410 chapter 4

Chapter 4: FIN 410 Investment Analysis

What is a Mutual Fund?

• Definition: A mutual fund is an investment vehicle consisting of a portfolio of stocks, bonds, or other securities, managed by an investment company.

• Pooling of Funds: It combines the funds of many investors, allowing for better diversification and management.

• Fund Manager: Decisions on buying and selling securities are made by a fund manager, who receives compensation for these services.

How Does a Mutual Fund Work?

• Share Purchase: Investors buy shares in the mutual fund.

• Investing: The pooled money is used to purchase a diversified range of assets.

• Income Distribution: Any income generated by the fund is distributed among shareholders.

• Value Fluctuation: The value of the fund shares fluctuates based on market conditions.

Advantages of Mutual Funds

Diversification

• Spreads investment risk across many assets, reducing the impact of poor performance of any single investment.

• Provides exposure to diverse sectors and regions with minimal investment effort.

Professional Management

• Managed by professional money managers, who make investment decisions on behalf of investors.

• Investors do not have to worry about making critical investment decisions themselves.

Minimum Initial Investment

• Minimum initial purchases can be as low as $250, with many funds setting the threshold at $1,000 to $2,500.

• Subsequent investments can be as low as $50, making it accessible to a wider range of investors.

Disadvantages of Mutual Funds

Risk

• Fund values can decline, potentially resulting in losses greater than the initial investment.

• There are no guarantees from government or private entities regarding mutual fund values.

Costs

• Mutual funds have management fees and other associated costs that do not typically exist with direct purchases of individual securities.

• The emergence of ETFs (Exchange Traded Funds) raises questions about justifying higher costs associated with actively managed mutual funds.

Taxes

• Investors may be liable for taxes on distributions (dividends and capital gains) as well as when selling mutual fund shares in taxable accounts.

Investment Companies and Fund Types

• Definition: An investment company pools funds from individual investors to make investments.

Largest Fund Companies (Examples)

• Vanguard

• Fidelity

• American Funds

• T. Rowe Price

• Franklin Templeton

• JPMorgan

• Dimensional Fund Advisors

• PIMCO

• MFS

• BlackRock

Fund Families and Market Share

• Fund families have rankings based on total net assets and estimated net flows.

Types of Mutual Funds

Open-End Funds

• Can buy and sell shares at any time, based on the net asset value (NAV).

• Fund size limitations may arise if it becomes too large; however, existing investors can still add money.

Closed-End Funds

• Have a fixed number of shares traded on the market.

• Prices may vary from their NAV, potentially trading at a premium or discount.

Mutual Fund Operations

• Ownership: Mutual funds are corporations owned by shareholders who elect a board of directors.

• Creation: Typically created by asset managers or brokerage firms offering investment advisory services.

Regulatory Aspects

• Tax Exemption: A regulated investment company does not pay taxes on its investment income but must pass most net income to shareholders.

• Prospectus Requirement: Funds must provide a prospectus containing detailed information and annual reports to shareholders.

Mutual Fund Costs & Fees

Sales Charges (Loads)

• Front-End Load: Charge upon purchase.

• Back-End Load: Charge upon sale of shares.

12b-1 Fees

• Can be up to 1% annually for distribution and marketing.

Management Fees

• Generally range from 0.25% to 1.5% of total assets.

• Expense ratios provide an all-inclusive view of fees.

Trading Costs

• Not reported directly, but turnover indicates activity level and associated costs; higher turnover implies higher trading costs.

Types of Funds

Short Term Funds

• Money market mutual funds (MMMFs) typically maintain a stable $1.00 NAV, making them resemble bank accounts.

Long Term Funds

• Classified by investment objectives, such as growth, income, or capital appreciation.

• Varieties include stock funds, bond funds, balanced funds, sector funds, and more.

Fund Performance

• Important to understand the riskiness of fund categories when considering historical performance.

• Funds with high costs often underperform compared to their benchmarks.

Share Classes of Mutual Funds

Class A Shares

• Have front-end sales loads; lower annual expenses; suitable for long-term investors.

Class B Shares

• No front-end sales loads; higher annual expenses; may convert to Class A after a set period.

Class C Shares

• No front-end sales loads; higher annual expenses than A or B; often suitable for short-term investors.

Institutional and Retirement Shares

• Class I Shares: Lower expense ratios, available to institutional investors.

• Class R Shares: Designed for retirement accounts with variable fees and expenses.

Exchange Traded Funds (ETFs)

• ETFs are traded index funds, existing in large numbers with substantial total assets.

• Have low expenses, can be sold short, and options exist on ETFs.

Popular ETFs

• SPDR (S&P 500) - Ticker: SPY

• Diamond (Dow Jones) - Ticker: DIA

• Cubes (Nasdaq 100) - Ticker: QQQ

Comparison with Mutual Funds

• ETFs offer tax advantages and avoid unnecessary capital gains taxes due to their “in-kind” structure.

Hedge Funds

• Unlike mutual funds, hedge funds have fewer restrictions on diversification and liquidity, targeting qualified investors.

• Common fee structures include management fees and performance incentives based on profitability and other benchmarks.

Investment Strategies

• Market neutral, distressed securities, macroeconomic adjustments, short selling, and market timing.

Summary

• When considering mutual fund investments, understanding the structure, costs, risks, and various fund types is essential for effective investment management.