1. Mutual Funds: Professionally Managed Portfolios
Chapter 12
Mutual Funds: Professionally Managed Portfolios

2. Mutual Funds Learning Goals
Describe the basic features of mutual funds, and note what they have to offer as investment vehicles.
Distinguish between open- and closed-end funds, as well as other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges.
Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.

3. Mutual Funds Learning Goals (cont’d)
Discuss the investor services offered by mutual funds and how these services can fit into an investment program.
Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes.
Identify the sources of return and compute the rate of return earned on a mutual fund investment.

4. Mutual Funds
Mutual Fund: an investment company that invests its shareholders’ money in a diversified portfolio of securities
Investors own a share of the fund proportionate to the amount of the investment
First started in 1924
Nearly 8,000 mutual funds available today
More mutual funds in existence today than stocks listed on NYSE and AMEX combined
54 million U.S. households own mutual funds

5. Attractions of Mutual Funds
Portfolio Diversification
Owning numerous securities reduces risk
Professional management
Ability to invest small amounts
Service
Automatic reinvestment of dividends
Withdrawal plans
Exchange privileges
Convenience
Easy to buy and sell; high liquidity
Funds handle recordkeeping
Easy to track prices

6. Drawbacks of Mutual Funds
Substantial Transaction Costs
Management fee
Commission fees on load funds
Lower-than-Market Performance
Consistently beating the market is difficult
Many mutual funds just keep even with overall stock market index

7. Figure 12.1 The Comparative Performance of Mutual Funds Versus the Market

8. How Mutual Funds are Organized
Management company runs the funds’ daily operations
Investment advisor buys and sells stocks or bonds and oversees the investment portfolio
Distributor sells the fund shares
Direct to the public
Through brokers
Custodian physically safeguards the securities
Transfer agent keeps track of purchases and redemption requests from shareholders

9. Open-End Investment Companies
Investors buy and sell shares directly with the mutual fund company without a secondary market
Have an unlimited number of shares
Purchase and selling price is determined by the Net Asset Value (NAV) of the fund
All purchases and sales are completed at the end of the day after the stock markets have closed

10. Closed-End Investment Companies
Sell only the initial offering
Subsequent trades are done in a secondary market, similar to the common stock market
Have a limited number of shares
Investment advisor doesn’t have to worry about cash inflow or outflows
Purchase and selling price is determined by supply and demand
Generally sell at premium or discount (usually discount) to NAV

11. Exchange-Traded Funds (ETF)
A basket of securities designed to track a specific market index
Similar to index mutual funds
Trade like individual stocks on stock exchanges
Can buy and sell ETFs any time of the day
Low management expenses due to limited trading by investment advisor
Low turnover helps avoid taxes until ETF is sold
Types of ETFs
“Diamonds” (DIA) track DJIA
“Spiders” (SPY) track S&P 500
“Qubes (QQQ) track NASDAQ 100

12. Load and No-Load Funds
Load Fund: a mutual fund that charges a commission when shares are bought
Typically sold through a broker
No-load Fund: a mutual fund that does not charge a commission when shares are bought
Typically sold directly to investor by mutual fund
Cost savings tend to give investors a head start in achieving superior rates of return
Low-load Fund: a mutual fund that charges a small commission (2% to 3%) when shares are bought

13. Load and No-Load Funds
Back-end load: a commission charged on the sale of shares in a mutual fund
12(b)-1 fee: fee charged by some mutual funds to cover management and other operating costs; amounts to as much as 1% of the average net assets

14. Other Fees and Costs
Management fee: compensation paid to professional managers who administer the fund’s investment portfolio
This fee is paid by all types of funds (load vs. no-load; open-end vs. closed-end)
Fee is charged annually on average net assets
Administrative costs: the normal costs of doing business, such as trading expenses
Taxes on mutual funds
Mutual funds do not pay taxes if income and capital gains are passed on to shareholders
Shareholders are taxed on their share of income and capital gains annually

15. Figure 12.2 Fund Fees and Charges on the Web
©2003 Morningstar, Inc. Used with permission.

16. Table 12.1 Mutual Fund Fee Table (Required by Federal Law)

17. Unit Investment Trusts (UIT)
Fixed pool of securities, normally bonds
Not actively managed; securities in portfolio remain static
Have shares that represent a proportionate share of the trust

18. Real Estate Investment Trusts (REIT)
Closed-end investment company that invests in mortgages and various types of real estate investments
Provide high dividends along with capital appreciation potential
Types of REITs
Property/equity REITs invest in shopping centers, hotels, apartments, office buildings and other real estate
Mortgage REITs invest in mortgages
Hybrid REITS invest in both properties and mortgages

19. Hedge Funds Not really mutual funds; private limited partnerships
Not regulated by mutual fund regulations
General partner runs fund and takes 10-20% of profits; limited partners are investors
Only sold to “accredited investors”—net worth greater than $1,000,000 and/or annual income over $200,000
Use arbitrage strategies, options, short sales and other complex strategies

20. Types of Mutual Funds
Growth Fund: primary goals are capital gains and long-term growth
Invest in large, well-established companies with above-average growth potential
Little or no dividend income
Moderately risk investments for more aggressive investors

21. Types of Mutual Funds (cont’d)
Aggressive Growth Fund: highly speculative mutual fund that seeks large profits from capital gains
Invest in small, unseasoned companies with high price/earnings ratios
Often look for turnaround situations
Prices are often highly volatile
High risk investments for very aggressive investors

22. Types of Mutual Funds (cont’d)
Value Fund: seeks stocks that are undervalued in the market
Focus is on intrinsic value of stocks and requires extensive fundamental analysis
Invest in stocks with low P/E ratios, high dividend yields and promising futures
Looks for undiscovered companies with potential for future growth
Less risky investments for relatively conservative investors looking for moderate growth

23. Types of Mutual Funds (cont’d)
Equity-income Fund: emphasizes current income and capital preservation
Focus is on high current income with some long-term capital appreciation
Invest in high-yielding common stocks, convertible securities or preferred stocks
Invests in “blue chip” stocks and other high-grade securities
Typically less price volatility than overall stock market
Less risky investments for relatively conservative investors looking for moderate growth

24. Types of Mutual Funds (cont’d)
Balanced Fund: generates a balanced return of both current income and long-term capital gains
Invest in blend of fixed-income securities and common stocks, with 30% to 40% in fixed income
Allocation between stocks and bonds typically remains constant or varies very little
Emphasis between fixed-income and common stocks can be shifted as market conditions change
Less risky investments for relatively conservative investors looking for moderate growth

25. Types of Mutual Funds (cont’d)
Growth-and-Income Fund: seeks both long-term growth and current income, with primary emphasis on capital gains
Focus is on long-term capital appreciation with some high income to provide limited stability
Invest in blend of commons stocks and fixed-income securities, with up to 90% in common stocks
Moderate risk investments for investors who can tolerate moderate price volatility

26. Types of Mutual Funds (cont’d)
Bond Funds: invests in various kinds and grades of bonds, with income as primary objective
Advantages of bond funds over individual bonds:
More liquid
Offer high diversification
Bond funds automatically reinvest interest
Lower risk investments for investors who are looking for steady income
Some price volatility occurs with changing interest rates

27. Types of Bond Funds
Government bond funds: invest in U.S. Treasury and agency securities
Mortgage-backed bond funds: invest in mortgage-backed securities of U.S. government, such as GNMA’s
High-grade corporate bond funds: invest in corporate bonds rated triple-B or better
High-yield corporate bond funds: invest in lower rated corporate bonds (junk bonds)
Convertible bond funds: invest in securities that can be converted into common stocks

28. Types of Bond Funds (cont’d)
Municipal bond funds: invest in tax-exempt securities issued by states and political subdivisions
Single-state fund: invests in municipal issues of only one state to provide double tax-free income
Intermediate-term bond funds: invest in bonds with maturities of 7 to 10 years or less
Short-term bond funds: invest in bonds with maturities of 2 to 5 years
Often used as alternative to money market funds when interest rates are low

29. Money Market Funds
Invest in short-term securities with maturities of less than 90 days
Interest rates move up and down with market rates
Trade at a constant net asset value of $1 per share
Considered a safe, convenient investment to accumulate capital and temporarily store idle funds
Types of money market funds:
General purpose: invests in all types of money market investments
Government securities: invest only in U.S. Treasury bills and other short-term government securities
Tax-exempt: invest in very short-term tax-exempt municipal securities

30. Types of Mutual Funds
Index Funds: buys and holds a portfolio of stocks (or bonds) equivalent to those in a specific market index
Objective is to match, not beat, the specific index
Strategy is buy-and-hold, which provides tax advantages with very little taxable capital gains
Operating costs are very low due to low turnover in investment portfolio

31. Types of Mutual Funds (cont’d)
Sector Funds: investments are restricted to a particular segment of the market
Investments are concentrated in one specific industry sector
Objective is to produce capital gains
Considered speculative because limited diversification can increase investment risks

32. Types of Mutual Funds (cont’d)
Socially Responsible Funds: funds that actively and directly incorporate ethics and morality into the investment decision
Specific stocks are evaluated on financial criteria and moral, ethic or environmental tests
Stocks that do not meet these tests are not considered for the investment portfolio
Examples of excluded companies:
Tobacco or alcohol
Gambling
Nuclear energy
Returns may be reduced due to limited investment opportunities

33. Types of Mutual Funds (cont’d)
Asset Allocation Funds: funds that spread investors’ money across stocks, bonds, and money market securities
Provides built-in asset allocation by professional investment manager
As market conditions change over time, the asset allocation mix changes as well
Provides convenience of “one-stop shopping” without having to own several mutual funds

34. Types of Mutual Funds (cont’d)
International Funds: funds that do all or most of their investing in foreign securities
Objective is to benefit from changes in:
International market conditions
Valuation of U.S. dollar
Funds can specialize in international stocks, bonds or money market securities
Funds can specialize in growth, value, aggressive growth and other types of stocks
Funds can specialize in specific countries or regions of the world
Considered fairly high-risk due to currency exchange risks

35. Mutual Fund Investor Services
Automatic Investment Plans
Regular investment from checking or savings account or paycheck
Monthly amounts as small as $25
Excellent way to build up investment over time
Automatic Reinvestment of Interest, Dividends, and Capital Gains
Systematic Withdrawal Plans

36. Mutual Fund Investor Services (cont’d)
Conversion (Exchange) Privileges
Load funds usually allow exchanges between mutual funds in the same fund family without paying additional sales loads
Exchanges between funds can trigger capital gains taxes in non-retirement accounts
Phone Switching
Easy Establishment of Retirement Plans

37. Investor Uses of Mutual Funds
Accumulation of Wealth
Storehouse of Value
Speculation and Short-Term Trading

38. Selecting Mutual Funds
Determine if you want to use mutual funds in portfolio
Mutual funds increase diversification
Mutual funds offer expertise in areas where investor may not be informed
Can use stocks and mutual funds
Compare mutual fund’s investment objective to investor’s objective
Compare range of services offered

39. Sources of Information
Fund prospectus
The Wall Street Journal
Barron’s, Money, Fortune or Forbes
Morningstar Mutual Funds
Value Line Mutual Fund Survey
Websites such as Yahoo.finance.com

40. Figure 12.5 Some Relevant Information About Specific Mutual Funds
©2003 Morningstar, Inc. Used with permission.

41. Factors in Comparing Mutual Funds
Fund’s investment performance
Tax efficiency
Fee structure
How particular fund fits into your portfolio
Investment skills of fund managers
Load or No-Load funds
Closed-End or Open-End funds

42. Comparing Closed-End and Open-End Funds
Brokerage commissions apply to closed-end funds
Open-end funds have greater liquidity
Closed-end funds trade at premium (or discount) to NAV
Avoid closed-end funds trading at premium
Look for closed-end funds trading at discount

43. Sources of Return from Mutual Funds
Dividend income
Capital gains distributions
Change in price/NAV
Unrealized capital gains (paper profits): capital gain that has not been realized since fund’s holdings have not been sold

44. Calculating Return: Holding Period Return
Returns include distributions of dividends, distributions of capital gains, or NAV appreciation
Return for specific holding period
Best for one year returns since does not use present value

45. Chapter 12 Review Learning Goals
Describe the basic features of mutual funds, and note what they have to offer as investment vehicles.
Distinguish between open- and closed-end funds, as well as other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges.
Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.

46. Chapter 12 Review (cont’d)
Learning Goals (cont’d)
Discuss the investor services offered by mutual funds and how these services can fit into an investment program.
Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes.
Identify the sources of return and compute the rate of return earned on a mutual fund investment.

47. Additional Chapter Art

48. Figure 12.3 Mutual Fund Quotes

49. Figure 12.4 The Effects of Reinvesting Income

50. Figure 12.6 Selected Performance on CEFs

51. Table 12.2 A Report of Mutual Fund Income and Capital Changes (For a share outstanding throughout the year)