Financial Markets and Institutions: Abridged 10 Edition

Financial Markets and Institutions
Abridged 10th Edition

by Jeff Madura
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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1
23 Mutual Fund Operations
Chapter Objectives
■ provide a background on mutual funds

■ describe the various types of stock and bond mutual
funds
■ describe the performance of mutual funds
■ describe key characteristics of money market funds
■ describe other types of funds
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
Background on Mutual Funds
■ Mutual funds serve as a key financial intermediary.

■ Mutual funds provide an important service for individual
investors who wish to invest funds.
■ Mutual funds are sometimes referred to as open-end
funds because they are open to investors, meaning that
they will sell shares to investors at any time. In addition,
they allow investors to sell (redeem) the shares back to
the fund at any time.
■ Mutual funds have grown at a rapid pace over time.
3 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Exhibit 23.1 How Mutual Funds Finance Economic
Growth
Exhibit 23.2 Growth in Mutual Funds
Note: The numbers shown here include money market funds.

Source: Investment Company Institute.
Pricing Shares of the Mutual Fund

■ The price per share of a mutual fund is equal to the net
asset value (NAV) per share, which represents the value
of the portfolio (per share) after accounting for expenses
incurred from managing the fund.
■ When a mutual fund pays its shareholders dividends, its
NAV declines by the per share amount of the dividend
payout.
Mutual Fund Distributions to Shareholders

Funds can generate returns to their shareholders in three
ways.
1. First, they can pass on any earned income (from
dividends or coupon payments) as dividend payments to
the shareholders.
2. Second, they distribute the capital gains resulting from
the sale of securities within the fund.
3. A third type of return to shareholders is through mutual
fund share price appreciation.
Regulation of Mutual Funds

Information Contained in a Prospectus.
■ The minimum amount of investment required.
■ The investment objective of the mutual fund.
■ The return on the fund over the past year, the past three
years, and the past five years, in comparison to a broad
market index.
■ The exposure of the mutual fund to various types of risk.
■ The services (such as check writing, ability to transfer
money by telephone, etc.) offered by the mutual fund.
■ The fees incurred by the mutual fund (such as management
fees) that are passed on to the investors.
■ Names of their portfolio managers and the length of time
that they have been employed by the fund in that position.
Management of Mutual Funds

Each mutual fund is managed by one or more portfolio
managers, who must focus on the stated investment
objective of that fund.
■ Interaction of Mutual Funds with Other Financial
Institutions
■ The managing of a mutual fund sometimes leads to
interaction with other financial institutions.
■ Some mutual funds are owned by commercial banks.
■ Mutual Fund Use of Financial Markets
■ Each type of mutual fund uses one or more financial
markets to manage its portfolio.
Exhibit 23.3 Interaction between Mutual Funds and
Other Financial Institutions
Exhibit 23.4 How Mutual Funds Utilize Financial
Markets
Expenses Incurred by Mutual Fund Shareholders

■ Mutual funds pass their expenses to shareholders.
■ The expenses include compensation to the portfolio
managers and other employees, research support,
recordkeeping and clerical fees, and marketing fees.
■ Sales Charge - Mutual funds may be referred to as
either as a load fund or a no-load fund.
■ Load funds are promoted by registered representatives of
brokerage firms, who earn a sales charge upon the
investment in the fund (commonly referred to as a front-end
load) ranging between 3 and 8.5 percent.
■ No-load funds are promoted strictly by the mutual fund of
concern, thereby avoiding an intermediary.
Exhibit 23.5 How the Accumulated Value Can Be Affected by
Expenses (Assume Initial Investment of $10,000 and a Return before
Expenses of 9.2 Percent)
Expenses Incurred by Mutual Fund Shareholders (Cont.)

■ 12b-1 Fees
■ Some mutual funds charge shareholders a 12b-l fee (in
reference to SEC rule 12b-l) as part of the fund’s annual
expenses to cover administrative or marketing expenses.
■ These fees are controversial because many mutual funds do
not clarify how they use the money received from the fees.
Governance of Mutual Funds

■ Usually run by an investment company whose owners are
different from the shareholders in the mutual funds.
■ Each mutual fund has a board of directors that is supposed
to represent the fund’s shareholders.
■ Mutual funds also have a compliance officer who is
supposed to ensure that the fund’s operations are in line
with its objective and guidelines for trading.
■ Governance of Corporations by Mutual Funds
Regardless of whether mutual funds monitor their own
management effectively, they have the power to monitor
the management of the firms in which they invest.
Mutual Fund Categories
■ Mutual funds are classified as

■ Stock (or equity) mutual funds
■ Bond mutual funds
■ Money market funds
■ Stock funds are dominant when measured by the market
value of total assets among mutual funds.
Exhibit 23.6 Distribution of Investment in Mutual
Funds
Stock Mutual Fund Categories

■ Growth Funds
■ Typically composed of stocks of companies that have not fully
matured and are expected to grow at a higher than average rate in
the future.
■ The primary objective is to achieve an increase in the value with
less concern about the generation of steady income.
■ Capital Appreciation Funds

■ Also known as aggressive growth funds - Composed of stocks
that have potential for very high growth but may also be unproven.
■ These funds are suited to investors who are willing to risk a
possible loss in value.

■ Growth and Income Funds
■ Contains a unique combination of growth stocks, high-
dividend stocks, and fixed-income bonds.
■ For investors looking for potential for capital appreciation
along with some stability in income.
■ International and Global Funds
■ Created to enable investors to invest in foreign securities
without incurring excessive costs.
■ Specialty Funds
a. Focus on a group of companies sharing a particular
characteristic.

■ Index Funds
■ Composed of stocks that, in aggregate, are expected to move
in line with a specific index.
■ These funds may be attractive to investors who wish to invest
in a particular foreign market but do not have much
knowledge about the specific stocks in that market.
■ Multifund Funds
■ Invest in a portfolio of different mutual funds.
■ Investors incur two types of management expenses: (1) the
expenses of managing each individual mutual fund and (2)
the expenses of managing the multifund mutual fund.
Bond Mutual Fund Categories

■ Income Funds
■ Composed of bonds that offer periodic coupon payments and
vary in exposure to risk.
■ Best suited for investors who rely on the fund for periodic
income and plan to maintain the fund over a long period of
time.
■ Tax-Free Funds
■ Mutual funds containing municipal bonds
■ Allow investors in high tax brackets with even small
amounts of money to avoid taxes while maintaining a low
degree of credit risk.
Bond Mutual Fund Categories

■ High-Yield (Junk) Bond Funds
■ Typically, the bonds are issued by highly leveraged firms.
■ Investors desiring high returns and willing to incur high risk
may consider bond portfolios with at least two-thirds of the
bonds rated below Baa by Moody’s or BBB by Standard &
Poor’s.
■ International and Global Bond Funds
■ Contain bonds issued by corporations or governments based
in other countries.
■ Maturity Classifications
■ Commonly segmented according to the maturities of the
bonds they contain.
Asset Allocation Funds

■ Contain a variety of investments (such as stocks, bonds, and
money market securities).
■ These funds may even concentrate on international securities
if the portfolio managers forecast favorable economic
conditions in foreign countries.
Growth and Size of Mutual Funds
■ In the 1980s, investment in bond funds exceeded that of
stock funds, but since the mid-1990s, investment in stock
funds has been higher.
Exhibit 23.7 Growth in the Number of Stock Funds
and Bond Funds
Exhibit 23.8 Investment in Bond and Stock Mutual
Funds
Performance of Mutual Funds
Valuation of Stock Mutual Funds

■ Change in Market Conditions
■ A change in a stock mutual fund’s valuation is related to a
change in stock market conditions.
■ Beta measures the sensitivity of a mutual fund’s exposure to
a change in stock market conditions.
■ Change in Sector Conditions
The valuation of a stock mutual fund focused on a specific
sector is influenced by conditions in that sector.
■ Change in Management Abilities
Mutual funds in the same sector can experience differences
in valuation because of differences in management abilities.
Valuation of Bond Mutual Funds

■ Change in the Risk-Free Rate
The prices of bonds tend to be inversely related to changes in
the risk-free interest rate.
■ Change in the Risk Premium
The prices of bonds tend to decline in response to an increase
in the risk premiums required by investors who purchase
bonds.
■ Change in Management Abilities
The performance levels of bond mutual funds in a specific
bond classification can vary because of differences in the
abilities of the funds’ portfolio managers.
Performance from Diversifying among Funds

■ The performance of a mutual fund may be driven by a single
economic factor.
■ Diversification among types of mutual funds can reduce the
volatility of returns on the overall investment.
Research on Mutual Fund Performance

■ Studies have attempted to assess mutual fund performance
over time.
■ Most studies that assess mutual fund performance find that
mutual funds do not outperform benchmarks, especially
when accounting for the type of securities that each fund
invests in.
Money Market Funds
■ Money market mutual funds, called money market funds

(MMFs), sell shares to individuals and use the proceeds
to invest in money market (short-term) instruments for
their investors.
■ The main difference between money market funds and
mutual funds is that money market funds focus their
investment in money market securities.
■ MMFs can be distinguished from one another and from
other mutual funds by the composition, maturity, and risk
of their assets.
Exhibit 23.9 Growth in Money Market Fund Assets
Money Market Funds
Asset Composition of Money Market Funds

Commercial paper, CDs, repurchase agreements, and
Treasury securities are the most common components.
Risk of Money Market Funds

■ MMFs usually have a low level of credit risk because the
money market securities they invest in have low credit risk.
■ Exposure to interest rate risk is low.
■ MMFs are normally characterized as having relatively low
risk and low expected returns and so are popular among
investors who need a conservative investment medium.
Exhibit 23.10 Composition of Taxable Money Market
Fund Assets in Aggregate
Money Market Funds
Management of Money Market Funds

The role of MMF portfolio managers is to maintain an asset
portfolio that satisfies the underlying objective of a fund.
■ Shifting Investments among Money Market Funds

■ Investors who are concerned about a potential increase in
credit risk can move their money into MMFs that are
heavily invested in Treasury bills.
■ If investors expect rising interest rates, they can move their
money into MMFs that are heavily invested in securities
with very short-term maturities.
Other Types of Funds
Closed-End Funds
■ Issue shares and use the proceeds to make investments
in stocks or bonds representing a particular sector or
country for their investors.
■ Some closed-end funds engage in secondary offerings of
new shares and use the proceeds to expand their
investment portfolios.
■ Market Price of Closed-End Funds
The market price of a closed-end fund can deviate from the
aggregate value of the underlying stocks (measured by net asset
value per share).
Exchange-Traded Funds
■ Designed to mimic particular stock indexes and are traded
on a stock exchange just like stocks.
■ Exchange-traded funds have become very popular in
recent years because they are an efficient way for
investors to invest in a particular stock index.
■ One disadvantage of ETFs is that each purchase of
additional shares must be executed through the exchange
where they are traded.
■ Short Sales of ETFs - Like closed-end funds, ETFs can
be sold short.
Exchange-Traded Funds
■ Popular ETFs
■ Exchange-traded funds are classified as broad based, sector,
or global, depending on the specific index that they mimic.
■ The broad-based funds are the most popular, but both sector
and global ETFs have experienced substantial growth in
recent years.
■ A popular ETF is the PowerShares QQQ, or Cube (its trading
symbol is QQQQ), which represents the Nasdaq 100 index of
technology firms.
■ Another popular ETF is the Standard & Poor’s Depository
Receipt (SPDR or Spider), which represents the S&P 500
index.
Venture Capital Funds

■ Venture capital (VC) funds use money that they receive
from wealthy individuals and some institutional investors
to invest in companies.
■ Invested monies are pooled and used to create a
diversified equity portfolio.
■ Venture capital funds tend to focus on technology firms,
which have the potential for high returns but also exhibit a
high level of risk.
■ A VC fund typically plans to exit from its original
investment in a business within about four to seven years.
Private Equity Funds

■ Private equity funds pool money provided by individual
and institutional investors and buy majority (or entire)
stakes in businesses.
■ When a private equity fund purchases a business, it
assumes control and is able to restructure the business in
a manner that will improve its performance.
■ The Market for Private Equity Businesses
■ The potential to capitalize on inefficiencies in this market
has attracted much more investment in private equity and
has led to the creation of many new private equity funds.
Hedge Funds
■ Sell shares to wealthy individuals and financial institutions
and use the proceeds to invest in securities.
■ They differ from open-end mutual funds in several ways.
■ Require a much larger initial investment (such as $1
million).
■ Many hedge funds are not “open” in the sense that they
may not always accept additional investments or
accommodate redemption requests unless advance notice is
provided.
■ Hedge funds have been subject to minimal regulation.
■ Hedge funds invest in a wide variety of investments to
achieve high returns.
Hedge Funds
■ Use of Financial Leverage
■ Use borrowed funds to complement the equity that they
receive and invest.
■ The use of financial leverage allows them to make more
investments with a given amount of equity and can magnify
the returns.
■ Hedge Fund Fees
■ Hedge funds charge a management fee of between 1 and 2
percent of the investment per year.
■ In addition, they charge an incentive fee that is based on
the return of the fund. The typical incentive fee is 20
percent of the return.
Hedge Funds
■ Financial Problems Experienced by LTCM
■ One of the best-known hedge funds was Long-Term Capital
Management (LTCM), which was created in 1994 and
managed by a group of partners who had a very strong track
record.
■ LTCM had investments in relatively risky bonds and lost
more than $2 billion, or about 40 percent of its total equity.
■ On September 23, 1998, the Federal Reserve Bank of New
York organized a rescue of LTCM by 14 large commercial
banks and securities firms.
Hedge Funds
■ Performance of Hedge Funds during the Credit
Crisis Some hedge funds failed during the credit crisis in
2008 because they had invested heavily in mortgage related
securities just before subprime mortgage values collapsed.
■ Short Selling by Hedge Funds
■ One reason for the success of some hedge funds is that they
can take a very large short position (selling stocks that they
do not own) on overvalued stocks.
■ During the credit crisis in 2008, hedge funds were accused
of making market conditions worse by taking short
positions in some of the financial institutions that held
subprime mortgages or other mortgage-related securities.
Hedge Funds
■ Madoff Fund Scandal
■ Bernard Madoff managed a large and well-respected hedge
fund that included various institutions, charities, and wealthy
individuals among its investors.
■ Madoff admitted that he had been periodically using money
from new investors to pay off investors who wanted to cash
out of the fund.
■ The potential losses to investors were estimated to be as high
as $50 billion, making this possibly the biggest financial
scandal in U.S. history.
Hedge Funds
■ Hedge Funds of Funds
Some “hedge funds of funds” have been created to pool
smaller investments by individuals and invest in hedge
funds.
Hedge Funds
■ Regulatory Reform of Hedge Funds
■ The Financial Reform Act of 2010 contained provisions to
stabilize the financial system.
■ Mandates that hedge funds managing more than $100 million
register with the SEC as investment advisors.
■ Must also disclose financial data that can be used by the
Financial Stability Oversight Council (created by the
Financial Reform Act) in order to assess systemic risk in the
financial system.
■ Prevents commercial banks from investing more than 3% of
their capital in hedge funds, private equity funds, or real
estate funds.
Real Estate Investment Trusts

■ A closed-end fund that invests in real estate or
mortgages.
■ Real estate investment trusts can be classified as
■ Equity REITs, which invest directly in properties
■ Mortgage REITs, which invest in mortgage and construction
loans
■ Hybrid REITs, which invest in both properties and
mortgages.
■ Impact of Credit Crisis on REITs
■ Many mortgages experienced late payments or default,
leading to losses at mortgage REITs.
SUMMARY
 Mutual funds accommodate financing needs of

corporations, the Treasury, and municipal governments
by purchasing newly issued stocks and bonds in the
primary market. They also frequently purchase securities
in the secondary market. They enable individual
investors to diversify their investments with a limited
amount of funds. The more common types of mutual
funds include capital appreciation funds, growth and
income funds, income funds, tax-free funds, high yield
funds, international funds, global funds, asset allocation
funds, and specialty funds.
SUMMARY (Cont.)
 The performance of stock mutual funds is highly

influenced by the stock market conditions, the prevailing
conditions of the sectors in which the mutual fund
invests, and the management abilities of their portfolio
managers. The performance of bond mutual funds is
relatively strong in periods when interest rates decline
and when the credit risk premium on bonds declines.
 Money market funds (MMFs) invest in short-term
securities, such as commercial paper, repurchase
agreements, CDs, and Treasury bills. The expected
returns on MMFs are relatively low, but the risk levels are
also low.
SUMMARY (Cont.)
 Closed-end funds are similar to mutual funds, except that they

are closed to new investors and to redemptions and their shares
are traded on a stock exchange. Exchange-traded funds (ETFs)
are designed to mimic particular stock indexes and are traded on
a stock exchange. Venture capital (VC) funds use money that
they receive from wealthy individuals and some institutional
investors to invest in young, growing firms that need equity
funding but are not ready or willing to go public. Private equity
funds pool money provided by individual and institutional
investors and buy majority (or entire) stakes in businesses.
Hedge funds sell shares to wealthy individuals and financial
institutions and use the proceeds to invest in securities. They are
subject to minimal regulation and commonly pursue investments
that can achieve high returns but are also exposed to a high
degree of risk. Real estate investment trusts (REITs) are closed-
end funds that invest in real estate or mortgages.

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Financial Markets and Institutions

Abridged 10th Edition

■ provide a background on mutual funds

■ Mutual funds serve as a key financial intermediary.

Note: The numbers shown here include money market funds.

Pricing Shares of the Mutual Fund

Mutual Fund Distributions to Shareholders

Regulation of Mutual Funds

Management of Mutual Funds

Expenses Incurred by Mutual Fund Shareholders

Expenses Incurred by Mutual Fund Shareholders (Cont.)

Governance of Mutual Funds

■ Mutual funds are classified as

Source: Investment Company Institute.

Stock Mutual Fund Categories

■ Capital Appreciation Funds

Stock Mutual Fund Categories

Stock Mutual Fund Categories

Bond Mutual Fund Categories

Bond Mutual Fund Categories

Asset Allocation Funds

Source: Investment Company Institute.

Source: Investment Company Institute.

Valuation of Stock Mutual Funds

Valuation of Bond Mutual Funds

Performance from Diversifying among Funds

Research on Mutual Fund Performance

■ Money market mutual funds, called money market funds

Source: Investment Company Institute.

Asset Composition of Money Market Funds

Risk of Money Market Funds

Source: Investment Company Institute.

Management of Money Market Funds

■ Shifting Investments among Money Market Funds

Venture Capital Funds

Private Equity Funds

Real Estate Investment Trusts

 Mutual funds accommodate financing needs of

 The performance of stock mutual funds is highly

 Closed-end funds are similar to mutual funds, except that they

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