Chapter 12

Mutual Funds:
Professionally
Managed Portfolios

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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

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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

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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

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The Comparative Performance of
Mutual Funds Versus the Market

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

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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

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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
NAV = Value of all securities − Liabilities total shares outstanding

• All purchases and sales are completed at the end of the

day after the stock markets have closed

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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

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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
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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

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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

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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

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Figure 12.2
Fund Fees and
Charges on the
Web

Source: Data from

www.morningstar.com,
September 10, 2009.
©2009 Morningstar, Inc.

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

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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

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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

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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

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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

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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

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Types of Mutual Funds (cont’d)

• 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

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Types of Mutual Funds (cont’d)

• 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
– Less risky investments for relatively conservative investors looking
for moderate growth

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Types of Mutual Funds (cont’d)

• 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
– Less risky investments for relatively conservative investors
looking for moderate growth

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Types of Mutual Funds (cont’d)

• 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

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Types of Mutual Funds (cont’d)

• 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

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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

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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

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 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

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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

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Types of Mutual Funds (cont’d)

• 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

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Types of Mutual Funds (cont’d)

• 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

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Types of Mutual Funds (cont’d)

• 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

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Types of Mutual Funds (cont’d)

• 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

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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

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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
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Investor Uses of Mutual Funds

• Accumulation of Wealth
• Storehouse of Value
• Speculation and Short-Term Trading
– By definition and law this is illegal.

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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

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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

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Figure 12.5
Some Relevant
Information
About Specific
Mutual Funds

Source: Morningstar, Inc.,

Principia, release date: August 31,
2009.

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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

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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

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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

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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

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