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Chapter 12 Mutual Funds: Professionally Managed Portfolios.

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Presentation on theme: "Chapter 12 Mutual Funds: Professionally Managed Portfolios."— Presentation transcript:

1 Chapter 12 Mutual Funds: Professionally Managed Portfolios

2 2 Mutual Funds Learning Goals 1.Describe the basic features of mutual funds, and note what they have to offer as investment vehicles. 2.Distinguish between open- and closed-end funds, as well as other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges. 3.Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.

3 3 Mutual Funds Learning Goals (cont’d) 4.Discuss the investor services offered by mutual funds and how these services can fit into an investment program. 5.Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes. 6.Identify the sources of return and compute the rate of return earned on a mutual fund investment.

4 4 Mutual Funds Mutual Fund: an investment company that invests its shareholders’ money in a diversified portfolio of securities –Investors own a share of the fund proportionate to the amount of the investment First started in 1924 Nearly 8,000 mutual funds available today More mutual funds in existence today than stocks listed on NYSE and AMEX combined 54 million U.S. households own mutual funds

5 5 Attractions of Mutual Funds Portfolio Diversification –Owning numerous securities reduces risk Professional management Ability to invest small amounts Service –Automatic reinvestment of dividends –Withdrawal plans –Exchange privileges Convenience –Easy to buy and sell; high liquidity –Funds handle recordkeeping –Easy to track prices

6 6 Drawbacks of Mutual Funds Substantial Transaction Costs –Management fee –Commission fees on load funds Lower-than-Market Performance –Consistently beating the market is difficult –Many mutual funds just keep even with overall stock market index

7 7 Figure 12.1 The Comparative Performance of Mutual Funds Versus the Market

8 8 How Mutual Funds are Organized Management company runs the funds’ daily operations Investment advisor buys and sells stocks or bonds and oversees the investment portfolio Distributor sells the fund shares –Direct to the public –Through brokers Custodian physically safeguards the securities Transfer agent keeps track of purchases and redemption requests from shareholders

9 9 Open-End Investment Companies Investors buy and sell shares directly with the mutual fund company without a secondary market Have an unlimited number of shares Purchase and selling price is determined by the Net Asset Value (NAV) of the fund All purchases and sales are completed at the end of the day after the stock markets have closed

10 10 Closed-End Investment Companies Sell only the initial offering –Subsequent trades are done in a secondary market, similar to the common stock market Have a limited number of shares Investment advisor doesn’t have to worry about cash inflow or outflows Purchase and selling price is determined by supply and demand Generally sell at premium or discount (usually discount) to NAV

11 11 Exchange-Traded Funds (ETF) A basket of securities designed to track a specific market index Similar to index mutual funds Trade like individual stocks on stock exchanges Can buy and sell ETFs any time of the day Low management expenses due to limited trading by investment advisor Low turnover helps avoid taxes until ETF is sold Types of ETFs –“Diamonds” (DIA) track DJIA –“Spiders” (SPY) track S&P 500 –“Qubes (QQQ) track NASDAQ 100

12 12 Load and No-Load Funds Load Fund: a mutual fund that charges a commission when shares are bought –Typically sold through a broker No-load Fund: a mutual fund that does not charge a commission when shares are bought –Typically sold directly to investor by mutual fund –Cost savings tend to give investors a head start in achieving superior rates of return Low-load Fund: a mutual fund that charges a small commission (2% to 3%) when shares are bought

13 13 Load and No-Load Funds Back-end load: a commission charged on the sale of shares in a mutual fund 12(b)-1 fee: fee charged by some mutual funds to cover management and other operating costs; amounts to as much as 1% of the average net assets

14 14 Other Fees and Costs Management fee: compensation paid to professional managers who administer the fund’s investment portfolio –This fee is paid by all types of funds (load vs. no-load; open-end vs. closed-end) –Fee is charged annually on average net assets Administrative costs: the normal costs of doing business, such as trading expenses Taxes on mutual funds –Mutual funds do not pay taxes if income and capital gains are passed on to shareholders –Shareholders are taxed on their share of income and capital gains annually

15 15 Figure 12.2 Fund Fees and Charges on the Web ©2003 Morningstar, Inc. Used with permission.

16 16 Table 12.1 Mutual Fund Fee Table (Required by Federal Law)

17 17 Unit Investment Trusts (UIT) Fixed pool of securities, normally bonds Not actively managed; securities in portfolio remain static Have shares that represent a proportionate share of the trust

18 18 Real Estate Investment Trusts (REIT) Closed-end investment company that invests in mortgages and various types of real estate investments Provide high dividends along with capital appreciation potential Types of REITs –Property/equity REITs invest in shopping centers, hotels, apartments, office buildings and other real estate –Mortgage REITs invest in mortgages –Hybrid REITS invest in both properties and mortgages

19 19 Hedge Funds Not really mutual funds; private limited partnerships Not regulated by mutual fund regulations General partner runs fund and takes 10-20% of profits; limited partners are investors Only sold to “accredited investors”—net worth greater than $1,000,000 and/or annual income over $200,000 Use arbitrage strategies, options, short sales and other complex strategies

20 20 Types of Mutual Funds Growth Fund: primary goals are capital gains and long-term growth –Invest in large, well-established companies with above-average growth potential –Little or no dividend income –Moderately risk investments for more aggressive investors

21 21 Types of Mutual Funds (cont’d) Aggressive Growth Fund: highly speculative mutual fund that seeks large profits from capital gains –Invest in small, unseasoned companies with high price/earnings ratios –Often look for turnaround situations –Prices are often highly volatile –High risk investments for very aggressive investors

22 22 Types of Mutual Funds (cont’d) Value Fund: seeks stocks that are undervalued in the market –Focus is on intrinsic value of stocks and requires extensive fundamental analysis –Invest in stocks with low P/E ratios, high dividend yields and promising futures –Looks for undiscovered companies with potential for future growth –Less risky investments for relatively conservative investors looking for moderate growth

23 23 Types of Mutual Funds (cont’d) Equity-income Fund: emphasizes current income and capital preservation –Focus is on high current income with some long-term capital appreciation –Invest in high-yielding common stocks, convertible securities or preferred stocks –Invests in “blue chip” stocks and other high-grade securities –Typically less price volatility than overall stock market –Less risky investments for relatively conservative investors looking for moderate growth

24 24 Types of Mutual Funds (cont’d) Balanced Fund: generates a balanced return of both current income and long-term capital gains –Invest in blend of fixed-income securities and common stocks, with 30% to 40% in fixed income –Allocation between stocks and bonds typically remains constant or varies very little –Emphasis between fixed-income and common stocks can be shifted as market conditions change –Less risky investments for relatively conservative investors looking for moderate growth

25 25 Types of Mutual Funds (cont’d) Growth-and-Income Fund: seeks both long-term growth and current income, with primary emphasis on capital gains –Focus is on long-term capital appreciation with some high income to provide limited stability –Invest in blend of commons stocks and fixed-income securities, with up to 90% in common stocks –Moderate risk investments for investors who can tolerate moderate price volatility

26 26 Types of Mutual Funds (cont’d) Bond Funds: invests in various kinds and grades of bonds, with income as primary objective –Advantages of bond funds over individual bonds: More liquid Offer high diversification Bond funds automatically reinvest interest –Lower risk investments for investors who are looking for steady income –Some price volatility occurs with changing interest rates

27 27 Types of Bond Funds Government bond funds: invest in U.S. Treasury and agency securities Mortgage-backed bond funds: invest in mortgage- backed securities of U.S. government, such as GNMA’s High-grade corporate bond funds: invest in corporate bonds rated triple-B or better High-yield corporate bond funds: invest in lower rated corporate bonds (junk bonds) Convertible bond funds: invest in securities that can be converted into common stocks

28 28 Types of Bond Funds (cont’d) Municipal bond funds: invest in tax-exempt securities issued by states and political subdivisions –Single-state fund: invests in municipal issues of only one state to provide double tax-free income Intermediate-term bond funds: invest in bonds with maturities of 7 to 10 years or less Short-term bond funds: invest in bonds with maturities of 2 to 5 years –Often used as alternative to money market funds when interest rates are low

29 29 Money Market Funds Invest in short-term securities with maturities of less than 90 days Interest rates move up and down with market rates Trade at a constant net asset value of $1 per share Considered a safe, convenient investment to accumulate capital and temporarily store idle funds Types of money market funds: –General purpose: invests in all types of money market investments –Government securities: invest only in U.S. Treasury bills and other short-term government securities –Tax-exempt: invest in very short-term tax-exempt municipal securities

30 30 Types of Mutual Funds Index Funds: buys and holds a portfolio of stocks (or bonds) equivalent to those in a specific market index –Objective is to match, not beat, the specific index –Strategy is buy-and-hold, which provides tax advantages with very little taxable capital gains –Operating costs are very low due to low turnover in investment portfolio

31 31 Types of Mutual Funds (cont’d) Sector Funds: investments are restricted to a particular segment of the market –Investments are concentrated in one specific industry sector –Objective is to produce capital gains –Considered speculative because limited diversification can increase investment risks

32 32 Types of Mutual Funds (cont’d) Socially Responsible Funds: funds that actively and directly incorporate ethics and morality into the investment decision –Specific stocks are evaluated on financial criteria and moral, ethic or environmental tests –Stocks that do not meet these tests are not considered for the investment portfolio –Examples of excluded companies: Tobacco or alcohol Gambling Nuclear energy –Returns may be reduced due to limited investment opportunities

33 33 Types of Mutual Funds (cont’d) Asset Allocation Funds: funds that spread investors’ money across stocks, bonds, and money market securities –Provides built-in asset allocation by professional investment manager –As market conditions change over time, the asset allocation mix changes as well –Provides convenience of “one-stop shopping” without having to own several mutual funds

34 34 Types of Mutual Funds (cont’d) International Funds: funds that do all or most of their investing in foreign securities –Objective is to benefit from changes in: International market conditions Valuation of U.S. dollar –Funds can specialize in international stocks, bonds or money market securities –Funds can specialize in growth, value, aggressive growth and other types of stocks –Funds can specialize in specific countries or regions of the world –Considered fairly high-risk due to currency exchange risks

35 35 Mutual Fund Investor Services Automatic Investment Plans –Regular investment from checking or savings account or paycheck –Monthly amounts as small as $25 –Excellent way to build up investment over time Automatic Reinvestment of Interest, Dividends, and Capital Gains Systematic Withdrawal Plans

36 36 Mutual Fund Investor Services (cont’d) Conversion (Exchange) Privileges –Load funds usually allow exchanges between mutual funds in the same fund family without paying additional sales loads –Exchanges between funds can trigger capital gains taxes in non-retirement accounts Phone Switching Easy Establishment of Retirement Plans

37 37 Investor Uses of Mutual Funds Accumulation of Wealth Storehouse of Value Speculation and Short-Term Trading

38 38 Selecting Mutual Funds Determine if you want to use mutual funds in portfolio –Mutual funds increase diversification –Mutual funds offer expertise in areas where investor may not be informed –Can use stocks and mutual funds Compare mutual fund’s investment objective to investor’s objective Compare range of services offered

39 39 Sources of Information Fund prospectus The Wall Street Journal Barron’s, Money, Fortune or Forbes Morningstar Mutual Funds Value Line Mutual Fund Survey Websites such as Yahoo.finance.com

40 40 Figure 12.5 Some Relevant Information About Specific Mutual Funds ©2003 Morningstar, Inc. Used with permission.

41 41 Factors in Comparing Mutual Funds Fund’s investment performance Tax efficiency Fee structure How particular fund fits into your portfolio Investment skills of fund managers Load or No-Load funds Closed-End or Open-End funds

42 42 Comparing Closed-End and Open-End Funds Brokerage commissions apply to closed-end funds Open-end funds have greater liquidity Closed-end funds trade at premium (or discount) to NAV –Avoid closed-end funds trading at premium –Look for closed-end funds trading at discount

43 43 Sources of Return from Mutual Funds Dividend income Capital gains distributions Change in price/NAV –Unrealized capital gains (paper profits): capital gain that has not been realized since fund’s holdings have not been sold

44 44 Calculating Return: Holding Period Return Returns include distributions of dividends, distributions of capital gains, or NAV appreciation Return for specific holding period Best for one year returns since does not use present value

45 45 Chapter 12 Review Learning Goals 1.Describe the basic features of mutual funds, and note what they have to offer as investment vehicles. 2.Distinguish between open- and closed-end funds, as well as other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges. 3.Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.

46 46 Chapter 12 Review (cont’d) Learning Goals (cont’d) 4.Discuss the investor services offered by mutual funds and how these services can fit into an investment program. 5.Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes. 6.Identify the sources of return and compute the rate of return earned on a mutual fund investment.

47 Chapter 12 Additional Chapter Art

48 48 Figure 12.3 Mutual Fund Quotes

49 49 Figure 12.4 The Effects of Reinvesting Income

50 50 Figure 12.6 Selected Performance on CEFs

51 51 Table 12.2 A Report of Mutual Fund Income and Capital Changes (For a share outstanding throughout the year)


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