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CHAPTER 15

MUTUAL FUNDS: AN EASY WAY TO DIVERSIFY

CHAPTER CONTEXT: THE BIG PICTURE

This chapter on mutual fund investing is the last in the five-chapter section titled “Part 4: Managing Your Investments.” Other chapters in this section considered the need to understand the investing process and to plan carefully before making an investment. Previous chapters also outlined specific common stock, bond, preferred stock, and real estate investing strategies. This chapter brings together many of the concepts, investing terms, and principles considered in the previous four chapters. Special attention is given to understanding and minimizing fees and expenses associated with mutual fund investing. Important student messages fundamental to this chapter are (1) the importance of understanding why investors use mutual funds within an investment plan, and (2) how mutual funds can be used to accomplish financial planning goals.

CHAPTER SUMMARY

This chapter introduces the concept of mutual fund investing as an easy, affordable, and risk-reducing extension of stock, bond, and real estate investing. Advantages and disadvantages of mutual fund investing are presented. Pricing issues, fees, and expenses relating to mutual fund investing are presented in detail. The net asset value formula is presented. To help investors choose among the approximately 8,000 mutual funds, the text provides guidelines for selecting mutual funds, with recommendations on establishing investment goals, identifying funds that meet objectives, and evaluating funds. Sources and examples of mutual fund information are presented and discussed.

LEARNING OBJECTIVES AND KEY TERMS

After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms:

1. Weigh the advantages and disadvantages of investing in mutual funds.a. mutual fund

2. Differentiate between types of mutual funds and investment trusts.a. investment companyb. open-end investment company or mutual fundc. net asset valued. closed-end investment company or mutual fund e. unit investment trust

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

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f. real estate investment trust or REIT g. loadh. load fundi. back-end loadj. no-load fundk. expense ratiol. turnover ratem. 12b-1 fee

3. Calculate mutual fund returns4. Classify mutual funds according to objectives.

a. money market mutual fundsb. tax-exempt money market mutual fundsc. government securities money market mutual fundsd. stock fundse. balanced mutual fundsf. asset allocation fundsg. life-cycle fundsh. target retirement fundsi. bond fundsj. exchange traded funds (ETFs)

5. Select a mutual fund that’s right for you.a. mutual fund prospectus

CHAPTER OUTLINE

I. Why Invest in Mutual Funds?A. Advantages of mutual fund investingB. Disadvantages of mutual fund investingC. Mutual Fund-Amentals

II. Investment CompaniesA. Open-end investment companies or mutual fundsB. Closed-end fund or investment companyC. Unit investment trustsD. Real estate investment trusts (REITs)

III. The Costs of Mutual FundsA. Load versus no-load fundsB. Management fees and expensesC. 12b-1 fees


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IV. Calculating Mutual Fund Returns

V. Types and Objectives of Mutual FundsA. Money market mutual fundsB. Stock mutual funds

1. Aggressive growth funds2. Small-company growth funds3. Growth funds4. Growth-and-income funds5. Sector funds6. Index funds7. International funds

C. Balanced mutual fundsD. Asset allocation fundsE. Life cycle and target retirement fundsF. Bond funds

1. U. S. Government Funds or GNMA bond funds2. Municipal bond funds3. Corporate bond funds4. Bond funds and their maturities

G. ETFs or Exchange traded funds

VI. Mutual Funds ServicesA. Services provided

1. Automatic investment and withdrawal plans2. Automatic reinvestment of interest, dividends, and capital gains3. Wiring and funds express options4. Phone switching5. Easy establishment of retirement plans6. Check writing7. Bookkeeping and help with taxes

VII. Buying a Mutual FundA. Step 1: Determining your goalsB. Step 2: Meeting your objectivesC. Step 3: Selecting a fund

1. Where to look - Sources of information2. Internet screening to find the right mutual fund

D. Making the purchase1. Buying direct2. Buying through a “mutual fund supermarket”


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APPLICABLE PRINCIPLES

Principle 3: Diversification Reduces RiskAn investment of $1,000 or less in a mutual fund provides instant diversification by providing investors with a proportional ownership in up to 1,000 different stocks. It’s this instant diversification that gives smaller investors the same ability to reduce risk and obtain returns that many big investors with lots of money receive.

Principle 4: Diversification and RiskMany investors view the diversification of mutual funds as eliminating all risk. This is incorrect. If there’s a market crash, or if the securities a mutual fund owns are not diversified across industries and the stocks drop in tandem, mutual funds will not provide protection.

Principle 1: The Risk-Return Trade-OffThere are currently more than 8,000 mutual funds actively traded in the U.S., but the level of risk associated with these funds varies dramatically. Investors who purchase risky mutual funds that invest in speculative securities and junk bonds should expect higher returns because they are accepting higher risk.

CLASSROOM APPLICATIONS

1. As an individual or group project, ask students to research mutual funds on the Internet. Provide them with URLs for a variety of investment web sites, or have them start with a comprehensive site such as http://finance.yahoo.com/. Use the fund information factors listed in Classroom Applications 3 as a basis for their research. Share the results with the class.

2. Ask students to research the purchasing process involved in buying no-load mutual funds. Ask them to secure copies (from the Web or by mail) of the account applications for individual and retirement accounts from different mutual fund companies. What kinds of information are requested on the applications? What kinds of mutual fund services must they understand and make decisions about as part of the purchase process? Could they individually complete the application, or would they need assistance from the toll-free information line for the investment company? Would it be worthwhile to pay a commission for purchase assistance, or would they “go it alone?”

3. Share copies of Morningstar or Value Line mutual fund analysis reports with the class.

Bring several copies of recent Friday editions of The Wall Street Journal. Ask students to locate the following information:

Current net asset value (NAV) and most recent NAV change


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Fund family, fund name, and ticker symbol Fund investment objective and investment style Manager’s history Year-to-date and 4-week returns 1-, 3-, and 5-year historical performance Category rating Morningstar or Value Line rating Calendar-year return compared to the S&P 500, or other applicable index Percent of portfolio invested by market capitalization and sector weightings Fund fees and expenses

Request students share the results of their search. Ask students why net asset values vary among funds. Do they see any correlation among commissions charged, annual expenses, and year-to-date returns? Why might an individual’s actual returns from a mutual fund be higher or lower than the returns reported in the paper? Would they invest in the mutual fund? Why or why not?

4. Encourage students to visit the web sites for any of the major mutual fund investment companies to review the general information about mutual funds and mutual fund investing. Many companies offer an “investment university” or other section that provides fundamental information on mutual fund investing. Ask the students to compare and contrast the information on two separate sites, assessing the content, level of instruction, and ease of use.

REVIEW QUESTION ANSWERS

1. Mutual funds work by pooling investors’ money, and then investing the funds in stocks, bonds, and various short-term securities. Professional managers oversee these investments. Basically, when you purchase shares in a mutual fund, you are buying a fraction of a very large portfolio, and this helps diversify your holdings, thus reducing unsystematic risk.

Mutual funds simply offer a way of holding a basket of investments like stocks and bonds. However, a mutual fund, specifically an open-ended mutual fund, is very different from individual stocks and bonds because they are not traded on the secondary market. Shares of an open-ended mutual fund are always bought and sold directly from the investment company. Conversely closed-ended mutual funds are traded on the secondary market.

2. Advantages of mutual funds include: Diversification: mutual funds are an inexpensive way to diversify, because when

someone purchases shares in a mutual fund, they are purchasing a small fraction of the already diversified holdings of the mutual fund. This directly relates to the idea of Principle 8: Risk & Return go Hand in Hand.



Professional management: because fund managers control millions of dollars, work full time managing assets, and have access to the best research, professional managers are in a good position to evaluate investments. Mutual funds provide an inexpensive way to gain access to professional management.

Minimal transactions costs: because mutual funds trade in such large quantities, they pay far less in terms of commissions than individual investors.

Liquidity: mutual funds are liquid enough to provide easy access to money. Flexibility: since there are over 7,000 mutual funds, there should be a fund for every

conceivable investment objective. Service: mutual funds provide services like bookkeeping, checking accounts, automatic

systems to add or withdraw from accounts, reinvestment options, and the ability to buy or sell with a single phone call.

Avoidance of bad brokers: mutual fund managers only make money when their investors make money. Brokers make money by trading. Thus, with a mutual fund, investors avoid potential bad advice, high sales commissions, and churning that can come with a bad broker.

3. Disadvantages associated with mutual funds include: Lower-than-market performance: only 15 percent of all mutual funds beat or tied the

performance of the S&P 500 index between 1985 and 2000. Costs: some funds charge sales fees and high annual expense fees. The higher the costs

associated with some mutual funds, the lower overall returns. Risks: in an attempt to boost performance and beat the “market” some mutual fund

managers take very specialized and segmented investment approaches that have the effect of increasing risks. Non-diversified mutual funds (e.g., sector funds) pose greater risks than diversified mutual funds.

Systematic risk: Principle 4 says that investors can't diversify away market risk. In the case of a market crash, most mutual funds will also lose value.

Taxes: mutual funds tend to trade frequently, and when they sell a security for a profit, investors have to pay taxes on such capital gains.

4. Systematic risk results from factors that affect all stocks, such as political unrest, economic uncertainty, or war. The term systematic refers to something that affects the entire system, in this case, risk. Principle 4 states that systematic risk is non-diversifiable.

5. Three ways mutual fund investors make money include: As the values of all the securities held by the mutual fund increase, the value of each

mutual fund share also goes up. Dividends. If the fund sells a security for more than it originally paid for it, the shareholders will

receive this appreciation as a periodic capital gain distribution.


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All three are included in the total return calculation. Adding the dividends and capital gains to the period price difference solves this formula. This sum is then divided by the original price.

6. A mutual fund, or investment company, is generally set up as a corporation or trust and is owned by the fund shareholders, who elect a board of directors. The fund is actually run by a management company. Management companies like Fidelity and Vanguard typically manage many different mutual funds; however, an investment advisor, or team of advisors, oversees the day-to-day operation of each fund. In this position, the advisor chooses investments, directs allocations, and monitors performance. The investment advisor, usually from the management company, receives a percent of the total value of the fund on an annual basis as compensation. This annual management fee (charged by all mutual funds) is usually included with other operating expenses in the total expense ratio of the mutual fund. These expenses normally run between 1/4 percent and 2 percent, although it can be much more.

7. Four types of investment companies include: Open-end investment companies: the term open-end investment company refers to the

“typical” mutual fund. This type of investment company can issue an unlimited number of ownership shares. In other words, as many people who want to invest in a mutual fund can always buy shares.

Closed-end fund: a closed-end fund company, also known as an investment company, can't issue new shares in response to investor demand. A closed-end fund has a fixed number of shares and all shares trade on a supply and demand basis, more like common stock than mutual funds. Often shares in some closed-end funds actually sell above or below their net asset value.

Unit investment trusts: a unit investment trust is simply a fixed pool of securities, with each unit representing a proportionate ownership in that pool. Unit investment trusts are not managed. These trusts are most appropriate for long-term investors.

Real estate investment trusts (REITs): a REIT is similar to a mutual fund, but instead of pooling investors’ money to purchase stocks, bonds, and short-term securities, a REIT manager uses the pooled money to purchase real estate.

8. REITs (real estate investment trusts) are similar to mutual funds in almost every respect except that REITs specialize in real estate rather than securities. A REIT must collect at least 75 percent of its income from real estate and must distribute at least 95 percent of that income in the form of dividends. There are three different types of REITs: equity, mortgage, and a hybrid of the two. REITs are useful as a diversification tool, because they do not move closely with the general stock market.

9. A load fund charges a sales commission to purchase and sometimes to sell shares. A no-load mutual fund does not charge a commission to purchase or sell shares. Generally, load funds



are sold through brokers, financial advisors, and financial planners. Commissions on load funds can be quite large, typically in the 4 percent to 6 percent range. No-load funds are generally sold directly to investors by investment companies or through no-load mutual fund supermarkets.

A back-end load, or contingent deferred sales charge (CDSC), is a commission charged to the investor when shares are redeemed, typically within a certain period of time from initial purchase. The charges normally decrease with time but can be as much as 5 percent. Marketing fees or “12b-1” fees are annual fees that range from 1/4 percent to 1 percent or more and cover marketing expenses, such as direct mail or television advertising. These fees do not benefit the investor at all and should be avoided.

10. Expenses ratios, which typically range from 0.25 percent to 2.0 percent of the value of the portfolio, include the following costs: Salaries for advisors, custodians, transfer agents, and underwriters. Security trading commissions Legal fees Operating expenses

All of these expenses are paid from the assets of the mutual fund; therefore, the total cost of these expenses increases as the value of the portfolio increases. This then reduces the value of the portfolio and the subsequent NAV of the shares. Since the NAV is being reduced by the cost of the expenses it counteracts the increases realized with investment gains and negatively impacts the long-term performance of the fund.

The primary expense not included in the expense ratio is the 12b-1 fee. The fee does not benefit current share holders at all because it is used to cover the costs of promotion and marketing – nothing to do with investment management or performance.

All expenses hurt the net return to the shareholders. For example if the fund had a gross return of 9 percent, but had an expenses ratio of 1.25 percent and charged a 12b-1 fee of 0.50 percent then the net return to the shareholders is only 7.25 percent.

11. The six major classes of mutual funds are: Money market mutual funds Stock mutual funds Balanced mutual funds Asset allocation funds Life cycle and target retirement funds Bond fundsBalanced funds and asset allocation funds are quite similar in that both invest in a mix of stock, bonds, and money market securities. Asset allocation funds differ from balanced


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funds because they move money between stocks and bonds, change their asset allocation, in an attempt to outperform the market. In effect, asset allocation funds can be viewed as balanced funds that practice market timing.

12. Money market mutual funds invest primarily in Treasury bills and other very short-term notes, unless they are tax-exempt funds or government securities funds, in which case they invest in municipal debt or government securities respectively, in any case the investments typically have maturities of less than 30 days. Because these investments are of such short maturity, they are considered practically risk free, especially the government securities money market mutual funds.

13. An index fund is one that tries to track a market index like the S&P 500 or the Dow Jones Industrial Average. This is accomplished by buying the same stocks, in the same proportions that comprise the index. Index funds tend to outperform other mutual funds because of their very low expense ratios, which can be anywhere from .25 percent to 1.25 percent lower than those on other funds. Index funds don't try to beat the market; they just mimic the market and provide diversification.

14. The three major types of bond funds are government, municipal, and corporate. The primary advantage of owning government bonds is that they are considered default risk free. A secondary advantage of government issued Treasury bonds is the income tax advantage. The primary advantage of owning municipal bonds is the income tax advantage. Corporate bonds do not have a specific advantage, but they do normally pay a higher coupon rate than either government or municipal bonds.

15. An ETF is a hybrid between a mutual fund and an individually traded security, and most ETFs track an market index such as the NASDAQ 100, S&P 500, or the Wilshire 5000; a sector of the market; or a particular geographic region. Unlike mutual funds, these investments can be traded throughout the day on the American Stock Exchange.

16. Trading ETFs may increase the total cost of ownership because there is a commission to the broker and the trader handling the transaction charges a bid-ask spread. These two costs are not directly incurred when buying and selling open-ended mutual funds.

17. Mutual funds offer many services to their customers; here are seven of the most noteworthy: Automatic investment and withdrawal plans: By establishing an automatic investment

plan, you essentially make your investments an expense, with the added benefit of reducing risk through dollar cost averaging.

Automatic reinvestment of current income: this plan functions very similarly to compound interest. By having your interest, dividends, and capital gains reinvested you then begin to earn a return on the shares just purchased.



Wiring and funds express options: this allows the fund company to directly deposit funds into your bank account for easy access, or, more importantly, allows you to make same day purchases of your mutual fund from your bank account to make investing easier.

Telephone switching: benefits the customer by adding flexibility and ease when changing your portfolio allocation.

Retirement plans: some of the easiest retirement plans to establish are with mutual funds. The investment company provides you with all the necessary paperwork and then handles all of the administrative duties, normally for a nominal periodic custodial fee.

Check writing: with the check writing privileges, the account functions like an interest bearing checking account - though normally restricted to money market mutual funds.

Bookkeeping and tax help: though not all companies offer “tax cost” analysis, most offer clear and concise statements showing account value, average annual return, and total shares owned.

18. An automatic investment plan relates to Principle 10: Just Do It! This benefits the investor because these plans automatically deduct a predetermined amount of money on a fixed interval from a checking or savings account and deposits that money into the mutual fund account. This automates the process and forces the investor to continue investing rather than spending their money.

19. The first step in buying a mutual fund involves determining exactly what your investment goals are and the time horizon associated with meeting those goals. Second, you must identify mutual funds that meet your objectives. Information to look for includes: the fund's goals and investment strategy, the fund manager's past experience, any investment limitations, any tax consequences, redemption rules, services provided, 10-year performance record, fund fees and expenses, and the fund's annual turnover ratio. Finally, once a fund has been found, you must closely review the fund's past performance and scrutinize the costs associated with the funds.

20. A mutual fund supermarket, such as the one from Schwab, is a service that allows investors to purchase multiple mutual fund families from one source for little or no fee. The company that provides the service receives their income directly from the mutual funds rather than charging a commission to the investor. The greatest advantage of working with a mutual fund supermarket is that you receive a consolidated statement of all your holdings rather than one statement from each fund family.

PROBLEM AND ACTIVITY ANSWERS

1. The net asset value for the mutual fund in question is $19.38.


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2. The following calculations assume a 10 percent per year price appreciation over the 2-year holding period. Beginning value = [initial investment x (1 – applicable up-front commissions)]

o Class A = [$2,500.00 x (1 – 0.055)] = $2,362.50o Class B = [$2,500.00 x (1 – 0.0)] =$2,500.00o Class C = [$2,500.00 x (1 – 0.0)] =$2,500.00

Net percentage return = gross percentage return – expenseso Class A = 10% – 0.90% – 0.25% = 8.85%o Class B = 10% – 0.90% – 0.50% = 8.60%o Class C = 10% – 0.90% – 1.00% = 8.10%

Commissions = [transaction amount – sales charge] Initial commission (Class A only) = purchase amount x commission rate

o Class A = $2,500.00 x 0.055 = $137.50 Back-end (CDSC) commission (Class B and C only) = sales amount x commission rate

First determine ending “sales” valueSales Price:o Class B FV = $2,948.49

PV = $2,500; N = 2; I/Y = 8.6% “Net return”; PMT =$0; o Class C FV = $2,921,40

PV = $2,500; N = 2; I/Y = 8.1% “Net return”; PMT =$0;

Commission:o Class B = $2,948.49 x 0.040 = $117.94 (4% sales charge in second year)o Class C = $2,921.40 x 0.000 = $0.00 (0% sales charge after first year)

Total dollar expenses = [value of gross return – value of net return] 2-year gross dollar return (All share classes)

= [beginning value x (1 + gross return# of years)] – beginning valueo Class A = [$2,362.50 x 1.102] – $2,362.50 = $496.13o Class B = [$2,500.00 x 1.102] – $2,500.00 = $525.00o Class C = [$2,500.00 x 1.102] – $2,500.00 = $525.00

2-year net dollar return = [beginning value x (1 + net return# of years)] – beginning value

o Class A = [$2,362.50 x 1.08852] – $2,362.50 = $436.67o Class B = [$2,500.00 x 1.08602] – $2,500.00 = $448.49o Class C = [$2,500.00 x 1.08102] – $2,500.00 = $421.40



Total (2-year) expenseso Class A = $496.13 – $436.67 = $59.46o Class B = $525.00 – $448.49 = $76.71o Class C = $525.00 – $421.40 = $103.60

3. Growth funds = I Balanced funds = BU.S. Government bond funds = J International funds = AGrowth and Income funds = F Small company funds = KLife cycle funds = G Asset allocation funds = DSector funds = E Aggressive growth funds = HIndex funds = C

4. Your total return in the Zap fund is 35.32% according to the following formula:

Current income = dividends + capital gains $6.70 = $2.10 + $4.60

Capital gain or loss = ending NAV – beginning NAV $7.11 = $46.21 – $39.10

5. Thomas’s total return including reinvestment is 64.10 percent as shown below:

This shows that although the NAV increased by only 23.85 percent, his account value increased by over 64 percent because of the reinvestment of current income.

6. Class B would be the better investment for someone who knows that the fund will be sold at the end of five years. For this length holding period the negative impact of front-end loads outweighs the negative impact of a higher annual fee. However, with a longer time horizon the higher annual fee charged by class B and C shares will allow the total returns of the A shares to surpass. Net percentage return = gross percentage return – expenses

o Class A = 12% – 0.55% – 0.25% = 11.20%o Class B = 12% – 0.90% – 0.50% = 10.60%o Class C = 12% – 1.00% – 1.00% = 10.00%

Initial commission = purchase amount x commission rateCopyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

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o Class A = $10,000.00 x 0.0575 = $575.00 Back-end (CDSC) commission = sales amount x commission rate

(First determine ending “sales” value)o Class B = $16,549.15 x 0.010 = $165.49 (1% sales charge in fifth year)o Class C = $16,105.10 x 0.000 = $0.00 (0% sales charge after first year)

Total ending “sales” value after commissions = net investment less any remaining CDSCo Class A = [$9,425 x 1.11205] = $16,025.27o Class B = [$10,000.00 x 1.10605] x [1 – 0.010] = $16,383.66o Class C = [$10,000.00 x 1.10005] = $16,105.10

7. a. She would pay $12.00/sh for the open-end fund and $21.95/sh for the closed-end fund. b. Because the closed-end fund is selling for less than its NAV it is trading for a discount.

The amount of the discount is $2.10 ($24.05 – $21.95) per share. c. No, because the closed-end fund is selling at a discount, it is possible that the fund is

not widely traded and therefore lacks liquidity. Remember, closed-end funds are bought and sold in the secondary market similarly to stocks and bonds, so the price is partly depended on supply and demand.

8. a. Ending investment value, no reinvestment, and assuming dividends are paid at year end(This is simpler to solve using Excel or other spreadsheet. Furthermore, the numbers as shown may not add to the actual amounts shown due to rounding error.)

YearBeg

(No reinvest)Cap App (7.4%) End

Dividends (2.1%)

Total Value (End + Div)

1 $10,000.00 $740.00 $10,740.00 $225.54 $10,965.542 $10,740.00 $794.76 $11,534.76 $242.23 $12,002.533 $11,534.76 $853.57 $12,388.33 $260.15 $13,116.254 $12,388.33 $916.74 $13,305.07 $279.41 $14,312.405 $13,305.07 $984.58 $14,289.65 $300.08 $15,597.06

Total Div = $1,307.41

b. Ending investment value, with reinvestment, and assuming dividends are paid at year end. (Again, this is simpler to solve using Excel or other spreadsheet. Furthermore, the numbers as shown may not add to the actual amounts shown due to rounding error.)

YearBeg

(With reinvest)Cap App (7.4%) End

Dividends (2.1%)

Total Value (End + Div)

1 $10,000.00 $740.00 $10,740.00 $225.54 $10,965.542 $10,965.54 $811.45 $11,776.99 $247.32 $12,024.313 $12,024.31 $889.80 $12,914.11 $271.20 $13,185.314 $13,185.30 $975.71 $14,161.01 $297.38 $14,458.405 $14,458.40 $1,069.92 $15,528.32 $326.09 $15,854.41

Total Div = $1,367.53



c. The difference of $257.35 ($15,854.41 – $15,597.06) is attributable to the compounded return of the reinvested dividends.

9. The total cost for purchasing 100 shares equals the cost:a. Investment cost + Transaction fees = [$19 x 100] + [($19 x 100) x 0.04] = $1,976.00b. Investment cost + Transaction fees = [$19.50 x 100] + 0 = $1,950.00c. Investment cost + Transaction fees = [$19.25 x 100] + $15 = $1,940.00

10. a. The lower cost alternative to purchase is the no-load fund as it doesn’t charge a transaction fee.

b. Without considering the transaction fees the lower cost to own for 6 months is the ETF. Investing in the mutual fund would result in a net gain of 6.575% (7% - (0.85%/2)), whereas investing in the ETF would result in a net gain of 6.875% (7% - (0.25%/2)).

However if you consider the transaction fee of the ETF the answer can vary based on the amount purchased. To determine the “breakeven amount” divide the fee by the difference in return. If the difference in the fee (0.3% semi-annually) is considered then the transaction amount must be above $6,666.66 (20 / 0.3%) for the ETF to be a better deal.

c. Without considering the transaction fees the lower cost to own for 2 years is again the ETF. Investing in the mutual fund would result in a net gain of 19.14% (10% - 0.85%)2, whereas investing in the ETF would result in a net gain of 20.05% (10% - 0.25%)2.

However if you consider the transaction fee then the transaction amount must be above $2,197.80 (20 / 0.91%) for the ETF to be a better deal.

d. Without considering the transaction fees the lower cost to own for 2 years is again the ETF. Investing in the mutual fund would result in a net loss of 22.88% (-10% - 0.85%)2, whereas investing in the ETF would result in a net gain of 21.55% (-10% - 0.25%)2.

However if you consider the transaction fee then the transaction amount must be above $1,503.76 (20 / 1.33%) for the ETF to be a better deal.

DISCUSSION CASE 1 ANSWERS

1. Telecommunication stocks tend to be quite volatile and, with $15,000 to invest, it would be very difficult for Rick to achieve adequate diversification. A mutual fund will provide Rick


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with diversification, professional management, minimal transaction costs, liquidity, flexibility, and a number of useful services.

2. Rick should consider investing in a telecom or aggressive growth fund, although he should not invest entirely in one fund or in one sector. He might also look into an index fund or other diversified growth fund. These types of mutual funds attempt to maximize capital appreciation. While these funds offer almost unlimited future growth, they also are more risky than bond funds or growth and income funds. Rick’s best move would be to thoroughly research several mutual funds of various styles and sectors and to choose two or three funds that best meet his investment objective and time horizon.

3. There are many factors to be considered when investing in the securities markets. Rick should first consider his risk and volatility tolerance. Will he be able to sleep after a gain of 10 percent one day and a loss of 12 percent the next? Second, he should define his investment objective and time horizon; a high-tech mutual fund would not be appropriate if Rick needs the money in two years. After narrowing his choices, Rick should thoroughly evaluate the fund, including everything from manager’s tenure to turnover ratio and from fund fees to investment services. Last, but not least, he would be advised to periodically monitor his investment choices.

4. Mutual funds provide diversification, but they do not eliminate all risk. By purchasing only one fund, Rick will be subject to business risk: the risk of poor decisions made by the company. Also, no matter how many funds he purchases, he will always be subject to systematic risk: risk that affects the entire market as a whole.

5. Closed-end funds don't sell directly to investors, nor will they buy back shares upon demand. The price of the shares in a closed-end fund is determined by supply and demand for those shares, not by their net asset value. Therefore, shares in some closed-end funds sell above, while others sell below, their net asset value. Thus, if Rick is worried about liquidity and marketability, he should invest in open-end mutual funds, which will always repurchase their shares.

6. The bottom line is that Rick should keep his expenses as low as possible; expenses erode returns. Expenses only benefit the company, not the investor. Rick should avoid funds with sales commissions and instead seek out no-load funds with minimal expenses.

7. The results of the students will vary but should consider both risk and volatility.

DISCUSSION CASE 2 ANSWERS



1. Because of her short, three-year time horizon, she needs very safe and liquid investments. A money market mutual fund or a short-term high-quality bond fund would be appropriate in meeting Mahalia's objective, because one of the objectives of both investment alternatives is preservation of capital.

2. Sources like Morningstar, The Wall Street Journal, Lipper Analytical Services, Consumer Reports, Business Week, Kiplinger's Personal Finance, Smart Money, Money, Value Line, and Mahalia's local newspaper are all good published sources of mutual fund ratings. However, some of the most comprehensive investment information is found on the Internet.

3. Mahalia should look for the following information when reviewing a mutual fund prospectus: The fund's goal and investment strategy. The fund manager's past experience. Any investment limitations that the fund may have. Tax efficiency and any tax considerations important to investors. The investment and redemption process for buying and selling shares. Services provided to investors. Performance over the past 10 years or since the fund’s inception. Fund fees and expense ratios. The fund's annual turnover ratio.

4. A fund's past volatility and investment approach tend to continue into the future. There is some, albeit weak, evidence of consistency in fund performance. Looking only at short-term performance won't help Mahalia gauge a fund's future performance, but a review of past performance can give her further insights into the philosophy and style of the fund.

5. Loads, fees, and expenses are extremely important given Mahalia's goal. Given her short-term time horizon and a need to maximize annual returns, she should be very aware of any mutual fund expenses and try to avoid them if at all possible. Mahalia should avoid funds with sales commissions and instead seek out no-load funds with minimal expenses.

6. Six reasons why a bond fund might appeal to Mahalia are: Immediate diversification Liquidity (open-ended funds) Professional management Regular income Bonds can be bought directly from a broker Bond funds don’t mature

7. For safety, income, and liquidity, Mahalia should consider purchasing a U.S. Government bond fund or a AAA corporate bond fund.


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8. The shorter-term bond funds are generally more stable; however, they also offer lower annual returns. Bond funds do not have a specific maturity, but do maintain an average weighted maturity, based on current portfolio holdings. Mahalia should match the average maturity to her investment horizon.

9. Student answers may vary, but any four of the following six basic services would be correct: Automatic investment and withdrawal plans: this would benefit Mahalia if she would

like to continue investing on a periodic basis. By establishing an automatic investment plan, she essentially makes her investments an expense, with the added benefit of reducing risk through dollar cost averaging.

Automatic reinvestment of interest, dividends, and capital gains: automatic reinvestment has the same effect as compound interest in speeding the accumulation of wealth with a mutual fund.

Wiring and funds express options: this allows the fund company to directly deposit funds into Mahalia’s bank account for easy access, or, more importantly, allows her to make same day purchases of her money market or bond mutual fund from her bank account.

Telephone switching: this service allows Mahalia to move money from a bond fund to a money market fund simply by making a phone request. As she gets closer to her goal, this service will be of great value.

Easy establishment of retirement plans: IRA, 401(k), and Keogh plans are all available and relatively easy to establish using the forms provided by the find company. The fund company even handles the administrative duties after the plan is established.

Check writing: when Mahalia finally needs money to make a down payment on a house, all she will need to do is write a check from her money market account.

Bookkeeping and help with taxes: calculations associated with tax issues related to mutual funds can often get complicated. Some larger mutual fund companies provide bookkeeping services to make this easier.


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