Chapter 16

Investing in Mutual Funds

Chapter 16

Investing in Mutual Funds

Chapter 16Learning 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

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Why Investors Purchase Mutual Funds

Objective 1: Describe the characteristics of mutual fund investments

An estimated 96 million individuals own mutual funds

Mutual funds grew from 361 in 1970 to over 11,000 in late 2006

In 2006 the combined value of assets owned by mutual funds in the United States totaled over $11.2 trillion

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Why Investors Purchase Mutual Funds (continued)

The major reasons investors purchase mutual funds are:

Professional managementWho is the fund’s manager?Managers can changeBe aware of the scandal involving late

tradingDiversificationInvestors funds are used to purchase a

variety of investments: this variety provides some safety

Drawbacks?4

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Why Investors Purchase Mutual Funds (continued)

CHARACTERISTICS OF MUTUAL FUNDS

Closed-end funds (3% 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

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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

Open-end funds (93% of funds)Shares are issued and redeemed by the

investment company at the request of investorsInvestors can buy and sell shares at the net asset

value (NAV)

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Why Investors Purchase Mutual Funds (continued)

Net Asset Value (NAV) =

Value of the fund’s portfolio - Liabilities

Number of shares outstanding

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Why Investors Purchase Mutual Funds (continued) LOAD FUNDS AND NO-LOAD FUNDSLoad 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 FundInvestors pay no sales charge up front.You deal directly with the fund with 800

numbers or Websites or from discount brokers.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

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Why Investors Purchase Mutual Funds (continued)

MANAGEMENT FEES AND OTHER CHARGESManagement 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 advertising and

marketing costs of the fundCannot exceed 1% of a fund’s assets per year

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

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Classification of Mutual FundsObjective 2: Classify mutual funds by

investment objective

STOCK FUNDSAggressive 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

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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

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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 less than $2 billion

Socially responsible funds avoid investing in companies that produce harmful products

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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)

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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

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

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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

Money market funds: Invest in CD’s, government securities, and other safe investments

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Classification of Mutual Funds (continued)

OTHER FUNDS

- Funds of funds: Invest in shares of other mutual funds

- Lifecycle funds: Invest in more risk-oriented securities and become increasingly conservative and income-oriented as a specified retirement date approaches.

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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

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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 meaning there is a professional fund manager or a team of managers

An index mutual fund is the mirror image of a specific index

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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

Consider managed funds vs. indexed funds

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How to Decide to Buy or Sell Mutual Funds (continued)

THE INTERNET

Use web sites to research a fund.Finance.yahoo.com

www.businessweek.com

www.morningstar.com (also other advisory services, such as Value Line)

www.smartmoney.com

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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

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How to Decide to Buy or Sell Mutual Funds (continued)

MUTUAL FUND PROSPECTUSMutual fund prospectus tells the funds objective and:

A statement describing the risk factorsA description of the fund’s past performanceA statement describing the type of investments in

the fund’s portfolioInformation on how to open an accountDividends, distributions and taxesInformation about the fund’s managementThe process for investors to buy or sell sharesServices provided to investorsThe turnover ratio of the fund’s investments

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How to Decide to Buy or Sell Mutual Funds (continued)

MUTUAL FUND ANNUAL REPORTPerformance, investments, assets and liabilities

FINANCIAL PUBLICATIONSBusiness Week, Forbes, Kiplinger's Personal

Finance and Money are sources of informationBusiness Week’s Online “Mutual Fund

Scoreboard” includes information such as the... Fund’s overall rating compared to all other funds,

and to funds in the same category Fund size, sales charge and expense ratio Performance over selected time periods

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The Mechanics of a Mutual Fund TransactionObjective 4: Describe how and why mutual

funds are bought and sold

You can open an account from $250 to $2,500 and up 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

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The Mechanics of a Mutual Fund Transaction (continued)

RETURN OF INVESTMENTIncome 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 on Schedule D and 1040)

Capital gain distributions: Payments to shareholders from sale of securities held by the fund (Show on Schedule D and 1040)

Income and capital gain distributions can be automatically reinvested

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The Mechanics of a Mutual Fund Transaction (continued)

Measure return

total dollar return =

income dividend + capital gain distribution

+ change in share market value when sold

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The Mechanics of a Mutual Fund Transaction (continued)

TAXES AND MUTUAL FUNDSIncome dividends are reported on your federal tax

return

Capital gain distributions are taxed as long term capital gains regardless of how long you own shares in the mutual fund

Capital gains or losses, when selling the shares are taxed on short-term or long-term basis depending on the length of time the funds are held

Funds reinvested in the purchase of additional shares are still taxable

The “turnover ratio” of a fund affects your tax liability

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The Mechanics of a Mutual Fund Transaction (continued)

PURCHASE OPTIONS (open-ended)Regular account transactionVoluntary savings planContractual planReinvestment plan

Automatic investments: Money is taken from your checking account monthly and invested in a fund

Withdrawals: Various withdrawal options; you can withdraw funds by phone, letter, online, etc.

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Mutual Fund Online ActivityGo online to www.morningstar.com,

www.cbsmarketwatch.com or other investment information sites. Research mutual funds

Find a fund that you think would be a good investment for you

Pair off with another student. Compare your mutual fund selections. Discuss your investment objectives and how this fund will meet those objectives

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