Mutual Funds:Criticism of managed mutual funds, Money Market Fund

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Management of Financial Institutions - MGT 604

Lecture # 23

Mutual Funds

Criticism of managed mutual funds

Historically, only a small percentage of actively managed mutual funds, over long periods

of time, have returned as much, or more than comparable index mutual funds. This, of

course, is a criticism of one type of mutual fund over another.

Another criticism concerns sales commissions on load funds, an upfront or deferred fee as

high as 8.5 percent of the amount invested in a fund (although the average up-front load is

no more than 5% normally). *(Mutual Funds have to qualify to charge the maximum

allowed by law, which is 8.5% and most of them DO NOT qualify for this.) In addition, no-

load funds typically charge a 12b-1 fee in order to pay for shelf space on the exchange the

investor uses for purchase of the fund, but they do not pay a load directly to a mutual fund

broker, who sells it. Critics point out those high sales commissions can sometimes represent

a conflict of interest, as high commissions benefit the sales people but hurt the investors.

Although in reality, "A shares", which appear to have the highest up front load, (around 5%)

are the "cheapest" for the investor, if the investor is planning on 1) keeping the fund for

more than 5 years, 2) investing more than 100,000 in one fund family, which likely will

qualify them for "break points", which is a form of discount, or 3) staying with that "fund

family" for more than 5 years, but switching "funds" within the same fund company. In this

case, the up front load is best for the client, and at times "outperforms" the "no load" or "B

or C shares". High commissions can sometimes cause sales people to recommend funds that

maximize their income. This can be easily solved, buy working with a "registered

investment advisor" instead of a "broker", where the investment advisor can charge strictly

for advise, and not charge a "load, or commission" for their work, at all.

This is a discussion of criticism, and solutions regarding one mutual fund over another.12b-

1 fees, which are found on most "no load funds", can motivate the fund company to focus

on advertising to attract more and more new investors, as new investors would also cause

the fund assets to increase, thus increasing the amount of money that the mutual fund

managers make.

Mutual fund managers and companies need to disclose by law, if they have a conflict of

interest due to the way they are paid. In particular fund managers may be encouraged to take

more risks with investor's money than they ought to: Fund flows (and therefore

compensation) towards successful, market beating funds are much larger than outflows

from funds that lose to the market. Fund managers may therefore have an incentive to

purchase high risk investments in the hopes of increasing their odds of beating the market

and receiving the high inflows, with relatively less fear of the consequences of losing to the

market.

Many analysts, however, believe that the larger the pool of money one works with, the

harder it is to manage actively, and the harder it is to squeeze good performance out of it.

This is true, due to the fact that there are only so many companies that one can identify to

put the money into ( buy shares of) that fit with the "style" of the mutual fund, due to what

is disclosed in the prospectus. Thus some fund companies can be focused on attracting new

customers, and forget to "close" their mutual funds to new customers, when they get too

big, to invest the assets properly, thereby hurting its existing investors' performance. A great

deal of a fund's costs are flat and fixed costs, such as the salary for the manager. Thus it can

be more profitable for the fund to try to allow it to grow as large as possible, instead of

limiting its assets. Most fund companies have closed some funds to new investors to

maintain the integrity of the funds for existing investors. If the funds reach more than 1

billion dollars, many times, these funds, have gotten too large, before they are closed, and

Management of Financial Institutions - MGT 604

when this happens, the funds tend to not have a place to put the money and can and tend to

lose value.

Other criticisms of mutual funds are that some funds illegally are guilty of market timing

(although many fund companies tightly control this) and that some fund managers, also

illegal, accept extravagant gifts in exchange for trading stocks through certain investment

banks, which presumably charge the fund more for transactions than would non-gifting

investment bank. This practice, although done, is completely illegal. As a result, all fund

companies strictly limit -- or completely bar -- such gifts.

Scandals of mutual funds

In September 2003, the United States mutual fund industry was beset by a scandal in which

several major fund companies permitted and facilitated "late trading" and "market timing".

Mutual-fund families in the United States

A family of mutual funds is a group of funds that are marketed under one or more brand

names, usually having the same distributor (the company which handles selling and

redeeming shares of the fund in transactions with investors), and investment advisor (which

is usually a corporate cousin of the distributor).

There are several hundred families of registered mutual funds in the United States, some

with a single fund and others offering dozens. Many fund families are units of a larger

financial services company such as an asset manager, bank, brokerages, or insurance

company. Additionally, multiple funds in a family can be part of the same corporate

structure; that is, one underlying corporation or business trust may divide itself into more

than one fund, each of which issues shares separately.

Mutual Funds in Pakistan

Mutual Funds were introduced in Pakistan in 1962, with the public offering of National

Investment (Unit) Trust (NIT) which is an open-end mutual fund in the public sector. This

was followed by the establishment of the Investment Corporation of Pakistan (ICP) in 1966,

which subsequently offered a series of closed-end mutual funds. Up to date, twenty six (26)

closed-end ICP mutual funds have been floated. Initially there was both public and private

sector participation in the management of these funds, but with the nationalization in the

seventies, the government role become more dominant and today these mutual funds are

totally in the public sector. Later, the government also allowed the private sector to establish

mutual funds. Currently there exists one open-ended and eleven closed-ended mutual funds

under private sector management.

Rules Govern Mutual Funds in Pakistan

There are two rules govern mutual funds in Pakistan, which are:

Investment Companies and Investment Advisors' Rules, 1971. (govern closed-end

mutual funds)

Asset Management Companies Rules, 1995. (govern open-ended mutual funds)

These rules however only apply to private sector operated mutual funds and are not

applicable to NIT and ICP mutual funds.

Money Market Fund

We begin with a discussion of money market funds for several reasons:

1. They are the safest for the trainee investor;

2. They are the easiest, least complicated to follow and understand;

3. Almost without exception, every mutual fund investment company offers money market

funds;

Management of Financial Institutions - MGT 604

4. Money market funds represent an indispensable investment tool for the beginning

investor.

5. They are the most basic and conservative of all the mutual funds available;

Money market funds should be considered by investors seeking stability of principal, total

liquidity, and earnings that are as high, or higher, than that Available through bank

certificates of deposit. And unlike bank cash deposits, money market funds have no early

withdrawal penalties.

Specifically, a money market fund is a mutual fund that invests its assets only in the most

liquid of money instruments. The portfolio seeks stability by investing in very short-term,

interest-bearing instruments issued by the state and local governments, banks, and large

corporations. The money invested is a loan to these agencies, and the length of the loan

might range from overnight to one week or, in some cases, as long as 90 days. These debt

certificates are called "money market instruments"; because they can be converted into cash

so readily, they are considered the equivalent of cash.

To understand why money market mutual funds is recommended as an ideal investment, let

me reemphasize just seven of the advantages they offer:

1. Safety of principal, through diversification and stability of the short-term portfolio

investments

2. Total and immediate liquidity, by telephone or letter

3. Better yields than offered by banks, 1% to 3% higher

4. Low minimum investment, some as low as $100

5. Professional management, proven expertise

6. Generally, no purchase or redemption fees, no-load funds

Income Funds

The objective of income mutual funds is to seek a high level of current income

commensurate with each portfolio's risk potential. In other words, the greater the risk, the

greater the potential for generous income yields; but the greater the risk of principal loss as

well.

The risk / reward potential are low to high, depending upon the type of securities that make

up the fund's portfolio. The risk is very low when the fund is invested in government

obligations, blue chip corporations, and short-term agency securities. The risk is high when

a fund seeks higher yields by investing in long-term corporate bonds, offered by new,

undercapitalized, risky companies.

Who should invest in income funds?

Investors seeking current income higher than money market rates, who are willing to

accept moderate price fluctuations

Investors willing to "balance" their equity (stock) portfolios with a fixed income

investment

Investors who want a portfolio of taxable bonds with differing maturity dates

Investors interested in receiving periodic income on a regular basis

Income and Growth Funds

The primary purposes of income and growth funds are to provide a steady source of income

and moderate growth. Such funds are ideal for retirees needing a supplement source of

income without forsaking growth entirely.

Management of Financial Institutions - MGT 604

Growth and Income Funds

The primary objectives of growth and income funds are to seek long-term growth of

principal and reasonable current income. By investing in a portfolio of stocks believed to

offer growth potential plus market or above - market dividend income, the fund expects to

investors seeking growth of capital and moderate income over the long term (at least five

years) would consider growth and income funds. Such funds require that the investor be

willing to accepts some share-price volatility, but less than found in pure growth funds

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