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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
VU
Lecture # 23
Mutual Funds
Criticism of managed mutual funds
Historically, only a small percentage of actively managed mutual funds, over long periods
of time, have returned as much, or more than comparable index mutual funds. This, of
course, is a criticism of one type of mutual fund over another.
Another criticism concerns sales commissions on load funds, an upfront or deferred fee as
high as 8.5 percent of the amount invested in a fund (although the average up-front load is
no more than 5% normally). *(Mutual Funds have to qualify to charge the maximum
allowed by law, which is 8.5% and most of them DO NOT qualify for this.) In addition, no-
load funds typically charge a 12b-1 fee in order to pay for shelf space on the exchange the
investor uses for purchase of the fund, but they do not pay a load directly to a mutual fund
broker, who sells it. Critics point out those high sales commissions can sometimes represent
a conflict of interest, as high commissions benefit the sales people but hurt the investors.
Although in reality, "A shares", which appear to have the highest up front load, (around 5%)
are the "cheapest" for the investor, if the investor is planning on 1) keeping the fund for
more than 5 years, 2) investing more than 100,000 in one fund family, which likely will
qualify them for "break points", which is a form of discount, or 3) staying with that "fund
family" for more than 5 years, but switching "funds" within the same fund company. In this
case, the up front load is best for the client, and at times "outperforms" the "no load" or "B
or C shares". High commissions can sometimes cause sales people to recommend funds that
maximize their income. This can be easily solved, buy working with a "registered
investment advisor" instead of a "broker", where the investment advisor can charge strictly
for advise, and not charge a "load, or commission" for their work, at all.
This is a discussion of criticism, and solutions regarding one mutual fund over another.12b-
1 fees, which are found on most "no load funds", can motivate the fund company to focus
on advertising to attract more and more new investors, as new investors would also cause
the fund assets to increase, thus increasing the amount of money that the mutual fund
managers make.
Mutual fund managers and companies need to disclose by law, if they have a conflict of
interest due to the way they are paid. In particular fund managers may be encouraged to take
more risks with investor's money than they ought to: Fund flows (and therefore
compensation) towards successful, market beating funds are much larger than outflows
from funds that lose to the market. Fund managers may therefore have an incentive to
purchase high risk investments in the hopes of increasing their odds of beating the market
and receiving the high inflows, with relatively less fear of the consequences of losing to the
market.
Many analysts, however, believe that the larger the pool of money one works with, the
harder it is to manage actively, and the harder it is to squeeze good performance out of it.
This is true, due to the fact that there are only so many companies that one can identify to
put the money into ( buy shares of) that fit with the "style" of the mutual fund, due to what
is disclosed in the prospectus. Thus some fund companies can be focused on attracting new
customers, and forget to "close" their mutual funds to new customers, when they get too
big, to invest the assets properly, thereby hurting its existing investors' performance. A great
deal of a fund's costs are flat and fixed costs, such as the salary for the manager. Thus it can
be more profitable for the fund to try to allow it to grow as large as possible, instead of
limiting its assets. Most fund companies have closed some funds to new investors to
maintain the integrity of the funds for existing investors. If the funds reach more than 1
billion dollars, many times, these funds, have gotten too large, before they are closed, and
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Management of Financial Institutions - MGT 604
VU
when this happens, the funds tend to not have a place to put the money and can and tend to
lose value.
Other criticisms of mutual funds are that some funds illegally are guilty of market timing
(although many fund companies tightly control this) and that some fund managers, also
illegal, accept extravagant gifts in exchange for trading stocks through certain investment
banks, which presumably charge the fund more for transactions than would non-gifting
investment bank. This practice, although done, is completely illegal. As a result, all fund
companies strictly limit -- or completely bar -- such gifts.
Scandals of mutual funds
In September 2003, the United States mutual fund industry was beset by a scandal in which
several major fund companies permitted and facilitated "late trading" and "market timing".
Mutual-fund families in the United States
A family of mutual funds is a group of funds that are marketed under one or more brand
names, usually having the same distributor (the company which handles selling and
redeeming shares of the fund in transactions with investors), and investment advisor (which
is usually a corporate cousin of the distributor).
There are several hundred families of registered mutual funds in the United States, some
with a single fund and others offering dozens. Many fund families are units of a larger
financial services company such as an asset manager, bank, brokerages, or insurance
company. Additionally, multiple funds in a family can be part of the same corporate
structure; that is, one underlying corporation or business trust may divide itself into more
than one fund, each of which issues shares separately.
Mutual Funds in Pakistan
Mutual Funds were introduced in Pakistan in 1962, with the public offering of National
Investment (Unit) Trust (NIT) which is an open-end mutual fund in the public sector. This
was followed by the establishment of the Investment Corporation of Pakistan (ICP) in 1966,
which subsequently offered a series of closed-end mutual funds. Up to date, twenty six (26)
closed-end ICP mutual funds have been floated. Initially there was both public and private
sector participation in the management of these funds, but with the nationalization in the
seventies, the government role become more dominant and today these mutual funds are
totally in the public sector. Later, the government also allowed the private sector to establish
mutual funds. Currently there exists one open-ended and eleven closed-ended mutual funds
under private sector management.
Rules Govern Mutual Funds in Pakistan
There are two rules govern mutual funds in Pakistan, which are:
Investment Companies and Investment Advisors' Rules, 1971. (govern closed-end
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mutual funds)
Asset Management Companies Rules, 1995. (govern open-ended mutual funds)
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These rules however only apply to private sector operated mutual funds and are not
applicable to NIT and ICP mutual funds.
Money Market Fund
We begin with a discussion of money market funds for several reasons:
1. They are the safest for the trainee investor;
2. They are the easiest, least complicated to follow and understand;
3. Almost without exception, every mutual fund investment company offers money market
funds;
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Management of Financial Institutions - MGT 604
VU
4. Money market funds represent an indispensable investment tool for the beginning
investor.
5. They are the most basic and conservative of all the mutual funds available;
Money market funds should be considered by investors seeking stability of principal, total
liquidity, and earnings that are as high, or higher, than that Available through bank
certificates of deposit. And unlike bank cash deposits, money market funds have no early
withdrawal penalties.
Specifically, a money market fund is a mutual fund that invests its assets only in the most
liquid of money instruments. The portfolio seeks stability by investing in very short-term,
interest-bearing instruments issued by the state and local governments, banks, and large
corporations. The money invested is a loan to these agencies, and the length of the loan
might range from overnight to one week or, in some cases, as long as 90 days. These debt
certificates are called "money market instruments"; because they can be converted into cash
so readily, they are considered the equivalent of cash.
To understand why money market mutual funds is recommended as an ideal investment, let
me reemphasize just seven of the advantages they offer:
1. Safety of principal, through diversification and stability of the short-term portfolio
investments
2. Total and immediate liquidity, by telephone or letter
3. Better yields than offered by banks, 1% to 3% higher
4. Low minimum investment, some as low as $100
5. Professional management, proven expertise
6. Generally, no purchase or redemption fees, no-load funds
Income Funds
The objective of income mutual funds is to seek a high level of current income
commensurate with each portfolio's risk potential. In other words, the greater the risk, the
greater the potential for generous income yields; but the greater the risk of principal loss as
well.
The risk / reward potential are low to high, depending upon the type of securities that make
up the fund's portfolio. The risk is very low when the fund is invested in government
obligations, blue chip corporations, and short-term agency securities. The risk is high when
a fund seeks higher yields by investing in long-term corporate bonds, offered by new,
undercapitalized, risky companies.
Who should invest in income funds?
Investors seeking current income higher than money market rates, who are willing to
accept moderate price fluctuations
Investors willing to "balance" their equity (stock) portfolios with a fixed income
investment
Investors who want a portfolio of taxable bonds with differing maturity dates
Investors interested in receiving periodic income on a regular basis
Income and Growth Funds
The primary purposes of income and growth funds are to provide a steady source of income
and moderate growth. Such funds are ideal for retirees needing a supplement source of
income without forsaking growth entirely.
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Management of Financial Institutions - MGT 604
VU
Growth and Income Funds
The primary objectives of growth and income funds are to seek long-term growth of
principal and reasonable current income. By investing in a portfolio of stocks believed to
offer growth potential plus market or above - market dividend income, the fund expects to
investors seeking growth of capital and moderate income over the long term (at least five
years) would consider growth and income funds. Such funds require that the investor be
willing to accepts some share-price volatility, but less than found in pure growth funds
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Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  7. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS:Banking Inspection Department
  8. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Debt Management
  9. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Training Programs by SBP
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  11. MAJOR DRIVERS OF FINANCIAL INDUSTRY:GLOBAL FINANCIAL SYSTEM, The World Bank
  12. INTERNATIONAL FINANCIAL INSTITUTIONS:ADB Projects in Pakistan, Paris Club
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  18. ROLE OF COMMERCIAL BANKS:Problem bank management, BANKING SECTOR REFORMS
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  21. ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday
  45. RECAP:FINANCIAL INSTITUTIONS, CENTRAL BANK,