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Mutual Funds


The Wall Street Journal publishes a mutual fund section regularly. 11. Web Links ... Investment style. Types of securities owned by fund. Stocks. Bonds (or ... – PowerPoint PPT presentation

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Title: Mutual Funds

Mutual Funds
  • Chapter 14

Understanding Mutual Funds
  • A pool of money from numerous investors used to
    invest in a portfolio of securitiesmanaged by a
    professional portfolio manager
  • When you own shares in a mutual fund, you own a
    small part of the portfolio
  • Distributions of interest income, dividend income
    and capital gain/losses occur to investor in
    terms of the proportion of the total number of
    mutual fund shares owned

Understanding Mutual Funds
  • There are over 8,200 mutual funds today
  • Compared to about 600 in 1980
  • The net assets of mutual funds is about 7
  • Why are they so popular?
  • Bull market for stocks and bonds
  • Growth of self-directed retirement plans

Figure 14.1 Growth of Mutual Funds
How a Mutual Fund Operates
  • A mutual fund raises money by selling shares of
    the fund to the investing public
  • The funds are used to purchase assets such as
    stocks, bonds, money market securities, etc.
  • The shareholder of the mutual fund is said to
    indirectly own the assets held by the mutual fund
  • AKA open-ended investment companies
  • Constantly issues new shares and redeems existing

How a Mutual Fund Operates
  • The funds NET ASSET VALUE represents
  • The market value of the funds assets less any
    liabilities, divided by the number of shares

How To Buy Mutual Fund Shares
  • Can purchase either
  • Through your stockbroker or
  • Directly from the mutual fund
  • Check the funds website
  • Review the funds prospectus
  • States the funds investment objectives, types of
    securities it can purchase, fees, recent
  • Send in your application along with a check

Services Offered
  • Automatic reinvestment of distributions
  • Effectively increases the number of shares you
  • Automatic investment plans
  • Can be as little as 50 a month
  • Exchange privileges
  • Transfer within fund family
  • Check writing
  • Mostly money market funds (and a few others)
    allow minimum checks (500 each)
  • Doesnt replace a regular checking account

Regulation and Taxation
  • Regulated by SEC
  • Must present certain types of information in
    prospectus and other reports
  • Limits types of advertising
  • If mutual fund retains investment profit, it must
    pay taxes on it therefore, most mutual funds
    distribute the gains to shareholders
  • Shareholders must report these distributions for
    tax purposes, as well as any gain/loss on
    redemption of shares

Where to Get Mutual Fund Information
  • Internet
  • Moneys February issue is heavily devoted to
    mutual funds
  • The Wall Street Journal publishes a mutual fund
    section regularly

Web Links
  • Information about mutual funds

Classifying Mutual Funds
  • Can be classified based on
  • Investment objectives
  • Investment style
  • Types of securities owned by fund
  • Stocks
  • Bonds (or income)
  • Hybrid (balanced)
  • Money market

Figure 14.2 Distribution of Mutual Fund Assets
Classifying Mutual Funds
  • Common subcategories for stock funds
  • Aggressive growth
  • Growth and income
  • Long-term growth
  • Small-company growth
  • International
  • Common subcategories for bond funds
  • Government
  • High-yield corporate (junk bonds)
  • Investment-grade corporate
  • World income

Classifying Mutual Funds
  • Common subcategories for money market funds
  • Government
  • Taxable
  • Tax-exempt

Mutual Fund Styles
  • Even mutual funds that fall into the same
    subcategory can have different management styles
  • One fund may try to achieve growth by investing
    in stocks with potential for strong earnings
    growth whereas
  • Another fund may try to achieve same objective by
    selecting stocks it currently believes to be
    currently undervalued in the market

Different Fund Types
  • Some fairly new fund types
  • Asset allocation funds
  • Invest in a mixture of stocks, bonds and money
    market instruments, shifting allocation of money
    in an attempt to gain high returns with low risk
  • Index funds
  • Attempt to replicate performance of a major stock
    index (most popular is SP 500)
  • Why are these so appealing?
  • Very low fees (not that much management to be
  • Most mutual fund managers cant consistently
    outperform the market
  • Sector funds
  • Invest only in one industry

Advantages of Mutual Funds
  • Diversification
  • Can increase your return without increasing your
    risk (or may even reduce your risk)
  • But doesnt eliminate risk!
  • Not all mutual funds are diversifiedtheyre not
    meant to be

Advantages of Mutual Funds
  • Smaller minimum investments
  • Can purchase a piece of a well-diversified
    portfolio for a relatively small investment
  • Money market mutual funds minimum investment ?
  • Stock and bond mutual funds minimum investment ?
    1,000 - 3,000 (less for IRAs)
  • Additional investments can be as little as 50 -
  • Many funds offer automatic investment plans that
    require initial investments of as little as 50

Advantages of Mutual Funds
  • Professional Management
  • Do all mutual funds always beat the market?
  • Over the past 10 years, stock funds have had an
    average annual return about 2 less than the SP
    500 (10.8 vs. 12.7)

Picking the Right Mutual Funds
  • Step 1 Choose your investment goals and assess
    your risk/return position
  • You can then identify the types (group) of mutual
    funds that meet your criteria
  • Step 2 Assess the fees and performance of the
    mutual funds

Fees and Expenses
  • Several types of fees
  • Load Charges fees associated with either buying
    or redeeming mutual fund shares
  • Front-endpaid when shares are purchased
  • Cannot exceed 8.5
  • Example You deposit 1000 in a fund with a 2
    front-end loadonly 980 goes toward purchase of
    shares, the remaining 20 is a fee
  • Most funds use front-end loads with very few
    actually charging the maximum 8.5
  • Redemption fee (back-end load)paid when shares
    are sold
  • Often depends on how long the shares were
    ownedwith a lower fee charged for a longer
    holding period

Fees and Expenses
  • Trend is toward low front-end loads or no-loads
  • No charges associated with buying or selling the
    mutual fund
  • Over half of all mutual funds are no-load
  • Annual operating expenses
  • Includes fees paid to portfolio manager,
    transaction costs, printing costs
  • Paid from investment income before it is
  • Average is about 1.5 for stock funds 1.1 for
    bond funds
  • 12b-1 fees
  • Pays for distribution costs (such as advertising)
    in lieu of a load charge

Fees and Expenses
  • Evaluating fees and expenses
  • Not all funds charge the same operating fee
    shop around
  • Can range from 0.1 to 2.5
  • Fees and expenses can have a dramatic impact on
    the value of your investment over time
  • No definitive evidence shows that funds charging
    higher fees earn higher returns
  • Everything else being equal, youre better off
    buying a no-load fund with low operating costs

  • Need to examine absolute performance AND relative
    performance as well as risk
  • When comparing fund to a benchmark, choose the
    right benchmark

The Relationship Between Past and Future
  • Some funds beat the market some years and not
  • Should we try to predict which funds will beat
    the averages next year (or during the next 5
    years) or not?
  • Randomly choosing funds will probably lead to the
    same results according to some people
  • Others argue that superior funds may
    under-perform some years, but over the long run
    produce superior returns

The Relationship Between Past and Future
  • Results are mixed
  • Conclusion
  • Dont chase returnsthe fees are too great and
    your results probably wont be stellar
  • Past performance in NO WAY GUARANTEES FUTURE

Performance and Taxes
  • Mutual funds pass along income/gains to
    shareholders as distributions, so that the mutual
    fund does not have to pay taxes
  • The more distributions paid to you, the more
    taxes youll pay

Performance and Taxes
  • Example Compare the after-tax return on these
    two funds (assuming a 28 tax bracket)
  • For both funds the value of the securities held
  • Fund A did not sell the securities
  • Fund B did sell and passed the gain along to
    shareholders (who had to pay taxes on the gain)

When Not to Buy Mutual Fund Shares
  • Most mutual funds have regularly scheduled
    distribution dates
  • For tax purposes, shouldnt buy shares in a
    mutual fund right before a distribution
  • Youd owe taxes on that immediate distribution

What About Index Funds
  • Designed to track performance of a broad stock or
    bond market index
  • Most popular track the SP500
  • Number of index funds has grown rapidly

Managing Mutual Fund Investments
  • Lump-Sum Investing vs Dollar Cost Averaging
  • Lump-Sum Investing
  • Invest a lump sum (presumably a larger amount)
    all at once
  • Dollar Cost Averaging
  • Investing an equal amount at regular intervals
    (presumably smaller amounts than a lump sum)
  • This is what would happen if you had automatic
    withdrawal from checking account to a mutual fund
  • Under certain conditions can lead to a higher
    return than a lump sum purchase
  • If NAV declines during the year you can end up
    buying more shares than you would have had you
    lump summed
  • Your ultimate return would be greater in this

Making Changes to Your Mutual Fund Investments
  • Will your goals remain the same for the next
    30-40 years?
  • Nothe mix of your investments will need to
    change over time
  • Youll also need to rebalance over time
  • Adjusting investments periodically to return to
    the target asset allocation

  • Example Youve decided you want an investment
    mix of 50 of your wealth in an aggressive growth
    fund and 50 in an international stock fund.
  • You place 1,000 in each fund at the beginning of
    the year
  • The aggressive growth fund earns 42 and the
    international stock fund earns 15.7.
  • Your wealth is now at this weight

  • How do you accomplish a rebalancing?
  • Sell shares in the over-weighted fund and buy
    some shares in the under-weighted fund or
  • When you invest additional money, put more of it
    into the under-weighted fund

When to Sell a Mutual Fund
  • One reason many people sell shares is due to poor
  • BUT, selling shares based on poor short-term
    performance may be a bad idea
  • Are you chasing past returns?
  • This rarely produces superior returns over the
    long run
  • Even the best funds have poor performance at
  • If you have a good fund, keep it even if it
    offers poor short-term performance

When to Sell a Mutual Fund
  • There are viable reasons for selling a fund
  • Performance lags benchmarks for an extended time
    period (3 years or so)
  • Fund gets very large very fast
  • Expenses keep rising
  • Fund is trying to capitalize on its popularity
  • Management turnover