Chapter 20 Mutual Funds and Asset Allocation Lawrence J. Gitman Jeff Madura Introduction to Finance

20-1 Copyright © 2001 Addison-Wesley Describe the operations of stock mutual funds, and explain how these funds are used by investors. Describe the operations of bond mutual funds, and explain how these funds are used by investors. Describe the operations of money market mutual funds, and explain how these funds are used by investors. Explain the meaning of asset allocation and the factors that influence a particular investor’s asset allocation decision. Learning Goals

20-2 Copyright © 2001 Addison-Wesley Stock Mutual Funds A stock mutual fund is an investment company that sells shares to individuals and pools the proceeds to invest in stocks. Mutual funds are popular because they enable individual investors to hold diversified portfolios of stocks with a small investment. In addition, they are managed by professional portfolio managers who specialize in making investment decisions.

20-3 Copyright © 2001 Addison-Wesley Stock Mutual Funds How Stock Mutual Funds Operate  Each mutual fund is managed by professional managers who make decisions about which securities to select.  On some occasions, funds with large stakes in particular stocks will try to influence the management of poorly performing firm’s rather than sell them.  The net asset value (NAV) is the current market value per share of the assets in a stock mutual fund.

20-4 Copyright © 2001 Addison-Wesley Stock Mutual Funds How Stock Mutual Funds Operate  The NAV is calculated as the market value of all fund assets dividend by the number of shares outstanding.  When the prices of stocks within the mutual fund increase, so does the mutual fund’s NAV.  Mutual fund investors can experience gains from three sources: increases in NAV, dividend distributions from companies within the fund, and capital gains generated by selling stocks within the fund for profit.

20-5 Copyright © 2001 Addison-Wesley Figure 20.1 Stock Mutual Funds How Stock Mutual Funds Operate

20-6 Copyright © 2001 Addison-Wesley Stock Mutual Funds How Stock Mutual Funds Operate  Load funds charge fees or commissions to investors who invest in the fund while no-load funds do not.  More than half of all mutual funds charge 12b-1 fees which cover marketing and distributions costs.  These 12b-1 fees are limited to.25 percent for mutual funds designated as no-load funds.  There is currently no evidence that load funds outperform no-load funds.

20-7 Copyright © 2001 Addison-Wesley Stock Mutual Funds How Stock Mutual Funds Operate  All mutual funds incur annual expenses, including administrative expenses, portfolio management fees, and trading commissions.  These expenses vary substantially among funds. And can be measured by the expense ratio which is equal to the annual expenses divided by the NAV.  Evidence suggests that mutual funds with lower expense ratios outperform those with higher ratios.

20-8 Copyright © 2001 Addison-Wesley Fund Investment Objectives  Growth funds  Capital appreciation funds  Internet funds  Income funds  International and global funds  Index funds Stock Mutual Funds

20-9 Copyright © 2001 Addison-Wesley Figure 20.2 (Panel 1) Open-End Mutual Fund Quotations

20-10 Copyright © 2001 Addison-Wesley Figure 20.2 (Panel 2) Open-End Mutual Fund Quotations

20-11 Copyright © 2001 Addison-Wesley Figure 20.3 (Panel 1) Closed-End Fund Quotations

20-12 Copyright © 2001 Addison-Wesley Figure 20.3 (Panel 2) Closed-End Fund Quotations

20-13 Copyright © 2001 Addison-Wesley Bond Mutual Funds How Bond Mutual Funds Operate  Bond funds generate interest income and attempt to achieve appreciation in the fund’s NAV.  In terms of expenses and sales charges, bond funds operate much like stock funds.  Like stock funds, bond funds can be load or no-load, and open or closed-end.

20-14 Copyright © 2001 Addison-Wesley Bond Mutual Funds Bond Fund Investment Objectives  Maturity Classifications Intermediate-term bond funds Long-term bond funds  Type-of-Issuer Classifications Treasury bond funds GNMA funds Corporate bond funds Municipal bond funds International and Global bond funds

20-15 Copyright © 2001 Addison-Wesley Figure 20.4 (Panel 1) Mutual Fund Performance

20-16 Copyright © 2001 Addison-Wesley Figure 20.4 (Panel 2) Mutual Fund Performance

20-17 Copyright © 2001 Addison-Wesley Money Market Mutual Funds Money Market Fund Objective  Money market mutual funds are investment companies that sell shares to individuals and pool the proceeds to invest in money market securities.  All money market funds are relatively low risk and highly liquid portfolios.  Money market funds can be distinguished according to their maturity (which affects interest rate risk) and issuer characteristics (which affects the default risk and tax status of the fund).

20-18 Copyright © 2001 Addison-Wesley Figure 20.5 (Panel 1) Money Market Fund Quotations

20-19 Copyright © 2001 Addison-Wesley Figure 20.5 (Panel 2) Money Market Fund Quotations

20-20 Copyright © 2001 Addison-Wesley Asset Allocation Asset allocation is the decision of how to divide investment funds across various classes of financial assets. Allocating funds across a diversified portfolio of securities within one type of financial asset class has limited benefits. By diversifying across classes, however, investors can reduce their exposure to any one force (such as stock market conditions or interest rates).

20-21 Copyright © 2001 Addison-Wesley Asset Allocation Impact of Investor’s Profile on Asset Allocation  Impact of investor’s stage in life  Impact of investor’s degree of risk tolerance  Impact of investor’s expectations

Chapter 20 End of Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance