1 C HAPTER 13 Investing in Mutual Funds a.k.a. Investment Companies “Mutual Funds will bore you to...

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CHAPTER 13Investing in Mutual Funds

a.k.a. Investment Companies

“Mutual Funds will bore you to wealth.” – Industry saying

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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 10,000 funds to choose from Many people choose mutual funds for their

retirement account investments [401(k), 403(b), IRA and Roth IRA, etc.]

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Mutual Funds

STOCKS BONDS CASH

Professional Money Management

Diversification

Stock mutual funds

Bond mutual funds

Money market mutual funds

Balanced mutual funds

a “mutual” fund

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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

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Growth of Mutual Fund Industry

YearNumber of

Mutual Funds

1940 70

1970 350

1980 600

1990 2,000

2000 9,000

2010 10,119 Source: Investment Company Institute, www.ici.org

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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? Uh, wait a minute. Did I mention that there are no guarantees.

Always be sure to read the fine print, okay?

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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 versus No-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

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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

(continued)

Load Funds versus No-load Funds

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Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F-1

Maximum sales charge 5.75% None None None

Maximum sales charge on reinvested dividends

None None None None

Maximum deferred sales charge None 5.00% 1.00% None

Redemption or exchange fees None None None None

Annual Operating Expenses Class A Class B Class C Class F-1

Management Fees 0.24% 0.24% 0.24% 0.24%

Distribution and/or Service Fees (a.k.a. 12b-1)

0.23% 1.00% 1.00% 0.25%

Other Expenses 0.14% 0.14% 0.18% 0.17%

Total: 0.61% 1.38% 1.42% 0.66%

Investment Company

of America

This is a load fund.

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Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F



None None None None

Maximum deferred sales charge

None 4.00% 1.00% None

Redemption or exchange fees None None None NoneAnnual Operating Expenses Class A Class B Class C Class F

Management Fees 0.75% 0.75% 0.75% 0.75%


0.30% 1.00% 1.00% 0.00%

Other Expenses 0.20% 0.43% 0.38% 0.35%

Total: 1.25% 2.18% 2.13% 1.10%

Alliance Large Cap

Growth Fund

Another load fund.

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Example of Shareholder Fees:Transaction fees Class A Class C Financial Institutional



None None None None

Maximum deferred sales charge None 0.95% None None

Redemption or exchange fees None None None None

Legg Mason

Value Trust

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.

Annual Operating Expenses Class A Class C Financial Institutional

Management Fees 0.67% 0.67% 0.67% 0.67%


0.25% 0.95% 0.25% 0.00%

Other Expenses 0.09% 0.16% 0.18% 0.10%

Total: 1.01% 1.78% 1.10% 0.77%

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Example of Shareholder Fees:

Transaction fees

Maximum sales charge None


None


None

Redemption or exchange fees NoneAnnual Operating Expenses Class A

Management Fees 0.14%


Other Expenses 0.03%

Total: 0.17%

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.

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Example of Shareholder Fees:

Transaction fees

Maximum sales charge None


None


None

Redemption or exchange fees NoneAnnual Operating Expenses Class A

Management Fees 0.07%


Other Expenses 0.03%

Total: 0.10%

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.

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Examples of Dollar Costs:

Hypothetical $10,000 Investment with 5% Return

1 Year

3 Years

5 Years

10 Years

Class A $634 $759 $896 $1,293

Class B (assuming no redemption) 140 437 755 1,447

Class C (assuming no redemption) 145 449 776 1,702

Class F-1 (excludes advisor fee) 67 211 368 822

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?

Investment Company

of America

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1 Year

3 Years

5 Years

10 Years

Class A $672 $878 $1,101 $1,741

Class C 181 561 965 2,096

Financial Intermediary Class 112 350 607 1,341

Institutional Class 79 246 428 955

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?

Legg Mason

Value Trust

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1 Year

3 Years

5 Years

10 Years

Investor Class $17 $55 $96 $217

Admiral Class 6 19 34 77

The fees for passively-managed index funds will almost always be less than actively-managed funds. The Admiral Class shares were

available with a minimum of only $100,000 but now can be had with as little as $10,000. 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 0.06%.

Vanguard 500 Index

Fund

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Breakpoint Sales Reductions:

Investment (either purchased or accumulated) Sales Charge

Less than $25,000 5.75%

$25,000 but less than $50,000 5.00%

$50,000 but less than $100,000 4.50%

$100,000 but less than $250,000 3.50%

$250,000 but less than $500,000 2.50%

$500,000 but less than $750,000 2.00%

$750,000 but less than $1,000,000 1.50%

$1,000,000 or more None

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?

Investment Company

of America

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Contingent Deferred Sales Charge (CDSC) on Class B Shares

Year of Redemption Contingent Deferred Sales Charge

1 5.0%

2 4.0%

3 4.0%

4 3.0%

5 2.0%

6 1.0%

7+ 0.0%

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.

CDSC Reduction over Time:Investment Company

of America

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10-Year Rates of Return:

Investment10-Year Return

Growth of $10,000

Investment Company of America, Class A 3.74%* $14,437

Alliance Large Cap Growth Fund, Class A 3.74%* $14,381

Legg Mason Value Trust, Primary (Class C) 0.37% $10,376

Vanguard Index 500 Fund 4.02% $14,825

Standard & Poor’s 500 Index 4.12% $14,972

Fees are important, but they 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.

So, Which One Would You Pick?

*4.36% ($15,323) and 4.19% ($15,079), respectively, without sales charge

A

B

C

D

as of March 31, 2012

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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. A shares

B. B shares

C. C shares

D. F or I sharesThe correct answer is (B). They normally become A shares

after 6 to 8 years.

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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. A shares

B. B shares

C. C shares

D. F or I shares

The correct answer is (C). They sometimes revert to A or F shares after many years.

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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. A shares

B. B shares

C. C shares

D. 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.

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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.

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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

(continued)

Which do you think is

riskiest?

Which do you think is

riskiest?

Classification of Mutual Funds

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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

(continued)Classification of Mutual Funds

What are the advantages /

disadvantages of each of these types?

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Classification of Mutual Funds 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.

(continued)

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Classification of Mutual Funds 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

(continued)

The choices are endless. So are the fees…

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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, “US Total Market”, EAFE) Why?

Usually much lower annual operating expenses Many actively managed funds don’t beat the indexes!

Unfortunately, index funds can become 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 few companies!

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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

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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”

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Fund Families: Top Ten Families

1. Vanguard Group2. Fidelity Investments 3. American Funds (CR&M)

4. PIMCO Funds5. J. P. Morgan Chase6. Franklin Templeton Investments7. BlackRock Funds8. Federated Investors9. Bank of New York / Dreyfus Corporation10. T. Rowe PriceSource: Investment Company Institute, http://www2.iii.org/financial/securities/mutualfunds August 2010

Because of the mutual fund scandals of 2003, three of the

companies that used to be amongst the top ten are no longer here.

Examples: Offerings from the top three families

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“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.

Wait a minute, Paiano! Did you just say,

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“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

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A Sample Stock Mutual Fund

Is 78 Years “Long-term” Enough? 6%, 8%, 9%, 10%? How ‘bout almost 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

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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?!

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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!

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And That’s Not the Only One!

Do you remember this slide from chapter 1? As of December 31, 2011

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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!

1 C HAPTER 13 Investing in Mutual Funds a.k.a. Investment Companies “Mutual Funds will bore you to...

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