Chapter 13 Investing in Mutual Funds Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

13-2 Investing in Mutual Funds Chapter Learning Objectives LO13.1Explain the characteristics of mutual fund investments. LO13.2Classify mutual funds by investment objective. LO13.3Evaluate mutual funds. LO13.4Describe how and why mutual funds are bought and sold.

13-3 Learning Objective LO13.1 Explain the Characteristics of Mutual Fund Investments 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 a fund manager Many mutual funds chosen for inclusion in retirement account investments

13-4 Investment Company Pools the money of many investors – its shareholders – to invest in a variety of securities Employs the fund manager who is compensated for selecting securities appropriate to the fund’s stated objective “Financial Intermediary”

13-5 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 –Risk reduction

13-6 Advantages and Disadvantages of Investing in Mutual Funds

13-7 Characteristics of Funds Closed-end funds (≈ 6% of funds) –Fixed number of shares –Trade like shares of common stock –Actively managed Exchange-traded funds (≈ 9% of funds) –Invests in securities contained in a specific securities index Open-end mutual funds (≈ 85% of funds) –Shares issued and redeemed on demand –Actively managed

13-8 Closed-End Funds Fixed number of shares issued when the fund is organized Shares traded on stock exchanges or the over-the-counter market. Trade price set by supply and demand

13-9 Exchange Traded 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 You can use limit orders and sell short or use margin

13-10 Open-End Funds Open-end funds ≈ 85% of all funds –Shares issued and redeemed by the investment company at the request of investors –Investors free to buy and sell shares at the net asset value (NAV)

13-11 Net Asset Value Net asset value (NAV): The value of the fund’s portfolio minus liabilities divided by the number of outstanding shares NAV calculated at the close of trading

13-12 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

13-13 Costs: Load Funds vs. No-Load Funds 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

13-14 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 the number of years shares are held

13-15 Costs: Management Fees and Other Charges Management fee –Charged yearly (.25%-1.5% average) based on a percentage of assets 12b-1 fees (distribution fee) –Annual fee to defray advertising and marketing costs –Cannot exceed 1% of assets per year Cannot exceed 0.25% for a fund to be called “no load” Expense ratio –Total expenses associated with the management fees and operating costs of the fund

13-16 Typical Mutual Fund Fees

13-17 Learning Objective LO13.2 Classify Mutual Funds by Investment Objective

13-18 Stock Funds

13-19 Bond Funds

13-20 Other Funds

13-21 A Family of Funds One investment company manages a group of mutual funds –Each fund has a different financial objective –Exchange privileges allow movement from one fund to another within the family with low or no charge Fidelity Investments – ual_funds_overview.shtml.cvsrhttp://personal.fidelity.com/products/funds/mut ual_funds_overview.shtml.cvsr Franklin Templeton Funds –

13-22 Learning Objective LO13.3 Evaluate Mutual Funds Managed Funds vs. Index Funds Managed fund  a 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 500

13-23 Sources of Fund Information 1.Internet websites provide current values – – – – 2.Check fund companies’ Internet sites – – –

13-24 Sources of Fund Information 3.Professional Advisory Services –Lipper Analytical Services –Morningstar, Inc. –Value Line –Mutual fund newsletters –Available in libraries and from brokerage firms and online

13-25 Mutual Fund Prospectus –Fund objective(s) –Statement describing the risk factors –The fund’s past performance –The type(s) of investments in the fund’s portfolio –Information about dividends, distributions and taxes –The fund’s management –Limitations or requirements for the fund –Procedure to buy or sell shares –Services provided to investors –Turnover ratio of the fund’s investments

13-26 Other Sources of Fund Information Mutual fund annual report –Performance, investments, assets and liabilities Financial Publications –Bloomberg Businessweek, Forbes, Kiplinger's Personal Finance, Money, and The Wall Street Journal –A mutual fund’s information usually 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

13-27 Learning Objective LO13.4 The Mechanics of a Mutual Fund Transaction Open an account: –$250 to $2,000 and up depending on the fund family and the fund

13-28 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 Distribution –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

13-29 Taxes and Mutual Funds TransactionTaxed as: Income dividendOrdinary income Capital gain distribution Long-term capital gains regardless of how long held Capital gains or lossesShort- or long-term gains depending on how long you held the fund shares

13-30 Purchase Options * Investor may deal with one company, get one statement, yet have a choice of a wide variety of funds *

13-31 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 –Sometimes called “Front-end Load Plans” Reinvestment plans –Automatically reinvests dividends and capital gains in the fund

13-32 Closed-end funds & exchange-traded funds –Traded on stock exchanges and in the over the counter market –Sold like common stock shares Open-end fund –Shares sold to the fund sponsoring company Withdrawal Options

Withdraw a fixed dollar amount each period until account 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 distribution; principal untouched Mutual Fund Withdrawal Options 4 Options available if minimum balance ($5,000+)

13-34 Chapter Summary Learning Objective LO13.1 Major advantages of mutual funds are professional management and diversification. Three types of funds: –Closed-end funds = a fund whose shares are issued only when the fund is organized –Exchange-traded funds = a fund that invests in the stocks contained in a specific stock index or securities index –Open-end funds = a fund whose shares are sold and redeemed by the investment company at the net asset value (NAV) at the request of investors. Both closed-end and exchange-traded funds are traded on a stock exchange or in the over-the- counter market

13-35 Chapter Summary Learning Objective LO13.1 Mutual funds can also be classified as: –A shares (commissions charged when shares purchased) –B shares (commissions charged when money is withdrawn during the first five years) –C shares (no commission to buy or sell shares, but higher, ongoing fees). Other possible fees include management fees and 12b-1 fees. Together all management fees and operating costs are referred to as an expense ratio.

13-36 Chapter Summary Learning Objective LO13.2 The major categories of stock mutual funds, in terms of the types of securities in which they invest, are: - Aggressive growth- Large Cap - Equity income- Midcap - Global- Regional - Growth- Sector - Index- Small cap - International- Socially responsible

13-37 Chapter Summary Learning Objective LO13.2 Bond funds include: –High-yield (junk) –Intermediate corporate –Intermediate U.S. government –Long-term corporate –Long-term U.S. government –Municipal –Short-term corporate –Short-term U.S. government –World bond funds

13-38 Chapter Summary Learning Objective LO13.2 Other funds invest in a mix of different stocks, bonds, and other investment securities that include: –Asset allocation funds –Balanced funds –Fund of funds –Lifecycle funds –Money market funds A family-of-funds concept allows shareholders to switch among funds as different funds offer more potential, financial reward, or security.

13-39 Chapter Summary Learning Objective LO13.3 Managed fund or an index fund? –With a managed fund, a professional fund manager (or team of managers) chooses the securities that are contained in the fund. –Over many years, index funds have outperformed the majority of managed funds. –Because an index mutual fund is a mirror image of a specific index, the dollar value of a share in an index fund also increases or decreases when the index increases or decreases.

13-40 Chapter Summary Learning Objective LO13.3 To help evaluate different mutual funds, investors can use the information from: –The Internet –Professional advisory services –The fund’s prospectus –The fund’s annual report –Financial publications –Newspapers

13-41 Chapter Summary Learning Objective LO13.4 Closed-end funds and ETFs –The shares of a closed-end fund or exchange- traded fund are bought and sold on organized stock exchanges or the over-the-counter market. Open-end Funds –Shares may be purchased through a salesperson who is authorized to sell them, through an account executive of a brokerage firm, from a mutual fund supermarket, or from the investment company that sponsors the fund. –Open-end fund shares can be sold to the investment company that sponsors the fund.

13-42 Chapter Summary Learning Objective LO13.4 Shareholders in mutual funds can receive a return in one of three ways: –Income dividends –Capital gain distributions when the fund buys and sells securities in the fund’s portfolio at a profit –Capital gains when the shareholder sells shares in the mutual fund at a higher price than the price paid. To ensure having all of the documentation you need for tax reporting purposes, it is essential that you keep accurate records. A number of purchase and withdrawal options are available for mutual fund investors.