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Investing in Mutual Funds

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Title: Investing in Mutual Funds


1
CHAPTER 13
Investing in Mutual Funds
a.k.a. Investment Companies
Mutual Funds will bore you to wealth.
Industry saying
2
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.

3
Mutual Funds
  • STOCKS BONDS CASH

Balanced mutual funds
Bond mutual funds
Stock mutual funds
Money market mutual funds
a mutual fund
Professional Money Management Diversification
4
Why Investors Purchase Mutual Funds
  • Professional management
  • Who is the funds 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

5
Growth of Mutual Fund Industry
Year Number 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
6
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?
7
Annual Operating Expenses
  • Management fees
  • Charged yearly (0.2 to 2 or more) based on a
    percentage of the funds 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

9
Load Funds versus No-load Funds
(continued)
  • 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 doesnt mean the overall fees are low
  • Over time, a no-load fund can wind up costing
    more in fees than a load fund

Load
10
Example of Shareholder Fees
Investment Company of America
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
This is a load fund.
11
Example of Shareholder Fees
Alliance Large Cap Growth Fund
Transaction fees Class A Class B Class C Class F
Maximum sales charge 4.25 None None None
Maximum sales charge on reinvested dividends None None None None
Maximum deferred sales charge None 4.00 1.00 None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class B Class C Class F
Management Fees 0.75 0.75 0.75 0.75
Distribution and/or Service Fees (a.k.a. 12b-1) 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
Another load fund.
12
Example of Shareholder Fees
Legg Mason Value Trust
Transaction fees Class A Class C Financial Institutional
Maximum sales charge 5.75 None None None
Maximum sales charge on reinvested dividends None None None None
Maximum deferred sales charge None 0.95 None None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class C Financial Institutional
Management Fees 0.67 0.67 0.67 0.67
Distribution and/or Service Fees (a.k.a. 12b-1) 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
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.
13
Example of Shareholder Fees
Vanguard 500 Index Fund
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends None
Maximum deferred sales charge None
Redemption or exchange fees None
This is an index fund. This fund does no
research. They simply buy all the 500 stocks in
the SP 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.
Annual Operating Expenses Class A
Management Fees 0.14
Distribution and/or Service Fees (a.k.a. 12b-1) ?
Other Expenses 0.03
Total 0.17
?There is a 20 annual fee if your account value
is less than 10,000.
14
Example of Shareholder Fees
Fidelity Spartan 500 Index Fund
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends None
Maximum deferred sales charge None
Redemption or exchange fees None
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.
Annual Operating Expenses Class A
Management Fees 0.07
Distribution and/or Service Fees (a.k.a. 12b-1) ?
Other Expenses 0.03
Total 0.10
?Like the Vanguard fund, there is a low balance
annual fee of 10 if your account is below
10,000.
15
Examples of Dollar Costs
Investment Company of America
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 doesnt include the advisors
annual fee. Adding the advisors 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?
16
Examples of Dollar Costs
Legg Mason Value Trust
Hypothetical 10,000 Investment with 5 Return 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 doesnt include the advisors 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?
17
Examples of Dollar Costs
Vanguard 500 Index Fund
Hypothetical 10,000 Investment with 5 Return 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 SP 500
has an expense ratio of 0.06.
18
Breakpoint Sales Reductions
Investment Company of America
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?
19
CDSC Reduction over Time
Investment Company of America
Contingent Deferred Sales Charge (CDSC) on Class B Shares 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.
20
10-Year Rates of Return
So, Which One Would You Pick?
as of March 31, 2012
Investment 10-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 Poors 500 Index 4.12 14,972
A
B
C
D
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.
4.36 (15,323) and 4.19 (15,079),
respectively, without sales charge
21
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 shares
  • B shares
  • C shares
  • F or I shares

The correct answer is (B). They normally become
A shares after 6 to 8 years.
22
Mutual Funds Fees What are __?
  • 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 shares
  • B shares
  • C shares
  • F or I shares

The correct answer is (C). They sometimes revert
to A or F shares after many years.
23
Mutual Funds Fees What are __?
  • 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 shares
  • B shares
  • C shares
  • 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.
24
Classification of Mutual Funds
  • 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

These classifications are just some of the major
types of stock mutual funds. There are many,
many more.
25
Classification of Mutual Funds
(continued)
  • 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

Which do you think is riskiest?
Which do you think is riskiest?
26
Classification of Mutual Funds
(continued)
  • 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

What are the advantages / disadvantages of each
of these types?
27
Classification of Mutual Funds
(continued)
  • 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 dont mind being charged twice!
  • Often marketed as a total mutual fund solution
  • Retirement (401k), College Education, etc.

28
Classification of Mutual Funds
(continued)
  • 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

The choices are endless. So are the fees
29
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 (SP 500, US Total Market, EAFE)
  • Why?
  • Usually much lower annual operating expenses
  • Many actively managed funds dont 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!

30
The Buzz about ETFs
  • 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 ETFs
  • 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

31
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
32
Fund Families Top Ten Families
  1. Vanguard Group
  2. Fidelity Investments
  3. American Funds (CRM)
  4. PIMCO Funds
  5. J. P. Morgan Chase
  6. Franklin Templeton Investments
  7. BlackRock Funds
  8. Federated Investors
  9. Bank of New York / Dreyfus Corporation
  10. T. Rowe Price

Examples Offerings from the top three families
Because of the mutual fund scandals of 2003,
three of the companies that used to be amongst
the top ten are no longer here.
Source Investment Company Institute,
http//www2.iii.org/financial/securities/mutualfun
ds August 2010
33
Mutual Fund Scandals?!
Wait a minute, Paiano! Did you just say,
  • 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.
34
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

35
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

36
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?!
37
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

Lets run some hypotheticals!
38
And Thats Not the Only One!
Do you remember this slide from chapter 1? As of
December 31, 2011
39
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 dont 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!
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