Mutual Funds and Exchange-Traded Funds

Chapter 12
Mutual Funds and

Exchange-Traded
Funds
Mutual Funds and Exchange-
Traded Funds
Learning Goals
1. Describe the basic features of mutual funds and note what they
have to offer as investments.
2. Distinguish between open- and closed-end funds, exchange-
traded funds, and other types of professionally managed
investment companies, and discuss the various types of fund
loads, fees, and charges.
3. Discuss the types of funds available and the variety of investment
objectives these funds seek to fulfill.
4. Discuss the investor services offered by mutual funds and how
these services can fit into an investment program.
5. Describe the investor uses of mutual funds along with the
variables to consider when assessing and selecting funds for
investment purposes.
6. Identify the sources of return and compute the rate of return
earned on a mutual fund investment.
Copyright ©2017 Pearson Education, Ltd. All rights reserved. 12-2
The Mutual Fund Concept
Mutual fund (also called investment company): a

type of financial services organization that receives
money from a group of investors and then uses those
funds to purchase a portfolio of securities.
– Investors own a share of the fund proportionate to the
amount of the investment.
• An Overview of Mutual Funds
• Exchange-Traded Funds
• Some Important Considerations
• Other Types of Investment Companies


– First mutual fund started in 1924.
– By 1940 the number of mutual funds had grown to 68, and
by 2015 there were more than 9,300 of them with $15.8
trillion of assets under management.
– There are more mutual funds in existence today than
stocks listed on all the major U.S. stock exchanges
combined.
– 43% of U.S. households owned mutual funds in 2014.
– Worldwide, more than 79,000 mutual funds are in
operation with $31.4 trillion in assets collectively.

Figure 12.1 U.S. Mutual Fund Assets
under Management by Type of Fund
Source: Data from the 2015 Investment Company Institute Factbook, https://www.ici.org/pdf/2015_factbook.pdf.


– Pooled Diversification: idea of combining money from a
group of people with similar investment goals and
investing that money in a diversified portfolio.
• Each investor who owns shares in a fund is, in effect, a
part owner of that fund’s diversified portfolio of
securities.
– Active versus Passive Management
• Actively managed fund: manager’s goal is to identify
and invest in securities that will achieve superior
performance.
• Passively managed fund: managers make no attempt
to select a portfolio that will outperform a benchmark.
These funds are designed to mimic the performance of
a particular benchmark or stock index.

– Attractions and Drawbacks of Mutual Fund Ownership
• Attractions:
– Portfolio diversification
– Full time professional management
– Ability to invest small amounts
– Service
» Automatic reinvestment of dividends and capital gains
» Record keeping for taxes
» Exchange privileges
– Convenience
» Easy to buy and sell
» Easy to track prices and performance


– Attractions and Drawbacks of Mutual Fund Ownership
• Drawbacks:
– Transaction Costs
» Management Fee
» Commission Fees (“sales load”)
» Expense ratio: a charge, expressed as a percentage
of assets managed by the fund, that fund investors
pay each year.
– Spotty performance record
» Consistently beating the market is difficult.
» Many mutual funds just keep even with overall stock
market index.


– Performance of Mutual Funds
• Consistently beating the market is no easy task, even
for professional money managers.
– Across a wide variety of funds, a majority of portfolio
managers trail their benchmark.
– Although a handful of funds have given investors above-
average or even spectacular rates of return, most mutual
funds do not meet those levels of performance.
• Long-term returns from mutual funds have been
substantial, but a good deal of those returns can be
traced to strong market conditions and/or the
reinvestment of dividends and capital gains.

Figure 12.2 Percentage of Mutual Funds
Outperformed by Their Benchmarks from
2009 to 2014
(Source: SPIVA U.S. Scorecard, mid-year 2014, http://www.spindices.com/documents/spiva/spiva-us-mid-year-2014.pdf)


– How Mutual Funds are Organized and Run
• The fund itself is organized as a separate corporation or
trust.
• A management company runs the fund’s daily operations.
• An investment advisor buys and sells stocks or bonds and
otherwise oversees the investment portfolio. Includes
participants such as a money manager, securities
analysts, and traders.
• A distributor sells the fund shares
– Directly to the public or through authorized dealers.
• A custodian physically safeguards the securities.
• A transfer agent keeps track of purchase and redemption
requests from shareholders.


– Open- or Closed-End Funds
• Open-end Funds: mutual funds that regularly receive
new infusions of cash from investors and use that
money to purchase a portfolio of securities.
– Investors buy and sell shares directly with the mutual
fund company without a secondary market.
– Fund can issue an unlimited number of shares as investors
contribute new money to the fund.
– Net asset value (NAV): the total market value of
securities held in the fund divided by the fund’s
outstanding shares; Transactions between the funds and
their customers generally occur at the end-of-day NAV.


– Open- or Closed-End Funds
• Open-end Funds
– Investors are free to withdraw their money from the fund
and when they do so the fund manager redeems
investors’ shares in cash.
– Withdrawal requests may force the fund manager to sell
securities (and reduce size of portfolio) to obtain the cash
to distribute to investors.
» Fire sale: occurs when a fund must sell illiquid assets
quickly to raise cash to meet investors’ withdrawal
requests.
» Redemption fee: charge that investors pay if they
sell shares in the fund only a short time after buying
them.


– Closed-End Investment Companies
• Closed-end Funds: operate with a fixed number of
shares outstanding and do not regularly issue new
shares of stock.
• Sell shares in the fund only at the initial offering.
– Subsequent trades are done in a secondary market,
similar to the common stock market.
• Investment advisor doesn't have to worry about cash
inflow or outflows.
• Market price of the fund’s shares is determined by
supply and demand and may not equal net asset value.
• Generally sell at premium or discount (usually discount)
to NAV.

• Exchange-Traded Funds
• Exchange-traded fund (ETF): a type of open-end
fund that trades as a listed security on one of the stock
exchanges.
– combines some of the operating characteristics of an
open-end fund with some of the trading characteristics of
a closed-end fund.
– Created when a portfolio of securities is purchased and
placed in a trust, and then shares are issued that
represent claims against the trust.
– Investors can buy or sell their shares at any time during
trading hours.
– Low management expenses due to limited trading by
investment advisor.
– Low turnover helps avoid taxes until ETF is sold.

Figure 12.3 How an ETF Works

Figure 12.4 Assets Invested in
Exchange-Traded Funds
(Source: Data from 2015 Investment Company Institute Factbook, p. 10, http://www.icifactbook.org/2015_factbook.pdf.)


– Load and No-Load Funds
• Load fund: mutual fund that charges a commission
when shares are bought.
• No-load fund: fund that levies no sales charges.
• Low-load funds: fund that offers discounts for large
investments.
• Back-end load: fund levies commissions when shares
are sold.
• 12 (b)-1 fee (“hidden loads”): fee charged by some
mutual funds to cover management and other operating
costs; amounts to as much as 1% of the average net
assets.


– Other Fees and Costs
• Management fee: compensation paid to professional
managers who administer the fund’s portfolio.
• Administrative costs: the normal costs of doing
business
• Exchange fee: some funds charge this whenever you
transfer money from one fund to another within the
same fund family.
• The SEC requires mutual funds to fully disclose all of
their fees and expenses in a standardized, easy-to-
understand format.

Table 12.1 Mutual Fund Fee
Table (Required by Federal Law)


– Real Estate Investment Trusts
• Real Estate Investment Trust (REIT): a type of
close-end investment company that invests money in
mortgages and various types of real estate
investments.
• Investors receive both the capital appreciation and the
current income from real estate ownership without
having to deal with property management.
– Also receive attractive dividend yields (around 4.0%).
• Three basic types:
– Property/equity REIT invests in shopping centers, hotels,
apartments and office buildings.
– Mortgage REIT invests in mortgages.
– Hybrid REIT invests in both properties and mortgages.

– Hedge Funds
• Hedge Funds: Pooled investment fund that accepts
investors’ money and invests those funds on a
collective basis.
– Not really mutual funds; private limited partnerships.
– Not regulated by mutual fund regulations.
– General partner runs fund and takes 10-20% of profits;
limited partners are investors.
– Only sold to “accredited investors”—net worth greater
than $1,000,000 and/or annual income over $200,000.
– Often take complex market positions that involve both
long and short positions, use of various arbitrage
strategies, as well as the use of options, futures and other
derivative securities.

Types of Funds and Services
Categorizing funds according to their investment

policies and objectives is common practice in the
mutual fund industry.
• Types of Mutual Funds
• Investor Services


– Growth Fund: objective is capital appreciation.
• Invest primarily in well-established large- or mid-cap
companies with above-average growth potential.
• Offer little to no dividend income.
• Invest in stocks with greater than average risk.


– Aggressive-Growth Funds: highly speculative with
portfolios of primarily “high-flying” common stocks.
• Invest in small, unseasoned companies with high
price/earnings multiples.
• Often invest in companies recovering from a period of
poor financial performance.
• Among the most volatile of all mutual funds.
• These funds perform well when markets are good and
often experience substantial losses when markets are
bad.


– Value Funds: confine their investing to stocks considered
to be under-valued by the market.
• Focus is on intrinsic value of stocks and requires
extensive fundamental analysis.
• Invest in stocks with low P/E ratios, high dividend yields
and moderate amounts of financial leverage.
• Less risky investments for relatively conservative
investors looking for attractive returns.


– Equity-income Funds: purchase stocks with high
dividend yields.
• Focus is on high current income with some long-term
capital appreciation.
• Invest heavily in high-grade common stocks, some
convertible securities and preferred stocks, and
occasionally even junk bonds or certain types of high-
grade foreign bonds.
• Lean heavily towards blue chips, public utilities, and
financial shares.
• Typically less price volatility than overall stock market.
• Generally viewed as a fairly low-risk way of investing in
stocks.


– Balanced Funds: tend to hold a balanced portfolio of both
stocks and bonds for the purpose of generating a balanced
return of both current income and long-term capital gains.
• Bonds are used principally to provide current income.
• Stocks are selected mainly for their long-term growth
potential.
• Tend to be less risky than funds that invest exclusively
in common stocks.


– Growth-and-Income Funds: seeks a balanced return
made up of both current income and long-term capital
gains, but with primary emphasis on capital gains.
• Invest most of their money in equities; not unusual to
have 80-90% of their capital in common stocks.
• Confine most of their investing to quality issues; growth
oriented blue chips and high-quality income stocks.
• Involve a fair amount of risk, so most suitable for
investors who can tolerate the risk and price volatility.


– Bond Funds: Invest exclusively in various types and
grades of bonds, with income as the primary investment
objective.
• Advantages of bond funds over investing directly in
bonds:
– More liquid.
– Offer higher diversification.
– Bond funds automatically reinvest interest and other
income.
• Generally considered to be a fairly conservative form of
investment.
– Some price volatility occurs with changing interest rates.


– Bond Funds: many types.
– Government bond funds: invest in U.S. Treasury and
agency securities
– High-grade corporate bond funds: invest chiefly in
investment-grade securities rated BBB or better.
– High-yield corporate bond funds: risky; invest in junk
bonds.
– Municipal bond funds: invest in tax-exempt securities.
– Mortgage-backed bond funds: invest in mortgage-
backed securities of the U.S. government, such as GNMAs.
– Convertible bond funds: invest in securities that can be
converted or exchanged into common stocks.
– Intermediate-term bond funds: invest in bonds with
maturities of 10 years or less.


– Money Market Mutual Funds: invest in short-term
money market instruments, such as bank certificates of
deposit, U.S. Treasury bills, and the like.
• Maximum average maturity of their holdings cannot
exceed 90 days; makes them highly liquid.
• Returns move up and down with interest-rate
conditions.
• At least 95% of the fund’s assets must be invested in
top-rated/prime-grade securities.
• Considered a safe, convenient investment to
accumulate capital and temporarily store idle funds.


– Money Market Mutual Funds
• Several types:
– General-purpose money funds: invest in all types of
money market instruments.
– Government securities money funds: invest only in
U.S. Treasury bills and other short-term government
securities.
– Tax-exempt money funds: limit investing to only very
short (30- to 90-day) tax-exempt municipal securities.


– Index Funds: buys and holds a portfolio of stocks (or
bonds) equivalent to those in a specific market index, like
the S&P 500.
• Objective is to match, not beat, the specific index.
• Low-cost investment management (computerized).
• Strategy is buy-and-hold, which provides tax
advantages with very little taxable capital gains.


– Sector Funds: investments are restricted to a particular
sector (or segment) of the market.
• Example: A health care sector fund would focus on
stocks issued by drug companies, hospital management
firms, medical suppliers, and biotech concerns.
• Other popular sector funds concentrate in technology,
financial services, real estate (REITs), natural
resources, and telecommunications.
• Objective is to produce capital gains.
• Considered speculative because limited diversification
can increase investment risks.


– Socially Responsible Funds: funds that actively and directly
incorporate ethics and morality into the investment decision.
• Specific stocks are evaluated on financial criteria and moral,
ethical or environmental tests.
• Stocks that do not meet these tests are not considered for
the investment portfolio.
• Examples of excluded companies:
– Tobacco or alcohol
– Gambling
– Weapons
– Fossil fuels
• Tend to favor firms that produce “responsible” products or
services, that have strong employee relations and positive
environmental records, and that are socially responsive to
the communities in which they operate.

– Asset Allocation Funds: funds that spread investors’
money across different types of asset classes: stocks,
bonds, and money market securities. Many of them also
include foreign securities and some even include inflation-
resistant investments.
• Provides built-in asset allocation by a professional
investment manager.
• As market conditions change over time, the asset
allocation mix changes as well.
• Target date fund: follows an asset allocation plan tied
to a specific target date.
– Asset allocation begins heavy on stocks and shifts to a
more conservative allocation emphasizing bonds.
– Appeals to investors who want to save for retirement.


– International Funds: funds that do all (international) or
most (global; may include U.S. multinational firms) of their
investing in foreign securities.
• Funds can specialize in international stocks, bonds or
money market securities.
• Funds can specialize in growth, value, aggressive
growth and other types of stocks.
• Funds can specialize in specific countries or regions of
the world.

– Automatic Investment Plans: service that allows fund
shareholders to automatically funnel fixed amounts of
money from their paychecks or bank accounts into a
mutual fund.
• Monthly amounts as small as $25
• Offer convenience and an excellent way to build up
investment over time.

– Automatic Reinvestment Plans: Enable investors to
keep their capital fully employed by using dividend and/or
capital gains income to buy additional shares in the fund.
• Offered by just about every open-end fund.
• Most funds do not charge commissions for purchases
made with reinvested funds.
• IRS still treats dividends and capital gains distributions
as cash receipts and taxes them as investment income
in the year received.
• Enable investors to earn fully compounded rates of
return.

Figure 12.5 The Effects of
Reinvesting Dividends
(Source: Author’s calculations and Yahoo!Finance.)

– Regular Income
• Systematic withdrawal plan: Offered by most open-
end funds, once enrolled, the investor automatically
receives a predetermined amount of money each month
or quarter.
– Most funds require minimum investment of $5,000 or
more.
– Size of minimum payment must be $50 or more per
period (no limit on maximum).
– Fund pays out the monthly or quarterly income first from
dividends and realized capital gains; then if authorized,
fund can tap the principal or original paid-in capital to
meet the required periodic payments.

– Conversion (Exchange) Privileges: Investment
management companies that offer a number of different
funds (fund families) often provide conversion privileges
that enable shareholders to move money from one fund to
another, either by phone or internet.
• Benefits
– Allow investors to meet ever-changing long term goals.
– Permit investors to manage their holdings more
aggressively by moving in and out of funds as the
investment environment changes.
• Drawback
– Exchanges between funds can trigger capital gains taxes.

– Retirement Programs
• Today all mutual funds provide a service that allows
individuals to set up tax deferred retirement programs
as either IRA or Keogh accounts.
– Or through their place of employment, to participate in a
tax-sheltered retirement plan, such as 401(k).
– Fund sets up plans and handles all the administrative
details so shareholders can easily take advantage of
available tax savings.

Investing in Mutual Funds
It is possible to narrow down the list of alternative

mutual funds by matching your investment needs
with the investment objectives of the funds.
• Investor Uses of Mutual Funds
• The Selection Process
• Investing in Closed-End Funds
• Measuring Performance


– Accumulation of Wealth:
• Investor uses mutual funds over the long haul to build
up investment capital.
– Modest amount of risk may be acceptable
– Preservation of capital and capital stability are most
important.
– Storehouse of Value
• Find a place where investment capital can be fairly
secure and relatively free from deterioration, yet still
generate a relatively attractive rate of return.
– Short and intermediate term bond funds
– Money funds


– Speculation and Short-Term Trading
• Investors may aggressively trade in and out of funds as
the investment climate changes.
– Load charges can be reduced or eliminated by dealing in
families of funds offering low-cost conversion privileges or
by dealing only in no-load funds.
• Investors may use mutual funds as long-term
investment but seek high rates of return by investing in
funds that follow very aggressive trading strategies.
– Examples of such funds: Leverage funds, option funds,
emerging-market funds, small-cap aggressive-growth
funds, sector funds.


– Determine if you want to use mutual funds
in portfolio:
• Mutual funds increase diversification.
• Mutual funds offer expertise in areas where investor
may not be informed.
• Can use stocks and mutual funds.
– Objectives and Motives for Using Funds
• Compare mutual fund’s investment objective to
investor’s objective.
• Tolerance for risk exposure
• Intended use: wealth accumulation, value storehouse or
speculation.
• Compare range of services offered.


– What the Funds Offer
• Sources of Information on Funds:
– Fund prospectus
– The Wall Street Journal
– Barron’s, Money, Fortune or Forbes
– Morningstar Mutual Funds
– Value Line Mutual Fund Survey
– Websites such as Yahoo! Finance


– Whittling Down the Alternatives
• Fund’s investment performance
• Tax efficiency
• Fee structure
• How particular fund fits into your portfolio
• Investment skills of fund managers
• Load or No-Load funds
• Closed-End or Open-End funds


– Stick with No-Loads or Low-Loads
• Empirical results generally do not support the idea that
load funds provide added value.
• As a rule, to maximize returns, you should seriously
consider sticking to no-load or low-load funds (total
load charges of less than 3%).


– Some Key Differences between Closed-End and Open-End
Funds
• Brokerage commissions apply to closed-end funds
• Open-end funds have greater liquidity
• Closed-end funds do not provide the full range of
services.
• Closed-end funds trade at premium (or discount) to
NAV
– As a rule, CEFs trade at discounts

Figure 12.6 Selected
Performance of CEFs
Source: http://news.morningstar.com/CELists/CEReturns.html, accessed July 4, 2015.


– What to Look for in a Closed-End Fund
• Pay special attention to the size of the premium and
discount.
– Funds trading at deep discounts can enhance returns.
– Avoid new issues (IPOs) and funds that sell at steep
premiums.
• Analyze CEFs just as you would any other mutual fund:
– Expense ratio
– Turnover rate
– Past performance
– Cash Position
– History of the discount
– Probably won’t get a prospectus

– Sources of Return
• Dividend income: derived from the dividend and
interest income earned on the security holdings of the
mutual fund.
• Capital gains distributions: payments derived from
the capital gains actually earned by the fund; apply
only to realized capital gains.
• Unrealized capital gain (paper profits): Change in
the price (or NAV) of fund; Capital gain that has not
been realized since fund’s holding have not been sold.
– For Closed-End companies, changes in the price discounts
or premiums are important as well.

Table 12.2 A Report of Mutual Fund Income
and Capital Changes (For a Share
Outstanding Throughout the Year)

– Measures of Return
• Returns include distributions of dividends, distributions
of capital gains, or NAV appreciation
• Return for specific holding period
• Best for one year returns since does not use present
value

– The Matter of Risk
• Market risk
– Because mutual funds are so well diversified, they tend to
perform very much like the market, or segment of the
market that the fund targets.
– Be aware of the effect the general market has on the
investment performance of a mutual fund.
• Management practices
– Conservatively managed funds tend to have less risk of
loss of capital and more stability in the net asset value
than aggressively managed funds.

Chapter 12 Review Learning
Goals
1. Describe the basic features of mutual funds and note what
they have to offer as investments.
2. Distinguish between open- and closed-end funds, ETFs, and
other types of professionally managed investment companies,
and discuss the various types of fund loads, fees, and
charges.
3. Discuss the types of funds available and the variety of
investment objectives these funds seek to fulfill.
4. Discuss the investor services offered by mutual funds and how
these services can fit into an investment program.
5. Describe the investor uses of mutual funds along with the
variables to consider when assessing and selecting funds for
investment purposes.
6. Identify the sources of return and compute the rate of return
earned on a mutual fund investment.

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Chapter 12

Mutual Funds and

Mutual fund (also called investment company): a

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 12-3

• An Overview of Mutual Funds

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Copyright ©2017 Pearson Education, Ltd. All rights reserved. 12-5

• An Overview of Mutual Funds

• An Overview of Mutual Funds

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• An Overview of Mutual Funds

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• An Overview of Mutual Funds

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(Source: SPIVA U.S. Scorecard, mid-year 2014, http://www.spindices.com/documents/spiva/spiva-us-mid-year-2014.pdf)

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• An Overview of Mutual Funds

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• An Overview of Mutual Funds

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• An Overview of Mutual Funds

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• An Overview of Mutual Funds

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• Some Important Considerations

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• Some Important Considerations

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• Other Types of Investment Companies

• Other Types of Investment Companies

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Categorizing funds according to their investment

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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• Types of Mutual Funds

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