Chapter 13

Investing In Mutual Funds

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Kapoor Dlabay Hughes Ahmad

Prepared by Cyndi Hornby, Fanshawe College 2009 McGraw-Hill Ryerson Ltd.

Learning Objectives - Chapter 13

1. Describe the characteristics of mutual funds.

2. Classify mutual funds by investment choice.

3. Evaluate mutual funds for investment purposes.

4. Describe how and why mutual funds are bought and sold.

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Learning Objective # 1

Describe the characteristics of mutual funds.

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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 selected by professional managers who work for investment companies.

Each investor has a right to a proportional share of the assets of the fund and any income it earns

Many people choose mutual funds for their retirement account.

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Why Investors Purchase Mutual Funds

Professional management Who is the fund’s manager? Managers can change so investors must be careful

Diversification Investors funds are pooled and used to purchase a

variety of investments. Funds own stock in hundreds of different companies Buys from different asset classes (stocks, bonds &

other securities Investment Company

A firm that, for a management fee, invests the pooled finds of small investors in securities appropriate to its stated investment objectives

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Characteristics of Mutual Funds

Closed-end funds A fund of finite size Shares are issued by an investment company

only when the fund is originally set up After all original shares are sold you can only

purchase shares from another investor Open-end 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.

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Characteristics of Mutual FundsNet Asset Value

The current market value of the securities contained in the mutual funds portfolio minus the mutual funds liabilities divided by the number of shares outstanding

Calculated at the close of trading each day

(Value of the fund’s portfolio – Liabilities)Number of shares outstanding

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Characteristics of Mutual Funds

Index Fund An affordable way for investors to invest in a diversified

basket of securities; constructed to track the components of a market index such as the S&P 500 or the S&P/TSX Composite

Exchange Traded Funds (ETF’s) An affordable way for investors to invest in a diversified

basket of securities; provides the diversification of an index fund with the flexibility of a stock

Short Sell The practice of selling a borrowed stock in the hope of

covering the sale by buying it at a lower price later

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Characteristics of Mutual Funds

Load Fund A mutual fund in which investors pay a commission (as high as

8.5%) every time they purchase or sell shares No-Load fund

No sales charge Front-end load

A sales fee charged with each purchase; reduces the funds actually invested. Most fund companies have lowered the maximum front-end load on their funds to around 6 %

Back-end load Also referred to as a contingent deferred sales load. One to six

percent of withdrawals on sliding scale decreasing with time held, then zero if selling after a set number of years.

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Management Fees & Other Charges

Expense Ratio Expressed as a fixed percentage of the fund’s total

value, called the Management Expense Ratio (MER). Ranges from 0.25 percent (rare) to 4 percent, to cover investment company’s costs. Fee is up to 0.5 percent higher for back-end load funds.

Special Fees Annual RRSP, RRIF, RESP trustee fee Account set up fee Short term trading fee Processing fee Service fees

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Learning Objective # 2

Classify mutual funds by investment choice.

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Classification of Mutual Funds

Money Market Funds Income and liquidity through investment in short-

term money market instruments T-bills, commercial paper, short-term government

bonds Mortgage funds

Aim for income and safety Hold a group of mortgages

Bond Funds Aim for safety of principal and income but are

subject to capital gains and losses, which have tax implications.

Government and corporate debt securities.

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Classification of Mutual Funds

Dividend Funds Aim for tax-advantage income Possibility of capital growth Invest in preferred shares High quality common shares

Balanced and Asset Allocation funds Provide a mixture of safety, income and capital

appreciation. Equity or Common Stock funds

Capital gains Common shares

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Classification of Mutual Funds

Specialty funds Sacrifice diversification in an effort to build

capital gains. One industry, geographical area Segment of the capital market

International or Global funds Subset of specialty funds

Real Estate funds Long-term growth through capital appreciation Income-producing real property

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Classification of Mutual Funds

Ethical funds Investment decisions that are guided by moral

criteria Segregated funds

Insurance companies as an alternative Guarantee that a portion of your principal will

be returned to you at maturity Labour-sponsored venture capital

corporations (LSVCCs) Sponsored by labour organizations Invest in small to medium-sized businesses

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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 with low or no charge.

Market Timer: an individual who helps investors decide when to switch their investments from one fund to another, usually within the same family

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Learning Objective # 3

Evaluate mutual funds for investment purposes.

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Steps to Evaluate Mutual Funds

Perform a financial checkup to make sure you are ready to invest.

Obtain the money needed to purchase mutual funds.

Determine your investment objectives. Find a fund with an objective that

matches your objective. Evaluate, evaluate, and evaluate any

mutual fund before buying or selling.

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Reading a Mutual Fund Quotein the Newspaper

Net asset value and asset value change. Company and fund name. Fund objective. Total return over various time periods. Ranking among funds with the same

objective. Sales load or no load (NL). Percent of annual average net

expenses.

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Other Sources of Fund Information

Mutual fund prospectus. 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 about dividends, distributions

and taxes. Information about the fund’s management. Limitations when choosing investments

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Other Sources of Fund Information

Process to buy and sell shares Service provided and cost How often investment portfolio changes Provides a wealth of information to help

you make an investment choice Summarizes fund’s objectives Provides a summary of the fess charged

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Other Sources of Fund Information

Mutual Fund Annual Report Performance, investments, assets and

liabilities Mutual Fund Guidebooks Financial Publications

IE: Money Canadian Business Report on Business

The Internet Internet search engines Investment company web pages

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Learning Objective # 4

Describe how and why mutual funds are bought and sold.

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Advantages of Mutual Funds

Diversification Professional Management Ease of buying and selling Small amount of money required to

open an account Multiple withdrawal options Distribution or reinvestment of

income and capital gains Switching privileges in fund family Multiple services

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Disadvantages of Mutual Funds

Purchase and withdrawal costs Ongoing management fees Potential poor performance No control over capital gains

distribution Complicated tax reporting issues Potential market risk with all

investments Some sales personnel are aggressive

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Mutual Fund Transactions

Return on investment Income dividends

The earnings a fund pays to shareholders after it has deducted expenses from its dividend and interest income

Capital gain distributions The payments made to a fund’s

shareholders that result from the sale of securities in the fund’s portfolio

Sell shares at a higher price than you paid

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Mutual Fund Transactions

Taxes and Mutual Funds Most returns subject to taxation Companies required to send statement

specifying how much received in dividends and capital gains distribution

Although you do not receive cash (as the returns are reinvested) they are still taxable

Can be taxed in year when your burden is already heavy

May be taxed for full year even if you own for only part of the year

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Mutual Fund Transactions

Purchase options Closed-end through the stock exchange Open-end, no-load directly from the

investment company by phone or through the mail, or a sales representative

Reinvestment Plan Dividends and capital gains reinvested to

buy additional shares

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Mutual Fund Transactions

Withdrawal Options Closed-end funds sold to another investor Open-end funds sold to the investment

company that sponsors the fund shares redeemed at their Net Asset Value

Withdraw specified, fix dollar amount until fund exhausted

Sell certain number of shares over period Withdraw fixed percentage of asset growth Withdraw all asset growth, leave principal

untouched

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Summary of Learning Objectives Describe the characteristics of mutual

fund investments Major reasons chosen are professional

management and diversification Closed end fund is one whose shares are

only issued when fund set up Open end fund shares are sold and

redeemed by the investment company at the net asset value (NAV) at the request of the investors

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Summary of Learning Objectives

Describe the characteristics of mutual fund investments A load fund charges commission every

time your purchase shares No commission is charged to purchase

a no-load fund Can also be front-end or back-end load Other possible fees include

management fees and contingent deferred sales loads

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Summary of Learning Objectives Classify mutual funds by investment

objectives Tailored to meet the investment

objectives of their customersMoney market fundsMortgage fundsBond fundsDividend fundsBalanced and Asset Allocation fundsEquity or Common Stock fundsSpecialty funds

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Summary of Learning Objectives Classify mutual funds by investment

objectives Tailored to meet the investment objectives

of their customers International or Global funds Real Estate funds Ethical funds Segregated funds Labour-sponsored venture capital corporations

Many companies use fund family concept to allow investors to switch among funds for more potential, financial reward and security

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Summary of Learning Objectives Evaluate mutual funds for

investment purposes Responsibility for choosing the right fund rests with the investor

Information found in newspapers, financial objectives of fund, information in prospectus and annual reports, financial publications, professional advisory services, and the Internet

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Summary of Learning Objectives Describe how and why mutual funds

are bought and sold The advantages and disadvantages have

made mutual funds the investment of choice for many

Share of closed end funds are sold on organized stock exchanges

Share of open end funds can be purchased from authorized salesperson, brokerage firm, mutual fund supermarket or investment company

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Summary of Learning Objectives Describe how and why mutual funds

are bought and sold Shareholders in mutual funds can

receive return in one of three ways;Income dividendsCapital gain distributionsCapital gains when sold at a higher

price than originally paid A number of purchase and

withdrawal options are available

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