were more than 79,000 mutual funds in operation in 2014, which collectively held $31.4 trillion in assets. U.S. mutual funds held roughly half of those assets. Measured by the number of funds or by assets under management, U.S. stock funds hold the largest share of mutual fund assets. Figure 12.1 shows the major types of mutual funds and their share of total assets under management. Funds that invest primarily in U.S. stocks (domestic equity) managed 42% of assets held by mutual funds in 2014, and funds investing in foreign stocks held another 14% of industry assets. The share of mutual fund assets invested in domestic and world stocks has been rising in recent years, while the share of assets invested in fixed-income securities such as bonds and money market instruments has fallen. The decline in assets invested in fixed-income instruments reflects the historically low interest rates that have prevailed in the market in recent years.
Figure 12.1U.S. Mutual Fund Assets under Management by Type of Fund
The chart shows the distribution of mutual fund assets under management by type of fund. Funds that invested in either domestic or foreign stocks managed 56% of industry assets, while funds that invested in fixed-income assets such as bonds and money market instruments managed 36% of industry assets. Just three years earlier, equity and fixed-income funds held roughly an equal share of industry assets, but with interest rates stuck at historically low levels, investors have been moving out of bonds and into stocks.
(Source: Data from the 2015 Investment Company Institute Factbook, https://www.ici.org/pdf/2015_factbook.pdf .)
How Mutual Funds Get Started
Mutual funds appeal to investors from all walks of life and all income levels. Both inexperienced and highly experienced investors hold mutual funds in their portfolios. All of these investors have a common view: Each has decided, for one reason or another, to turn over at least a part of his or her investment management activities to professionals.
Pooled Diversification
The mutual fund concept is based on the simple idea of combining money from a group of people with similar investment goals and investing that money in a diversified portfolio. This idea is called pooled diversification . Mutual funds make it easy for investors to hold well-diversified portfolios, even if the amount of money that they can invest is relatively small. It’s not uncommon for a single mutual fund to hold hundreds of different stocks or bonds. For example, as of March 2015 Fidelity Contrafund held 335 different securities, while the Dreyfus GNMA fund held 830 securities. That’s far more diversification than most individual investors could ever hope to attain by purchasing individual securities on their own. Yet each investor who owns shares in a fund is, in effect, a part owner of that fund’s diversified portfolio of securities.
No matter what the size of the fund, as the securities it holds move up and down in price, the market value of the mutual fund shares moves accordingly. When the fund receives dividend and interest payments, they too are passed on to the mutual fund shareholders and distributed on the basis of prorated ownership. Thus, if you own 1,000 shares in a mutual fund and that represents 1% of shares outstanding, you will receive 1% of the dividends paid by the fund. When the fund sells a security for a profit, it also passes the capital gain on to fund shareholders on a prorated basis.
Active versus Passive Management
Broadly speaking, mutual funds fall into one of two categories based on how they decide which securities to buy. In an actively managed fund , a professional portfolio manager conducts an analysis to determine which securities are likely to exhibit above-average future performance. The portfolio manager might conduct fundamental analysis by combing through companies’ financial reports and developing complex valuation models to estimate the intrinsic value of many different securities. The manager would then invest in those securities whose intrinsic values were greater than their market prices. Alternatively, the manager might use technical analysis to try to spot trends that predict the direction in which securities prices will move in the near future. In either case, the manager’s goal is to identify and invest in securities that will achieve superior performance.
Comparing the portfolio’s performance to a benchmark assesses whether the manager succeeds or fails in that task. The benchmark to which a particular fund is compared should have a similar risk profile as the fund. For example, if a particular fund’s objective is to invest in large, blue-chip companies, that fund’s benchmark might be the S&P 500 stock index. The fund manager’s goal is to generate higher returns, after fees, than the S&P 500 Index. On the other hand, if a particular fund focuses on investing in small-cap stocks, the S&P 500 would be a poor benchmark because small-cap stocks are riskier than the large-cap firms in that index. Instead, an index like the Russell 2000 Index would be an appropriate benchmark.
Consider the consequences of setting an inappropriate benchmark for a fund. Suppose a fund investing in small-cap stocks sets the S&P 500 as its benchmark. Because stocks in the S&P 500 are less risky than small-cap stocks, over time we would expect returns on the S&P 500 to be lower than returns on a small-cap portfolio. In other words, a small-cap fund should outperform the S&P 500, not because the fund manager is skillful, but because the fund invests in riskier assets. To the extent that fund managers are judged based on their ability to earn a return above some benchmark, there will be at least some incentive for the fund to compare its performance to a less risky benchmark.
Watch Your Behavior
Beating the Benchmarks Investment companies that offer a variety of mutual funds often advertise that a high fraction of their funds outperform their benchmarks. Investors should be wary of these claims. Mutual fund families often close funds that trail their benchmarks (or merge them into other funds outperforming the benchmark). This “survivorship bias” artificially raises the percentage of mutual funds in a particular family outperforming a benchmark. Numerous studies have shown that without the benefit of survivorship bias, most mutual funds trail their benchmarks.
In a passively managed fund, managers make no attempt to select a portfolio that will outperform a benchmark. Instead, passively managed funds are designed to mimic the performance of a particular benchmark or stock index. The Vanguard S&P 500 Index fund described at the beginning of this chapter is a perfect example of a passively managed fund. In these funds, the manager’s goal is to track the performance of the index as closely as possible while keeping expenses as low as possible. Indeed, the management fees charged by passively managed funds are, on average, a small fraction of the fees charged by actively managed funds. Purveyors of passively managed funds appeal to investors by arguing that actively managed funds offer only the possibility of earning superior returns, but their higher expenses are a certainty.
Attractions and Drawbacks of Mutual Fund Ownership
Among the many reasons for owning mutual funds, one of the most important is the portfolio diversification that they can offer. As we saw above, fund shareholders can achieve diversification benefits by spreading fund holdings over a wide variety of industries and companies, thus reducing risk. Because they buy and sell large quantities of securities, mutual funds generally pay lower transactions costs than individual investors would pay to trade the same securities. Another appeal of mutual funds is full-time professional management. In the case of actively managed funds, investors delegate the task of selecting securities to a highly trained fund manager, but even in a passively managed fund, there are record-keeping chores and other routine tasks that fund managers can perform more efficiently than can individual investors. Still another advantage is that most mutual fund investments can be started with a modest amount of investment capital. With a few thousand dollars an investor can purchase a claim on a portfolio containing hundreds of different securities. The services that mutual funds offer also make them appealing to many investors. These services include automatic reinvestment of dividends and capital gains, record keeping for taxes, and exchange privileges. Finally, mutual funds offer convenience. They are relatively easy to buy and sell, and investors can easily find up-to-date information about a fund’s price and its recent performance.
There are, of course, some costs associated with mutual fund ownership. Mutual funds charge a variety of fees which, in some cases, can be quite significant. Some funds carry a “sales load,” which is an up-front fee that investors pay to acquire shares in the fund (like a commission). Funds charge other fees to cover the expenses of running the fund. These expenses include the compensation of the portfolio manager and staff, advertising expenses, and other administrative and operating costs. Collectively, these fees (excluding the separate sales load) are known as the fund’s expense ratio . The expense ratio is a charge, expressed as a percentage of assets managed by a fund, that fund investors pay each year. Investors pay these expenses each year regardless of whether the fund has a good year or a bad year. Expense ratios vary a great deal from one fund to another. The expense ratio for the median (mean) actively managed fund was 1.25% (0.86%) in 2014. If you invest $10,000 in a fund charging a 1.25% expense ratio, you will pay $125 per year in fees regardless of how the fund’s investments perform. The expense ratios charged by passively managed funds are typically much lower. The median (mean) expense ratio for passive funds was 0.44% (0.11%) in 2014. Some mutual funds justify higher fees by claiming that their managers will generate superior returns, but investors should be wary of those claims. There is not much evidence that mutual funds on average earn above-average returns. There are some notable exceptions, of course, but most actively managed funds do little more than keep up with the market. In many cases, they don’t even do that. For example, 82% of actively managed large-cap equity funds trailed their benchmark over the 10-year period ending in 2014. The spotty performance record and relatively high fees of actively managed funds have drawn more and more investors to passively managed funds over time.
Investor Facts
Passive Funds Gaining Ground In 2014, U.S. equity funds that were passively managed received $166.6 billion of new money from investors, while actively managed equity funds had $98.4 billion in withdrawals. This is part of a long-term trend which has seen the share of passively managed equity funds grow from 9.4% in 2000 to 20.2% in 2014.
(Source: 2015 Investment Company Institute Factbook, http://www.icifactbook.org/pdf/2015_factbook.pdf )
Performance of Mutual Funds
For an actively managed fund, the goal is to earn a return that exceeds the fund’s benchmark by more than enough to cover the fund’s fees. But how successful are professional fund managers at achieving this goal? Figure 12.2 provides some evidence on that question. The figure shows the percentage of mutual funds in various categories that were outperformed by their benchmark over a five-year period from 2009 to 2014. The figure focuses on a five-year investment horizon in part to smooth out the volatility of year-to-year performance but also because investors want to know whether actively managed funds can deliver superior performance consistently. Unfortunately, the news in Figure 12.2 is not good for portfolio managers. Across a wide variety of funds, a majority of portfolio managers trail their benchmark. Looking at all U.S. equity funds, 74% of managers failed to earn a higher five-year return than their benchmark. Bond fund managers fared worse, with 85% of junk bond funds and 96% of long-term bond funds trailing their benchmarks. The only group in which a majority of fund managers beat their benchmark was the short-term bond category, and even there 49% of funds trailed the
Figure 12.2 Percentage of Mutual Funds Outperformed by Their Benchmarks from 2009 to 2014
Even with the services of professional money managers, it’s tough to outperform the market. In this case, only one fund category had a majority of funds that succeeded in beating the market during the five-year period from 2009 to 2014.
(Source: SPIVA U.S Scorecard, mid-year 2014, http://www.spindices.com/documents/spiva/spiva-us-mid-year-2014.pdf )
benchmark while 51% exceeded it. The message is clear: Consistently beating the market is no easy task, even for professional money managers. Although a handful of funds have given investors above-average and even spectacular rates of return, most mutual funds simply do not meet those levels of performance. This is not to say that the long-term returns from mutual funds are substandard or that they fail to equal what you could achieve by putting your money in, say, a savings account or some other risk-free investment outlet. Quite the contrary. The long-term returns from mutual funds have been substantial (and perhaps even better than what many individual investors could have achieved on their own), but a good deal of those returns can be traced to strong market conditions and/or to the reinvestment of dividends and capital gains.
How Mutual Funds Are Organized and Run
Athough it’s tempting to think of a mutual fund as a single large entity, that view is not really accurate. Funds split their various functions—investing, record keeping, safekeeping, and others—among two or more companies. To begin with, there’s the fund itself, which is organized as a separate corporation or trust. It is owned by the shareholders, not by the firm that runs it. In addition, there are several other major players:
· A management company runs the fund’s daily operations. Management companies are the firms we know as Fidelity, Vanguard, T. Rowe Price, American
Famous Failures in Finance When Mutual Funds Behaved Badly
For the 90 million Americans who own them, mutual funds are a convenient and relatively safe place to invest money. So it came as a big shock to investors in September 2003 when New York Attorney General Eliot Spitzer shook the mutual fund industry with allegations of illegal after-hours trading, special deals for large institutional investors, market timing in flagrant violation of funds’ written policies, and other abuses. Nearly 20 companies, including several large brokerages, were dragged into scandals.
Some of the abuses stemmed from market timing, a practice in which short-term traders seek to exploit differences between hours of operations of various global markets. An example best illustrates this practice. Suppose a U.S. mutual funds holds Japanese stocks. The Japanese market closes approximately 14 hours before the U.S. market does, but the net asset value of the mutual fund will be calculated at 4:00 p.m. when the U.S. market closes. Suppose on a Monday the U.S. market has a strong rally. Investors know that this means it is very likely that stocks will open higher on Tuesday morning in Japan, but by purchasing shares in the mutual fund, they can essentially buy Japanese stocks at prices that are “stale,” meaning that the prices do not reflect the good news that the U.S market rallied on Monday. Instead, the fund’s net asset value reflects the prices in Japan 14 hours earlier. By purchasing shares in the mutual fund on days when the U.S. market goes up and selling them on days when the U.S. market goes down, traders can earn profits that are far above normal. Most funds prohibit this kind of activity, yet exceptions were made for large institutional investors who traded millions of dollars’ worth of fund shares. According to the regulators, this practice resembles betting on a winning horse after the horse race is over.
More recently, investigations have uncovered abuses having to do with a mutual fund known as a “funds of funds.” Some large investment companies that offer many different funds give investors the option of investing in a fund that only holds shares of the investment company’s other funds. The manager of such a fund does not select individual securities, but instead decides how to allocate investors’ dollars across different mutual funds operated by the same fund family. Suppose that one of the investment company’s funds is hit by an unexpected, large request for withdrawals. Such an event could force the fund to conduct a fire sale, selling securities at discount prices to raise cash and lowering the fund’s return as a result. In steps the fund of funds manager. She simply reallocates some of the dollars under her control by purchasing shares in the fund hit with withdrawals and selling shares in other funds not facing pressure to distribute cash to shareholders. This practice benefits the fund family as a whole but not the shareholders in the fund of funds. They are effectively providing liquidity to other funds in the family hit by redemption requests without being compensated for doing so.
Critical Thinking Question
1. How are shareholders in a “fund of funds” harmed if their fund manager purchases shares in another fund that has been hit by unexpected investor withdrawals?
Century, and Dreyfus. They are the ones that create the funds in the first place. Usually, the management firm also serves as investment advisor.
· An investment advisor buys and sells stocks or bonds and otherwise oversees the portfolio. Usually, three parties participate in this phase of the operation: (1) the money manager, who actually runs the portfolio and makes the buy and sell decisions; (2) securities analysts, who analyze securities and look for viable investment candidates; and (3) traders, who buy and sell big blocks of securities at the best possible price.
· A distributor sells the fund shares, either directly to the public or through authorized dealers (like major brokerage houses and commercial banks). When you request a prospectus and sales literature, you deal with the distributor.
· A custodian physically safeguards the securities and other assets of the fund, without taking a role in the investment decisions. To discourage foul play, an independent party (usually a bank) serves in this capacity.
· A transfer agent keeps track of purchase and redemption requests from shareholders and maintains other shareholder records.
This separation of duties is designed to protect mutual fund shareholders. You can lose money as a mutual fund investor (if your fund’s stock or bond holdings go down in value), but that’s usually the only risk of loss you face with a mutual fund. Here’s why: In addition to the separation of duties noted above, one of the provisions of the contract between the mutual fund and the company that manages it is that the fund’s assets—stocks, bonds, cash, or other securities in the portfolio—can never be in the hands of the management company. As still another safeguard, each fund must have a board of directors, or trustees, who are elected by shareholders and are charged with keeping tabs on the management company. Nevertheless, as the Famous Failures in Finance box nearby explains, some mutual funds have engaged in some improper trading, which imposed losses on their investors.
Open- or Closed-End Funds
Some mutual funds, known as open-end funds , regularly receive new infusions of cash from investors, and the funds use that money to purchase a portfolio of securities. When investors send money to an open-end fund, they receive new shares in the fund. There is no limit to the number of shares that the mutual fund can issue, and as long as new money flows in from investors, the portfolio of securities grows. Of course, investors are free to withdraw their money from the fund, and when that happens the fund manager redeems investors’ shares in cash. Sometimes, withdrawal requests by fund shareholders may force the fund manager to sell securities (thus reducing the size of the portfolio) to obtain the cash to distribute to investors. In extreme cases, when investor withdrawals are unexpectedly large and the securities held by the fund are illiquid, the fund may have to conduct a fire sale . A fire sale occurs when a fund must sell illiquid assets quickly to raise cash to meet investors’ withdrawal requests. In a fire sale, the fund may have to substantially reduce the price of the securities it wants to sell to attract buyers. In such an instance, the buyers are essentially providing liquidity to the fund, and the discounted price that buyers receive on the securities that they purchase from the fund is effectively a form of compensation that they earn for providing that liquidity. To avoid having to sell securities at fire-sale prices and to reward investors who leave their money in the fund for a long time, some funds charge redemption fees. A redemption fee is a charge that investors pay if they sell shares in the fund only a short time after buying them. Unlike other fees that mutual funds charge, the redemption fees are reinvested into the fund and do not go to the investment company. All open-end mutual funds stand behind their shares and buy them back when investors decide to sell. There is never any trading of shares between individuals. The vast majority of mutual funds in the United States are open-end funds.
When investors buy and sell shares of an open-end fund, those transactions are carried out at prices based on the current market value of all the securities held in the fund’s portfolio and the number of shares the fund has issued. These transactions occur at a price known as the fund’s net asset value (NAV) . The NAV equals the total market value of securities held in the fund divided by the fund’s outstanding shares. Open-end funds usually calculate their NAVs at the end of each day, and it is at that price that withdrawals from or contributions to the fund take place. Of course, a fund’s NAV changes throughout the day as the prices of the securities that the fund holds change. Nevertheless, transactions between open-end funds and their customers generally occur at the end-of-day NAV.
Example
If the market value of all the assets held by XYZ mutual fund at the end of a given day equaled $10 million, and if XYZ on that particular day had 500,000 shares outstanding, the fund’s net asset value per share would be $20($10,000,000 ÷ 500,000)$20 ($10,000,000 ÷ 500,000). Investors who want to put new money into the fund obtain one new share for every $20 that they invest. Similarly, investors who want to liquidate their investment in the fund receive $20 for each share of the fund that they own.
An Introduction to Closed-End Funds
Closed-End Investment Companies
An alternative mutual fund structure is the closed-end fund. Closed-end funds operate with a fixed number of shares outstanding and do not regularly issue new shares of stock. The term closed means that the fund is closed to new investors. At its inception, the fund raises money by issuing shares to investors, and then it invests that pool of money in securities. No new investments in the fund are permitted, nor are withdrawals allowed. So how do investors acquire shares in closed-end funds, and how do they liquidate their investments in closed-end funds? Shares in closed-end investment companies, like those of any other common stock, are actively traded in the secondary market. Unlike open-end funds, all trading in closed-end funds is done between investors in the open market and not between investors and the fund itself. In other words, when an investor in a closed-end fund wants to redeem shares, he or she does not return them to the fund company for cash, as would be the case with an open-end fund. Instead, the investor simply sells the shares on the open market to another individual who wants to invest in the fund. In this respect, buying and selling shares in closed-end funds is just like trading the shares of a company like Apple or ExxonMobil. Investors who want to acquire shares in a particular fund must buy them from other investors who already own them.
An important difference between closed-end and open-end funds arises because investors in closed-end funds buy and sell their shares in the secondary market. For both open- and closed-end funds, the NAV equals the market value of assets held by the fund divided by the fund’s outstanding shares. However, whereas investors in open-end funds can buy or sell shares at the NAV at the end of each day, closed-end fund investors trade their shares during the trading day at the fund’s current market price. Importantly, in closed-end funds, the price of shares in the secondary market may or may not (in fact, usually does not) equal the fund’s NAV. When a closed-end fund’s share price is below its NAV, the fund is said to be trading at a discount, and when the share price exceeds the fund’s NAV, the fund is trading at a premium. We will have more to say later about how closed-end fund discounts and premiums can affect investors’ returns.
Because closed-end funds do not need to deal with daily inflows and outflows of cash from investors, the capital at their disposal is fixed. Managers of these funds don’t need to keep cash on hand to satisfy redemption requests from investors, nor must they constantly search for new investment opportunities simply because more investors want to be part of the fund.
Most closed-end investment companies are traded on the New York Stock Exchange, although a few are traded on other exchanges. As of 2014, the 568 closed-end funds operating in the United States managed $289 billion in assets, and 60% of the assets in closed-end funds were held in bond funds.
Exchange-Traded Funds
A relatively new form of investment company called an exchange-traded fund, or ETF for short, combines some of the operating characteristics of an open-end fund with some of the trading characteristics of a closed-end fund. An exchange-traded fund (ETF) is a type of open-end fund that trades as a listed security on one of the stock exchanges. Exchange-traded funds are also sometimes referred to as exchange-traded portfolios, or ETPs. As the beginning of the chapter described, the first ETF was created in 1993, and it was designed to track the movements of the S&P 500 stock index. Nearly all ETFs were structured as index funds up until 2008 when the SEC cleared the way for actively managed ETFs, which, like actively managed mutual funds, create a unique mix of investments to meet a specific investment objective.
In terms of how shares are created and redeemed, ETFs function in essentially the opposite way that mutual funds do. Mutual funds receive cash from investors, and then they invest that cash in a portfolio of securities. An ETF is created when a portfolio of securities is purchased and placed in a trust, and then shares are issued that represent claims against that trust.
An Advisor’s Perspective
Joseph A. Clark Managing Partner, Financial Enhancement Group
“Mutual funds made sense right up until the invention of Excel.”
MyFinanceLab
To be more precise, suppose a company called Smart Investors wants to create an ETF. Smart Investors, the ETF sponsor, decides that it wants its ETF to track the S&P 500 stock index. Smart Investors contacts an entity known as an authorized participant (AP), which is usually a large institutional investor of some kind. The essential trait of an AP is that it has the ability to acquire a large quantity of shares relatively quickly. The AP acquires a portfolio of shares in which all of the companies in the S&P 500 Index are represented (and in proportions that match those of the index) and delivers those shares to Smart Investors, who then places the shares in a trust. In exchange, Smart Investors gives the AP a block of equally valued shares in the ETF. This block of shares is called a creation unit. The number of ETF shares in one creation unit may vary, but 50,000 shares per creation unit is a common structure. Therefore, each ETF share represents a 1/50,000th claim against the shares held in trust by Smart Investors. The AP takes the shares that it receives and sells them to investors so the shares can begin trading freely on the secondary market. Figure 12.3 illustrates the relationships of the ETF, the authorized participant, and investors.
Example
An authorized participant has acquired a portfolio of stocks that includes all stocks in the S&P 500 Index. The total market value of these stocks is $100 million. The AP transfers these shares to Smart Investors, who in turn issues 100 creation units containing 50,000 ETF shares each to the AP. Therefore, the AP holds a total of 5,000,000 ETF shares. The AP sells the shares to investors at a price of $20 each, so the total value of ETF shares outstanding equals the value of the shares held in trust. Each day the ETF share price will move in sync with changes in the value of the securities held in the trust.
ETFs provide liquidity to investors just as closed-end funds do. That is, investors in ETFs can buy or sell their shares at any time during trading hours. But unlike closed-end funds, an ETF does not necessarily have a fixed number of shares. Going back to our example of the Smart Investors ETF that tracks the S&P 500 Index, if investor demand for this ETF is strong, then Smart Investors can work with the authorized participant to purchase a larger block of shares, creating additional creation units and
Figure 12.3 How an ETF Works
An ETF is created when an authorized participant delivers a portfolio of securities to the ETF sponsor, which in turn delivers ETF shares to the authorized participant. Those shares are then sold to investors and traded on an exchange.
issuing new ETF shares. The process can also work in reverse. If at some point in time interest in the S&P 500 ETF wanes, the authorized participant can buy up 50,000 ETF shares in the open market and then sell those shares back to Smart Investors in exchange for some of the shares held in trust (remember, 50,000 ETF shares equals 1 creation unit). So the number of outstanding ETF shares may ebb and flow over time, unlike a closed-end fund’s fixed number of shares.
Because authorized participants can create new ETF shares or redeem outstanding shares, the ETF share price generally matches the NAV of shares held in trust. In other words, ETFs generally do not trade at a premium or a discount as closed-end funds do. For example, suppose at a particular point in time the share price of an S&P 500 ETF is trading below the NAV (i.e., below the value of the shares held in trust). In this case, the authorized participant can simply buy up ETF shares on the open market, deliver them back to the sponsor (e.g., Smart Investors) who created the ETF, and reclaim the shares from the trust. The authorized participant would make a profit on this transaction because the value of the ETF shares that they purchased was less than the value of the shares that they received. Of course, as the authorized participants begin buying up ETF shares to execute this transaction, they would put upward pressure on the ETF price. In short, the actions of authorized participants help to ensure that ETF prices closely, if not perfectly, match the NAVs of the securities held in trust.
A Behavioral Difference between ETFs and Mutual Funds
Investors seem to be pleased with the advantages that ETFs provide. Figure 12.4 documents the explosive growth in ETFs since 1995. Starting from less than $1 billion in 1994, assets invested in ETFs totaled almost $2 trillion in 2014, a compound annual growth rate of roughly 50%! As you would expect, the variety of ETFs has dramatically increased as well. In 1995 there were just two ETFs available on U.S. markets, but by 2014 that number had skyrocketed to 1,411 ETFs. Of these, the vast majority were index ETFs. With so many index ETFs available, it is not surprising that investors can find an ETF to track almost any imaginable sector
Figure 12.4Assets Invested in Exchange-Traded Funds
Assets invested in exchange-traded funds grew from roughly $1 billion to $2 trillion from 1995 to 2014.
(Source: Data from 2015 Investment Company Institute Factbook, p. 10, http://www.icifactbook.org/2012_factbook.pdf.)
of the stock market including technology stocks, utilities, and many others. There are also ETFs that focus on other asset classes such as bonds, commodities, real estate, and currencies. By far the most common type of ETF is one that focuses on large-cap U.S. stocks.
ETFs combine many of the advantages of closed-end funds with those of traditional (open-end) funds. As with closed-end funds, you can buy and sell ETFs at any time of the day by placing an order through your broker (and paying a standard commission, just as you would with any other stock). In contrast, you cannot trade a traditional open-end fund on an intraday basis; all buy and sell orders for those funds are filled at the end of the trading day, at closing prices. ETFs can also be bought on margin, and they can be sold short. Moreover, because index ETFs are passively managed, they offer many of the advantages of any index fund, including low costs and low taxes. In fact, the fund’s tax liability is kept very low because ETFs rarely distribute any capital gains to shareholders.
Thus, you could hold index ETFs for decades and never pay a dime in capital gains taxes (at least not until you sell the shares).
Some Important Considerations
When you buy or sell shares in a closed-end investment company (or in ETFs, for that matter), you pay a commission, just as you would with any other listed or OTC stock. This is not the case with open-end mutual funds. The cost of investing in an open-end fund depends on the fees and load charges that the fund levies on its investors.
Load and No-Load Funds
The load charge on an open-end fund is the commission you pay when you buy shares in a fund. Generally speaking, the term load fund describes a mutual fund that charges a commission when shares are bought. (Such charges are also known as front-end loads.) A no-load fund levies no sales charges. Although load charges have fallen over time, they can still be fairly substantial. The average front load charge in an equity fund has fallen from 7.9% in 1980 to around 5.4% in 2014. However, many funds offer discounts on their sales loads. Some funds charge no sales load for investments made automatically each month through a retirement account, and others offer discounts for large investments. On average, the sales load that investors actually pay has fallen from about 3.9% in 1990 to 0.9% in 2014. Funds that offer these types of discounts are known as low-load funds .
Occasionally, a fund will have a back-end load . This means that the fund levies commissions when shares are sold. These loads may amount to as much as 5% of the value of the shares sold, although back-end loads tend to decline over time and usually disappear altogether after five or six years from date of purchase. The stated purpose of back-end loads is to enhance fund stability by discouraging investors from trading in and out of the funds over short investment horizons.
Investor Facts
Falling Fund Expenses The expenses that mutual funds charge investors have fallen considerably since 1980. The average expense charge paid by investors in stock funds in 1980 equaled 2.32% of fund assets. This figure fell nearly 60% to 0.70% by the end of 2014. Growing popularity of index funds, which have low expenses, partly accounts for this trend, but expenses have fallen even among actively managed funds. Bond funds experienced a similar decline in fees and expenses.
Although there may be little or no difference in the performance of load and no-load funds, the cost savings with no-load funds tend to give investors a head start in achieving superior rates of return. Unfortunately, the true no-load fund is becoming harder to find, as more and more no-loads are charging 12(b)-1 fees.
Known appropriately as hidden loads, 12(b)-1 fees are designed to help funds cover their distribution and marketing costs. They can amount to as much as 1% per year of assets under management. In good markets and bad, investors pay these fees right off the top, and that can take its toll. Consider, for instance, $10,000 invested in a fund that charges a 1% 12(b)-1 fee. That translates into a charge of $100 per year—certainly not an insignificant amount of money. The 12(b)-1 fee is included with a fund’s other operational fees as part of the fund’s expense ratio.
Watch Your Behavior
You Don’t Always Get What You Pay For Intuitively you might expect that mutual funds that perform better would charge higher fees, but in fact the opposite is true—funds with lower performance charge higher fees. Apparently, underperforming funds target their marketing at investors who are relatively insensitive to fund performance, and the funds charge high fees to those rather inattentive investors. This is why it is important for investors to watch a fund’s performance and its fees very closely.
(Source: Javier Gil-Bazo and Pablo Ruiz-Verdu, “The Relation Between Price and Performance in the Mutual Fund Industry,” Journal of Finance, October 2009.)
To try to bring some semblance of order to fund charges and fees, the Financial Industry Regulatory Authority (FINRA) instituted a series of caps on mutual fund fees. According to the latest regulations, a mutual fund cannot charge more than 8.5% in total sales charges and fees, including front- and back-end loads as well as 12(b)-1 fees. Thus, if a fund charges a 5% front-end load and a 1% 12(b)-1 fee, it can charge a maximum of only 2.5% in back-end load charges without violating the 8.5% cap. In addition, FINRA set a 1% cap on annual 12(b)-1 fees and, perhaps more significantly, stated that true no-load funds cannot charge more than 0.25% in annual 12(b)-1 fees. If they do, they must drop the no-load label in their sales and promotional material.
Other Fees and Costs
Another cost of owning mutual funds is the management fee. This is the compensation paid to the professional managers who administer the fund’s portfolio. You must pay this fee regardless of whether a fund is load or no-load and whether it is an open- or closed-end fund or an exchange-traded fund. Unlike load charges, which are one-time costs, investment companies levy management and 12(b)-1 fees annually, regardless of the fund’s performance. In addition, there are the administrative costs of operating the fund. These are fairly modest and represent the normal cost of doing business (e.g., the commissions paid when the fund buys and sells securities). The various fees that funds charge generally range from less than 0.2% to as much as 2% of average assets under management. In addition to these management fees, some funds charge an exchange fee, assessed whenever you transfer money from one fund to another within the same fund family, or an annual maintenance fee, to help defer the costs of providing service to low-balance accounts.
The SEC requires the mutual funds themselves to fully disclose all of their fees and expenses in a standardized, easy-to-understand format. Every fund profile or prospectus must contain, up front, a fairly detailed fee table, much like the one illustrated in Table 12.1 . This table has three parts. The first specifies all shareholder transaction costs. This tells you what it’s going to cost to buy and sell shares in the mutual fund. The next section lists the annual operating expenses of the fund. Showing these expenses as a percentage of average net assets, the fund must break out management fees, 12(b)-1 fees, and any other expenses. The third section provides a rundown of the total cost over time of buying, selling, and owning the fund. This part of the table contains both transaction and operating expenses and shows what the total costs would be over hypothetical 1-, 3-, 5-, and 10-year holding periods. To ensure consistency and comparability, the funds must follow a rigid set of guidelines when constructing the illustrative costs.
Other Types of Investment Companies
In addition to open-end, closed-end, and exchange-traded funds, other types of investment companies are (1) real estate investment trusts, (2) hedge funds, (3) unit investment trusts, and (4) annuities. Unit investment trusts, annuities, and hedge funds are similar to mutual funds to the extent that they, too, invest primarily in marketable securities, such as stocks and bonds. Real estate investment trusts, in contrast, invest primarily in various types of real estate–related investments, like mortgages. We’ll look at real estate investment trusts and hedge funds in this section.
Table 12.1 Mutual Fund Fee Table (Required by Federal Law)
The following table describes the fees and expenses that are incurred when you buy, hold, or sell shares of the fund.
|
Shareholder Fees (Paid by the Investor Directly) |
|
|
Maximum sales charge (load) on purchases (as a % of offering price) |
3% |
|
Sales charge (load) on reinvested distributions |
None |
|
Deferred sales charge (load) on redemptions |
None |
|
Exchange fees |
None |
|
Annual account maintenance fee (for accounts under $2,500) |
$12.00 |
|
Annual Fund Operating Expenses (Paid from Fund Assets) |
|
|
Management fee |
0.45% |
|
Distribution and service 12(b)-1 fee |
None |
|
Other expenses |
0.20% |
|
Total Annual Fund Operating Expenses |
0.65% |
|
Example |
|
This example is intended to help an investor compare the cost of investing in different funds. The example assumes a $10,000 investment in the fund for 1, 3, 5, and 10 years and then redemption of all fund shares at the end of those periods. The example also assumes that an investment returns 5% each year and that the fund’s operating expenses remain the same. Although actual costs may be higher or lower, based on these assumptions an investor’s costs would be:
|
1 year |
$ 364 |
|
3 years |
$ 502 |
|
5 years |
$ 651 |
|
10 years |
$1,086 |
An Advisor’s Perspective
Phil Putney Owner, AFS Wealth Management
“A REIT is a way that an investor can invest in commercial-grade real estate.”
MyFinanceLab
Real Estate Investment Trusts
A real estate investment trust (REIT) is a type of closed-end investment company that invests money in mortgages and various types of real estate investments. A REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. The investor, therefore, owns a part of the real estate portfolio held by the real estate investment trust. The basic appeal of REITs is that they enable investors to receive both the capital appreciation and the current income from real estate ownership without all the headaches of property management. REITs are also popular with income-oriented investors because of the very attractive dividend yields they provide.
There are three basic types of REIT. First is the property REIT or equity REIT. These are REITs that invest in physical structures such as shopping centers, hotels, apartments, and office buildings. The second type is called a mortgage REIT, so called because they invest in mortgages, and the third type is the hybrid REIT, which may invest in both properties and mortgages. Mortgage REITs tend to be more income-oriented. They emphasize their high current yields, which is to be expected from a security that basically invests in debt. In contrast, while equity REITs may promote their attractive current yields, most of them also offer the potential for earning varying amounts of capital gains (as their property holdings appreciate in value). In early 2015 there were 177 equity REITs, which together held $846 billion in various real estate assets. Equity REITs dominated the market. There were only 39 mortgage REITs with assets valued at $61 billion, and hybrid REITs had all but disappeared from the market.
REITs must abide by the Real Estate Investment Trust Act of 1960, which established requirements for forming a REIT, as well as rules and procedures for making investments and distributing income. Because they are required to pay out nearly all their earnings to the owners, REITs do quite a bit of borrowing to obtain funds for their investments. A number of insurance companies, mortgage bankers, and commercial banks have formed REITs, many of which are traded on the major securities exchanges. The income earned by a REIT is not taxed, but the income distributed to the owners is designated and taxed as ordinary income. REITs have become very popular in the past five to ten years, in large part because of the very attractive returns they offer. Comparative average annual returns are listed below; clearly, REITs have at least held their own against common stocks over time:
|
Period |
REITs* |
S&P 500 |
Nasdaq Composite |
|
5-yr. (2009–2014) |
16.6% |
15.4% |
15.8% |
|
10-yr. (2002–2012) |
7.5% |
7.7% |
8.1% |
|
(*Source: National Association of Real Estate Investment Trusts, REIT Watch, January 2015, https://www.reit.com/sites/default/files/reitwatch/RW1501.pdf ) |
In addition to their highly competitive returns, REITs offer desirable portfolio diversification properties and very attractive dividend yields (around 4.0%), which are generally well above the yields on common stock.
What Is a Hedge Fund?
Hedge Funds
First of all, in spite of the name similarities, it is important to understand that hedge funds are not mutual funds. They are totally different types of investment products! Hedge funds are set up as private entities, usually in the form of limited partnerships and, as such, are largely unregulated. The general partner runs the fund and directly participates in the fund’s profits—often taking a “performance fee” of 10% to 20% of the profits, in addition to a base fee of 1% to 2% of assets under management. The limited partners are the investors and consist mainly of institutions, such as pension funds, endowments, and private banks, as well as high-income individual investors. Because hedge funds are unregulated, they can be sold only to “accredited investors,” meaning the individual investor must have a net worth in excess of $1 million and/or an annual income (from qualified sources) of at least $200,000. Many hedge funds are, by choice, even more restrictive, and limit their investors to only very-high-net-worth individuals. In addition, some hedge funds limit the number of investors they’ll let in (often to no more than 100 investors).
These practices, of course, stand in stark contrast to the way mutual funds operate. While hedge funds are largely unregulated, mutual funds are very highly regulated and monitored. Individuals do not need to qualify or be accredited to invest in mutual funds. Although some mutual funds do have minimum investments of $50,000 to $100,000 or more, they are the exception rather than the rule. Not so with hedge funds—many of them have minimum investments that can run into the millions of dollars. Also, mutual fund performance is open for all to see, whereas hedge funds simply do not divulge such information, at least not to the general public. Mutual funds are required by law to provide certain periodic and standardized pricing and valuation information to investors, as well as to the general public, whereas hedge funds are totally free from such requirements. The world of hedge funds is very secretive and about as non-transparent as you can get.
Investor Facts
Hedge Funds Fudge the Numbers A recent study found that hedge funds misreport their returns when they lose money. The study found an unusually low frequency of small losses and an unusually high frequency of small gains in self-reported hedge fund returns. This pattern suggests that when hedge funds lose money, as long as the loss is not too large, they will fudge their results to report a small gain instead.
Hedge funds and mutual funds are similar in one respect, however: Both are pooled investment vehicles that accept investors’ money and invest those funds on a collective basis. Put another way, both sell shares (or participation) in a professionally managed portfolio of securities. Most hedge funds structure their portfolios so as to reduce volatility and risk while trying to preserve capital (i.e., “hedge” against market downturns) and still deliver positive returns under different market conditions. They do so by taking often very complex market positions that involve both long and short positions, the use of various arbitrage strategies (to lock in profits), as well as the use of options, futures, and other derivative securities. Indeed, hedge funds will invest in almost any opportunity in almost any market as long as impressive gains are believed to be available at reasonable levels of risk. Thus, these funds are anything but low-risk, fairly stable investment vehicles.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 12.1 What is a mutual fund? Discuss the mutual fund concept, including the importance of diversification and professional management.
2. 12.2 What are the advantages and disadvantages of mutual fund ownership?
3. 12.3 Briefly describe how a mutual fund is organized. Who are the key players in a typical mutual fund organization?
4. 12.4 Define each of the following:
a. Open-end investment companies
b. Closed-end investment companies
c. Exchange-traded funds
d. Real estate investment trusts
e. Hedge funds
5. 12.5 What is the difference between a load fund and a no-load fund? What are the advantages of each type? What is a 12(b)-1 fund? Can such a fund operate as a no-load fund?
6. 12.6 Describe a back-end load, a low load, and a hidden load. How can you tell what kinds of fees and charges a fund has?
Types of Funds and Services
1. LG 3
2. LG 4
Some mutual funds specialize in stocks, others in bonds. Some have maximum capital gains as an investment objective; some have high current income. Some funds appeal to speculators, others to income-oriented investors. Every fund has a particular investment objective, and each fund is expected to conform to its stated investment policy and objective. Categorizing funds according to their investment policies and objectives is a common practice in the mutual fund industry. The categories indicate similarities in how the funds manage their money and also their risk and return characteristics. Some of the more popular types of mutual funds are growth, aggressive growth, value, equity-income, balanced, growth-and-income, bond, money market, index, sector, socially responsible, asset allocation, and international funds.
Of course, it’s also possible to define fund categories based on something other than stated investment objectives. For example, Morningstar, the industry’s leading research and reporting service, has developed a classification system based on a fund’s actual portfolio position. Essentially, it carefully evaluates the makeup of a fund’s portfolio to determine where its security holdings are concentrated. It then uses that information to classify funds on the basis of investment style (growth, value, or blend), market segment (small-, mid-, or large-cap), or other factors. Such information helps mutual fund investors make informed asset allocation decisions when structuring or rebalancing their own portfolios. That benefit notwithstanding, let’s stick with the investment-objective classification system noted above and examine the various types of mutual funds to see what they are and how they operate.
Types of Mutual Funds
Growth Funds
The objective of a growth fund is simple: capital appreciation. They invest principally in well-established large- or mid-cap companies that have above-average growth potential. They offer little (if anything) in the way of dividends because the companies whose shares they buy reinvest their earnings rather than pay them out. Growth funds invest in stocks that have greater than average risk.
Aggressive-Growth Funds
Aggressive-growth funds are the so-called performance funds that tend to increase in popularity when markets heat up. Aggressive-growth funds are highly speculative with portfolios that consist mainly of “high-flying” common stocks. These funds often buy stocks of small, unseasoned companies, and stocks with relatively high price/earnings multiples. They often invest in companies that are recovering from a period of very poor financial performance, and they may even use leverage in their portfolios (i.e., buy stocks on margin). Aggressive-growth funds are among the most volatile of all mutual funds. When the markets are good, aggressive-growth funds do well; conversely, when the markets are bad, these funds often experience substantial losses.
Value Funds
Value funds confine their investing to stocks considered to be undervalued by the market. That is, the funds look for stocks whose prices are trading below intrinsic value. In stark contrast to growth funds, value funds look for stocks with relatively low price-to-earnings ratios, high dividend yields, and moderate amounts of financial leverage.
Value investing is not easy. It involves extensive evaluation of corporate financial statements and any other documents that will help fund managers estimate stocks’ intrinsic values. The track record of value investing is quite good. Even though value investing is regarded by many as less risky than growth investing, the long-term return to investors in value funds is competitive with that from growth funds and even aggressive-growth funds. Thus, value funds are often viewed as a viable investment alternative for relatively conservative investors who are looking for the attractive returns that common stocks have to offer without taking too much risk.
Equity-Income Funds
Equity-income funds purchase stocks with high dividend yields. Capital preservation is also an important goal of these funds, which invest heavily in high-grade common stocks, some convertible securities and preferred stocks, and occasionally even junk bonds or certain types of high-grade foreign bonds. As far as their stock holdings are concerned, they lean heavily toward blue chips, public utilities, and financial shares. In general, because of their emphasis on dividends and current income, these funds tend to hold higher-quality securities that are subject to less price volatility than the market as a whole. They’re generally viewed as a fairly low-risk way of investing in stocks.
Balanced Funds
Balanced funds tend to hold a balanced portfolio of both stocks and bonds for the purpose of generating a balanced return of both current income and long-term capital gains. They’re much like equity-income funds, but balanced funds usually put more into fixed-income securities. The bonds are used principally to provide current income, and stocks are selected mainly for their long-term growth potential. Balanced funds tend to be less risky than funds that invest exclusively in common stocks.
Growth-and-Income Funds
Growth-and-income funds also seek a balanced return made up of both current income and long-term capital gains, but they place a greater emphasis on growth of capital. Unlike balanced funds, growth-and-income funds put most of their money into equities. In fact, it’s not unusual for these funds to have 80% to 90% of their capital in common stocks. They tend to confine most of their investing to quality issues, so growth-oriented blue-chip stocks appear in their portfolios, along with a fair amount of high-quality income stocks. Part of the appeal of these funds is the fairly substantial returns many have generated over the long haul. These funds involve a fair amount of risk, if for no other reason than the emphasis they place on stocks and capital gains. Thus, growth-and-income funds are most suitable for those investors who can tolerate the risk and price volatility.
Bond Funds
As the name implies, bond funds invest exclusively in various types and grades of bonds—from Treasury and agency bonds to corporate and municipal bonds and other debt securities such as mortgage-backed securities. Income from the bonds’ interest payments is the primary investment objective.
There are three important advantages to buying shares in bond funds rather than investing directly in bonds. First, the bond funds are generally more liquid than direct investments in bonds. Second, they offer a cost-effective way of achieving a high degree of diversification in an otherwise expensive asset class. (Most bonds carry minimum denominations of $1,000 to $5,000.) Third, bond funds will automatically reinvest interest and other income, thereby allowing you to earn fully compounded rates of return.
Bond funds are generally considered to be a fairly conservative form of investment, but they are not without risk. The prices of the bonds held in the fund’s portfolio fluctuate with changing interest rates. In today’s market, investors can find everything from high-grade government bond funds to highly speculative funds that invest in nothing but junk bonds or even in highly volatile derivative securities. Here’s a list of the different types of domestic bond funds available to investors and their chief investment types.
· Government bond funds invest in U.S. Treasury and agency securities.
· High-grade corporate bond funds invest chiefly in investment-grade securities rated BBB or better.
· High-yield corporate bond funds are risky investments that buy junk bonds for the yields they offer.
· Municipal bond funds invest in tax-exempt securities. These are suitable for investors who seek tax-free income. Like their corporate counterparts, municipal bond funds can be packaged as either high-grade or high-yield funds. A special type of municipal bond fund is the so-called single-state fund, which invests in the municipal issues of only one state, thus producing (for residents of that state) interest income that is exempt from both federal and state taxes (and possibly even local/city taxes as well).
· Mortgage-backed bond funds put their money into various types of mortgage-backed securities of the U.S. government (e.g., GNMA issues). These funds appeal to investors for several reasons: (1) They provide diversification; (2) they are an affordable way to get into mortgage-backed securities; and (3) they allow investors to reinvest the principal portion of the monthly cash flow, thereby enabling them to preserve their capital.
· Convertible bond funds invest primarily in securities that can be converted or exchanged into common stocks. These funds offer investors some of the price stability of bonds, along with the capital appreciation potential of stocks.
· Intermediate-term bond funds invest in bonds with maturities of 10 years or less and offer not only attractive yields but relatively low price volatility as well. Shorter (two- to five-year) funds are also available; these shorter-term funds are often used as substitutes for money market investments by investors looking for higher returns on their money, especially when short-term rates are way down.
Clearly, no matter what you’re looking for in a fixed-income security, you’re likely to find a bond fund that fits the bill. According to the 2015 Investment Company Fact Book, bond funds account for approximately 21% of U.S. mutual fund and exchange-traded fund assets.
Money Market Funds
Money market mutual funds , or money funds for short, apply the mutual fund concept to the buying and selling of short-term money market instruments—bank certificates of deposit, U.S. Treasury bills, and the like. These funds offer investors with modest amounts of capital access to the high-yielding money market, where many instruments require minimum investments of $100,000 or more. At the close of 2014, money market funds held approximately 15% of U.S. mutual fund assets, a figure that had been shrinking for several years due to the extraordinarily low interest rates on short-term securities available since the 2008 recession.
There are several kinds of money market mutual funds:
· General-purpose money funds invest in any and all types of money market investment vehicles, from Treasury bills and bank CDs to corporate commercial paper. The vast majority of money funds are of this type.
Famous Failures in Finance Breaking the Buck
Traditionally, investors have viewed money market mutual funds as the safest type of mutual fund because they generally invest in low-risk, short-term debt securities. These funds generally maintain their share price at $1, and they distribute the interest they earn on short-term securities to investors. The very first money market mutual fund, The Reserve Fund, was formed in 1971. Unfortunately, when Lehman Brothers filed for bankruptcy on September 15, 2008, the Reserve Fund was caught holding $785 million in short-term loans to Lehman. Those holdings were suddenly worthless, and that caused The Reserve Fund’s share price to “break the buck” by falling to $0.97. Investors in the fund became worried about the fund’s other holdings, and a flood of redemption requests poured in. Ultimately, the fund could not satisfy all of the redemption requests that it received, so the fund ceased operations and liquidated its assets. In response to this event and others during the financial crisis, the SEC imposed new restrictions on money market funds, forcing them to hold securities with higher credit ratings and greater liquidity than had been required in the past.
· Government securities money funds effectively eliminate any risk of default by confining their investments to Treasury bills and other short-term securities of the U.S. government or its agencies.
· Tax-exempt money funds limit their investing to very short (30- to 90-day) tax-exempt municipal securities. Because their income is free from federal income taxes, they appeal predominantly to investors in high tax brackets.
Just about every major brokerage firm has at least four or five money funds of its own, and hundreds more are sold by independent fund distributors. Because the maximum average maturity of their holdings cannot exceed 90 days, money funds are highly liquid investment vehicles, although their returns do move up and down with interest-rate conditions. They’re also nearly immune to capital loss because at least 95% of the fund’s assets must be invested in top-rated/prime-grade securities. In fact, with the check-writing privileges they offer, money funds are just as liquid as checking or savings accounts. Many investors view these funds as a convenient, safe, and (reasonably) profitable way to accumulate capital and temporarily store idle funds.
Index Funds
“If you can’t beat ’em, join ’em.” That saying pretty much describes the idea behind index funds. Essentially, an index fund buys and holds a portfolio of stocks (or bonds) equivalent to those in a market index like the S&P 500. Rather than try to beat the market, as most actively managed funds do, index funds simply try to match the market. They do this through low-cost investment management. In fact, in most cases, a computer that matches the fund’s holdings with those of the targeted index runs the whole portfolio almost entirely.
Investor Facts
A Long Investing Voyage One fund that takes an extreme approach to passive investing is the Voya Corporate Leader Trust. Established with a portfolio of 30 stocks in 1935, the fund is prohibited from adding new companies to its portfolio. Over the years, stocks dropped out of the fund due to mergers, spinoffs, or bankruptcies, so by 2015 the fund held just 21 stocks. However, in the decade from 2005 to 2015, the fund handily outperformed the S&P 500 Index.
The approach of index funds is strictly buy-and-hold. Indeed, about the only time an index-fund portfolio changes is when the targeted market index alters its “market basket” of securities. A pleasant by-product of this buy-and-hold approach is that the funds have extremely low portfolio turnover rates and, therefore, very little in realized capital gains. As a result, aside from a modest amount of dividend income, these funds produce very little taxable income from year to year, which leads many high-income investors to view them as a type of tax-sheltered investment. Index funds have grown in popularity over the years. Since 1999, equity index funds have increased their market share (relative to all equity mutual funds) from 9.4% to 20.2%. In other words, for every $5 that investors place in stock mutual funds, they invest $1 in indexed funds. The most popular index funds are those tied to the S&P 500, accounting for roughly 33% of all assets held in indexed mutual funds.
Sector Funds
A sector fund is a mutual fund that restricts its investments to a particular sector (or segment) of the market. For example, a health care sector fund would focus on stocks issued by drug companies, hospital management firms, medical suppliers, and biotech concerns. Among the more popular sector funds are those that concentrate in technology, financial services, real estate (REITs), natural resources, telecommunications, and health care. The overriding investment objective of a sector fund is usually capital gains. A sector fund is generally similar to a growth fund and should be considered speculative, particularly because it is not well diversified.
Socially Responsible Funds
For some, investing is far more than just cranking out financial ratios and calculating investment returns. To these investors, the security selection process also includes the active, explicit consideration of moral, ethical, and environmental issues. The idea is that social concerns should play just as big a role in investment decisions as do financial matters. Not surprisingly, a number of funds cater to such investors. Known as socially responsible funds , they actively and directly incorporate ethics and morality into the investment decision. Their investment decisions, in effect, revolve around both morality and profitability.
Socially responsible funds consider only certain companies for inclusion in their portfolios. If a company does not meet the fund’s moral, ethical, or environmental tests, fund managers simply will not buy the stock, no matter how good the bottom line looks. These funds refrain from investing in companies that derive revenues from tobacco, alcohol, gambling, weapons, or fossil fuels. In addition, the funds tend to favor firms that produce “responsible” products or services, that have strong employee relations and positive environmental records, and that are socially responsive to the communities in which they operate.
Asset Allocation Funds
Studies have shown that the most important decision an investor can make is how to allocate assets among different types of investments (e.g., between stocks and bonds). Asset allocation deals in broad terms (types of securities) and does not focus on individual security selection. Because many individual investors have a tough time making asset allocation decisions, the mutual fund industry has created a product to do the job for them. Known as asset allocation funds , these funds spread investors’ money across different types of asset classes. Whereas most mutual funds concentrate on one type of investment—whether stocks, bonds, or money market securities—asset allocation funds put money into all these assets. Many of them also include foreign securities, and some even include inflation-resistant investments, such as gold, real estate, and inflation-indexed bonds.
Investor Facts
Age and Asset Allocation Although there are several important factors to consider when determining the right asset allocation, an old guideline bases the decision on age. The rule says that the percentage of a portfolio invested in stocks should equal 100 minus the investor’s age. For example, a 25-year-old’s portfolio would be 75% invested in stock, but as the investor ages, the rule shifts the allocation from riskier stocks to less risky fixed-income securities. However, since people are living longer now and their money has to last longer in retirement, many financial planners recommend subtracting the investor’s age from 110 or 120 to determine their stock allocation.
These funds are designed for people who want to hire fund managers not only to select individual securities but also to allocate money among the various markets. Here’s how a typical asset allocation fund works. The money manager establishes a desired allocation mix for the fund, which might look something like this: 50% to U.S. stocks, 30% to bonds, 10% to foreign securities, and 10% to money market securities. The manager purchases securities in these proportions, and the overall portfolio maintains the desired mix. As market conditions change over time, the asset allocation mix changes as well. For example, if the U.S. stock market starts to soften, the fund may reduce the (domestic) stock portion of the portfolio to, say, 35%, and simultaneously increase the foreign securities portion to 25%. There’s no assurance, of course, that the money manager will make the right moves at the right time.
One special type of asset allocation fund is known as a target date fund. A target date fund follows an asset allocation plan tied to a specific target date. In the beginning, the fund’s asset allocation is heavily tilted toward stocks, but as time passes and the fund’s target date approaches, the portfolio becomes more conservative with the allocation shifting away from stocks toward bonds. These funds appeal to investors who want to save money for retirement. For example, a 25-year-old worker might choose a fund with a target date of 2055, whereas a 45-year-old might select a fund with a target date of 2035. By choosing target dates that correspond (at least roughly) to their expected retirement dates, both investors can be assured that the fund managers will gradually lower the risk profile of their investments as retirement approaches.
International Funds
In their search for more diversification and better returns, U.S. investors have shown a growing interest in foreign securities. Sensing an opportunity, the mutual fund industry has been quick to respond with international funds —mutual funds that do all or most of their investing in foreign securities. A lot of people would like to invest in foreign securities but simply do not have the know-how to do so. International funds may be just the vehicle for such investors, provided they have at least a fundamental understanding of international economics issues and how they can affect fund returns.
Technically, the term international fund describes a type of fund that invests exclusively in foreign securities. Such funds often confine their activities to specific geographic regions (e.g., Mexico, Australia, Europe, or the Pacific Rim). In contrast, global funds invest in both foreign securities and U.S. companies—usually multinational firms. Regardless of whether they’re global or international (we’ll use the term international to apply to both), you can find just about any type of fund you could possibly want. There are international stock funds, international bond funds, and even international money market funds. There are aggressive-growth funds, balanced funds, long-term growth funds, and high-grade bond funds. There are funds that confine their investing to large, established markets (like Japan, Germany, and Australia) and others that stick to emerging markets (such as Thailand, Mexico, Chile, and even former Communist countries like Poland). In 2014 about 25% of all assets invested in stock mutual funds were invested in international funds.
Investor Services
Investors obviously buy shares in mutual funds to make money, but there are other important reasons for investing in mutual funds, not the least of which are the valuable services they provide. Some of the most sought-after mutual fund services are automatic investment and reinvestment plans, regular income programs, conversion privileges, and retirement programs.
Automatic Investment Plans
It takes money to make money. For an investor, that means being able to accumulate the capital to put into the market. Mutual funds have come up with a program that makes savings and capital accumulation as painless as possible. The program is the automatic investment plan . This service allows fund shareholders to automatically funnel fixed amounts of money from their paychecks or bank accounts into a mutual fund. It’s much like a payroll deduction plan.
This fund service has become very popular because it enables shareholders to invest on a regular basis without having to think about it. Just about every fund group offers some kind of automatic investment plan for virtually all of its stock and bond funds. To enroll, you simply fill out a form authorizing the fund to siphon a set amount (usually a minimum of $25 to $100 per period) from your bank account at regular intervals. Once enrolled, you’ll be buying more shares on a regular basis. Of course, if it’s a load fund, you’ll still have to pay normal sales charges on your periodic investments, though many load funds reduce or eliminate the sales charge for investors participating in automatic investment plans. You can get out of the program at any time, without penalty, by simply calling the fund. Although convenience is perhaps the chief advantage of automatic investment plans, they also make solid investment sense. One of the best ways of building up a sizable amount of capital is to add funds to your investment program systematically over time. The importance of making regular contributions to your investment portfolio cannot be overstated. It ranks right up there with compound interest.
Automatic Reinvestment Plans
An automatic reinvestment plan is another of the real draws of mutual funds and is offered by just about every open-end fund. Whereas automatic investment plans deal with money you are putting into a fund, automatic reinvestment plans deal with the dividends the funds pay to their shareholders. The automatic reinvestment plans of mutual funds enable you to keep your capital fully employed by using dividend and/or capital gains income to buy additional shares in the fund. Most funds do not charge commissions for purchases made with reinvested funds. Keep in mind, however, that even though you may reinvest all dividends and capital gains distributions, the IRS still treats them as cash receipts and taxes them as investment income in the year in which you received them.
Automatic reinvestment plans enable you to earn fully compounded rates of return. By plowing back profits, you can put them to work in generating even more earnings. Indeed, the effects of these plans on total accumulated capital over the long run can be substantial. Figure 12.5 shows the long-term impact of reinvested dividend and capital gain income for the S&P 500 Index. In the illustration, we assume that the investor starts with $10,000 in January 1988. The upper line shows how much money accumulates if the investor keeps reinvesting dividends as they arrive, and the lower line shows what happens if the investor fails to do so. Over time, the difference in these two approaches becomes quite large. With reinvested dividends, the investor would have had a portfolio worth $149,223 by July 2015, but if the investor had failed to reinvest dividends, the portfolio value would have reached just $80,787.
Regular Income
Automatic investment and reinvestment plans are great for the long-term investor. But what about the investor who’s looking for a steady stream of income? Once again, mutual funds have a service to meet this need. Called a systematic withdrawal plan , it’s offered by most open-end funds. Once enrolled, an investor automatically receives a predetermined amount of money every month or quarter. Most funds require a minimum investment of $5,000 or more to participate, and the size of the minimum payment normally must be $50 or more per period (with no limit on the maximum). The funds will pay out the monthly or quarterly income first from dividends and realized capital gains. If this source proves to be inadequate and the shareholder so authorizes, the fund can then tap the principal or original paid-in capital to meet the required periodic payments.
Conversion Privileges
Sometimes investors find it necessary to switch out of one fund and into another. For example, your objectives or the investment climate itself may have changed. Conversion (or exchange) privileges were devised to meet such needs
Figure 12.5 The Effects of Reinvesting Dividends
Reinvesting dividends can have a tremendous impact on one’s investment position. This graph shows the results of investing $10,000 in the S&P 500 in January 1988 with and without reinvestment of dividends.
(Source: Author’s calculations and Yahoo!Finance.)
conveniently and economically. Investment management companies that offer a number of different funds—known as fund families —often provide conversion privileges that enable shareholders to move money from one fund to another, either by phone or via the Internet. The only constraint is that the switches must be confined to the same family of funds. For example, you can switch from a Dreyfus growth fund to a Dreyfus money fund, or any other fund managed by Dreyfus.
Conversion privileges are usually considered beneficial because they allow you to meet ever-changing long-term goals, and they also permit you to manage your mutual fund holdings more aggressively by moving in and out of funds as the investment environment changes. Unfortunately, there is one major drawback. For tax purposes, the exchange of shares from one fund to another is regarded as a sale transaction followed by a subsequent purchase of a new security. As a result, if any capital gains exist at the time of the exchange, you are liable for the taxes on that profit, even though the holdings were not truly “liquidated.”
Retirement Programs
As a result of government legislation, self-employed individuals are permitted to divert a portion of their pretax income into self-directed retirement plans (SEPs). Also, U.S. workers are allowed to establish individual retirement arrangements (IRAs). Indeed, with legislation passed in 1997, qualified investors can now choose between deductible and nondeductible (Roth) IRAs. Even those who make too much to qualify for one of these programs can set up special nondeductible IRAs. Today all mutual funds provide a service that allows individuals to set up tax-deferred retirement programs as either IRA or Keogh accounts—or, through their place of employment, to participate in a tax-sheltered retirement plan, such as a 401(k). The funds set up the plans and handle all the administrative details so that the shareholder can easily take full advantage of available tax savings.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 12.7 Briefly describe each of the following types of mutual funds:
a. Aggressive-growth funds
b. Equity-income funds
c. Growth-and-income funds
d. Bond funds
e. Sector funds
f. Socially responsible funds
2. 12.8 What is an asset allocation fund and how does it differ from other types of mutual funds? How does a target date fund work?
3. 12.9 If growth, income, and capital preservation are the primary objectives of mutual funds, why do we bother to categorize funds by type? Do you think such classifications are helpful in the fund selection process? Explain.
4. 12.10 What are fund families? What advantages do fund families offer investors? Are there any disadvantages?
5. 12.11 Briefly describe some of the investor services provided by mutual funds. What are automatic reinvestment plans, and how do they differ from automatic investment plans?
Investing in Mutual Funds
1. LG 5
2. LG 6
Suppose you are confronted with the following situation. You have money to invest and are trying to select the right place to put it. You obviously want to pick a security that meets your idea of acceptable risk and will generate an attractive rate of return. The problem is that you must make the selection from a list containing thousands of securities. That’s basically what you’re facing when trying to select a suitable mutual fund. However, if you approach the problem systematically, it may not be so formidable a task. First, it might be helpful to examine more closely the various investor uses of mutual funds. With this background, we can then look at the selection process and at several measures of return that you can use to assess performance. As we will see, it is possible to whittle down the list of alternatives by matching your investment needs with the investment objectives of the funds.
Investor Uses of Mutual Funds
Mutual funds can be used in a variety of ways. For instance, performance funds can serve as a vehicle for capital appreciation, whereas bond funds can provide current income. Regardless of the kind of income a mutual fund provides, investors tend to use these securities as (1) a way to accumulate wealth, (2) a storehouse of value, or (3) a speculative vehicle for achieving high rates of return.
Accumulation of Wealth
This is probably the most common reason for using mutual funds. Basically, the investor uses mutual funds over the long haul to build up investment capital. Depending on your goals, a modest amount of risk may be acceptable, but usually preservation of capital and capital stability are considered important. The whole idea is to form a “partnership” with the mutual fund in building up as big a pool of capital as possible. You provide the capital by systematically investing and reinvesting in the fund and the fund provides the return by doing its best to invest your resources wisely.
Storehouse of Value
Investors also use mutual funds as a storehouse of value. The idea is to find a place where investment capital can be fairly secure and relatively free from deterioration yet still generate a relatively attractive rate of return. Short- and intermediate-term bond funds are logical choices for such purposes, and so are money funds. Capital preservation and income over the long term are very important to some investors. Others might seek storage of value only for the short term, using, for example, money funds as a place to “sit it out” until a more attractive opportunity comes along.
Speculation and Short-Term Trading
Although speculation is becoming more common, it is still not widely used by most mutual fund investors. The reason, of course, is that most mutual funds are long-term in nature and thus not meant to be used as aggressive trading vehicles. However, a growing number of funds (e.g., sector funds) now cater to speculators. Some investors have found that mutual funds are, in fact, attractive for speculation and short-term trading.
One way to do this is to aggressively trade in and out of funds as the investment climate changes. Load charges can be avoided (or reduced) by dealing in families of funds offering low-cost conversion privileges and/or by dealing only in no-load funds. Other investors might choose mutual funds as a long-term investment but seek high rates of return by investing in funds that follow very aggressive trading strategies. These are usually the fairly specialized, smaller funds such as leverage funds, option funds, emerging-market funds, small-cap aggressive-growth funds, and sector funds. In essence, investors in such funds are simply letting professional money managers handle their accounts in a way they would like to see them handled: aggressively.
The Selection Process
When it comes to mutual funds, there is one question every investor has to answer right up front. Why invest in a mutual fund to begin with—why not “go it alone” by buying individual stocks and bonds directly? For beginning investors and investors with little capital, the answer is simple: With mutual funds, you are able to achieve far more diversification than you could ever obtain on your own. Plus, you get the help of professional money managers at a very reasonable cost. For more seasoned investors, the answers are probably more involved. Certainly, diversification and professional money management come into play, but there are other reasons as well. The competitive returns mutual funds offer are a factor, as are the services they provide. Many seasoned investors simply have decided they can get better returns by carefully selecting mutual funds than by investing on their own. Some of these investors use part of their capital to buy and sell individual securities on their own and use the rest to buy mutual funds that invest in areas they don’t fully understand or don’t feel well informed about. For example, they’ll use mutual funds to get into foreign markets or buy mortgage-backed securities.
Watch Your Behavior
Index fund fees Because index funds are designed to mimic the return of a market index, they typically do not invest resources in trying to identify over- or undervalued stocks. As a consequence, index fund fees tend to be quite low, averaging just 11 basis points in 2014 according to the Investment Company Institute. Yet some investors continue to invest in index funds with fees that are 10 to 20 times higher than the fees charged by a typical fund. Predictably, investors in these funds tend to earn much lower returns than investors who buy shares in index funds that charge lower fees.
(Sources: 2015 Investment Company Institute Factbook, http://www .icifactbook.org/pdf/2015_factbook.pdf ; Edwin J. Elton, Martin J. Gruber, Jeffrey A. Busse, “Are Investors Rational? Choices Among Index Funds,” Journal of Finance, 2004, Vol. 59, Issue 1, pp. 261–288.)
Once you have decided to use mutual funds, you must decide which fund(s) to buy. The selection process involves putting into action all you know about mutual funds in order to gain as much return as possible from an acceptable level of risk. It begins with an assessment of your investment needs. Obviously, you want to select from those thousands of funds the one or two (or six or eight) that will best meet your total investment needs.
Objectives and Motives for Using Funds
The place to start is with your investment objectives. Why do you want to invest in a mutual fund, and what are you looking for in a fund? Obviously, an attractive rate of return would be desirable, but there is also the matter of a tolerable amount of risk exposure. Probably, when you look at your own risk temperament in relation to the various types of mutual funds available, you will discover that certain types of funds are more appealing to you than others. For instance, aggressive-growth or sector funds are usually not attractive to individuals who wish to avoid high exposure to risk.
Another important factor is the intended use of the mutual fund. Do you want to invest in mutual funds as a means of accumulating wealth, as a storehouse of value, or to speculate for high rates of return? This information puts into clearer focus the question of what you want to do with your investment dollars. Finally, there is the matter of the services provided by the fund. If you are particularly interested in certain services, be sure to look for them in the funds you select.
What the Funds Offer
Just as each individual has a set of investment needs, each fund has its own investment objective, its own manner of operation, and its own range of services. These elements are useful in helping you to assess investment alternatives. Where do you find such information? One obvious place is the fund’s profile, or its prospectus. Publications such as the Wall Street Journal, Barron’s, Money, Fortune, and Forbes also provide a wealth of operating and performance statistics.
There are also a number of reporting services that provide background information and assessments on funds. Among the best in this category are Morningstar Mutual Funds and Value Line Mutual Fund Survey (which produces a mutual fund report similar to its stock report). There also are all sorts of performance statistics available on the Internet. For example, there are scores of free finance websites, like Yahoo! Finance, where you can obtain historical information on a fund’s performance, security holdings, risk profile, load charges, and purchase information.
Whittling Down the Alternatives
At this point, fund selection becomes a process of elimination. You can eliminate a large number of funds from consideration simply because they fail to meet your specified needs. Some funds may be too risky; others may be unsuitable as a storehouse of value. Thus, rather than try to evaluate thousands of different funds, you can narrow down the list to two or three types of funds that match your investment needs. From here, you can whittle down the list a bit more by introducing other constraints. For example, because of cost considerations, you may want to consider only no-load or low-load funds (more on this topic below). Or you may be seeking certain services that are important to your investment goals.
Another attribute of a fund that you may want to consider is its tax efficiency. As a rule, funds that have low dividends and low asset turnover do not expose their shareholders to high taxes and therefore have higher tax-efficiency ratings. And while you’re looking at performance, check out the fund’s fee structure. Be on guard for funds that charge abnormally high management fees.
Another important consideration is how well a particular fund fits into your portfolio. If you’re trying to follow a certain asset allocation strategy, then be sure to take that into account when you’re thinking about adding a fund to your portfolio. In other words, evaluate any particular fund in the context of your overall portfolio.
Finally, how much weight should you give to a fund’s past performance when deciding whether you want to invest? Although it may seem intuitive that funds with good past performance should make better investments, remember superior past performance is no guarantee of future success. In fact, we would make the stronger statement that past performance has almost no correlation with future performance. Accordingly, we recommend that you place more weight on other factors such as the fund’s investment objective and its costs when making your investment decisions.
Stick with No-Loads or Low-Loads
There’s a long-standing “debate” in the mutual fund industry regarding load funds and no-load funds. Do load funds add value? If not, why pay the load charges? As it turns out, empirical results generally do not support the idea that load funds provide added value. Load-fund returns, on average, do not seem to be any better than the returns from no-load funds. In fact, in many cases, the funds with abnormally high loads and 12(b)-1 charges often produce returns that are far less than what you can get from no-load funds. In addition, because of compounding, the differential returns tend to widen with longer holding periods. These results should come as no surprise because big load charges and/or 12(b)-1 fees reduce your investable capital—and therefore the amount of money you have working for you. In fact, the only way a load fund can overcome this handicap is to produce superior returns, which is no easy thing to do year in and year out. Granted, a handful of load funds have produced very attractive returns over extended periods of time, but they are the exception rather than the rule.
Obviously, it’s in your best interest to pay close attention to load charges (and other fees). As a rule, to maximize returns, you should seriously consider sticking to no-load funds or to low-loads (funds that have total load charges, including 12(b)-1 fees, of 3% or less). There may well be times when the higher costs are justified, but far more often than not, you’re better off trying to minimize load charges. That should not be difficult to do because there are thousands of no-load and low-load funds from which to choose. What’s more, most of the top-performing funds are found in the universe of no-loads or low-loads. So why would you even want to look anywhere else?
Investing in Closed-End Funds
The assets of closed-end funds (CEFs) represent just over 1.5% of the $18 trillion invested in open-end mutual funds. Like open-end funds, CEFs come in a variety of types and styles, including funds that specialize in municipal bonds, taxable bonds, various types of equity securities, and international securities, as well as regional and single-country funds. Historically, unlike the open-end market, bond funds have accounted for the larger share of assets in closed-end funds. In 2014 there was $170 billion worth of bond CEFs assets, or 59% of CEFs assets. Equity CEFs totaled $119 billion in assets for 2014.
Some Key Differences between Closed-End and Open-End Funds
Because closed-end funds trade like stocks, you must deal with a broker to buy or sell shares, and the usual brokerage commissions apply. Open-end funds, in contrast, are bought from and sold to the fund operators themselves. Another difference between open- and closed-end funds is their liquidity. You can buy and sell relatively large dollar amounts of an open-end mutual fund at its net asset value (NAV) without worrying about affecting the price. However, a relatively large buy or sell order for a CEF could easily bump its price up or down. Like open-end funds, most CEFs offer dividend reinvestment plans, but in many cases, that’s about it. CEFs simply don’t provide the full range of services that mutual fund investors are accustomed to.
An Advisor’s Perspective
Bryan Sweet Owner, Sweet Financial Services
“Sometimes the price and the NAV are not equal.”
MyFinanceLab
All things considered, probably the most important difference is the way these funds are priced in the marketplace. As we discussed earlier in the chapter, CEFs have two values—a market value (or stock price) and an NAV. They are rarely the same because CEFs typically trade at either a premium or a discount. A premium occurs when a fund’s shares trade for more than its NAV; a discount occurs when the fund’s shares trade for less than its NAV. As a rule, CEFs trade at discounts. Exactly why CEFs trade at a discount is not fully understood, and financial experts sometimes refer to this tendency as the closed-end fund puzzle. The puzzle is that closed-end fund share prices are priced lower than the corresponding NAVs. It’s as if when you buy shares in a CEF, you are buying the underlying stocks in the fund at a discount. Some of the possible reasons that CEFs trade at a discount include the following.
· Investors anticipate that the fund’s future performance may be poor, so they pay less for shares in the fund up front.
· Shares held by the fund are illiquid, so if they are ever sold, they will sell for less than their current market prices.
· Shares held by the fund have built-in unrealized capital gains, and because investors will eventually be required to pay taxes on those gains, they are unwilling to pay the full NAV when they purchase fund shares.
· Investor sentiment may cause fund prices to deviate from NAVs; when sentiment is positive, fund shares trade at a premium, but when investors are more pessimistic, fund shares trade at a discount.
Information about CEFs is widely available in print and online sources. Figure 12.6 illustrates some of the free CEF information that you can find at Morningstar’s website. In addition to each fund’s name, you can quickly determine whether it currently trades at a discount or a premium relative to NAV. Morningstar also provides the year-to-date return based on the performance of the fund’s share price as well as the return based on the fund’s NAV.
The premium or discount on CEFs is calculated as follows:
Premium (or discount)=(Share price−NAV)÷NAVPremium (or discount)=(Share price−NAV)÷NAVEquation12.1
Example
Suppose Fund A has an NAV of $10. If its share price is $8, it sells at a 20% discount. That is,
Premium (or discount)=($8−$10)/$10=−$2/$10=−0.20=20%Premium (or discount)=($8−$10)/$10=−$2/$10=−0.20=20%
This negative value indicates that the fund is trading at a discount (or below its NAV). On the other hand, if this same fund were priced at $12 per share, it would be trading at a premium of 20%—that is, ($12−$10)/$10=$2/$10=0.20($12−$10)/$10=$2/$10=0.20.
Figure 12.6 Selected Performance of CEFs
The figure demonstrates information about closed-end funds available at no cost from the Morningstar website.
(Source: http://news.morningstar.com/CELists/CEReturns.html , accessed July 4, 2015. Courtesy of Morningstar, Inc. Used with permission.)
What to Look for in a Closed-End Fund
If you know what to look for and your timing and selection are good, you may find that some deeply discounted CEFs provide a great way to earn attractive returns. For example, if a fund trades at a 20% discount, you pay only 80 cents for each dollar’s worth of assets. If you can buy a fund at an abnormally wide discount (say, more than 10%) and then sell it when the discount narrows or turns to a premium, you can enhance your overall return. In fact, even if the discount does not narrow, your return will be improved because the yield on your investment is higher than it would be with an otherwise equivalent open-end fund.
Example
Suppose a CEF trades at $8, a 20% discount from its NAV of $10. If the fund distributed $1 in dividends for the year, it would yield 12.5% ($1 divided by its $8 price). However, if it was a no-load, open-end fund, it would be trading at its higher NAV and therefore would yield only 10% ($1 divided by its $10 NAV).
Thus, when investing in CEFs, pay special attention to the size of the premium and discount. In particular, keep your eyes open for funds trading at deep discounts because that feature alone can enhance returns. One final point to keep in mind about closed-end funds. Stay clear of new issues (IPOs) of closed-end funds and funds that sell at steep premiums. Never buy new CEFs when they are brought to the market as IPOs. Why? Because IPOs are nearly always brought to the market at hefty premiums, which are necessary to cover the underwriter spread. Thus, you face the almost inevitable fate of losing money as the shares fall to a discount, or at the minimum, to their NAVs within a month or two.
For the most part, except for the premium or discount, you should analyze a CEF just like any other mutual fund. That is, check out the fund’s expense ratio, portfolio turnover rate, past performance, cash position, and so on. In addition, study the history of the discount. Also, keep in mind that with CEFs, you probably will not get a prospectus (as you might with an open-end fund) because they do not continuously offer new shares to investors.
Measuring Performance
As in any investment decision, return performance is a part of the mutual fund selection process. The level of dividends paid by the fund, its capital gains, and its growth in capital are all-important aspects of return. Such return information enables you to judge the investment behavior of a fund and to appraise its performance in relation to other funds and investments. Here, we will look at different measures that investors can use to assess mutual fund returns. Also, because risk is so important in defining the investment behavior of a fund, we will examine mutual fund risk as well.
Sources of Return
An open-end mutual fund has three potential sources of return: (1) dividend income, (2) capital gains distribution, and (3) change in the price (or net asset value) of the fund. Depending on the type of fund, some mutual funds derive more income from one source than from another. For example, we would normally expect income-oriented funds to have much higher dividend income than capital gains distributions.
Open-end mutual funds regularly publish reports that recap investment performance. One such report is the Summary of Income and Capital Changes, an example of which appears in Table 12.2 . This statement, found in the fund’s profile or prospectus,
Table 12.2 A Report of Mutual Fund Income and Capital Changes (For a Share Outstanding throughout the Year)
|
|
|
2016 |
2015 |
2014 |
|
* Portfolio turnover rate relates the number of shares bought and sold by the fund to the total number of shares held in the fund’s portfolio. A high turnover rate (in excess of 100%) means the fund has been doing a lot of trading. |
||||
|
1. |
Net asset value, beginning of period |
$24.47 |
$27.03 |
$24.26 |
|
2. |
Income from investment operations |
|
|
|
|
3. |
Net investment income |
$ 0.60 |
$ 0.66 |
$ 0.50 |
|
4. |
Net gains on securities (realized and unrealized) |
6.37 |
(1.74) |
3.79 |
|
5. |
Total from investment operations |
$ 6.97 |
($ 1.08) |
$ 4.29 |
|
6. |
Less distributions: |
|
|
|
|
7. |
Dividends from net investment income |
($ 0.55) |
($ 0.64) |
($ 0.50) |
|
8. |
Distributions from realized gains |
(1.75) |
(0.84) |
(1.02) |
|
9. |
Total distributions |
($ 2.30) |
($ 1.48) |
($ 1.52) |
|
10. |
Net asset value, end of period |
$29.14 |
$ 24.47 |
$ 27.03 |
|
11. |
Total return |
28.48% |
(4.00%) |
17.68% |
|
12. |
Ratios/supplemental data |
|
|
|
|
13. |
Net assets, end of period ($000) |
$307,951 |
$153,378 |
$108,904 |
|
14. |
Ratio of expenses to average net assets |
1.04% |
0.85% |
0.94% |
|
15. |
Ratio of net investment income to average net assets |
1.47% |
2.56% |
2.39% |
|
16. |
Portfolio turnover rate * |
85% |
144% |
74% |
gives a brief overview of the fund’s investment activity, including expense ratios and portfolio turnover rates. Of interest to us here is the top part of the report (which runs from “Net asset value, beginning of period” to “Net asset value, end of period”—lines 1 to 10). This part reveals the amount of dividend income and capital gains distributed to the shareholders, along with any change in the fund’s net asset value.
Dividend income (see line 7 of Table 12.2 ) is derived from the dividend and interest income earned on the security holdings of the mutual fund. It is paid out of the net investment income that’s left after the fund has met all operating expenses. When the fund receives dividend or interest payments, it passes these on to shareholders in the form of dividend payments. The fund accumulates all of the current income for the period and then pays it out on a prorated basis. Thus, if a fund earned, say, $2 million in dividends and interest in a given year and if that fund had one million shares outstanding, each share would receive an annual dividend payment of $2. Because the mutual fund itself is tax exempt, any taxes due on dividend earnings are payable by the individual investor. For funds that are not held in tax-deferred accounts, like IRAs or 401(k)s, the amount of taxes due on dividends will depend on the source of such dividends. That is, if these distributions are derived from dividends earned on the fund’s common stock holdings, then they are subject to a preferential tax rate of 15%, or less. However, if these distributions are derived from interest earnings on bonds, dividends from REITs, or dividends from most types of preferred stocks, then such dividends do not qualify for the preferential tax treatment, and instead are taxed as ordinary income.
Capital gains distributions (see line 8) work on the same principle, except that these payments are derived from the capital gains actually earned by the fund. It works like this: Suppose the fund bought some stock a year ago for $50 and sold that stock in the current period for $75 per share. Clearly, the fund has achieved capital gains of $25 per share. If it held 50,000 shares of this stock, it would have realized a total capital gain of $1,250,000 (i.e., $25×50,000=$1,250,000$25×50,000=$1,250,000). Given that the fund has one million shares outstanding, each share is entitled to $1.25 in the form of a capital gains distribution. (From a tax perspective, if the capital gains are long-term, then they qualify for the preferential tax rate of 15% or less; if not, then they’re treated as ordinary income.) Note that these (capital gains) distributions apply only to realized capital gains (that is, the security holdings were actually sold and the capital gains actually earned).
Unrealized capital gain (or paper profits) are what make up the third and final element of a mutual fund’s return. When the fund’s holdings go up or down in price, the net asset value of the fund moves accordingly. Suppose an investor buys into a fund at $10 per share and sometime later the fund’s NAV is quoted at $12.50. The difference of $2.50 per share is the unrealized capital gain. It represents the profit that shareholders would receive (and are entitled to) if the fund were to sell its holdings. (Actually, as Table 12.2 shows, some of the change in net asset value can also be made up of undistributed income.)
For closed-end investment companies, the return is derived from the same three sources as that for open-end funds, and from a fourth source as well: changes in price discounts or premiums. But because the discount or premium is already embedded in the share price of a fund, for a closed-end fund, the third element of return—change in share price—is made up not only of change in net asset value but also of change in price discount or premium.
Measures of Return
A simple but effective measure of performance is to describe mutual fund returns in terms of the three major sources noted above: dividends earned, capital gains distributions received, and change in price. When dealing with investment horizons of one year or less, we can convert these fund payoffs into a return figure by using the standard holding period return (HPR) formula. The computations are illustrated here using the 2016 figures from Table 12.2 . In 2016 this hypothetical no-load, open-end fund paid 55 cents per share in dividends and another $1.75 in capital gains distributions. It had a price at the beginning of the year of $24.47 that rose to $29.14 by the end of the year. Thus, summarizing this investment performance, we have
|
Price (NAV) at the beginning of the year (line 1) |
$24.47 |
|
Price (NAV) at the end of the year (line 10) |
$29.14 |
|
Net increase |
$ 4.67 |
|
Return for the year: |
|
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Dividends received (line 7) |
$ 0.55 |
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Capital gains distributions (line 8) |
$ 1.75 |
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Net increase in price (NAV) |
$ 4.67 |
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Total return |
$ 6.97 |
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Holding period return (HPR) (Total return/beginning price) |
28.48% |
This HPR measure is comparable to the procedure used by the fund industry to report annual returns: This same value can be seen in Table 12.2 , line 11, which shows the fund’s “Total return.” It not only captures all the important elements of mutual fund return but also provides a handy indication of yield. Note that the fund had a total dollar return of $6.97, and on the basis of a beginning investment of $24.47, the fund produced an annual return of nearly 28.5%.
HPR with Reinvested Dividends and Capital Gains
Many mutual fund investors have their dividends and/or capital gains distributions reinvested in the fund. How do you measure return when you receive your (dividend/capital gains) payout in additional shares of stock rather than cash? With slight modifications, you can continue to use holding period return. The only difference is that you must keep track of the number of shares acquired through reinvestment.
To illustrate, let’s continue with the example above. Assume that you initially bought 200 shares in the mutual fund and also that you were able to acquire shares through the fund’s reinvestment program at an average price of $26.50 a share. Thus, the $460 in dividends and capital gains distributions [($0.55 + $1.75)×200][($0.55 + $1.75)×200] provided you with another 17.36 shares in the fund (i.e., $460/$26.50). The holding period return under these circumstances would relate the market value of the stock holdings at the beginning of the period with the holdings at the end.
Holding period return=(Number of shares at end of period×Ending price)−(Number of shares at beginning of period×Initial price)(Number of shares at beginning of period×Initial price)Holding period return=(Number of shares at end of period×Ending price)−(Number of shares at beginning of period×Initial price)(Number of shares at beginning of period×Initial price)Equation12.2
Thus, the holding period return on this investment would be
Holding period return=(217.36×$29.14)−(200×$24.47)(200×$24.47)=($6,333.87)−($4,894.00)($4,894.000)=29.4%––––––––––––––Holding period return=(217.36×$29.14)−(200×$24.47)(200×$24.47)=($6,333.87)−($4,894.00)($4,894.000)=29.4%__
This holding period return, like the preceding one, provides a rate-of-return measure that you can use to compare the performance of this fund to those of other funds and investment vehicles.
Measuring Long-Term Returns
Rather than use one-year holding periods, it is sometimes necessary to assess the performance of mutual funds over extended periods of time. In these cases, using the holding period return as a measure of performance would be inappropriate because it ignores the time value of money. Instead, when faced with multiple-year investment horizons, we can use the present value–based internal rate of return (IRR) procedure to determine the fund’s average annual compound rate of return.
To illustrate, refer once again to Table 12.2 . Assume that this time we want to find the annual rate of return over the full three-year period (2014 through 2016). We see that the mutual fund had the following annual dividends and capital gains distributions:
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Item |
2016 |
2015 |
2014 |
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Annual dividends paid |
$0.55 |
$0.64 |
$0.50 |
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Annual capital gains distributed |
$1.75 |
$0.84 |
$1.02 |
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Total distributions |
$2.30 |
$1.48 |
$1.52 |
Given that the fund had a price of $24.26 at the beginning of the period (1/1/14) and was trading at $29.14 at the end of 2016 (three years later), we have the following time line of cash flows.
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Subsequent Cash Flows |
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Initial Cash Flow |
Year 1 |
Year 2 |
Year 3 |
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$24.26 |
$1.52 |
$1.48 |
$2.30 + $29.14$2.30 + $29.14 |
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(Beginning Price) |
(Distributions) |
(Distributions) |
(Distributions + Ending Price) |
We want to find the discount rate that will equate the annual dividends/capital gains distributions and the ending price in year 3 to the beginning (2014) price of the fund ($24.26).
Using standard present value calculations, we find that the mutual fund in Table 12.2 provided an annual rate of return of 13.1% over the three-year period. That is, at 13.1%, the present value of the cash flows in years 1, 2, and 3 equals the beginning price of the fund ($24.26). Such information helps us assess fund performance and compare the return performance of various investments.
According to SEC regulations, if mutual funds report historical returns, they must do so in a standardized format that employs fully compounded, total-return figures similar to those obtained from the above present value–based calculations. The funds are not required to report such information, but if they do cite performance in their promotional material, they must follow a full-disclosure manner of presentation that takes into account not only dividends and capital gains distributions but also any increases or decreases in the fund’s NAV that have occurred over the preceding 1-, 3-, 5-, and 10-year periods.
Returns on Closed-End Funds
The returns of CEFs have traditionally been reported on the basis of their NAVs. That is, price premiums and discounts were ignored when computing return measures. However, it is becoming increasingly common to see return performance expressed in terms of actual market prices, a practice that captures the impact of changing market premiums or discounts on holding period returns. As you might expect, the greater the premiums or discounts and the greater the changes in these values over time, the greater their impact on reported returns. It’s not at all uncommon for CEFs to have different market-based and NAV-based holding period returns. Using NAVs, you find the returns on CEFs in exactly the same way as you do the returns on open-end funds. In contrast, when using actual market prices to measure return, all you need do is substitute the market price of the fund (with its embedded premium or discount) for the corresponding NAV in the holding period or internal rate of return measures.
Some CEF investors like to run both NAV-based and market-based measures of return to see how changing premiums (or discounts) have affected the returns on their mutual fund holdings. Even so, as a rule, NAV-based return numbers are generally viewed as the preferred measures of performance. Because fund managers often have little or no control over changes in premiums or discounts, NAV-based measures are felt to give a truer picture of the performance of the fund itself.
The Matter of Risk
Because most mutual funds are so diversified, their investors are largely immune to the unsystematic risks normally present with individual securities. Even with extensive diversification, however, most funds are still exposed to a considerable amount of systematic risk or market risk. In fact, because mutual fund portfolios are so well diversified, they often tend to perform very much like the market—or like the segment of the market that the fund targets. Although a few funds, like gold funds, tend to be defensive (countercyclical), market risk is still an important ingredient for most types of mutual funds, both open- and closed-end. You should be aware of the effect the general market has on the investment performance of a mutual fund. For example, if the market is trending downward and you anticipate that trend to continue, it might be best to place any new investment capital into something like a money fund until the market trend reverses.
Another important risk consideration revolves around the management practices of the fund itself. If the portfolio is managed conservatively, the risk of a loss in capital is likely to be much less than that for aggressively managed funds. Alternatively, the more speculative are the investment goals of the fund, the greater the risk of instability in the net asset value. But, a conservatively managed portfolio does not eliminate all price volatility. The securities in the portfolio are still subject to inflation, interest rate, and general market risks. However, these risks are generally less with funds whose investment objectives and portfolio management practices are more conservative.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 12.12 How important is the general behavior of the market in affecting the price performance of mutual funds? Explain. Does the future behavior of the market matter in the selection process? Explain.
2. 12.13 What is the major/dominant type of closed-end fund? How do CEFs differ from open-end funds?
3. 12.14 Identify three potential sources of return to mutual fund investors and briefly discuss how each could affect total return to shareholders. Explain how the discount or premium of a closed-end fund can also be treated as a return to investors.
4. 12.15 Discuss the various types of risk to which mutual fund shareholders are exposed. What is the major risk exposure of mutual funds? Are all funds subject to the same level of risk? Explain.
MyFinanceLab
Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know and where to go when you need to practice.
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What You Should Know |
Key Terms |
Where to Practice |
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LG 1 Describe the basic features of mutual funds and note what they have to offer as investments. Mutual fund shares represent ownership in a diversified, professionally managed portfolio of securities. Many investors who lack the time, know-how, or commitment to manage their own money turn to mutual funds. Mutual funds’ shareholders benefit from a level of diversification and investment performance they might otherwise find difficult to achieve. They also can invest with a limited amount of capital and can obtain investor services not available elsewhere. |
1. actively managed fund , p. 471 2. expense ratio , p. 472 3. mutual fund , p. 469 4. passively managed fund , p. 471 5. pooled diversification , p. 470 |
MyFinanceLab Study Plan 12.1 |
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LG 2 Distinguish between open- and closed-end funds, ETFs, and other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges. Open-end funds have no limit on the number of shares they may issue. Closed-end funds have a fixed number of shares outstanding and trade in the secondary markets like shares of common stock. Exchange-traded funds (ETFs) possess characteristics of both open-end and closed-end funds. Other types of investment companies are unit investment trusts, hedge funds (private, unregulated investment vehicles available to institutional and high-net-worth individuals), REITs (which invest in various types of real estate), and variable annuities. Mutual fund investors face an array of loads, fees, and charges, including front-end loads, back-end loads, annual 12(b)-1 charges, and annual management fees. Some of these costs are one-time charges (e.g., front-end loads). Others are paid annually (e.g., 12(b)-1 and management fees). Investors should understand fund costs, which can drag down fund performance and return. |
1. back-end load , p. 480 2. closed-end fund , p. 476 4. hedge fund , p. 482 6. low-load fund , p. 480 7. net asset value (NAV) , p. 475 8. no-load fund , p. 480 9. open-end fund , p. 475 10. real estate investment trust (REIT) , p. 482 11. redemption fee 12(b)-1 fee , p. 475 |
MyFinanceLab Study Plan 12.2 |
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LG 3 Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill. Each fund has an established investment objective that determines its investment policy and identifies it as a certain type of fund. Some popular types of funds are growth, aggressive-growth, value, equity-income, balanced, growth-and-income, asset allocation, index, bond, money, sector, socially responsible, and international funds. The different categories of funds have different risk-return characteristics. |
1. aggressive-growth fund , p. 484 2. asset allocation fund , p. 488 3. automatic investment plan , p. 489 4. automatic reinvestment plan , p. 490 5. balanced fund , p. 485 7. conversion (exchange) privilege , p. 490 8. equity-income fund , p. 485 9. fund families , p. 491 |
MyFinanceLab Study Plan 12.3 |
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LG 4 Discuss the investor services offered by mutual funds and how these services can fit into an investment program. Mutual funds also offer special services, such as automatic investment and reinvestment plans, systematic withdrawal programs, low-cost conversion and phone-switching privileges, and retirement programs. |
1. growth-and-income fund , p. 485 2. growth fund , p. 484 3. index fund , p. 486 4. international fund , p. 489 5. money market mutual fund (money fund) , p. 486 6. sector fund , p. 488 7. socially responsible fund , p. 488 8. systematic withdrawal plan , p. 490 9. target date fund value fund , p. 489 10. value fund, p. 484 |
MyFinanceLab Study Plan 12.4 |
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LG 5 Describe the investor uses of mutual funds along with the variables to consider when assessing and selecting funds for investment purposes. Investors can use mutual funds to accumulate wealth, as a storehouse of value, or as a vehicle for speculation and short-term trading. Fund selection generally starts by assessing the investor’s needs and wants. The next step is to consider what the funds have to offer with regard to investment objectives, risk exposure, and investor services. The investor then narrows the alternatives by aligning his or her needs with the types of funds available and, from this short list of funds, applies the final selection tests: fund performance and cost. |
1. capital gains distributions , p. 499 2. dividend income , p. 499 |
MyFinanceLab Study Plan 12.5 |
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LG 6 Identify the sources of return and compute the rate of return earned on a mutual fund investment. The payoff from investing in a mutual fund includes dividend income, distribution of realized capital gains, growth in capital (unrealized capital gains), and—for closed-end funds—the change in premium or discount. Various measures of return recognize these elements and provide simple yet effective ways of gauging the annual rate of return from a mutual fund. Risk is also important to mutual fund investors. A fund’s extensive diversification may protect investors from business and financial risks, but considerable market risk still remains because most funds tend to perform much like the market, or like that segment of the market in which they specialize. |
MyFinanceLab Study Plan 12.6 Video Learning Aid for Problems P12.11, P12.16 |
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Log into MyFinanceLab, take a chapter test, and get a personalized Study Plan that tells you which concepts you understand and which ones you need to review. From there, MyFinanceLab will give you further practice, tutorials, animations, videos, and guided solutions. Log into http://www.myfinancelab.com |