🏦Financial Institutions and Markets Unit 13 – Mutual Funds and Portfolio Management

What Are Mutual Funds?

• Mutual funds pool money from many investors to purchase a diversified portfolio of securities (stocks, bonds, money market instruments)
• Provide individual investors access to professional money management and a wide range of investments
• Each investor owns shares representing a portion of the holdings in the fund's portfolio
• Net Asset Value (NAV) represents the price per share and is calculated as: $NAV = \frac{Total\ value\ of\ securities - Liabilities}{Number\ of\ shares\ outstanding}$
• Open-end funds continuously offer new shares to investors and buy back shares at the current NAV
• Closed-end funds issue a fixed number of shares that trade on stock exchanges at market-determined prices
• Mutual funds charge fees, such as sales loads and annual operating expenses, which can impact investor returns

Types of Mutual Funds

• Equity funds primarily invest in stocks and aim for capital appreciation
  • Growth funds focus on companies with high growth potential (technology sector)
  • Value funds invest in undervalued stocks believed to be trading below their intrinsic value
  • Sector funds specialize in specific industries or sectors (healthcare, energy)
• Fixed-income funds invest in bonds and other debt securities to generate income
  • Government bond funds invest in U.S. Treasury securities and government agency bonds
  • Corporate bond funds invest in bonds issued by corporations with varying credit qualities
  • Municipal bond funds invest in bonds issued by state and local governments, offering tax-exempt income
• Money market funds invest in short-term, high-quality debt instruments (Treasury bills, commercial paper) and aim to maintain a stable $1 NAV
• Balanced funds invest in a mix of stocks and bonds to provide both growth and income
• Index funds aim to track the performance of a specific market index (S&P 500) by holding the same securities in the same proportions

How Mutual Funds Work

• Investors buy shares in a mutual fund, and their money is pooled together
• Fund managers use the pooled money to construct a diversified portfolio based on the fund's investment objectives
• Mutual funds are required to price their shares each business day, typically after the market closes
• Investors can buy or sell shares at the fund's NAV, which is calculated daily
• Mutual funds distribute income (dividends, interest) and capital gains to shareholders
  • Distributions can be reinvested to purchase additional shares or paid out in cash
• Shareholders receive periodic statements showing their account balances, transactions, and fund performance
• Mutual funds are subject to regulatory oversight by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940

Portfolio Management Basics

• Portfolio management involves constructing and managing a collection of investments to meet specific goals
• Asset allocation refers to the process of dividing a portfolio among different asset classes (stocks, bonds, cash) based on an investor's risk tolerance and objectives
• Diversification helps manage risk by investing in a variety of securities and asset classes
  • Diversification aims to reduce the impact of any single investment on the overall portfolio
• Rebalancing involves periodically adjusting the portfolio to maintain the desired asset allocation
• Portfolio managers consider factors such as economic conditions, market trends, and individual security analysis when making investment decisions
• Risk management techniques, such as hedging and derivatives, can be used to mitigate portfolio risk
• Tax efficiency is an important consideration, as taxes can significantly impact investment returns

Investment Strategies

• Active management involves fund managers actively selecting securities in an attempt to outperform a benchmark index
  • Managers rely on research, analysis, and their judgment to make investment decisions
• Passive management, or indexing, aims to replicate the performance of a specific market index by holding the same securities in the same proportions
• Growth investing focuses on companies with high growth potential, often characterized by high price-to-earnings ratios and low dividend yields
• Value investing seeks to identify undervalued stocks trading below their intrinsic value
• Momentum investing involves buying securities that have recently performed well and selling those that have performed poorly
• Contrarian investing involves going against prevailing market sentiment by buying securities that are out of favor or selling those that are popular
• Income investing focuses on generating regular income through dividends and interest payments

Risk and Return Analysis

• Risk refers to the uncertainty of an investment's future returns
• Standard deviation measures the dispersion of returns around the average return and is a common measure of risk
• Beta measures the sensitivity of a security's returns to market movements
  • A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 indicates lower volatility
• Systematic risk, or market risk, affects the entire market and cannot be diversified away
• Unsystematic risk, or firm-specific risk, can be reduced through diversification
• The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return
  • $E(R_i) = R_f + \beta_i[E(R_m) - R_f]$, where $E(R_i)$ is the expected return of security $i$, $R_f$ is the risk-free rate, $\beta_i$ is the beta of security $i$, and $E(R_m)$ is the expected return of the market
• Sharpe ratio measures risk-adjusted return by comparing the excess return of a portfolio to its standard deviation

Performance Evaluation

• Performance evaluation assesses how well a mutual fund has achieved its investment objectives
• Total return measures the overall return of a fund, including capital appreciation and income
• Benchmark comparison involves comparing a fund's performance to a relevant market index or peer group
• Risk-adjusted return measures, such as Sharpe ratio and Treynor ratio, evaluate performance while considering the level of risk taken
• Attribution analysis determines the sources of a fund's returns, such as asset allocation, security selection, and timing
• Tracking error measures how closely a fund's returns match its benchmark index
• Expense ratios and turnover rates can impact a fund's performance and should be considered in the evaluation process
• Morningstar ratings provide a quantitative assessment of a fund's risk-adjusted performance relative to its peers

Regulatory Environment

• Mutual funds are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940
  • The Act requires funds to register with the SEC, disclose information to investors, and adhere to certain operational standards
• The Investment Advisers Act of 1940 regulates the activities of investment advisers, including those who manage mutual funds
• Mutual funds must provide investors with a prospectus, which discloses the fund's investment objectives, risks, fees, and other important information
• Funds are required to maintain detailed records and undergo regular audits
• The SEC conducts periodic inspections and can take enforcement actions against funds that violate regulations
• Mutual funds must adhere to strict rules regarding pricing, valuation, and redemption of shares
• Regulations aim to protect investors, ensure transparency, and maintain the integrity of the mutual fund industry