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Chapter 15

Mutual Funds: An Easy Way to Diversify

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What Is a Mutual Fund?

Investment company that pools money from investors to buy stocks, bonds, and other investments. Investors own a share of the fund proportionate to the amount of the investment.

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Why Invest in Mutual Funds?

Benefit the small investor – diversification and reduced risk.

Level the playing field between corporations and the individual investor.

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Advantages of Mutual Fund Investing

Diversification -- owning numerous securities reduces risk

Professional management Minimal transaction costs Liquidity Flexibility Service Avoidance of bad brokers

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Disadvantages of Mutual Fund Investing

Lower-than-market performance– 1989-1998, average annual returns

» actively managed stock funds, 15.6%» S & P 500 stock index, 19.2%

CostsRisks -- Unsystematic risk Risk -- Systematic riskCapital gains taxes

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To Operate, Mutual Funds

Pool money from investors with similar goals.

Invest in numerous securities.

Hire a management company to run the fund.

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To Operate, Mutual Funds (cont’d)

Hire an investment advisor to manage the fund’s portfolio

Hire a– a custodian to safeguard fund holdings– a transfer agent to act as recordkeeper – an underwriter to sell new shares

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Ways of Making Money With Mutual Funds

Increases in market value (appreciation)

Dividends Capital gains

distribution

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Types of Investment Companies

Open-end investment companies or mutual funds

Closed-end investment companies or mutual funds

Unit investment trustsReal estate investment trusts (REITs)

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Open-End Investment Companies or Mutual Funds

Have an unlimited number of shares Buy and sell shares directly to investors

without a secondary market Purchase and selling price is determined by

the net asset value of the fund

NAV = value of all securities - liabilities total shares

outstanding

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Closed-End Investment Companies or Mutual Funds

Have a limited number of sharesSell only the initial offering. Subsequent

trades are done in a secondary market, similar to the common stock market.

Purchase and selling price is determined by supply and demand.

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Unit Investment Trusts

Fixed pool of securities, normally municipal bonds

Have shares that represent a proportionate share of the trust

Are passive investments that operate on a buy-and-hold strategy

Normally require $1,000 minimum investment Long time horizon recommended

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Real Estate Investment Trusts (REITs)

Professional managers invest pooled funds in a diversified portfolio of real estate.

Require that 75% of fund income is generated from real estate investments and must distribute 95% of income as dividends.

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Real Estate Investment Trusts (cont’d)

Have 3 types (equity; mortgage; hybrid).Lack the liquidity of most mutual funds,

but more liquidity than direct real estate investments.

Actively traded REITs recommended.Offer diversification independent of the

stock market.

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Equity REITs

Buy property directly Manage the

property Investors hope the

real estate appreciates in value

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Mortgage REITs

Buy mortgages. Do not have any

capital appreciation. Investors only

receive interest payments on the mortgages.

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Hybrid REITs

Invest in both properties and mortgages.

Investments result in both capital appreciation and interest income.

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The Costs of Mutual FundsLoad funds-- sales commissions

charged to the investor when purchasing fund shares.

Back-end load funds -- commissions charged to the investor when selling the shares; may be a sliding scale.

No-load funds -- no commission charged.

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The Costs of Mutual Funds (cont’d)

Management fees and expenses -- fees associated with the operation of the company.– expense ratio– turnover rate

12b-1 fees -- fees charged to cover the fund’s cost of advertising and marketing.

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Types and Objectives of Mutual Funds

Money market mutual fundsStock mutual fundsBalanced mutual fundsAsset allocation fundsLife-cycle fundsBond funds

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Money Market Mutual Funds (MMMFs)

Invest in short-term securities with maturities of less than 30 days

Trade at a constant net asset value of $1 per share

Work much like an interest bearing checking account with some limitations

Considered practically risk free

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Specialized Types of MMMFs

Tax-exempt MMMFs -- invest in only muni’s

Government securities MMMFs -- invest in government paper to reduce risk, but lower return

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Stock Mutual Funds

Aggressive growth fundsSmall-company growth fundsGrowth fundsGrowth-and-income fundsSector funds Index funds International funds

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Balanced Mutual Funds

Try to balance objectives of long-term growth, income, and stability of the capital invested

Invest in common stock, preferred stock, and bonds

Less volatile than stock funds

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Asset Allocation Funds

Are similar to balanced mutual funds in the mix of securities

Practice market timing to attempt to outperform the market

Risky due to the turnover rate and associated transaction costs

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Life-Cycle Funds

Are similar to asset allocation funds.

Tailor holdings to best meet the needs of investors in a certain stage of the life cycle, such as age or risk tolerance.

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Bond Funds

A small investment buys shares in a diversified bond portfolio.

More liquid than individual bonds.Provide professional management.Provide regular income.

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Bond Funds (cont’d)

Can incur more expenses than purchasing bonds directly.

Don’t mature to pay a guaranteed lump sum investment like individual bonds do.

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Types of Bond Funds

U.S. government and GNMA bond funds

Municipal bond fundsCorporate bond fundsSpecialized maturity length (short-,

intermediate-, and long-term) funds

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Services Offered by Mutual Funds

Automatic investment and withdrawal plans Automatic reinvestment of interest, dividends,

and capital gains Wiring and funds express options Phone switching Easy establishment of retirement plans Check writing Bookkeeping and help with taxes

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Buying a Mutual Fund

Step 1: Determine your investment goals.

Step 2: Identify funds that meet your objectives.

Step 3: Evaluate the fund.

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Step 1: Determine Your Investment Goals

Determine your time horizon for each goal

Determine your risk toleranceDetermine your personal investment

preferencesDetermine your tax planning strategies

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Step 2: Identify Funds That Meet Your Objectives

Look to third-party publications– Morningstar Mutual Funds

Determine the fund’s objectiveDetermine the fund’s investment style

– value– growth

Read the prospectus

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Information Contained in the Prospectus

The fund’s goal and investment strategyThe fund manager’s past experienceAny limitation on investments that the

fund may haveAny tax considerations of importance to

the investors

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Information Contained in the Prospectus (cont’d)

The redemption and investment process for buying and selling shares in the fund

Services provided investorsPerformance over the past 10 years or

since the fund has been in existenceFund fees and expensesThe fund’s annual turnover ratio

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Step 3: Evaluate the Fund

Always compare funds with the same objective.

Evaluate the fund’s long-term performance.

Look at returns in both up and down markets.

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Sources of Information The Wall Street Journal Forbes or Business Week Kiplinger’s Personal

Finance Smart Money or

Consumer Reports Wiesenberger Investment

Companies Service Morningstar Mutual Funds

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Mutual Fund Quotes in The Wall Street Journal

NAV – net asset value (price)NAV change – gain or loss from prior

day’s NAV Total return – NAV change plus

accumulated incomeTotal return – NAV change plus income

for different time periods, in percent.

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Mutual Fund Quotes (cont’d)

Ranking – Performance comparison among funds with same objective for different time periods.

Max initial sales com – the largest allowable sales commission charged

Annual Exp – covers all expenses associated with running and advertising the fund

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Calculating Fund Returns

Returns include distributions of dividends, distributions of capital gains, or NAV appreciation

Total return =

dividends + capital gains + (ending NAV – beginning NAV) beginning NAV

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Calculating Fund Returns

With reinvestment of all distributions, total return includes the NAV share increase and the increased number of shares

Total return =

(No. of ending shares x ending price) –

(No. of beginning shares x beginning price)

(No. of beginning shares x beginning price)

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Making the Purchase Buy through a

financial services broker, banker, planner– Probably a load

Buy directly from the mutual fund – – No load– 1-800…– Internet

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Making the Purchase (cont’d)

Buy through a “mutual fund supermarket”– 8 major players, 3 largest include:

» Fidelity Funds Network» Charles Schwab» Jack White

– Minimum account balances vary– Transaction fees vary

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SummaryWhat is a mutual fund and how does it

operate? Mutual fund advantages and

disadvantagesTypes of investment companies

– Open and closed end mutual funds– Unit investment trusts– REITs

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Summary (cont’d)

Costs of owning a mutual fund– Loads -- front-end and back-end– Fees -- management and 12b-1

Understand fund objectives and categories

Understand fund services

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Summary (cont’d)

Sources of mutual fund investment information– Newspapers, magazines, Internet– Investment company prospectus

How do you buy a mutual fund?Types of mutual fund returns

– Dividends or capital gains distributions– NAV appreciation