13 Investing in Mutual Funds Mutual Fund = an investment vehicle offered by investment companies to those who wish to: –Pool money –Buy stocks, bonds, and other financial securities –Have buy/sell decisions made by fund manager Many mutual funds chosen for inclusion in retirement account investments (e.g., 401(k)s) 13-1

Objective 1 Explain the Characteristics of Mutual Fund Investments Investment Company Pools the money of many investors – its shareholders – to invest in a variety of securities Employs fund manager who is compensated for selecting securities appropriate to the fund’s stated objective “Financial Intermediary” 13-2

How a Mutual Fund Works

Why Investors Purchase Mutual Funds Professional Management –Who is the fund’s manager? –How has the fund performed under the current managers? Diversification –Investor’s funds are used to purchase a variety of investments (shares of many different companies) –Risk reduction 13-4

Characteristics of Funds Closed-End Funds (7% of all Mutual Funds) –Fixed number of shares issued when the fund is organized –Trade like shares of common stock on stock exchanges –Trade price set by supply & demand –Actively managed – Most sell at a discount relative to their net asset value Exchange-Traded Funds (6% of all Mutual Funds) –Invests to replicate the composition of a specific securities index –Performance mirrors index performance –Low management fees –Trade on exchanges throughout the day like stock –Prices determined by supply and demand –Can be sold short and traded with limit orders Open-End Mutual Funds (87% of all Mutual Funds) –Shares issued and redeemed on demand –Actively managed 13-5

Net Asset Value Net Asset Value (NAV): Current market value of assets held by a fund AUM = “Assets Under Management” –Net Assets = Fund Assets (AUM) - Liabilities –NAV calculated at the close of trading 13-6 Example: $52,500,000 value of fund net assets 3,500,000 number of shares = $15 per share

Open-End Funds Open-End Funds ≈ Majority of funds –Shares issued and redeemed by investment company at the request of investors –Investors free to buy and sell shares at the net asset value (NAV) –No broker or stock exchange required –Wide variety of services Automatic deposit and withdrawal Exchanges among family of funds 13-7

Costs: Load Funds vs. No-Load Funds Load Fund –Sometimes called an “A” fund –Commission (sales charge) up to 8.5% Average = 3 to 5% –Paid every time shares purchased –Purchased through brokerage firms or registered representatives Salespeople prepared to explain the fund and help determine if it meets the investor’s financial goals No-Load Fund –No up-front sales charge –No salespeople –Investor deals directly with the investment company via 800 numbers or Web sites, or from discount brokers 13-8

Costs: Load Funds vs. No-Load Funds Contingent Deferred Sales Charge (CDSC) –“Back-end load” –“B” fund –“Redemption fee” –Charged upon withdrawal of funds (1-5%) –Generally decreases on a sliding scale depending on number of years shares are held Disappears after about 5 years Knowing your holding period is key factor 13-9

Costs: Management Fees and Other Charges Management Fee –Charged yearly (.25%-1.5% of NAV average) based on a percentage of AUM 12b-1 Fee –Annual fee to defray advertising and marketing costs –Cannot exceed 1% of AUM per year Expense Ratio –Total expenses associated with management fees and operating costs of the fund 13-10

Typical Mutual Fund Fees 13-11

Objective 2 Classify Mutual Funds by Investment Objective 13-12

Stock Funds 13-13

Bond Funds 13-14

Other Funds 13-15

Balancing Risk and Returns on Mutual Funds

A Family of Funds One investment company manages a group of mutual funds portfolios –Each fund has a different financial objective –Exchange privileges allow movement from one fund to another within the family with low or no charge –Listed alphabetically in newspapers Names of popular investment companies?

Objective 3 Evaluate Mutual Funds Managed Funds vs. Index Funds Managed Fund  fund manager makes all decisions regarding what securities are included in the fund’s portfolio Index Fund  securities held by the fund replicate those contained in a specific index like the S&P

Sources of Fund Information 1.Internet sites provide current values – – – – 2.Check mutual fund companies’ Internet sites – – 3.Professional Advisory Services –Lipper Analytical Services –Morningstar, Inc. –Value Line –Mutual fund newsletters 13-19

Mutual Funds Have Different Investment Objectives Prospectus – a mutual fund’s investment objectives and policies must be stated in this document. Two Types: Traditional prospectus (long) Profile prospectus (short)

Mutual Fund Prospectus Data –Fund objective(s) –Statement describing risk factors –Description of fund’s past performance –Statement describing type of investments in fund’s portfolio –Information about dividends, distributions, and taxes –Information about fund’s management –Procedure to buy and sell shares –Services provided to investors –Turnover Ratio of the fund’s investments: how often the fund’s portfolio changes 13-21

Other Sources of Fund Information Mutual Fund Annual Report –Performance, investments, assets & liabilities Financial Publications –Business Week, Forbes, Kiplinger's Personal Finance, WSJ, and Money –Business Week’s mutual fund survey includes: Fund’s overall rating compared to all other funds, and to funds in the same category Fund size, sales charge, and expense ratio Historical returns for the past ten years 13-22

Objective 4 Describe How and Why Mutual Funds are Bought and Sold The Mechanics of a Mutual Fund Transaction Open an account: –On Your Own: $250 to $3,000 and up depending on the fund family and the fund –At Work: Select mutual funds for a tax- deferred retirement savings account 13-23

Return on Investment 3 Ways to Make Money on Mutual Funds Income Dividends –Earnings paid from dividend and interest income –Taxed as ordinary income Capital Gains Distributions –Distributions when the fund buys and sells securities –Taxed as long-term gains Capital Gains (or Losses) –Capital gains (or losses) when you sell shares at a price different than price you originally paid –Taxed as short- or long-term gains 13-24

Purchasing Open-End Fund Shares –Regular Account Transactions Easiest Simply buy shares in amount and when desired –Voluntary Savings Plans Allows for smaller than usual purchases on a recurring basis –Contractual Savings Plans Require regular purchases over a specified period –Reinvestment Plans Automatically reinvests dividends and capital gains in the fund 13-25

The Wisdom of Automatic Reinvestment

Closed-End Funds and Exchange-Traded Funds –Traded on stock exchanges and in over the counter market –Sold like common stock shares Open-End Funds –Shares sold to the fund sponsoring company –Systematic withdrawal methods 1.Withdraw fixed dollar amount each period until account is exhausted 2.Liquidate or “sell off” a certain number of shares each period 3.Withdraw a fixed percentage of asset growth; principal untouched 4.Withdraw all income dividends and capital gains distributions; principal untouched Withdrawal Options 13-27

Wrap Up Chapter Quiz Concept Check NAV Problem Concept Check Importance of Fund Objective Concept Check Managed Fund vs. Indexed Fund Concept Check Purchasing Closed- End Funds and ETFs