How often are fund operating expenses deducted from each mutual fund account? Do mutual funds charge lower fees when investment performance is poor, and higher fees when they perform very well?

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March 25

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How often are fund operating expenses deducted from each mutual fund account? Do mutual funds charge lower fees when investment performance is poor, and higher fees when they perform very well?
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1. How often are fund operating expenses deducted from each mutual fund account?
2. Do mutual funds charge lower fees when investment performance is poor, and higher fees when they perform very well?

For the vast majority of funds, annual fees are a constant percentage of assets under management, so if the annual expense ratio is 1%, your net return is -11% if the fund’s gross return is -10%, and 29% if the gross return is 30%.

1. At a commission-based full-service broker, clients can purchase the ELM Fund in two ways:
 Class A Class C Sales load imposed on purchases 4% 0% Deferred sales charge on redemptions within one year 0% 1% Total annual operating expenses 0.75% 1.5%

For simplicity, assume a flat NAV over time, say \$100/share.  Compute the total cost of each share class over (1) a six-month holding period, (2) a five-year holding period, and (3) a twelve-year holding period, as a percentage of the original principal.

A(1)=4+.75/2 = 4.375%

A(2)=4+(5)(.75) = 7.75%

A(3)=4+(12)(.75)= 13%

C(1)=1+1.5/2 = 1.75%

C(2)=(5)(1.5) = 7.5%

C(3)=(12)(1.5)= 18%

1. Why would fund shareholders receive (1) short-term capital gain, or (2) long-term capital gain distributions?
2. How often must dividend and capital gains distributions be paid?
3. If a fund shareholder reinvests their distributions, does that delay income taxes until the shares are sold?
4. Suppose a mutual fund has purchased Crabapple shares at various times and prices. The fund manager wants to minimize taxes paid by its shareholders.  On April 1, 2020, which Crabapple shares should be sold first and which Crabapple shares last when the fund needs cash?  Assume the current stock price is 120.
 Price Paid Purchase Month 100 January 2019 150 January 2020 70 April 2013 140 May 2016 110 December 2019

The biggest losers should be sold first, and the short-term winners, especially those with big gains, should be sold only as a last resort.

1. From a tax perspective, is it better to buy a mutual fund with substantial unrealized short-term capital gains or a fund with substantial realized short-term capital gains?

An unrealized short-term gain will become a long-term gain if the stock is held for more than 12 months before sale.

1. Fund X and Fund Y are stock mutual funds and each trade at a NAV of \$20/share. On December 22nd, Fund X will distribute a \$1/share short-term capital gains distribution, and Fund Y will distribute a \$1/share long-term capital gains distribution.  Which of the following is the dumbest thing to do for the investor, regarding taxes?

Buy Fund X shares on December 23rd

Buy Fund Y shares on December 23rd

Buy Fund X shares on December 21st

Buy Fund Y shares on December 21st

The smartest thing to do is wait until after the distributions are paid, before buying shares.

1. If all of a MMF investments are zero-coupon and fixed-rate, so none reprice before maturity, what is the longest weighted average maturity of those investments that is permitted?
2. The true NAV of a MMF is \$1. If the MMF has a modified duration of two months, then if market interest rates suddenly increase by 2% (a huge jump), what is the new true NAV of the fund?  You can find the formula on page 125 of your coursepack.
3. From (1) the fund sponsor’s perspective and (2) from the investor’s perspective, what are the good and bad things about pegging the MMF share price at \$1?

The pegged \$1 price saves a lot of money in administrative costs, and investors don’t have to worry about capital gains and losses.  The peg also provides a (false) sense that the investment is risk free (for prime and muni MMFs).

1. If other investors withdraw significant sums at \$1/share when true NAV of a Prime MMF is below \$1, who loses, and is it rational for you to participate in a “run” on the fund?

The remaining shareholders lose, so get out for \$1 while you can!  Runs on prime MMFs are rational.

1. On 2/1/2020, here is the schedule of investments for the ABC money market fund. All are fixed-rate.  Does this fund satisfy the weekly liquidity requirement for MMFs?   What about the daily requirement?
 Value Maturity Date Treasury Bills 30 8/5/2020 Commercial Paper 100 2/4/2020 Jumbo CDs 200 2/25/2020 FHLB Discount Notes 40 3/15/2020 Fannie Mae Notes 10 2/2/2020 Cash (Bank Checking Account) 20

Daily percentage = [20 + 30 +10]/400

Weekly percentage = [20 + 30 +10 + 100 + 40]/400

March 30

1. An active bond mutual fund manager expecting an increase in market interest rates in the near future should _____ the average maturity/duration of their bond portfolio now.
2. If an active bond mutual fund manager expects GDP growth of -1% in the upcoming year, versus the consensus GDP growth forecast of 2%, which investment should they buy, BB corporate bonds or AA corporate bonds?
3. Considering Treasury, Investment-Grade Corporate, High-Yield Corporate, and Municipal bond funds, which types of funds should probably hold the most cash reserves (as a percentage of assets) in the form of checking account deposits, MMFs, or T-bills?
4. What is the fundamental difference between (1) putting 60% of your money in a stock fund and 40% in a bond fund, and then not paying attention for the next 5 years, and (2) putting all your money in a hybrid fund that allocates 60% to stocks and 40% to bonds, and then not paying attention for the next 5 years?
5. If a closed-end fund trades at a 15% premium to NAV, should you buy it or avoid it, and why?
6. If a closed-end fund trades at a 15% discount to NAV, why don’t most fund sponsors initiate a stock buyback program, offering to buy all shares for NAV, helping shareholders?

CEF sponsors earn fees as a percentage of assets under management.  If they buy back shares, they reduce the management fees they earn!

1. In what situation might there be a real advantage to organizing an investment company as a closed-end fund, rather than a mutual (open-end) fund?
2. Describe the personal tax advantage of the Vanguard 500 index ETF over the Vanguard 500 index mutual fund. Currently, about 36% of the NAV of the Vanguard 500 mutual fund represents unrealized capital gains.
3. Suppose the GLD ETF price is \$125/share. Would an authorized participant want to purchase 100,000 GLD ETF shares in the market and immediately request an in-kind redemption of gold bullion if the price of gold bullion is \$1,350/ounce?  Assume that the rate of in-kind exchange is 100,000 GLD shares for 9,400 ounces of gold bullion.

It would cost 1350(9400)=12,690,000  to buy 9400 ounces of gold.  It would cost 12,500,000 to buy 100,000 GLD ETF shares.  So, the AP would buy the ETF shares and immediately an in-kind redemption for the gold itself.

1. ETFs don’t allow retail investors to buy new shares from them, so how do ETFs increase their assets under management over time, and thus earn higher annual fees?

If retail investors think a particular ETF is attractive, they will buy it, driving up the market price relative to the NAV of the ETF.  The ETF will trade at a premium, so APs will buy the underlying assets and do an in-kind purchase of ETF shares.  This serves to increase the number of ETF shares outstanding.

Introduction

Investing in mutual funds, bond funds, and exchange-traded funds (ETFs) offers individuals a diverse range of investment options. These investment vehicles provide opportunities to participate in various asset classes, such as stocks, bonds, and commodities, while offering potential benefits and considerations for investors. In this essay, we will explore several important aspects related to these investment vehicles, including fund fees, capital gain distributions, fund taxation, fund liquidity requirements, and the advantages of ETFs.

Fund Operating Expenses

Fund operating expenses are typically deducted annually as a percentage of the assets under management. This means that the expenses are deducted proportionally from each mutual fund account.

Fee Structure

Mutual funds generally charge a constant percentage of assets under management as annual fees. Lower fees are not typically tied to poor investment performance, and higher fees are not necessarily linked to superior performance.

Total Cost of Share Classes

Using the example of the ELM Fund, Class A shares have a sales load and lower operating expenses compared to Class C shares (Wu et al., 2015). The total cost of each share class is calculated over different holding periods as a percentage of the original principal.

Capital Gain Distributions

Mutual fund shareholders may receive short-term or long-term capital gain distributions depending on the fund’s investment activities. Short-term gains result from the sale of assets held for one year or less, while long-term gains stem from assets held for more than one year.

Dividend and Capital Gains Distributions

Mutual funds are required to distribute dividend and capital gains to shareholders at least annually, and these distributions are typically subject to income taxes.

Minimizing Taxes on Fund Sales

To minimize taxes paid by shareholders, fund managers should sell shares based on the “biggest losers first” principle, prioritizing shares with the most significant losses. Short-term winners should be sold as a last resort, especially those with substantial gains (Oktaviyani & Munandar, 2017).

Section 2: Bond Funds

Active Bond Fund Management

If an active bond fund manager expects an increase in market interest rates, they should decrease the average maturity/duration of their bond portfolio. This strategy helps mitigate the negative impact of rising rates on bond prices.

Economic Outlook and Bond Investments

Considering a negative GDP growth forecast, an active bond fund manager may prefer to invest in AA corporate bonds instead of BB corporate bonds. The higher credit quality of AA corporate bonds provides better protection against default risk during an economic downturn.

Cash Reserves in Bond Funds

Among various bond fund types, municipal bond funds and high-yield corporate bond funds may need to hold the most cash reserves as a percentage of assets, primarily in the form of checking account deposits, money market funds (MMFs), or Treasury bills (Aizenman et al., 2015).

Section 3: Closed-End Funds and ETFs

If a closed-end fund trades at a 15% premium to its net asset value (NAV), it is generally advisable to avoid purchasing it. The premium suggests that the market price is significantly higher than the underlying value, which can limit potential returns.

Vanguard 500 index ETF offers a personal tax advantage over the Vanguard 500 index mutual fund. This advantage arises because ETFs have lower capital gain distributions due to the ability to transfer shares in-kind, minimizing taxable events for shareholders.

Increasing Assets Under Management in ETFs

ETFs increase their assets under management by attracting retail investors who buy shares on the market, driving up the market price relative to the NAV. Authorized participants then create new shares by purchasing underlying assets and exchanging them for ETF shares in an in-kind transaction.

Conclusion

Understanding the intricacies of mutual funds, bond funds, and ETFs is crucial for making informed investment decisions. By grasping concepts such as fund fees, capital gain distributions, fund liquidity requirements, and the advantages of ETFs, investors can develop effective investment strategies. Furthermore, considering economic outlooks and tax advantages can enhance portfolio performance and optimize investment outcomes.

References

Aizenman, J., Jinjarak, Y., Lee, M., & Park, D. (2015). Developing countries’ financial vulnerability to the eurozone crisis: an event study of equity and bond markets. Journal of Economic Policy Reform, 19(1), 1–19. https://doi.org/10.1080/17487870.2015.1018831

Oktaviyani, R., & Munandar, A. A. (2017). Effect of Solvency, Sales Growth, and Institutional Ownership on Tax Avoidance with Profitability as Moderating Variables in Indonesian Property and Real Estate Companies. Binus Business Review : Management, Accounting and Hospitality Management, 8(3), 183. https://doi.org/10.21512/bbr.v8i3.3622

Wu, G., Inderbitzin, A., & Bening, C. R. (2015). Total cost of ownership of electric vehicles compared to conventional vehicles: A probabilistic analysis and projection across market segments. Energy Policy, 80, 196–214. https://doi.org/10.1016/j.enpol.2015.02.004

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