Presentation on theme: "Personal Finance: An Integrated Planning Approach"— Presentation transcript:
1Personal Finance: An Integrated Planning Approach Winger and FrascaChapter 12Mutual Funds and Other Pooling Arrangements:Simplifying and (Maybe) Improving Your Investment Performance
2IntroductionThere are various types of pooling arrangements such as mutual funds, unit investment trusts, and limited partnerships.Mutual funds are important investment choices for investors because they provide diversification and professional management for a fee.Choosing a mutual fund involves the selection of the proper mix of risk and return.The risk tolerance of investors must be factored into the investment decision when constructing a portfolio.
3Chapter ObjectivesTo understand why pooling arrangements are important alternatives to direct investmentTo identify the important characteristics of open-end and closed-end mutual fundsTo be able to evaluate a mutual fund within a risk and return frameworkTo recognize the characteristics of unit investment trusts and real estate investment trusts and how each differs from mutual funds
4Chapter Objectives (Continued) To understand the basic framework of limited partnerships and why they appeal only to a limited number of investorsTo learn the basics of portfolio construction and maintenance and appreciate why mutual funds simplify the process
5Topic Outline Mutual Funds Other Pooling Arrangements Constructing and Maintaining Your Personal Portfolio
7Mutual FundsA mutual fund is an investment company that pools the funds of many individuals to invest in stocks, bonds, and other investment securities.Investors buy shares in the mutual fund.The mutual fund buys: Shares in companies and/or, bonds of companies, municipalities, governments and/or, other investment securitiesA fund’s net asset value (NAV) is the total value of all the assets the fund owns (minus any liabilities) divided by the number of shares issued by the fund.
8Example: Fund X’s NAV Company # of Shares Price per Total Owned Share ValueIBM $ $12,000Xerox ,000GM ,000Value of the fund’s portfolio $27,000Number of shares issued ,000Fund X’s NAV $ 27.00
9Load Versus No-Load Funds A load is a commission paid to buy or sell fund shares.Loads range from 1% to over 9% of the NAV.No-load funds have no commission to buy shares (called a “front-end” load) but some charge a commission to sell (called a “back-end” load).The load pays the fund salesperson who should provide investment advice for this fee.There is no evidence that load funds perform better than no-load funds.
10Open-End Funds These are the most popular types of funds. They advertise extensively to attract investors.The largest and best known are Fidelity and Vanguard.You can deal directly with the fund or through a salesperson to buy and sell shares.Completing an application form is easy.Shares are purchased/sold at NAV (plus load, if applicable).You can use many fund services.
11Closed-End Funds These fund shares trade in the securities markets. You trade shares as you would the shares of any company.While you do pay a broker’s commission, there are no loads.Shares can trade at premiums or discounts to NAV.Discounts can be attractive because you are, in effect, getting a bargain.If you buy the share at a discount, you, in effect, buy $1.00 worth of securities for less than $1.00.
12The Fund’s Objectives Type of Fund Fund Objective ___________ _______________________________Growth Price appreciation over timeIncome High current returnBalanced Good current return with some growthMoney Mkt. High liquidity and returns better thanbank returnsMaximum Exploit opportunities to earn very highAppreciation returns
13The Fund’s Objectives (Continued) Type of Fund Fund Objective____________ ______________________________Sector Invests in only one industryInternational Earn returns in countries outsidethe United StatesGlobal Earn returns in both the UnitedStates and foreign countriesIndex Earn returns equal to a market indexreturn
14Important Mutual Fund Services Reinvestment plans: Can reinvest dividends and capital gainsTransactions by telephone and InternetFund switching within a fund familyCan sell shares of one fund and reinvest in shares of another fund within the fund familyBe careful of loads thoughAdaptability to IRAs due to low costs and wide range of investment objectives
15Selecting a Mutual Fund Evaluate performance.Review the fund’s current portfolio.Examine expenses and turnover.Review evaluations in popular magazines and newspapers.Consult a professional evaluation service such as Morningstar or Lipper Analytical Services.
16Performance Measurements Growth of $10,000 over timeExample: A cumulative total return of 173.8% means that the $10,000 invested 10 years ago has earned $17,380 and the investment is now worth $27,380Assumes that all dividends are reinvested as they are earned each quarterAverage Annual Total Return (AATR)Expresses the cumulative return as a yearly average10.62% for example above
17Risk-Adjusted Rate of Return (RAROR) Adjusts a fund’s AATR by its beta value and compares this adjusted return to the overall market returnRAROR = (AATR/Beta) – S&P 500 ReturnExample: AATR = 10.62%; Beta = 0.94; S&P 500 Return = 11.07%RAROR = (10.62%/0.94) – 11.07%= 11.30% – 11.07% = %This fund outperformed the S&P 500 return.
18Interpreting RAROR A positive RAROR indicates good fund management. A negative RAROR indicates poor fund management.It is important to have positive RAROR consistently over time – do not rely too heavily on one year’s number.
19Other Evaluation Items Review the fund’s current portfolioIs there adequate diversification?Review the fund’s operating expensesUsually expressed as a percent of net assetsLow expense ratios are desirableCompare to other funds with similar investment objectivesExamine the portfolio turnover percentTurnover percent measures the trading frequencyHigh numbers = high trading
20External Fund Evaluations Popular business publications such as:The Wall Street Journal – the Friday issue especiallyBusiness WeekForbes MagazineMoney MagazineProfessional EvaluationsMorningstar: Web site has free featuresLipper Analytical Services: Also check out their Web siteBoth sources have more extensive research for a fee
21Unit Investment Trusts (UITs) Similar to an open-end fundTrust units (shares) are purchased from and redeemed by the fund originator.Redemption is at current market value.Major differenceA trust’s portfolio is unmanaged. Once it is established, it is left virtually unchanged.This leads to very low operating costs.However, they have loads.
22Creation of a UIT Trust Originator Buys a Portfolio of Bonds and Sells Trust Units to Individual InvestorsInvestor AInvestor BInvestor ZWho May Hold Their Units to Maturity orMay Sell Back to Originator—at Current Market Value
23Exchange-Traded Funds (ETFs) These are a variation of the UIT.These are similar to closed-end funds that trade in the securities markets.They have relatively fixed portfolios.The most popular ETFs are based on broad market indexes (QQQ, Spiders, Diamonds, etc.).There are also some ETFs that are based on market segments such as sectors (iShares, Holders, etc.).
24ETF Advantages and Disadvantages Positions can be taken quickly—similarly to any individual stock.ETF shares can be purchased on margin.They have very low expense ratios.Investors have more control over the recognition of capital gains/losses by determining when to sell shares.Although commissions must be paid on every trade, they can be much less than on load funds.
25Real Estate Investment Trusts (REITs) Similar to a closed-end fundEquity per share (EqPS) of a REIT is similar to NAV and is calculated as follows:EqPS = (REIT assets – liabilities)/(REIT shares outstanding)Types of REITsEquity trusts: Invest in rental propertiesMortgage trusts: Invest in mortgagesThe investment appeal is that this is an easy way to include real estate in an investment portfolio.
26Limited Partnerships (LP) These are formed by a general partner who runs the business.Limited partners only invest money and not time.LPs invest in various activities such as:Real estateEnergy programsEquipment leasing
27LP Advantages and Disadvantages The unique feature is the pass through of business profits and losses to limited partners.Losses can have significant advantages if used to offset other taxable income.The current tax code, however, severely limits such deductions.This limitation makes LPs an undesirable investment vehicle for most investors.Moreover, LP interests cannot be easily sold, making the investment highly illiquid.
28Investment Clubs Characteristics Advantages Disadvantage Low monthly contributions such as $25 – $50Members do research on specific stocksFrequent meeting, usually monthlyAdvantagesDiversificationHelp with investing research workloadPossibility of a profitFun and fellowshipDisadvantageToo much fun, not enough research
29Portfolio Construction: Aggressive Investor Any portfolio construction should begin with an understanding of the investor’s risk tolerance.The portfolio characteristics for aggressive investors, those with a high risk-tolerance, should be:High risk tolerance and high future return preferencePriority of specific future goals is not strongThis type of portfolio is appropriate for wealth investors and those with no dependents.
30Portfolio Construction: Cautious Investor Those investors who would be considered cautious from a risk-tolerance standpoint are:Anyone with dependentsInvestors planning for retirementInvestors planning a major purchaseThe characteristics of this portfolio are:Low risk toleranceHigh preference for future returnStrong priority of specific future goals
31Portfolio Construction: Investor Who Needs Income Investors that fit this type of portfolio are:RetireesPersons with dependents to supportPersons with no major future expensesThe characteristics of this type of portfolio are:Moderate risk toleranceReturn preference for current returnModerately strong priority of specific future goals
32Investment Selection Aggressive investor: Cautious investor: 100% stocks: 1/3 large company, 1/3 small company, 1/3 internationalCautious investor:30% large company growth stocks, the balance in bonds, including zero couponInvestor who needs current income:50% high-quality corporate bonds, 25% medium-quality corporate bonds, and 25% income stocks
33Maintaining a Portfolio (Portfolio Rebalancing) Stocks Bonds(1) Amount Invested Initially $10, $10,000(2) Current Market Values 15, ,000(3) Adjustment withConstant Ratio Plan * – 3, ,000(4) Adjusted Balances , ,000____________* A variable ratio plan would sell more stocks and buy more bonds.
34401 (k) Plan Considerations Don’t reject participation because this is a disciplined way to save and it is free money if your employer matches any portion of your contribution.Diversify broadly using a variety of funds.Coordinate out-of-plan investments with in-plan investments.Don’t try to time the market, even though gains are not taxed.Avoid excessive conservatism.
35Discussion Questions What is a mutual fund? Explain two advantages of investing in mutual funds.Explain the differences between open-end and closed-end mutual funds.Explain how to evaluate the risk and return characteristics of a mutual fund.Exchange-traded funds are a very popular investment choice. Explain two advantages of these funds.Explain the difference between no-load and load.
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