Mutual Funds

Mutual Funds:A mutual fund is an investment vehicle that accepts deposits from
investors with the sole purpose of investing in stocks, bonds and other
securities to generate profits for the shareholder of the fund. Thus it
allows the investor to diversify his holdings for greater safety and
participate in above average market returns through the sound
investment principles of an experienced fund manager. Depending on the
funds investment objective, the risk-return profile varies widely but
generally a mutual fund is safer than an equity investment whereas riskier
than an investment in bonds or bank accounts.
Based on the investment objectives, every fund selects an investment
strategy, such as growth or income. Investment in mutual funds has the
advantage that it allows participation from retail customers with low
starting amounts and money can be invested continually through SIPs and
it is easier to reinvest profits.
Open-ended Mutual Funds
Open ended mutual funds sells new shares continuously or buys them
back from the shareholder dealing directly with the investor(no-loads
funds) or through broker-dealers, who receive the load of a sell or buy
order. The purchase price is the net asset value (NAV) at the end of the
trading day, which is the total assets of the fund minus its liabilities
divided by the number of shares outstanding for that day.
NetAssetValue
TotalAsset s TotalLiabi lities

No.ofouts tan dingshares
The number of shares of an open ended fund varies with its existence
depending on how many shares are bought or redeemed by the investors.
A major disadvantage to open-end funds is that they need cash to redeem
their shares for investors who want to cash out which requires either
having a lot of cash on hand earning just the prevailing interest rate or
raise cash by selling securities and incur capital gains tax for the
remaining investors.
Close-ended Mutual Funds
Close ended funds sell shares in an initial public offering and the proceeds
are used to buy securities based on the investment objective of the fund.
The shares in the fund have a net asset value but the investment
company does not redeem the shares. Instead the shares trade on a stock
exchange just like stocks. Thus the share price is driven by the demand
and supply in the market and the shares trade at a premium or discount
to their NAV.
Exchange traded funds

These are like closed-end mutual funds based on a portfolio of securities
representing a category or an index and are traded as stocks on a normal
stock exchange.
ETFs differ from close-ended funds in that they have an arbitrage
mechanism that allows certain institutional investors to exchange the
basket of securities for creation units consisting of 50,000 ETFs or a
multiple thereof.
When the ETF share price is significantly higher than the NAV, then
investors can buy the basket of securities on the open market, exchange
the securities with ETF shares and sell the shares for a profit. When the
NAV is significantly higher, then investors trade their ETF shares for the
basket of securities, then sell the securities on the exchanges for a profit.
Thus arbitrage opportunities are short lived and driven by how efficiently
demand and supply reach a state of equilibrium.
Mutual Fund Fees
Numerous fees are associated with specific functions of a mutual fund
which may vary from .5% to 8.5%. Management fees are paid as
compensation to the fund manager for administering the fund and varies
between 2-5%. Distribution and service fees cover expenses to bring in
new investors and is used to pay bonuses to employees. Redemption fees
are levied on investors when shares of the fund are sold and reinvestment fees are charged when the investor invests his profits in the
fund.
Different fees and expenses and different schedules apply to each class of
shares. Although the portfolio held and investment philosophy is the same
the classes are distinguished by holding time and hence differential fees
and expenses.
Expense Ratio
The expense ratio summarises operating expenses such as management
fees and administrative fees but not the transaction costs in buying selling
TotalOpera tingExpenses
ExpenseRatio
AverageNet AsseValue
of securities. It is expressed as
Any money paid for expenses is money not invested and hence is a
performance metric across mutual funds. Frequently high expense funds
underperform index funds which are minimally managed with low expense
ratios.
Valuation of a Close-ended Fund

Total return and distribution ratesTotal Re turn Share Pr icechange Distributi onRate
Distributi onRate TotalAnnua lDistribut ion / NAV

Thus the distributions for the year added to the share price change gives
the total returns.
Expenses reduce the returns of funds and a metric used to measure such
expenses is the expense ratio. The adjusted expense ratio is the expense
ratio minus the interest expenses.
LeverageThe leverage ratio is the asset value divided by the value used to
purchase the asset, so if an asset cost $100,000 on which the CEF puts
down $20,000, then the leverage ratio is 5 to 1 or 80%, because 80% of
the asset is purchased with borrowed money.
Leverage is achieved by issuing debt or preferred shares. The leverage
TotalAsset s
LeverageRatio
NetAssets
ratio measures the total leverage used by a fund.
Leverage is only beneficial if the income earned from the leveraged assets
exceeds the expenses of the leverage.
The leverage ratio should not exceed 40% as it makes it increasingly
difficult for the fund to raise more debt and may force it to sell assets in a
down market for a loss.
Discounts and PremiumsSince fund shares cannot be exchanged for the underlying securities, the
share price of the fund differs from the net asset value of the fund, which
the actual value of the securities represented by each CEF share.
Premiums and discounts result because the supply and demand for the
shares usually differs from the supply and demand for the underlying
Share Pr ice
Pr emium / Discount
1
NAV
securities.
Measuring relative premiums or discounts with Z-Score
The average premium/discount of a fund or CEF class determines the
relative premium/discount. It is measured as a Z-score as
ZScore
CurrentDis count / Pr emium AverageDis count / Pr emium

Std.Dev.ofAverageD iscount / Pr emium
If we assume mean discount over past year:-10%

Standard deviation:-4%
Current discount:- -6%
Z Statistic-(-6-(-10))/4=1
Example of calculation of fund premium/discount and expense
ratio:-
Let us consider the following closed-end fund as taken from the ClosedEnd Fund association

Mutual Funds

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Mutual Funds

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Mutual Funds:A mutual fund is an investment vehicle that accepts deposits from

TotalAsset s TotalLiabi lities

Exchange traded funds

Valuation of a Close-ended Fund

Distributi onRate TotalAnnua lDistribut ion / NAV

CurrentDis count / Pr emium AverageDis count / Pr emium

If we assume mean discount over past year:-10%

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