Mutual Funds Chapter 16 Tools & Techniques of Investment Planning Copyright 2007, The National...

Mutual Funds Chapter 16Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• A mutual fund is a company (or a trust) that sells shares of its own stock and utilizes the proceeds to make other investments.

• These investments may include:– Stocks of publicly traded companies– Corporate or municipal bonds– Real estate– Short term money market instruments


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When is the use of this tool indicated?

• When an investor has limited capital to work with.– He/she cannot afford to purchase a broad enough range of

securities to achieve adequate diversification.

• When the investor is unwilling or unable to select, manage, or keep records on a large number of securities.

• When the investor wants to be able to sell shares or increase his holdings at any time.


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When is the use of this tool indicated?

• When an investor would like to hire a skilled, professional investment manager, but does not have enough assets to meet the usual minimum asset size for most money management firms.

• When an investor would like to invest “passively” and capture market returns for a particular asset class– Example: Large cap U.S. stocks


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Advantages

• Mutual funds can be an excellent vehicle to carry out a well-conceived investment plan.– Once an investor has a disciplined, well thought out strategy,

there are many choices available in the mutual fund universe to execute the investment plan with reasonable costs.

• They can provide a high degree of security of principal and income through diversification of securities.

• The purchase of shares in a mutual fund allows an investor to hire top notch investment management expertise.– This frees the investor from the responsibility of managing the

portfolio of securities on a day-to-day basis.


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Advantages

• Most mutual funds “maintain a market” in their own shares.– Such mutual funds are referred to as “open-end” investment

companies.• They have obligated themselves to buy back their shares from

investors.• An investor can require the fund to redeem its shares at any time,

providing a high degree of liquidity.

– A small category of funds are known as “closed-end” funds.• They do not buy and sell their own shares.• Their shares are traded on the open market.• They may be listed on the organized stock exchanges or traded on

the over-the-counter market.


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Advantages

• Several large discount brokerage firms have created “fund supermarkets.”– An investor can have a wide mix of funds, from hundreds of

separate fund groups, all in one brokerage account.– Investors can easily put together a diversified portfolio of funds

from different fund families, with top-notch management and low costs.

• Concept of a “family of funds.”– A company will sponsor a number of funds with different

investment objectives and underlying assets.– The investor can quickly, conveniently move assets into one or

more funds that better meet his investment needs or desires.• Typically without any additional sales charges


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Advantages

• Some funds provide increased tax efficiency, at least in the short term.– Mutual funds may have significant realized capital losses that

can be used to offset taxable capital gain distributions in the future.

• Typically after down periods in the market

– A fund may have significant unrealized depreciation in assets.• Future appreciation, up to the original cost basis of the security, is

“tax free” within the fund itself.


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Disadvantages

• Purchasing shares from many mutual funds involves payment of a sales charge.– This sales charge is commonly called a “load” and covers the

cost of marketing the fund through brokerage firms and certain other fees.

– On average, the typical front end loads are:• 4.75% of the original investment in bond funds• 5.75% of the original investment in stock funds

– Many funds now offer various share classes, with varying fees and commission structures (front load, back load, level load, etc.)

– “No-load” funds do not charge a sales fees and market their products directly to the public.


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Disadvantages

• Annual management fees and administrative charges can reduce the overall return on the investment.– Management fees can range from 0.5% to 3% or more of the

value of the investment.– Administrative charges can range from $5 to $25 annually per

account.• These are frequently waived for accounts that reach a minimum

balance.• Professional management eliminates an investor’s personal

involvement in the management of the fund.– The investor cannot control the selection of specified assets or

the timing or purchases and sales.– He cannot control the amount of any capital gain distribution, or

when it must be reported.


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Tax Implications

• Ordinary income distributions are generally taxed to individual shareholders at ordinary income tax rates.– Under JGTRRA 2003, “qualified dividend income” is treated as

net capital gain and is eligible for the 15% / 5% tax rates.• Must be qualified dividend income in the hands of the fund• Cannot be short-term capital gain or interest from bonds

• Capital gain distributions are generally treated as long-term capital gain, and are taxable in the year in which the distribution is declared.

• The income paid from municipal bond funds is not subject to federal income tax, but is normally taxed at the state level.– Capital gains are fully taxable.


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Tax Implications

• A “switch” made within a family of funds is a taxable event.– During a “switch,” shares of one fund are technically sold and

shares of another fund are purchased.– These sales are taxable events and result in a gain or loss.

• The sale or other disposition of less than all of an investor’s shares can cause difficulty in determining the basis of the shares sold.– Also applies when shares are acquired on various dates at

various prices.• Some funds are set up as limited partnerships

– Allows investors an exemption from state and local taxes on interest from U.S. government securities

– Exemption does not apply in all states


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Alternatives

• Variable Annuity– Includes ownership of large portfolio of securities and

management by professional investment advisers.

• Exchange-traded Funds– Baskets of securities traded on an exchange.– They can be structured as unit investment trusts holding a fixed

basket of stocks or other investments, or as open end mutual funds tracking a market index.

• Real Estate Investment Trusts– The majority of assets are invested in shopping centers,

apartment buildings, office buildings, and other large-scale real estate ventures.


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Where and How do I get it?

• Most load funds are sold through brokerage firms.– They receive part of the load charge as a fee for selling shares

in the fund.– Many brokerage firms are affiliated with particular fund groups

or have their own set of mutual funds that they market to their clients.

• Generally include a money market fund, one or more common stock funds, bond funds, and a fund specializing in tax-exempt securities.

– Orders to buy and sell fund shares are treated like any other transaction and require that the investor have an account with the brokerage firm.


Investment Planning


Where and How do I get it?

• No-load funds are bought and sold directly through the funds themselves.– They are also sold through “fund supermarkets” at large

discount brokers.– They are widely advertised.– Interested investors can directly contact the fund by calling,

writing, or visiting the fund’s website.


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What fees or other costs are involved?

• Load Funds– The sales charge generally ranges from 3% to 5.75% of the net

asset value of the fund.• Net asset value is the total value of the fund’s assets, minus any

liabilities, divided by the number of outstanding shares of the fund.• The load fee may be as high as 8.5%.

– Some load funds also charge a redemption fee.• May be as high as 5% of the value of any shares sold• Assessed whenever the investor sells shares of the fund and is

subtracted from the amount the investor is paid• May be waived if the investor sell shares of the fund but reinvests

the money in another fund of the same group


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• Load Funds– The load, plus the “12b-1 fee,” plus the redemption charges

cannot exceed 8.5%.– The fee structure of load funds is quite complex.– Over the past 10 years, there has been a shift from front end

load funds to back end load funds and level load funds and a number of variations.

• Front-end load = “A” shares

• Back-end load = “B” shares

• Level-load funds = “C” shares


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• Closed-End Funds– The cost of buying and selling the shares include transaction

costs that are determined by the number of shares traded and the total value of the transaction.

– Typically, this cost will be 2% to 3% of the total value of the shares purchased or sold.


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• No-Load Funds– These funds do not charge a fee for the purchase or sale of

their shares.– They may be purchased or sold at their indicated net asset

value with no additional sales charges.– They do assess administrative charges and management

fees.– They also may charge “12b-1 fees” to cover the costs of

marketing and advertising.• Range from 0.2% to 1.25% on an annual basis

– Service charges of 0.5% to 3% of the investment may be charged when shares are purchased or dividends reinvested.


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How do I select the best of its type?

• The selection process should begin with an evaluation of the fund’s investment objective, which can be found in the fund’s “prospectus.”

• Mutual fund objectives can be grouped into a few common categories:– Growth Funds – More aggressive than common stock funds;

concentrate on long-term capital gains and high future income; generally invest in more speculative issues that provide little or no current income

– Income Funds – Specialize in securities that pay higher-than-average current rates of return from either dividends or interest; frequently invest a high percentage of their assets in bonds rather than common stocks


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– Balanced Funds – Their primary objective is preservation of capital and moderate growth of income and principal; secondary consideration is capital gains; investments are diversified among both stocks and bonds

– Tax Exempt Funds – Provide investors with high after-tax returns on their investments Index Funds – Designed to track a particular market index, such as the S&P 500, with very low annual expenses; the idea is to given an investor a vehicle to achieve “market performance” in a particular asset class (“passive investing”)

– Sector Funds – Restrict investments to a particular sector of the market; tend to be more volatile than a more diversified portfolio


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– Diversified Common Stock Funds – Concentrate principally on long-term capital growth, with current income being a secondary consideration; a majority of the assets are invested in good quality common stocks with the balance in cash or short-term government notes; a more conservative approach is followed here

– Specialty Funds – Concentrate their investments in a single industry, in a group of related industries, in an industry within a specific geographic region, or even in non-security assets such as real estate investment trusts that purchase real property or loans secured by real property

– Hedge Funds – Use the most aggressive techniques, including high leverage, short sales, and the purchase of put and call options to achieve maximum growth of capital; for the most speculative investor


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– Money Market Funds – Invest exclusively in money market instruments such as Treasury bills, CDs, and corporate commercial paper; often no-load funds; provide current income and relative safety of principal

– Commodity Funds – Designed to bring the small investor into the commodities market; organized as limited partnerships; offer an inflation-hedge in an inflationary environment and an opportunity for large gains; have a high degree of risk

– Bond Funds – Allow an investor to indirectly participate in the bond market without the acquiring the expertise necessary to invest in the market directly; offer a variety of portfolio types and proven track records


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– Foreign Stock and Bond Funds – Open-end and closed-end funds that invest in foreign stocks and bonds; some invest exclusively in the securities of one nation while other invest more broadly in foreign regions, or in all foreign markets

– Asset Allocation Funds – Invest in several different traditional funds; substitute for the investor’s own allocation of investment dollars; offer diversification within asset classes and among asset classes


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• Historical performance– Relatively few funds have outperformed the market as a whole

over long periods of time.• Some have consistently done better than others.

– Each fund’s prospectus will give some indication of its rate of return during the last five or 10 years.

• Often show what a typical investment would have returned in the form of dividends and capital gains

– Many funds perform quite differently in bull markets as compared to bear markets.


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• Low sales charges, management fees, and expense ratios– These can sharply reduce an investor’s overall rate of return.– Funds that charge high portfolio management fees have to

provide better than average returns to compensate for those charges.

• The range of services offered by the fund– Most funds will provide for automatic reinvestment of dividends

into additional shares of the fund.– Automatic payout of a specified amount on a monthly, quarterly,

or annual basis.– Many offer convenient methods for purchasing shares at the

day’s NAV, either by telephone, by wire transfer, or by logging onto the internet.


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• “Family of Funds”– Provide the investor with flexibility in terms of diversification

and the opportunity to alter his investment objective.– One person may have a variety of investment needs, and the

opportunity to make investments in a number of funds within the same management is attractive.

• Figure 16.1 Mutual Fund Worksheet– Investment objectives– Fund’s performance vs. index– Risk vs. return

• Diversified vs. non-diversified– Expenses and Fees– Tax consequences


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Where can I find out more about it?

• Morningstar (www.morningstar.com)– Generally considered the best source of unbiased mutual fund

information

• CDA/Weisenberger’s Investment Companies Yearbook• Forbes (www.forbes.com)

– Publishes an annual survey of mutual funds– Evaluates the performance of funds in both up and down

markets

• Brokerage houses• Quarterly reports from funds• Investment Company Institute (www.ici.org)


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Where can I find out more about it?

• Barron’s (www.barrons.com)• The Wall Street Journal (www.wsj.com)• Moody’s Bank and Finance Manual (www.Moodys.com)• The Value Line Investment Survey (www.valueline.com)

Mutual Funds Chapter 16 Tools & Techniques of Investment Planning Copyright 2007, The National...

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