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MGT604 - Management of Financial Institutions - Lecture Handout 23

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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 upfront 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
  • 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 is 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
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 mutual funds)
  • Asset Management Companies Rules, 1995. (govern open-ended mutual funds)

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;
  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.

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