Chapter Eighteen

Mutual Funds
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McGraw-Hill/Irwin

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Mutual Fund
Definition

Security that gives small investors access to a well diversified portfolio of

Equities Bonds Other securities

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

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Mutual Fund cont.

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

Majority of mutual funds fail to beat the market

Past performance is no guarantee of future results

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Advantages and Disadvantages of Mutual Funds

Diversification Professional Management Time Savings Performance Expenses Selection problems

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Diversification

Chose securities from different industries Economy does not affect companies equally

Advantages and Disadvantages of Mutual Funds

Alternatively diversify portfolio in different kinds of assets such as

Bonds Preferred stock Convertible securities International securities Real estate
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Mutual Funds cont.

Buy different types of mutual funds to achieve diversification, e.g. Corporate U.S. government bond fund Domestic equity fund International equity fund Real estate investment trust Municipal bond fund Short-term money market fund
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Closed-End versus Open-End Funds

Close & Open refer to distribution & redemption

Closed-end fund

Fixed number of shares Cannot buy the shares directly from the fund (except at the inception of the fund) Limitation on shares outstanding Fund does not stand ready to buy shares back Purchasers/sellers must trade with each other
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Closed-End versus Open-End Funds

Open-end fund

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

Total value of securities - Liabiliti es Net asset value (NAV) Shares oustanding

Example Total value of securities . $140 million Liabilities $5 million Shares outstanding .. 10 million

$140 million - $5 million NAV $13.50 10 million shares

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Exchange Traded Funds (ETFs)

Passively managed Low-cost Tax-efficient baskets of stocks Focus on

Countries Sectors Regions Indices
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Exchange Traded Funds (ETFs)

Best advancement for individual investors in the past decade No other development, with the possible exception of the rise of Eliot Spitzer, New York attorney-general, has inflicted greater damage to the mutual fund industry that has monopolized the investor market for the past 50 years
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Exchange Traded Funds (ETFs)

Index-based funds imitate market indexes e.g.

S&P 500 Index (SPDRs) Dow Jones Index (called DIAMONDS)

Major advantage of ETFs: Investor can buy the market or an industry just like buying a common stock
ETFs discussed more fully in the next chapter
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Investing in Open-Ended Funds

Load versus No-Load Funds No-Load Funds Information on Mutual Funds

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

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Load versus No-Load Funds

Fund type
Load funds Low-load funds
Back-end load No Load

Commission in %
7.25% or higher 2 to 3% Exit fee 2 to 3% may decline with time
Zero
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No-Load Funds

Do not charge commissions Sold directly by investment company through

Advertisements Prospectuses 800-number telephone orders

About 50% of all mutual fund assets are no-load funds

Account for approx. 50% of new sales Why buy load funds when you can buy no-load funds? (HOPE for a better return!)
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No-Load Funds

How do no-load funds justify their existence? Answer: charge assets management fee plus expenses (12b-1 fees) - 0.75 to 1.25% Load funds have similar management fees Fund with a 12b-1 fee of .25% or less is still considered a no-load fund

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

$72.50 7.82% $927.50

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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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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 Diversity of Mutual Funds

Matching Investment Objectives with Fund Types Money Market Funds Growth Funds Growth with Income Balanced Funds Index Funds Bond Funds Sector Funds
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Differing Objectives and the Diversity of Mutual Funds

Sector Funds (riskier)

Energy Medical Technology Computer Technology Leisure Defense

Foreign Funds
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Differing Objectives and the Diversity of Mutual Funds

Specialty Funds - investing primarily in the

securities of a particular
Industry Sector Type of security Geographic region
Examples:
Underlined hyperlinks

www.sbs.gov.uk/phoenix www.calvertgroup.com www.usfunds.com

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Differing Objectives and the Diversity of Mutual Funds

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

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Differing Objectives and the Diversity of Mutual Funds

Hedge Funds continued

Engage in wide range of activities for superior return:

Buying (long) Short selling Buy/sell puts and calls at the same time in the attempt to gain an edge Limited partnership Charge management fees only on profits (20%)

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Matching Investment Objectives with Fund Types

Volatility of return Safety of principal

Little deviation of returns Choose money market funds Intermediate-term bond funds Expect lower returns

Aggressive growth stock funds

Provide the highest expected return Biggest risk
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Matching
OBJECTIVES

FUND TYPES
Almost all mutual funds allow redemption at any time Bond funds provide highest annual current yield Aggressive growth funds the lowest yield Balanced funds
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Liquidity

Income

Growth-Income

Example- Diversify by Fund Type

% Weight Type of Fund

50% 35% 10% 5%

U.S. Common Stocks Bonds Money Market Funds International Stock Fund
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The Prospectus

Investment Objectives and Policies Portfolio (or Investment Holdings) Management Fees and Expenses Turnover Rate Expense ratio Per share income Capital changes
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Shareholder Services

Automatic reinvestment Safekeeping Exchange privilege Preauthorized check plan Systematic withdrawal plan Checking privileges
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Dollar Averaging
Investor buys Fixed dollars worth Given security Regular intervals Regardless of securitys price Ignores current market outlook
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 In January, low price $12, purchased large numbers: 16.66 shares In April, high price $19, purchased low numbers: 10.52 shares

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Computing Total Return on Your Investment

Assume invested in a fund for one year Three potential sources of return:
Change in net asset value (NAV) Dividends distributed Capital gains distributed

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Websites
www.morningstar.com

Comments
Basic site containing detailed information about mutual funds, portfolio tracking, & analysis Provides mutual fund data & quotes along with portfolio tracking & financial planning information Permits tracking of mutual funds in portfolios
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www.quicken.com

www.my.yahoo.com

Websites
moneycentral.msn.com

Comments
Provides information about mutual funds Investment Company Institute

www.ici.org

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Summary

Investment funds allow investors to pool their resources under professional managers Closed-end a fixed number of shares, and purchasers and sellers of shares must deal with each other (via brokers) Open-end fund are more prevalent
Ready to sell new shares or buy back old shares

Load fund up to 7.25% sales commissions No-Load fund

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Summary
Mutual funds specialize: Money market management Growth in common stocks Bond portfolio management Special sectors of the economy
Energy Computers Foreign investments

Funds with an international orientation have enjoyed strong popularity in the last decade
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Summary
Examining a funds prospectus one can determine

Investment objectives Policies Portfolio holdings Turnover rate Management fees (SEC 12b-1) Special services
Automatic reinvestment of distributions Exchange privileges among different funds Systematic withdrawal plans Check writing privileges

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Summary
Return to fund holders may come from Capital appreciation Yield Over the long term, mutual funds have not outperformed the popular market averages offer an opportunity for
Low-cost Efficient diversification Normally have experienced management

Few funds have above-average returns

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