CHAPTER 4 Mutual Funds Chapter Sections:

CHAPTER 4 Mutual Funds Chapter Sections:
Advantages and Drawbacks of Mutual Fund Investing Investment Companies and Fund Types Mutual Funds Operations Mutual Funds Costs and Fees Short-Term Funds Long-Term Funds Mutual Fund Performance Closed-End Funds, Exchange Traded Funds, and Hedge Funds Mutual Funds: Investments for the Masses

What is a Mutual Fund? An investment company that invests its shareholders’ money in a diversified portfolio of securities “Investment company” is the legal term “Mutual fund” is the popular term Professional management Diversification Each fund has a specific objective Almost 12,000 funds to choose from Many people choose mutual funds for their retirement account investments (401k, 403b, Traditional IRA, Roth IRA, etc.)

Mutual Funds STOCKS BONDS “CASH” Professional Money Management
Balanced mutual funds Bond mutual funds Stock mutual funds Money market mutual funds a “mutual” fund a.k.a. investment company Professional Money Management Diversification

Growth of Mutual Fund Industry
Year Number of Mutual Funds 1940 70 1970 350 1980 600 1990 2,000 2000 9,000 2017 11,783* Source: Investment Company Institute, *Includes open-end, closed-end, and ETFs

Growth of Mutual Fund Industry
(continued) In 1980, five million Americans owned funds Holding 3% of their household financial assets As of December 2017, million Americans in 57.3 million households owned mutual funds That is 45.4% of all U. S. households Mutual fund assets totaled $22.4 trillion dollars* Holding 24% of their household financial assets Mutual funds are now the nation’s largest financial intermediary, followed by commercial banks (second largest) and life insurance companies (third largest) Source: Investment Company Institute, 2018 Investment Company Fact Book, *Includes open-end, closed-end, and ETFs as of December 2017.

Growth of Mutual Fund Assets
Year Assets ($US trillions) 2007 $13.0 trillion 2008 10.4 2009 12.2 2010 13.1 2011 13.0 2012 14.7 2013 17.1 2014 18.2 2015 18.1 2016 19.2 2017 $22.4 trillion As we saw in chapter 1, 2008 was a very difficult year. Notice the drop from $13 trillion to $10.4 trillion. Source: Investment Company Institute, *Includes open-end, closed-end, and ETFs

Advantages of Mutual Funds
Pooled Diversification A process whereby investors buy into a diversified portfolio of securities for the collective benefit of the individual investors This variety provides some safety that is difficult for an individual investor to obtain on their own Professional management The mutual fund managers are supposed to know what they are doing (They are certainly getting paid enough!) Low initial outlay of capital You can start with $25 to $50 per month “PITA” factor is low – The Wealthy Barber

Drawbacks of Mutual Funds
Transaction Costs Some mutual funds charge sales fees called “loads” Front-end loads, back-end loads, etc. Many others are “no-load” funds But some “no-load” funds can wind up costing you more than “load” funds over time Annual Operating Expenses Typically from 0.5% (or less) to 2.5% (or more) Many mutual funds do not match the market’s performance What? Aren’t the mutual fund managers supposed to know what they are doing?

Open-end versus Closed-end Funds
Open-end mutual funds (≈80% of mutual funds) A type of investment company in which investors buy shares from, and sell them back to, the mutual fund itself, with no limit on the number of shares the fund can issue Shares are issued and redeemed by the investment company at the request of investors Investors can buy shares from (purchase) and sell shares to (redeem) the investment company at any time When people refer to a mutual fund, they are almost exclusively referring to an open-end mutual fund. As of December 2017, there were 9,356 open-end mutual funds totaling $18.75 trillion dollars in assets.

(continued) Closed-end mutual funds (<5% of mutual funds) A type of investment company that operates with a fixed number of shares outstanding Shares are issued by an investment company only when the fund is organized After all original shares are sold you can only purchase shares from another investor Bought and sold like stocks on the open market Incur brokerage commissions Closed-end investment companies are not as popular with individual investors as open-end investment companies. At the end of December 2017, there were only 530 closed-end mutual funds holding only $275 billion dollars in assets. In recent years, both numbers have been shrinking.

(continued) Net Asset Value The underlying value of one share in a particular mutual fund Add up the value of the securities in the mutual fund Subtract any liabilities (normally close to zero) Divide by the number of shares Open-end mutual funds are sold at net asset value (with a sales load added to load funds). Since closed-end mutual funds are bought and sold on the open market, their price usually either reflects a premium or discount to the net asset value (usually a discount). They are very rarely priced at their net asset value.

(continued) Net Asset Value = Value of the fund’s portfolio - Liabilities Number of shares outstanding Example: $10,050,000 - $50,000 = $10 NAV 1,000,000 shares Offering price = NAV + sales commission Example: $10 + ($10 * 5%) = $10.50 Offering Price

(continued) Advantages / Disadvantages? Open-end investment company Always able to buy and sell – no market forces Very popular – wide range of choices Large purchases or redemptions can make management of the fund more difficult Mutual fund company can “close the fund” to new investors Closed-end investment company Must pay broker’s commission (like a stock) Must be bought/sold via the marketplace Often sold at premium or discount to NAV Easier to manage assets for investment advisors Which would (or do) you prefer?

A New Type of Mutual Fund: ETFs
Exchange-traded Funds (≈16% of mutual funds) An open-end mutual fund that trades on the stock exchanges like closed-end mutual funds There is no limit to the number of shares The mutual fund company issues shares as needed But the investor must purchase the fund using a brokerage account Incurring brokerage transaction fees (commissions) However, some mutual fund companies have found a way to eliminate the brokerage transaction fees They have opened their own brokerage firms and if you purchase their ETFs through their brokerage firm, they waive the commission – Very smart marketing! A recent entry to the industry, ETFs are becoming very, very popular. We will discuss why later on.

Growth of ETF Industry End of Year Number of Funds Billions of Dollars
2006 359 $423 billion 2007 629 608 2008 728 531 2009 797 777 2010 923 992 2011 1,135 1,048 2012 1,195 1,337 2013 1,295 1,675 2014 1,412 1,974 2015 1,595 2,100 2016 1,716 2,500 2017 1,897 $3,401 billion ($3.4 trillion) Again, take note of the drop in value in 2008 even as the growth in the number of ETFs was continuing apace. Source:

How are Mutual Funds Regulated?
Investment Company Act of 1940 Foundation of the modern mutual fund industry Defined “regulated investment company” a.k.a. “pass-through” investment vehicle Does not pay taxes on its investment income The shareholders pay the taxes To qualify, an investment company must… Hold almost all its assets as investments in stocks, bonds, and other traditional securities, and Very limited ability to use derivatives & other risky strategies Use no more than 5% of its assets when acquiring a particular security, and Create an organization with “checks & balances”

(continued)

How are Mutual Funds Organized?
The Mutual Fund A Corporation run by a Board of Directors Board of Directors voted in by Shareholders (investors) Sponsored the fund’s creator Investment Advisor (a.k.a. Management Company) Portfolio Manager (sometimes a team or a committee) Research Analysts (usually focus on a specific industry) Distributors Distributes the shares to the public or to dealers Much the same role as an investment banker Mutual funds are technically continuous Initial Public Offerings – must have an annual prospectus & report

How are Mutual Funds Organized?
(continued) Custodian The company that actually holds the securities Often a bank or trust company Transfer Agent Keeps track of purchase and redemption requests from shareholders Independent Public Accounting Firm Certifies the fund’s financial reports Why the large diversification of tasks and companies? Mutual funds are highly regulated in order to protect shareholders’ investment from fraud and collapse. How often have you heard of a scandal at a mutual fund company? Until 2003, never.

“Mutual Fund Scandals?!”
Wait a minute, Paiano! Did you just say, “Mutual Fund Scandals?!” “You want me to invest in an industry that is plagued with scandal?!” Since 1940, the mutual fund industry has been regulated and escaped any hint of impropriety In 2003, some practices that were not quite illegal but obviously unethical were uncovered Only a handful of funds and people were affected Strong, Janus, Bank of America, Putnum, Alliance The vast majority of companies never engaged in any of the shenanigans Instead of losing $99, on a $100,000 account (example: Enron or WorldCom), investors lost $0.01 on a $100,000 account.

Annual Operating Expenses
Management fees Charged yearly (.25%-2% average) based on a percentage of the fund’s asset value Paid to portfolio managers and analysts who make the investment decisions 12b-1 fees Annual fee to defray advertising, servicing, and distribution costs of the fund – up to 1% per year Accounting and other expenses Trustee fee Only for retirement and other tax-qualified accounts – typically $10 to $30 per year

Annual Operating Expenses
(continued) Trading Costs Not disclosed in the annual prospectus So how does an investor know how much the trading costs are? You can ask the mutual fund or just look at the… Annual Turnover Measure of how much trading a mutual fund does Measured in percentage of the amount a portfolio “turns over” each year 100% turnover, 50% turnover, etc. The higher the turnover, the higher the trading costs Also gives you an idea how long they hold investments 100% turnover: They hold on average one year 50% turnover: They hold on average two years

Load versus No-load Funds
A mutual fund that charges a commission when shares are bought Typically 3% to 5% Used to compensate the financial representative Along with the fund distributor No-load Fund A mutual fund that does not charge a commission when shares are bought Traditionally sold directly to shareholders The endless debate: Should you purchase a Load Fund or No-load Fund?

(continued) Types of Load Funds Front-end Load – a.k.a. Class A Commission is paid when shares are purchased Normally have lower annual operating expenses Back-end Load – a.k.a. Class B Commission is paid when shares are redeemed Most back-end load funds have a Contingent Deferred Sales Charge (CDSC) The CDSC declines to zero over a period of 3 to 6 years 5% first year, 4% second year, 3% third year, etc. Normally, the back-end load pay higher annual operating expenses (12b-1 fees) until the CDSC declines to zero Eventually, the Class B shares revert to Class A shares

(continued) Types of Load Funds (continued) No-load Funds (Huh?) – a.k.a. Class C No front-end nor back-end commissions Except 1% back-end charge if redeemed within one year However, many Class C funds have higher annual operating expenses in perpetuity (or for a long time) There are those 12b-1 fees again Hence, they can wind up costing more than the Class A or Class B shares over time The SEC now says you can not call a mutual fund a “no-load” fund if the 12b-1 fee is greater than 0.25% So, Class C shares are now not allowed to be called “no-load” funds even though many in the industry still do

(continued) Types of No-load Funds Advisor No-load Funds – a.k.a. Class F, Class I Held in advisor’s “wrap account” a.k.a. “Management account,” “Wealth Management Account” Advisor charges 1% to 2% to “manage the account” “True” No-load Funds Mutual fund company deals directly with public May not have a 12b-1 fee greater than 0.25% These are the darlings of the popular media “Bypass the middleman! Who needs a financial advisor?” But that does not mean the overall fees are low Over time, a no-load fund can wind up costing you more than a load fund You must compare the annual operating expenses

Example of Shareholder Fees:
AB* Large Cap Growth Fund Transaction fees Class A Class B Class C Advisor Class† Maximum sales charge 4.25% None Maximum sales charge on reinvested dividends Maximum deferred sales charge 4.00% 1.00% Redemption or exchange fees Annual Operating Expenses Class A Class B Class C Advisor Class† Management Fees 0.53% Distribution and/or Service Fees (a.k.a. 12b-1) 0.25% 1.00% 0.00% Other Expenses 0.13% 0.17% Total: 0.91% 1.70% 1.66% 0.66% This is a load fund. *nee Alliance §Closed to new investors †nee Class F All data on next 9 slides of as December 31, Check website for links to web pages and prospectuses.

New Economy Fund Transaction fees Class A Class B Class C Class F2 Maximum sales charge 5.75% None Maximum sales charge on reinvested dividends Maximum deferred sales charge 5.00% 1.00% Redemption or exchange fees Annual Operating Expenses Class A Class B Class C Class F2 Management Fees 0.38% Distribution and/or Service Fees (a.k.a. 12b-1) 0.24% 1.00% 0.0% Other Expenses 0.16% 0.17% 0.21% 0.18% Total: 0.78% 1.56% 1.59% 0.56% This is another load fund.

Legg Mason Value Trust Transaction fees Class A Class C FI Institutional Maximum sales charge 5.75% None Maximum sales charge on reinvested dividends Maximum deferred sales charge 0.95% Redemption or exchange fees Annual Operating Expenses Class A Class C FI Institutional Management Fees 0.68% Distribution and/or Service Fees (a.k.a. 12b-1) 0.25% 0.95% 0.00% Other Expenses 0.12% 0.14% 0.21% 0.13% Total: 1.05% 1.77% 1.14% 0.81% This was a very famous (now infamous) no-load load mutual fund. The class C shares (nee Primary Class) were and still are the most popular. They added the class A shares a few years ago. Legg Mason has since changed the name of the mutual fund to ClearBridge Value Trust. (Why? You’ll see why later!)

Vanguard 500 Index Fund Transaction fees Maximum sales charge None Maximum sales charge on reinvested dividends Maximum deferred sales charge Redemption or exchange fees This is an index fund. This fund does no research. They simply buy all the 500 stocks in the S&P 500 Index. The term for this is “passive management.” (More later) Index funds are usually “true” no-load mutual funds and usually (but not always) have very low fees. Annual Operating Expenses Class A Management Fees 0.12% Distribution and/or Service Fees (a.k.a. 12b-1)  Other Expenses 0.02% Total: 0.14% There is a $20 annual fee if your account value is less than $10,000 unless you enroll in electronic delivery of financial communications.

Fidelity 500 Index Fund Vanguard pioneered low fee mutual funds and was able to overtake Fidelity as the number #1 mutual fund company. Fidelity responded by eliminating all sales loads, creating their own index funds, and lowering their fees below Vanguard. In fact, some are now free! Transaction fees Maximum sales charge None Maximum sales charge on reinvested dividends Maximum deferred sales charge Redemption or exchange fees Annual Operating Expenses Class A Management Fees 0.015% Distribution and/or Service Fees (a.k.a. 12b-1)  Other Expenses 0% Total: Fidelity recently removed their “low balance” annual fee of $12 if your account was below $2,000.

Examples of Dollar Costs:
AB Large Cap Growth Fund Hypothetical $10,000 Investment with 5% Return 1 Year 3 Years 5 10 Class A $514 $707 $916 $1,518 Class B (assuming no redemption) 173 540 931 1,819 Class C (assuming no redemption) 269 528 911 1,985 Advisor Class (excludes advisor fee) 67 216 377 845 Although it looks as though the Advisor shares (Class F) are the best deal, this does not include the advisor’s annual fee. Adding the advisor’s typical fee of 1% to 2% per year would easily add an additional $1,300 to $2,600 to the total cost. Over the long term, which is the best deal? (Oh, by the way, guess which shares are the most popular with brokerage firms these days.)

Legg Mason Value Trust Hypothetical $10,000 Investment with 5% Return 1 Year 3 Years 5 10 Class A $676 $890 $1,121 $1,783 Class C (formerly Primary Class) 180 558 960 2,085 Financial Intermediary Class 116 362 627 1,384 Institutional Class 83 263 459 1,024 The class C shares of this “no load” fund wind up costing more than the class A shares! Again, the Financial Intermediary Class seems to be a better deal but it does not include the advisor’s annual fee. The Institutional Class looks great. How can I get them? Well, for starters, are you a large pension fund, university endowment, or tax-exempt charity? Oh, and by the way, do you have at least $1 million to invest with us?

Vanguard 500 Index Fund Hypothetical $10,000 Investment with 5% Return 1 Year 3 Years 5 10 Investor Class $14 $45 $79 $179 Admiral Class 4 13 23 51 The fees for passively-managed index funds will almost always be less than actively-managed funds*. The Admiral Class shares used to be available with a minimum of only $100,000. Any takers? (In the fall of 2010, they lowered the minimum to $10,000.) Do you remember the exchange-traded funds (ETFs)? They often have fees lower than the index funds! The Vanguard ETF that tracks the total U. S. stock market has an expense ratio of 0.04%. Just recently, Fidelity just announced two index funds with zero annual fees! (How can they make any money doing that?!) *Careful! Some 401(k) plans have high-fee index funds! Huh? Why? Because they can. Aye! Who would do that to their employees? Ah, Southwestern College, for one.

Breakpoint Sales Reductions:
New Economy Fund Investment (either purchased or accumulated) Sales Charge Less than $25,000 5.75% $25,000 but less than $50,000 5.00% $50,000 but less than $100,000 4.50% $100,000 but less than $250,000 3.50% $250,000 but less than $500,000 2.50% $500,000 but less than $750,000 2.00% $750,000 but less than $1,000,000 1.50% $1,000,000 or more None Class A shares qualify for a sales reduction if you invest a larger amount or as your investment grows. Some brokers failed to inform their clients of this feature. Instead, as the client approached the breakpoint, the broker would advise them to start another fund. Why?

CDSC Reduction over Time:
AB Large Cap Growth Fund Contingent Deferred Sales Charge (CDSC) on Class B Shares Year of Redemption Contingent Deferred Sales Charge 1 4.0% 2 3.0% 3 2.0% 4 1.0% The back-end sales charge on Class B shares typically is reduced over time until it is eliminated. However, as we noted, the Class B shares pay more in annual fees. Annuities from life insurance companies usually have this type of “surrender charge” schedule. However, they often start at 20% or 25%!

So, Which One Would You Pick?
10-Year Rates of Return: So, Which One Would You Pick? as of December 31, 2018 Investment 10-Year Return Growth of $10,000 AB Large Cap Growth Fund, Class A 15.13%* $40,911 New Economy Fund, Class A 14.03%* $37,159 Legg Mason Value Trust, Class C 10.43% $29,975 Vanguard Index 500 Fund 12.87% $33,870 Standard & Poor’s 500 Index 13.12% $34,304 A B C formerly Primary Class D Fees are important, but they certainly do not tell you the whole story. When comparing mutual funds, you must look at many attributes, not the least of which are the rates of return, preferably over long time periods. What is unusual about the last 10 years? *(15.63%, $42,727) and (14.71%, $39,426) respectively, without sales charge (a.k.a. NAV, net asset value)

Mutual Funds Fees: What are __?
These shares do not have an up-front sales load. Instead, they assess a decreasing back-end load if you withdraw your money within 6 years. The annual operating expense is higher (courtesy of the 12b-1 fees). A shares B shares C shares F or I shares The correct answer is (B). They normally eventually become A shares after 6 to 8 years.

These shares do not have an up-front fee and only a 1% back-end fee if redeemed within one year. The advisor called them “no-load” but you notice that their annual operating expense is higher than other share classes (again, courtesy of those ubiquitous 12b-1 fees). A shares B shares C shares F or I shares The correct answer is (C). They sometimes revert to A or F shares after many years.

Your financial advisor tells you that these shares have no sales fees and a very low annual operating expense. She mumbles something about “wealth management.” These shares are: A shares B shares C shares F or I shares The correct answer is (D). She also did her best not to explain to you that her brokerage firm will charge you an extra 2% each year. Oh, by the way, there are dozens of other share classes depending upon the mutual fund company. Don’t worry. All of them are variations on the four main themes we learned today.

Types of Mutual Funds Aggressive Growth Funds Growth Funds
Highly speculative mutual funds that seek large profits from capital gains Dey Iz Rollin’ De’ Dice! Growth Funds Mutual funds whose primary goals are capital gains and long-term growth Typically invest in high-growth companies Some fund companies now have a category or two more speculative than Aggressive Growth. They are sometimes called Ultra Funds or Momentum Funds. (Example: Janus 20) What do you think about this strategy?

Types of Mutual Funds Capital Appreciation Funds
(continued) Capital Appreciation Funds Mutual funds that seek long-term growth of capital How does it differ from a growth fund? Most growth funds have a provision that states they will invest primarily in growth stocks, usually staying between 80% & 100% invested in the market Capital Appreciation Funds can often invest in anything they like and anywhere they like In general, they tend to be as risky as growth and aggressive growth funds (although not always) The well-known Fidelity Magellan Fund is a Capital Appreciation Fund

Types of Mutual Funds Growth-and-Income Funds Value Funds
(continued) Growth-and-Income Funds Mutual funds that seek both long-term growth and current income, with primary emphasis on capital gains Sometimes own bonds to augment the income Sometimes referred to as “Blend” (of Growth & Value) Value Funds Mutual funds that seek stocks that are undervalued in the market by investing in shares that have low P/E multiples and high dividend yields Often look for companies out-of-favor with investors Some folks lump growth-and-income funds and value funds together

Types of Mutual Funds Equity-Income Funds
(continued) Equity-Income Funds Mutual funds that emphasize current income and capital preservation by investing primarily in high-yielding, income-producing common stocks Railroads, Foods, Utilities, REITs, etc. They will also invest in bonds to generate income when the investment advisor believes that stock prices have risen to levels that threaten preservation of capital Many Equity-Income Funds did very well during the 2000 to 2002 bear market after lagging the market badly during the late 1990’s bull market. Every type of fund was clobbered in 2008.

Types of Mutual Funds More Stock Fund Classifications
(continued) More Stock Fund Classifications Large Cap – largest companies Mid Cap – medium-sized companies Small Cap – smallest companies Domestic – companies based in U.S. Global – based anywhere in globe International – based outside U.S. Regional – Japan, Far East, Latin America, etc. Emerging Markets – India, Mexico, Brazil, Russia, Philippines, China, Turkey, etc. Sector – energy, technology, health care, etc. Market Timing – dumb Which do you think is the riskiest? Which do you think is the riskiest?

Types of Mutual Funds Bond Funds – a.k.a. Fixed-income Funds
(continued) Bond Funds – a.k.a. Fixed-income Funds Mutual funds that invest in various kinds and grades of bonds, with income as the primary objective High-Yield Bond Funds – a.k.a. Junk Bond Funds Are often more correlated with stocks than bonds Corporate Bond Funds Convertible Bond Funds Municipal and Insured Municipal Bond Funds Popular with high net worth individuals Income is free from Federal taxes State-specific municipal bond funds Income is free from state taxes as well

Types of Mutual Funds Bond Funds (continued)
U.S. Backed Bonds (Fannie Mae, etc.) a.k.a. Mortgage-backed Bond Funds Government Bond Funds – a.k.a. Treasury Bond Funds, Government Securities Funds Income is free from state and local taxes Long-term Bond Funds Intermediate-term Bond Funds Short-term Bond Funds Global and International Bond Funds Which do you think is the riskiest? Careful!

Types of Mutual Funds Balanced Funds
(continued) Balanced Funds Mutual funds whose objective is to generate a balanced return of both current income and long-term capital gains Invest in both stocks and bonds Normally 60% stocks and 40% bonds But allocation can change as the investment environment changes Example: The prospectus of the American Balanced Fund states that the fund is “managed as the complete U. S. investment program of a prudent investor.” They can never be more than 75% stocks, 25% bonds or less than 50% stocks, 50% bonds.

Types of Mutual Funds Asset Allocation Funds
(continued) Asset Allocation Funds Mutual funds that spread investors’ money across stocks, bonds, and money market securities Very similar to Balanced Funds However, the investment advisor often more diligently tries to “fine-tune” the allocation as market conditions change Whereas a Balanced Fund usually stays around 60% stocks / 40% bonds, An Asset-Allocation Fund might try to move money into cash when they thought the market might fall For all their hype, the returns of many Asset Allocation Funds are very close to Balanced Funds. Some trail Balanced Funds considerably because they “timed the market” badly.

Types of Mutual Funds Money Market Mutual Funds (review)
(continued) Money Market Mutual Funds (review) Mutual funds that invest in short-term money market instruments Much the same as money market accounts at banks and credit unions EXCEPT money market mutual funds are not guaranteed General Purpose – Treasury bills, commercial paper Government Securities – Only Treasury bills Tax-exempt – very short-term municipal securities They are essentially as safe as guaranteed money market accounts since they invest in exactly the same securities but they are not guaranteed! (Did we already mention that?) Research “Breaking the Buck.”

Types of Mutual Funds Mutual Funds of Mutual Funds
(continued) Mutual Funds of Mutual Funds a.k.a. Lifestyle Funds, Target-Date Funds Choose the fund that matches your time horizon … College 2020, Retirement 2035, etc. The company will populate the mutual fund with other mutual funds to match the time horizon Often from the same company’s mutual fund choices As the time horizon shortens, the mutual fund will change the mix of mutual funds Some are “Target-Risk” Funds Choose your risk tolerance & they choose the funds “A mutual fund of mutual funds? You are kidding, right?” No. These are very popular now because of employer-sponsored retirement plans such as 401(k) and 403(b) plans.

Types of Mutual Funds Specialty Funds Hedge Funds “Bear” Funds
(continued) Specialty Funds Hedge Funds Traditionally only open to “sophisticated investors” But now available to those with as little as $5,000 to $10,000 No regulatory oversight – have become a major force 1% to 2% operating expense; take 20% of the profits “Bear” Funds Precious Metals / Hard Assets Funds REIT Funds Boutique / Exotic Funds StockCar Stocks Fund Pauze Tombstone Fund The Chicken Little Growth Fund (I am not making this up!) The choices are endless. So are the fees…

Types of Mutual Funds Index Funds – a.k.a. Passively-managed
(continued) Index Funds – a.k.a. Passively-managed Mutual funds that buy and hold a portfolio of stocks or bonds equivalent to those in a specific market index No “active management” performed – no research The mutual fund simply buys all the stocks in the S&P 500, Dow Jones Industrial Average, Russell 2000, etc. Why? Can offer much lower annual fees (no research) Many actively-managed mutual funds do not beat the market Because of the annual fee, an index fund can not actually match the market’s performance, but it should come very close (providing the annual fee is not excessive) Whereas, an actively-managed fund could substantially out perform or under perform the market index

Types of Mutual Funds Index Funds (continued)
The rationale for index funds came from research done in the early 1970’s that statistically showed that many of the actively-managed funds did not beat the market “A monkey throwing darts at a dartboard…” However, many actively-managed funds do beat their respective indexes over time Look for a fund family where most all funds have consistently beaten their indexes over decades! (Psst! There are only a few major companies) In the late ’90’s, index funds became a victim of their own success

Standard & Poor’s 500 (a.k.a. S&P 500) Dow Jones Industrial Average (a.k.a. the Dow) Dow Jones U.S. Total Stock Market Index nee Dow Jones Wilshire 5000, nee Wilshire 5000 a.k.a. Total Market Index NASDAQ Composite & NASDAQ 100 MSCI World (Global) & EAFE Index (International) Countless other index funds available now Index funds are the current “perfect investment.” For the failsafe superlative treatment, visit What, if any, are the downsides to index funds?

Indexes sometimes become skewed toward a particular sector of the economy or region of the world (more about this phenomenon later in the semester) MSCI EAFE 12/31/1989 S&P 500 3/31/2000 Japan, 59.8% P/E: 51.9 Info Tech, 33.3% P/E: 59.2 All else, 66.7% P/E: 19.3 All else, 40.2% P/E: 13.0

Types of Mutual Funds Exchange-Traded Funds – a.k.a. ETFs
(continued) Exchange-Traded Funds – a.k.a. ETFs An open-end mutual fund that trades as a listed security on a stock exchange Trades like a stock as does a closed-end fund But there is no limit on the number of shares Becoming very popular because they can be bought and sold throughout the day like stocks Unlike open-end mutual funds, which always trade at the end-of-day net asset value Most all ETFs are passively-managed index funds But there now are also some actively-managed ETFs And they have cool names like “Spider,” “Diamond,” and “Cube”

Types of Mutual Funds Socially Responsible Funds
(continued) Socially Responsible Funds Mutual funds that actively and directly incorporate ethics and morality into the investment decisions Started out with some funds refusing to invest in companies that sold alcohol or tobacco Moved to companies that pollute, build weapons or nuclear power plants, destroy the rain forests, etc. And then to companies that exploit labor It is surprising that there any companies left to invest in … Silliness aside, many Socially Responsible Funds have done quite well for their investors

Types of Mutual Funds Socially Irresponsible Funds (???)
(continued) Socially Irresponsible Funds (???) Possibly as a backlash to socially responsible funds (and their perceived political overtones) There is a mutual fund called The Vice Fund Yep! You guessed it! It invests in tobacco and alcohol … (The manager says he simply loves Philip Morris!) And all the other corporate nasties you can think of Gambling, Defense firms And although it is still a very small fund with high annual fees, it has done very well for its investors (

Types of Mutual Funds Growth Blend Value Large Medium Small Size Style
(continued) Growth Blend Value Large Medium Small Size Style Morningstar, a company that analyzes mutual funds, designed the “style box” to help investors identify investment alternatives. They say they are fabulous. No one I know uses them; neither do I. Now they have “ownership zones.” They say they are even better.

Fund Families A family of funds exists when one investment company manages a group of mutual funds Funds in the family vary in their objectives You can move your money from one fund to another within a fund family Almost always with no charge But, if the fund is in a taxable account, you could generate a taxable transaction Recently, fees are being charged for “excessive” transfers within the fund family Done to discourage “market timing” by investors Forbes sez, “Choose a Family, Not a Fund”

Fund Families: Top Ten Families
Vanguard Group Fidelity Investments American Funds (The Capital Group) T. Rowe Price J. P. Morgan Chase & Co. BlackRock Funds Franklin Templ eton Investments TIAA / Nuveen Dimensional Funds PIMCO Examples: Offerings from the top three families Source: Investment News, John Waggoner, ici.org, Largest Mutual Fund Companies by Assets Sep 2017 Note: Other sources have the top 10 listed differently.

Mutual Fund Investor Services
Automatic Investment Plans Mutual fund service that allows shareholders to automatically send fixed amounts of money from their paychecks or bank accounts into the fund a.k.a. Dollar-Cost Averaging (more later) “Pay yourself first!” In my humble opinion, this is the absolute best way to invest in a mutual fund. You do not worry about whether or not it is a good time to invest. Every month is a good time to invest $50 that comes right out of your paycheck or checking account. P.S. It is practically the only way most people will ever invest!

(continued) Automatic Reinvestment Plan Mutual fund service that enables shareholders to automatically buy additional shares in the fund through the reinvestment of dividends, interest, and capital gains Automatic Reinvestment Plans allow an investor to earn fully compounded rates of return. Unless an investor needs the income, it is always a good idea to reinvest dividends and capital gains received from a mutual fund. By the way, automatic reinvestment of dividends, interest, and capital gains is the default when you open a new mutual fund account.

(continued) Systematic Withdrawal Plan Mutual fund service that enables shareholders to automatically receive a predetermined amount of money monthly or quarterly Sometimes annually Normally electronically transferred directly to your checking account Conversion Privilege – a.k.a. Exchange Privilege Allows shareholders to move money from one fund to another within the same family of funds May trigger tax consequences if not in a retirement account

Mutual Fund Transactions
Purchase options Closed-end & ETFs through the stock exchange Open-end Through a broker Directly from the investment company Best way is auto-contributions (payroll, checking) Sell options Through a broker or through the mutual fund Best way is auto-withdrawals (into your checking)

Taxes and Mutual Funds Two types of taxes for Regular Accounts
Income dividends Taxed as income (20% max, 15% typical, 5% min) Capital gains distributions Taxed as capital gains (20% max, 15%, 5% min) Reinvested dividends and capital gains are still taxable transactions Save your year-end statements Congress may change this someday (doubtful!) Unrealized capital gains (a.k.a. paper profits) would not be taxed until you sell your mutual fund shares (forget it!) Tax-deferred Retirement Accounts (401(k), etc.) Pay no taxes until retirement All proceeds taxed as income (except Roth tax-free)

Sources of Mutual Fund Information
Mutual Fund Prospectus 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 Information about dividends, distributions & taxes Information about the fund’s management No one reads them! Unless they have taken BUS-123 It is really not that hard (Check out a few on the web site) Mutual Fund Annual Report Performance, investments, assets and liabilities

(continued) Financial publications Morningstar, Lipper, etc. Business Week, Forbes, Kiplinger's Personal Finance, and Money are sources of information on mutual funds Mutual fund surveys usually include: Fund’s overall rating compared to other funds Fund’s rating compared to funds in the same category Fund size, sales charge and expense ratio Risk of loss factor and toll-free number History for past three, five, and ten years

(continued) Financial web sites finance.yahoo.com (Used to be really good, now really bad) Mutual fund companies’ Internet sites Investment Company Institute web site Hurray! The mutual fund web sites are again promoting education.

“So, How Do I Pick a Mutual Fund?”
Pick a Mutual Fund that… Invests in high-quality stocks or bonds Is well-diversified across several industries and sectors of the economy Has a long-term perspective and a manager or (better yet) a management team with many years of experience Avoid companies that “shuffle” their managers every few years (which is virtually all of them!) Has been around for decades and performed consistently well in both good and bad markets

A Sample Stock Mutual Fund
Is 80+ years “long-term” enough for you? 6%, 8%, 9%, 10%? How about 12%? “But stocks are very risky” Short-term, Yes. Long-term, No! “But now is not a good time to invest” “Excuse me, when is it ever a good time to invest?” Okay, so what if you had invested on the worst day of the year for the past 20 years? How did you do? “But what about market downturns?” Keep a long-term perspective, and Dollar Cost Average…

Dollar-Cost Averaging
A system of buying an investment at regular intervals with a fixed dollar amount With Dollar-Cost Averaging, there is always “Good News” “The market is up! Good News!” Your account is worth more “The market is down! Good News!” Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account Your average cost-per-share should be lower than your average price-per-share

Hypotheticals Most mutual fund companies have a system for running “hypotheticals” a.k.a. “Illustrations” “Hypothetical illustrations” Examples of returns of investments Lump sum principals, or Streams of investments a.k.a. Dollar-Cost Averaging Or combinations of both Must be approved by SEC and FINRA And contain disclaimers about past versus future performance Let’s run some hypotheticals!

And That Ain’t the Only One!
As of December 31, 2018

But What About the Investors?
What types of returns do many typical mutual fund investors earn? Uh, not so good. What?! How can that be? It’s easy! Many typical mutual fund investors Buy High, Sell Low. “Most mutual fund investors do worse than the mutual funds they invest in.”

Bottom Line on Mutual Funds
Choose a fund family and stick with them Re-evaluate them periodically (once or twice a year?) But make changes judiciously and sparingly As you approach retirement, migrate from stock funds to bond funds But do not give up on stocks entirely Dollar-Cost Average $50 a month, $100 a month, whatever is affordable… For the most part, Forget About Them! Do not be one of the mutual fund investors that does worse than your mutual funds!

CHAPTER 4 – REVIEW Mutual Funds Chapter Sections:
Advantages and Drawbacks of Mutual Fund Investing Investment Companies and Fund Types Mutual Funds Operations Mutual Funds Costs and Fees Short-Term Funds Long-Term Funds Mutual Fund Performance Closed-End Funds, Exchange Traded Funds, and Hedge Funds Next week: Chapter 5, Introduction to Stocks

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CHAPTER 4 Mutual Funds Chapter Sections:

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