Ch17

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 17

Investing in Mutual Funds

Copyright ©2004 Pearson Education, Inc. All rights reserved. 17-2

Chapter Objectives

• Identify the types of stock funds

• Present the types of bond funds

• Explain how to choose among mutual funds

• Describe quotations of mutual funds

• Explain how to diversify among mutual funds


Background on Mutual Funds

• Stock mutual funds: funds that sell shares to individuals and invest the proceeds in stocks

• Bond mutual funds: funds that sell shares to individuals and invest the proceeds in bonds

• All are managed by professional portfolio managers who decide what securities to purchase



• Motives for investing in mutual funds– Low initial investment

– Expertise of portfolio manager

– To meet specific investment goals

• Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities owed– Usually reported on a per share basis



• Open-end versus closed-end funds– Open-end mutual funds: funds that sell

shares directly to investors and repurchase those shares whenever investors wish to sell them

• Usually managed by investment companies that are subsidiaries of a large financial conglomerate

• Family: a group of separately managed open-end mutual funds held by one investment company



– Closed-end mutual funds: mutual funds that sell shares to investors but do not repurchase them; instead fund shares are purchased and sold on stock exchanges

• Premium: the amount by which a closed-end fund’s share price in the secondary market is above the fund’s NAV

• Discount: the amount by which a closed-end fund’s share price in the secondary market is below the fund’s NAV



• Load versus no-load funds– No-load mutual funds: funds that sell directly

to investors and do not charge a fee

– Load mutual funds: funds whose shares are sold by a stockbroker who charges a fee (or load) for the transaction

– Loads can have significant impact on their investment performance



Exhibit 17.1: Comparison of Returns from a No-Load Fund and a Load Fund



• Expense ratio: the annual expenses per share divided by the net asset value of a mutual fund– Average expense ratio is 1.5 percent

– Reported components of expense ratios• Mutual funds incur expenses for administrative,

legal, and clerical expenses as well as portfolio management fees



– Relationship between expense ratios and performance

• Funds with lower expense ratios then to outperform other funds


Types of Mutual Funds

• Types of stock mutual funds– Growth funds: mutual funds that focus on

stocks that have potential for above-average growth

– Capital appreciation funds: mutual funds that focus on stocks that are expected to grow at a very high rate



– Small capitalization (small-cap) funds: mutual funds that focus on funds that are relatively small

– Mid-size capitalization (mid-cap) funds: mutual funds that focus on medium-size firms

– Equity income funds: mutual funds that focus on firms that pay a high level of dividends



– Balanced growth and income funds: mutual funds that contain both growth stocks and stocks that pay high dividends

– Sector funds: mutual funds that focus on a specific industry or sector, such as technology stocks

• Technology funds: mutual funds that focus on stocks of Internet-based firms and therefore represent a particular type of sector fund



– Index funds: mutual funds that attempt to mirror the movements of an existing stock index

– International stock funds: mutual funds that focus on firms that are based outside the U.S.

– Socially responsible stock funds: mutual funds that screen out firms viewed as offensive by some


Financial Planning Online: Index Mutual Funds

• Go to: http://www.indexfunds.com/

• This Web site provides news and other information about index mutual funds that can guide your investment decisions.

http://www.indexfunds.com/



• Example

– You are considering investing in either a no-load

mutual fund that focuses on growth stocks or an

index mutual find. When ignoring expenses

incurred by the mutual funds, you expect that the

growth fund will generate an annual return of 9

percent versus an annual return of 8 percent for

the index fund.



The growth fund has an expense ratio of 1.5

percent versus an expense ratio of 0.2

percent for the index fund.


Growth Fund Index FundFund's portfolio return (exludes expenses) 9.00% 8.00%Expense ratio 1.50% 0.20%Your annual return 7.50% 7.80%


Based on your expectations about the portfolio returns, you returns would be:



• Types of bond mutual funds– Treasury bond funds: mutual funds that focus on

investment in Treasury bond

– Ginnie Mae funds: mutual funds that invest in bonds issued by the Government National Mortgage Association

– Corporate bond funds: mutual funds that focus on bonds issued by high-quality firms that tend to have a low degree of default risk



– High-yield (junk) bond funds: mutual funds that focus on relatively risky bonds issued by firms that are subject to default risk

– Municipal bond funds: mutual funds that invest in municipal bonds

– Index bond funds: mutual funds that are intended to mimic performance of a specified bond index



– International bond funds: mutual funds that focus on bonds issued by non-U.S. firms or governments

• Global bond funds: mutual funds that invest in foreign bonds as well as U.S. bonds

– Maturity classifications — some funds are also segmented by their maturities


Return and Risk of a Mutual Fund

• Return from investing in a mutual fund– Dividend distributions

• Dividends received on stocks in the funds are distributed to shareholders

– Capital gains distributions• Proceeds received from the sale of securities

are distributed to shareholders

– Capital gains from redeeming shares• If price received at redemption exceed price paid



• Example– You invest in an equity income fund

focused on large, well-established stocks that pay high dividends. You also invest in a growth fund focused on young firms that are attempting to expand and therefore pay no dividends.

– You are curious about your tax liabilities on distributions from these investments.



The equity income mutual fund distributes $1,000 of dividends over the year, while the growth fund distributes $1,000 of long-term capital gains.

Your marginal tax rate on ordinary income is about 40 percent. The capital gains tax rate is 20 percent.



• Given this information, the taxes on the distribution are as follows:

Large Stock Fund Small Stock FundDividends $1,000 $0Capital gains $0 $1,000Total income $1,000 $1,000Tax on divs (40%) $400 $0Tax on cap gains (20% $0 $200Total taxes $400 $200After-tax income $600 $800



• Comparing returns among stock mutual funds

– Great variation among types of funds over a particular time period

– Not necessarily an indicator of future performance



• Risk from investing in a stock mutual fund– Market risk: the susceptibility of a mutual

fund’s performance to general stock market conditions

– Focus on Ethics: Risk from investing in hedge funds

• Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions



Exhibit 17.3: Comparison of Returns among Types of Mutual Funds (based on 1999 data)


Return and Risk of a Mutual Fund• Tradeoff between expected return and

risk of stock funds– Conservative — stock index fund

• Limited return and risk

– Moderate — growth stock fund• Moderate return and risk

– High risk — growth stock fund in one sector• High return and risk



Exhibit 17.4: Tradeoff between Expected Return and Risk



• Risk from investing in a bond mutual fund– Interest rate risk: for a bond mutual fund,

its susceptibility to interest rate movements

– Longer-term bonds most sensitive

– Must also consider default risk

– Bond funds can have either interest rate risk, default risk, or both



Exhibit 17.5: Classifying Bond Mutual Funds according to Interest Rates and Default Risk



• Tradeoff between expected return and risk of bond funds– Conservative — short-term Treasury bond fund

• No default risk and limited interest rate risk• Low return

– Moderate — Ginnie Mae bond fund• Slight default risk and moderate interest rate risk• Moderate return

– High risk — junk bond fund• High default risk and high interest rate risk• Potentially high return



Exhibit 17.6: Tradeoff between Expected Return and Risk of Bond Mutual Funds


Deciding Among Mutual Funds

• Determining your preferred characteristics of a mutual fund– Minimum initial investment

– Investment objective (type of fund)

– Investment company

• Reviewing a mutual fund’s prospectus– Prospectus: a document that provides financial

information about a mutual fund, including expenses and past performance



– Investment objective: in a prospectus, a brief statement about the general goal of the mutual fund

– Investment strategy: in a prospectus, a summary of the types of securities that are purchased by the mutual fund in order to achieve its objective

– Past performance — 1 year, 3 years, 5 years


Decide Among Mutual Funds

– Fees and Expenses• Maximum load

• Redemption fee or back-end load

• Expenses, including management fees

• Expense ratio

– Risk

– Distribution of dividends and capital gains



– Minimum investment and minimum balance

– How to buy or redeem shares

• Making the decision– Narrow down your choices to a small

number and use a table for comparison

• Consider the following tables comparing 4 stock funds and 4 bond funds



With $1,000 to invest in a stock mutual fund:

Internet Fund Load Status Expense Ratio

Recent Annual Performance

#1 No-load 1.50% 13%#2 No-load 0.80% 12%#3 No-load 2.00% 14%#4 3% load 1.70% 11%

With $1,000 to invest in a bond mutual fund:

High-YieldBond Funds Load Status Expense Ratio

TypicalTerms toMaturity

#1 4% load 1.00% 6 - 8 years#2 No-load 0.90% 15 - 20 years#3 No-load 0.80% 5 - 7 years#4 No-load 1.20% 5 - 7 years


Financial Planning Online: Online Services by Mutual Funds• Go to: http://www.vanguard.com

• This Web site provides an example of what an investment company that manages mutual funds can provide online to its customers. You can monitor your account online and transfer money from one fund to another within the same family.

http://www.vanguard.com/


Quotations of Mutual Funds

• Quotations available from financial publications– Open-end funds

• Column 1 — Investment company in bold type with funds listed beneath

• Column 2 — NAV

• Column 3 — Net change in NAV

• Column 4 — Return year to date



– Closed-end funds listed on the exchanges where they are traded

• Column 1 — Fund name and symbol

• Column 2 — Exchange where traded

• Column 3 — NAV

• Column 4 — Market price

• Column 5 — Premium or discount

• Column 6 — return over the last year



– Lipper indexes are useful for assessing the recent performance of a particular fund or funds with a specific objective

• Column 1 — type of index

• Column 2 — preliminary closing

• Column 3 — percent change from previous day

• Column 4 — percent change from previous week

• Column 5 — percent change since December 31


Diversification Among Mutual Funds

• Diversify among several types of funds to lower risk

• Best strategy is to diversify across stock

and bond mutual funds

• Can also diversify among mutual funds representing different countries



• Diversification through mutual fund supermarkets: an arrangement offered by some brokerage firms that enables investors to diversify among various mutual funds and to receive a summary consolidated statement for these funds



Exhibit 17.10: Diversifying among Mutual Funds That Are Primarily Affected by Different Factors


Financial Planning Online: Diversifying among Mutual Funds

• Go to: http://www.mfea.com

• Click on: Asset Allocation

• This Web site provides suggested asset allocation models that fit your financial situation and your degree of risk tolerance.

http://www.mfea.com/


How Mutual Funds Fit within Your Financial Plan

• Key decisions about mutual funds for your financial plan are:– Should you consider investing in mutual

funds?

– What types of mutual funds would you invest in?


Integrating Key Concepts

Integrating Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management

• Part 3: Financing

• Part 4: Protecting Your Assets and Income

• Part 5: Investing– In Chapter 13 we learned about investment fundamentals

– In Chapter 14 we learned about stock analysis and valuation

– In Chapter 15 we learned about investing in stocks

– In Chapter 16 we learned about investing in bonds

– In Chapter 17 we learned about investing in mutual funds

– In Chapter 18 we will cover asset allocation

• Part 6: Retirement and Estate Planning

Ch17

Economy & Finance

Transcript of Ch17