part 4: managing your investments chapter 15 mutual funds: an easy way to diversify

PART 4:MANAGING YOUR INVESTMENTS

Chapter 15Chapter 15

Mutual Funds: An EasyMutual Funds: An EasyWay to Diversify Way to Diversify

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Mutual FundsMutual Funds

Pool investors’ money, investing in Pool investors’ money, investing in stocks, bonds, and various short-stocks, bonds, and various short-term securities.term securities.

Professional managers tend to the Professional managers tend to the investments.investments.

Allow investors to diversify, even Allow investors to diversify, even with a small investment.with a small investment.

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Why Invest in Mutual Why Invest in Mutual Funds?Funds?

Advantages of mutual funds:Advantages of mutual funds: Professional managementProfessional management

Access to the best research to evaluate Access to the best research to evaluate investment alternatives.investment alternatives.

Minimal transaction costs Minimal transaction costs Low commissions because of volume, which Low commissions because of volume, which

may translate into higher returns.may translate into higher returns. Liquidity Liquidity

Easy to buy and sell on phone or online.Easy to buy and sell on phone or online.

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Advantages of mutual funds:Advantages of mutual funds:

Flexibility – over 8,000 funds to choose from, Flexibility – over 8,000 funds to choose from, covering many objectives and risk levels.covering many objectives and risk levels.

Service – provide bookkeeping, checking Service – provide bookkeeping, checking accounts, automatic additions or withdrawals.accounts, automatic additions or withdrawals.

Avoidance of bad brokers – avoid potentially Avoidance of bad brokers – avoid potentially bad advice, high sales commissions, and bad advice, high sales commissions, and churning.churning.

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Disadvantages of mutual funds:Disadvantages of mutual funds:

Lower than market performance – mutual Lower than market performance – mutual funds underperform the market on average.funds underperform the market on average.

Costs – sales fee or load can be as high as Costs – sales fee or load can be as high as 8.5% in addition to annual expense ratio at 8.5% in addition to annual expense ratio at 3%. 3%.

Risks – not all mutual funds are safe; Risks – not all mutual funds are safe; specialized funds may lack diversification specialized funds may lack diversification outside a specific industry.outside a specific industry.

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Disadvantages of mutual funds:Disadvantages of mutual funds:

Systematic risk - mutual funds do not Systematic risk - mutual funds do not diversify away systematic risk. Even diversify away systematic risk. Even mutual funds will suffer in a crash.mutual funds will suffer in a crash.

Taxes – mutual funds trade frequently, Taxes – mutual funds trade frequently, so investors may pay taxes on capital so investors may pay taxes on capital gains. You cannot defer taxes.gains. You cannot defer taxes.

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Mutual Fund-AmentalsMutual Fund-Amentals

A mutual fund pools money from A mutual fund pools money from investors with similar financial investors with similar financial goals.goals.

You are investing in a diversified You are investing in a diversified portfolio that’s professionally portfolio that’s professionally managed according to set goals.managed according to set goals.

Investment objectives are clearly Investment objectives are clearly stated.stated.

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Make money 3 ways in a mutual Make money 3 ways in a mutual fund:fund: As the value of the securities in the fund As the value of the securities in the fund

increases, the value of each mutual fund increases, the value of each mutual fund share also rises.share also rises.

Most pay dividends or interest to Most pay dividends or interest to shareholders.shareholders.

Shareholders receive a capital gains Shareholders receive a capital gains distribution when the fund sells a security distribution when the fund sells a security for more than originally paid.for more than originally paid.

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Organization of a mutual fund:Organization of a mutual fund: Fund is set up as a corporation or trust, Fund is set up as a corporation or trust,

owned by shareholders.owned by shareholders. Shareholders elect a board of directors.Shareholders elect a board of directors. Fund is run by a management company.Fund is run by a management company. Each individual fund hires an investment Each individual fund hires an investment

advisor to oversee the fund.advisor to oversee the fund. Contracts with a custodian, a transfer Contracts with a custodian, a transfer

agent, and an underwriter. agent, and an underwriter.

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Custodian – acts as a third party Custodian – acts as a third party safeguarding the fund’s assets; makes safeguarding the fund’s assets; makes payments for the fund’s securities and payments for the fund’s securities and receives money when securities are sold.receives money when securities are sold. Is often a bank.Is often a bank.

Transfer agent – is a record keeper; keeps Transfer agent – is a record keeper; keeps track of purchases and redemptions and track of purchases and redemptions and distributing dividends and capital gains.distributing dividends and capital gains.

Underwriter – is responsible for selling Underwriter – is responsible for selling new shares in the mutual fund.new shares in the mutual fund.

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Investment CompaniesInvestment Companies

A firm that invests the pooled A firm that invests the pooled money of a number of investors in money of a number of investors in return forreturn fora fee.a fee.

Types of investment companies:Types of investment companies: Open-End Investment CompaniesOpen-End Investment Companies Closed-End Investment CompaniesClosed-End Investment Companies Unit Investment TrustsUnit Investment Trusts Real Estate Investment TrustsReal Estate Investment Trusts

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Open-End Investment Open-End Investment CompaniesCompanies

These mutual funds are the most popular These mutual funds are the most popular form of investment companies.form of investment companies.

Open-end means the investment company Open-end means the investment company can issue an unlimited number of can issue an unlimited number of ownership shares.ownership shares.

Shares do not trade in the secondary Shares do not trade in the secondary market, must buy or sell through the market, must buy or sell through the fund.fund.

Price based on net asset value (NAV). Price based on net asset value (NAV). [Total market value of all securities less [Total market value of all securities less

liabilities] ÷ total shares outstandingliabilities] ÷ total shares outstanding

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Closed-End Investment Closed-End Investment CompaniesCompanies

Has a fixed number of shares, Has a fixed number of shares, cannot issue new shares.cannot issue new shares.

Shares sold initially by investment Shares sold initially by investment company, afterwards they trade like company, afterwards they trade like a common stock.a common stock.

Price based on demand, not NAV.Price based on demand, not NAV.

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Unit Investment TrustsUnit Investment Trusts

A fixed pool of securities with each A fixed pool of securities with each unit representing a proportionate unit representing a proportionate ownership in the pool.ownership in the pool.

They are not managed.They are not managed. Fund purchases a fixed amount of Fund purchases a fixed amount of

bonds, holds them until maturity, bonds, holds them until maturity, then the trust dissolves.then the trust dissolves.

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Real Estate Investment Real Estate Investment TrustsTrusts

Like a mutual fund specializing in Like a mutual fund specializing in real estate. real estate. Has a professional manager.Has a professional manager. Uses pooled funds.Uses pooled funds. Is actively managed.Is actively managed.

Must collect 75% of its income from Must collect 75% of its income from real estate and distribute 95% of real estate and distribute 95% of that income in the form of dividends.that income in the form of dividends.

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Real Estate Investment Real Estate Investment TrustsTrusts

Types of REITs:Types of REITs: Equity – buys property directly and Equity – buys property directly and

manages it. Investors look for appreciation manages it. Investors look for appreciation in value.in value.

Mortgage – investment is limited to Mortgage – investment is limited to mortgages. Investors receive interest mortgages. Investors receive interest payments only.payments only.

Hybrid – a combination of the two. Invests Hybrid – a combination of the two. Invests in both property and mortgages, receiving in both property and mortgages, receiving both interest and capital appreciation.both interest and capital appreciation.

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Load Versus No-Load Load Versus No-Load FundsFunds

A load mutual fund charges a sales A load mutual fund charges a sales commission. They are sold through commission. They are sold through brokers, financial advisors and brokers, financial advisors and financial planners.financial planners. Class A – front-end sales loadClass A – front-end sales load Class B – back-end loadClass B – back-end load Class C – pay coming and goingClass C – pay coming and going

A no-load fund doesn’t charge a A no-load fund doesn’t charge a commission.commission.

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Management Fees and Management Fees and ExpensesExpenses

Invest in a fund with a low expense ratioInvest in a fund with a low expense ratio Ratio compares funds expenses to total assets Ratio compares funds expenses to total assets

(expense ratio = expenses ÷ assets).(expense ratio = expenses ÷ assets). This ratio typically ranges from 0.25% to 2.0%.This ratio typically ranges from 0.25% to 2.0%.

Look at the turnover rate Look at the turnover rate Measures the level of the fund’s trading activity.Measures the level of the fund’s trading activity.

The higher the turnover rate, the higher the fund’s The higher the turnover rate, the higher the fund’s expenses.expenses.

12b-1 Fees 12b-1 Fees Marketing expenses for advertising and sales Marketing expenses for advertising and sales

promotion.promotion.

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Money Market Mutual Money Market Mutual FundsFunds

Invest in Treasury bills, CDs, and other Invest in Treasury bills, CDs, and other short-term investments, less than 30 short-term investments, less than 30 days.days.

Regarded as practically risk-free.Regarded as practically risk-free. Carry no loads, trade at a constant $1 Carry no loads, trade at a constant $1

NAV, and have minimal expenses. NAV, and have minimal expenses. Tax-exempt money market fund invests Tax-exempt money market fund invests

only in short-term municipal debt only in short-term municipal debt (which is exempt from federal taxes).(which is exempt from federal taxes).

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Stock Mutual FundsStock Mutual Funds

Aggressive Growth Funds – maximize Aggressive Growth Funds – maximize capital appreciation while ignoring capital appreciation while ignoring income. Have wider price swings than income. Have wider price swings than other funds.other funds.

Small-Company Growth Funds – similar Small-Company Growth Funds – similar to aggressive growth funds but limited to aggressive growth funds but limited to investments in small companies. Look to investments in small companies. Look to uncover and invest in undiscovered to uncover and invest in undiscovered companies with unlimited growth companies with unlimited growth potential.potential.

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Growth and Income Funds – provide a Growth and Income Funds – provide a steady stream of income with the steady stream of income with the potential for increasing value. Less potential for increasing value. Less risky, stable dividends, less price risky, stable dividends, less price movement.movement.

Sector Funds – specialized mutual fund Sector Funds – specialized mutual fund investing 65% of its assets in securities investing 65% of its assets in securities from a specific industry. Less risky than from a specific industry. Less risky than an individual stock, but more risky than an individual stock, but more risky than a traditional mutual fund.a traditional mutual fund.

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Index Funds – try to track a market Index Funds – try to track a market index, such as the S&P 500, by index, such as the S&P 500, by buying stocks in that index. Provide buying stocks in that index. Provide diversification at a low cost.diversification at a low cost.

International Funds – concentrate on International Funds – concentrate on securities from other countries, may securities from other countries, may have political and currency risks. have political and currency risks.

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Balanced Mutual FundsBalanced Mutual Funds

Hold both common stock and bonds.Hold both common stock and bonds. Objective is to earn steady income Objective is to earn steady income

and some capital gains.and some capital gains. Aimed at those needing income to Aimed at those needing income to

live on and moderate stability in live on and moderate stability in their investment.their investment.

Ratio of stocks to bonds varies.Ratio of stocks to bonds varies.

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Asset Allocation FundsAsset Allocation Funds

Similar to a balanced fund, invest in Similar to a balanced fund, invest in stocks, bonds, and money market stocks, bonds, and money market securities.securities.

Differ in that they move money between Differ in that they move money between stocks and bonds to outperform the stocks and bonds to outperform the market.market.

It is a balanced fund practicing market It is a balanced fund practicing market timing.timing.

Likely to produce additional transaction Likely to produce additional transaction costs rather than additional returns.costs rather than additional returns.

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Life Cycle and TargetLife Cycle and TargetRetirement FundsRetirement Funds

Life cycle is the newest type of funds. Life cycle is the newest type of funds. An asset allocation fund that tailors An asset allocation fund that tailors holdings to investor’s characteristics, holdings to investor’s characteristics, such as age and risk tolerance. such as age and risk tolerance.

Target retirement funds are managed Target retirement funds are managed based on when you plan to retire. based on when you plan to retire.

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Bond FundsBond Funds

Bond FundsBond Funds $1000 investment $1000 investment

buys a diversified buys a diversified portfolio.portfolio.

More liquidityMore liquidity Professional Professional

management management Have automatic Have automatic

reinvestmentreinvestment

Individual BondsIndividual Bonds Save mutual fund Save mutual fund

expensesexpenses Bond funds do not Bond funds do not

mature, individual mature, individual bonds dobonds do

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Bond funds can be Bond funds can be differentiated by the type of differentiated by the type of

bond and by maturitybond and by maturity..Type of BondType of Bond U.S. GovernmentU.S. Government MunicipalMunicipal CorporateCorporate

MaturityMaturity Short-termShort-term Intermediate-Intermediate-

termterm Long-termLong-term

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U.S. Government Bond U.S. Government Bond FundsFunds

or GNMA Fundsor GNMA FundsU.S. Treasury Bond U.S. Treasury Bond

FundsFunds Specialize in Specialize in

Treasury securities.Treasury securities. No default risk, but No default risk, but

will fluctuate with will fluctuate with changes in interest changes in interest rates.rates.

GNMA FundsGNMA Funds Specialize in mortgage-Specialize in mortgage-

backed securities.backed securities. Carry interest rate riskCarry interest rate risk

and prepayment risk.and prepayment risk.

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Bond FundsBond Funds Municipal Bond Funds – interest is Municipal Bond Funds – interest is

generally tax-exempt from federal generally tax-exempt from federal taxes.taxes. Aimed at those looking to avoid taxes.Aimed at those looking to avoid taxes.

Corporate Bond Funds – invest in Corporate Bond Funds – invest in various types of corporate bonds, various types of corporate bonds, including high quality and junk bonds.including high quality and junk bonds. As interest rates rise, NAV goes down.As interest rates rise, NAV goes down.

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Bond funds and their maturities:Bond funds and their maturities: Short-term – 1-5 years in maturityShort-term – 1-5 years in maturity Intermediate-term – 5-10 years in maturityIntermediate-term – 5-10 years in maturity Long-term – 10-30 years in maturityLong-term – 10-30 years in maturity

As interest rates change, long-term As interest rates change, long-term bonds fluctuate more than short-term.bonds fluctuate more than short-term.

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ETFs or Exchange ETFs or Exchange Traded FundsTraded Funds

First issued in 1993, these are hybrids First issued in 1993, these are hybrids between a mutual fund and an individual between a mutual fund and an individual stock or bond.stock or bond.

Trade on an exchange just like securities Trade on an exchange just like securities and can be bought or sold throughout and can be bought or sold throughout the day.the day.

2 ETFs dominate the market2 ETFs dominate the market Qubes (QQQ) tracks the NASDAQ 100 Index.Qubes (QQQ) tracks the NASDAQ 100 Index. Spiders (SPDRS) tracks the S&P 500.Spiders (SPDRS) tracks the S&P 500.

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Advantages of ETFs:Advantages of ETFs: Trade on an exchange and can be Trade on an exchange and can be

bought and sold throughout the day.bought and sold throughout the day. Can be sold short or bought on margin.Can be sold short or bought on margin. Low annual expenses.Low annual expenses. More tax efficient than mutual funds.More tax efficient than mutual funds.

Most trading is between shareholders so Most trading is between shareholders so that the funds do not have to sell stocks to that the funds do not have to sell stocks to meet redemption demands of investors.meet redemption demands of investors.

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Disadvantages of ETFs:Disadvantages of ETFs: Pay a commission because they trade Pay a commission because they trade

like stocks.like stocks. Don’t necessarily trade at NAV.Don’t necessarily trade at NAV. Bid-ask spread because buying from Bid-ask spread because buying from

another investor.another investor. Expensive for those who trade often, Expensive for those who trade often,

incur brokerage costs. incur brokerage costs.

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Mutual Fund ServicesMutual Fund Services

Automatic investment and withdrawal plans Automatic investment and withdrawal plans Automatic reinvestment of interest, Automatic reinvestment of interest,

dividends, and capital gainsdividends, and capital gains Wiring and funds express optionsWiring and funds express options Phone switchingPhone switching Easy establishment of retirement plansEasy establishment of retirement plans Check writingCheck writing Bookkeeping and help with taxesBookkeeping and help with taxes

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Buying a Mutual FundBuying a Mutual Fund

Step 1: Determining Your GoalsStep 1: Determining Your Goals Buying a mutual fund involves Buying a mutual fund involves

determining your investment goals determining your investment goals and time horizon.and time horizon.

Understand why you are investing:Understand why you are investing: To receive additional incomeTo receive additional income Supplement your retirement incomeSupplement your retirement income Save for a child’s educationSave for a child’s education

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Step 2: Meeting Your ObjectivesStep 2: Meeting Your Objectives Identify the fund’s objectives by Identify the fund’s objectives by

looking at objective classifications.looking at objective classifications. Don’t assume the fund’s name Don’t assume the fund’s name

reflects the strategy or objectives.reflects the strategy or objectives. MorningstarMorningstar provides an investment provides an investment

style box to understand the style box to understand the investment style.investment style.

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Step 2: Meeting Your ObjectivesStep 2: Meeting Your Objectives Look in the prospectus for:Look in the prospectus for:

Fund’s goals and investment strategyFund’s goals and investment strategy Fund manager’s past experienceFund manager’s past experience Any investment limitations the fund may haveAny investment limitations the fund may have Tax considerations of importance to investorsTax considerations of importance to investors Redemption and investment processRedemption and investment process Services providedServices provided Performance over past 10 yearsPerformance over past 10 years Fund fees and expensesFund fees and expenses Fund’s annual turnover rateFund’s annual turnover rate

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Step 3: Evaluating the FundStep 3: Evaluating the Fund Look closely at past performance and Look closely at past performance and

scrutinize their costs.scrutinize their costs. Past performance does not predict future Past performance does not predict future

results, but it does give insight.results, but it does give insight. Limit comparisons to funds with similar Limit comparisons to funds with similar

objectives.objectives. Investigate how the fund did during Investigate how the fund did during

upturns and downturns. upturns and downturns.

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Step 3: Evaluating the FundStep 3: Evaluating the Fund Sources of Information:Sources of Information:

Wall Street JournalWall Street Journal ForbesForbes – annual mutual fund survey – annual mutual fund survey Kiplinger’s PersonalKiplinger’s Personal FinanceFinance magazine magazine MorningstarMorningstar www.morningstar.comwww.morningstar.com

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Making the Purchase:Making the Purchase: Buy direct – use phone or internet.Buy direct – use phone or internet. Buy through a mutual fund supermarket Buy through a mutual fund supermarket

– such as Fidelity or Schwab.– such as Fidelity or Schwab.

part 4: managing your investments chapter 15 mutual funds: an easy way to diversify

Documents

disadvantages of mutual

systematic risk mutual

taxes mutual funds trade

safe specialized funds

mutual fundamentals

mutual fund pools money

high sales commissions

risk levels