chapter 13 mutual funds: professionally managed portfolios

Chapter 13

Mutual Funds: Professionally Managed Portfolios

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-2

Mutual Funds

• Learning Goals

1. Describe the basic features of mutual funds, and note what they have to offer as investment vehicles.

2. 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.

3. Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.


Mutual Funds

• Learning Goals (cont’d)

4. Discuss the investor services offered by mutual funds and how these services can fit into an investment program.

5. Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes.

6. Identify the sources of return and compute the rate of return earned on a mutual fund investment.


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 8,300 mutual funds available today

• More mutual funds in existence today than stocks listed on NYSE and AMEX combined

• Nearly half of all U.S. households own mutual funds


Attractions of Mutual Funds

• 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


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


Figure 13.2 Mutual Fund Performance


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


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

NAV Value of all securities Liabilities total shares outstanding


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


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


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.


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.

• Multiple-class sales charge: different shares classes of the same mutual fund are offered with different fee structures.


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


Figure 13.4 Fund Fees

©2003 Morningstar, Inc. Used with permission.


Table 13.2 Fund Fees


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

• Tend to be very costly due to high sales commissions and high management fees


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 other complex strategies


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


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



• 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



• 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




• 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 25% to 30% 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




• 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



• 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


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.


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

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


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



• 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



• 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



• 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



• 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


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


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

• Phone switching

• Easy establishment of retirement plans


Investor Uses of Mutual Funds

• Accumulation of Wealth

• Storehouse of Value

• Speculation and Short-Term Trading


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


Sources of Information

• Fund prospectus

• The Wall Street Journal

• Barron’s, Money, Fortune or Forbes

• Morningstar Mutual Funds

• Wiesenberger Investment Companies Service

• Value Line Mutual Fund Survey


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


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

Premium (or discount) (Share price NAV) / NAV


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


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

Holding periodreturn

Number ofshares at end

of period

Endingprice

Number of

shares at beginningof period

Initialprice

Number of sharesat beginning of period

Initialprice


Chapter 13 Review

• Learning Goals

1. Describe the basic features of mutual funds, and note what they have to offer as investment vehicles.

2. 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.

3. Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill.


Chapter 13 Review (cont’d)

• Learning Goals (cont’d)

4. Discuss the investor services offered by mutual funds and how these services can fit into an investment program.

5. Gain an appreciation of the investor uses of mutual funds, along with the variables to consider when assessing and selecting funds for investment purposes.

6. Identify the sources of return and compute the rate of return earned on a mutual fund investment.

chapter 13 mutual funds: professionally managed portfolios

Documents