11

Chapter Eighteen

Mutual FundsMcGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All

Rights Reserved.

22

Mutual Fund Mutual Fund

Definition -Definition - Security that gives small investors access to a Security that gives small investors access to a

well diversified portfolio of well diversified portfolio of • Equities Equities • BondsBonds• Other securitiesOther securities

Shareholders participates in gain/loss of fundShareholders participates in gain/loss of fund Shares issued & redeemed as neededShares issued & redeemed as needed

33

Mutual Fund cont.Mutual Fund cont.

Net asset value (NAV) determined each dayNet asset value (NAV) determined each day Portfolio objective stated in prospectusPortfolio objective stated in prospectus

Majority of mutual funds fail to beat the marketMajority of mutual funds fail to beat the market

Past performance is no Past performance is no guarantee of future resultsguarantee of future results

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Advantages and Disadvantages Advantages and Disadvantages of Mutual Fundsof Mutual Funds

DiversificationDiversification Professional ManagementProfessional Management Time SavingsTime Savings PerformancePerformance ExpensesExpenses Selection problemsSelection problems

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Chose securities from different industries Chose securities from different industries Economy does not affect companies equallyEconomy does not affect companies equally

DiversificationDiversification

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Advantages and Disadvantages Advantages and Disadvantages of Mutual Fundsof Mutual Funds

Alternatively diversify portfolio in different Alternatively diversify portfolio in different kinds of assets such as kinds of assets such as • Bonds Bonds • Preferred stock Preferred stock • Convertible securitiesConvertible securities• International securitiesInternational securities• Real estateReal estate

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Mutual Funds cont.Mutual Funds cont.Buy different types of mutual funds to achieveBuy different types of mutual funds to achievediversification, e.g. diversification, e.g. Corporate Corporate U.S. government bond fundU.S. government bond fund Domestic equity fundDomestic equity fund International equity fundInternational equity fund Real estate investment trustReal estate investment trust Municipal bond fundMunicipal bond fund Short-term money market fundShort-term money market fund

Correlation <1

Correlation <1

with each other

with each other

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Closed-End versus Open-End FundsClosed-End versus Open-End Funds Close & Open refer to distribution & Close & Open refer to distribution &

redemptionredemptionClosed-end fundClosed-end fund

Fixed number of sharesFixed number of shares Cannot buy the shares directly from the fund Cannot buy the shares directly from the fund (except at the inception of the fund) (except at the inception of the fund) Limitation on shares outstandingLimitation on shares outstanding Fund does not stand ready to buy shares backFund does not stand ready to buy shares back Purchasers/sellers must trade with each otherPurchasers/sellers must trade with each other

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Closed-End versus Open-End FundsClosed-End versus Open-End FundsOpen-end fundOpen-end fund

Represents opposite of closed-end fundRepresents opposite of closed-end fund Always ready to sell new sharesAlways ready to sell new shares Always ready to buy back old sharesAlways ready to buy back old shares Shares of closed-end funds trade on securityShares of closed-end funds trade on security exchanges or over-the-counter just as any exchanges or over-the-counter just as any

other stock mightother stock might

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oustanding Shareses Liabiliti- securities of valueTotal (NAV) easset valuNet

Example Example Total value of securities ……. $140 millionTotal value of securities ……. $140 millionLiabilities ……………………… $5 millionLiabilities ……………………… $5 millionShares outstanding ………….. 10 millionShares outstanding ………….. 10 million

$13.50 shares million 10

million $5 -million 140$ NAV

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Exchange Traded Funds (ETFs)Exchange Traded Funds (ETFs) Passively managedPassively managed Low-cost Low-cost Tax-efficient baskets of stocks Tax-efficient baskets of stocks Focus on Focus on

• Countries Countries • SectorsSectors• Regions Regions • IndicesIndices

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Exchange Traded Funds (ETFs)Exchange Traded Funds (ETFs) Best advancement for individual investors Best advancement for individual investors

in the past decadein the past decade No other development, with the possible No other development, with the possible

exception of the rise of Eliot Spitzer, New exception of the rise of Eliot Spitzer, New York attorney-general, has inflicted greater York attorney-general, has inflicted greater damage to the mutual fund industry that damage to the mutual fund industry that has monopolized the investor market for has monopolized the investor market for the past 50 yearsthe past 50 years

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Exchange Traded Funds (ETFs)Exchange Traded Funds (ETFs)

Index-based funds imitate market indexes e.g.Index-based funds imitate market indexes e.g.• S&P 500 Index (SPDRs)S&P 500 Index (SPDRs)• Dow Jones Index (called DIAMONDS)Dow Jones Index (called DIAMONDS)

Major advantage of ETFs:Major advantage of ETFs:

Investor can buy “the market” or Investor can buy “the market” or ““an industry” just like buying an industry” just like buying

a common stocka common stockETFs discussed more fully in the next chapterETFs discussed more fully in the next chapter

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Investing in Open-Ended FundsInvesting in Open-Ended Funds Load versus No-Load FundsLoad versus No-Load Funds No-Load FundsNo-Load Funds Information on Mutual FundsInformation on Mutual Funds

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More than 95% of the investment funds More than 95% of the investment funds in U.S. are open-endedin U.S. are open-ended

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Load versus No-Load FundsLoad versus No-Load FundsFund typeFund type Commission in %Commission in %

Load fundsLoad funds 7.25% or higher7.25% or higher

Low-load fundsLow-load funds 2 to 3%2 to 3%

Back-end loadBack-end loadExit fee 2 to 3% Exit fee 2 to 3%

may decline with time may decline with time

No LoadNo Load Zero Zero

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No-Load FundsNo-Load Funds

Do not charge commissions Do not charge commissions Sold directly by investment company through Sold directly by investment company through

• AdvertisementsAdvertisements• ProspectusesProspectuses• 800-number telephone orders800-number telephone orders

About 50% of all mutual fund assets are no-load funds About 50% of all mutual fund assets are no-load funds Account for approx. 50% of new salesAccount for approx. 50% of new sales Why buy load funds when you can buy no-load Why buy load funds when you can buy no-load

funds? (HOPE for a better return!)funds? (HOPE for a better return!)

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No-Load FundsNo-Load Funds

How do no-load funds justify their existence? How do no-load funds justify their existence? Answer: charge assets management fee plus Answer: charge assets management fee plus

expenses (12b-1 fees) - 0.75 to 1.25% expenses (12b-1 fees) - 0.75 to 1.25% Load funds have similar management feesLoad funds have similar management fees

Fund with a 12b-1 fee of .25% or less is still Fund with a 12b-1 fee of .25% or less is still considered a no-load fundconsidered a no-load fund

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Invest $1,000 in a load mutual fund Invest $1,000 in a load mutual fund Pay a 7.25% commissionPay a 7.25% commission Only 92.75% go toward purchasing sharesOnly 92.75% go toward purchasing shares $1,000 investment becomes $927.50$1,000 investment becomes $927.50 Fund must go up by $72.50 or 7.82% just Fund must go up by $72.50 or 7.82% just

to break evento break even

%82.750.927$

50.72$

2020

Figure 18-2 Load and No-Load Fund Assets as a Share of Fund Assets, 1984 -2003

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Figure 18-2 Load and No-Load Fund Assets as a Share of Fund Assets, 1984 -2003

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Differing Objectives and the Differing Objectives and the Diversity of Mutual FundsDiversity of Mutual Funds

Matching Investment Objectives with Fund TypesMatching Investment Objectives with Fund Types Money Market FundsMoney Market Funds Growth FundsGrowth Funds Growth with IncomeGrowth with Income Balanced FundsBalanced Funds Index FundsIndex Funds Bond FundsBond Funds Sector FundsSector Funds

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Differing Objectives and the Differing Objectives and the Diversity of Mutual FundsDiversity of Mutual Funds

Sector Funds (riskier)Sector Funds (riskier)• EnergyEnergy• Medical TechnologyMedical Technology• Computer TechnologyComputer Technology• LeisureLeisure• DefenseDefense

Foreign FundsForeign Funds

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Differing Objectives and the Differing Objectives and the Diversity of Mutual FundsDiversity of Mutual Funds

Specialty Funds - Specialty Funds - investing primarily in the investing primarily in the securitiessecurities of a particular of a particular • IndustryIndustry • SectorSector • Type of Type of securitysecurity • Geographic Geographic regionregion

www.sbs.gov.uk/phoenixwww.calvertgroup.comwww.usfunds.com

Examples:

Underlined hyperlinks

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Differing Objectives and the Differing Objectives and the Diversity of Mutual FundsDiversity of Mutual Funds

Hedge Funds Hedge Funds • The name is misleading The name is misleading • Not restricted to hedging/reducing riskNot restricted to hedging/reducing risk• Neither bullish or bearishNeither bullish or bearish• Highly leveragedHighly leveraged

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Differing Objectives and the Differing Objectives and the Diversity of Mutual FundsDiversity of Mutual Funds

Hedge Funds Hedge Funds continuedcontinued

• Engage in wide range of activities for superior return:Engage in wide range of activities for superior return: Buying (long) Buying (long) Short sellingShort selling Buy/sell puts and calls at the same time in the Buy/sell puts and calls at the same time in the

attempt to gain an edgeattempt to gain an edge• Limited partnershipLimited partnership• Charge management fees only on profits (20%)Charge management fees only on profits (20%)

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Matching Investment Objectives Matching Investment Objectives with Fund Typeswith Fund Types

Volatility of return Volatility of return Safety of principal Safety of principal

• Little deviation of returnsLittle deviation of returns• Choose money market funds Choose money market funds • Intermediate-term bond fundsIntermediate-term bond funds• Expect lower returnsExpect lower returns

Aggressive growth stock funds Aggressive growth stock funds • Provide the highest expected returnProvide the highest expected return• Biggest riskBiggest risk

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MatchingMatchingOBJECTIVESOBJECTIVES FUND TYPESFUND TYPES

LiquidityLiquidity Almost all mutual funds allowAlmost all mutual funds allow redemption at any timeredemption at any time

IncomeIncome

Bond funds provideBond funds provide highest annual current yieldhighest annual current yield Aggressive growthAggressive growth funds the lowest yieldfunds the lowest yield

Growth-IncomeGrowth-Income Balanced fundsBalanced funds

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Example- Diversify by Fund Type Example- Diversify by Fund Type % Weight% Weight Type of FundType of Fund

50%50% U.S. Common StocksU.S. Common Stocks

35%35% BondsBonds

10%10% Money Market FundsMoney Market Funds

5%5% International Stock FundInternational Stock Fund

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The Prospectus The Prospectus

Investment Objectives and PoliciesInvestment Objectives and Policies Portfolio (or “Investment Holdings”)Portfolio (or “Investment Holdings”) Management Fees and ExpensesManagement Fees and Expenses Turnover RateTurnover Rate Expense ratioExpense ratio Per share income Per share income Capital changesCapital changes

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Shareholder ServicesShareholder Services

Automatic reinvestmentAutomatic reinvestment SafekeepingSafekeeping Exchange privilegeExchange privilege Preauthorized check planPreauthorized check plan Systematic withdrawal planSystematic withdrawal plan Checking privilegesChecking privileges

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Dollar AveragingDollar Averaging

Investor buys Investor buys Fixed dollar’s worth Fixed dollar’s worth Given security Given security Regular intervalsRegular intervals Regardless of security’s price Regardless of security’s price Ignores current market outlookIgnores current market outlook

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In January, low price $12, purchased In January, low price $12, purchased large numbers: 16.66 shareslarge numbers: 16.66 shares In April, high price $19, purchased In April, high price $19, purchased low numbers: 10.52 shareslow numbers: 10.52 shares

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Computing Total Return on Your InvestmentComputing Total Return on Your InvestmentAssume invested in a fund for one yearThree potential sources of return:

Change in net asset value (NAV) Dividends distributed Capital gains distributed

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WebsitesWebsites CommentsComments

www.morningstar.comwww.morningstar.com

Basic site containing Basic site containing detailed information about detailed information about mutual funds, portfolio mutual funds, portfolio tracking, & analysistracking, & analysis

www.quicken.comwww.quicken.com

Provides mutual fund data Provides mutual fund data & quotes along with & quotes along with portfolio tracking & financial portfolio tracking & financial planning informationplanning information

www.my.yahoo.comwww.my.yahoo.com Permits tracking of mutual Permits tracking of mutual funds in portfoliosfunds in portfolios

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WebsitesWebsites CommentsCommentsmoneycentral.msn.commoneycentral.msn.com Provides information Provides information

about mutual fundsabout mutual funds

www.www.iciici.org.org Investment Company Investment Company InstituteInstitute

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SummarySummary Investment funds allow investors to pool Investment funds allow investors to pool

their resources under professional managerstheir resources under professional managers Closed-end a Closed-end a fixed fixed number of shares, and number of shares, and

purchasers and sellers of shares must deal purchasers and sellers of shares must deal with each other (via brokers)with each other (via brokers)

Open-end fund are more prevalentOpen-end fund are more prevalent• Ready to sell new shares or buy back old sharesReady to sell new shares or buy back old shares• Load fund up to 7.25% sales commissionsLoad fund up to 7.25% sales commissions• No-Load fundNo-Load fund

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SummarySummaryMutual funds specialize:Mutual funds specialize: Money market managementMoney market management Growth in common stocksGrowth in common stocks Bond portfolio managementBond portfolio management Special sectors of the economy Special sectors of the economy

• Energy Energy • Computers Computers • Foreign investmentsForeign investments

Funds with an international orientation have Funds with an international orientation have enjoyed strong popularity in the last decadeenjoyed strong popularity in the last decade

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SummarySummaryExamining a fund’s prospectus one can determineExamining a fund’s prospectus one can determine Investment objectives Investment objectives PoliciesPolicies Portfolio holdingsPortfolio holdings Turnover rateTurnover rate Management fees (SEC 12b-1)Management fees (SEC 12b-1) Special servicesSpecial services

• Automatic reinvestment of distributionsAutomatic reinvestment of distributions• Exchange privileges among different fundsExchange privileges among different funds• Systematic withdrawal plansSystematic withdrawal plans• Check writing privilegesCheck writing privileges

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SummarySummaryReturn to fund holders may come from Return to fund holders may come from Capital appreciation Capital appreciation Yield Yield Over the long term, mutual funds have not Over the long term, mutual funds have not

outperformed the popular market averagesoutperformed the popular market averages offer an opportunity foroffer an opportunity for

• Low-costLow-cost• Efficient diversificationEfficient diversification• Normally have experienced managementNormally have experienced management

Few funds have above-average returnsFew funds have above-average returns