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Chapter 3 Appendix

Mutual Fund Evaluation Term Project

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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A small man—anyone with a portfolio of, say, under $100,000—is unlikely to do as well investing his own money as he can do in a

no-load fund

Paul Samuelson

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Outline Introduction Classification of Mutual Funds

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Introduction A mutual fund is an existing portfolio of

assets into which someone may invest directly• Facilitates diversification

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Introduction (cont’d) Mutual funds are extremely popular

investment vehicles for both the small and the large investor• Many institutions place a substantial part of

their money with mutual funds

• By the end of 2003, there were about 8,300 mutual funds in the United States with assets totaling $7.4 trillion

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Classification of Mutual Funds Open End versus Closed End Net Asset Value versus Market Value Load versus No Load Management Fees Buying Mutual Fund Shares Mutual Fund Objectives

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Open End versus Closed End There are two types of investment

companies:• Open-end funds:

– May grow in size as new investors open accounts

– May grow in size as existing investors add to their accounts

– Have no set number of shares outstanding

– Buy back their shares from investors (redemption)

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Open End versus Closed End (cont’d)

There are two types of investment companies (cont’d):• Closed-end funds:

– Have a fixed number of shares that trade like shares of common stock

– Are unmanaged portfolios of stock with each share representing partial ownership of the portfolio

– May trade on an exchange

– Can be sold to other investors

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Net Asset Value versus Market Value

You buy and sell an open-end fund based on its net asset value

• Open-end fund: equals the fund’s assets minus its liabilities divided by the number of shares currently existing in the fund

• Closed-end fund: trades at market-determined portfolio prices that may be more or less than the net asset value

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Load versus No Load Load funds:

• Have a sales charge associated with the purchase of new shares

– A commission split between:• A mutual fund salesperson

• An investment firm

• A national distributor

– Typically ranges between 1.0 percent and 8.5 percent

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Load versus No Load (cont’d) No-load funds:

• Have no sales charge

• Shares are bought and sold at net asset value

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Examples of Exchange-Traded Funds

SPDR = Standard & Poor’s Depository Receipt (traded on the American Stock Exchange).HOLDR = Holding Company Depository Receipt (created by Merrill Lynch, traded on the American Stock Exchange).iShares = Index shares (created by Barclays Global Investors, traded on the American Stock Exchange, the Chicago Board Options Exchange, and the New York Stock Exchange).Source: Morningstar.com

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Management Fees Management fees include:

• Postage costs• Clerical time• Commissions on the underlying assets• Redemption fee

– A fee to pay redemption expenses, ranging between 1 percent and 2 percent

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Management Fees (cont’d) Management fees include (cont’d):

• Management fee– Paid to fund manager

– Taken directly from the fund’s assets

– Averages about 0.75 percent of fund’s total assets

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Buying Mutual Fund Shares Fund prospectus outlines:

• The fund’s purpose• The management team• The mailing address and phone number• The fund’s intended investment activity

Funds also provide descriptive brochures and other correspondence to anyone who inquires

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Buying Mutual Fund Shares (cont’d)

New account application asks for:• Name, address, tax ID• Investor’s choice of shareholder options:

– Dividend reinvestment

– Automatic monthly investment

– Systematic withdrawal

– IRA designation

– Telephonic fund switching option

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Mutual Fund Objectives The fund objective is the type of

investment anticipated:• Capital appreciation and growth funds seek

appreciation in the value of shares• Income funds seek current income from fixed-

income securities and from dividends• Growth and income funds seek a combination

of income and capital appreciation

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Mutual Fund Objectives (cont’d)

The fund objective is the type of investment anticipated (cont’d):

• Balanced funds invest in growth and income securities

• Bond funds invest in debt only• Money market funds seek stability of

principal through investment in short-term debt instruments

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Mutual Fund Objectives (cont’d)

The fund objective is the type of investment anticipated (cont’d):

• Tax-free funds invest in municipal securities that are free from federal, and sometimes state, taxes

• Special-purpose funds may focus on a particular industry or region