Chapter 4 (exam 3)

Chapter 4 (exam 3) - Chapter 4 Chapter 4 Mutual Funds...

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Unformatted text preview: Chapter 4 Chapter 4 Mutual Funds Indirect Investing Indirect Investing • Alternative to direct investment in or ownership of securities • Refers to buying and selling shares of intermediaries that hold portfolio of securities » Shares are ownership interest in portfolio Shares are • Shareholders pay expenses Investment Companies Investment Companies • Financial services organization that: » Sells shares in itself » Uses the funds to invest in marketable securities • Three types: Open­end investment companies Closed­end investment companies Unit investment trusts Unit Investment Trusts Unit Investment Trusts • • • Holds unmanaged, fixed­income portfolio Assets not actively traded Trust ceases to exist when securities mature Closed­end Investment Companies Closed­end Investment Companies • • • • • Trade on exchanges Relatively few in number Include various types of equity and bond funds Typically sell at discounts and premiums to net asset value (NAV) NAV: Total market value of the security portfolio divided by total shares Open­end Investment Companies Open­end Investment Companies • Number of shares outstanding is constantly changing • Investors buy from and sell to investment company at NAV • Commonly referred to as mutual funds Mutual Fund Categories Mutual Fund Categories • • • • • • • Money market Equity Specialized sector Bond Balance and income Indexed International Costs of Mutual Funds Costs of Mutual Funds • Fee structure » Front-end load » Back-end load » No load • Operating expenses Costs of Mutual Funds Costs of Mutual Funds • 12 b­1 charges » distribution costs » alternative to load • All fees must be stated in the prospectus Impact of Costs on Impact of Costs on Investment Performance Performance Performance • Reported on a regular basis in the popular press • Measured over a given time period as a percent of • • initial investment Total returns include reinvested dividends and capital gains Evidence shows that average mutual fund performance is generally less than broad market performance Fees and Mutual Fund Returns Fees and Mutual Fund Returns Rate of return = NAV1 − NAV0 + Income and capital gain distributions NAV0 Mutual Fund Returns: An Example Mutual Fund Returns: An Example Initial NAV = $20 Income distributions of $.15 Capital gain distributions of $.05 Ending NAV = $20.10 Trading Scandals with Mutual Funds Trading Scandals with Mutual Funds • Late trading » Allowing some investors to purchase or sell later than other investors • Market timing » Allowing investors to trade more frequently than others • Net effect is wealth transfer • Reforms Taxes on Mutual Funds Taxes on Mutual Funds • Investor directed portfolios can be structured to take advantage of taxes while mutual funds cannot • High turnover leads to tax inefficiency • More disclosure on taxes was required in 2000 Exchange­Traded Funds (ETFs) Exchange­Traded Funds (ETFs) • Basket of stocks that tracks a sector, investment • • • • style or the market as a whole Have characteristics of index mutual funds and closed­end funds (e.g., passive) Trade throughout the day on an exchange Can be bought on margin or sold short Tax efficient: control over capital gains distributions Example Problems Example Problems • The composition of the Fingroup Fund portfolio is: Stock Shares Price A 200,000 $35 B 300,000 $40 C 400,000 $20 D 600,000 $25 Accrued management fees = $30,000. There are 4 million shares outstanding. What is the NAV of the fund? Example Problems Example Problems Total value of assets = $42,000,000 NAV = ($42mil ­ $30k) / 4,000,000 NAV = $10.49 Example Problems Example Problems • A closed­end fund starts the year with a net asset value of $12.00. By the end of the year, NAV equals $12.10. At the beginning of the year, the fund is selling at a 2% premium to NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund paid year­end distributions (income and capital gains) of $1.50. What is the rate of return to an investor during the year? Example Problems Example Problems Beginning price = 12(1.02) = $12.24 End price = 12.10(1­.07)= $11.25 Although NAV increased, the price fell by $.99 Return = [(11.25 – 12.24) + 1.50] / 12.24 Return = 4.2% Example Problems Example Problems • Suppose you have $1,000 to invest in a mutual fund. The Investments Funds sells Class A shares with a front­end load of 6% and Class B shares with 12b­1 fees of .5% annually as well as back­end load fees that start at 5% and fall by 1% for each full year the investor holds the portfolio. Assume the portfolio rate of return net of operating expenses is 10% annually. If you plan to sell the fund after four years, are Class A or Class B shares the better choice for you? What if you plan to sell after 15 years? ...
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