FIN 3244 Ch.10
How can you tell what kind of fees and charges a fund has?
The easiest way to know if a front-end load, back-end load or 12(b)-1 fee is charged is to look at the expense table found in the mutual fund's prospectus. Expense tables must (by SEC rules) fully disclose types and amounts of fees and charges as they exist at the time of purchase. Be aware that these fees can be changed by the fund.
Describe a back-end load and a hidden load.
A back-end load is a redemption fee that an investor pays when s/he sells fund shares. Redemption fees typically decline over time and disappear entirely after the first three to five years of ownership. They are intended to provide an incentive for investors to retain the fund.
What is the difference between load and no-load funds? What are the advantages of each type?
A load fund is a mutual fund that charges a fee to purchase fund shares. A no-load fund does not charge investors a fee. No-load funds offer an advantage because, by avoiding loads (may be as high as a total of 8.5%), investors buy more fund shares with the same amount of capital. Other things being equal, this results in larger profits
What is a 12(b)-1 fund? Can such a fund operate as a no-load fund?
A mutual fund can legally refer to itself as a no-load fund if it charges no more that ¼ of a percent (.25%) in annual 12(b)-1 fees. A true no-load fund doesn't charge any 12(b)-1 fees. Load funds are limited by law to a maximum annual 12(b)-1 fee of 1%. 12(b)-1 fees can significantly reduce returns over time.
What is a mutual fund?
A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors. Mutual funds represent ownership in a managed portfolio of securities. The mutual fund concept revolves around diversification. Diversification reduces the overall risk borne by the investor without reducing the average return. This, together with the fact that mutual funds provide professional management that frees individual investors from managing their own portfolios, makes mutual funds attractive to individuals.
Contrast mutual fund ownership with direct investment in stocks and bonds.
Arguments for mutual fund ownership: Greater level of diversification Professional management Investment may be able to be established with limited capital Arguments for direct investment in stocks and bonds: Greater control over the types of investments made Closer fit to risk preferences of the individual investor Continuous pricing, faster trades, availability of different types of market orders
What is an automatic reinvestment plan?
Automatic reinvestment plans enable mutual fund investors to keep their capital fully invested. This is important because it lets investors earn fully compounded rates of return. Normally, dividends and capital gains distributions are paid out as cash. Through automatic reinvestment plans, however, those dividends and capital gains distributions are used to buy additional fund shares resulting in the number of shares owned by an investor increasing over time. Most reinvested plans allow investors to avoid brokerage commissions and front-end loads on their reinvested dividends and capital gains shares
Describe the process by which an ETF is created
ETFs originate with a 'sponsor' who chooses the investment objective of the ETF. The 'sponsor works with an entity known as an 'authorized participant' which is typically a large institutional investor, such as a broker dealer. The authorized participant provides the stocks, bonds, etc. (the assets that make up the ETF portfolio and are known as a 'creation basket') to the sponsor which places the creation basket in trust for the authorized participant (AP). In return for the creation basket, the sponsor issues a 'creation unit,' to the AP; a large block of ETF shares. The AP can either keep the ETF shares, sell part of them, or all of them on a stock exchange. ETF shares are listed on a number of stock exchanges, where investors can purchase them as they would shares of a publicly traded company. A creation unit is destroyed when an AP returns the specified number of ETF shares in a creation unit to the sponsor and retakes possession of the equivalent value of assets held in trust. In other words, the creation unit is redeemed for its underlying assets. Since the sponsor (ETF) has its shares backed, but they are no longer backed by assets, the shares are destroyed. The composition of the assets returned to the AP, typically mirror that of the creation basket.
What are the disadvantages of mutual fund ownership?
Funds can be quite expensive to acquire if they are load funds or charge other types of fees such as 12(b)-1 fees. While it's expected that indexbased, passively-managed mutual funds will have a slightly lower return than that of the index they benchmark (mimic), actively-managed mutual funds generally don't outperform the market, either. Only a few have been able to do so with any degree of regularity. This is partly a result of their high expenses which reduce investor returns
Describe an ETF and explain its characteristics. Contrast it with index mutual funds.
Most passively managed exchange-traded funds (the vast majority) are similar to index mutual funds but trade like stocks. Each share represents a basket of securities (a portfolio) that closely tracks one specific index. ETFs are low cost since they have no research fees, minimal operational expenses and are tax efficient. ETFs are formed using a payment-in-kind creation unit. As a result, cash isn't used to create ETF portfolios so they aren't bought and sold, but rather, created and destroyed. The result is that ETFs avoid all or most capital gains taxes and save investors capital gains distribution taxes. ETFs do distribute dividends and interest payments to shareholders. SPDRs are continually priced throughout the day, whereas, mutual funds trade only at their NAV at the close of the market. Since SPDRs trade like stocks, brokerage fees (commissions) are paid each time a trade is made. Index-mimicking mutual funds tend to be no-load which means that numerous small purchases can be made without paying commission fees. Both SPDRS and index mutual funds have low costs, low turnover, and low tax liabilities.
Briefly describe how mutual funds operate
Mutual funds are open-ended investment companies. Investors in mutual funds are essentially buying a small piece of a large, well-diversified portfolio of securities. Mutual funds receive money from shareholders and invest it in a portfolio of securities. Investors in a given mutual fund are all part-owners of that portfolio.
How important is the general behavior of the market in affecting the price performance of mutual funds? Explain. Does the future behavior of the market matter in the selection process? Explain.
Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a whole or a given market segment (depending on what securities the portfolio holds.) When economic conditions are good and the stock market (or market segment) moves up, mutual funds do well. When the market falls, mutual funds do poorly. It's very important to try to determine the future market direction. Combining past performance of existing fund managers with future market expectations helps to choose among funds. Recognize, however, that past performance obtained by a previous manager, doesn't provide any information about the present manager.
What are the advantages of mutual fund ownership?
The main advantages of mutual funds are the provision of diversification, full-time professional management, and the ability of investors with modest amounts of capital to invest in them. Additionally, mutual funds handle all paperwork and record keeping, deal in fractional shares, and automatically reinvest dividends if an investor so desires.
Discuss the various types of risk to which mutual fund shareholders are exposed. What is the major risk exposure of mutual funds? Are all funds subject to the same level of risk?
The major risk for mutual funds is market risk (systemic risk) because mutual funds are large, diversified portfolios. Therefore, their fortunes are generally tied to the behavior of the market. A second type of risk arises from management practices. If a mutual fund is managed aggressively, the probability of a loss in capital may be high. This doesn't imply that a conservative strategy is the only feasible strategy for a mutual fund The more aggressive the fund management, the greater the potential return and the greater the amount of risk.
Describe the process by which an ETF's share price in the marketplace remains close to its net asset value per share.
The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. If investors buy ETF shares, they create a demand for them and raise their price. If they sell the underlying securities, they are decreasing demand for them which should bring their prices down. Both of these actions narrow the gap between the ETF and its underlying asset value. If the ETF is trading at a premium to (higher than) its underlying value, investors can sell ETF shares or buy the underlying assets. Selling ETF shares decreases demand for them and lowers their price, while buying the individual securities increases their demand and raises their price. Again, both actions bring the prices of the ETF shares and its underlying assets closer together When a deviation between an ETF's market price and its underlying value occurs, APs may engage in trading strategies similar to those described above, but they purchase or sell creation units directly with the sponsor. For example, when an ETF is trading at a premium, it's profitable for APs to short-sell the ETF during the day (bringing the ETF share price down) while simultaneously buying the underlying securities (raising the price of the individual securities in the ETF portfolio.) At the end of the day, the AP delivers the creation basket of securities to the ETF and exchanges it for ETF shares that they use to cover their short sales. When an ETF is trading at a discount, APs can profit from buying ETF shares and shortselling the underlying securities. At the end of the day, the AP return a creation unit of ETF shares to the sponsor and exchanges them for the underlying securities of the ETF. They then, use these securities to cover their short positions. Actions by authorized participants help keep the market-determined price of ETF shares close to their underlying value. When creation units are returned to the sponsor by the AP, they're destroyed. They have no value any longer since there are no longer any underlying assets to back them. You can almost think of an ETF share as representing a pawn ticket. The ticket has value as long as it can redeem whatever item was pawned. Once the ticket redeems the item, it no longer has any value. Notice too, that there is no exchange of money between the sponsor and the AP, thus nothing was bought or sold. There was only an exchange of equally valued items. Since there's no buying or selling, no capital gains are generated by ETFs. This is a large part of the explanation of why they are tax efficient.
Identify 3 potential sources of return to mutual fund investors and briefly discuss how each could affect total return to shareholders.
The three sources of return for mutual funds are (1) dividend/interest distributions, (2) capital gains distributions, and (3) capital gains (the difference between the fund's net asset value when shares are sold and when they were purchased.) E
Define an Open-end investment company.
Their primary characteristic is that an open-end fund can issue an unlimited number of shares with little to no impact of their share price. -MF & ETF's
