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Chapter 5 Mutual Funds.docx

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FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 5 MUTUAL FUND INVESTMENT COMPANIES AND FUND TYPES  Investment company: a business that specializes in pooling funds from individual investors and investing them  Two fundamental types of investment companies: 1. Open-end fund: an investment company that stands ready to buy and sell shares at any time  When buying, fund simply issues them and then invests the money received  When selling, fund sells some of its assets and uses the cash to redeem the shares 2. Closed-end fund: an investment company with a fixed number of shares that are bought and sold only in the open stock market  If buying shares, must buy them from another investor  Net asset value (NAV): the value of assets less liabilities held by a mutual fund, divided by the number of shares outstanding NET ASSET VALUE = (ASSETS – LIABILITIES)/NUMBER OF OUTSTANDING SHARES o NAV of a mutual fund will change essentially every day simply because the value of the assets held by the fund fluctuates with the exception of money market mutual funds o In open-end fund, because the fund stands ready to redeem shares at any time, shares are always worth their NAV o In closed-end fund, their share prices at any point in time may or may not be equal to their NAV MUTUAL FUND OPERATIONS  Mutual fund is simply a corporation owned by shareholders who elect a board of directors o Board of directors responsible for hiring a manager to oversee the fund’s operations o Although mutual funds often belong to a larger “family” of funds, every fund is a separate company owned by its shareholders o Funds are created by banks or investment advisory firms (mutual fund companies that specialize in managing mutual funds) EX. A company like RBC might one day decide that there is a demand for a fund that buys stock in companies that grow and process lumber. RBC forms a mutual fund that specializes in such companies and calls it RBC Lumber fund. Fund manager would be appointed, and shares in the fund are sold to the public and as shares are sold, money received is invested. If successful, large amount of money will be attracted and RBC will benefit from fees earned. If not successful, board can vote to liquidate it and return shareholders’ money or merge it with another fund.  Investment advisory firms can (and often will) create new funds from time to time and through time, this process leads to a family of funds all managed by the same advisory firm  Each fund in the family will have its own fund manager, but advisory firm will generally handle record keeping, marketing, and research that underlies the fund’s investment decisions  Treated as a “flow-through entity” where instead of paying taxes on investment income, fund passes through all realized investment income to fund shareholders, who then pay taxes on these distributions as though they owned the security directly o Fund acts as a conduit, funneling gains and losses to fund owners  Must include a prospectus (supplied to investors wishing to purchase shares) and annual report containing financial statements along with specific information concerning the fund’s expenses, gains and losses, holdings, objectives, and management MUTUAL FUND COSTS AND FEES  There are four types of expenses and fees associated with buying and owning mutual fund shares: 1. Sales charges or “loads”  Front-end loads: a sales charge levied on purchases of shares in some mutual funds; expressed as a percentage of the offering price, not the NAV  Load funds: funds that charge loads  Offering price: price in excess of the net asset value  Load: difference between the offering price and the net asset value EX. Suppose a load fund has an offering price of $100 and the NAV is $98. The front-end load is $2, which as a percentage of the $100 offering price is $2/$100 = 2% You are paying $100 for something worth only $98, so the load is really $2/$98 = 2.04% FIN501 investment analysis I 2. Special fees are charged for certain funds and under certain conditions i. Annual RRSP, RRIF, or RESP trustee fee ii. Account set-up fee iii. Short-term trading fee iv. Processing fees 3. Management fees  Fee generally ranges from 1%-2% of total fund assets every year 4. Trading costs  Turnover: a measure of how much trading a fund does, calculated as the lesser of total purchases or sales during a year divided by average daily assets o High turnover indicates more frequent trading and higher trading costs o A fund with a turnover of 1.0 has sold off its entire portfolio and replaced it once during the year SHORT-TERM FUNDS  Money market mutual funds (MMMFs): mutual fund with short-term debt obligations issued by governments and corporations specializing in money market instruments o Invests mainly in high-quality, low-risk instruments with maturities less than 90 days and relatively little risk o Money market funds net asset value are always $10 per share because it is invested in safe, interest- bearing, short-maturity assets, where NAV will not drop below $10 per share  Fund simply sets the number of shares equal to the fund’s asset value divided by 10  As fund earns interest on its investments, the fund owners are simply given more shares  Money market deposit accounts (MMDAs): similar to money market mutual funds, but offers CDIC prodection LONG-TERM FUNDS  Mutual funds were classified as stock, bond, or income funds but now it is becoming increasingly difficult to place all funds into these three categories  Stock fund exist in great variety; nine separate general types and some subtypes: 1. Capital appreciation VS income  First four types of stock funds traded off capital appreciation and dividend income i. Capital appreciation – investing in companies that have the best prospects for share price appreciation without regard to dividends, company size or country  It means investing in unproven companies or perceived out-of-favour companies ii. Growth – seeking capital appreciation but investing in larger, more established companies that are less volatile  Emphasis on growth means greater risk iii. Growth and income – seeking capital appreciation but focusing on dividend-paying companies iv. Equity income – focus on stocks with relatively high dividend yield, thereby
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