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Mutual Fund Characteristics

A Mutual Funds is defined as an investment company (corporation or business trust) under the terms of the Investment Company Act of 1940. The investment company purchases a portfolio of securities (equities, debt securities, money market or other types of securities or tangible assets) based on the guidelines and investment strategy of the fund. Mututal funds were designed to allow an investor of modest means to be able to obtain the same level of professional advice and access and diversification of investments that a wealthy investor would be able to obatain. A purchaser becomes a shareholder in the fund and is entitled to a pro rata share of the assets held by the fund. The purchaser / shareholder is also entitled to a pro rata share of the income, dividend and/or capital gaines earned by the assets of the fund. These pooled investments of many investors can eventually create a very sizable fund. The funds are listed in the financial sections of newspapers (along with the NAV share price of the fund and recent market performance statistics) and also on-line, and shares are sold to the public (less a sales charge) and redeemed on request (plus a redemption charge) to any investor with a bona fide cash investment. Mutual funds are also allowable investments under U.S. 401K and I.R.A. investment guidelines.

Mutual funds are regulated financial institutions:

Investment Company Act of 1940 defines the funds structure and also indicates that the funds are subject to regulation by the SEC (Division of Investment Management and the Office of Compliance Inspections and Examinations).

Securities Act of 1933 indicates that mutual funds must register their shares prior to offering them to the public and they must also provide notice filings to those states in which they intend to offer their shares

Securities Exchange Act of 1934 regulates broker-dealers who sell mutual fund shares to the public

Investment Advisers Act of 1940 requires that investment advisers to mutual funds must be registered

Internal Revenue Code of 1986 grants pass-through tax treatment to mutual funds by not taxing them at the corporate level as long as the fund adheres to certain operational requirements

Funds must comply with state notice filing requirements and anti-fraud statutes of any state where the mutual fund shares will be offered

If a mutual fund is managed by or sold through a bank or other depository institution then its operations may also may be affected by the federal and atate banking statutes that govern those institutions

mutual funds are also required to hire an independent bank or trust company to hold and account for all the cash and securities investments of the fund

Structural characteristics of mutual funds:

Open-end: as more investors invest, more shares in the fund are created to acommodate them.

Closed end: set number of issued shares available at any given time.

Taxable vs. tax exempt: invests in government, state and local debt obligations to obtain non-taxed return for investor; or invests in private entities where interest, dividend and capital gains are taxed.

Load/No-load; pure/true/100% no-load (12-b-1 fees): is there a sales commission to invest in the fund up-front or to exit the fund? Does the fund also pass on administrative fees prior to making disbursements to investors? 12(b)(1) fees are usually fund promotion costs that are passed on to investors.

Management fees: are charged to fund investors for research, salaries, investment costs, etc.

Taxation: unless the investment in the mutual fund is in a non-taxable fund, or is held in an IRA / 401K account, then the mututal fund investments may distribute taxable dividend income and taxable capital gains annually, both which must be reported by the individual investor.

Shares in a mutual fund must always be sold back (redeemed) to the fund itself. One may not sell shares to another individual or institution on one's on, it is not a bona fide transaction.

The structure and administration of mutual funds were originally defined by the Investment Company Act (1940), which established a board of Directors / Trustees for each fund. These independent directors / trustees act on the behalf of investors and are required to maintain oversight of the pricing of the shares of the fund and to have oversight for the establishment of the fees (compensation) that fund managers receive.

Mututal funds have no or few employees. For instance, the

Investment Adviser / Management Company is not an employee of the corporation. Rather, they are contracted to select and manage the assets of the fund based on the pre-determined guidelines and criteria of the fund's objective and strategy.

Distributor is contracted to sell the shares in the fund, either directly to the public or through third-party arrangements with broker-dealers, insurance companies, banks, etc.

Custodian maintains the assets of the fund in secure, separate custodial / trust account(s) to protect the shareholder's interests.

Independent Account is contracted to prepare the quarterly / annual financial statements and reports of the fund.

Transfer Agent is contracted to handle the buying / selling of shares and their related payments.

Mutual Funds may also have different classes of shares: Class A, B and C. The shares are identical with the exception of the fee and commission structure of each respective class. For instance, Class A shares may have a higher up-front cost to purchase but have lower annual expenses (thus are suitable for long-term investors) and no back-end (sales) cost. In addition, Class A shares may also have what are known as "breakpoints": the greater the amount that one initially invests the lower the sales commission charge. Both Class B and C shares have no up-front purchase fees but higher annual expense than Class A shares. All investors holding the same class of share are treating equally: the all receive the same investment rate of return and all receive distribution of dividend income, interest income and/or capital gains in proportion to the amount of shares that they hold in the fund.

There are 5 broad categories of mutual funds:

Stock (Equity, the most numerous type of mututal fund, invests in equities in the U.S. and of other nations)

Bond (the second most numerous type of mutual fund available)

Hybrid

Money Market (short-term securities issued by the U.S. government, states and municipalities, GSE agencies, financial institutions and non-financial corporations)

Specialty

The name of the fund usually siginifies the investment strategy / objective of the fund. However, the by-laws of many mutual funds also allow the fund to hold a fixed percentage (of the the total fund investments) of other types of investments, for instance money market investments for cash purposes and some equity funds also hold debt investments.

Stock (Equity) Funds

Large Growth Domestic

Mid Cap Growth Domestic

Small Growth Domestic

Large Blend Domestic

Mid Cap Blend Domestic

Small Blend Domestic

Large Value Domestic

Mid Cap Value Domestic

Small Value Domestic

Moderate Allocation Domestic

Conservative Allocation Domestic

Specific Industry Domestic (Communications, Financial, Health, Natural Resources, Technology, Utilities, etc.)

Large Growth International

Large Value International

European

Pacific / Asia

Japan

Latin America

Emerging Markets

 

Bond Funds

Corporate (General)

Corporate (Intermediate)

Corporate (Short-term)

Global (General)

Global (Short-term)

Government (U.S. Treasury issues)

Government (Short-term)

High-yield

Mortgage-backed

National municipal

National municipal (Short-term)

Emrging markets

Municipal (State)

Strategic

 

Hybrid

Assel allocation

Blanced (Equity and fixed-income investments)

Flexible

Income

 

Money Market (invest in securities that mature in one year or less)

National tax-exempt

State tax-exempt

Taxable government

Taxable non-government

 

Specialty

Index

Real Estate (invest in the shares of REITs)

Precious Metals

Floating Rate (Bank loans)

Sector / Single industry (Biotech, Communications, Financial, Health, Natural Resources, Technology, Transportation, Utilities, etc.)

Country

Social responsibility / Fair trade

Mutual funds normally report the performance of the fund (which also normally includes the reinvestment of earned dividends) in several forms: 1-week percentage return, 3-month percentage return, one-year percentage return, five-year percentage return and year-to-date percentage return.

The performance is affected by the level of fees charged by the fund. For instance, the annual trading expense incurred by the fund as part of its daily course of business of purchasing and selling investments or for the purpose of redeeming fund shares can reduce the annual return.

Fund performance is also always affected by investor behavior. When equity markets have already started to improve many investors begin moving money into equity mutual funds. However, the price of equities have already started moving higher and the fund manager has to put cash inflows to work purchasing these higher priced shares. The more educated and prudent investment would have been to purchase the particular investment when the share price was low, however investors were sitting out the market and only moved money to the mututal fund when they responded to the impetus of equity prices rising. The same is true when the market declines. As investors see the decline in the market they redeem their shares in the mututal fund causing the fund manager to sell at the declining prices, and the large volume of redemptions further depresses equity prices.

Mutual Fund Credit Issues

Some banks provide and participate in Redemption Facilities for mutual funds, which is a committed USD denominated, 364-Day Senior, Unsecured Revolving Credit Facility. These syndicated facilities are used by the mutual fund company for short-term liquidity purposes to make cash payments to investors who redeem shares in various funds managed by the respective mutual fund company.

The Redemption Facilities specifically indicate that the facility cannot be utilized for the purpose of leverage and insure against any long-term utilization by having a 30-day maturity for any outstanding drawn amount.

The credit issue is whether escalating fund share redemptions during a market disruption would result in the market value of the securities (debt and equities) held by the fund declining rapidly enough such that there would be insufficient assets or cash to cover the amount drawn under the Redemption Facility.

However, federal regulations maintain strict standards on the use of leverage by mutual fund.

As per Section 18 of the Investment Company Act of 1940,

 

a. Qualification on issuance of senior securities. It shall be unlawful for any registered closed-end company to issue any class of senior security, or to sell any such security of which it is the issuer, unless

 

1. if such class of senior security represents an indebtedness

 

A. immediately after such issuance or sale, it will have an asset coverage of at least 300 per centum (3X coverage);

 

2. if such class of senior security is a stock

 

A. immediately after such issuance or sale it will have an asset coverage of at least 200 per centum (2X coverage);

Mutual funds that invest in the securities of foreign nations are subject to currency risk and political risk. If the value of the local currency declines in relation to the value of the currency of the fund's domicile, and the fund is not properly hedged then a loss will be incurred if shares are redeemed, assets are sold and the funds repatriated.

Mutual Fund Legal Issues

Recent indictments and negotiated settlements brought by the New York State Attorney General's Office against several mutual funds (and hedge funds, brokerage firms and banks) illustrate some of the credit analyst concerns with the industry. Some of the exposed practices included:

Market Timing: rapid purchase into the fund prior to the revaluation of the fund based on the underlying equities that it holds and then selling the fund shares the next day after the revaluation, which in itself is not illegal; however, many of the funds actually had prohibitions against it but allowed large investors to engage in rapid in-out trades. This practice is quite lucrative as many funds did not employ fair-value pricing of stocks of overseas companies whose overseas market price data was many hours old. In addition, it increased transaction costs which were spread across all investors in the fund, which meant that some investors were subsidizing the market timers but not benefitting from the trading. The performance of the funds themselves suffered as a higher proportion of investments had to held as cash in low yielding money market accounts in order to have sufficient liquidity to redeem the shares of the market timers.

Late-trading: which is an illegal activity of mutual funds accepting fund share orders (buy or sell) after the EST 4:00pm closing and the fund share price has been set.

Revenue sharing: mutual funds make advanced payments to brokers so that the broker will promote the fund to a potential investor.

Failure to apply for fair value pricing in a timely manner.

Selective Disclosure

Soft Dollars or the practice of funds providing brokerages with cash in return for everything from research to office supplies.

On June 23, 2004, the SEC commissioners voted (3 - 2) to approve proposed reforms to the mutual fund industry. The SEC is proposing that by the end of 2005 that 3/4 of mutual fund directors must be independent of the mutual fund company (it is presently 1/2).

Unit Investment Trust (UIT)

A unit investment trust is also defined as an investment company (corporation or business trust) under the terms of the Investment Company Act of 1940 and is a portfolio of securities (equities and taxable and non-taxable bonds) held by a small, registered investment company and investments in the trust are sold in fractional, undivided interests to unit holders (individual investors). UITs have a fixed termination date on which the net assets of the trust are distributed proportionately to the unit holders. UIT shares may only be redeemed by the UIT who may also reoffer them to the public.

Closed-end Funds

A closed-end fund is also defined as an investment company (corporation or business trust) under the terms of the Investment Company Act of 1940 and also is a pooled investment fund, however it is not open-ended (new shares in the fund are created as new investors wish to invest in the fund). Rather, it has a fixed amount of shares at the intitial public offering of the fund and during the life-time of the fund. If there is high investor demand for investment in the fund then at some point the value of the share will exceed the net asset value of the fund's investments divided by the number of shares.

Determining the Net Asset Value (NAV) of an equity fund

NAV (Net Asset Value) is the market value of a fund share, synonymous with a bid price. In the case of no-load funds, the NAV, market price, and offering price are all the same figure, which the public pays to buy shares; load fund market or offer prices are quoted after adding the sales charge to the net asset value. NAV is calculated by most funds after the close of the exchanges each day (4:00 pm) by taking the closing market value of all the underlying securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares outstanding. The number of shares outstanding can vary each day depending on the number of purchases and redemptions. The NAV also changes in response to the increase and decrease of the value of the underlying securities.

A credit analysis problem for evaluating mutual funds is that the share price of the fund is not continuously priced during the course of a business day. An additional problem for the fund is that the sheer volume of daily trades and number of investments means that the fund may actually require up to an hour after closing to accurately value the share price in the fund. Thus, although the fund is actively trading / investing during the course of a business day, its share price is actually from approximately 5:00 pm the previous business day and does not reflect the present change in pricing of the securities in the fund's portfolio.

Non-U.S. Funds

In the United Kingdom, mututal funds are known as investment trusts. A type of investment trust known as a Split Capital Investment Trust, which are closed-end funds that are traded on the London Stock Exchange, are funds that are structured such that the assets are divided among two classes of shares. During early 2004 several of these funds were suspended and under investigaton for share price manipulation (as the result of fund cross-ownership between various "competing" funds) and for the marketing practices by the managers of these funds.

UCITS (Undertaking for Collective Investment in Transferable Securities) is an investment Fund authorised in an EU Member State under Council Directive 85/611/EEC of December 1985 (the UCITS Directive").