Mutual Funds
4-1
Net Asset Value
Used as a basis for valuation of
investment company shares
– Selling new shares
– Redeeming existing shares
Calculation
Market Value of Fund Assets Fund Liabilities
NAV
Fund shares outstanding
4-2
Open-End and Closed-End Funds: Key Differences
Shares Outstanding
Closed-end: no change unless new stock is offered
Open-end: changes when new shares are sold or
old shares are redeemed
Pricing
Open-end: Fund share price = Net Asset Value
(NAV)
Closed-end: Fund share price may trade at a
premium or discount to NAV
4-3
NAV calculation
ABC Fund ($Millions except NAV)
Most Mutual Funds
Market Value Securities have little or no
Long Term Debt
+ Cash & Receivables $550.00
- Current Liabilities 75.00
NAV Total (20.00)
# Fund Shares $605.00
NAV 20.00
$ 30.25
4-4
How Funds Are Sold
Directly marketed
–
You find them
–
• May avoid front end load
Front end load is an up front cost (fee) to
purchase a share of a mutual fund.
Sales force distributed
–
–
Recommended by a broker or planner
–
Usually will have a front end load
• May be revenue sharing on sales force
distributed
Potential conflict of interest 4-5
Potential Conflicts of Interest:
Revenue Sharing
Brokers put investors in funds that may that
____________________________
may not be the most appropriate
Mutual funds could direct trading
_____________________
to higher cost brokers
Revenue sharing is _________
not illegal but it must be
________
disclosed to the investor
4-6
4.4 Costs of Investing in
Mutual Funds
4-7
Costs of Investing in Mutual Funds
Fee Structure
–
Front-end load
–
Back-end load (contingent), (redemption fee)
Operating expenses
–
Buying and selling commissions, administrative
12 b-1expenses
charges and advisory fees for the managers
–
–
Marketing costs paid by the fundholders
–
Alternative to a load, but assessed annually
Maximum is 1% of assets
4-8
Costs of Investing in Mutual Funds
Fees, loads and performance
– Gross performance of load funds is statistically
identical to gross performance of no load funds
– Why pay a load charge?
– Funds with high expenses tend to be poorer
performers.
• 12 b-1 charges should be added to expense ratios
• Costs found in the fund prospectus and may be
compared via Morningstar
4-9
NAV and the Effective Load
Cost to initially purchase one share of a load fund = NAV +
front-end load (%) (if any).
Stated Loads typically range from ________
0 to 8.5%
If you invest $10,000 in a fund with an 8.5% front-end load, you
actually acquire shares worth $9,150; the other $850 goes to
the broker.
The load is designed to offset expenses of marketing the fund
and goes to the broker who sells the fund to the investor.
The effective load is greater than the stated load: In the above
example, the actual % commission cost (effective load) is:
– $850 / $9150 = 9.3%; which is > stated load.
4-10
Costs of Investing in Mutual Funds
Avoiding the load:
– Can sometimes choose different class of fund
shares.
– Best alternative may depend on
_______________________________________.
amount invested and expected holding period
4-11
Costs of Investing in Mutual Funds
Expense ratios:
Funds charge annual operating expenses and
annual advisory or management fees against the
NAV.
– Expense ratios are calculated as
Annual Expenses / Average NAV
– A "well managed" fund probably should have an expense ratio
of less than ___.
All costs and charges must2%
be revealed in the
fund's prospectus.
4-12
Converting gross pretax returns to net
pretax returns:
This year you invested $10,000 in a mutual fund with a
6% load (one time fee) and estimated annual expenses of
1.35%. The gross return is 17.5%. What is your return
net of loads and expenses?
Amount initially invested = $10,000 – (0.06 x $10,000) = $9,400
Amount after gross return = $9,400 x 1.175 = $11,045
Amount after fees = $11,045 - (0.0135 x $11,045) = $10,895.89*
Net rate of return = ($10,895.89 - $10,000) / $10,000 = 8.96%
In MF prospectus and annual reports the MF returns are
net of operating expenses, 12b-1 fees and commissions,
but the returns do not include loads.
* This example calculates expenses using ending NAV.
4-13
Table 4.2 Impacts of Costs on Investment
Performance
Conclusions? Optimal choice fee structure is
• Time dependent • Investment size dependent
4-14
Sample Problems
4-15
Problem 1
NAV is $10.70 Front-end load is 6%
Every dollar paid results in only ____
$.94 going
toward purchase of shares.
Offer price =
NAV = $10.70 = $11.38
1 - load 1-.06
4-16
Problem 2
Offer price $12.30 Front-end load is 5%
$.95
Every dollar paid results in only ____
going toward purchase of shares.
NAV = offer price x (1- load)
= $12.30 x 0.95
= $11.69
4-17
Problem 3
NAV = (Market Value of Assets – Liabilities) Shares Outstanding
A. (200,000)x($35) = $ 7,000,000
B. (300,000)x($40) = $12,000,000 Liabilities
C. (400,000)x($20) = $ 8,000,000 $30,000
D. (600,000)x($25) = $15,000,000 $42,000,000
Shares Outstanding
$42,000,000 – $30,000 = $10.49 = NAV 4,000,000
4,000,000
4-18
Problem 4
Turnover rate = Value of stocks sold and replaced
Market Value Assets
MVA = $42M
Value of stocks sold = (600,000x$25)= $15,000,000 or
Value of stocks purchased = (200kx$50)+(200kx$25) = $15,000,000
Market Value Assets = $42,000,000
$15,000,000 = 0.357 or 35.7%
$42,000,000
AHP = 0.5 x 1/Turnover
Average holding period?
= 0.5 x 1/0.357 = 1.4 yrs
4-19
Problem 5
a. The empirical research suggests that past performance is
not highly predictive of future performance, especially for
better performing funds. There may be some tendency for
the fund to perform better than average next year, but it is
unlikely that the fund will be in the top 10%.
b. Evidence suggests that bad performance is more likely to
persist. Probably related to high fund costs or high
turnover rates. Excessive costs are detrimental to a
fund’s returns.
4-20
Problem 6
As an initial approximation, your return equals the return on the
shares minus the total of the expense ratio and purchase costs:
– Return 12% 1.2% 4% = 6.8%
But the precise return is less than this because the 4% load is
paid up front, not at the end of the year.
To purchase the shares, you would have had to invest:
– $20,000 / (1 0.04) = $20,833
The shares net increase in value (12% 1.2%) from $20,000 to:
– $20,000 (1.12 0.012) = $22,160
The rate of return is:
($22,160 $20,833) / $20,833 = 6.37%
4-21
Problem 7
a. Sell after 4 years: Suppose you have $1000 to invest. The initial
investment in Class A shares is ____ net of the front-end load. After 4
$940
years, your portfolio will be worth:
$940 (1.10)4 = $1,376.25
Class B shares allow you to invest the full $1,000, but your investment
performance net of 12b-1 fees will be only 9.5%, and you will pay a 1%
back-end load fee if you sell after 4 years.
Your redemption value after 4 years will be:
$1,000 (1.095)4 x 0.99 = $1,423.28
Class B shares are the better choice if your horizon is 4 years.
4-22
Problem 7 Cont.
b. Sell after 15 years:
What is the breakeven time?
With a 15-year horizon, the Class A shares will be worth:
$940 (1.10) =
15 $940 x (1.10) N
= $1,000 x (1.095) N
$3,926.61
[$1,000 / $940 ] = (1.10)N / (1.095)N
For the Class B shares, there is 1.06383
no back-end load/ in
= [1.10 this case
1.095] N since the
horizon is greater than 5 years. Therefore, the value of the Class NB
shares will be: LN 1.06383 = LN [1.10 / 1.095]
LN 1.06383 = N x LN [1.10 / 1.095]
$1,000 (1.095)15 =
$3,901.32 0.061875 = N x 0.004556
N = 13.581 years
At this longer horizon, Class A shares are the better choice. Why?
4-23
Problem 8
Suppose that finishing in the top half of all portfolio managers is
purely luck, and that the probability of doing so in any year is
exactly 50%.
Then the probability that any particular manager would finish in
the top half of the sample five years in a row is 0.505 = 0.03125.
We would then expect to find that [350 0.03125] 11 managers
finish in the top half for each of the five consecutive years.
4-24
Problem 9
Trading costs will reduce the portfolio return by
(0.4%)x(0.50)= 0.2%
Over many years of savings these costs can greatly
reduce the value of your portfolio.
Remember also that the high turnover rate can have tax
consequences that further reduces your after-tax return.
4-25
