1. Chapter 4 Comparing Mutual Funds

2. Categories of Mutual Funds There are 4 main categories of mutual funds: –Money market funds. –Bond funds. –Stock funds. –Hybrid funds. The categorization is based on the main type of securities a fund holds.

3. Money Market Funds Money market funds: –Are the fund type that is most like bank savings accounts, though they are not insured by the federal government. –Pay relatively low rates of interest (i.e., have a low yield). –Afford a high degree of safety, because they generally do not decline in value. –Ordinarily have a stable NAV of $1 per share.

4. Money Market Funds Tax-exemptNationalSingle stateTaxable U.S. government General purpose

5. Bond Funds Bond funds: –Normally pay a higher rate of interest than money market funds. –Do not have the same level of security as money market funds; they can decline in value. –Have a NAV that can vary from day to day. –Invest in bonds. These are, in essence, loans to a government or a corporation that promises to repay the money with interest.

6. Bond Funds (1) Tax-exempt High yield National* Single state* Taxable U.S.StrategicGlobal * Further broken down into short, intermediate or long.

7. Bond Funds (2) U.S. bond funds U.S. government* High quality* Specific focus * Further broken down into short, intermediate or long.

8. Stock Funds Stock funds: –Generally don’t provide much income. –Are owned by investors who believe the funds’ NAVs will appreciate in value. –Invest in stocks. These are, in essence, ownership positions in corporations.

9. Stock Funds U.S. General* Absolute return Sector International or global General* Geographic focus Sector * Further broken down by style box or investment objective.

10. Style Box Style boxes classify funds in a grid along two dimensions. They were popularized by Morningstar. These dimensions are: Investment style,which summarizes the types of stocks the fund invests in. –Value = cheaply priced –Core or blend = gravitates around index –Growth = fast-growing companies Market capitalization or market cap, which equals the stock price times the number of shares outstanding. –Small-cap ($300 Million to $2 billion) –Mid-cap (More than $2 billion to Less than $10 billion) –Large-cap (More than $10 billion)

11. Style Box Pros and Cons Arguments for the style box classification: It allows investors to compare funds using similar approaches. It helps investors to diversify among funds with different approaches. Arguments against the style box: Funds can move among style boxes as the market changes; this is not necessarily style drift. Funds that remain firmly within one style box may miss opportunities to make money.

12. Style Box Morningstar Style Box Source: Morningstar

13. Hybrid Funds Hybrid funds: –Invest in a combination of bonds and stocks.

14. Hybrid Funds Target Date or Life Cycle Asset AllocationU.S.*Global * Further broken down by conservative/moderate/aggressive.

15. Evaluating Fund Performance Most investors evaluate fund performance by looking at return and risk. –Return is always total return. –Risk is the variability in fund returns, usually measured by the standard deviation in returns. Most investors use one of three methods for comparing funds: –Peer group comparison. –Index comparison. –Risk-adjusted performance calculation.

16. Total Return Interest and dividend income Realized gains or losses from sales of securities Unrealized gains or losses on securities still held Total return includes all sources of return.

17. Peer Group Comparison A peer group comparison evaluates fund performance relative to other funds in the same subcategory. –These funds form a peer group or competitive universe. A fund is measured against a peer group in two ways: –The fund’s return is compared to the average return. –The fund’s return is ranked within the peer group. Lipper and Morningstar are the primary providers of peer group information for all fund types except money market funds. –Lipper and iMoneyNet are the primary providers for money market funds.

18. Index Comparison An index comparison evaluates fund performance relative to a market index or benchmark. –A market index is a hypothetical portfolio of securities chosen to represent the market or a segment of it. –Indexes are maintained by independent firms. –Barclays Capital, Dow Jones, J.P. Morgan, MSCI, Russell Investments and Standard & Poor’s are well-known index providers. A fund’s return is compared to the index return. –If the fund return is higher, the fund outperforms. –If the fund return is lower, the fund underperforms.

19. Risk-Adjusted Performance Comparison A risk-adjusted performance comparison evaluates fund performance relative to the risk that it is has taken. –Peer group and index comparisons provide some adjustment for risk. The best-known risk-adjusted comparison is the Morningstar star rating. –Fund performance is divided by Morningstar’s proprietary measure of risk. –The results are ranked within peer groups.

20. Yield and Expense Comparisons Some investors focus only on yield. –Yield is the portion of return that comes from interest and dividend payments. –Can be misleading for all funds other than money market funds, since changes in the value of securities are not considered. Some investors focus only on expenses or the cost of owning a fund. –They often prefer to own index funds or passively managed funds, which normally have low expenses.

21. Performance Comparisons Be sure to understand which expenses are – or are not – included in a performance calculation. Calculations may include: –Annual expenses only. Lipper method –Annual expenses plus sales loads. Morningstar method –No expenses at all. This is called gross performance (as opposed to net of fees)