Chapter 15

1. Chapter 15 Mutual Funds: An Easy Way to Diversify

2. Learning Objectives • Weigh the advantages and disadvantages of investing in mutual funds • Differentiate between types of mutual funds, ETFs, and investment trusts • Calculate mutual fund returns • Classify mutual funds according to objectives • Select a mutual fund that’s right for you

3. Introduction • Mutual fund - an investment that raises money from investors, pools the money, and invests it in stocks, bonds, and other investments • Each investor owns a share of the fund proportionate to his/her investment • A professional manager will select the securities and manage the fund

4. Figure 15.1 Mutual Fund Growth

5. Table 15.1 A Listing of Sector Diversification and the 10 Largest Holdings of Vanguard’s Windsor II FundInvestments, March 31, 2011

6. Why Invest in Mutual Funds? • Advantages of mutual funds: • Diversification • Professional management • Minimal transaction costs • Liquidity • Flexibility • Service • Avoidance of bad brokers

7. Why Invest in Mutual Funds? • Disadvantages of mutual funds: • Lower-than-market performance • Costs • Risks • You can’t diversify away a market crash • Taxes

8. Mutual Fund-Amentals • A mutual fund pools money from investors with similar financial goals • A mutual fund investor is investing in a diversified portfolio that is professionally managed according to set goals • Investment objectives are clearly stated

9. Mutual Fund-Amentals • As the value of the securities in the fund increases, the value of each mutual fund share also rises • Most pay dividends or interest to shareholders • Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid

10. Mutual Fund-Amentals • Fund is set up as a corporation or trust • Shareholders elect a board of directors • Fund is run by a management company • Each individual fund hires an investment advisor to oversee the fund, supervising buying and selling of securities

11. Figure 15.2 Pooled Investments

12. Investment Companies • A company that invests the pooled money of a number of investors in return for a fee • Open-End Investment Companies or Mutual Funds can issue as many shares as investors want • These account for 95% of all mutual funds • Net asset value (NAV) – the price of a share of a mutual fund. It is updated only once a day, at the end of the trading day

13. Investment Companies • Closed-End Investment Companies • Can’t issue new shares. Once all shares are initially sold, buying and selling takes place between investors • Value of the shares is determined by the value of the investments plus investor demand • Unit Investment Trusts • A fixed pool of securities, generally municipal bonds. Bonds are purchased and held to maturity, at which point the trust is dissolved

14. Investment Companies • Real Estate Investment Trusts (REITs) • Similar to a mutual fund, but invests in real estate such as shopping centers or rental property. • These do not necessarily follow the market, and are subject to risks in the real estate market • Hedge Funds • Have very few controls, charge high fees, very risky, no transparency. Investors must have a net worth of at least $1 million

15. Load Versus No-Load Funds • Load - commission charged on a mutual fund • Load fund - mutual fund on which a load is charged • Class A shares - front-end sales load (when you purchase) • Class B shares - back-end (deferred) load (when you sell) • Class C shares – pay on both purchase and sale • No-load fund - doesn’t charge commission, you deal directly with the mutual fund company

16. Management Fees and Expenses • Expense ratio - the ratio of a mutual fund’s expenses to its total assets (typically .25% - 2% of your investment, even if the fund lost money) • Invest in a fund with a low expense ratio • Turnover rate - measures the level of the fund’s trading activity, the buying and selling of securities • The higher the turnover rate, the higher the fund’s expenses

17. 12b-1 Fees • Annual fee, generally ranging from 0.25% to 1.00% of a fund’s assets, that the mutual fund charges its shareholders for marketing costs • Investors don’t get any benefit from paying this fee • Funds with this fee don’t perform any better than comparable funds without the fee • Try to avoid funds with this fee

18. Table 15.2 Different Mutual Fund Costs

19. Calculating Mutual Fund Returns • Returns can be in the form of dividends, capital gains, or a change in net asset value (price per share) • Automatic reinvestments of dividends result in increases in the NAV and number of shares you own • Calculating returns can help you spot funds that have been consistent winners over time

20. Money Market Mutual Funds • These funds invest in Treasury bills, CDs, and other short-term investments, < 30 days • Carry no loads, trade at a constant $1 NAV, and have minimal expense ratios • A variation is tax-exempt money market fund • Invests only in short-term municipal debt • Government securities money market mutual fund – invests only in government securities

21. Stock Mutual Funds • Aggressive growth funds • Small company growth funds • Growth funds • Growth-and-income funds • Sector funds • Index funds • International funds

22. Figure 15.3 How Mutual Fund Assets Are Invested (Year-End 2009)

23. Balanced Mutual Funds • Tries to balance objectives of long-term growth, income, and stability • Hold both common stock and bonds and sometimes preferred stock • Aimed at those needing income to live on and moderate stability in their investment • Less volatile than stock mutual funds

24. Asset Allocation Funds • Invest in stocks, bonds, and money market securities • Moves money between stocks and bonds to (hopefully) outperform the market by trying to practice market timing

25. Life Cycle and TargetRetirement Funds • Life cycle funds are mutual funds that try to tailor their holdings to the investor’s individual characteristics, such as age and risk • Target retirement funds are managed based on when you plan to retire • The closer you get to retirement, the more conservative the investments

26. Bond Funds • Mutual funds that invest primarily in bonds • Fluctuate in value with market interest rates • Use for small amounts of money, to keep investments liquid • Otherwise, use individual bonds where there is no professional management or fees

27. Bond Funds • U.S. Government Bond Funds or GNMA Bond funds – invest in U.S. securities or government-backed mortgages • Municipal Bond Funds – city or state, generally tax-exempt • Corporate Bond Funds – can be risky • Bonds and their maturities: • Short-term (1-5 years) • Intermediate-term (5-10 years) • Long-term (10-30 years)

28. ETFs or Exchange Traded Funds • An ETF is a hybrid between a mutual fund and an individually traded stock or bond • Trades on an exchange like individual stocks do and can be bought and sold through the trading day • Like a mutual fund, it contains many stocks or other securities

29. ETFs or Exchange Traded Funds • Charge lower annual expenses but still pay trading commissions • More tax-efficient than most mutual funds • Allow investors to stake out an investment position in a sector, industry, or country • Investors can make their move during the market’s trading hours

30. Table 15.3 ETFs Versus Mutual Funds

31. Table 15.4 Advantages and Disadvantages of ETFs

32. Mutual Fund Services • Automatic investment and withdrawal plans – you can make automated regular investments while you are working and withdrawals when you are retired • Automatic reinvestment of interest, dividends, and capital gains • Wiring and funds express options – you can have your funds sent to your bank account on the same day each month

33. Mutual Fund Services • It is easy to manage your funds using the phone and Internet access • Easy establishment of retirement plans – the fund will handle administration and give you support • Check writing with money market mutual funds • Bookkeeping and help with taxes – taxes can be complicated; some funds will assist with this

34. Buying a Mutual Fund • Step 1: Determining Your Goals • Goals and time horizon? When will you need the money • Why are you investing? Income, retirement, education for children? • Tax-deferred investments? • What is your risk tolerance? How risky do you want to be?

35. Buying a Mutual Fund • Step 2: Meeting Your Objectives • Look at (sub)classifications of funds and their objectives • Morningstar provides an investment style box to understand the fund’s investment style

36. Table 15.5 Mutual Fund Information on the Web

37. Table 15.5 Mutual Fund Information on the Web (cont.)

38. Buying a Mutual Fund • Step 3: Selecting the Fund • Where to look—sources of information • Mutual fund prospectus – a description of the mutual fund, including its objectives and risks, its expenses, the manager’s history, and other information • Internet screening to find the right mutual fund – Morningstar and Yahoo Finance

39. Checklist 15.1

40. Table 15.6 What’s in a Mutual Fund Prospectus?

41. Table 15.7 Web Sources for Screening Mutual Funds

42. Typical Online Mutual Fund Quote Chart of performance Name and Ticker Symbol NAV and Change for the Day Increase/ Decrease for the year since January 1 Dividend percentage

43. What does the fund invest in? (Small companies with potential value) Morningstar Rating

44. This box summarizes the investments making up the fund Who is the manager and what is his/her history? What is the minimum and subsequent investment requirements?

45. This box tells the objectives of the fund Dividend, turnover ratio and average for funds in the same category Fees and expenses, as well as averages for funds in the same category

46. How is the money in the fund invested? What are the top 10 stocks in the fund, and how have they done so far this year?

47. Table 15.8 Screening Criteria for Mutual Funds

48. Buying a Mutual Fund • Step 4: Making the Purchase • Buy direct – use phone or internet and deal directly with mutual fund companies • Buy through a mutual fund “supermarket”– such as Fidelity or Charles Schwab, which offer funds from many different families

49. Summary • When you buy a mutual fund, you’re buying a share of a very large portfolio which goes up and down as the value of the mutual fund’s investments goes up and down. • There are open-end and close-end investment companies, unit investment trusts and real estate investment trusts.

50. Summary • Be very wary of mutual fund expenses—no-load mutual funds don’t charge commission. • Funds are classified according to objective. • When selecting a mutual fund, determine your goals, find funds that meet your objectives, and evaluate.