Chapter 3- An Overview of the Mutual Fund Industry

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Chapter 3- An Overview of the Mutual Fund Industry
2013-07-31 00:05:49

SUMMARY Mutual funds offer a number of services to investors for which investors pay a management fee and administrative expenses. The services include professional investment management, cost reduction due to economies of scale, automatic record keeping, special services such as automatic investment plans, and investment flexibility. The sum of the management fees and administrative expenses is referred to as the MER (Management Expense Ratio). Administrative expenses are also referred to as Management Expenses. Investment funds, of which mutual funds are just one type, have a long history dating back to the 19th century. The earlier types of funds are fixed trusts and closed-end investment funds. Fixed trusts are unmanaged portfolios of debt securities that all reach maturity at the same time. Fixed trusts, therefore, have limited lives and they are not a common type of investment today. Closed-end investment funds are corporations that are in the business of investing in securities. The capital of these companies is relatively fixed. Shares of these companies are bought and sold like the stock of any other type of company. Mutual funds differ from closed-end funds in that their capital is unlimited. In addition, investors buy and sell shares of mutual funds only from the mutual fund itself and not from other investors. There is no secondary market for mutual fund units, since they all trade on the primary market. There are a number of basic mutual funds. These include money market funds, fixed-income funds, balanced funds, common equity funds, and different types of specialized funds. Each fund is characterized by the different types of securities making up its investment portfolio and in the risk and return characteristics of those securities. Over the 20-year period from 1991 to 2010, the volatility characteristics of money market, bond, and equity mutual funds have shown the same patterns as the individual securities making up their portfolios; that is, money market funds are less volatile than bond funds, which are less volatile than equity funds. Volatility results from the interplay of many risk factors. These risks include unique risk, market risk, interest rate risk, default risk and exchange rate risk for foreign investments.
Show Answers:

  1. Name and briefly describe the five services offered by mutual funds.
    The five services offered by mutual funds are professional management, cost savings,automatic record keeping, special services, and investment flexibility. Professionalmanagement is the principal service provided, with professional investment managersresponsible for selecting and managing the fund’s portfolio. Cost savings are provided by thelarge-volume purchases of securities made by mutual funds; these economies of scale can bepassed on to investors. Automatic record keeping makes tracking investment performanceeasier. Special services include automatic investment plans. Investment flexibility is providedby the large number of mutual funds available.
  2. Explain why mutual funds charge management fees and administrative expenses. What arethey called if they are combined?
    Mutual funds charge management fees to pay for the services provided by the portfoliomanagers and administrative fees to pay for administrative charges incurred in themanagement of the fund. If you combine the two fees, it is called the management expenseratio. (MER)
  3. What is a no-load fund? Do no-load funds charge management fees?
    A no-load fund is a fund that does not charge any type of sales fee when purchasing orselling units of the fund. Even though the fund is referred to as a no-load fund, it will stillcharge management fees and management expenses.
  4. What types of investment funds are there besides mutual funds? Briefly explain each.
    The other types of investment funds, in addition to mutual funds, are fixed trusts andclosed-end investment funds. Fixed trusts are made up of debt securities having the same maturity date, and they are unmanaged. Closed-end investment funds are companies setup to invest in other companies. Their shares are bought and sold in the secondary (stock)market, and their total capital is relatively fixed. There are also real estate investment trusts(REITs) that invest in various types of real estate. They also trade on the secondary markets.
  5. List and briefly describe the six basic mutual fund categories (or types).
    • The SIX basic mutual fund types are money market funds, fixed-income funds, balanced funds, equity funds, and specialized funds. Money market funds consist of money market securities such as T-bills; they are the lowest risk of any mutual fund. Fixed-income funds include mortgage, bond, and preferred share funds. Balanced funds consist of money market, debt, and equity securities; the weight of each of these types of securities in a balanced fund’s portfolio will depend on the portfolio manager’s assessment of the future performance of the money market, bond, and stock markets. Equity funds consist of common stock. Specialized funds tend to focus on one type of investment and if all investments are in one industry, they are called sector funds. There are many specialty bond funds and many specialty equity funds.
    • (International or Global Fund)
  6. Briefly discuss the volatility characteristics of money market, bond, and equity mutual fundswith respect to each other from 1991 to 2010.
    For the period 1991 to 2010, money market, bond, and equity funds exhibit the same characteristics of the securities making up their portfolios; that is, money market funds are less volatile than bond funds, which are less volatile than equity funds.
  7. What is the difference between unique risk and market risk?
    Unique risk is risk that results from less than complete diversification. Market risk is the risk that remains even if a mutual fund is completely diversified. All equity mutual funds have some market risk as well as a certain degree of unique risk.