Finance 431 - Grinder
Chapter #4
Mutual Funds
  1. Investment Companies and Fund Types
    1. Closed-End Fund (Investment Trust)
      1. Definition:  A fund that issues a fixed number of shares. After the initial issue, the only way to buy the fund is by purchasing shares on the market or if the fund conducts a special public issue of shares or a rights offering
      2. Pricing Closed-End funds is more complex than pricing an individual security since there are two values to consider:
        1. Net Asset Value (NAV)
          1. NAV is an estimate of the current value of the securities in a fund.


            Where: Qi is the quantity of shares of security i held by the fund; Pi is the market price of security I; Liab includes the net liabilities of the fund; N of the number of outstanding shares of the fund.

          3. Using data from Templeton Dragon Fund's (Ticker: TDF): Financial Statement from June 30, 2010, we can calculate its NAV for June 30, 2010 as follows:


          4. NAVs for closed-end funds are calculated once a week (on Fridays) and reported in the next Monday's Wall Street Journal (Daily in the online version for many closed end-funds). Templeton Dragon Fund's NAV reported in the 01/07/11 Wall Street Journal Online is $34.02.
        2. Market Price - This is the price at which the closed end fund is traded. For instance The Templeton Dragon Fund's market price on 01/07/11 was $31.59. Thus the fund is selling for a discount of 7.14% from its NAV [($31.59 - $34.02)/$34.02].
    2. Open-End Fund (Mutual Fund)
      1. Definition: Open-end funds issue shares of the fund to buyers and purchase shares of the fund from sellers.  In other words, the mutual funds trade shares directly with investors. The number of shares outstanding is constantly changing.
      2. Example: The SouthernSun Small Cap Fund. (Ticker: SSSFX) is an open-end mutual fund that recently earned top honors in the Wall Street Journal with a one-year return of 48.35% percent for 2010.
      3. With an open-end fund there is only one price to consider: the fund's NAV.   SouthernSun Small Cap Fund's NAV (from the January 12, 2011 - Wall Street Journal online) is $20.02.
  2. Mutual Fund Costs and Fees
    1. Loads or sales charges
    2. Types of loads
      1. No-loads: Created during the 1970s bear market to attract investors into mutual funds.
      2. Front-end loads:  8.5 percent was the most common load for years.  If you invested $2,500 in a mutual fund with an 8.5% load, $212.50 went to commissions and only $2,287.50 was actually invested in the fund.  Most loads today are in the 4-6 percent range. For instance, the Legg Mason Batterymarch Global Equity Fund (Class A, Ticker: CFIPX)has a front-end load of 5.75% as well as annual operating expenses including a 0.85% management fee, a 0.25% 12b-1 fee, and a fee covering other expenses of 0.91% (Source:  Legg Mason Batterymarch Global Equity Fund Prospectus, February 26, 2010)
      3. Back-end loads (redemption fees, exit fees, contingent deferred sales charges).  This is paid when a fund is sold. The fee goes down the longer you hold the fund.  Long-term investors may not have to pay the fee. 
      4. Level Loads:  A fee is charged every year on the fund.
    3. 12-b1 fees:SEC rule that allows funds to levy a fee to help defray marketing and distribution costs.  The fee can be used to pay brokers for their sales efforts, or it can be used to pay for advertising.
    4. Management Fees
    5. Trading costs and turnover
    6. Expense Reporting is reported in a fund's prospectus.
  3. Short-Term Funds (Money Market Mutual Funds)
  4. Long-Term Funds
    1. Stock Funds
      1. Capital Appreciation vs. Income
      2. Company Size-Based Funds
      3. International Funds
      4. Sector Funds
      5. Index Funds
    2. Taxable and Municipal Bond Funds
    3. Stock and Bond Funds
  5. Mutual Fund Performance
  6. Taxes
    1. Mutual funds are not taxed if they follow strict guidelines concerning diversification (Not allowed to own more than 10 percent of the voting stock of a single corporation), and distribution of taxable income (98 percent of net income and realized capital gains must be distributed before the end of the calendar year in which they are realized.)
    2. Investors are taxed on distributions.
      1. Dividends, net short-term capital gains, and interest income are taxed as ordinary income.
      2. Long-term capital gains are taxed at a maximum rate of 28 percent.
      3. New investors in a fund need to know when distributions will be made.  Otherwise, they may be stuck with an unwanted tax bill.  For example, suppose you invest $50,000 in a fund at the end of the year before the fund makes its annual distribution.  NAV is $25 per share so you would receive 2,000 shares.  When the fund makes its distribution of say  $0.75 a share, you would receive $1,500, and the value of your shares, other things being equal would drop to $48,500.  If you are in a 30 percent tax bracket, you would owe $1,500 × 0.30 = $450 in taxes on the distribution so your overall position in the fund is:






        -$  450

        Overall Position


  7. Exchange Traded Funds
    1. One of the problems with mutual funds is that the Net Asset Value Per Share is determined based on closing market prices. This means that even if your order to buy or sell shares of a mutual fund is received in the morning, it will not be filled until the end of the day when the mutual fund is priced.
    2. In 1993, the American Stock Exchange responded to this inconvenience by trading Standard & Poor’s Depositary Receipts (SPDRs). This fund has the advantage of trading throughout the day. Orders for buying and selling can be placed through your broker and executed immediately.
    3. SPDRs are very similar to an index fund such as the Vanguard 500 Index Fund in that they are indexed to the Standard and Poor's 500 Index using the market value weights of the S&P 500.
    4. The annual management fees charged for this fund is slightly less than that charged to Vanguard S&P500 Index Fund investors. Also since ETFs are Unit Investment Trusts they cannot be traded actively. This restriction minimizes trading commissions and reduces tracking errors. (A unit investment trust is similar to a closed end investment company. It is a professionally selected, but unmanaged, portfolio of securities designed to meet some stated investment objective." -see Robert Strong, Practical Investment Management 3rd ed. page 325)
    5. The success of SPDRs led to other ETFs such as the Nasdaq-100 Index Tracking Stock (QQQQ), MidCap SPDRs (Standard & Poor’s MidCap 400 Depository Receipts), Select Sector SPDRs, DIAMONDS (The Dow Industrials), iShares - Barclays Global Investors, HOLDRs (Merrill Lynch), and Nasdaq BLDRs (Baskets of Listed Depositary Receipts.)
    6. Consider the following features of ETFs versus Index Funds and Individual Securities (Source: NASDAQ Web Site):

      ETF Comparison - While similar to an index mutual fund,
      ETFs differ from mutual funds in significant ways.
      Attribute ETF Index
      Diversification Yes Yes No
      Traded throughout the day Yes No Yes
      Can be bought on margin Yes No Yes
      Can be sold short Yes No Yes
      Tracks an index or sector Yes Yes No
      Tax efficient as turnover is low Yes Possibly No
      Low Expense Ratio Yes Sometimes Not a factor
      Trade at any brokerage firm Yes No Yes

      The ETF Heatmap

  8. Hedge Funds
    1. Definition: "An unregistered investment company not accessible by the general public and significantly less regulated than a mutual fund." - see text page 124.
    2. Example: See the front page of the January 12, 2005 Wall Street Journal for an article entitled "Ex-Trader Creates Hot Hedge Fund and a Traffic Jam." The article examines Eric Mindich's Eton Park Capital Management Fund which, acccording to the article, requires a minimum investment of $5 million, "stiff" management fees, 20% of investment profits, and a commitment of 4½ years. The fund has more than $3 billion under management.
    3. Example: The Blow-up Artist: Can Victor Niederhoffer survive another market crisis? from The New Yorker, October 15, 2007. Also available from the EWU JFK Library via EBSCOhost