1. Investing in Mutual Funds
Chapter 16
Investing in Mutual Funds
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
16-1

2. Chapter 16 Learning Objectives
Describe the characteristics of mutual fund investments
Classify mutual funds by investment objective
Evaluate mutual funds for investment purposes
Describe how and why mutual funds are bought and sold
16-2

3. Why Investors Purchase Mutual Funds
Objective 1: Describe the characteristics of mutual fund investments
An estimated 87 million individuals own mutual funds
Mutual funds grew from 361 in 1970 to over 12,000 in late 2009
In 2009 the combined value of assets owned by mutual funds in the United States totaled over $12.2 trillion
16-3

4. Why Investors Purchase Mutual Funds (continued)
The major reasons investors purchase mutual funds are:
Professional management
Who is the fund’s manager?
Managers can change
Be aware of the scandal involving late trading
16-4

5. Why Investors Purchase Mutual Funds (continued)
The major reasons investors purchase mutual funds are: (continued)
Diversification
Investors funds are used to purchase a variety of investments: this variety provides some safety
16-5

6. Why Investors Purchase Mutual Funds (continued)
CHARACTERISTICS OF MUTUAL FUNDS
Closed-end funds (2% of funds)
Shares are issued by an investment company only when the fund is organized
After all original shares are sold you can purchase shares only from another investor who is willing to sell
16-6

7. Why Investors Purchase Mutual Funds (continued)
CHARACTERISTICS OF MUTUAL FUNDS (con’t)
Exchange-Traded fund
Fund that invests in the stocks contained in a specific stock index
16-7

8. Why Investors Purchase Mutual Funds (continued)
CHARACTERISTICS OF MUTUAL FUNDS (con’t)
Open-end funds (92% of funds)
Shares are issued and redeemed by the investment company at the request of investors
Investors can buy and sell shares at the net asset value (NAV)
16-8

9. Why Investors Purchase Mutual Funds (continued)
Net Asset Value (NAV) Value of the fund’s portfolio - Liabilities Number of shares outstanding
16-9

10. Why Investors Purchase Mutual Funds (continued)
LOAD FUNDS AND NO-LOAD FUNDS
Load Fund
Investors pay a commission (sales charge) up to 8.5% every time they purchase shares. This is sometimes called a front load. (Class A shares)
Average charge is 3-5% for which an investor can get purchase advice and explanations.
No-Load Fund
Investors pay no sales charge up front.
You deal directly with the fund with 800 numbers or websites or from discount brokers.
16-10

11. Why Investors Purchase Mutual Funds (continued)
LOAD FUNDS AND NO-LOAD FUNDS
Contingent deferred sales load (back-end load) (Class B shares)
Charged upon withdrawal of funds (1-5%)
Generally decreases on a sliding scale depending on the number of years shares are held
16-11

12. Why Investors Purchase Mutual Funds (continued)
MANAGEMENT FEES AND OTHER CHARGES
Management fee
Charged yearly (0. 5%-1% average) based on a percentage of the funds asset value
12b-1 fees (Class C shares)
Annual fee to defray distribution and marketing costs of the fund
Cannot exceed 1% of a fund’s assets per year
16-12

13. Why Investors Purchase Mutual Funds (continued)
MANAGEMENT FEES AND OTHER CHARGES (continued)
Expense Ratio consists of the different management fees and additional fund operating costs for a specific mutual fund: this fee should not exceed 1 percent
16-13

14. Classification of Mutual Funds
Objective 2: Classify mutual funds by investment objective
STOCK FUNDS
Aggressive growth funds buy stocks in small, fast-growing companies
Equity income funds invest in stock of companies with a long history of paying dividends
Global stock funds buy stock in companies in the U.S. and other countries
16-14

15. Classification of Mutual Funds (continued)
STOCK FUNDS (con’t)
Growth stock funds buy stock in companies with higher-than-average revenue and earnings growth
Index funds buys stocks that mirror an index
International funds invest in foreign stocks sold in securities market throughout the world
Large-cap funds invest in companies with capitalization of $10 billion or more
16-15

16. Classification of Mutual Funds (continued)
STOCK FUNDS (con’t)
Mid-cap funds invest in companies with total capitalization of $2 to $10 billion
Regional funds buy stock in companies in a specific region of the world
Sector funds buy stock in companies in a particular industry such as biotechnology
Small-cap funds buy stock in lesser-known companies with a capitalization of between $300 million and $2 billion
Socially responsible funds avoid investing in companies that produce harmful products
16-16

17. Classification of Mutual Funds (continued)
BOND FUNDS
High-yield (junk) bond funds buy corporate bonds that are higher risk and higher yield
Intermediate corporate bonds (5-10 years)
Intermediate U.S. bond funds buy treasury notes with maturities of 5-10 years
Long-term corporate bonds (> 10 years)
16-17

18. Classification of Mutual Funds (continued)
BOND FUNDS (con’t)
Long-term U.S. bond funds: U.S. Treasury and U.S. zero-coupon bonds with maturities > than 10 years
Municipal bonds: Invest in municipal bonds that provide investors tax-free interest income
Short-term corporate bond funds: Investment grade bonds with maturities of 1-5 years
16-18

19. Classification of Mutual Funds (continued)
BOND FUNDS (con’t)
Short-term U.S. bond funds invest in U.S. Treasury issues of 1-5 years
World bond funds buy bonds of foreign companies and governments
16-19

20. Classification of Mutual Funds (continued)
OTHER FUNDS
Asset allocation funds: Invest in various asset classes, such as stocks, and bonds, with precise amounts within each type
Balanced funds: Invest in both stocks and bonds, with the primary objectives of conserving principal, providing income as well as growth
16-20

21. Classification of Mutual Funds (continued)
OTHER FUNDS
-Funds of funds: Invest in shares of other mutual funds
-Lifecycle funds (target date funds): Initially invest in more risk-oriented securities and become increasingly conservative and income-oriented as a specified retirement date approaches
Money Market funds: Invest in CD’s, government securities, and other safe investments
16-21

22. Classification of Mutual Funds (continued)
FAMILY OF FUNDS
A family of funds exists when one investment company manages a group of mutual funds
Each fund in the family has a different financial objective
Exchange privileges allow you to move your money from one fund to another within the fund family with little or no charge for the transaction
16-22

23. How to Decide to Buy or Sell Mutual Funds
Objective 3: Evaluate mutual funds for investment purposes
MANAGED FUNDS VERSUS INDEXED FUNDS
Most mutual funds are managed funds which means there is a professional fund manager or a team of managers choosing the investments
An index mutual fund is the mirror image of a specific index
16-23

24. How to Decide to Buy or Sell Mutual Funds (continued)
MANAGED FUNDS VERSUS INDEXED FUNDS (con’t)
Majority of the managed funds have failed to outperform the S&P 500 index over a long period of time
Index funds have a lower expense ratio, typically around 0.50 percent or less
Research is the key to determining the best investment
16-24

25. How to Decide to Buy or Sell Mutual Funds (continued)
THE INTERNET
Use web sites to research a fund.
(also other advisory services, such as Value Line)
16-25

26. How to Decide to Buy or Sell Mutual Funds (continued)
HOW TO READ THE MUTUAL FUNDS SECTION OF THE NEWSPAPER
The fund family and fund name
Net asset value
Net Change is the difference between the price paid for the last share today and the price paid for the last share on the previous trading day
Year-to-date percentage of increase or decrease for a fund
16-26

27. How to Decide to Buy or Sell Mutual Funds (continued)
MUTUAL FUND PROSPECTUS
Mutual fund prospectus includes the funds objective and:
A statement describing the risk factors
A description of the fund’s past performance
A statement describing the type of investments in the fund’s portfolio
Dividends, distributions and taxes
Information about the fund’s management
The process for investors to buy or sell shares
Services provided to investors
The turnover ratio of the fund’s investments
Information on how to open an account
Performance, investments, assets and liabilities
16-27

28. How to Decide to Buy or Sell Mutual Funds (continued)
FINANCIAL PUBLICATIONS
Business Week, Forbes, Fortune, Kiplinger's Personal Finance and Money are sources of information
Money Magazine: Investors Guide 2010 includes information such as the...
Fund size and type of fund
Actual fund name
Performance over selected time periods
Expense ratio as a percent of assets
Minimum investment required to open an account
16-28

29. The Mechanics of a Mutual Fund Transaction
Objective 4: Describe how and why mutual funds are bought and sold
You can open an account from $250 to over $2,500 depending on the fund & family
Open-end, no-load funds can be bought directly from the investment company by phone, mail, online, or from a discount broker
Closed-end or exchange-traded funds are purchased through a securities exchange or in the over-the-counter market
16-29

30. The Mechanics of a Mutual Fund Transaction (continued)
RETURN OF INVESTMENT
Income dividends: earnings funds pay to shareholders from dividend and interest income (Taxed as regular income)
Capital gains: sell shares at a price > than you paid (Report directly on Schedule D or Form 1040). When selling the shares are taxed on a short-term or long-term basis depending on the length of time the funds are held
16-30

31. The Mechanics of a Mutual Fund Transaction (continued)
RETURN OF INVESTMENT (continued)
Capital gain distributions: Payments to shareholders from sale of securities held by the fund (Show on Schedule D and Form 1040) These are taxed as long term capital gains regardless of how long you own shares in the mutual fund
Income and capital gain distributions can be automatically reinvested
16-31

32. The Mechanics of a Mutual Fund Transaction (continued)
TAXES AND MUTUAL FUNDS:
Funds reinvested in the purchase of additional shares are still taxable
The “turnover ratio” measures the percentage of the fund that has been replaced in one year. In funds that are not tax deferred (401(k) or 403(b)), this will affect your tax liability
16-32

33. The Mechanics of a Mutual Fund Transaction (continued)
PURCHASE OPTIONS
Automatic investments: Money is taken from your checking account monthly and invested in a fund
Reinvestment Plan: Income from dividends and capital gains distributions are automatically used to repurchase additional shares
Telephone Switching: Call your fund and move money from one fund to another in the same family
Withdrawals: Various withdrawal options; you can withdraw funds by phone, letter, online, etc.
16-33