Mutual Funds: An Easy Way to Diversify

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Chapter 15

• Mutual Funds An Easy Way to Diversify

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What is a Mutual Fund?

• Investment company that pools money from
  investors to buy stocks, bonds, and other
  investments. Investors own a share of the fund
  proportionate to the amount of the investment.

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Why Invest in Mutual Funds?

• Benefit the small investor diversification and
  reduced risk
• Level the playing field between corporations and
  the individual investor

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Advantages of Mutual Fund Investing

• Diversification owning numerous securities
  reduces risk
• Professional management
• Minimal transaction costs
• Liquidity
• Flexibility
• Service
• Avoidance of bad brokers

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Disadvantages of Mutual Fund Investing

• Lower-than-market performance
• 1985 2000, 84.5 of average annual returns
  trailed the SP 500 Index
• Costs
• Risks Unsystematic risk
• Risk Systematic risk
• Capital gains taxes

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To Operate, Mutual Funds

• Pool money from investors with similar goals
• Invest in numerous securities
• Hire a management company to run the fund

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To Operate, Mutual Funds (contd)

• Hire an investment advisor to manage the funds
  portfolio
• Hire
• a custodian to safeguard fund holdings.
• a transfer agent to act as record keeper.
• an underwriter to sell new shares.

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Ways of Making Money With Mutual Funds

• Increases in market value (appreciation)
• Dividends
• Capital gains distribution

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Types of Investment Companies

• Open-end investment companies or mutual funds
• Closed-end investment companies or mutual funds
• Unit investment trusts
• Real estate investment trusts (REITs)

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Open-End Investment Companies or Mutual Funds

• Have an unlimited number of shares
• Buy and sell shares directly to investors without
  a secondary market
• Purchase and selling price is determined by the
  net asset value of the fund
• NAV value of all securities - liabilities
  total shares outstanding

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Closed-End Investment Companies or Mutual Funds

• Have a limited number of shares
• Sell only the initial offering. Subsequent trades
  are done in a secondary market, similar to the
  common stock market.
• Purchase and selling price is determined by
  supply and demand.

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Unit Investment Trusts

• Fixed pool of securities, normally municipal
  bonds
• Have shares that represent a proportionate share
  of the trust
• Are passive investments that operate on a
  buy-and-hold strategy
• Normally require 1,000 minimum investment
• Long time horizon recommended

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Real Estate Investment Trusts (REITs)

• Professional managers invest pooled funds in a
  diversified portfolio of real estate.
• REITs require that 75 of fund income is
  generated from real estate investments and must
  distribute 95 of income as dividends.

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Real Estate Investment Trusts (contd)

• Have 3 types (equity mortgage hybrid)
• Lack the liquidity of most mutual funds, but more
  liquidity than direct real estate investments
• Actively traded REITs recommended
• Offer diversification independent of the stock
  market

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Equity REITs

• Buy property directly
• Manage the property
• Investors hope the real estate appreciates in
  value

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Mortgage REITs

• Buy mortgages
• Do not have any capital appreciation
• Investors only receive interest payments on the
  mortgages

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Hybrid REITs

• Invest in both properties and mortgages
• Investments result in both capital appreciation
  and interest income

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The Costs of Mutual Funds

• Load funds sales commissions charged to the
  investor when purchasing fund shares
• Back-end load funds commissions charged to the
  investor when selling the shares may be a
  sliding scale
• No-load funds no commission charged

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The Costs of Mutual Funds (contd)

• Management fees and expenses fees associated
  with the operation of the company
• Expense ratio
• Turnover rate
• 12b-1 fees fees charged to cover the funds
  cost of advertising and marketing

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Types and Objectives of Mutual Funds

• Money market mutual funds
• Stock mutual funds
• Balanced mutual funds
• Asset allocation funds
• Life-cycle funds
• Bond funds

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Money Market Mutual Funds (MMMFs)

• Invest in short-term securities with maturities
  of less than 30 days
• Trade at a constant net asset value of 1 per
  share
• Work much like an interest bearing checking
  account with some limitations
• Considered practically risk-free

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Specialized Types of MMMFs

• Tax-exempt MMMFs invest in only munis
• Government securities MMMFs invest in
  government paper to reduce risk, but lower return

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Stock Mutual Funds

• Aggressive growth funds
• Small-company growth funds
• Growth funds
• Growth-and-income funds
• Sector funds
• Index funds
• International funds

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Balanced Mutual Funds

• Try to balance objectives of long-term growth,
  income, and stability of the capital invested
• Invest in common stock, preferred stock, and
  bonds
• Less volatile than stock funds

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Asset Allocation Funds

• Are similar to balanced mutual funds in the mix
  of securities
• Practice market timing to attempt to outperform
  the market
• Risky due to the turnover rate and associated
  transaction costs

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Life-Cycle Funds

• Are similar to asset allocation funds
• Tailor holdings to best meet the needs of
  investors in a certain stage of the life-cycle,
  such as age or risk tolerance

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Bond Funds

• A small investment buys shares in a diversified
  bond portfolio
• More liquid than individual bonds
• Provide professional management
• Provide regular income

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Bond Funds (contd)

• Can incur more expenses than purchasing bonds
  directly
• Dont mature to pay a guaranteed lump sum
  investment like individual bonds do

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Types of Bond Funds

• U.S. government and GNMA bond funds
• Municipal bond funds
• Corporate bond funds
• Specialized maturity length (short-,
  intermediate-, and long-term) funds

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Services Offered by Mutual Funds

• Automatic investment and withdrawal plans
• Automatic reinvestment of interest, dividends,
  and capital gains
• Wiring and funds express options
• Phone switching
• Easy establishment of retirement plans
• Check writing
• Bookkeeping and help with taxes

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Buying a Mutual Fund

• Step 1 Determine your investment goals.
• Step 2 Identify funds that meet your objectives.
• Step 3 Evaluate the fund.

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Step 1 Determine Your Investment Goals

• Determine your time horizon for each goal.
• Determine your risk tolerance.
• Determine your personal investment preferences.
• Determine your tax planning strategies.

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Step 2 Identify Funds That Meet Your Objectives

• Look to third-party publications
• Morningstar Mutual Funds
• Determine the funds objective.
• Determine the funds investment style
• Value
• Growth
• Read the prospectus.

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Information Contained in the Prospectus

• The funds goal and investment strategy
• The fund managers past experience
• Any limitation on investments that the fund may
  have
• Any tax considerations of importance to the
  investors

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Information Contained in the Prospectus (contd)

• The redemption and investment process for buying
  and selling shares in the fund
• Services provided investors
• Performance over the past 10 years or since the
  fund has been in existence
• Fund fees and expenses
• The funds annual turnover ratio

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Step 3 Evaluate the Fund

• Always compare funds with the same objective
• Evaluate the funds long-term performance
• Look at returns in both up and down markets

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Sources of Information

• The Wall Street Journal
• Forbes or Business Week
• Kiplingers Personal Finance
• Smart Money or Consumer Reports
• Wiesenberger Investment Companies Service
• Morningstar Mutual Funds

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Mutual Fund Quotes in The Wall Street Journal

• NAV net asset value (price)
• NAV change gain or loss from prior days NAV
• Total return NAV change plus accumulated income
• Total return NAV change plus income for
  different time periods, in percent

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Mutual Fund Quotes (contd)

• Ranking performance comparison among funds with
  same objective for different time periods
• Max initial sales com the largest allowable
  sales commission charged
• Annual Exp covers all expenses associated with
  running and advertising the fund

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Calculating Fund Returns

• Returns include distributions of dividends,
  distributions of capital gains, or NAV
  appreciation.
• Total return
• dividends capital gains (ending NAV
  beginning NAV) beginning NAV

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Calculating Fund Returns

• With reinvestment of all distributions, total
  return includes the NAV share increase and the
  increased number of shares.
• Total return
• (No. of ending shares x ending price)
• (No. of beginning shares x beginning price)
• (No. of beginning shares x beginning price)

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Making the Purchase

• Buy through a financial services broker, banker,
  planner
• Probably a load
• Buy directly from the mutual fund
• No load
• 1-800
• Internet

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Making the Purchase (contd)

• Buy through a mutual fund supermarket
• 8 major players, 2 largest are
• Fidelity Funds Network
• Charles Schwab
• Minimum account balances vary
• Transaction fees vary

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Summary

• What is a mutual fund and how does it operate?
• Mutual fund advantages and disadvantages
• Types of investment companies
• Open and closed end mutual funds
• Unit investment trusts
• REITs

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Summary (contd)

• Costs of owning a mutual fund
• Loads front-end and back-end
• Fees management and 12b-1
• Understand fund objectives and categories
• Understand fund services

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Summary (contd)

• Sources of mutual fund investment information
• Newspapers, magazines, Internet
• Investment company prospectus
• How do you buy a mutual fund?
• Types of mutual fund returns
• Dividends or capital gains distributions
• NAV appreciation