13 Investing in Mutual Funds

• Mutual Fund = an investment vehicle offered by investment companies to those who wish to:

– Pool money

– Buy stocks, bonds, and other financial securities

– Have buy/sell decisions made by fund manager

• Many mutual funds chosen for inclusion in retirement account investments (e.g., 401(k)s)

13-1

Objective 1Explain the Characteristics of

Mutual Fund Investments

Investment Company

• Pools the money of many investors – its shareholders – to invest in a variety of securities

• Employs fund manager who is compensated for selecting securities appropriate to the fund’s stated objective

• “Financial Intermediary”

13-2

How a Mutual Fund Works

Why Investors Purchase Mutual Funds

• Professional Management– Who is the fund’s manager?

– How has the fund performed under the current managers?

• Diversification– Investor’s funds are used to purchase a variety

of investments (shares of many different companies)

– Risk reduction

13-4

Characteristics of Funds

• Closed-End Funds (7% of all Mutual Funds)– Fixed number of shares issued when the fund is organized– Trade like shares of common stock on stock exchanges– Trade price set by supply & demand– Actively managed – Most sell at a discount relative to their net asset value

• Exchange-Traded Funds (6% of all Mutual Funds)– Invests to replicate the composition of a specific securities index– Performance mirrors index performance – Low management fees– Trade on exchanges throughout the day like stock– Prices determined by supply and demand– Can be sold short and traded with limit orders

• Open-End Mutual Funds (87% of all Mutual Funds)– Shares issued and redeemed on demand– Actively managed

13-5

Net Asset Value

Net Asset Value (NAV):

Current market value of assets held by a fund

AUM = “Assets Under Management”

– Net Assets = Fund Assets (AUM) - Liabilities

– NAV calculated at the close of trading

13-6

Example: $52,500,000 value of fund net assets 3,500,000 number of shares = $15 per share

Open-End Funds

Open-End Funds ≈ Majority of funds

– Shares issued and redeemed by investment company at the request of investors

– Investors free to buy and sell shares at the net asset value (NAV)

– No broker or stock exchange required

– Wide variety of services

• Automatic deposit and withdrawal

• Exchanges among family of funds

13-7

Costs: Load Funds vs. No-Load Funds

• Load Fund– Sometimes called an “A” fund

– Commission (sales charge) up to 8.5%

• Average = 3 to 5%

– Paid every time shares purchased

– Purchased through brokerage firms or registered representatives

• Salespeople prepared to explain the fund and help determine if it meets the investor’s financial goals

• No-Load Fund

– No up-front sales charge

– No salespeople

– Investor deals directly with the investment company via 800

numbers or Web sites, or from discount brokers 13-8

Costs: Load Funds vs. No-Load Funds

Contingent Deferred Sales Charge (CDSC)

– “Back-end load”

– “B” fund

– “Redemption fee”

– Charged upon withdrawal of funds (1-5%)

– Generally decreases on a sliding scale depending on number of years shares are held

• Disappears after about 5 years

• Knowing your holding period is key factor 13-9

Costs: Management Fees and Other Charges

• Management Fee– Charged yearly (.25%-1.5% of NAV average)

based on a percentage of AUM

• 12b-1 Fee– Annual fee to defray advertising and

marketing costs

– Cannot exceed 1% of AUM per year

• Expense Ratio– Total expenses associated with management

fees and operating costs of the fund13-10

Typical Mutual Fund Fees

13-11

Objective 2Classify Mutual Funds by

Investment Objective

Long-term Funds

Stock Funds Bonds Funds Other Funds

13-12

Stock FundsLong-term

Funds

Stock Funds Bonds Funds Other Funds

Growth

Equity income

Price growth vs. Dividend Income

Aggressive Growth

Socially responsibleInvest in socially responsible firms

Economic SectorsSector funds

Company Size

Regional

Index funds Match index holdings

% U.S. vs. International

Small-cap

Mid-cap

Global

International

Large-cap

13-13

Bond FundsLong-term Funds

Stock Funds Bonds Funds Other Funds

High-yield

Intermediate Corporate bonds

Intermediate U.S. Gov't bonds

Long-term corporate bonds

Long-term U.S. gov't bonds

Municipal bonds

Short-term corporate bonds

Short-term U.S.gov't bonds 13-14

Other Funds

Long-term Funds

Stock Funds Bonds Funds Other Funds

Money Market Funds

Asset Allocation Funds

Balanced Funds

Lifecycle Funds

Fund of Funds

13-15

Balancing Risk and Returns on Mutual Funds

A Family of Funds

One investment company manages a group of mutual funds portfolios

– Each fund has a different financial objective

– Exchange privileges allow movement from one fund to another within the family with low or no charge

– Listed alphabetically in newspapers

13-17

Names of popular investment companies?

Objective 3Evaluate Mutual Funds

Managed Funds vs. Index Funds

• Managed Fund fund manager makes all decisions regarding what securities are included in the fund’s portfolio

• Index Fund securities held by the fund replicate those contained in a specific index like the S&P 500

13-18

Sources of Fund Information1. Internet sites provide current values

– http://finance.yahoo.com

– www.businessweek.com

– www.morningstar.com

– www.smartmoney.com

2. Check mutual fund companies’ Internet sites

– www.troweprice.com

– www.vanguard.com

3. Professional Advisory Services– Lipper Analytical Services

– Morningstar, Inc.

– Value Line

– Mutual fund newsletters13-19

Mutual Funds Have Different Investment Objectives

Prospectus – a mutual fund’s investment objectives and policies must be stated in this document.

Two Types:

• Traditional prospectus (long)

• Profile prospectus (short)

Mutual Fund Prospectus Data

– Fund objective(s)

– Statement describing risk factors

– Description of fund’s past performance

– Statement describing type of investments in fund’s portfolio

– Information about dividends, distributions, and taxes

– Information about fund’s management

– Procedure to buy and sell shares

– Services provided to investors

– Turnover Ratio of the fund’s investments: how often the fund’s portfolio changes 13-21

Other Sources of Fund Information

• Mutual Fund Annual Report– Performance, investments, assets & liabilities

• Financial Publications– Business Week, Forbes, Kiplinger's Personal

Finance, WSJ, and Money – Business Week’s mutual fund survey

includes: • Fund’s overall rating compared to all other funds,

and to funds in the same category• Fund size, sales charge, and expense ratio• Historical returns for the past ten years

13-22

Objective 4Describe How and Why Mutual

Funds are Bought and Sold

The Mechanics of a Mutual Fund Transaction

• Open an account:– On Your Own: $250 to $3,000 and up

depending on the fund family and the fund – At Work: Select mutual funds for a tax-

deferred retirement savings account

13-23

Return on Investment

3 Ways to Make Money on Mutual Funds

Income Dividends– Earnings paid from dividend and interest income

– Taxed as ordinary income

Capital Gains Distributions – Distributions when the fund buys and sells securities

– Taxed as long-term gains

Capital Gains (or Losses)– Capital gains (or losses) when you sell shares at a

price different than price you originally paid

– Taxed as short- or long-term gains 13-24

Purchasing Open-End Fund Shares

– Regular Account Transactions• Easiest • Simply buy shares in amount and when desired

– Voluntary Savings Plans• Allows for smaller than usual purchases on a

recurring basis

– Contractual Savings Plans• Require regular purchases over a specified period

– Reinvestment Plans• Automatically reinvests dividends and capital gains

in the fund

13-25

The Wisdom of Automatic Reinvestment

• Closed-End Funds and Exchange-Traded Funds – Traded on stock exchanges and in over the counter market

– Sold like common stock shares

• Open-End Funds

– Shares sold to the fund sponsoring company

– Systematic withdrawal methods

1. Withdraw fixed dollar amount each period until account is exhausted

2. Liquidate or “sell off” a certain number of shares each period

3. Withdraw a fixed percentage of asset growth; principal untouched

4. Withdraw all income dividends and capital gains distributions; principal untouched

Withdrawal Options

13-27

Wrap Up

• Chapter Quiz

• Concept Check 13-1- NAV Problem

• Concept Check 13-2- Importance of Fund Objective

• Concept Check 13-3- Managed Fund vs. Indexed Fund

• Concept Check 13-4- Purchasing Closed-End Funds and ETFs