Mutual Funds

1
CHAPTER 4
Mutual Funds
Chapter Sections Advantages and Drawbacks of
Mutual Fund Investing Investment Companies and
Fund Types Mutual Funds Operations Mutual Funds
Costs and Fees Short-Term Funds Long-Term
Funds Mutual Fund Performance Closed-End Funds,
Exchange Traded Funds, and Hedge Funds
Mutual Funds Investments for the Masses
2
What is a Mutual Fund?

• An investment company that invests its
  shareholders money in a diversified portfolio of
  securities
• Investment company is the legal term
• Mutual fund is the popular term
• Professional management
• Diversification
• Each fund has a specific objective
• Over 10,000 funds to choose from
• Many people choose mutual funds for their
  retirement account investments (401k, 403b,
  Traditional IRA, Roth IRA, etc.)

3
Mutual Funds

• STOCKS BONDS CASH

Balanced mutual funds
Bond mutual funds
Stock mutual funds
Money market mutual funds
a mutual fund a.k.a. investment company
Professional Money Management Diversification
4
Growth of Mutual Fund Industry
Year Number of Mutual Funds
1940 70
1970 350
1980 600
1990 2,000
2000 9,000
2011 10,664
Source Investment Company Institute,
www.ici.org, Includes open-end, closed-end, and
ETFs
5
Growth of Mutual Fund Industry
(continued)

• In 1980, five million Americans owned funds
• Holding 3 of their household financial assets
• As of December 2011, 92 million Americans in 52
  million households owned mutual funds
• That is approximately 44 of all U. S. households
• Mutual fund assets totaled 13.0 trillion
  dollars
• Holding 23 of their household financial assets
• Mutual funds are now the nations largest
  financial intermediary, followed by commercial
  banks (second largest) and life insurance
  companies (third largest)

Source Investment Company Institute,
www.ici.org, Includes open-end, closed-end,
ETFs, and UITs as of December 2011. By the way,
at the end of 2010, the amount was 13.1
trillion at the end of 2009, the amount was
12.16 trillion at the end of 2008, it was
10.35 trillion, and at the end of 2007, it was
12.98 trillion dollars. 2008 was a very rough
year.
6
Advantages of Mutual Funds

• Pooled Diversification
• A process whereby investors buy into a
  diversified portfolio of securities for the
  collective benefit of the individual investors
• This variety provides some safety that is
  difficult for an individual investor to obtain on
  their own
• Professional management
• The mutual fund managers are supposed to know
  what they are doing
• (They are certainly getting paid enough!)
• Low initial outlay of capital
• You can start with 25 to 50 per month
• PITA factor is low The Wealthy Barber

7
Drawbacks of Mutual Funds

• Transaction Costs
• Some mutual funds charge sales fees called
  loads
• Front-end loads, back-end loads, etc.
• Many others are no-load funds
• But some no-load funds can wind up costing you
  more than load funds over time
• Annual Operating Expenses
• Typically from 0.5 (or less) to 2.5 (or more)
• Many mutual funds do not match the markets
  performance
• What? Arent the mutual fund managers supposed
  to know what they are doing?

8
Open-end versus Closed-end Funds

• Open-end mutual funds (gt90 of mutual funds)
• A type of investment company in which investors
  buy shares from, and sell them back to, the
  mutual fund itself, with no limit on the number
  of shares the fund can issue
• Shares are issued and redeemed by the investment
  company at the request of investors
• Investors can buy shares from (purchase) and sell
  shares to (redeem) the investment company at any
  time

When people refer to a mutual fund, they are
almost exclusively referring to an open-end
mutual fund. As of December 11, there were 8,684
open-end mutual funds totaling 11.6 trillion
dollars in assets.
9
Open-end versus Closed-end Funds
(continued)

• Closed-end mutual funds (lt10 of mutual funds)
• A type of investment company that operates with a
  fixed number of shares outstanding
• Shares are issued by an investment company only
  when the fund is organized
• After all original shares are sold you can only
  purchase shares from another investor
• Bought and sold like stocks on the open market
• Incur brokerage commissions

Closed-end investment companies are not as
popular with individual investors as open-end
investment companies. At the end of December
2011, there were only 634 closed-end mutual funds
holding only 239 billion dollars in assets.
10
Open-end versus Closed-end Funds
(continued)

• Net Asset Value
• The underlying value of one share in a particular
  mutual fund
• Add up the value of the securities in the mutual
  fund
• Subtract any liabilities (normally close to zero)
• Divide by the number of shares

Open-end mutual funds are sold at net asset value
(with a sales load added to load funds). Since
closed-end mutual funds are bought and sold on
the open market, their price usually either
reflects a premium or discount to the net asset
value (usually a discount). They are very rarely
priced at their net asset value.
11
Open-end versus Closed-end Funds
(continued)

• Net Asset Value
• Value of the funds portfolio - Liabilities
• Number of shares outstanding
• Example 10,050,000 - 50,000 10 NAV
• 1,000,000 shares
• Offering price NAV sales commission
• Example 10 (10 5) 10.50 Offering Price

12
Open-end versus Closed-end Funds
(continued)

• Advantages / Disadvantages?
• Open-end investment company
• Always able to buy and sell no market forces
• Very popular wide range of choices
• Large purchases or redemptions can make
  management of the fund more difficult
• Mutual fund company can close the fund to new
  investors
• Closed-end investment company
• Must pay brokers commission (like a stock)
• Must be bought/sold via the marketplace
• Often sold at premium or discount to NAV
• Easier to manage assets for investment advisors

Which would (or do) you prefer?
13
A New Type of Mutual Fund ETFs

• Exchange-traded Funds
• An open-end mutual fund that trades on the
  exchanges like closed-end mutual funds
• There is no limit to the number of shares
• The mutual fund company issues shares as needed
• But the investor must purchase the fund using a
  brokerage account
• Incurring brokerage transaction fees (commissions)

A recent entry to the industry, ETFs are becoming
increasingly popular. At the end of 2011, there
were 1,166 ETFs totaling 1,048 billion. At the
end of 2010, there 950 ETFs totaling 992 billion
in assets. At the end of 2009, there were 820
ETFs totaling 777 billion. At the end of 2008,
there were 743 totaling 531 billion. At the end
of 2007, there were 629 totaling 608 billion.
And at the end of 2006, there were 359 totaling
423 billion dollars. Again, take note of the
steep drop in value in 2008.
14
How are Mutual Funds Regulated?

• Investment Company Act of 1940
• Foundation of the modern mutual fund industry
• Defined regulated investment company
• a.k.a. pass-through investment vehicle
• Does not pay taxes on its investment income
• The shareholders pay the taxes
• To qualify, an investment company must
• Hold almost all its assets as investments in
  stocks, bonds, and other traditional securities,
  and
• Very limited ability to use derivatives other
  risky strategies
• Use no more than 5 of its assets when acquiring
  a particular security, and
• Create an organization with checks balances

15
(continued)
16
How are Mutual Funds Organized?

• The Mutual Fund
• A Corporation run by a Board of Directors
• Board of Directors voted in by Shareholders
  (investors)
• Sponsored the funds creator
• Investment Advisor (a.k.a. Management Company)
• Portfolio Manager (sometimes a team or a
  committee)
• Research Analysts (usually focus on a specific
  industry)
• Distributors
• Distributes the shares to the public or to
  dealers
• Much the same role as an investment banker
• Mutual funds are technically continuous Initial
  Public Offerings must have an annual prospectus
  report

17
How are Mutual Funds Organized?
(continued)

• Custodian
• The company that actually holds the securities
• Often a bank or trust company
• Transfer Agent
• Keeps track of purchase and redemption requests
  from shareholders
• Independent Public Accounting Firm
• Certifies the funds financial reports

Why the large diversification of tasks and
companies? Mutual funds are highly regulated in
order to protect shareholders investment from
fraud and collapse. How often have you heard of
a scandal at a mutual fund company? Until 2003,
never.
18
Mutual Fund Scandals?!
Wait a minute, Paiano! Did you just say,

• You want me to invest in an industry that is
  plagued with scandal?!
• Since 1940, the mutual fund industry has been
  regulated and escaped any hint of impropriety
• In 2003, some practices that were not quite
  illegal but obviously unethical were uncovered
• Only a handful of funds and people were affected
• Strong, Janus, Bank of America, Putnum, Alliance
• The vast majority of companies never engaged in
  any of the shenanigans

Instead of losing 99,999 on a 100,000 account
(example Enron or WorldCom), investors lost 1
on a 100,000 account.
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Annual Operating Expenses

• Management fees
• Charged yearly (.25-2 average) based on a
  percentage of the funds asset value
• Paid to portfolio managers and analysts who make
  the investment decisions
• 12b-1 fees
• Annual fee to defray advertising, servicing, and
  distribution costs of the fund up to 1 per
  year
• Accounting and other expenses
• Trustee fee
• Only for retirement accounts typically 10 to
  30

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Annual Operating Expenses
(continued)

• Trading Costs
• Not disclosed in the annual prospectus
• So how does an investor know how much the trading
  costs are?
• You can ask the mutual fund or just look at
  the
• Annual Turnover
• Measure of how much trading a mutual fund does
• Measured in percentage of the amount a portfolio
  turns over each year
• 100 turnover, 50 turnover, etc.
• The higher the turnover, the higher the trading
  costs
• Also gives you an idea how long they hold
  investments
• 100 turnover They hold on average one year
• 50 turnover They hold on average two years

21
Load versus No-load Funds

• Load Fund
• A mutual fund that charges a commission when
  shares are bought
• Typically 3 to 5
• Used to compensate the financial representative
• Along with the fund distributor
• No-load Fund
• A mutual fund that does not charge a commission
  when shares are bought
• Traditionally sold directly to shareholders

The endless debate Should you purchase a Load
Fund or No-load Fund?
22
Load versus No-load Funds
(continued)

• Types of Load Funds
• Front-end Load a.k.a. Class A
• Commission is paid when shares are purchased
• Normally have lower annual operating expenses
• Back-end Load a.k.a. Class B
• Commission is paid when shares are redeemed
• Most back-end load funds have a Contingent
  Deferred Sales Charge (CDSC)
• The CDSC declines to zero over a period of 3 to 6
  years
• 5 first year, 4 second year, 3 third year,
  etc.
• Normally, the back-end load pay higher annual
  operating expenses (12b-1 fees) until the CDSC
  declines to zero
• Eventually, the Class B shares revert to Class A
  shares

23
Load versus No-load Funds
(continued)

• Types of Load Funds (continued)
• No-load Funds (Huh?) a.k.a. Class C
• No front-end nor back-end commissions
• Except 1 back-end charge if redeemed within one
  year
• However, many Class C funds have higher annual
  operating expenses in perpetuity (or for a long
  time)
• There are those 12b-1 fees again
• Hence, they can wind up costing more than the
  Class A or Class B shares over time
• The SEC now says you can not call a mutual fund a
  no-load fund if the 12b-1 fee is greater than
  0.25
• So, Class C shares are now not allowed to be
  called no-load funds even though many in the
  industry still do

24
Load versus No-load Funds
(continued)

• Types of No-load Funds
• Advisor No-load Funds a.k.a. Class F, Class I
• Held in advisors wrap account
• a.k.a. Management account, Wealth Management
  Account
• Advisor charges 1 to 2 to manage the account
• True No-load Funds
• Mutual fund company deals directly with public
• May not have a 12b-1 fee greater than 0.25
• These are the darlings of the popular media
• Bypass the middleman! Who needs a financial
  advisor?
• But that does not mean the overall fees are low
• Over time, a no-load fund can wind up costing you
  more than a load fund
• You must compare the annual operating expenses

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Example of Shareholder Fees
Growth Fund of America
Transaction fees Class A Class B Class C Class F-1
Maximum sales charge 5.75 None None None
Maximum sales charge on reinvested dividends None None None None
Maximum deferred sales charge None 5.00 1.00 None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class B Class C Class F-1
Management Fees 0.28 0.28 0.28 0.28
Distribution and/or Service Fees (a.k.a. 12b-1) 0.24 1.00 1.00 0.25
Other Expenses 0.19 0.18 0.21 0.15
Total 0.71 1.46 1.49 0.68
This is a load fund.
26
Example of Shareholder Fees
Alliance Large Cap Growth Fund
Transaction fees Class A Class B Class C Class F
Maximum sales charge 4.25 None None None
Maximum sales charge on reinvested dividends None None None None
Maximum deferred sales charge None 4.00 1.00 None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class B Class C Class F
Management Fees 0.75 0.75 0.75 0.75
Distribution and/or Service Fees (a.k.a. 12b-1) 0.30 1.00 1.00 0.00
Other Expenses 0.20 0.43 0.36 0.32
Total 1.25 2.18 2.11 1.07
Another load fund.
27
Example of Shareholder Fees
Legg Mason Value Trust
Transaction fees Class A Class C FI Institutional
Maximum sales charge 5.75 None None None
Maximum sales charge on reinvested dividends None None None None
Maximum deferred sales charge None 0.95 None None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class C FI Institutional
Management Fees 0.67 0.67 0.67 0.67
Distribution and/or Service Fees (a.k.a. 12b-1) 0.25 0.95 0.25 0.00
Other Expenses 0.09 0.16 0.18 0.10
Total 1.01 1.78 1.10 0.77
This is a very famous, now infamous, mutual fund.
They just recently changed from Primary Class
shares to Class C shares and added Class A
shares.
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Example of Shareholder Fees
Vanguard 500 Index Fund
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends None
Maximum deferred sales charge None
Redemption or exchange fees None
This is an index fund. This fund does no
research. They simply buy all the 500 stocks in
the SP 500 Index. The term for this is passive
management. (More later) Index funds are usually
true no-load mutual fund and usually (but not
always) have very low fees.
Annual Operating Expenses Class A
Management Fees 0.14
Distribution and/or Service Fees (a.k.a. 12b-1) ?
Other Expenses 0.03
Total 0.17
?There is a 20 annual fee if your account value
is less than 10,000.
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Example of Shareholder Fees
Fidelity Spartan 500 Index Fund
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends None
Maximum deferred sales charge None
Redemption or exchange fees None
Vanguard pioneered low fee mutual funds and was
able to overtake Fidelity as the number 1 mutual
fund company for a short time. Fidelity responded
by eliminating all sales loads, creating their
own index funds, and lowering their fees below
Vanguard.
Annual Operating Expenses Class A
Management Fees 0.025
Distribution and/or Service Fees (a.k.a. 12b-1) ?
Other Expenses 0.07
Total 0.095
?Like the Vanguard fund, there is a low balance
annual fee of 10 if your account is below
10,000.
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Examples of Dollar Costs
Growth Fund of America
Hypothetical 10,000 Investment with 5 Return 1 Year 3 Years 5 Years 10 Years
Class A 643 789 947 1,407
Class B (assuming no redemption) 149 462 797 1,543
Class C (assuming no redemption) 152 471 813 1,779
Class F-1 (excludes advisor fee) 69 218 379 847
Although it looks as though the F shares are the
best deal, this does not include the advisors
annual fee. Adding the advisors typical fee of
1 to 2 per year would easily add an additional
1,200 to 2,400 to the total cost. Over the
long term, which is the best deal?
31
Examples of Dollar Costs
Legg Mason Value Trust
Hypothetical 10,000 Investment with 5 Return 1 Year 3 Years 5 Years 10 Years
Class A 672 878 1,101 1,741
Class C (formerly Primary Class) 181 561 965 2,096
Financial Intermediary Class 112 350 607 1,341
Institutional Class 79 246 428 955
The class C shares of this no load fund wind up
costing more than the class A shares! Again, the
Financial Intermediary Class seems to be a better
deal but it does not include the advisors annual
fee. The Institutional Class looks great. How
can I get them? Well, for starters, are you a
large pension fund, university endowment, or
tax-exempt charity? Oh, and by the way, do you
have at least 1 million to invest?
32
Examples of Dollar Costs
Vanguard 500 Index Fund
Hypothetical 10,000 Investment with 5 Return 1 Year 3 Years 5 Years 10 Years
Investor Class 17 55 96 217
Admiral Class 5 16 28 64
The fees for passively-managed index funds will
almost always be less than actively-managed
funds. The Admiral Class shares used to be
available with a minimum of only 100,000. Any
takers? (In the fall of 2010, they lowered the
minimum to 10,000.) Do you remember the
exchange-traded funds (ETFs)? They often have
fees lower than the index funds! The Vanguard
ETF that tracks the total U. S. stock market has
an expense ratio of 0.05.
33
Breakpoint Sales Reductions
Growth Fund of America
Investment (either purchased or accumulated) Sales Charge
Less than 25,000 5.75
25,000 but less than 50,000 5.00
50,000 but less than 100,000 4.50
100,000 but less than 250,000 3.50
250,000 but less than 500,000 2.50
500,000 but less than 750,000 2.00
750,000 but less than 1,000,000 1.50
1,000,000 or more None
Class A shares typically qualify for a sales
reduction if you invest a larger amount or as
your investment grows. Some brokers fail to
inform their clients of this feature. Instead,
as the client approaches the breakpoint, the
broker will advise them to start another fund.
Why?
34
CDSC Reduction over Time
Growth Fund of America
Contingent Deferred Sales Charge (CDSC) on Class B Shares Contingent Deferred Sales Charge (CDSC) on Class B Shares
Year of Redemption Contingent Deferred Sales Charge
1 5.0
2 4.0
3 4.0
4 3.0
5 2.0
6 1.0
7 0.0
The back-end sales charge on Class B shares
typically is reduced over time until it is
eliminated. However, as we noted, the Class B
shares usually pay more in annual fees.
35
10-Year Rates of Return
So, Which One Would You Pick?
as of December 31, 2012
Investment 10-Year Return Growth of 10,000
Growth Fund of America, Class A 7.60 20,792
Alliance Large Cap Growth Fund, Class A 7.29 20,211
Legg Mason Value Trust, Class C 2.22 12,455
Vanguard Index 500 Fund 6.99 19,644
Standard Poors 500 Index 7.10 19,849
A
B
formerly Primary Class
C
D
Fees are important, but they certainly do not
tell you the whole story. When comparing mutual
funds, you must look at many attributes, not the
least of which are the rates of return,
preferably over longer periods of time.
8.24 and 7.75, respectively, without sales
charge (a.k.a. NAV, net asset value)
36
Mutual Funds Fees What are __?

• These shares do not have an up-front sales load.
  Instead, they assess a decreasing back-end load
  if you withdraw your money within 6 years. The
  annual operating expense is higher (courtesy of
  the 12b-1 fees).
• A shares
• B shares
• C shares
• F or I shares

The correct answer is (B). They normally
eventually become A shares after 6 to 8 years.
37
Mutual Funds Fees What are __?

• These shares do not have an up-front fee and
  only a 1 back-end fee if redeemed within one
  year. The advisor called them no-load but you
  notice that their annual operating expense is
  higher than other share classes (again, courtesy
  of those ubiquitous 12b-1 fees).
• A shares
• B shares
• C shares
• F or I shares

The correct answer is (C). They sometimes revert
to A or F shares after many years.
38
Mutual Funds Fees What are __?

• Your financial advisor tells you that these
  shares have no sales fees and a very low annual
  operating expense. She mumbles something about
  wealth management. These shares are
• A shares
• B shares
• C shares
• F or I shares

The correct answer is (D). She also did her best
not to explain that her brokerage firm will
charge you an extra 2 each year.
39
Types of Mutual Funds

• Aggressive Growth Funds
• Highly speculative mutual funds that seek large
  profits from capital gains
• Dey Iz Rollin De Dice!
• Growth Funds
• Mutual funds whose primary goals are capital
  gains and long-term growth
• Typically invest in high-growth companies

Some fund companies now have a category or two
more speculative than Aggressive Growth. They
are sometimes called Ultra Funds or Momentum
Funds. (Example Janus 20) What do you think
about this strategy?
40
Types of Mutual Funds
(continued)

• Capital Appreciation Funds
• Mutual funds that seek long-term growth of
  capital
• How does it differ from a growth fund?
• Most growth funds have a provision that states
  they will invest primarily in growth stocks,
  usually staying between 80 100 invested in
  the market
• Capital Appreciation Funds can often invest in
  anything they like and anywhere they like
• In general, they tend to be as risky as growth
  and aggressive growth funds (although not always)

The well-known Fidelity Magellan Fund is a
Capital Appreciation Fund
41
Types of Mutual Funds
(continued)

• Growth-and-Income Funds
• Mutual funds that seek both long-term growth and
  current income, with primary emphasis on capital
  gains
• Sometimes own bonds to augment the income
• Sometimes referred to as Blend (of Growth
  Value)
• Value Funds
• Mutual funds that seek stocks that are
  undervalued in the market by investing in shares
  that have low P/E multiples and high dividend
  yields
• Often look for companies out-of-favor with
  investors

Some folks lump growth-and-income funds and value
funds together
42
Types of Mutual Funds
(continued)

• Equity-Income Funds
• Mutual funds that emphasize current income and
  capital preservation by investing primarily in
  high-yielding, income-producing common stocks
• Railroads, Foods, Utilities, REITs, etc.
• They will also invest in bonds to generate income
  when the investment advisor believes that stock
  prices have risen to levels that threaten
  preservation of capital

Many Equity-Income Funds did very well during the
2000 to 2002 bear market after lagging the market
badly during the late 1990s bull market. Every
type of fund was clobbered in 2008.
43
Types of Mutual Funds
(continued)

• More Stock Fund Classifications
• Large Cap largest companies
• Mid Cap medium-sized companies
• Small Cap smallest companies
• Domestic companies based in U.S.
• Global based anywhere in globe
• International based outside U.S.
• Regional Japan, Far East, Latin America, etc.
• Emerging Markets India, Mexico, Brazil, Russia,
  Philippines, China, Turkey, etc.
• Sector energy, technology, health care, etc.
• Market Timing dumb

Which do you think is the riskiest?
Which do you think is the riskiest?
44
Types of Mutual Funds
(continued)

• Bond Funds a.k.a. Fixed-income Funds
• Mutual funds that invest in various kinds and
  grades of bonds, with income as the primary
  objective
• High-Yield Bond Funds a.k.a. Junk Bond Funds
• Are often more correlated with stocks than bonds
• Corporate Bond Funds
• Convertible Bond Funds
• Municipal and Insured Municipal Bond Funds
• Popular with high net worth individuals
• Income is free from Federal taxes
• State-specific municipal bond funds
• Income is free from state taxes as well

45
Types of Mutual Funds
(continued)

• Bond Funds (continued)
• U.S. Backed Bonds (Fannie Mae, etc.)
• a.k.a. Mortgage-backed Bond Funds
• Government Bond Funds a.k.a. Treasury Bond
  Funds, Government Securities Funds
• Income is free from state and local taxes
• Long-term Bond Funds
• Intermediate-term Bond Funds
• Short-term Bond Funds
• Global and International Bond Funds

Which do you think is the riskiest? Careful!
46
Types of Mutual Funds
(continued)

• Balanced Funds
• Mutual funds whose objective is to generate a
  balanced return of both current income and
  long-term capital gains
• Invest in both stocks and bonds
• Normally 60 stocks and 40 bonds
• But allocation can change as the investment
  environment changes

The prospectus of the American Balanced Fund
states that the fund is managed as the complete
U. S. investment program of a prudent investor.
They can never be more than 75 stocks, 25 bonds
or less than 50 stocks, 50 bonds.
47
Types of Mutual Funds
(continued)

• Asset Allocation Funds
• Mutual funds that spread investors money across
  stocks, bonds, and money market securities
• Very similar to Balanced Funds
• However, the investment advisor often more
  diligently tries to fine-tune the allocation as
  market conditions change
• Whereas a Balanced Fund usually stays around 60
  stocks / 40 bonds,
• An Asset-Allocation Fund might try to move money
  into cash when they thought the market might fall

For all their hype, the returns of many Asset
Allocation Funds are very close to Balanced
Funds. Some trail Balanced Funds considerably
because they timed the market badly.
48
Types of Mutual Funds
(continued)

• Money Market Mutual Funds (review)
• Mutual funds that invest in short-term money
  market instruments
• Much the same as money market accounts at banks
  and credit unions EXCEPT money market mutual
  funds are not guaranteed
• General Purpose Treasury bills, commercial
  paper
• Government Securities Only Treasury bills
• Tax-exempt very short-term municipal securities

They are essentially as safe as guaranteed money
market accounts since they invest in exactly the
same securities but they are not guaranteed!
(Did we already mention that?) Breaking the Buck
49
Types of Mutual Funds
(continued)

• Mutual Funds of Mutual Funds
• a.k.a. Lifestyle Funds, Target-Date Funds
• Choose the fund that matches your time horizon
• College 2020, Retirement 2035, etc.
• The company will populate the mutual fund with
  other mutual funds to match the time horizon
• Often from the same companys mutual fund choices
• As the time horizon shortens, the mutual fund
  will change the mix of mutual funds
• Some are Target-Risk Funds
• Choose your risk tolerance they choose the funds

A mutual fund of mutual funds? You are kidding,
right? No. These are very popular now because
of retirement plans
50
Types of Mutual Funds
(continued)

• Specialty Funds
• Hedge Funds
• Traditionally only open to sophisticated
  investors
• But now available to those with as little as
  5,000 to 10,000
• No regulatory oversight have become a major
  force
• 1 to 2 operating expense take 20 of the
  profits
• Bear Funds
• Precious Metals / Hard Assets Funds
• REIT Funds
• Boutique / Exotic Funds
• StockCar Stocks Fund
• Pauze Tombstone Fund
• The Chicken Little Growth Fund (I am not making
  this up!)

The choices are endless. So are the fees
51
Types of Mutual Funds
(continued)

• Index Funds a.k.a. Passively-managed
• Mutual funds that buy and hold a portfolio of
  stocks or bonds equivalent to those in a specific
  market index
• No active management performed no research
• The mutual fund simply buys all the stocks in the
  SP 500, Dow Jones Industrial Average, Russell
  2000, etc.
• Why?
• Can offer much lower annual fees (no research)
• Many actively-managed mutual funds do not beat
  the market
• Because of the annual fee, an index fund can not
  actually match the markets performance, but it
  should come very close (providing the annual fee
  is not excessive)
• Whereas, an actively-managed fund could
  substantially out perform or under perform the
  market index

52
Types of Mutual Funds
(continued)

• Index Funds (continued)
• The rationale for index funds came from research
  done in the early 1970s that statistically
  showed that many of the actively-managed funds
  did not beat the market
• A monkey throwing darts at a dartboard
• However, many actively-managed funds do beat
  their respective indexes over time
• Look for a fund family where most all funds have
  consistently beaten their indexes over decades!
• (Psst! There are only a few major companies)

In the late 90s, index funds became a victim of
their own success.
53
Types of Mutual Funds
(continued)

• Index Funds (continued)
• Standard Poors 500 (a.k.a. SP 500)
• Dow Jones Industrial Average (a.k.a. the Dow)
• Dow Jones U.S. Total Stock Market Index
• nee Dow Jones Wilshire 5000, nee Wilshire 5000
• a.k.a. Total Market Index
• NASDAQ Composite NASDAQ 100
• MSCI World (Global) EAFE Index (International)
• Countless other index funds available now

Index funds are the current perfect investment.
For the failsafe superlative treatment, visit
www.ifa.com. What, if any, are the downsides to
index funds?
54
Types of Mutual Funds
(continued)

• Index Funds (continued)
• Indexes sometimes become skewed toward a
  particular sector of the economy or region of the
  world (more about this phenomenon later)

MSCI EAFE 12/31/1989
SP 500 3/31/2000
Info Tech, 33.3 P/E 59.2
Japan, 59.8 P/E 51.9
All else, 66.7 P/E 19.3
All else, 40.2 P/E 13.0
55
Types of Mutual Funds
(continued)

• Exchange-Traded Funds a.k.a. ETFs
• An open-end mutual fund that trades as a listed
  security on a stock exchange
• Trades like a stock as does a closed-end fund
• But there is no limit on the number of shares
• Becoming very popular because they can be bought
  and sold throughout the day like stocks
• Unlike open-end mutual funds, which always trade
  at the end-of-day net asset value
• Most all ETFs are passively-managed index funds
• But there are also some actively-managed ETFs

And they have cool names like Spider,
Diamond, and Cube
56
Types of Mutual Funds
(continued)

• Socially Responsible Funds
• Mutual funds that actively and directly
  incorporate ethics and morality into the
  investment decisions
• Started out with some funds refusing to invest in
  companies that sold alcohol or tobacco
• Moved to companies that pollute, build weapons or
  nuclear power plants, destroy the rain forests,
  etc.
• And then to companies that exploit labor
• It is surprising that there any companies left to
  invest in

Silliness aside, many Socially Responsible Funds
have done quite well for their investors
57
Types of Mutual Funds
(continued)

• Socially Irresponsible Funds (???)
• Possibly as a backlash to socially responsible
  funds (and their perceived political overtones)
• There is a mutual fund called The Vice Fund
• Yep! You guessed it!
• It invests in tobacco and alcohol
• (The manager says he simply loves Philip Morris!)
• And all the other corporate nasties you can think
  of
• Gambling, Defense firms

And although it is still a very small fund with
high annual fees, it has done very well for its
investors (www.vicefund.com)
58
(No Transcript)
59
Types of Mutual Funds
(continued)
Morningstar, a company that analyzes mutual
funds, designed the style box to help investors
identify investment alternatives. They say they
are fabulous. No one I know uses them neither
do I. Now they have ownership zones. They say
they are even better.
60
Fund Families

• A family of funds exists when one investment
  company manages a group of mutual funds
• Funds in the family vary in their objectives
• You can move your money from one fund to another
  within a fund family
• Almost always with no charge
• But, if the fund is in a taxable account, you
  could generate a taxable transaction
• Recently, fees are being charged for excessive
  transfers within the fund family
• Done to discourage market timing by investors

Forbes sez, Choose a Family, Not a Fund
61
Fund Families Top Ten Families

1. Vanguard Group
2. Fidelity Investments
3. American Funds (CRM)
4. PIMCO Funds
5. J. P. Morgan Chase
6. Franklin Templeton Investments
7. BlackRock Funds
8. Federated Investors
9. T. Rowe Price
10. Bank of New York / Dreyfus Corporation

Examples Offerings from the top three families
Source Investment Company Institute,
http//www2.iii.org/financial/securities/mutualfun
ds Dec 2011
62
Mutual Fund Investor Services

• Automatic Investment Plans
• Mutual fund service that allows shareholders to
  automatically send fixed amounts of money from
  their paychecks or bank accounts into the fund
• a.k.a. Dollar-Cost Averaging (more later)
• Pay yourself first!

In my humble opinion, this is the absolute best
way to invest in a mutual fund. You do not worry
about whether or not it is a good time to invest.
Every month is a good time to invest 50 that
comes right out of your paycheck or checking
account. P.S. It is practically the only way most
people will ever invest!
63
Mutual Fund Investor Services
(continued)

• Automatic Reinvestment Plan
• Mutual fund service that enables shareholders to
  automatically buy additional shares in the fund
  through the reinvestment of dividends, interest,
  and capital gains

Automatic Reinvestment Plans allow an investor to
earn fully compounded rates of return. Unless an
investor needs the income, it is always a good
idea to reinvest dividends and capital gains
received from a mutual fund.
64
Mutual Fund Investor Services
(continued)

• Systematic Withdrawal Plan
• Mutual fund service that enables shareholders to
  automatically receive a predetermined amount of
  money monthly or quarterly
• Sometimes annually
• Normally electronically transferred directly to
  your checking account
• Conversion Privilege a.k.a. Exchange Privilege
• Allows shareholders to move money from one fund
  to another within the same family of funds
• May trigger tax consequences if not in a
  retirement account

65
Mutual Fund Transactions

• Purchase options
• Closed-end ETFs through the stock exchange
• Open-end
• Through a broker
• Directly from the investment company
• Best way is auto-contributions (payroll,
  checking)
• Sell options
• Closed-end ETFs through the stock exchange
• Open-end
• Through a broker or through the mutual fund
• Best way is auto-withdrawals (into your checking)

66
Taxes and Mutual Funds

• Two types of taxes for Regular Accounts
• Income dividends
• Taxed as income (20 max, 15 typical, 5 min)
• Capital gains distributions
• Taxed as capital gains (20 max, 15, 5 min)
• Reinvested dividends and capital gains are still
  taxable transactions
• Save your year-end statements
• Congress may change this someday (doubtful!)
• Unrealized capital gains (a.k.a. paper profits)
  would not be taxed until you sell your mutual
  fund shares (forget it!)
• Tax-deferred Retirement Accounts (401(k), etc.)
• Pay no taxes until retirement
• All proceeds taxed as income (except Roth
  tax-free)

67
Sources of Mutual Fund Information

• Mutual Fund Prospectus
• A statement describing the risk factors
• A description of the funds past performance
• A statement describing the type of investments in
  the funds portfolio
• Information about dividends, distributions
  taxes
• Information about the funds management
• No one reads them!
• Unless they have taken BUS-123
• It was not that hard, was it?
• Mutual Fund Annual Report
• Performance, investments, assets and liabilities

68
Sources of Mutual Fund Information
(continued)

• Financial publications
• Morningstar, Lipper, etc.
• Business Week, Forbes, Kiplinger's Personal
  Finance, and Money are sources of information on
  mutual funds
• Mutual fund surveys usually include
• Funds overall rating compared to other funds
• Funds rating compared to funds in the same
  category
• Fund size, sales charge and expense ratio
• Risk of loss factor and toll-free number
• History for past three, five, and ten years

69
Sources of Mutual Fund Information
(continued)

• Financial web sites
• finance.yahoo.com
• www.businessweek.com
• www.morningstar.com
• Mutual fund companies Internet sites
• www.fidelity.com
• www.troweprice.com
• www.vanguard.com
• www.americanfunds.com
• www.dodgeandcox.com
• www.franklintempleton.com
• Investment Company Institute web site
• www.ici.org

Hurray! The mutual fund web sites are again
promoting education.
70
So, How Do I Pick a Mutual Fund?

• Pick a Mutual Fund that
• Invests in high-quality stocks or bonds
• Is well-diversified across several industries and
  sectors of the economy
• Has a long-term perspective and a manager or
  (better yet) a management team with many years of
  experience
• Avoid companies that shuffle their managers
  every few years (which is virtually all of them!)
• Has been around for decades and performed
  consistently well in both good and bad markets

71
A Sample Stock Mutual Fund

• Is 79 years long-term enough for you?
• 6, 8, 9, 10? How about almost 12?
• But stocks are very risky
• Short-term, Yes. Long-term, No!
• But now is not a good time to invest
• Excuse me, when is it ever a good time to
  invest?
• Okay, so what if you had invested on the worst
  day of the year for the past 20 years? How did
  you do?
• But what about market downturns?
• Keep a long-term perspective, and
• Dollar Cost Average

72
Dollar-Cost Averaging

• A system of buying an investment at regular
  intervals with a fixed dollar amount
• With Dollar-Cost Averaging, there is always Good
  News
• The market is up! Good News!
• Your account is worth more
• The market is down! Good News!
• Next month, you will get more shares at a lower
  price when the 50 or 100 comes out of your
  paycheck or checking account
• Your average cost-per-share should be lower than
  your average price-per-share

73
Hypotheticals

• Most mutual fund companies have a system for
  running hypotheticals
• a.k.a. Illustrations Hypothetical
  illustrations
• Examples of returns of investments
• Lump sum principals, or
• Streams of investments
• a.k.a. Dollar-Cost Averaging
• Or combinations of both
• Must be approved by SEC and FINRA
• And contain disclaimers about past versus future
  performance

Lets run some hypotheticals!
74
And That Aint the Only One!
As of December 31, 2012
75
Bottom Line on Mutual Funds

• Choose a fund family and stick with them
• Most mutual fund investors do worse than the
  mutual funds they invest in
• Re-evaluate them periodically (once or twice a
  year?)
• But make changes judiciously and sparingly
• As you approach retirement, migrate from stock
  funds to bond funds
• But do not give up stocks entirely (ICA
  illustration)
• Dollar-Cost Average
• 50 a month, 100 a month, whatever is
  affordable
• For the most part, Forget About Them!

Do not be one of the mutual fund investors that
does worse than your mutual funds!
76
CHAPTER 4 REVIEW
Mutual Funds
Chapter Sections Advantages and Drawbacks of
Mutual Fund Investing Investment Companies and
Fund Types Mutual Funds Operations Mutual Funds
Costs and Fees Short-Term Funds Long-Term
Funds Mutual Fund Performance Closed-End Funds,
Exchange Traded Funds, and Hedge Funds
Next week Chapter 5, The Stock Market