INDIRECT INVESTMENT - INDIRECT INVESTMENT - MUTUAL FUNDSMUTUAL FUNDS

Dr. BALAMURUGAN MUTHURAMAN

Chapter - 4

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MUTUAL FUNDSDefinition: Financial intermediary through which savers pool their monies for collective investment, primarily in publicly trades securities.

A fund is “mutual” in the sense that all of its returns minus its expenses, are shared by its shareholders.

Returns consist of dividends, realized and unrealized capital gains (losses)

Expenses consist of advisory fee for servicing the shareholders, annual fee for distribution (12b-1)

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SEEKING HIGHER RETURNS

Objective is to maximize return with minimum risk

Efficient Market hypothesis and undervalued securities

Behavioral Finance

Mean reversion in the equity market

Individual securities have two main sources of risk: alpha and beta.

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DEFINITIONS FOR RETURNS

Return = Interest or Dividends +/- Price ChangeInitial Investment

Risk = Variation (or range) of possible returns

Goal => Maximize return and minimize risk

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SEEKING HIGHER RETURNS

• Random walk

– No predictable relationship between past changes and future changes in stock prices

– Based on extensive empirical studies

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SEEKING HIGHER RETURNS • Efficient Market Hypothesis (EMH)

– Theory regarding information content of market prices

– May explain random walk studies– Paradox of EMH and value of research

• Behavioural finance– Most investors do not behave perfectly rationally,

but are influenced by psychological factors

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REDUCING PORTFOLIO RISK• Alpha risk

• Alpha - company specific risk usually accounts for 50%-70% of security’s price volatility;

• can be reduced by diversification

• Beta risk– Beta - market risk accounts for 30%-50% of price volatility.

– Stock market risk; cannot be reduced by diversification

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BENEFITS OF INVESTING IN MUTUAL FUNDS

• Diversification :Typically lowers ; global fund may also lower

• Professional Management: Professional qualifications (CFA); access to company executives; in house research team, wall street research.

• Lower Transaction Costs: Lower admn. cost, savings on record keeping, better execution of securities.

• Convenience: Automatic deposits/ withdrawal, tax reporting, retirement planning, educational materials.

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BENEFITS OF INVESTING IN MUTUAL FUNDS

• Higher minimum requirements for individual bonds (usually $25,000; T-bonds $1,000). Lot size is usually $100,000. One $25,000 bond lacks diversification.

•Cost : 2% - 4% of value.

•Bond mutual fund minimum: As low as $1,000. Can redeem fund on any business day. Do not have to hold till maturity.

•Fund offers more diversification. Offer convenient services, such as monthly income payments, compared to quarterly or semi-annually for individual bonds

•Similar advantages for stock funds

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DISADVANTAGES OF INVESTING IN MUTUAL FUNDS

•Need to pay fees/expenses even when fund performs poorly

•Increased diversification may prevent the chance of “hitting the jackpot” from one security

•Online trading and security research on the internet have reduced the advantage of cost and research access

•Less control over securities portfolio and therefore timing of realized capital gains for tax purposes.

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POPULAR WAYS TO PURCHASE INDIVIDUAL SECURITIES

• On-line trading• Separate account

– Portfolio of individual securities managed separately by a bank, broker, or financial adviser

– Account minimums lowered for consultant– Pre-packaged model portfolios– “Baskets” available through the internet

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STRUCTURE OF A MUTUAL FUND

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MUTUAL FUND COMPLEX

Shareholders (Savers)

Management Company

Distribution

Transfer Agency

Broker

Stock Funds

Fixed Income Funds

Money MarketFunds

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STRUCTURE OF ACOMMERCIAL BANK

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MUTUAL FUND VERSUS BANK DEPOSITMutual Fund Bank Deposit

• Rate of Return Tracks T-bill closely but usually higher because of credit risk

Does not track T-bill closely; longer maturity results in higher rate

• Time Redemptions daily

MMDA: allows limited daily withdrawalsCDs: penalty for early withdrawal

• Liquidity Highly liquid CDs: funds “locked-up” for fixed period

• Diversification No more than 5% in any one issuer

Generally cannot loan more than 15% to one borrower

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Mutual Fund Bank Deposit

• Risk 95% must be in highest rated paper; average 90-day security maturity; no FDIC insurance

Loans subject to credit review; try to match asset maturity to liabilities; FDIC insurance ($100K)

• Capital Management company, not fund, has capital; no regulatory requirement or guarantee

Banks must have capital meeting meeting regulatory requirements; FDIC guarantees deposits ($100K limit)

• Tax May offer tax-exempt interest to shareholders

May not offer tax-exempt interest to depositors

• Fees Fee income from management contract

Primarily spread income from principal risk

MUTUAL FUND VERSUS BANK DEPOSIT

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