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Mutual Funds

Mutual Funds. Chapter 14. Understanding Mutual Funds. A pool of money from numerous investors used to invest in a portfolio of securities—managed by a professional portfolio manager When you own shares in a mutual fund, you own a small part of the portfolio

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Mutual Funds

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  1. Mutual Funds Chapter 14

  2. Understanding Mutual Funds • A pool of money from numerous investors used to invest in a portfolio of securities—managed by a professional portfolio manager • When you own shares in a mutual fund, you own a small part of the portfolio • Distributions of interest income, dividend income and capital gain/losses occur to investor in terms of the proportion of the total number of mutual fund shares owned

  3. Understanding Mutual Funds • There are over 8,200 mutual funds today • Compared to about 600 in 1980 • The net assets of mutual funds is about $7 trillion • Why are they so popular? • Bull market for stocks and bonds • Growth of self-directed retirement plans

  4. Figure 14.1: Growth of Mutual Funds

  5. How a Mutual Fund Operates • A mutual fund raises money by selling shares of the fund to the investing public • The funds are used to purchase assets such as stocks, bonds, money market securities, etc. • The shareholder of the mutual fund is said to indirectly own the assets held by the mutual fund • AKA open-ended investment companies • Constantly issues new shares and redeems existing shares

  6. How a Mutual Fund Operates • The fund’s NET ASSET VALUE represents • The market value of the fund’s assets less any liabilities, divided by the number of shares outstanding

  7. How To Buy Mutual Fund Shares • Can purchase either: • Through your stockbroker or • Directly from the mutual fund • Check the fund’s website • Review the fund’s prospectus • States the fund’s investment objectives, types of securities it can purchase, fees, recent performance • Send in your application along with a check

  8. Services Offered • Automatic reinvestment of distributions • Effectively increases the number of shares you own • Automatic investment plans • Can be as little as $50 a month • Exchange privileges • Transfer within fund family • Check writing • Mostly money market funds (and a few others) allow minimum checks ($500+ each) • Doesn’t replace a regular checking account

  9. Regulation and Taxation • Regulated by SEC • Must present certain types of information in prospectus and other reports • Limits types of advertising • If mutual fund retains investment profit, it must pay taxes on it; therefore, most mutual funds distribute the gains to shareholders • Shareholders must report these distributions for tax purposes, as well as any gain/loss on redemption of shares

  10. Where to Get Mutual Fund Information • Internet • Money’s February issue is heavily devoted to mutual funds • The Wall Street Journal publishes a mutual fund section regularly

  11. Web Links • Information about mutual funds: • www.morningstar.com

  12. Classifying Mutual Funds • Can be classified based on • Investment objectives • Investment style • Types of securities owned by fund • Stocks • Bonds (or income) • Hybrid (balanced) • Money market

  13. Figure 14.2: Distribution of Mutual Fund Assets

  14. Classifying Mutual Funds • Common subcategories for stock funds • Aggressive growth • Growth and income • Long-term growth • Small-company growth • International • Common subcategories for bond funds • Government • High-yield corporate (junk bonds) • Investment-grade corporate • World income

  15. Classifying Mutual Funds • Common subcategories for money market funds • Government • Taxable • Tax-exempt

  16. Mutual Fund ‘Styles’ • Even mutual funds that fall into the same subcategory can have different management styles • One fund may try to achieve growth by investing in stocks with potential for strong earnings growth; whereas • Another fund may try to achieve same objective by selecting stocks it currently believes to be currently undervalued in the market

  17. Different Fund Types • Some fairly new fund types • Asset allocation funds • Invest in a mixture of stocks, bonds and money market instruments, shifting allocation of money in an attempt to gain high returns with low risk • Index funds • Attempt to replicate performance of a major stock index (most popular is S&P 500) • Why are these so appealing? • Very low fees (not that much management to be done) • Most mutual fund managers can’t consistently outperform the market • Sector funds • Invest only in one industry

  18. Advantages of Mutual Funds • Diversification • Can increase your return without increasing your risk (or may even reduce your risk) • But doesn’t eliminate risk! • Not all mutual funds are diversified—they’re not meant to be

  19. Advantages of Mutual Funds • Smaller minimum investments • Can purchase a piece of a well-diversified portfolio for a relatively small investment • Money market mutual funds minimum investment  $1,000 • Stock and bond mutual funds minimum investment  $1,000 - $3,000 (less for IRAs) • Additional investments can be as little as $50 - $100 • Many funds offer automatic investment plans that require initial investments of as little as $50

  20. Advantages of Mutual Funds • Professional Management • Do all mutual funds always beat the market? • Over the past 10 years, stock funds have had an average annual return about 2% less than the S&P 500 (10.8% vs. 12.7%)

  21. Picking the Right Mutual Funds • Step 1: Choose your investment goals and assess your risk/return position • You can then identify the types (group) of mutual funds that meet your criteria • Step 2: Assess the fees and performance of the mutual funds

  22. Fees and Expenses • Several types of fees • Load Charges: fees associated with either buying or redeeming mutual fund shares • Front-end—paid when shares are purchased • Cannot exceed 8.5% • Example: You deposit $1000 in a fund with a 2% front-end load—only $980 goes toward purchase of shares, the remaining $20 is a fee • Most funds use front-end loads with very few actually charging the maximum 8.5% • Redemption fee (back-end load)—paid when shares are sold • Often depends on how long the shares were owned—with a lower fee charged for a longer holding period

  23. Fees and Expenses • Trend is toward low front-end loads or no-loads • No charges associated with buying or selling the mutual fund • Over half of all mutual funds are no-load • Annual operating expenses • Includes fees paid to portfolio manager, transaction costs, printing costs • Paid from investment income before it is distributed • Average is about 1.5% for stock funds; 1.1% for bond funds • 12b-1 fees • Pays for distribution costs (such as advertising) in lieu of a load charge

  24. Fees and Expenses • Evaluating fees and expenses • Not all funds charge the same operating fee %—shop around • Can range from 0.1% to 2.5+% • Fees and expenses can have a dramatic impact on the value of your investment over time • No definitive evidence shows that funds charging higher fees earn higher returns • Everything else being equal, you’re better off buying a no-load fund with low operating costs

  25. Performance • Need to examine absolute performance AND relative performance as well as risk • When comparing fund to a benchmark, choose the right benchmark

  26. The Relationship Between Past and Future Performance • Some funds beat the market some years and not others • Should we try to predict which funds will beat the averages next year (or during the next 5 years) or not? • Randomly choosing funds will probably lead to the same results according to some people • Others argue that superior funds may under-perform some years, but over the long run produce superior returns

  27. The Relationship Between Past and Future Performance • Results are mixed • Conclusion • Don’t chase returns—the fees are too great and your results probably won’t be stellar • Past performance in NO WAY GUARANTEES FUTURE PERFORMANCE

  28. Performance and Taxes • Mutual funds pass along income/gains to shareholders as distributions, so that the mutual fund does not have to pay taxes • The more distributions paid to you, the more taxes you’ll pay

  29. Performance and Taxes • Example: Compare the after-tax return on these two funds (assuming a 28% tax bracket) • For both funds the value of the securities held rose • Fund A did not sell the securities • Fund B did sell and passed the gain along to shareholders (who had to pay taxes on the gain)

  30. When Not to Buy Mutual Fund Shares • Most mutual funds have regularly scheduled distribution dates • For tax purposes, shouldn’t buy shares in a mutual fund right before a distribution • You’d owe taxes on that immediate distribution

  31. What About Index Funds • Designed to track performance of a broad stock or bond market index • Most popular track the S&P500 • Number of index funds has grown rapidly

  32. Managing Mutual Fund Investments • Lump-Sum Investing vs Dollar Cost Averaging • Lump-Sum Investing • Invest a lump sum (presumably a larger amount) all at once • Dollar Cost Averaging • Investing an equal amount at regular intervals (presumably smaller amounts than a lump sum) • This is what would happen if you had automatic withdrawal from checking account to a mutual fund • Under certain conditions can lead to a higher return than a lump sum purchase • If NAV declines during the year you can end up buying more shares than you would have had you lump summed • Your ultimate return would be greater in this instance

  33. Making Changes to Your Mutual Fund Investments • Will your goals remain the same for the next 30-40 years? • No—the mix of your investments will need to change over time • You’ll also need to rebalance over time • Adjusting investments periodically to return to the target asset allocation

  34. Rebalancing • Example: You’ve decided you want an investment mix of 50% of your wealth in an aggressive growth fund and 50% in an international stock fund. • You place $1,000 in each fund at the beginning of the year • The aggressive growth fund earns 42% and the international stock fund earns 15.7%. • Your wealth is now at this weight:

  35. Rebalancing • How do you accomplish a rebalancing? • Sell shares in the over-weighted fund and buy some shares in the under-weighted fund or • When you invest additional money, put more of it into the under-weighted fund

  36. When to Sell a Mutual Fund • One reason many people sell shares is due to poor performance • BUT, selling shares based on poor short-term performance may be a bad idea • Are you chasing past returns? • This rarely produces superior returns over the long run • Even the best funds have poor performance at times • If you have a good fund, keep it even if it offers poor short-term performance

  37. When to Sell a Mutual Fund • There are viable reasons for selling a fund • Performance lags benchmarks for an extended time period (3 years or so) • Fund gets very large very fast • Expenses keep rising • Fund is trying to capitalize on its popularity • Management turnover

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