Chapter 13

Investing in Mutual Funds

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Investing in Mutual Funds

1. Explain the characteristics of mutual fund investments.

2. Classify mutual funds by investment objective.

3. Evaluate mutual funds.

4. Describe how and why mutual funds are bought and sold.

Chapter Objectives

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Objective 1Explain the Characteristics of

Mutual Fund Investments

• Mutual Fund = an investment vehicle offered by investment companies to those who wish to:– Pool money

– Buy stocks, bonds, and other financial securities

– Have buy/sell decisions made by a fund manager

• Many mutual funds chosen for inclusion in retirement account investments

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Investment Company

• Pools the money of many investors – its shareholders – to invest in a variety of securities

• Employs the fund manager who is compensated for selecting securities appropriate to the fund’s stated objective

• “Financial Intermediary”

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Why Investors Purchase Mutual Funds

• Professional management– Who is the fund’s manager?

– How has the fund performed under the current managers?

• Diversification– Investor’s funds are used to purchase a

variety of investments

– Risk reduction

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Characteristics of Funds

• Closed-end funds– Fixed number of shares– Trade like shares of common stock– Actively managed

• Exchange-traded Funds– Invests in securities contained in a specific

securities index

• Open-end mutual funds– Shares issued and redeemed on demand– Actively managed

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Closed-End Funds

• Fixed number of shares issued when the

fund is organized• Shares traded on stock exchanges

•Trade price set by supply & demand• Most sell at a discount relative to their

net asset value• Discount is sometimes substantial

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Exchange Traded Funds

• Invests to replicate the composition of a specific securities index– Performance mirrors index performance

• Low management fees

• Trade on exchanges throughout the day like stock– Prices determined by supply and demand

• Can be sold short and traded with limit orders

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Net Asset Value

• Net asset value (NAV):– Assets under Management (AUM)

• The current market value of the assets held by the fund

– Net Assets = AUM - Liabilities

• NAV calculated at the close of trading

gOutstandin Shares

Net AssetsNAV

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Open-End Funds

• Open-end funds ≈ 90% of all funds– Shares issued and redeemed by the

investment company at the request of investors

– Investors free to buy and sell shares at the net asset value (NAV)

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Costs: Load Funds vs. No-Load Funds

• Load Fund– Sometimes called an “A” fund– Commission (sales charge) up to 8.5%

• Average = 3 to 5%

– Paid every time shares purchased – Purchased through brokerage firms or

registered representatives• Salespeople prepared to explain the fund and

help determine if it meets the investor’s financial goals

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Costs: Load Funds vs. No-Load Funds

• No-Load Fund

– No up-front sales charge

– No salespeople

– Investor deals directly with the investment

company via 800 numbers or web sites, or

from discount brokers

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Costs: Load Funds vs. No-Load Funds

• Contingent deferred sales charge (CDSC)– “Back-end load”

– “B” fund

– “Redemption fee”

– Charged upon withdrawal of funds (1-5%)– Generally decreases on a sliding scale

depending on the number of years shares are held

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Costs: Management Fees and Other Charges

• Management fee– Charged yearly (.25%-1.5% average) based

on a percentage of AUM

• 12b-1 fees– Annual fee to defray advertising and

marketing costs– Cannot exceed 1% of AUM per year

• Expense ratio– Total expenses associated with the

management fees and operating costs of the fund

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Typical Mutual Fund Fees

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Objective 2Classify Mutual Funds by

Investment Objective

Long-term Funds

Stock Funds Bonds Funds Other Funds

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Stock FundsLong-term

Funds

Stock Funds Bonds Funds Other Funds

Growth

Equity income

Price growth vs. Dividend Income

Aggressive Growth

Socially responsibleInvest in socially responsible firms

Economic SectorsSector funds

Company Size

Regional

Index funds Match index holdings

% U.S. vs. International

Small-cap

Mid-cap

Global

International

Large-cap

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Bond FundsLong-term Funds

Stock Funds Bonds Funds Other Funds

High-yield

Intermediate Corporate bonds

Intermediate U.S. Gov't bonds

Long-term corporate bonds

Long-term U.S. gov't bonds

Municipal bonds

Short-term corporate bonds

Short-term U.S.gov't bonds

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Other Funds

Long-term Funds

Stock Funds Bonds Funds Other Funds

Money Market Funds

Asset Allocation Funds

Balanced Funds

Lifecycle Funds

Fund of Funds

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A Family of Funds

• One investment company manages a group of mutual funds– Each fund has a different financial

objective– Exchange privileges allow movement from

one fund to another within the family with low or no charge

• Fidelity Investments– http://personal.fidelity.com/products/funds/mutual_funds_overview.shtml.cvsr

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Objective 3Evaluate Mutual Funds

Managed Funds vs. Index Funds

• Managed fund a fund manager makes all decisions regarding what securities are included in the fund’s portfolio

• Index fund securities held by the fund replicate those contained in a specific index like the S&P 500

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Sources of Fund Information

1. Internet websites provide current values

– http://finance.yahoo.com

– www.businessweek.com

– www.morningstar.com

– www.smartmoney.com

2. Check fund companies’ Internet sites

– www.troweprice.com

– www.vanguard.com

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Sources of Fund Information

3. Professional Advisory Services– Lipper Analytical Services

– Morningstar, Inc.

– Value Line

– Mutual fund newsletters

– Available in libraries and from brokerage firms

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Mutual Fund Prospectus– Fund objective(s)

– Statement describing the risk factors

– Description of the fund’s past performance

– Statement describing the type of investments in the fund’s portfolio

– Information about dividends, distributions and taxes

– Information about the fund’s management

– Information about limitations or requirements for the fund

– Procedure to buy or sell shares

– Services provided to investors

– Turnover ratio of the fund’s investments13-24

Other Sources of Fund Information

• Mutual fund annual report– Performance, investments, assets & liabilities

• Financial Publications– Business Week, Forbes, Kiplinger's Personal

Finance and Money – Business Week’s mutual fund survey

includes: • Fund’s overall rating compared to all other funds,

and to funds in the same category• Fund size, sales charge and expense ratio• Historical returns for the past ten years

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Objective 4Describe How and Why Mutual

Funds are Bought and Sold

The Mechanics of a Mutual Fund Transaction

• Open an account:– $250 to $3,000 and up depending on the fund

family and the fund

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Return on Investment

3 Ways to Make Money on Mutual Funds

Income Dividends– Earnings paid from dividend and interest income– Taxed as ordinary income

Capital Gains Distribution – Distributions when the fund buys and sells

securities– Taxed as long-term gains

Capital Gains (or Losses)– Capital gains (or losses) when you sell shares at a

price different than price you originally paid– Taxed as short- or long-term gains

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Purchase Options

* Investor may deal with one company, get one statement, yet have a choice of a wide variety of funds

*

No Load Fund Management Co.

Load Authorized Agent

Fund Type

Closed End

Exchange Traded

Open EndFund

Supermarket*

Purchase From

Stock exchange or Over-the-counter market

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Purchasing Open-End Fund Shares

– Regular account transactions• Easiest • Simply buy shares in amount and when desired

– Voluntary savings plans• Allows for smaller than usual purchases on a

recurring basis

– Contractual savings plans• Require regular purchases over a specified period

– Reinvestment plans• Automatically reinvests dividends and capital gains

in the fund

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• Closed-end funds & exchange-traded

funds

– Traded on stock exchanges and in the over

the counter market

– Sold like common stock shares

• Open-end fund

– Shares sold to the fund sponsoring

company

Withdrawal Options

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1. Withdraw a fixed dollar amount each period until account exhausted

2. Liquidate or “sell off’ a certain number of shares each period

3. Withdraw a fixed percentage of asset growth; principal untouched

4. Withdraw all income dividends and capital gains distribution; principal untouched

Mutual Fund Withdrawal Options

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END OF CHAPTER 13

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Additional Video

Mutual Fund Awards BusinessWeek and S&P’s Best Fund Picks(Instructors see the notes section for directions.)

SYNOPIS: Helpful information about how BusinessWeek and Standard & Poor’s evaluate mutual funds is provided in this video. In addition, specific funds that are highly rated in the BusinessWeek survey are recommended.

1. Explain why investors still need to evaluate mutual funds when there is a professional manager or team of managers that choose the investments for a mutual fund.

2. What factors did BusinessWeek and Standard & Poor’s use to evaluate mutual funds? Would these same factors help you evaluate a mutual fund for your investment portfolio?

3. Specific small-cap, technology, and growth funds were described in this video. How would you research one of these funds to determine if the fund could help you obtain your investment goals?

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