Version #1__4_ lecture 1__1 in 1

ISLAMIC FUND
MANAGEMENT

Mutual fund industry
Dr. Hanudin Amin

MUTUAL FUNDS

Definition Purposes

• An investment vehicle that is made up of a pool of • Mutual funds have become an invaluable too for a
funds collected from many investors for the purpose wide range of investors
of investing in securities such as stocks, bonds,
money market instruments and similar assets • (1) Seeking to save for retirement
• (2) Sophisticated socialites focused on preserving
• In short, mutual funds pool the resources of many
small investors by selling them shares and using their assets and business
the proceeds to buy securities • Both create wealth

• The first mutual fund was established in Boston in • Fund managers will invest the funds received in the
1924 following, but not limited to:

• The industry grew very slowly at first, so that by • (1) Stocks ~ a share of a company held by an
1970, 360 funds held about $50 billion in assets individual

• Since then, the number of funds and the asset size • (2) Bonds ~ an instrument of indebtedness of
of the industry have increased dramatically the bond issuer to the holders

• This growth is attributed to the advent of money • (3) Money market instruments ~ Short-
market mutual funds in 1972 term, low risk financial instruments (e.g. treasury
bills)

• These create “portfolio”

History Asset types

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HOW DOES IT WORK?

Pool of Mutual fund Pool of funds Fund manager Investment
investors company outlets

Investors receive Investors pooled money The fund manager invests
distribution has greater buying power the money in a collection

A large number of investors of stocks, bonds etc.
with money to invest in
mutual funds

Successful investment adds value to the fund

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THE RETURNS + PRINCIPAL RETURN Investors POOL THER MONEY IN
BACK TO

Returns Fund

THE MONEY INVESTED GENERATES THE MONEY IS INVESTED IN

Securities

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MUTUAL FUNDS ARE ALL ABOUT
THESE…

a) Pool the resources of many small
investors by selling these investors
shares and using the proceeds to
buy securities

b) Allow small investors to obtain the
benefits of lower transaction costs in
purchasing securities

c) Provide small investors a diversified
portfolio that reduces risk

Dr. Hanudin Amin at Faculty of International Finance

KEY REASONS WHY INVESTORS ADORE MUTUAL
FUNDS

q Allowing investors to redeem Liquidity Denomination q Small investors can pool their
their shares at any time, intermediation intermediation funds with other investors to
despite long-term holdings purchase high face value
§Real ActivitiesKey reasons§Ethical securities
q Redeem shares at any time
q Sell shares at any time Diversification Professional q All investors come as a unit
q E.g open-end mutual funds m§Gaonveargneanmceent to buy big securities

q A mutual fund can hold several q Investors indirectly
hundred stocks and or bonds in participate in stocks and
its portfolio bonds markets

q Different companies q A professional fund
q Different region manager is known as an
q Different industries investment adviser
q Reduce the risk of the poor
q They ‘carefully’ chooses
performance of any one security the securities in which the
or business sector fund invests

Dr. Hanudin Amin at Faculty of International Finance q The fund managers
employ a team of
researchers, investment
analysts and strategists to
provide the detailed
market information for
investment

KEY DRAWBACKS OF MUTUAL FUNDS

q Values of funds change with the Volatility Delegated control q If investors intend to control the
fluctuations in investments (e.g.
stocks and bonds) specific stocks and bonds, mutual

q No guarantee a specific return or a funds are not in such
return of capital q Mutual funds do not consider

q If you are conservative investor, individual investor’s need
and need an absolute guarantee – q Mutual funds act at their invest to
fixed deposits
maximize profit, minimize loss
q However, mutual funds give a q Mutual funds are successful
better rate of return in the long
term because they spread the cost

q Not really meaningful to wealthy and running a portfolio among many
those who have millions of dollars to
invest shareholders

q Confined to the funds’ goals & not §Real ActivitieKsey limitation§Esthical
individual preferences
Limited flexibility Expenses related q Two major types of expenses
q The interest of many to§Gmovuetrnuaanlcfeund (1) those related to operating
the funds (2) those related to
Dr. Hanudin Amin at Faculty of International Finance selling the fund

q Operating expenses ~
management fees,
administration fees etc

q Costs relating to selling the
fund ~ front-end loads and
back-end loads”

q Higher expenses do not
guarantee better performance

q Nevertheless, mutual funds
have lower transaction costs

LECTURETTE #1

TRUST/FALSE QUESTIONS:
1. Liquidity intermediation is allowing investors to redeem their shares at any

time, despite long-term holdings

MULTIPLE CHOICE QUESTIONS:
1. _________ intermediation means that small investors can pool their funds

with other investors to purchase high face value securities.
(a) liquidity
(b) financial
(c) denomination
(d) share

2. Mutual funds offer investors all of the following except:
(a) greater-than-average returns
(b) diversified portfolios
(c) lower transaction costs
(d) professional investment management

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TYPES OF MUTUAL FUNDS BASED ON
STRUCTURE

Open-End Fund: investors • Continuously offer and redeem their units to the investors
may buy or redeem shares at • No restrictions on the amount of shares the fund issues
any point, where the price is • If demands is higher, the fund will continue to issue no matter how
determined by the net asset
many investors are
value of the fund • Buy back shares when investors wish to sell
• Has different risk, generally, the higher the return, the higher the loss

Closed-End Fund: a fixed • One time issuance of certificates, then are traded in the secondary
number of nonredeemable market
shares are sold through an
initial offering and are then • Fixed number of shares
traded in the OTC market.
• Behave like stocks , trade on an exchange and the price is determined
Price for the shares is by market demand after IPO process
determined by supply and

demand forces

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CALCULATING A MUTUAL FUND’S
NET ASSET VALUE

• Net Asset Value (NAV)

• Definition: Total value of the mutual fund’s stocks,
bonds, cash, and other assets minus any liabilities
such as accrued fees, divided by the number of
shares outstanding

Stocks $35,000,000
Bonds $15,000,000
Cash $3,000,000
$53,000,000
Total value of assets
Liabilities -$800,000
$52,200,000
Net worth
Outstanding shares 15 million

NAV = $52,200,000/15,000,000 = $3.48

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CALCULATING A MUTUAL FUND’S
NET ASSET VALUE

On January 1st, a mutual fund has the following assets and prices at 4:00 p.m.:

Stock Shares owned Price
1 1,000 $ 1.97
2 5,000 $48.26
3 1,000 $26.44
4 10,000 $67.49
5 3,000 $ 2.59

Calculate the net asset value (NAV) for the fund. Assume that 8,000 shares are
outstanding for the fund

NAV= $1,970 + $241,300 + $26,440 + $674,900 + $7,770 =$119.05/share
8,000

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MUTUAL FUND STRUCTURE:
THE ORGANIZATION

• The shareholders, or owners, of the mutual fund are the
investors

• The board of directors oversees the fund’s activities, hires
the investment advisor, an underwriter, etc., to manage the
day to day operations of the fund

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MUTUAL FUND STRUCTURE:
THE ORGANIZATION

Figure 1 The Organizational Structure of a Mutual Fund

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MUTUAL FUND STRUCTURE:
THE ORGANIZATION

• In theory, the board can fire the fund manager and
hire anyone they choose. For instance, the board
for the Fidelity Magellan Fund can fire Fidelity. Of
course, if the board hires a non-Fidelity
management team, the fund will probably lose its
name, and its reputation along with it

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INVESTMENT OBJECTIVE CLASSES

• There are four primary classes of mutual funds available
to investors:

Stock (equity) Bond funds Hybrid funds Money market
funds funds
• Funds consisting of • Funds consisting of
• Funds consisting of fixed income capital stock and bond • Funds consisting of
common and market debt securities various mixtures of
preferred stock securities money market
securities securities

• The next slide shows the distribution of
assets among these different classes

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INVESTMENT OBJECTIVE CLASSES

Figure 2 Distribution of Assets Among Types of Mutual Fund, 2004

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LECTURETTE #2

MULTIPLE CHOICE QUESTIONS:
1. Most mutual funds are structured in two ways. The most common structure is a(n) _________

fund, from which shares can be redeemed at any time at a price that is tied to the asset value of
the fund. A(n) _________ fund has a fixed number of nonredeemable shares that are traded in the
over-the-counter market.

(a) closed-end; open-end
(b) open-end; closed-end
(c) no-load; closed-end
(d) no-load; load
(e) load; no-load

2. Which of the following is an advantage to investors of an open-end mutual fund?
(a) Once all the shares have been sold, the investor does not have to put in more money
(b) The investors can sell their shares in the over-the-counter market with low transaction
fees
(c) The fund agrees to redeem shares at any time
(d) The market value of the fund’s shares may be higher than the value of the assets held
by the fund

Dr. Hanudin Amin at Faculty of International Finance

INVESTMENT OBJECTIVE CLASSES

Stock Funds Bond Funds
• Funds that invest in stocks, called • Funds that invest in bond
• Lower volatility than stocks
equity securities • Higher yield than MMF
• Capital Appreciation Funds seek rapid • Conservative investors with low risk

increase in share price, not being tolerance
• Safer as far as issuers will pay interest
concerned about dividends
• Total Return Funds seek a balance of + principal on the due date

current income and capital

appreciation
• World Equity Funds invest primarily in

foreign firms

Hybrid Funds Money Market Mutual Funds
• Combine stocks and bonds into a single • Defined as open-end funds that

fund. invest only in money market
• Invest in both stocks and bonds
• Less risky than stock funds securities
• Perform better than bond funds • Offer check-writing privileges
• Two categories? • Invest in low-risk, high quality debt

securities
• Net assets have grown

dramatically, as seen in the next

slide

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Figure 3 Net Assets of Money Market Mutual Funds, 1975-2003

Investment Objective Classes

• Money Market Mutual
Funds

• Although money market
mutual funds offer higher
returns than bank
deposits, the funds are
not federally insured

• Figure 4 shows the
distribution of assets in
MMMF, which are
relatively safe assets

Figure 4 Average Distribution of Money
Market Fund Assets, 2004

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• Repurchase agreement ~ REPO a type of short term loan whereby the seller of a
security agrees to buy it back at a future date

• CD~a saving certificate gives the bearer to receive interest
• T-BILL~ a short term debt obligation backed by the government with a maturity of

less than 1 year
• Commercial paper~a debt instrument issued by a corporation or bank to finance its

short term credit needs such as inventory and account receivable
• Corporate note ~ a short term, corporate bond – a company issues a capital note to

pay its short term liabilities, unsecured, received the lowest priority of all bonds
(Ranked higher than preferred or common stock)

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INVESTMENT OBJECTIVE CLASSES

Index Funds Features of index funds?

a) A portfolio constitutes of stocks belonging to (a) They have lower fees
some market index such S&P 500 index (b) They select and hold stocks to match the

b) A special class of mutual funds that do fit performance of a stock index
into any of the categories discussed so far (c) They do not require managers to select

c) The fund contains the stock of the index it is stocks and decide when to buy and sell
mimicking. For example, an S&P 500 index
fund would hold the equities comprising the
S&P 500

d) Offers benefits of traditional mutual funds
without the fees of the professional money
manager

The simplest type of investment funds to manage
Index funds are not actively managed. They simply hold the stocks in the index. They usually have significantly lower fees than actively
managed funds.

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REGULATION OF MUTUAL FUNDS

• Securities Act of 1933: specifies • Securities Exchange Act of 1934: details

disclosure requirements antifraud rules
• Primary purpose ~ to ensure buyers of • Exchange Act 1934
• Ensure the purchase and sale of mutual
securities receive complete and accurate
fund shares subject to various antifraud
information before investing
• Companies create ‘a registration provisions
• This Act requires mutual funds to publish
statement’ consists of a prospectus, about
full and accurate information on all
the company and audited financial
financial and corporate matters to
statements
• Helps to maintain investor confidence. prospective fund purchasers

Support the market

• Investment Company Act of 1940: requires • Investment Advisors Act of 1940: regulates

registration and minimal operating standards fund advisors
• The Act established rules to prevent • Public Utility Holding Company Act of

conflicts of interest, fraud and excessive 1935 requires the SEC to study investment

fees or charges for fund shares trusts ~ leading to Investment Company
• Investment companies are still in their
Act and Investment Advisors Act
infancy in 1940 • The study founds unfounded hot tips and
• In order to still investors’ confidence in
questionable performance fee
these companies and to protect the public • The IAA defines a person as an investment

interest, Congress passed the investment adviser through the offering of advice or

Company Act the making of recommendations on

securities as opposed to other types of

investments

CONFLICTS OF INTEREST
IN THE MUTUAL FUND INDUSTRY

• Investor confidence in the stability and • Government Response to Abuses
integrity of the mutual fund industry is critical
• Require more independent
• However, the usual problems of asymmetric directors
information and the principal-agent problem
arose, leading to abuses on the part of fund • Hardening the 4:00 valuation rule:
management this addresses the late trading
problem, but not market timing
• Mutual Fund Abuses
• Late trading: allowing trades after 4:00 • Increased and enforces redemption
pm to trade at today’s 4:00 NAV instead fees: fees to discourage market
of tomorrow’s price. This is illegal under timing by additional fees for short-
SEC regulations term redemptions
• Market timing: taking advantage of time
zone differences for determination of • Increased transparency: hits
NAV. This is not illegal under SEC operating practices, directors,
rulings investment managers,
compensation arrangements with
brokers, etc

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WALLAHU A’LAMU BIS-SHOWAAB

Dr. Hanudin Amin at Faculty of International Finance