Mutual Funds: An Easy Way to Diversify

15-2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 1. Weigh the advantages and disadvantages of investing in mutual funds. 2. Differentiate between types of mutual funds, ETFs, and investment trusts.

15-3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 3. Classify mutual funds according to objectives. 4. Select a mutual fund that is right for you. 5. Calculate mutual fund returns.

15-4 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Introduction A way of holding investments such as stocks and bonds. Mutual fund—an investment that raises from investors, pools the money, and invests it in stocks, bonds, and other investments. Each investor owns a share of the fund proportionate to his/her investment.

15-5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 15.1

15-6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Why Invest in Mutual Funds? Advantages of mutual funds: Professional management Minimal transaction costs Liquidity Flexibility Service Avoidance of bad brokers

15-7 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.1

15-8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Why Invest in Mutual Funds? Disadvantages of mutual funds: Lower-than-market performance Costs Risks You can’t diversity away a market crash. Taxes.

15-9 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Mutual Fund-Amentals A mutual fund pools money from investors with similar financial goals. You are investing in a diversified portfolio that’s professionally managed according to set goals. Investment objectives are clearly stated.

15-10 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Mutual Fund-Amentals As the value of the securities in the fund increases, the value of each mutual fund share also rises. Most pay dividends or interest to shareholders. Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid.

15-11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Mutual Fund-Amentals Fund is set up as a corporation or trust Shareholders elect a board of directors. Fund is run by a management company. Each individual fund hires an investment advisor to oversee the fund. Contracts with a custodian, a transfer agent, and an underwriter.

15-12 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 15.2

15-13 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Investment Companies Invest the pooled money of a number of investors in return for a fee. Open-End Investment Companies or Mutual Funds Net asset value (NAV)

15-14 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Investment Companies Closed-End Investment Companies Unit Investment Trusts Real Estate Investment Trusts (REITs)

15-15 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Load Versus No-Load Funds Load—commission charged on a mutual fund Load fund—mutual fund on which a load is charged. Class A shares– front-end sales load Class B shares– back-end load Class C shares – pay coming and going No-load fund—doesn’t charge commission.

15-16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Management Fees and Expenses Expense ratio—the ratio of a mutual fund’s expenses to its total assets Invest in a fund with a low expense ratio Turnover rate—measures the level of the fund’s trading activity. Higher turnover rate, higher the fund’s expenses.

15-17 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 12b-1 Fees Annual fee, generally ranging from 0.25 to 1.00% of a fund’s assets, that the mutual fund charges its shareholders for marketing costs.

15-18 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.2

15-19 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Calculating Mutual Fund Returns Return can be in the form of dividends, capital gains, or a change in net asset value Automatic reinvestments result in increases in the NAV and number of shares. Calculating returns can help you spot funds that have consistent winners over time.

15-20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Money Market Mutual Funds Invest in Treasury bills, CDs, and other short-term investments, less than 30 days. Carry no loads, trade at a constant $1 NAV, and have minimal expense ratios. Tax-exempt money market fund Government securities money market mutual fund

15-21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Stock Mutual Funds Aggressive growth funds Small company growth funds Growth funds Growth-and-income funds Sector funds Index funds International funds

15-22 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 15.3

15-23 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Balanced Mutual Funds Tries to balance objectives of long-term growth, income, and stability Hold both common stock and bonds and sometimes preferred stock. Aimed at those needing income to live on and moderate stability in their investment. Less volatile than stock mutual funds.

15-24 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Asset Allocation Funds Invest in stocks, bonds, and money market securities. Move money between stocks and bonds to outperform the market. Balanced funds that practice market timing.

15-25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Life Cycle and Target Retirement Funds Mutual funds that try to tailor their holdings to the investor’s individual characteristics, such as age and risk Target retirement funds are managed based on when you plan to retire.

15-26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Bond Funds Mutual funds that invest primarily in bonds. Fluctuate in value with market interest rates Use for small amounts of money, to keep investments liquid. Otherwise, use individual bonds where there is no professional management or fees.

15-27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Bond Funds U.S. Government Bond Funds of GNMA Bond funds Municipal Bond Funds Corporate Bond Funds Bonds and their maturities: Short-term (1-5 years) Intermediate-term (5-10 years) Long-term (10-30 years)

15-28 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall ETFs or Exchange Traded Funds A hybrid between a mutual fund and an individually traded stock or bond that trade on an exchange like individual securities do and can be bought and sold through the trading day.

15-29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall ETFs or Exchange Traded Funds Charge lower annual expenses but still pay trading commissions. More tax-efficient than most mutual funds. Allow investors to stake out an investment position in a sector, industry, or country. Investors can make their move during the market’s trading hours.

15-30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.3

15-31 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Mutual Fund Services Automatic investment and withdrawal plans Automatic reinvestment of interest, dividends, and capital gains Wiring and funds express options

15-32 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Mutual Fund Services Phone and internet switching Easy establishment of retirement plans Check writing Bookkeeping and help with taxes

15-33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Buying a Mutual Fund Step 1: Determining Your Goals Goals and time horizon Why are you investing? Tax-deferred investments? Risk tolerance

15-34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Buying a Mutual Fund Step 2: Meeting Your Objectives Look at (sub)classifications and objectives. Morningstar provides an investment style box to understand the investment style.

15-35 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 15.4

15-36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Buying a Mutual Fund Step 3: Evaluating the Fund Where to look—sources of information Mutual fund prospectus Internet screening to find the right mutual fund

15-37 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.4

15-38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 15.5

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15-40 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.5

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15-43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 15.6

15-44 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Buying a Mutual Fund Step 4: Making the Purchase Buy direct – use phone or internet. Buy through a mutual fund “supermarket”– such as Fidelity or Charles Schwab.

15-45 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary When you buy a mutual fund, you’re buying a share of a very large portfolio which goes up and down as the value of the mutual fund’s investments goes up and down. There are open-end and close-end investment companies, unit investment trusts and real estate investment trusts.

15-46 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary Be very wary of mutual fund expenses— no-load mutual funds don’t charge commission. Funds are classified according to objective. When selecting a mutual fund, determine your goals, find funds that meet your objectives, and evaluate.