copyright © 2011 pearson prentice hall. all rights reserved. chapter 12 mutual funds:...

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 12

Mutual Funds: Professionally Managed Portfolios

Copyright © 2011 Pearson Prentice Hall. All rights reserved.12-2

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

• By 1940 there were 68 funds and by 1980 there were 564 funds

• By the end of 2008 there were more than 8,000 mutual funds available, with more than $9.6 trillion under management

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

• More 45% of all U.S. households own a mutual fund


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


Drawbacks of Mutual Funds

• Substantial Transaction Costs» This term is relative; stocks have round trip commissions and frequently

there are other charges for research and advice and portfolio mgt

– 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• For a variety of reason this might be true; but there are many

funds that have beat the market on a consistent basis with less risk


Figure 12.1 The Comparative Performance of Managed Mutual Funds Versus Market BenchmarksSource: Standard & Poor’s, Standard & Poor’s Indices Versus Active Funds Scorecard, Year End 2008 .


The Comparative Performance of Mutual Funds Versus the Market

Go to morningstar.com, fund screen 10 years > S&P500 200 hits


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


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 12.2 Fund Fees and Charges on the Web

Source: Data from www.morningstar.com, September 10, 2009. ©2009 Morningstar, Inc.


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


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


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


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


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 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




• 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

– Exchanges between funds can trigger capital gains taxes in non-retirement accounts

• Not just load funds; any exchange of one fund (called selling) and the purchase of another fund will trigger a taxable event outside of retirement accounts

• Phone Switching

• Easy Establishment of Retirement Plans


Investor Uses of Mutual Funds

• Accumulation of Wealth

• Storehouse of Value

• Speculation and Short-Term Trading– By definition and law this is illegal.


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

• Value Line Mutual Fund Survey

• Websites such as Yahoo.finance.com


Figure 12.5 Some Relevant Information About Specific Mutual Funds

Source: Morningstar, Inc., Principia, release date: August 31, 2009.


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


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

copyright © 2011 pearson prentice hall. all rights reserved. chapter 12 mutual funds:...

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