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Chapter 5

Chapter 5 Detailed Note.docx

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York University
Administrative Studies
ADMS 3531
Dale Domian

Chapter 5 - Mutual Funds: Overview  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 manager, who is compensated for the service provided.  Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.  One of the reasons for the proliferation of mutual funds and fund types is that mutual funds have become consumer products  Created and marketed to the public in ways that are intended to promote buyer appeals 5.1 – Advantages and Drawbacks of Mutual Fund Investing Advantages ­ Diversification o When investing in a mutual fund, you are investing in a portfolio, or basket of securities o Diversification of mutual funds = reduced risk but doesn’t eliminate risk o Because a mutual fund might invest in hundreds (or thousands) of securities o If the value falls to zero, the decline will have a small impact on the mutual fund value ­ Professional Management o The mutual fund manager makes the decision of when to add or remove particular securities from the mutual fund o As the investor holding the mutual fund, do not have to make these crucial decisions ­ Minimum Initial Investment o Most funds have a minimum initial purchase of $2500, but some are as low as $1000 o After initial purchase, subsequent purchases are sometimes as low as $50 o Amounts vary from fund to fund Disadvantages ­ Risk o Value of you mutual fund investment, unlike bank deposit, could fall and be worth less than your initial investment o No gov’t or private agency guarantees the value of a mutual fund o Due to diversification, one limits their chances for large returns if one of these securities increases dramatically in value ­ Costs o Investing in mutual funds entails fees and expenses that do not usually accrue when purchasing individual securities directly 5.2 - Investment Companies and Fund Types  An Investment company is business that specializes in pooling funds (managing financial assets) from individual investors and making investments.  All mutual funds are investment companies but not all investment companies are mutual funds Open-End vs. Closed-End Funds  An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time.  A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by investors, only in the open market.  Difference between open vs. close – end  Closed-end fund, the fund itself does not buy or sell shares – 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 then closed-end funds  Mutual fund = open-end funds (strictly)  Sometimes, if an open-end fund gets too big, it will not take in new investors.  It will, however, take more money from its current investors.  Of course, current investors can withdraw money from the fund. Net Asset Value  Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares.  Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.  In contrast, share value of closed-end funds may differ from their NAV.  The NAV of a mutual fund will change essentially every day simply because the value of the assets held by the fund fluctuates  The price you will receive for shares you sell is the NAV Example: The RBC Canadian Equity Fund has 5365.1 million net assets. It has about 213749 shares outstanding. What is the NAV? 5365.1 M/213749 = $25.10 5.3 - Mutual Fund Operations Organization and Creation  A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.  Most mutual funds are created by investment advisory firms (say Fidelity Investments) or brokerage firms with investment advisory operations (say Merrill Lynch).  Investment advisory firms earn fees for managing mutual funds. Taxation of investment companies • Treated as ‘flow-through entity’ for tax purposes as long as all CRA rules are met o Important because mutual fund does not pay taxes on its investment income o The fund passes through all realized investment income to fund shareholders, who then pay taxes on these distributions as thought they owned the securities directly The Fund Prospectus and Annual Report  Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.  Mutual funds must also provide an annual report to their shareholders. 5.4 – Mutual Fund Costs and Fees Types of Expenses and Fees  Sales charges or “loads”  Front-end loads are charges levied on purchases.  Can range as high as 8.5%  typically it would be 5%  2% - 3%  low-load funds  A sales charge levied on purchases of shares in some mutual funds. When you purchase shares in a load fund, you pay a price in excess of the NAV, called the offering price. The difference between the offering price and the NAV is the load. Shares in no-load funds are sold at NAV.  Funds that charge loads are called load funds  Back-end loads are charges levied on redemptions.  Often called deferred sales charges (DSC)  Declines through time  Special Fees  Charged for certain funds and under certain conditions like  Annual RRSP, RRIF, or RESP trustee fee  Account set-up fee  Short-Term trading fee  Processing fees  Management fees:  Usually range from 0.25% to 1.00% of the funds total assets each year.  Are usually based on fund size and/or performance.  Trading costs  Not reported directly  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  Funds must report "turnover," which is related to the amount of trading.  The higher the turnover, the more trading has occurred in the fund.  The more trading, the higher the trading costs. Expense Reporting  Mutual funds are required to report expenses in a fairly standardized way in their prospectus.  Shareholder transaction expenses - loads and deferred sales charges.  Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees.  Funds report a hypothetical example showing total expenses paid by investors per $10,000 invested. Why Pay Loads and Fees?  After all, many good no-load funds exist.  But, you may want a fund run by a particular manager. All such funds are load funds.  Or, you may want a specialized type of fund.  Perhaps one that specialized in Italian companies  Loads and fees for specialized funds tend to be higher, because there is little competition among them. 5.5 - Short-Term Funds  Short-term funds are collectively known as money market mutual funds. Money Market Mutual Funds  Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments.  MMMFs maintain a $1.00 net asset value to make them resemble bank accounts.  There is no guarantee that the net asset value will be $1.00 or more.  A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.”  Following the Crash of 2008, a few MMMF “broke the buck.”  Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.  The distinction is that a bank money market account is a bank deposit and offers CDIC protection. 5.6 - Long-Term Funds  There are many different types of long-term funds, i.e., funds that invest in long-term securities.  Historically, mutual funds were classified as stock funds, bond funds, or balanced funds.  Today, the investment objective of the fund is the major determinant of the fund type. Stock Funds  Some stock funds trade off capital appreciation and dividend income.  Capital appreciation – invest in companies that have, in the opinion of the fund manager, the nest prospects for share price appreciation without regard to dividends, company size, or, for some funds, country  Main goal  Investing in unproven companies or perceived out-of-favour companies  Growth – tend to invest in larger, more established companies  Somewhat less volatile as a result  Dividends are not an important consideration  Growth and Income – with capital appreciation being the main goal, dividend –paying companies are part of the focus  Equity income – funds focus exclusively on stocks with relatively high dividend yields which maximizes the current income on the portfolio  Some stock funds focus on companies in a particular size range.  Small company -  Mid-cap  Large-cap  Some stock fund invest internationally.  Global  International  Region  Country  Emerging markets  Sector funds specialize in specific sectors of the economy, such as:  Biotechnology  Internet  Energy  Other fund types include:  Index funds  Social conscience, or “green,” funds  “Sin” funds (i.e., tobacco, liquor, gaming)  Tax-managed funds Bond Funds  Bond funds may be distinguished by their  Maturity range  Credit quality  Taxability  Bond type  Issuing country  Bond fund types include:  Short-term and intermediate-term funds  General funds  High-yield funds  Mortgage funds  World funds  Insured funds Stock and Bond Funds  Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.  Examples include:  Balanced funds  Asset allocation funds  Convertible funds  Income funds  Target Date Funds (also known as Lifecycle Funds)  The asset allocation chosen by target date funds is based on the anticipated retirement date of the investors holding the fund.  If a company offers a Target Date 2040 Fund, the fund is for people planning to retire in about 2040.  In 2011, say, this fund would have a large equity exposure.  In 2039, say, this fund would have a large bond exposure. 5.7 - Mutual Fund Performance  Mutual fu
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