C HAPTER 13

1. CHAPTER13 Investing in Mutual Funds a.k.a. Investment Companies “Mutual Funds will bore you to wealth.” – Industry saying

2. What is a Mutual Fund? • An investment chosen by people who pool their money to buy stocks, bonds, and other financial securities • a.k.a. Investment company (the legal term) • Professional management • Diversification • Each fund has a specific objective • Over 9,000 funds to choose from • Many people choose mutual funds for their retirement account investments [401(k), 403(b), IRA and Roth IRA, etc.]

3. Mutual Funds STOCKS BONDS CASH Balanced mutual funds Bond mutual funds Stock mutual funds Money market mutual funds a “mutual” fund Professional Money Management Diversification

4. Why Investors Purchase Mutual Funds • Professional management • Who is the fund’s manager? • Managers change often (like professional athletes!) • Look for an experienced management team • Diversification • Investors funds are pooled and used to purchase a variety of investments • This variety provides some safety that is difficult for individual investors to obtain on their own • “PITA” factor is low –The Wealthy Barber

5. Growth of Mutual Fund Industry Source: Investment Company Institute, www.ici.org

6. Mutual Fund Transactions • Purchase options • Through a broker • Directly from the investment company • Best way is auto-contribution (payroll, checking) • Dollar-cost averaging! • Sell options • Through a broker or through the mutual fund • Best way is auto-withdrawal (into your checking) You automatically invest $50 or $100 per month for thirty years and then you automatically withdraw $2,000 or $3,000 per month for the rest of your life! Sound interested?

7. Annual Operating Expenses • Management fees • Charged yearly (0.2% to 2% or more) based on a percentage of the fund’s asset value • Paid to portfolio managers and analysts who make the investment decisions • 12b-1 fees • Annual fee to defray advertising, servicing, and distribution costs of the fund • Accounting and other expenses • Trustee fee • For retirement accounts ($10-$30)

8. Load Funds versusNo-load Funds • Load Fund • Investors pay a sales commission (sales load) every time they purchase shares • Average fee is 3-5% for which an investor gets purchase advice and explanations • Often have lower annual operating expenses • No-Load Fund • Investors pay no sales fee, because there are no sales people • You deal directly with the investment company via 800 numbers or web sites • Often have higher annual operating expenses

9. Load Funds versusNo-load Funds (continued) • Types of Load Funds • Front-end Load – a.k.a. Class A • Upfront fee – lower annual operating expense • Back-end Load – a.k.a. Class B • Back-end fee – higher annual operating expense • No-load Funds (Huh?) – a.k.a. Class C • No upfront nor back-end fee – higher annual fees • Types of No-Load Funds • Advisor No-load Funds – a.k.a. Class F, Class I • Advisor charges 1% to 2% to “manage the account” • “True” No-load Funds • May not have a 12b-1 fee greater than 0.25% • But that doesn’t mean the overall fees are low • Over time, a no-load fund can wind up costing more in fees than a load fund Load

10. Investment Company of America Example of Shareholder Fees: This is a load fund.

11. Alliance Large Cap Growth Fund Example of Shareholder Fees: Another load fund.

12. Legg Mason Value Trust Example of Shareholder Fees: This was a very famous no-load mutual fund. The class C shares were (and still are) the most popular. It just added class A shares. Many in the industry still refer to it as a no-load fund.

13. Example of Shareholder Fees: Vanguard 500 Index Fund This is an index fund. This fund does no research. They simply buy all the 500 stocks in the S&P 500 Index. The term for this is “passive management.” (More later) Index funds are usually “true” no-load mutual fund and usually have very low fees. There is a $20 annual fee if your account value is less than $10,000.

14. Example of Shareholder Fees: Fidelity Spartan 500 Index Fund Vanguard pioneered low fee mutual funds and was able to overtake Fidelity as the number #1 mutual fund company. Fidelity responded by eliminating all sales loads, creating their own index funds, and lowering their fees below Vanguard. Like the Vanguard fund, there is a “low balance” annual fee of $10 if your account is below $10,000.

15. Examples of Dollar Costs: Investment Company of America Although it looks as though the F shares are the best deal, this doesn’t include the advisor’s annual fee. Adding the advisor’s typical fee of 1% to 2% per year would easily add an additional $1,200 to $2,400 to the total cost. Over the long term, which is the best deal?

16. Legg Mason Value Trust Examples of Dollar Costs: The class C shares of this “no load” fund wind up costing more than the class A shares! Again, the Financial Intermediary Class seems to be a better deal but it doesn’t include the advisor’s annual fee. The Institutional Class looks great. How can I get them? Well, for starters, are you a large pension fund, university endowment, or tax-exempt charity? Oh, and by the way, do you have at least $1 million to invest?

17. Vanguard 500 Index Fund Examples of Dollar Costs: The fees for passively-managed index funds will almost always be less than actively-managed funds. The Admiral Class shares are available with a minimum of only $100,000. Any takers? There is another type of mutual fund called an exchange-traded fund (ETF) that we will discuss later. They often have fees lower than the index funds! The Vanguard ETF that tracks the S&P 500 has an expense ratio of 0.07%.

18. Breakpoint Sales Reductions: Investment Company of America Class A shares typically qualify for a sales reduction if you invest a larger amount or as your investment grows. Some brokers fail to inform their clients of this feature. Instead, as the client approaches the breakpoint, the broker will advise them to start another fund. Why?

19. CDSC Reduction over Time: Investment Company of America The back-end sales charge on Class B shares typically is reduced over time until it is eliminated. However, as we noted, the Class B shares usually pay more in annual fees. This type of schedule is also typical of annuities, only usually it is worse.

20. So, Which One Would You Pick? 10-Year Rates of Return: as of September 30, 2010 A B C D Fees are important, but they certainly do not tell you the whole story. When comparing mutual funds, you must look at many attributes, not the least of which are the rates of return, preferably over longer periods of time. *2.40% and -3.69%, respectively, without sales charge

21. Mutual Funds Fees: What are __? These shares do not have an up-front sales load. Instead, they assess a decreasing back-end load if you withdraw your money within 6 years. The annual operating expense is higher (courtesy of the 12b-1 fees). • A shares • B shares • C shares • F or I shares The correct answer is (B). They normally become A shares after 6 to 8 years.

22. Mutual Funds Fees: What are __? These shares do not have an up-front or back-end sales load. The advisor called them “no-load” but you notice that their annual operating expense is higher than other share classes (again, courtesy of 12b-1 fees). • A shares • B shares • C shares • F or I shares The correct answer is (C). They sometimes revert to A or F shares after many years.

23. Mutual Funds Fees: What are __? Your financial advisor tells you that these shares have a very low annual operating expense. She mumbles something about “wealth management.” These shares are: • A shares • B shares • C shares • F or I shares The correct answer is (D). She also did her best not to explain that her brokerage firm will charge you an extra 2% each year.

24. Stock Mutual Funds Aggressive Growth– most risky a.k.a. Momentum, Ultra Growth – invests primarily in growth stocks (risky) Capital Appreciation– very flexible, often very risky Growth and Income– blend of growth & dividends a.k.a. Value, Blend Moderately risky Equity Income– emphasizes dividends, least risky Classification of Mutual Funds These classifications are just some of the major types of stock mutual funds. There are many, many more.

25. Stock Mutual Funds (continued) Large Cap– largest companies Mid Cap– medium-sized companies Small Cap– smallest companies Domestic – based in U.S. Global– based anywhere in globe International – based outside U.S. Regional – Japan, Far East, Latin America, etc. Sector – energy, technology, health care, etc. – dumb Market Timing– dumber Classification of Mutual Funds (continued) Which do you think is riskiest? Which do you think is riskiest?

26. Classification of Mutual Funds (continued) • Bond Mutual Funds • High-Yield Bonds (a.k.a. Junk Bonds) • Corporate Bonds • Municipal and Insured Municipal Bonds • State-specific municipal bond funds (exp: California) • U.S. Backed Bonds (Fannie Mae, etc.) • U.S. Bonds (Treasuries) • Long-term • Intermediate-term • Short-term • Domestic, Global, and International What are the advantages / disadvantages of each of these types?

27. Classification of Mutual Funds (continued) • Stock & Bond Funds (a.k.a. Balanced Funds) • Invest in both stocks and bonds • Stock and Bond Blend Funds • a.k.a. Asset allocation funds • Often marketed as “a complete investment program for the prudent investor” • Money Market Mutual Funds • Short-term investments (kinda’ like a checking acct) • Mutual Funds of Mutual Funds – “Life-cycle” • “Huh? Sure, I don’t mind being charged twice!” • Often marketed as a total mutual fund solution • Retirement (401k), College Education, etc.

28. Classification of Mutual Funds (continued) • Specialty Funds • Hedge Funds • Traditionally only open to “sophisticated investors” • Very risky and sky-high operating expenses • “Bear” Funds • Expect market to go down • Precious Metals and Commodities Funds • REIT Funds • Boutique / Exotic Funds • StockCar Stocks Fund • Pauze Tombstone Fund • The Chicken Little Growth Fund The choices are endless. So are the fees…

29. The Buzz about Index Funds • Index funds • No management (a.k.a. passively managed) • The mutual fund simply buys all the stocks in a specific index (S&P 500, Dow 30, Wilshire 5000) • Why? • Usually much lower annual operating expenses • Many actively managed funds don’t beat the indexes! • Unfortunately, index funds became victims of their own success (Example: Vanguard Index 500) • Many funds do beat the indexes • Look for a fund family where most all funds have consistently beaten the indexes over decades! • Psst! There are only a couple of companies!

30. The Buzz about ETF’s • Exchange-Traded Funds • The success of index funds bred a whole new type of mutual fund • Traded on the exchanges like stocks • Very low annual operating expenses • Even lower than index funds • But you incur brokerage commissions • Most all are index funds (passively managed) • But there are now actively-managed ETF’s • Which have higher fees (because of the active management) • Can be bought and sold throughout the trading day • Unlike all other mutual funds which only trade at the end-of-trading-day closing price

31. Fund Families • A family of funds exists when one investment company manages a group of mutual funds • Funds in the family vary in their objectives • You can move your money from one fund to another within a fund family • Almost always with no charge • But, if in a taxable account, you could and probably will generate a taxable transaction “Choose a Family, Not a Fund”

32. Fund Families: Top Ten Families • Vanguard Group • American Funds (CR&M) • Fidelity Investments • J. P. Morgan Chase • BlackRock Funds • Federated Investors • Bank of New York / Dreyfus Corporation • Franklin Templeton Investments • PIMCO Funds • Goldman Sachs and Company Examples: Offerings from the top three families Because of the mutual fund scandals of 2003, three of the companies that used to be amongst the top ten are no longer here. Source: Insurance Information Institute, http://www2.iii.org/financial/securities/mutualfunds July ‘09

33. Wait a minute, Paiano! Did you just say, “Mutual Fund Scandals?!” • “You want me to invest in an industry that is plagued with scandal?!” • Since 1940, the mutual fund industry has been regulated and escaped any hint of impropriety • In 2003, some practices that were not quite illegal but obviously unethical were uncovered • Only a handful of funds and people were affected • Strong, Janus, Bank of America, Putnum, Alliance • The vast majority of companies never engaged in the shenanigans Instead of losing $99,999 on a $100,000 account (example: Enron), investors lost $1 on a $100,000 account.

34. “So, How Do I Pick a Mutual Fund?” • Pick a Mutual Fund that… • Invests in high-quality stocks or bonds • Is well-diversified across several industries and sectors of the economy • Has a long-term perspective and a manager or (better yet) a management team with many years of experience • Avoid companies that “shuffle” their managers every few years (which is virtually all of them!) • Has been around for decades and performed consistently well in both good and bad markets

35. A Sample Stock Mutual Fund • Is 76 Years “Long-term” Enough? • 6%, 8%, 9%, 10%? How ‘bout 12%? • “But stocks have been very risky, right?” • Short-term? Yes. Long-term? No! • “But now is not a good time to invest” • What if you had invested on the worst day of the year for the past 20 years? • “But what about market downturns?” • Keep a long-term perspective, and • Dollar Cost Average

36. Dollar Cost Averaging • A system of buying an investment at regular intervals with a fixed dollar amount • With Dollar Cost Averaging, there is always “Good News” • “The market is up! Good News!” • Your account is worth more • “The market is down! Good News!” • Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account Yippee! Huh?!

37. Hypotheticals • Most mutual fund companies have a system for running “hypotheticals” • a.k.a. “Illustrations” “Hypothetical illustrations” • Examples of returns of investments • Lump sum principals, or • Streams of investments • a.k.a. Dollar-Cost Averaging • Or combinations of both lump sum & streams • Must be approved by SEC and FINRA • And contain disclaimers about past versus future performance Let’s run some hypotheticals!

38. Bottom Line on Mutual Funds • Choose a fund family and stick with them • “Most mutual fund investors do worse than the mutual funds they invest in” • Re-evaluate them periodically • But make changes judiciously and sparingly • As you approach retirement, migrate from stock funds to bond funds • But don’t give up on stocks entirely (ICA illustration) • Use Dollar Cost Averaging • $50 a month, $100 a month, whatever… • For the most part, Forget About Them! • I know. It makes investing boring, but it works!