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FIN 501 (31)
Chapter 5

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FIN 501
Edward Blinder

Chapter 5: Mutual Funds Mutual funds are simply a means of combining or pooling the funds of a large group of investors The buy and sell decisions for the resulting pool are then made by a fund managers, who is compensated for the service provided Since mutual funds provide indirect access to financial markets for individual investors, they are a form of financial intermediary One of the reasons for proliferation of mutual funds and fund types is that mutual funds have become consumer products They are created and marketed to the public in ways that are intended to promote buyer appeal Defined benefit plans are rapidly being replaced by defined contribution plans With a defined contribution plan, your employer will contribute money each pay period to a retirement account on your behalf, but you have to select where the funds go With this, the benefit you ultimately receive depends entirely on how your investments do; your employer only makes contribution You must choose from a group of mutual funds for your investments, so it is very important that you understand the different types of mutual funds, as well as their risk and returns 5.1 Investment Companies and Fund Types: Investment Company: a business that specializes in pooling funds from individual investors and investing them (specializes in managing financial assets for individual investors) All mutual funds are investment companies but not all investment companies are mutual funds Open-End versus Closed-End Funds: - Whenever you invest in a mutual fund, you do so by buying shares in the fund - Open-End Fund: an investment company that stands ready to buy and sell shares at any time o When an investor wishes to buy open-end fund shares, the fund simply issues them and then invests the money received o When someone wishes to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares o With an open-end fund, the number of shares outstanding fluctuates through time - Closed-End Fund: an investment company with a fixed number of shares that are bought and sold only in the open stock market o Number of shares is fixed and never changes o If you want to buy shares, you must buy them from another investor o If you wish to sell shares that you own, you must sell them to another investor - Key difference is that, with a closed-end fund, the fund itself does not buy or sell shares - Shares in closed-end funds are listed on stock exchanges just like ordinary shares of stock, where their shares are bought and sold in the same way - Open-end funds are more popular among individual investors than closed-end funds - The term mutual fund actually refers only to an open-end investment company - The term investment company has all but disappeared from common use, and investment companies are now generally called mutual funds Net Asset Value (NAV): the value of assets less liabilities held by a mutual fund, divided by the number of shares outstanding - With one important exception (money market mutual funds), the net asset value of a mutual fund will change essentially every day simply because the value of the assets held by the fund fluctuates - An open-end fund will generally redeem or buy back shares at any time. The price you receive for shares you sell is the net asset value - Because the shares of closed-end funds are bought and sold in the stock markets, their share prices at any point in time may or may not be equal to their net asset values Investment Companie s Open-End Closed- Funds End Funds Money market Long-term funds funds Stock Bond Blended Funds Funds Funds 5.2 Mutual Fund Operations: Mutual Fund Organization and Creation: - A mutual fund is simply a corporation - Like a corporation, a mutual fund is owned by its shareholders, the shareholders elect a board of directors; the board of directors is responsible for hiring a manager to oversee the funds operation - Although mutual funds often belong to a larger family of funds, every fund is a separate company owned by its shareholders - Most mutual funds are created by banks or by investment advisory firms, which are businesses that specialize in managing mutual funds - Investment advisory firms are also called mutual fund companies - Increasingly, such firms have additional operations such as discount brokerages and other financial services - In Canada, different mutual funds are offered by banks, insurance companies, and investment advisory firms - The largest provided is the RBC Asset Management Inc. with more than 50 million different mutual funds and $80 billion in assets under management - Investment advisory firms create mutual funds because they wish to manage them to earn fees - A typical management fee might be 1.5% of the total assets in the fund per year - Example: A fund with a $200 million in assets would not be large but nonetheless generate management fees of $3 million per year - The significant economic incentive to create funds and attract investors to them - An investment advisory firm such as RBC can (and often will) create new funds from time to time - Through time, this process leads to family of funds all managed by the same advisory firm - Each fund in the family will have its own fund manager, but the advisory firm will generally handle the record keeping, marketing, and much of the research that underlies the funds investment decisions - In principle, the directors a mutual fund in a particular family, acting on behalf of the fund shareholders, could vote to fire the investment advisory firm and hire a different one (rarely occurs) - Unhappy shareholders generally vote with their feet- that is, sell their shares and invest elsewhere Taxation of Investment Companies: - As long as an Investment Company meets certain rules set by the Canada Revenue Agency, it is treated as a flow-through entity for tax purposes - This is important because a mutual fund does not pay taxes on its investment income- Instead, the mutual fund passes through all realized investment income to fund shareholders, who then pay taxes on these distributions as though they owned the securities directly - The fund simply acts as a conduit, funneling gains and losses to fund owners The Fund Prospectus and Annual Report: - Mutual funds are required by law to produce a document known as a prospectus - The prospectus must be supplied to any investor wishing to purchase shares - Mutual funds must also provide an annual report to their shareholders - The annual report and the prospectus, which are sometimes combined, contain financial statements along with specific information concerning the funds expenses, gains and losses, holdings, objectives, and management 5.3 Mutual Fund Costs and Fees: All mutual funds have expenses that are paid by the funds shareholders Type of Expenses and Fees: 4 types of expenses/ fees 1. Sales charges or loads: o Front-end load: a sales charge levied on purchases of shares in some mutual funds o Funds that charge loads are called load funds o Funds that have no such charges are called no-load funds o Offering price: when you purchase shares in a load fund, you pay a price in excess of the net asset value o Load: the difference between the offering price and the net asset value o Shares in no-load funds are sold at net asset value o Front-end loads can range as high as 8.5% but 5% is more typical o Low-load funds: some funds, with front-end loads in the 2%- 3% range o Front-end loads are expressed as a percentage of the offering price, not the net asset value o Some funds have back-end loads, which are charges levied on redemptions (these loads
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