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Mutual Funds: An Easy Way to Diversify


Benefit the small investor diversification and reduced risk ... Diversification owning numerous securities reduces risk. Professional management ... – PowerPoint PPT presentation

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Title: Mutual Funds: An Easy Way to Diversify

Chapter 15
  • Mutual Funds An Easy Way to Diversify

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.

Why Invest in Mutual Funds?
  • Benefit the small investor diversification and
    reduced risk
  • Level the playing field between corporations and
    the individual investor

Advantages of Mutual Fund Investing
  • Diversification owning numerous securities
    reduces risk
  • Professional management
  • Minimal transaction costs
  • Liquidity
  • Flexibility
  • Service
  • Avoidance of bad brokers

Disadvantages of Mutual Fund Investing
  • Lower-than-market performance
  • 1985 2000, 84.5 of average annual returns
    trailed the SP 500 Index
  • Costs
  • Risks Unsystematic risk
  • Risk Systematic risk
  • Capital gains taxes

To Operate, Mutual Funds
  • Pool money from investors with similar goals
  • Invest in numerous securities
  • Hire a management company to run the fund

To Operate, Mutual Funds (contd)
  • Hire an investment advisor to manage the funds
  • Hire
  • a custodian to safeguard fund holdings.
  • a transfer agent to act as record keeper.
  • an underwriter to sell new shares.

Ways of Making Money With Mutual Funds
  • Increases in market value (appreciation)
  • Dividends
  • Capital gains distribution

Types of Investment Companies
  • Open-end investment companies or mutual funds
  • Closed-end investment companies or mutual funds
  • Unit investment trusts
  • Real estate investment trusts (REITs)

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

Closed-End Investment Companies or Mutual Funds
  • Have a limited number of shares
  • Sell 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.

Unit Investment Trusts
  • Fixed pool of securities, normally municipal
  • 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

Real Estate Investment Trusts (REITs)
  • Professional managers invest pooled funds in a
    diversified portfolio of real estate.
  • REITs require that 75 of fund income is
    generated from real estate investments and must
    distribute 95 of income as dividends.

Real Estate Investment Trusts (contd)
  • 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

Equity REITs
  • Buy property directly
  • Manage the property
  • Investors hope the real estate appreciates in

Mortgage REITs
  • Buy mortgages
  • Do not have any capital appreciation
  • Investors only receive interest payments on the

Hybrid REITs
  • Invest in both properties and mortgages
  • Investments result in both capital appreciation
    and interest income

The Costs of Mutual Funds
  • Load 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

The Costs of Mutual Funds (contd)
  • Management fees and expenses fees associated
    with the operation of the company
  • Expense ratio
  • Turnover rate
  • 12b-1 fees fees charged to cover the funds
    cost of advertising and marketing

Types and Objectives of Mutual Funds
  • Money market mutual funds
  • Stock mutual funds
  • Balanced mutual funds
  • Asset allocation funds
  • Life-cycle funds
  • Bond funds

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
  • Work much like an interest bearing checking
    account with some limitations
  • Considered practically risk-free

Specialized Types of MMMFs
  • Tax-exempt MMMFs invest in only munis
  • Government securities MMMFs invest in
    government paper to reduce risk, but lower return

Stock Mutual Funds
  • Aggressive growth funds
  • Small-company growth funds
  • Growth funds
  • Growth-and-income funds
  • Sector funds
  • Index funds
  • International funds

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
  • Less volatile than stock funds

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

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

Bond Funds
  • A small investment buys shares in a diversified
    bond portfolio
  • More liquid than individual bonds
  • Provide professional management
  • Provide regular income

Bond Funds (contd)
  • Can incur more expenses than purchasing bonds
  • Dont mature to pay a guaranteed lump sum
    investment like individual bonds do

Types of Bond Funds
  • U.S. government and GNMA bond funds
  • Municipal bond funds
  • Corporate bond funds
  • Specialized maturity length (short-,
    intermediate-, and long-term) funds

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

Buying a Mutual Fund
  • Step 1 Determine your investment goals.
  • Step 2 Identify funds that meet your objectives.
  • Step 3 Evaluate the fund.

Step 1 Determine Your Investment Goals
  • Determine your time horizon for each goal.
  • Determine your risk tolerance.
  • Determine your personal investment preferences.
  • Determine your tax planning strategies.

Step 2 Identify Funds That Meet Your Objectives
  • Look to third-party publications
  • Morningstar Mutual Funds
  • Determine the funds objective.
  • Determine the funds investment style
  • Value
  • Growth
  • Read the prospectus.

Information Contained in the Prospectus
  • The funds goal and investment strategy
  • The fund managers past experience
  • Any limitation on investments that the fund may
  • Any tax considerations of importance to the

Information Contained in the Prospectus (contd)
  • The redemption and investment process for buying
    and selling shares in the fund
  • Services provided investors
  • Performance over the past 10 years or since the
    fund has been in existence
  • Fund fees and expenses
  • The funds annual turnover ratio

Step 3 Evaluate the Fund
  • Always compare funds with the same objective
  • Evaluate the funds long-term performance
  • Look at returns in both up and down markets

Sources of Information
  • The Wall Street Journal
  • Forbes or Business Week
  • Kiplingers Personal Finance
  • Smart Money or Consumer Reports
  • Wiesenberger Investment Companies Service
  • Morningstar Mutual Funds

Mutual Fund Quotes in The Wall Street Journal
  • NAV net asset value (price)
  • NAV change gain or loss from prior days NAV
  • Total return NAV change plus accumulated income
  • Total return NAV change plus income for
    different time periods, in percent

Mutual Fund Quotes (contd)
  • 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

Calculating Fund Returns
  • Returns include distributions of dividends,
    distributions of capital gains, or NAV
  • Total return
  • dividends capital gains (ending NAV
    beginning NAV) beginning NAV

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)

Making the Purchase
  • Buy through a financial services broker, banker,
  • Probably a load
  • Buy directly from the mutual fund
  • No load
  • 1-800
  • Internet

Making the Purchase (contd)
  • Buy through a mutual fund supermarket
  • 8 major players, 2 largest are
  • Fidelity Funds Network
  • Charles Schwab
  • Minimum account balances vary
  • Transaction fees vary

  • What is a mutual fund and how does it operate?
  • Mutual fund advantages and disadvantages
  • Types of investment companies
  • Open and closed end mutual funds
  • Unit investment trusts
  • REITs

Summary (contd)
  • 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

Summary (contd)
  • 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