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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
VU
Lecture 22
Mutual funds
What are mutual funds?
An investment vehicle which is comprised of a pool of funds collected from many investors
for the purpose of investing in securities such as stocks, bonds, money market securities,
and similar assets. Mutual funds are operated by money mangers, who invest the fund's
capital and attempt to produce capital gains and income for the fund's investors. A mutual
fund's portfolio is structured and maintained to match the investment objectives stated in its
prospectus.
In business encyclopedia
Mutual funds belong to a group of financial intermediaries known as investment companies,
which are in the business of collecting funds from investors and pooling them for the
purpose of building a portfolio of securities according to stated objectives. They are also
known as open-end investment companies. Other members of the group are closed-end
investment companies (also known as closed-end funds) and unit investment trusts. In the
United States, investment companies are regulated by the Securities and Exchange
Commission under the Investment Company Act of 1940.
Mutual funds are generally organized as corporations or trusts, and, as such, they have a
board of directors or trustees elected by the shareholders. Almost all aspects of their
operations are externally managed. They engage a management company to manage the
investment for a fee, generally based on a percentage of the fund's average net assets during
the year. The management company may be an affiliated organization or an independent
contractor. They sell their shares to investors either directly or through other firms such as
broker-dealers, financial planners, employees of insurance companies, and banks. Even the
day-to-day administration of a fund is carried out by an outsider, which may be the
management company or an unaffiliated third party.
The management company is responsible for selecting an investment portfolio that is
consistent with the objectives of the fund as stated in its prospectus and managing the
portfolio in the best interest of the shareholders. The directors of the fund are responsible
for overall governance of the fund; they are expected to establish procedures and review the
performance of the management company and others who perform services for the fund.
Mutual funds are known as open-end investment companies because they are required to
issue shares and redeem (buy back) outstanding shares upon demand. Closed-end funds, on
the other hand, issue a certain number of shares but do not stand ready to buy back their
own shares from investors. Their shares are traded on an exchange or in the over-the-
counter market. They cannot increase or decrease their outstanding shares easily. A feature
common of both mutual funds and closed-end funds is that they are managed investment
companies, because they can change the composition of their portfolios by adding and
deleting securities and altering the amount invested in each security. Unit investment trusts
are not managed investment companies like the mutual funds because their portfolio
consists of a fixed set of securities for life. They stand ready, however, to buy back their
shares.
History of Mutual Funds
Massachusetts Investors Trust was founded on March 21, 1924, and, after one year, had 200
shareholders and $392,000 in assets. The entire industry, which included a few closed-end
funds, represented less than $10 million in 1924.
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Management of Financial Institutions - MGT 604
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The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock
market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act
of 1934. These laws require that a fund be registered with the Securities and Exchange
Commission (SEC) and provide prospective investors with a prospectus that contains
required disclosures about the fund, the securities themselves, and fund manager. The SEC
helped draft the Investment Company Act of 1940, which sets forth the guidelines with
which all SEC-registered funds today must comply.
With renewed confidence in the stock market, mutual funds began to blossom. By the end
of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail
index fund, the First Index Investment Trust, was formed in 1976 and headed by John
Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior thesis
at Princeton University. It is now called the Vanguard 500 Index Fund and is one of the
largest mutual funds ever with in excess of $100 billion in assets.
One of the largest contributors of mutual fund growth was individual retirement account
(IRA) provisions added to the Internal Revenue Code in 1975, allowing individuals
(including those already in corporate pension plans) to contribute $2,000 a year. Mutual
funds are now popular in employer-sponsored defined contribution retirement plans
(401(k)s), IRAs and Roth IRAs.
As of April 2006, there are 8,606 mutual funds that belong to the Investment Company
Institute (ICI), the national association of investment companies in the United States, with
combined assets of $9.207 trillion.
Types of international mutual funds
Open-end fund
The term mutual fund is the common name for an open-end investment company. Being
open-ended means that, at the end of every day, the fund issues new shares to investors, and
buys back shares from investors wishing to leave the fund.
Mutual funds may be legally structured as corporations or business trusts but in either
instance are classed as open-end investment companies by the SEC.
Other funds have a limited number of shares; these are either closed-end funds or unit
investment trusts, neither of which a mutual fund is.
Exchange-traded funds
A relatively new innovation, the exchange traded fund (ETF), is often formulated as an
open-end investment company. ETFs combine characteristics of both mutual funds and
closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued
or redeemed by institutional investors in large blocks (typically of 50,000). Investors
typically purchase shares in small quantities through brokers at a small premium or discount
to the net asset value; this is how the institutional investor makes its profit. Because the
institutional investors handle the majority of trades, ETFs are more efficient than traditional
mutual funds (which are continuously issuing new securities and redeeming old ones,
keeping detailed records of such issuance and redemption transactions, and, to effect such
transactions, continually buying and selling securities and maintaining liquidity position)
and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock
exchange, just like closed-end funds.
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Management of Financial Institutions - MGT 604
VU
Exchange traded funds are also valuable for foreign investors who are often able to buy and
sell securities traded on a stock market, but who, for regulatory reasons, are unable to
participate in traditional US mutual funds.
Equity funds
Equity funds, which consist mainly of stock investments, are the most common type of
mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the
United States. Often equity funds focus investments on particular strategies and certain
types of issuers.
Bond funds
Bond funds account for 18% of mutual fund assets. Types of bond funds include term
funds, which have a fixed set of time (short-, medium-, or long-term) before they mature.
Municipal bond funds generally have lower returns, but have tax advantages and lower risk.
High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With
the potential for high yield, these bonds also come with greater risk.
Money market funds
Money market funds hold 26% of mutual fund assets in the United States. Money market
funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit
(CDs), money market shares are liquid and redeemable at any time. The interest rate quoted
by money market funds is known as the 7 Day SEC Yield.
Funds of funds
Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e.,
they are funds comprised of other funds). The funds at the underlying level are typically
funds which an investor can invest in individually. A fund of funds will typically charge a
management fee which is smaller than that of a normal fund because it is considered a fee
charged for asset allocation services. The fees charged at the underlying fund level do not
pass through the statement of operations, but are usually disclosed in the fund's annual
report, prospectus, or statement of additional information. The fund should be evaluated on
the combination of the fund-level expenses and underlying fund expenses, as these both
reduce the return to the investor.
Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor),
although some invest in funds managed by other (unaffiliated) advisors. The cost associated
with investing in an unaffiliated underlying fund is most often higher than investing in an
affiliated underlying because of the investment management research involved in investing
in fund advised by a different advisor. Recently, FoFs have been classified into those that
are actively managed (in which the investment advisor reallocates frequently among the
underlying funds in order to adjust to changing market conditions) and those that are
passively managed (the investment advisor allocates assets on the basis of on an allocation
model which is rebalanced on a regular basis).
The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for
investors who are unable to or unwilling to determine their own asset allocation model.
Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market
to provide investors with these options and take the "guess work" out of selecting funds.
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Management of Financial Institutions - MGT 604
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The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030,
2050, etc. The more distant the target retirement date, the more aggressive the asset mix.
Hedge funds
Hedge funds in the United States are pooled investment funds with loose SEC regulation
and should not be confused with mutual funds. Certain hedge funds are required to register
with SEC as investment advisers under the Investment Advisers Act. The Act does not
require an adviser to follow or avoid any particular investment strategies, nor does it require
or prohibit specific investments. Hedge funds typically charge a management fee of 1% or
more, plus a "performance fee" of 20% of the hedge fund's profit. There may be a "lock-
up" period, during which an investor cannot cash in shares.
Usage of Mutual Funds
Mutual funds can invest in many different kinds of securities. The most common are cash,
stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can
invest primarily in the shares of a particular industry, such as technology or utilities. These
are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk
bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies,
corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock
and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and
foreign securities (global funds), or primarily foreign securities (international funds).
Most mutual funds' investment portfolios are continually adjusted under the supervision of a
professional manager, who forecasts the future performance of investments appropriate for
the fund and chooses those which he or she believes will most closely match the fund's
stated investment objective. A mutual fund is administered through a parent management
company, which may hire or fire fund managers.
Mutual funds are liable to a special set of regulatory, accounting, and tax rules. Unlike most
other types of business entities, they are not taxed on their income as long as they distribute
substantially all of it to their shareholders. Also, the type of income they earn is often
unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free
municipal bond income are also tax-free to the shareholder. Taxable distributions can be
either ordinary income or capital gains, depending on how the fund earned those
distributions.
Mutual funds vs. other investments
Mutual funds offer several advantages over investing in individual stocks. For example, the
transaction costs are divided among all the mutual fund shareholders, who also benefit by
having a third party (professional fund managers) apply their expertise, dedicate their time
to manage and research investment options. However, despite the professional management,
mutual funds are not immune to risks. They share the same risks associated with the
investments made. If the fund invests primarily in stocks, it is usually subject to the same
ups and downs and risks as the stock market.
Share classes
Many mutual funds offer more than one class of shares. For example, you may have seen a
fund that offers "Class A" and "Class B" shares. Each class will invest in the same pool (or
investment portfolio) of securities and will have the same investment objectives and
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Management of Financial Institutions - MGT 604
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policies. But each class will have different shareholder services and/or distribution
arrangements with different fees and expenses. These differences are supposed to reflect
different costs involved in servicing investors in various classes; for example, one class may
be sold through brokers with a front-end load, and another class may be sold direct to the
public with no load but a "12b-1 fee" included in the class's expenses (sometimes referred to
as "Class C" shares). Still a third class might have a minimum investment of $10,000,000
and be available only to financial institutions (a so-called "institutional" share class). In
some cases, by aggregating regular investments made by many individuals, a retirement
plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the
benefit of their typically lower expense ratios) even though no members of the plan would
qualify individually. As a result, each class will likely have different performance results.
A multi-class structure offers investors the ability to select a fee and expense structure that
is most appropriate for their investment goals (including the length of time that they expect
to remain invested in the fund).
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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,