1. Mutual fund investment primer Alan Palmiter Ahmed Taha © 2008

2. What is a mutual fund?

3. Fund Investors Management Company Investment Adviser Distribution Company Owners services Board

4. Source: Bogle / Federal Reserve Flow of Funds Accounts

5. A pop quiz …

6. 1.Mutual funds are primarily owned by: a.Individuals on their own (through fund group, broker) b.Individuals with retirement accounts (401(k), IRA) 2.Mutual funds mostly invest in: a.Stocks b.Bonds c.Notes (money market) 3.What have been annual returns on stock funds (last 20 years: 1987-2007): a.17.8% b.11.8% c.9.3% d.4.3% 4.Warren Buffet predicts that annual stock returns over the next 10 years will be: a.6.5% b.9.6% c.12.3% d.21.7% 5.Past performance of stock funds generally predicts future returns. a.Yes b.No c.Only low-performing funds 6.Mutual fund investors say they pay attention more to fees than to performance. a.True b.False

7. 7.As a mutual fund investor, you are entitled to: a.Prospectus (before you invest) b.Annual report (showing fund performance) c.Statements (showing breakdown of expenses / fees / trading costs) 8.Mutual funds only impose a sales charge at the time you invest. a.True b.False 9.Rate that average stock fund sells and replaces stock (“turnover”) in its portfolio: a.6% b.56% c.90% d.153% 10. What is a no-load fund? a.An unleveraged fund b.A fund without sales charges c.A fund without trading costs d.A fund without withdrawal fees 11. Think about your own largest mutual fund: a.Your current balance b.Fund’s investment objectives c.Fund’s sales charges, expense ratio, trading costs d.Fund’s performance last year 12. Consider your car/vehicle: a.Its make, model, year b.Its cost, total miles, safety rating, gas efficiency c.You get our point.

8. 1.Mutual funds are primarily owned by: a.Individuals on their own (through fund group, broker) b.Individuals with retirement accounts (401(k), IRA) 2.Mutual funds mostly invest in: a.Stocks b.Bonds c.Notes (money market) 3.What have been annual returns on stock funds (last 20 years: 1987-2007): a.17.8% b.11.8% [stock market] c.9.3% [average fund] d.4.3% [average fund investor] 4.Warren Buffet predicts that annual stock returns over the next 10 years will be: a.6.5% b.9.6% c.12.3% d.21.7% 5.Past performance of stock funds generally predicts future returns. a.Yes b.No c.Only low-performing funds 6.Mutual fund investors say they pay attention more to fees than to performance. a.True b.False

9. 7.As a mutual fund investor, you are entitled to: a.Prospectus (before you invest) b.Annual report (showing fund performance) c.Statements (showing breakdown of expenses / fees / trading costs) 8.Mutual funds only impose a sales charge at the time you invest. a.True b.False 9.Rate that average stock fund sells and replaces stock (“turnover”) in its portfolio: a.6% b.56% c.90% d.153% 10. What is a no-load fund? a.An unleveraged fund b.A fund without sales charges c.A fund without trading costs d.A fund without withdrawal fees 11. Think about your own largest mutual fund: a.Your current balance b.Fund’s investment objectives c.Fund’s sales charges, expense ratio, trading costs d.Fund’s performance last year 12. Consider your car/vehicle: a.Its make, model, year b.Its cost, total miles, safety rating, gas efficiency c.You get our point.

10. Who is average mutual fund investor?

11. Knowledge of basic fund characteristics –Asset class? –Fund risk? –Fund expenses? Investment acumen: relevance of past returns –Morningstar ***** –Asset classes?

12. US Households (112 million) Retirement account 51% 55 million own mutual funds (90% have Internet access) 79% (broker) Own fund on own 49% 29% (direct) 48% (IRAs) 52% (DC plans) Mutual funds ($10.5 T) Stocks 40% Money Mkt 40%Bonds 20%

13. A graphical look at business model …

14. $93,304 $59,034 $22,852

15. Investor profiles according to … (1)Industry (2)SEC (3)Finance literature

16. ICI Investor Preferences (2006)

17. William O. Douglas: ”The investors’ advocate”

18. Prospectus VFINX VFINX Disseminated –after investment / then once annually –Including electronically / filed SEC Disclosure –Investment strategies –Risks (narrative) –Performance (1/5/10 years) –Expenses (sales charge, 12b-1 fees, mgmt fees) –Turnover rate Effect –Omissions in fund literature not fraudulent, if info in prospectus Fund comparer (SEC website / NASD)SEC website NASD)

19. Statement of Additional Information Not disseminated –Available to investors (incorporated by ref into prospectus) / file SEC –No fraud liability if in SAI Disclosure –Fund organization –Investment policies / limitations –Management of fund –Proxy voting policies –Financial statements Can cover multiple funds Only place that discloses trading costs (commissions)

20. Annual and semi-annual statements Disseminated –Send semi-annually to all investors –Available on SEC website Disclosure –Annually, MDFP (what’s affecting performance, line graph comparison to relevant index) –Financials (including expenses, turnover rate) –List of portfolio holdings (now summary of significant holdings, chart of category breakdown) Focus of statement Is on performance, not expenses/costs

21. Advertising Regulated –SEC Rule 482 – must state where can get prospectus –NASD Rule 2210 – must file with Advertising Reg Dept Disclosure –Can include performance data (standardized format) –Info beyond prospectus Required disclaimer –“Consider investment objectives, risks, charges, expenses” –“Past performance does not guarantee future results” No longer does ad info have to come from prospectus

22. Investors’ Cognitive Biases Representativeness heuristic Endowment effect Anchoring heuristic Affect heuristic Definition: People believe that experience is representative of reality (“past is prologue”) Implications: You believe a fund’s historical returns will continue – you “buy high and sell law” You pour money into the latest “hot funds” Reality: Little evidence that returns are persistent for high-performing mutual funds (see)see

23. Investors’ Cognitive Biases Representativeness heuristic Endowment effect Anchoring heuristic Affect heuristic Definition: People value something more when they already own it Implication: You believe your funds are better than funds you don’t own. Reality: Investors overestimate their funds’ returns Investors exhibit brand and fund loyalty (staying in poor- performing funds).

24. Investors’ Cognitive Biases Representativeness heuristic Endowment effect Anchoring heuristic Affect heuristic Definition: People rely on “anchor values” in making number estimates Implication: You pay attention to fund advertising with “big numbers” (distorting your risk- return perceptions) Reality: Just changing fund name affects investors’ estimates of expected returns “Euro Star 100 fund” = 11.8% “Euro Star 500 fund” = 22.6%

25. Investors’ Cognitive Biases Representativeness heuristic Endowment effect Anchoring heuristic Affect heuristic Definition: People’s current affect (e.g., fear, pleasure) influences their decisions Implication: You are influenced by nice images of the future and lavish investment dinners Reality: Ads evoking positive emotions cause investors to not consider risk

26. A proposal … (1) Point of sale (2) Statements (3) Confirmations

27. Asset returns / risk (1926-2004) Average ReturnStandard Deviation Small Company Stocks12.7%33.1% Large Company Stocks10.4%20.3% Long-Term Corporate Bonds5.4%9.3% Treasury Bills3.7%3.1%

28. Fund XYZ performance Inv return Expenses/costsNet return 1-year 4.5% 2.1% 2.4% 5-years 7.6% 2.4% 5.2% 10-years11.5% 1.9% 9.6% 20-years 8.9% 1.6% 7.3%

29. Your statement (Fund XYZ) Beginning balance$10,000 Investments$ 2,000 Withdrawals$ -- Investment return$ 850 7.7% Expenses Sales charge$ 60 0.5% Adm/advisory fees$ 140 1.3% Trading costs$ 80 0.7% TOTAL$ 280 2.5% Net return$ 570 5.2% Ending balance$12,570 66% - lower expenses 34% - higher expenses Expenses (compare to other comparable funds) 2.5% XYZ 6.3%0.3% Your fund has about average expenses, but 40% of other similar funds have lower expenses. You could be saving up to 2.2% on fund expenses.

30. The end