Mutual Funds

Mutual Funds
• An investment company that issues its portfolio shares to
investors.

• Money from shareholders are pooled and invested in a wide

range of stocks, bonds, or money market securities.
• Managed by professional managers

• Each investor shares proportionately in the income and

investment gains and losses, as well as the brokerage
expenses and management fees.

• Open end fund: # of shares issued solely depends on

investor demand
• Bought and sold directly through the investment company (not
an exchange)
Net asset Value
• NAV: per share value of a mutual fund’s
investment holding.
Market Value of Assets  Portfolio Liabilitie s
NAV 
# of Shares Outstandin g

Example
A mutual fund has $100 mil in assets and $3 mil in
short term liabilities. 10.765 mil shares
outstanding. What is the NAV?
Solution
($100 mil - $3 mil) / 10.765 mil = $9.0107 per
share
Types of Mutual Funds Objective Funds Hold Growth Potential Income Potential Stability
Money Market Funds

Taxable money market Current income Cash investments None Moderate Very high
stability of principal
Tax-exempt money Tax-free income, Municipal cash investments None Moderate Very high
market stability of principal
Bond Funds
Taxable bond Current income Wide range of government None Moderate to high Low to moderate
and/or corporate bonds

Tax-exempt bond Tax-free income Wide range of municipal bonds None Moderate to high Low to moderate

Common Stock Funds

Balanced Current income Stocks and bonds Moderate Moderate to high Low to moderate
capital growth
Equity income High-yielding stocks, Moderate to high Moderate Low to moderate
convertible bonds
Value funds Low P/E, P/B stocks Moderate to high Low to moderate Low to moderate

Growth and income Dividend-paying stocks Moderate to high Low to moderate Low to moderate

Domestic growth Capital growth U.S. stocks with high potential High Very low Low
for growth
International growth Stocks of companies outside High Very low to low Very low
U.S.
Aggressive growth Aggressive growth Stocks with very high potential Very high Very low Very low
of capital for growth
Small cap Stocks of small companies Very high Very low Very low

Specialized Stocks of industry sectors High to very high Very low to Very low to low
moderate
Mutual Fund Advantages
• Broad diversification
• Diversified stock funds hold large and small company
stocks broadly spread across industries and economic
sectors
• Diversified bond funds hold bonds with different
maturities, coupon, and credit quality
 Ability to retain professional investment management at a
reasonable cost
 Investor convenience
 Many offer “fund family”
Mutual Fund Disadvantages
 Volatility can be significant
 Diversification doesn’t protect investors from the
risk of loss from an overall decline in financial
markets
 Mutual fund regulation doesn’t eliminate the risk of
an investment falling in value

• High management fees and sales

commissions
• No-load funds
 Figure 16.2 Impact of Costs and Taxes on 10% Return

$5,000

$4,526
$4,500

$4,000

$3,500
10% Return, no cost
$3,141
$3,000 10% Return, 1% cost
Ending Value

10% Return, 1% cost, 30% taxes

$2,500

$2,000

$1,500

$1,152
$1,000

$500

Begin w ith $100

$0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40
Years
Sources of Investment Returns

• Total Return: dividend and interest income and realized and

unrealized appreciation

• Income distribution: interest and dividend income after expenses.

• Capital gains unrealized until the fund sells the shares

(Unrealized capital gains)

• The realized capital gains are paid out to shareholders at the end
of the year (capital gains distributions)
 Mutual fund expenses
• Operating expense ratio: total of investment
advisory fees and costs of legal and accounting
services, etc., expressed as a percentage of the
fund’s average net assets (range from 0.2% to
2%)
• Lowest for money market mutual fund and
highest for international stock funds
• Tend to be lowest for large, liquid funds
• Load charges: one time sales commissions
• Front-end loads (charged at the time of
purchase)
• Back-end loads (charged at the time of sales
of shares)
• Low-end funds: sales fee ranging from 1% to
3%
• 12b-1 fees: marketing and distribution costs
• No-load funds: fund without front-end or
back-end load charges
 Mutual Fund Organization
• Mutual fund shareholders: own
mutual funds, elect the board of
directors

• Majority of the directors must be

independent directors

• Investment advisor: manages the

day-to-day operations

• Principal underwriter,
administrator, transfer agent,
custodian, and independent public
accountant
Exchange-Trade Funds (ETFs)
 Tradable shares in baskets of stocks that closely
track broad market averages, market sectors, or
major stock markets from around the world.
• Tradable shares in baskets of stocks that
closely track broad market averages, market
sectors, or major stock markets from around
the world.
• Standard and Poor’s Depository Receipts
(SPY), “spiders”: closely track S&P 500 Index
• Diamonds (DIA): track Dow Jones Industrial
Average
• QQQQ: track Nasdaq 100 Index
• Select Sector SPDRs: unbundled S&P Index to
give investors ownership in a particular
market sector or group of industries.
• Barclays Global Investors: offer “iShares” –
internationally indexed
 Closed-End Funds
• Issues a fixed number of shares at a given point in time

• Collect money from investors through and IPO and use this
money to invest in securities.

• No of securities are fixed at the time of IPO.

• When the market price exceeds its NAV, selling at a premium,

otherwise, selling at a discount (closed-end funds typically sell
at a discount)

• Suited to specialized investing in small or illiquid markets

Table 16.6 Hedge Funds Differ From Mutual Funds in a
Number of Ways
Mutual Funds Hedge Funds

Who Invests 92 million Americans own mutual fund shares. The Only sophisticated, high net worth investors are
only qualification for investing is having the eligible to invest. The typical investor is a
minimum investment to open an account with a fund wealthy individual or an institution such as an
company ‑‑ often $1,000 or less. endowment or foundation. A minimum
investment of $1 million or more is required.
Fees Mutual fund shareholders pay, on average, an annual Hedge fund investors often pay a portfolio
expense ratio of roughly 1.5% of assets. Load management fee of 1% to 2% of net assets, plus
charges can increase this to 2.5% to 5% per year. a performance-based fee that can run as high as
Funds must disclose fees and expenses in detail. 10% per year, depending upon performance.
Sales charges and other distribution fees are subject Fees are not subject to specific regulatory limits.
to specific regulatory limits.
Investment Securities laws restrict a mutual fund's ability to Leveraging strategies are hallmarks of hedge
Practices leverage, or borrow against the value of securities in funds. Investment policies do not have to be
its portfolio. Funds that use options, futures, forward disclosed, even to investors in the fund.
contracts, and short selling must "cover" their
positions with cash reserves or other liquid securities.
Investment policies must be fully disclosed to
investors.
Pricing and Mutual funds must value their portfolio securities and There are no specific rules on valuation or
Liquidity compute their share daily. They generally must also pricing. As a result, hedge fund investors may
allow shareholders to redeem shares on at least a be unable to determine the value of their
daily basis. investment at any given time. In addition, new
investors typically must pledge to keep their
money in a hedge fund for at least one year.
Taxes on distributions
• Shareholders pay taxes due once income dividends and
capital gains distributions are received.

• All income and capital gains distributions are generally

subject to income taxes.

• Turnover rate: expressed as a percentage of the fund’s

average assets (average turnover rate for stock mutual
fund: 79%)
Performance Evaluation Measures
The Sharpe Ratio

• The Sharpe ratio is a reward-to-risk ratio that focuses

on total risk.

• It is computed as a portfolio’s risk premium divided by

the standard deviation for the portfolio’s return.
Rp  R f
Sharpe ratio 
σp
Performance Evaluation Measures
The Treynor Ratio

• The Treynor ratio is a reward-to-risk ratio that looks at

systematic risk only.

• It is computed as a portfolio’s risk premium divided by

the portfolio’s beta coefficient.
Rp  R f
Treynor ratio 
βp
Performance Evaluation Measures
Jensen’s Alpha

• Jensen’s alpha is the excess return above or below the security market line.
It can be interpreted as a measure of how much the portfolio “beat the
market.”

• It is computed as the raw portfolio return less the expected portfolio return

α p R p   R f  β p ER M   R f  
as predicted by the CAPM.

“Extr Actua CAPM Risk-Adjusted ‘Predicted’

a” l Return
Retur retur
n n
13-18
Portfolio Performance Measurement
Comparing Performance Measures

• Because the performance rankings can be substantially

different, which performance measure should we use?

Sharpe ratio:

• Appropriate for the evaluation of an entire portfolio.

• Penalizes a portfolio for being undiversified, because in

general, total risk  systematic risk only for relatively well-
diversified portfolios.
Comparing Performance Measures
Treynor ratio and Jensen’s alpha:

• Appropriate for the evaluation of securities or portfolios

for possible inclusion into an existing portfolio.

• Both are similar, the only difference is that the Treynor

ratio standardizes returns, including excess returns,
relative to beta.

• Both require a beta estimate (and betas from different

sources can differ a lot).