Chapter 16

Investing in Mutual Funds

Investing in Mutual Funds

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

What is a Mutual Fund?

• An investment alternative where money from investors is pooled to buy stocks, bonds, and other financial securities selected by professional managers.

• Many people choose mutual funds for their retirement account investments. 401(k) or 403(b) IRA Roth IRA

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Mutual Fund Statistics

• 92 million individuals in 54 million households in the U.S. own mutual funds.

• Over 8,000 mutual funds by 2004.

• Over $8 trillion in assets owned by mutual funds in the U.S. by 2004.

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Why Investors Purchase Mutual Funds

• Professional management. Who is the fund’s manager? Managers can change. Be aware of the scandal involving late

trading.

• Diversification. Investors funds are used to purchase a

variety of investments. This variety provides some safety.

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Closed- and Open-End Funds

• Closed-end funds (7% of funds). Shares are issued by an investment company only

when the fund is organized. After all original shares are sold you can purchase

shares only from another investor who is willing to sell.

Traded on exchanges and over-the-counter.

• Open-end funds (91% of funds). Shares are issued and redeemed by the investment

company at the request of investors. Investors can buy and sell shares at the net asset

value (NAV).

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Exchange-Traded Funds

• Invests in the stocks contained in a specific stock market index, like the Standard and Poor’s 500 stock index.

• Performance of shares in the fund tend to mirror the performance of the index.

• Low management fees since there is less need for decisions made by a portfolio manager.

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Net Asset Value (NAV)

Value of the fund’s portfolio - Liabilities

Number of shares outstanding

For most mutual funds, NAV is calculated at the close of trading each day.

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Load Funds and No-Load Funds

• Load Fund. Investors pay a commission (sales charge) up

to 8.5% every time they purchase shares. This is sometimes called a front load. (Class A shares)

Average charge is 3-5% for which an investor can get purchase advice and explanations.

• No-Load Fund. Investors pay no sales charge up front. You deal directly with the fund with 800

numbers or web sites, or from discount brokers.

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Management Fees and Other Charges

• Contingent deferred sales load (back-end load) (Class B shares). Charged upon withdrawal of funds (1-5%). Generally decreases on a sliding scale depending

on the number of years shares are held.

• Management fee. Charged yearly (.5%-1.25% average) based on a

percentage of the funds asset value.

• 12b-1 fees (Class C shares). Annual fee to defray advertising and marketing

costs of the fund. 1% or less of a fund’s assets per year.

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Number of Mutual Funds by Type*

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

EquityFunds

Bond Funds HybridFunds

MoneyMarket,Taxable

MoneyMarket,

Nontaxable

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*Source: Year 2000 data from the U.S. Bureau of the Census, Statistical Abstract of the United States, 2001, page 744.

Classification of Mutual Funds

• Stock funds. Aggressive growth funds buy stocks in small, fast-

growing companies. Equity income funds invest in stock of companies

with a long history of paying dividends. Growth buy stock in companies with higher-than-

average revenue and earnings growth. Global funds buy stock in companies in the U.S.

and other countries, while international funds buy stock only in companies outside the United States.

Index buys stocks that mirror an index. Large-cap funds invest in companies with

capitalization of $5 billion or more. Mid-cap funds buy stock in companies whose

capitalization is between $1 and $5 billion.

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Classification of Mutual Funds

Regional funds buy stock in companies in a specific region of the world.

Sector funds buy stock in companies in a particular industry such as biotechnology.

Small-cap funds buy stock in lesser-known companies with a capitalization of less than 500 million.

Socially responsible funds avoid investing in companies that produce harmful products.

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(continued)

Classification of Mutual Funds

• Bond funds. High-yield (junk) bond funds buy corporate

bonds that are higher risk and higher yield. Index bond funds invest in a sampling of

bonds included in an index. Intermediate corporate bonds (5-10 years). Intermediate U.S. bond funds buy treasury

notes with maturities of 5-10 years. Long-term corporate bonds (> 10 years).

(continued)

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Classification of Mutual Funds

Long-term U.S. bond funds: U.S. Treasury and U.S. zero-coupon bonds with maturities > than 10 years.

Municipal bonds: Invest in municipal bonds that provide investors tax-free interest income.

Short-term U.S. bond funds invest in U.S.Treasury issues of 1-5 years.

Short-term corporate bond funds: Investment grade bonds with maturities of 1-5 years.

World bond funds buy bonds of foreign companies and governments.

(continued)

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Classification of Mutual Funds

• Other funds. Asset allocation funds: invest in various asset

classes, such as stocks, and bonds, with precise amounts within each type.

Balanced funds: Invest in both stocks and bonds, with the primary objectives of conserving principal, providing income as well as growth.

Money market funds: Invest in CD’s, government securities, and other safe investments.

(continued)

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Families of Funds

• A family of funds exists when one investment company manages a group of mutual funds.

• Each fund in the family has a different financial objective.

• Exchange privileges allow you to move your money from one fund to another within the fund family with little or no charge.

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Steps to Evaluate Mutual Funds

• Are you ready to invest in mutual funds? • Determine your risk tolerance. • Determine your investment objectives.• Obtain the money you need invest.• A fund’s objective should match your

investment objective.• Evaluate any mutual fund before buying

or selling (www.morningstar.com)• Consider managed funds vs. indexed

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Internet Sources of Fund Information

• Use web sites to research a fund. http://finance.yahoo.com www.businessweek.com www.morningstar.com (also other advisory services,

such as Value Line). www.smartmoney.com

• Check mutual fund companies Internet sites. www.trendstarfunds.com www.vanguard.com

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Reading a Mutual Fund Quotein the Newspaper

• Net asset value and asset value change.

• The fund family and fund name.

• Fund objective.

• Total return over various time periods.

• Ranking among funds with the same objective.

• Sales load fees if any, or no load (NL).

• Annual expenses.

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Other Sources of Fund Information

• Mutual fund prospectus tells the funds objective and: A statement describing the risk factors. A description of the fund’s past performance. A statement describing the type of investments in

the fund’s portfolio. Information on how to open an account. Dividends, distributions and taxes. Information about the fund’s management. The process for investors to buy or sell shares. Services provided to investors. The turnover ratio of the fund’s investments.

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Other Sources of Fund Information

• Mutual fund annual report. Performance, investments, assets and liabilities.

• Financial Publications. Business Week, Forbes, Kiplinger's Personal Finance

and Money are sources of information. Business Week’s mutual fund survey includes information

such as the...• Fund’s overall rating compared to all other funds, and to funds

in the same category.• Fund size, sales charge and expense ratio.• Performance for best and worst quarters.

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(continued)

Mutual Fund Transactions

• You can open an account from $250 to $3,000 and up depending on the fund & family.

• Open-end, no-load directly from the investment company by phone, mail, online, or from a discount broker.

• Closed-end or exchange-traded funds are purchased through a broker; traded on stock exchanges and over-the-counter.

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Mutual Fund Transactions

• There are several ways you can get a return on your investment. Capital gains: sell shares at a price > than you

paid (Report on Schedule D and 1040). Income dividends: earnings funds pay to

shareholders from dividend and interest income (Taxed as regular income).

Capital gain distributions: Payments to shareholders from sale of securities held by the fund (Show on Schedule D and 1040).

Income and capital gain distributions can be automatically reinvested.

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Mutual Fund Features

• Automatic investments: Money is taken from your checking account monthly and invested in a fund.

• Telephone Switching: Call your fund and move money from one fund to another in the same family.

• Withdrawals: Various withdrawal options; you can withdraw funds by phone, letter, online, etc.

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Mutual Fund Activity

• Go online to www.morningstar.com, www.cbsmarketwatch.com or other sources and do some research on mutual funds.

• Find a fund that you feel would be a good investment for you.

• Pair off with another student. Compare your mutual fund selections and discuss your investment objectives and how this fund will meet those objectives.

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