Investments

FIN 450
Chapter 4
Investment Companies: Mutual
Funds, Exchange-Traded Funds, etc.
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Chapter 4 - 2
• Introduction
– Shareholder accounts in mutual funds (all
investment companies are similar) have grown
from 23 million in 1990 to 50 million by 2009
– $ invested - over $11 trillion
– About 43% of US households have $ invested
in mutual funds
– Page 77
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– Example – book – how mutual funds work
• 1 person know a lot about investing – taken an
investments course
• 100 other people give him $ - he picks the
investments
– $100,000 portfolio; 1 share = $10; 10,000 shares
– If you invested $10,000 – 1,000 shares – 10%
– $90,000 – common stocks; $10,000 – T-bills
– Page 78
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• Advantages and Disadvantages of Mutual
Funds
– Probably the biggest advantage – easy way for
small investors (not much money) to diversify
• Normally, an investor has to buy at least 100 shares
to get lower commissions
• X At least 10 stocks to lower risk
• X average price of $50 = $50,000 – lot for most
people
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– Another advantage is letting a specialist (full-
time job) pick investments
• Stocks, bonds, commodities, etc.
• Stocks – computer or Japanese, etc.
• Commissions – low – fees are usually 1%
– That’s why mutual funds have grown
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• > 8,000 mutual funds to choose from
• Only 3,000 stocks on the NYSE
– Disadvantages
• The average mutual fund does not outperform the
overall stock market
• Rate of return = S&P 500 or DJIA
– Some exceptions – higher returns – some – negative rates
of return
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• Closed-End Versus Open-End Funds
– Closed-end – fixed # of shares
• If you want to buy shares, someone has to be willing
to sell theirs to you
– Open-end - # of shares are not fixed
• Up or down – 100,000 – 10,000 – 110,000
• Sell you shares or buy your shares
• 95%
• But first briefly – closed-end
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– Closed-end
• Listed just like a stock
• Pages 80-1
– Think NAV = stock prices – but it usually doesn’t
– Lower – reasons – poor record – low returns, heavily
invested in an unpopular industry, stocks are thinly traded
– may not be able to sell, etc.
– Few – premium – NAV > stock prices of the companies
that make up the portfolio of the mutual fund, high rates
of return in the past
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» NAV should equal market prices of stocks –
inefficiency in stock market
» 10 = 8.50 – discount 15% - could sell all the stocks
and get $10/share less a small commission
– Exchange Traded Funds
» Index mutual funds – DJIA - DIAMONDS

• Investing in Open-End Funds

– 95% of mutual funds
– Page 87
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• NAV will go up or down as stock prices in the portfolio go up
or down
• Examples – Dreyfus, Vanguard, etc.
– Load versus No-Load Funds
• Load – sales commission – stockbroker and financial planners
– sell funds to clients – as high as 7% (or higher)
– Low-load funds – 3%
– Back-end funds – when sell – pay commission – usually 5% -
decreases over time
• No-load – no sales commission – no salespersons – advertise
on TV and newspaper – 800# - you call them
• Both – management fees of about 1%
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– No-Load Funds
• Over 50% - increasing
• Studies – rates of return are equal – foolish to buy load funds –
paying sales commission – as long as you know what kind of
fund you want to invest in
• Information on Mutual Funds
– Page 98
• Differing Objectives and the Diversity of Mutual
Funds
– >8,000 – each different – to try to attract different type
investors
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– Money Market Funds
• Invest in short-term securities that pay interest
• US Treasury bills, jumbo CDs - $100,000 and up
– Pay higher interest than small $1,000 CDs in banks
– Pool together a lot of $ - 1,000s of investors
– 7% - 1% management fee = 6% > 5% small CDs
» Low risk picks – not much analysis
– Usually, minimum amount - $500 -$1,000 – buy
– Write checks – buy usually, minimum - $250
» Not checking account – but you can get $ out
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– Growth Funds
• Price of common stock going up
• No or very little dividends
• Aggressive – borrow $ to try to get high rates of
return
– Emerging small companies
– “hot” sectors of the economy (internet – 1998)
• Regular growth funds – do not borrow $
– Bigger, more stable companies that have been around a
few years
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– Growth with Income
• Both some price increase but also dividends
• Less risky, but probably less returns than growth
funds
– Balanced Funds
• Invest in common stocks, bonds, preferred stock,
convertible bonds, etc.
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– Index Funds
• No research
• Low fees
• Match an index – DJIA or S&P 500
• Assume you can’t beat the average return – efficient
stock market
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– Bonds funds
• Invest in bonds
• Interest
• Usually low risk
• Although if market interest rates go up, the price of
the bonds will go down if the manager sells
• Less risky than common stock, but lower rates of
return historically
– (1/2 – bond, ½ - stocks – same return – 3 years – Georgia)
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• Some specialize – corporate, US Government,
municipal (usually high income investors – no
taxes) (Mississippi – can diversify – Cleveland,
Jackson, Biloxi)
• Some – junk bonds – usually higher interest rates
but prices will drop if some companies default
– happened in1989 – could wipe out rate of return – no
interest
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– Sector Funds
• Energy, computer, medical, etc.
• Energy – Exxon Mobil, Texaco Chevron, etc. – less
diversified than typical mutual fund
• 1 industry – higher loss/reward potential
• But if you think prices are going up in the drug
industry – not sure which company to invest in –
some diversification
• Careful – probably overpriced – hot industry –
internet 1999
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– Foreign Funds
• Best rates of return – 1983-93
• Took a beating in 1998
• Include Templeton World Fund
• Page 91
– Specialty Funds
• Gold mining companies
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– Hedge Funds
• Lot of debt – use to buy usually small risky stocks –
try to get high returns – risky
– Matching Investment Objectives with Fund
Types
• From low risk to high risk
• Money market mutual funds, bonds, balanced,
growth with income, index, sector, growth,
specialty, foreign, aggressive growth, hedge
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• Liquidity – sell any at any time
• Need income to live on – money market mutual
fund or bond – interest
• Don’t need income to live on – want a lot of $ in the
future – growth
• Want some of both – growth and income, balanced
– in between the extremes
• Some investors like to diversify
– 50% common stock, 30% bonds, 10% foreign stocks, and
10% money market
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– Some investors like to change the % of their portfolios
» If they think common stock prices are going down – drop
the % to 25%, increase money markets to 35% temporarily
– Merrill Lynch, Dreyfus, Prudential – family of funds – switch –
very low fee – paperwork (though you might have to pay taxes)

• The Prospectus
– Mutual funds are required by the SEC to provide a
prospectus with full disclosure of objectives, risks,
management fees, expenses, etc.
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• Investment objectives and policies
– Spell out – low, medium, or high risk – bonds, stocks, etc.
– Also if they do anything out of the ordinary – borrow $ -
spelled out
• Portfolio (or Investment Holding)
– List securities included in the portfolio
– Common stock – Exxon Mobil, Xerox, etc.
– % - how much $
• Management Fees and Expenses
– Usually around 1%
– Manager – picking stocks, legal fees, accounting fees
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– Cost of annual reports, etc.
– Marketing – controversial – some say – don’t need to do
• Turnover Rate
– How fast – buy and sell stocks

• Distribution and Taxation

– After subtracting losses from gains, mutual
funds distribute the $ to stockholders each year
• 90% - no taxes for mutual fund – vast majority do
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• Form 1099-DIV – investor fills out – taxes
• If investor sells mutual fund shares – has to pay taxes – profit
he got
– Tax Differences between Mutual Funds and Individual
Stock Portfolios
• Tax – usually more – mutual fund – buy and sell a lot – sell –
pay taxes if selling price > buying price
• Shareholder Services
• Automatic reinvestment
– of dividends or capital gains
– Usually no sales charge
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• Safekeeping
– Stocks – safe
• Exchange Privilege
– Move money from common stock to money market and
back
– Usually limits on how many times per year – switch
– Call up – small fee – paperwork
• Preauthorized Check Plan
– Some people just can’t save $
– Mutual fund sets up a withdrawal of say $100 each month
from their checking account
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• Systematic Withdrawal Plan
– If retired – need cash each month
– Get out $200/month (less or more) – supplement social
security
• Checking Privileges
– Most let investors write checks, but the minimum is
usually $250
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• Investment Funds, Long-Term Planning, and
Dollar-Cost Averaging
– Fixed amount is invested each month regardless of the
stocks’ prices
• Want to buy low and sell high
• But some of the time – opposite – buy high and sell low
• Trying to pay below the average price
• Buy more shares when the price is low
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• Bad – if price keeps going down – keep buying
– Company – bankrupt – pouring $ into a bottomless pit

• Evaluating Fund Performance

– Past performance does not guarantee future
performance
– +20% - past 5 years
– Next year could be –20%
– (article – worst mutual funds in 1998 – best in 1999)
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• However, usually – good – several years – probably
continue into the future
– Computing Total Return on Your Investment
• Compare with DJIA or S&P 500 – higher or lower
return
• Expect growth – higher return – taking higher risks