Chapter 16 Investing in Mutual Funds

1. Chapter 16 Investing in Mutual Funds

2. Chapter 16Learning Objectives • Describe the characteristics of mutual fund investments • Classify mutual funds by investment objective • Evaluate mutual funds for investment purposes • Describe how and why mutual funds are bought and sold

3. Why Investors Purchase Mutual Funds Objective 1: Describe the characteristics of mutual fund investments • An estimated 96 million individuals own mutual funds • Mutual funds grew from 361 in 1970 to over 11,000 in late 2006 • In 2006 the combined value of assets owned by mutual funds in the United States totaled over $11.2 trillion

4. Why Investors Purchase Mutual Funds (continued) • The major reasons investors purchase mutual funds are: • 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 • Drawbacks?

6. Why Investors Purchase Mutual Funds (continued) CHARACTERISTICS OF MUTUAL FUNDS • Closed-end funds (3% 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

7. Why Investors Purchase Mutual Funds(continued) CHARACTERISTICS OF MUTUAL FUNDS (con’t) • Exchange-Traded fund • Fund that invests in the stocks contained in a specific stock index • Open-end funds (93% 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)

8. Why Investors Purchase Mutual Funds(continued) Net Asset Value (NAV) = Value of the fund’s portfolio - Liabilities Number of shares outstanding

9. Why Investors Purchase Mutual Funds(continued) 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 Websites or from discount brokers. • 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

10. Why Investors Purchase Mutual Funds(continued) MANAGEMENT FEES AND OTHER CHARGES • Management fee • Charged yearly (0. 5%-1% 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 • Cannot exceed 1% of a fund’s assets per year • Expense Ratio consists of the different management fees and additional fund operating costs for a specific mutual fund: this fee should not exceed 1 percent

12. Classification of Mutual Funds Objective 2: Classify mutual funds by investment objective • 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 • Global stock funds buy stock in companies in the U.S. and other countries

13. Classification of Mutual Funds(continued) • STOCK FUNDS(con’t) • Growth stock funds buy stock in companies with higher-than-average revenue and earnings growth • Index funds buys stocks that mirror an index • International fundsinvest in foreign stocks sold in securities market throughout the world • Large-cap funds invest in companies with capitalization of $10 billion or more

14. Classification of Mutual Funds(continued) • STOCK FUNDS(con’t) • Mid-cap funds invest in companies with total capitalization of $2 to $10 billion • 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 $2 billion • Socially responsible funds avoid investing in companies that produce harmful products

15. Classification of Mutual Funds(continued) • BOND FUNDS • High-yield (junk) bond funds buy corporate bonds that are higher risk and higher yield • 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)

16. Classification of Mutual Funds(continued) • BOND FUNDS (con’t) • 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 corporate bond funds: Investment grade bonds with maturities of 1-5 years • Short-term U.S. bond funds invest in U.S. Treasury issues of 1-5 years • World bond funds buy bonds of foreign companies and governments

17. Classification of Mutual Funds(continued) • 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

18. Classification of Mutual Funds(continued) • OTHER FUNDS - Funds of funds: Invest in shares of other mutual funds - Lifecycle funds: Invest in more risk-oriented securities and become increasingly conservative and income-oriented as a specified retirement date approaches.

19. Classification of Mutual Funds(continued) FAMILY 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

20. How to Decide to Buy or Sell Mutual Funds Objective 3: Evaluate mutual funds for investment purposes MANAGED FUNDS VERSUS INDEXED FUNDS • Most mutual funds are managed funds meaning there is a professional fund manager or a team of managers • An index mutual fund is the mirror image of a specific index

21. How to Decide to Buy or Sell Mutual Funds (continued) MANAGED FUNDS VERSUS INDEXED FUNDS(con’t) • Majority of the managed funds have failed to outperform the S&P 500 index over a long period of time • Index funds have a lower expense ratio, typically around 0.50 percent or less • Consider managed funds vs. indexed funds

22. How to Decide to Buy or Sell Mutual Funds (continued) THE INTERNET • Use web sites to research a fund. • Finance.yahoo.com • www.businessweek.com • www.morningstar.com (also other advisory services, such as Value Line) • www.smartmoney.com

23. How to Decide to Buy or Sell Mutual Funds (continued) HOW TO READ THE MUTUAL FUNDS SECTION OF THE NEWSPAPER • The fund family and fund name • Net asset value • Net Change is the difference between the price paid for the last share today and the price paid for the last share on the previous trading day • Year-to-date percentage of increase or decrease for a fund

25. How to Decide to Buy or Sell Mutual Funds (continued) MUTUAL FUND PROSPECTUS 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

26. How to Decide to Buy or Sell Mutual Funds (continued) • MUTUAL FUND ANNUAL REPORT • Performance, investments, assets and liabilities • FINANCIAL PUBLICATIONS • Business Week, Forbes, Kiplinger'sPersonalFinance and Money are sources of information • Business Week’s Online “Mutual Fund Scoreboard” 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 over selected time periods

27. The Mechanics of a Mutual Fund Transaction Objective 4: Describe how and why mutual funds are bought and sold • You can open an account from $250 to $2,500 and up depending on the fund & family • Open-end, no-load funds can be bought directly from the investment company by phone, mail, online, or from a discount broker • Closed-end or exchange-traded funds are purchased through a securities exchange or in the over-the-counter market

28. The Mechanics of a Mutual Fund Transaction (continued) RETURN OF INVESTMENT • Income dividends: earnings funds pay to shareholders from dividend and interest income (Taxed as regular income) • Capital gains: sell shares at a price > than you paid (Report on Schedule D and 1040) • 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

29. The Mechanics of a Mutual Fund Transaction (continued) Measure return • total dollar return = income dividend + capital gain distribution + change in share market value when sold

30. The Mechanics of a Mutual Fund Transaction (continued) TAXES AND MUTUAL FUNDS • Income dividends are reported on your federal tax return • Capital gain distributions are taxed as long term capital gains regardless of how long you own shares in the mutual fund • Capital gains or losses, when selling the shares are taxed on short-term or long-term basis depending on the length of time the funds are held • Funds reinvested in the purchase of additional shares are still taxable • The “turnover ratio” of a fund affects your tax liability

31. The Mechanics of a Mutual Fund Transaction (continued) PURCHASE OPTIONS (open-ended) • Regular account transaction • Voluntary savings plan • Contractual plan • Reinvestment plan • Automatic investments: Money is taken from your checking account monthly and invested in a fund • Withdrawals: Various withdrawal options; you can withdraw funds by phone, letter, online, etc.

32. Mutual Fund Online Activity • Go online to www.morningstar.com, www.cbsmarketwatch.com or other investment information sites. Research mutual funds • Find a fund that you think would be a good investment for you • Pair off with another student. Compare your mutual fund selections. Discuss your investment objectives and how this fund will meet those objectives