question
4. Mutual funds and other investment companies
Instructor: Seongcheol Paeng
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Ice Breaking
What is your interest and talent?
What is your dream in the future?
Why do you have the dream?
What are you doing now in order to make it true?
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Announcements
Syllabus: a few changes
Assignments: 1 paragraph (5~10 sentences) for each question, Ch1,Ch2,Ch4, Do not copy and paste. Paraphrase. You can resubmit.
Investment Essay: 3~5 pages (12-point, double space), any experience regarding investment, what did you learn from the experience?
Test: next Monday. All the answers are in my lecture notes. Memorizing is the best way to prepare. Do not copy and paste. Paraphrase. Some of the assignment's problems. But the answers should be different among lecture notes, assignments, and test solution because you have to paraphrase them.
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Table
4.1 Investment Companies
4.2 Types of Investment Companies
4.3 Mutual Funds
4.4 Costs of Investing in Mutual Funds
4.5 Taxation of Mutual Fund Income
4.6 Exchange-Traded Funds
4.7 Mutual Fund Investment Performance: A First Look
4.8 Information on Mutual Funds
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4.1 Investment Companies
Investment companies are financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities or other assets.
Investment companies perform several important functions for their investors:
1. Record keeping and administration. Investment companies issue periodic status reports, keeping track of capital gains distributions, dividends, investments, and redemptions, and they may reinvest dividend and interest income for shareholders.
2. Diversification and divisibility. By pooling their money, investment companies enable investors to hold fractional shares of many different securities. They can act as large investors even if any individual shareholder cannot.
3. Professional management. Investment companies can support full-time staffs of security analysts and portfolio managers who attempt to achieve superior investment results for their investors.
4. Lower transaction costs. Because they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees and commissions.
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4.1 Investment Companies
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4.2 Types of Investment Companies
Unit Investment Trusts
Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the fund.
There is little active management of a unit investment trust because once established, the portfolio composition is fixed; hence these trusts are referred to as unmanaged.
Sponsors of unit investment trusts earn their profit by selling shares in the trust at a premium to the cost of acquiring the underlying assets.
For example, a trust that has purchased $5 million of assets may sell 5,000 shares to the public at a price of $1,030 per share, which (assuming the trust has no liabilities) represents a 3% premium over the net asset value of the securities held by the trust. The 3% premium is the trustee’s fee for establishing the trust.
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4.2 Types of Investment Companies
Managed Investment Companies
There are two types of managed companies: closed-end and open-end. In both cases, the fund’s board of directors, which is elected by shareholders, hires a management company to manage the portfolio for an annual fee that typically ranges from .2% to 1.25% of assets.
Open-end funds stand ready to redeem or issue shares at their net asset value (although both purchases and redemptions may involve sales charges). When investors in open-end funds wish to “cash out” their shares, they sell them back to the fund at NAV.
In contrast, closed-end funds do not redeem or issue shares. Investors in closed-end funds who wish to cash out must sell their shares to other investors.
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4.2 Types of Investment Companies
Managed Investment Companies
Figure 4.1 is a listing of closed-end funds. The first column gives the name and ticker symbol of the fund. The next two columns give the fund’s most recent net asset value and closing share price.
The premium or discount in the next column is the percentage difference between price and NAV: (Price – NAV)/NAV.
Notice that these funds are all selling at discounts to NAV (indicated by negative differences).
Finally, the 52-week return based on the percentage change in share price plus dividend income is presented in the last column.
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4.2 Types of Investment Companies
Other Investment Organizations
Commingled Funds: Commingled funds are partnerships of investors that pool funds. The management firm that organizes the partnership, for example, a bank or insurance company, manages the funds for a fee.
Real Estate Investment Trusts (REITs): A REIT is similar to a closed-end fund. REITs invest in real estate or loans secured by real estate. Besides issuing shares, they raise capital by borrowing from banks and issuing bonds or mortgages. Most of them are highly leveraged, with a typical debt ratio of 70%.
There are two principal kinds of REITs. Equity trusts invest in real estate directly, whereas mortgage trusts invest primarily in mortgage and construction loans.
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4.2 Types of Investment Companies
Other Investment Organizations
Hedge Funds: Like mutual funds, hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager. Unlike mutual funds, however, hedge funds are commonly structured as private partnerships and thus subject to only minimal SEC (U.S. Securities and Exchange Commission) regulation.
Lock-ups allow hedge funds to invest in illiquid assets without worrying about meeting demands for redemption of funds. Moreover, because hedge funds are only lightly regulated, their managers can pursue investment strategies involving, for example, heavy use of derivatives, short sales, and leverage; such strategies typically are not open to mutual fund managers.
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4.3 Mutual Funds
Mutual funds are the common name for open-end investment companies. This is the dominant investment company today, accounting for 87% of investment company assets.
Investment Policies
Money Market Funds: These funds invest in money market securities such as commercial paper, repurchase agreements, or certificates of deposit.
Equity Funds: Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of securities.
Sector Funds: Some equity funds, called sector funds, concentrate on a particular industry. For example, Fidelity markets dozens of “select funds,” each of which invests in a specific industry such as biotechnology, utilities, energy, or telecommunications.
Bond Funds: As the name suggests, these funds specialize in the fixed-income sector. Within that sector, however, there is considerable room for further specialization.
International Funds: Many funds have an international focus. Global funds invest in securities worldwide, including the United States. In contrast, international funds invest in securities of firms located outside the United States. Regional funds concentrate on a particular part of the world, and emerging market funds invest in companies of developing nations.
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4.3 Mutual Funds
Investment Policies
Balanced Funds: Some funds are designed to be candidates for an individual’s entire investment portfolio. Balanced funds of funds invest in equity and bond funds in proportions suited to their investment goals.
Asset Allocation and Flexible Funds: These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector.
Index Funds: An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to each security’s representation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that replicates the composition of the Standard & Poor’s 500 stock price index.
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4.3 Mutual Funds
Investment Policies
Table 4.1 breaks down the number of mutual funds by investment orientation.
How Funds Are Sold
Mutual funds are generally marketed to the public either directly by the fund underwriter or indirectly through brokers acting on behalf of the underwriter.
Direct-marketed funds are sold through the mail, various offices of the fund, over the phone, or, more so, over the Internet. Investors contact the fund directly to purchase shares.
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4.3 Mutual Funds
How Funds Are Sold
Investors who rely on their broker’s advice to select their mutual funds should be aware that this advice may suffer from a conflict of interest if the broker receives compensation for directing the sale to a particular fund.
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4.4 Costs of Investing in Mutual Funds
Fee Structure
Operating Expenses: Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, may range from .2% to 2%.
In addition to operating expenses, many funds assess fees to pay for marketing and distribution costs.
Front-End Load: A front-end load is a commission or sales charge paid when you purchase the shares.
Back-End Load: A back-end load is a redemption, or “exit,” fee incurred when you sell your shares.
12b-1 Charges: The Securities and Exchange Commission allows the managers of so-called 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule that permits use of these plans.
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4.4 Costs of Investing in Mutual Funds
Fee Structure
Many funds offer “classes” that represent ownership in the same portfolio of securities, but with different combinations of fees.
Each investor must choose the best combination of fees.
Loads are paid only once for each purchase, whereas 12b-1 fees are paid annually. Thus, if you plan to hold your fund for a long time, a one-time load may be preferable to recurring 12b-1 charges.
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4.4 Costs of Investing in Mutual Funds
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4.4 Costs of Investing in Mutual Funds
Fees and Mutual Fund Returns
Example 4.3 To see how expenses can affect rate of return, consider a fund with $100 million in assets at the start of the year and with 10 million shares outstanding. The fund invests in a portfolio of stocks that provides no income but increases in value by 10%. The expense ratio, including 12b-1 fees, is 1%. What is the rate of return for an investor in the fund?
Initial NAV = $100m/10m shares = $10 per share
In the absence of expenses: fund assets =$100mX0.1 = $110m
NAV = $110m/10m=$11 per share
portfolio worth =$110m-$100mX0.01=$109m
NAV =$109m/10m=$10.90.
Rate of return = 9%
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4.4 Costs of Investing in Mutual Funds
Fees and Mutual Fund Returns
Fees can have a big effect on performance.
Table 4.2 considers an investor who starts with $10,000 and can choose among three funds that all earn an annual 12% return on investment before fees but have different fee structures.
The table shows the cumulative amount in each fund after several investment horizons.
Fund A has total operating expenses of .5%, no load, and no 12b-1 charges.
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4.4 Costs of Investing in Mutual Funds
Fees and Mutual Fund Returns
Fund B has no load but has 1% in management expenses and .5% in 12b-1 fees.
This level of charges is fairly typical of actively managed equity funds.
Finally, Fund C has 1% in management expenses, has no 12b-1 charges, but assesses an 8% front-end load on purchases.
Note the substantial return advantage of low-cost Fund A.
Moreover, that differential is greater for longer investment horizons.
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4.4 Costs of Investing in Mutual Funds
Fees and Mutual Fund Returns
Although expenses can have a big impact on net investment performance, it is sometimes difficult for the investor in a mutual fund to measure true expenses accurately.
This is because of the practice of paying for some expenses in soft dollars. A portfolio manager earns soft-dollar credits with a brokerage firm by directing the fund’s trades to that broker.
Soft dollars are a means of paying brokerage firms for their services through commission revenue, as opposed to through hard-dollar direct payments.
On the basis of those credits, the broker will pay for some of the mutual fund’s expenses, such as databases, computer hardware, or stock-quotation systems.
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4.5 Taxation of Mutual Fund Income
Investment returns of mutual funds are granted “pass-through status” under the U.S. tax code, meaning that taxes are paid only by the investor in the mutual fund, not by the fund itself.
If you manage your own portfolio, you decide when to realize capital gains and losses on any security; therefore, you can time those realizations to efficiently manage your tax liabilities.
When you invest through a mutual fund, however, the timing of the sale of securities from the portfolio is out of your control, which reduces your ability to engage in tax management.
A fund with a high portfolio turnover rate can be particularly “tax inefficient.” Turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio.
It measures the fraction of the portfolio that is “replaced” each year.
For example, a $100 million portfolio with $50 million in sales of some securities and purchases of other securities would have a turnover rate of 50%. High turnover means that capital gains or losses are being realized constantly, and therefore that the investor cannot time the realizations to manage his or her overall tax obligation.
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4.5 Taxation of Mutual Fund Income
An investor’s portfolio currently is worth $1 million. During the year, the investor sells 500 shares of FedEx at a price of $160 per share and 3,200 shares of Cisco at a price of $25 per share. The proceeds are used to buy 1,000 shares of IBM at $160 per share.
a. What is the portfolio turnover rate?
$160 X 500 + 3,200 X $25 = $160,000
Turnover = $160,000 in trades per $1 million of portfolio value = 16%.
b. If the shares in FedEx originally were purchased for $140 each and those in Cisco were purchased for $20, and the investor’s tax rate on capital gains income is 20%, how much extra will the investor owe on this year’s taxes as a result of these transactions?
Realized capital gains: $(160-140)× 500 = $10,000 (FedEx)
$(25-20)× 3,200 = $16,000 (Cisco)
Tax: .20× $(10,000+16,000) = $5,200.
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4.6 Exchange-Traded Funds
Exchange-traded funds (ETFs), first introduced in 1993, are offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock.
The first ETF was the “spider,” a nickname for SPDR, or Standard & Poor’s Depository Receipt, which is a unit investment trust holding a portfolio matching the S&P 500 Index.
Table 4.3, Panel A, presents some of the major sponsors of ETFs, and Panel B gives a very small flavor of the types of funds offered.
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4.6 Exchange-Traded Funds
Figure 4.2 shows the rapid growth in the ETF market since 1998.
Until 2008, most ETFs were required to track specified indexes, and ETFs tracking broad indexes still dominate the industry.
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4.6 Exchange-Traded Funds
Figure 4.3 shows that ETFs have captured a significant portion of the assets under management in the investment company universe.
Barclays Global Investors was long the market leader in the ETF market, using the product name iShares.
Since Barclays’s 2009 merger with BlackRock, iShares has operated under the BlackRock name.
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4.6 Exchange-Traded Funds
ETFs offer several advantages over conventional mutual funds.
First, as we just noted, a mutual fund’s net asset value is quoted—and therefore, investors can buy or sell their shares in the fund—only once a day. In contrast, ETFs trade continuously. Moreover, like other shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.
ETFs also offer a potential tax advantage over mutual funds. When small investors wish to redeem their position in an ETF, they simply sell their shares to other traders, with no need for the fund to sell any of the underlying portfolio. Large investors can exchange their ETF shares for shares in the underlying portfolio; this form of redemption also avoids a tax event.
ETFs are often cheaper than mutual funds. Investors who buy ETFs do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses may translate into lower management fees.
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4.7 Mutual Fund Investment Performance: A First Look
Casual comparisons of the performance of the Wilshire 5000 index versus that of professionally managed mutual funds reveal disappointing results for active managers.
Figure 4.4 shows that the average return on diversified equity funds was below the return on the Wilshire index in 27 of the 45 years from 1971 to 2015.
The average annual return on the index was 12.1%, which was 1% greater than that of the average mutual fund.
Of course, one might argue that there are good managers and bad managers, and that good managers can, in fact, consistently outperform the index.
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4.7 Mutual Fund Investment Performance: A First Look
Table 4.4 presents such an analysis from a study by Malkiel (1995).
The table shows the fraction of “winners” (i.e., top-half performers) in each year that turn out to be winners or losers in the following year.
This evidence is consistent with the notion that at least part of a fund’s performance is a function of skill as opposed to luck, so that relative performance tends to persist from one period to the next.
This suggests that the real value of past performance data is to avoid truly poor funds, even if identifying the future top performers is still a daunting task.
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4.8 Information on Mutual Funds
To illustrate the range of information available about funds, we consider Morningstar’s report on Fidelity’s Magellan Fund, reproduced in Figure 4.5.
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Assignments
Problem Sets (Paraphrase with your own words.)
1. Explain 4 functions of investment companies for their investors.
2. Consider a mutual fund that manages a portfolio of securities worth $230 million. Suppose the fund owes $3 million to its investment advisers and another $2 million for rent, wages due, and miscellaneous expenses. The fund has 5 million shares outstanding. Net asset value?
3. Explain about Hedge Fund.
4. Explain Fee Structure.
5. To see how expenses can affect rate of return, consider a fund with $200 million in assets at the start of the year and with 5 million shares outstanding. The fund invests in a portfolio of stocks that provides no income but increases in value by 8%. The expense ratio, including 12b-1 fees, is 2%. What is the rate of return for an investor in the fund?
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Assignments
Problem Sets (Paraphrase with your own words.)
6. An investor’s portfolio currently is worth $1 million. During the year, the investor sells 500 shares of FedEx at a price of $180 per share and 3,000 shares of Cisco at a price of $30 per share. The proceeds are used to buy 1,000 shares of IBM at $160 per share.
a. What is the portfolio turnover rate?
b. If the shares in FedEx originally were purchased for $140 each and those in Cisco were purchased for $20, and the investor’s tax rate on capital gains income is 20%, how much extra will the investor owe on this year’s taxes as a result of these transactions?
7. According to Figure 4.4, casual comparisons of the performance of the Wilshire 5000 index versus that of professionally managed mutual funds reveal disappointing results for active managers. But why people use mutual fund?
Deadline: before the class (7/1)
Submit it via email to seongcheol.paeng@csusb.edu
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