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Copyright © Houghton Mifflin Company. All rights reserved. 1–1

Mutual Funds

• Definition

• Risk and Return Relationship

• Pros and Cons of Investing in Mutual Funds

• Structure of a Mutual Fund and a Commercial Bank

• History of Mutual Funds

• Challenges Facing the Industry


Mutual Funds

•Definition: Financial intermediary through which savers pool their monies for collective investment, primarily in publicly trades securities.

•A fund is “mutual” in the sense that all of its returns minus its expenses, are shared by its shareholders.

•Returns consist of dividends, realized and unrealized capital gains (losses)

•Expenses consist of advisory fee for servicing the shareholders, annual fee for distribution (12b-1)


Seeking Higher Returns

• Objective is to maximize return with minimum risk

• Efficient Market hypothesis and undervalued securities

• Behavioral Finance

• Mean reversion in the equity market

• Individual securities have two main sources of risk: alpha and beta.


Definitions for Returns

• Return = Interest or Dividends +/- Price ChangeInitial Investment

• Risk = Variation (or range) of possible returns

• Goal => Maximize return and minimize risk


Seeking Higher Returns (for Same Risks)

• Random walk

– No predictable relationship between past changes and future changes in stock prices

– Based on extensive empirical studies


Seeking Higher Returns (for Same Risks) (cont.)

• Efficient market hypothesis (EMH)– Theory regarding information content of

market prices– May explain random walk studies– Paradox of EMH and value of research

• Behavioural finance– Most investors do not behave perfectly

rationally, but are influenced by psychological factors


Reducing Portfolio Risk

• Alpha risk• Alpha - company specific risk usually accounts for 50%-70%

of security’s price volatility;

• can be reduced by diversification

• Beta risk

– Beta - market risk accounts for 30%-50% of price volatility.

– Stock market risk; cannot be reduced by diversification


Benefits of Investing in Mutual Funds

• Diversification :Typically lowers ; global fund may also lower

• Professional Management: Professional qualifications (CFA); access to company executives; in house research team, wall street research.

• Lower Transaction Costs: Lower admn. cost, savings on record keeping, better execution of securities.

• Convenience: Automatic deposits/ withdrawal, tax reporting, retirement planning, educational materials.


Benefits of Investing in Mutual Funds

• Higher minimum requirements for individual bonds (usually $25,000; T-bonds $1,000). Lot size is usually $100,000. One $25,000 bond lacks diversification.

•Cost : 2% - 4% of value.

•Bond mutual fund minimum: As low as $1,000. Can redeem fund on any business day. Do not have to hold till maturity.

•Fund offers more diversification. Offer convenient services, such as monthly income payments, compared to quarterly or semi-annually for individual bonds

•Similar advantages for stock funds


Disadvantages of Investing in Mutual Funds

•Need to pay fees/expenses even when fund performs poorly

•Increased diversification may prevent the chance of “hitting the jackpot” from one security

•Online trading and security research on the internet have reduced the advantage of cost and research access

•Less control over securities portfolio and therefore timing of realized capital gains for tax purposes.


Popular Ways to Purchase Individual Securities

• On-line trading• Separate account

– Portfolio of individual securities managed separately by a bank, broker, or financial adviser

– Account minimums lowered for consultant or rep wraps

– Pre-packaged model portfolios– “Baskets” available through the internet


Assets of Mutual Funds 1985–2000

Stock and Bond Funds

Money Market Funds

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1985 1987 1989 1991 1993 1995 1997 1999

$ Billion

Source: Investment Company Institute (ICI)

$6,967 B


Growth of Financial Intermediaries*

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1990R 1992R 1994 1996 1998 2000

Mutual Funds

CommercialBanks

Life Insurance

Savings /Credit Unions

$ Billions

* Excludes bank-administered trusts and closed-end investment companiesSource: Federal Reserve Board, Federal Financial Institutions Examination Council, ICI


Structure of a Mutual Fund


Mutual Fund Complex

Shareholders (Savers)

Management Company

Distribution

Transfer Agency

Broker

Stock Funds

Fixed Income Funds

Money MarketFunds


Structure of aCommercial Bank


MM Fund VersusBank Deposit

MM Fund Bank Deposit

• Rate of Return Tracks T-bill closely but usually higher because of credit risk

Does not track T-bill closely; longer maturity results in higher rate

• Time Redemptions daily

MMDA: allows limited daily withdrawalsCDs: penalty for early withdrawal

• Liquidity Highly liquidCDs: funds “locked-up” for fixed period

• Diversification No more than 5% in any one issuer

Generally cannot loan more than 15% to one borrower


MM Fund VersusBank Deposit (cont.)

MM Fund Bank Deposit

• Risk 95% must be in highest rated paper; average 90-day security maturity; no FDIC insurance

Loans subject to credit review; try to match asset maturity to liabilities; FDIC insurance ($100K)

• Capital Management company, not fund, has capital; no regulatory requirement or guarantee

Banks must have capital meeting meeting regulatory requirements; FDIC guarantees deposits ($100K limit)

• Tax May offer tax-exempt interest to shareholders

May not offer tax-exempt interest to depositors

• Fees Fee income from management contract

Primarily spread income from principal risk


History of Mutual Funds

• 1940: Investment Company Act – established standards for fund promotion,

reporting, product pricing, and portfolio investing.

• 1950-60s: Industry experience growth.

• 1970s: Stock market declined. Difficult to sell stock fund. Investors interested in short-term or income-oriented investments


History of Mutual Funds (Cont’d)

• 1970s: Money market funds were created and became the savior of the industry.

• 1980s: High interest rate atmosphere. Banks were legally prevented from paying more than 4% - 5% interest. MM assets exceeded either stock or bond fund assets.

• 1990s: Spectacular growth in mutual fund industry. $800b in 1987 to $5t in 1999.



• Factors behind the rapid growth:– Bull market in U.S. stock.– Tax-advantaged retirement vehicles– attractive mutual fund products– enhanced services to fund shareholders.

• Distribution channels & pricing structures:– Broker - Dealers are the traditional distribution

channel



– Front-end load declined from 81/2% in 1960 to ~4% now.

– Currently broker-dealer may charge ‘back-end’ load. The load declines based on the length of investment.

– Annual distribution fee 12b-1paid by the fund to the distributor. Range is from 25 bp to 75bp.



• Direct marketing of funds: – MMF spurred direct marketing– ‘no-load’ funds. Charges are low- around

2%-3% and 12b-1 around 25bp.

• Retirement Plan:– Attractive service providers to plan

sponsors of 401(k) and other defined contribution plans.



– Employees can choose to contribute in specific funds. Fund Co provides disclosure documents and educational materials to each employee.

– In most cases sales loads may be waved and service fees may be negotiated .

Banks and Insurance Cos :– Glass-Steagall prohibition? Banks found ways to

offer their own or other’s funds to their customers.– Insurance Co- joint venture with funds to offer

variable annuities

copyright © houghton mifflin company. all rights reserved. 1–01–0 mutual funds definition risk...

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