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Welcome to the Military Families Learning Network Webinar

How to Read a Mutual Fund Prospectus

This material is based upon work supported by the National Institute of Food and Agriculture, U.S. Department of Agriculture, and the Office of Family Policy, Children and Youth, U.S. Department of Defense under Award Numbers 2010-48869-20685 and 2012-

48755-20306.

This material is based upon work supported by the National Institute of Food and Agriculture, U.S. Department of Agriculture, and the Office of Family Policy, Children and Youth, U.S. Department of Defense under Award Numbers 2010-48869-20685 and 2012-

48755-20306.

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Today’s Speaker

Dr. Michael Gutter is an Associate Professor, Interim FCS Program Leader, and Financial Management State Specialist for the Department of Family, Youth, and Community Sciences, in the Institute for Food and Agricultural Sciences at the University of Florida. He is also the Principal Investigator for the Personal Finance Concentration Area of the Military Families Learning Network. The common theme that connects Gutter's Research, Teaching and Outreach is helping households achieve financial security. He regularly tweets on personal finance topics under @mikegutter on Twitter.

Mutual Funds: A Handy Financial Tool for Building

WealthDr. Michael S. Gutter

Interim FCS Program Leader

University of Florida IFAS Extension

msgutter@ufl.edu

@mikegutter

Workshop Objectives• Learn about different types of mutual funds• Learn about the different ways in which

military families may need or access funds or similar investments

• Learn how to compare funds• Activity involving matching funds to family’s

objectives

Mutual Funds• May fit into your investment plan• Provide diversification • Understand your personal risk tolerance• Know your objectives • Research before purchasing any

investment vehicle

Open-end Investment Companies - Mutual Funds

• Have a variable capital structure

• Shares are bought and sold from the mutual fund

• Shares cannot sell for a discount from NAV

Closed-end Investment Companies

• Have a fixed capital structure• Shares are bought and sold in the

secondary markets• Shares may sell for a premium or

discount from NAV• Tendency for shares to sell at a

discount from NAV

What is a Mutual Fund?• An investment company pools the assets

of many investors to purchase securities• Funds can be invested in stocks, bonds,

money market instruments, real estate, precious metals

• Investors buy shares in the fund• Provides diversification to reduce risk

Poll Question:People Can Own Mutual Funds

1. Through employer sponsored retirement plans

2. 529 plans

3. Individual Retirement Accounts

4. Annuities

5. All of the above

6. None of the above

Advantages of Mutual Funds• Diversification

– Cost effective way to achieve diversification• Affordability

– Can often get started with small amounts– Allows for regular small deposits

• Liquidity– Can sell shares back to the investment company

• Professional Management– Professionals make decisions– Advantages and disadvantages

Word on Diversification

• Time Value of Money• Risk and Return• Diversification

– Thus the goal of diversification can be thought of as

– The reduction/elimination of idiosyncratic risk within a portfolio

Disadvantages of Mutual Funds• Funds held outside of a tax advantaged plan

– Taxes on capital gain & dividend distributions• Even when you reinvest distributions

• Lack of control of exactly which securities are purchased– Decided by fund manager– Index being tracked

• Risk– No guaranteed return– Market fluctuation

How Can You Profit?• Dividend Distributions• Capital Gain Distributions• Net Asset Value increases and you

redeem (sell) the shares• You can reinvest:

– Dividends– Capital gains distributions

Prospectus • Document that all companies offering

new securities for public sale must file with the SEC.

• It spells out in detail the financial position of the offering company, what the new funds will be used for, the qualifications of the corporate officers, risk factors, nature of competition, and any other material information.

Name of the Mutual Fund• Prospectus must be updated at least

annually

• May be a “consolidated” prospectus for several funds from the same fund family

– Example: Vanguard U.S. Stock Index Funds

Required Cover Statements

• Standardized “CYA” language

– Clearly states in bold print that there is no government approval of the fund

– To state that there is approval is a crime

• Tells investor about the availability of

– Statement of Additional Information (SAI)

– Annual and semi-annual reports to shareholders

Statement of Fund Investment Objective

• Varies with the type of mutual fund• Almost 30 different objectives (ICI)• Three PRIMARY Objectives:

– Stability (preservation of principal)• Example: Money market mutual funds

– Growth (increased value of principal over time)• Examples: Stock mutual funds, stock index funds

– Income (generating a stream of payments)• Example: Bond mutual funds

Example of a Mutual Fund Objective

The fund invests with the objective of capital growth. Although income is considered in the selection of securities, the Fund is not designed for investors seeking primarily income rather than capital appreciation.

Fees and Expenses• Shareholder Fees

– Charged to an individual investor’s account– Examples: sales load, redemption fee, account

maintenance fee, exchange fee

• Annual Fund Operating Expenses– Paid by mutual fund as a % of assets– Examples: management fee, 12b-1 fee, other

expenses

• Standardized hypothetical example– 1, 3, 5, and 10 years of fees on $10,000

Financial Highlights Table• NAV, beginning of period

• NAV, end of period

• Net assets, end of period

• Ratio: total expenses & average net assets

• Number of outstanding shares

• Total return for period

• Turnover rate

Net Asset Value• A share in a fund is purchased at NAV

(plus sales charges & fees)• Per share Net Asset Value=

Total Assets – Total LiabilitiesNumber of Shares Outstanding

Sources of Return to the Investor

• Income distributed in the form of dividends

• Capital gains distributions• Appreciation in the NAV• Change in the discount/premium

Investment Policies

The “personality” of a fund

– What it will do and won’t do

– Securities purchased to meet fund objective

– Investment quality of securities

– Use of speculative practices (e.g., selling on margin, futures contracts, derivatives)

– Limits on % of fund assets in one industry

Investment Risks

• Describes principal risks associated with investing in a particular fund – Example: currency risk (global fund)

• Describes risks associated with a type of investment – Example: interest rate risk on bond funds

• Describes range of quality ratings allowed– Example: low rated bonds in junk bond funds

Investment Advisor Information

• Name of advisor (e.g., The Vanguard Group)

• Beginning of operations (e.g., since 1975)

• Amount of assets under management (e.g., $592 billion in assets)

• Services provided by investment advisor

• compensation to investment advisor as a % of assets

• Special arrangements such as bonuses

Fund Distributions and Taxes

• Frequency of fund distributions– Dividends

– Capital gains

• Sale or exchange of shares is a “taxable event”

• Procedure for reinvesting distributions

How to Purchase Shares• Method(s) of Purchase

– Online, by check, by exchange, through a broker/sales agent

• Price of Purchase– NAV or NAV plus a sales load– Price breaks for large purchases

• Minimum Purchase Amounts– Minimum initial deposit and later deposits– Minimums for IRAs and automatic

purchase plans

How to Redeem Shares

• Methods by which shares can be redeemed (e.g., check-writing, telephone request, written request, wire transfers)

• Description of redemption price

– Example: “You redeem shares at the fund’s next-determined NAV after [company] receives your redemption request.”

• Process to exchange fund shares

Profile Prospectuses

• Short and sweet

– One double-sided page

• Key pieces of information only

– Short paragraphs

– Sometimes in “Q&A” format

• Should still request full prospectus

Five Key Factors to Scrutinize

• Fund objective

• Fees and expenses (for type of fund)

• Historical performance

• Investment policies relative to personal risk tolerance

• Minimum initial and subsequent deposits

The Load Fee

• Charged to investor when the shares are purchased

• Compensates the sales person (i.e., is analogous to brokerage commissions for buying securities)

• Varies with dollar amount purchased• Load expenses mean investors pay a

premium over the fund's NAV

The Load Fee

Front-End• Charging the load

(commission) on a mutual fund at the time of purchase

Contingent-Deferred • AKA Band-End Load:

fees assessed on a mutual fund account at redemption

• % percentage of net asset value; generally declines over time

Other Fees and Expenses• Early withdrawal fees (or exit fees• Management fees• Operating expenses• Exchange Fees

– a fee charged by many no-load fund families when moving money from one fund to another within the family

– Discourages investors from using the funds as trading accounts.

Sales Charges vs. Management Expenses

• The longer you hold an investment:– Less effect of sales fee (load) – Greater the effect of management

expenses• Your timeline can affect your choice

Total Annual Fund Operating Expenses

• Expense ratio– Let’s you know how much of the funds

assets are going towards annual expenses– Expressed as a percentage

• Expense Ratio = annual expenses ÷ fund assets

• Does not include – Loads (sales commissions)– Transaction Fees

Expense Ratios• Good way to compare the ongoing fees

of different mutual fund companies• Example:

– Company A expense ratio= .75– Company B = 1.5

Expense Ratios• Compare ratios for similar types of fund

Example: – Domestic to domestic– International to international– Index fund to index fund

Classes of Shares• Class A (front end loads)

– Pay commission when you buy the fund• Class B (back end loads)

– Pay commission if you sell before the specified period ends. AKA Contingent Deferred Sales Charges

• Class C– Carry a level load, collected every year

No Load Funds• No commission charged• Purchase directly from the investment

company• Can still charge other fees

– 12b-1– Purchase fees– Exchange fees

Tax Implications

Redeem Shares: Will you have a capital gain?

• $$$ = (NAV x # shares) – fees, commission– Capital Gain – Capital Loss

Taxes• Earnings in tax advantaged plans grow tax

free– Retirement plans, 529 plans

• Outside of those plans, taxes paid on distributions even if reinvested– Long –term capital gains tax rate is less than

tax rate for ordinary income– Capital losses can be used to offset capital

gains

Taxes• When you sell you have a capital gain,

loss or break even– Tax liability depends on amount gained or

lost• Amount of Capital Gain/Loss Sales Price – Cost Basis • Cost basis is purchase price (includes

any fees, commissions, etc. )

• Turnover – the relative frequency of trading securities

within a mutual fund or other portfolio• Turnover ratio

– for mutual funds, annual sales divided by the average monthly net assets (excluding securities with less than one-year maturities)

HOW DO WE DECIDE AMONGST THE THOUSANDS OF FUNDS?

So we know how they work, what they cost, how we measure it

Family of funds: group of mutual funds owned and marketed by the same company

Purchasing Mutual Funds• Broker

– Full Service– Online

• Directly from the investment fund company

• Through employer sponsored plan

Fund Objectives• Each fund will have a specific objective• Some general examples

– Growth– Income producing (dividend paying)– Social responsibility– Track an index

Basics

• Money market mutual fund• Bond fund• Common stock fund

Differences in Risk Orientation of Common Stock Funds

• Growth funds: stress appreciation potential; accept considerable risk

• Income funds: focus on stocks that pay high dividends; provide low risk and modest growth

• Blend funds: place more emphasis on stability than growth funds do but less than income funds do; seek growth as well as stability

Specialized Funds

• Sector funds• Bond funds• Index funds• Tax-exempt bond funds• Single country or regional funds

Investment Styles

• Index Funds• Large cap• Mid-size cap• Small cap• Growth• Value• Market Capitalization - Total market value of a company’s stock

• Specialty fund: designed for investors who seek special investment opportunities. One such fund might invest in precious metals, a second might focus on commodities or commodity trading, and a third might engage in option trading.

• Hedge funds: typically invest in derivatives, sell short, use leverage, and invest internationally. take substantial risks, to try for large rewards. Allow only “qualified investors” to participate.

• Blind pool: the precise purposes of the venture are not revealed to the pool of investors until later

• International funds: specializes in investments outside of the United States and helps the investor to further diversify his or her portfolio. International funds may specialize in specific countries or regions, such as the Pacific Rim.

• Global fund: invests in the United States and in foreign markets. The general philosophy is that we live in a global economy and that capital should flow toward those regions that offer optimal risk-return combinations.

The Composite Performance Measures: The Treynor Index

• Standardizes the return in excess of the risk-free return by the portfolio's beta

• Useful for comparing two managers on a risk adjusted basis but does not compare to market– Can calculate for the market and then use for

comparison• Uses the portfolio's volatility as the measure of risk• Assumes that the portfolio is well diversified, so the beta

(which measures systematic risk only) is the appropriate measure of risk

The Composite Performance Measures: The Sharpe Index

• Standardizes the return in excess of the risk-free return by the portfolio's standard deviation

• Uses the portfolio's variability as the measure of risk• Does not assume that the portfolio is well diversified• This is because it uses Standard deviation (which

measures total risk) is the appropriate measure of risk• Useful for comparing two managers on a risk adjusted

basis but does not compare to market– Can calculate for the market and then use for

comparison

Point of clarification

• Variability– Compare one year’s return with average

for the portfolio or security• Volatility

– Compares return relative to something else• Like benchmark

The Benchmark Problem

• The comparisons use an aggregate measure of the market

• The composition of many portfolios are not comparable to the market

• Examples would be specialized funds or global funds

• Treynor and Jensen use Beta but Beta can be biased

Advantages of Mutual Funds• Portfolio management• Risk reduction• Diversification• Convenience

Disadvantages of Mutual Funds

• Management fees, expenses, and loads for load funds reduce their returns.

• Large investors, such as mutual funds, usually adversely affect the market when they trade.

• Institutions usually restrict their analysis to a small percentage of traded stocks.

http://www.finra.org/Investors/ToolsCalculators

Okay let’s see what we learned…

• We are going to consider a unique case on the next slide. We will then go online and access one of our fund screeners.

• What fund did you pick and why?

Selecting Your Own Funds• Your financial goals

– Growth, income, combination– Asset allocation

• Available options– Employer sponsored plan– Individual plans

• Risk: Safety of investment and Individual comfort level• Minimum investment to get started• Timeline• Liquidity

– Can you access when needed (and what will be the cost)• Tax consequences

Activity • Meet Marco (28) and Sheila (27). Marco is

stationed at Eglin Air Force Base in Florida. His wife is an Extension agent. They recently decided to open a Roth IRA. They have no plans for this money prior to retirement. They are looking for growth in their investment over the long run. They can afford to invest between $2000 and $5000 per year. If you were them, what fund might you choose?

http://www.msuextension.org/solidfinances/resources/mutualfunds.pdf

Follow “The Rule of Three”

Start a File For Every Fund That You Own

• Most recent prospectus

• Copy of original application form

• Annual account statements

• Periodic statements

• Articles about the fund, manager, etc

Sources & Resources• Montana State University

– http://www.msuextension.org/solidfinances/pastrecordings.html

• Securities and Exchange Commission– http://www.sec.gov/investor/pubs/inwsmf.htm

• Investment Company Institute– www.ici.org

• Financial Industry Regulatory Authority (FINRA)– http://www.finra.org/Investors/SmartInvesting/Choo

singInvestments/MutualFunds/• Dr. Michael Gutter, 2011 webinar

Questions? Comments Experiences?

Next Personal Finance Webinar

Current Personal Finance Topics for Financial Practitioners• Tuesday, November 25, 2014, 11 a.m. ET• https://learn.extension.org/events/1714• Speaker: Dr. Barbara O’Neill• 1.5 CEUs for AFC-credentialed

participants

Military Families Learning Network

This material is based upon work supported by the National Institute of Food and Agriculture, U.S. Department of Agriculture, and the Office of Family Policy, Children and Youth, U.S. Department of Defense under Award Numbers 2010-48869-20685 and 2012-

48755-20306.

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