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Copyright © 2000 by Harcourt, Inc. All rights reserved.

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Chapter 12Mutual Fund and Pension Fund Management


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Statistics

By the end of 1997, 37.4% of U.S. households owned shares in mutual funds, up from 5.7% in 1980 and 25% in 1990.

The share of financial assets controlled by mutual funds increased from 3.68% in 1980 to 21.74% in 1997, making mutual funds the second largest financial institution in the U.S.


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Board of DirectorsOversees the fund’s activities, including approval of the contract with the management company and certain other service providers.

Investment Advisory/ Management

CompanyManages the fund’s portfolio according to the objectives and policies described by the fund’s prospectus.

DistributorSells fund shares, either directly to the public or through other firms.

Independent Public Accountant

Certify the fund’s financial statements.

Transfer AgentProcesses order to buy and redeem fund shares.

CustodianHolds the fund’s

assets, maintaining them separately to

protect shareholders

Mutual Fund

Shareholders

Structure of Mutual Fund Management


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Companies that manage the funds are often owned by other companies or privately owned.

Almost all mutual funds are externally managed, with operations conducted by investment companies and other affiliated organizations and independent contractors.

By law, at least 40% of the board of directors must be independent of the fund’s investment advisors.


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Recent Diversification and Consolidation Trends of Mutual Funds

Investment companies have diversified their products to include a wide range of financial services, including:

• discount brokerage;

• automated bill paying;

• insurance and annuities;

• debit cards; and

• internet-based investing and home-banking services.


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Consolidation has occurred for several reasons including:

• product line expansion;

• expansion of customer segments; and

• elimination of unprofitable mutual funds.

Investment companies have expanded into new markets in Asia and Europe where investors do not commonly invest in mutual funds.


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Types of Investment Companies

Open-end investment companies Closed-end investment companies Unit investment trusts


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Open-end Mutual funds

Continuously sell shares to the public. Are obligated to buy or sell their shares at a

fund’s net asset value (NAV) or share price. NAV is equal to:

Market Value in Dollars of Fund Securities - Its LiabilitiesNumber of Investor Shares Outstanding


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Funds usually value exchange-traded securities using the most recent closing price from the exchange in which the securities are primarily traded.

Open-end funds have liquidity needs because cash receipts from security sales are often delayed while redemption requests are typically honored at the end of the day’s NAV with checks cut the next day.


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Closed-end Mutual Funds

Funds issue a fixed number of shares and do not redeem shares.

Once issued, shares are traded on exchanges or over the counter, with supply and demand determining the share price which can be below or above NAV.

Often, closed-end fund shares trade at a discount, i.e, below NAV.


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Unit Investment Companies

They often issue unit investment trust (UITs) that offer interests in a fixed portfolio of securities that are held passively for an agreed period of time. Assets are then distributed among shareholders.

Real estate investment trusts (REITs) similarly offer shares in real estate investments.

Unit trusts may redeem shares at NAV, but may only redeem shares in large blocks.


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Percentage Allocation of Mutual Fund AssetsType 1975 1991 Beg 1998

Equity Fund 81.7% 27.3% 53%

Bond-Income Fund 10.2% 32.6% 23%

Money Market Fund 8.1% 40.1% 24%

Between 1975 and 1998, total investments in mutual funds grew from $45 billion to $4.9 trillion.

Mutual funds, within each class, have a wide variety of investment objectives.

At the end of 1997, mutual funds owned 19% of U.S corporate securities, 8% of U.S Treasury and agency securities, 10% of corporate and foreign bonds, and 32% of municipal securities.


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Cost of Mutual Fund Ownership

No-load funds

• No sale charges or Rule 12b-1 fees.

• Rule 12b-1 fees are annual charges to cover the cost of sales commissions and other marketing expenses and cannot exceed 1% of the fund’s average net assets per year.

Low-load funds

• Include Rule 12b-1 fees but no sale charges.


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Load funds • Front-load - upfront sales charge not to exceed

8.5% of the investment.• Back-end load - charged at time of redemption.

Other costs include fees and commissions paid to agents responsible for mutual fund services such as management fees paid to advisors.• Management fees are typically .5% to 1% of

fund assets annually.• Fees vary widely according to type of securities

held and fund turnover.


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Regulation of Mutual Funds

Investment Act of 1940• Requires all mutual funds to register with the SEC

and to meet certain operating standards.• Limits the ability of a mutual fund to take on

financial leverage.– Can’t issue senior securities– Can only borrow from banks and limits fund loans to

33.3% of funds assets.– With the SEC’s recent interpretation of the act, mutual

funds have access to other sources of short-term borrowing provided that stockholders and directors approve of such sources.


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The National Securities Market Improvement Act of 1996:• eliminates state regulation of mutual funds;• allows mutual funds to buy shares in other mutual

funds; and• allows shares of unregistered private pools, such

as hedge funds and venture capital funds, to be offered in an unlimited amount to “qualified shareholders.”

Subchapter M of the Internal Revenue Code • Investment companies pay no tax on investment

dividends, capital gains, or income if 90% of these payments are distributed to shareholders.


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Regulatory Concerns

Complexity of mutual fund prospectuses Oversight of mutual fund boards on fund

management Exaggerated fund performance claims in

advertisements Concerns over fund mergers


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Risk-adjusted Performance Measures

Standard Deviation of Returns (STD) Value at Risk (VAR) Sharp Ratio Modigliani or M-Square Measure Morningstar Ratings


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Standard Deviation of Returns

STD = [1/N × Sum (Ri - mean R)

Use monthly returns.Fund managers are interested in excess returns

over the risk-free rate or some appropriate benchmark index based on the fund’s objective.

The excess return is referred to as a fund’s tracking error.


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Sharpe Ratio

Average Monthly Excess Return Standard Deviation of Monthly Excess Returns

To annualize ratio, multiply the monthly ratio by the square root of 12.The higher the ratio, the higher the fund’s return for any level of risk.Ratio can serve as a basis for comparing funds with different risk levels.


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Modigliani or M-Square Measure

Fund’s Average Excess Return × STD of Index Excess ReturnSTD of the Funds’ Excess Return

Provides a measure equivalent to the return the fund would earn if its risk was the same as the market index.

The higher the ratio, the higher the fund’s return for any level of risk.


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Morningstar Ratings

Morningstar Return = Load-Adjusted Fund Excess Return Ave. Excess Return for Asset Class

Load-adjusted excess return subtracts the sales loads and the 90 day T-bill rate from the monthly fund returns.


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Morningstar Risk = Fund’s Average UnderperformanceAve. Underperformance of Its Asset Class

Underperformance is measured by counting the number of months that a fund’s excess return was negative, summing all negative returns, and dividing this sum by the total number of months over the measurement period.

To rate funds, Morningstar subtracts the risk score from the return score and ranks funds by this raw score within their asset class.


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Pension Plan

Private pension plans

• Types of plans:– defined benefits (DB); and

– defined contribution (DC).

• Meet obligations through the accumulation of assets.

Federal pension plans

• Social Security is the largest federal plan.

• Social Security is a “pay-as-you-go” system.


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State and local government plans

• Accumulate assets to pay for retirement benefits.

• Are not regulated by the same federal laws that govern private pension plans.

• Management differs from state to state depending on regulation and objectives.


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DB Plans

Promise a specified benefit or income stream at retirement.

The employer bears all the investment risk.• Employer makes contributions based on the age of

the plan participant, the level of benefits promised, and the plan’s expected investment return.

ERISA of 1974 mandates that plans be fully funded.


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A plan is fully funded if the present value of its assets equals the present value of the future pension obligations minus the present value of future contributions.

Fund liabilities are estimated using actuarial methods.

ERISA established the Pension Benefit Guaranty Corporation (PBGC) to assure, within limits, the payment of up to 85% of the vested benefits if a defined benefits pension fund fails.


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DC Plans

Per-employee contributions are specified but the amount of retirement income is not specified. Retirement income depends on:

• the plan’s investment returns; and

• the age and life expectancy of the plan’s owner at retirement.

401(k) plans are employer-sponsored DC plans.


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ERISA allowed IRAs for individuals with no access to private pension plans at work.• Currently, people covered by private pension plans

may also have IRAs. Roth IRAs allow anyone to make a contribution

regardless of whether they actively participate in a retirement plan.• Contributions are limited to $2,000 and are not tax-

deductible. Keogh or H.R. 10 plans allow self-employed

individuals and proprietors with small businesses to set up individual DC plans for themselves and their employees.


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Management Issues in DB Plans

What is the pension contract between all plan stakeholders?

How good is pension fund performance adjusted for risk and management costs?

What is the optimal allocation for pension assets?

Who owns pension surplus assets?


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Should an active or passive asset allocation management policy be pursued? Decision depends on:• performance return of the passive policy;• management cost entailed in following an active

policy; and• the additional risk entailed in following an active

strategy.• Other active management considerations include:

– fund managers investment style;– management fees;– the use of managed futures; and – the timing and frequency of asset rebalancing.


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Should pension fund smoothing be used?

• Smoothing is used to achieve a return equal to the assumed discount rate used to project pension benefit obligations.

• The trade-off is a reduction in a plan’s risk at the expense of higher potential returns.

• Techniques employed include:– guaranteed investment contracts (GIC);

– dedicated bond portfolios; and

– portfolio insurance or insured asset allocation.


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Cash Balance Plans (CBP)

They are like DB plans in that:

• the defined benefit is an agreement to a minimum rate of interest on employees’ accounts;

• they are insured by PBGC and are subject to ERISA regulations; and

• benefits are generally paid out in lump sums.


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CBPs are similar to DC plans in that:

• the employer contributes a minimum percentage of pay to the employees’ retirement accounts;

• employees receive regular account statements of benefits; and

• employees can take the accrued benefits with them if they leave the employer.

The advantages of CBPs to an employer are:

• lower administration costs;

• lower legal exposure; and

• lower cost of educating employees.


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The disadvantage for the employer is that it continues to bear the investment risk.

Employees carry the risk of inflation and the risk of outliving the accrued benefits of their plans like in the DC plan.


12-36 Information for Risk/Return Measures for XYZ Fund

Month Return (%) Rate (%) Return (%) Return(%) Return (%) Benchmark (%)XYX Risk-Free Benchmark XYZ Excess

Benchmark Excess

XYZ Excess Return Over

1 -1.66 .46 .16 -2.12 -.30 -1.82 2 3.37 .41 3.43 2.96 3.20 -.06 3 3.26 .43 1.87 2.83 1.44 1.39 4 4.61 .41 5.59 4.20 5.18 -.98 5 4.40 .43 3.93 3.97 3.51 .47 6 -1.45 .42 -3.79 -1.87 -4.21 2.34 7 -6.23 .44 -8.45 -6.67 -8.89 2.22 8 4.82 .44 5.94 4.38 5.50 -1.12 9 3.86 .43 3.76 3.43 3.33 .1010 1.56 .44 -1.45 1.12 -1.89 3.0111 4.36 .42 4.36 3.94 3.94 .0012 3.51 .44 2.41 3.07 1.97 1.10

Arithmetic MeanMonthly 2.03 1.48 1.60 1.05 .55Annualized 24.41 17.77 19.25 12.60 6.64Standard DeviationMonthly 3.27 4.06 3.28 4.06 1.43Annualized 11.34 14.06 11.36 14.08 4.97


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Value at Risk (VAR) for XYZ Fund

Mean Monthly Return = 2.03

STD of Monthly Return =3.27%

At the 95% confidence interval based on a normal distribution, the VAR is

2.03% - (1.96)(3.27) = - 4.38%

There is 2.5% probability of losing no more than $43.80 a month for a $1,000 investment


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Sharpe Ratio for XYZ Fund

Monthly Mean Excess Return = 1.60%

Monthly Standard Deviation of Excess Return = 3.28%

= 1.60% 3.28%

Sharpe Ratio = .49 monthly

Sharpe Ratio Annually = .49 × the square root of 12 = 1.69


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M-Squared Measure For XYZ Fund

Annualized Mean Excess Return for the Fund = 19.25%

Annualized Standard Deviation of Excess Return for the Fund = 11.36%

Standard Deviation of Excess Returns for the S&P 500 index = 15%

M-squared = 19.25%11.36%

× 15% = 25.42%

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Documents

mutual funds funds

funds assets

openend mutual funds

openend funds

funds investment advisors

funds activities

funds prospectus

mutual fund services