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FIN 200: Personal Finance

Topic 20–Mutual Funds Lawrence Schrenk, Instructor

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Learning Objectives

1. Define a mutual fund. ▪

2. Outline the main types of funds.

3. Describe the returns from and costs of a mutual fund. ▪

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Mutual Funds: Overview

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What and Why? What is a mutual fund?

Investment company that pools money Investors own a proportionate share of the

fund to the amount of their investment divided by the total value of the fund

Why were they developed? To give smaller investors access to

professional management and to increase the assets of mutual fund companies

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Advantages of Mutual Funds Diversification Full-Time Professional Management Modest Capital Investment Minimal Transaction Costs Services Offered Convenience/Liquidity

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Disadvantages of Mutual Funds Lack of Liquidity

Normally must be sold back to the fund Average to below average performance

Average Annual Returns 1989-1998 Actively managed stock funds 15.6% S&P 500 stock index 19.2%.

Fees and taxes can take a significant part of investor returns

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Disadvantages of Mutual Funds

Source: John Bogle, Common Sense on Mutual Funds: New Imperative for the Intelligent Investor, John Wiley & Sons, USA, 1999, p. 119)

Percentage of Actively Management Funds that failed to beat their benchmarks

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Mutual Funds: Types

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Number of Mutual Funds by Type

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

EquityFunds

Bond Funds HybridFunds

MoneyMarket,Taxable

MoneyMarket,

Nontaxable

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Major Types of Mutual Funds Major Asset Classes

Money Market Funds Stock Funds Bond Funds

Specialty Funds Index Funds Exchange Traded Funds (ETFs) Balanced Funds Etc.

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Stock Funds: Payout Approach Income Funds

Goal: Current income Dividend income

Growth Funds Goal: Capital Appreciation

Higher-than-average revenue/earnings growth Aggressive/Maximum Growth Funds

Goal: Extreme Capital Appreciation Highly speculative, seeking large profits from

capital gains Often buy stocks of small, untested companies

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Stock Funds: Geographic Approach

Domestic Funds U.S. Equities Only

Global Funds U.S. and International Equities

International Funds International Equities Only

Country/Regional Funds Specific Country/Region of the World

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Stock Funds: Firm Size

Large-Cap(italization) Funds Capitalization $5 billion or more

Mid-Cap(italization) Funds Capitalization between $1 and $5 billion

Small-Cap(italization) Funds Capitalization $1 billion or less

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Stock Funds: Other

Sector Funds Particular industry such as biotechnology.

Socially Responsible Funds Companies that don’t produce harmful

products. Index Funds

Mirror an index, like the S&P 500

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Bond Funds: Yield

High-Yield (Junk) Bond Funds Corporate bonds that are higher risk and

higher yield. Index Bond Funds

Sampling of bonds included in an index.

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Bond Funds: Maturity

Long Term Bond Funds Maturities > 10 Years

Intermediate Term Bond Funds Maturities 5-10 Years

Short Term Bond Funds Maturities 1-5 Years

Note: Can be either Government or Corporate Bond Funds

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Bond Funds: Issuer

Corporate Bond Funds Treasury Bond Funds Municipal Bond Funds International Bond Funds

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Asset Allocation Funds Various asset classes, such as

stocks, and bonds, with precise amounts within each type

Rotate among stocks, bonds, and cash

Goal: Invest in the asset classes expected to perform the best over the coming period of time (‘Timing’)

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Balanced Funds Goal: Balance between Capital

Gains and Current Income Stocks and bonds

High-Grade Common Stocks (60-75%) Fixed Income Securities (25-40%)

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Mutual Funds: Other

Money Market Funds Goal: Higher return (after fees and

expenses) than traditional bank savings or checking accounts

Short-term liquid financial instruments such as commercial paper and government treasury bills

Access to high-yielding money market instruments without having to pay $100,000 denominations

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Mutual Funds: Other

Single Industry Specialty Funds Option Trading Commodity Funds Oil Drilling Cattle Funds Electronics Gold Chemicals Health

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Life-Cycle Funds

Change allocation depending on the age of the investor.

Reduce their allocation to stocks and increase their allocation to bonds

These funds seek to perform the asset allocation decision normally done by the investor and to reduce transaction costs as well.

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Mutual Funds: Returns and Costs

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Mutual Fund Returns

Capital Gains Market Value Appreciation Capital gains at the share level are not taxed

until you sell your mutual fund shares. Distributions

Interest, dividends, realized capital gains, etc. Taxable even if you do not sell any mutual fund

shares

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Mutual Fund Returns: Types

Qualified Stock Dividends Short-Term Capital Gains Long-Term Capital Gains Bond Dividends and Interest

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Costs of Mutual Funds

Explicit Costs Management Fees

Charged by the Advisor Percentage of average assets, e.g. .75%

12b-1 Fees To cover cost of advertising and marketing

Total Expense Ratio Fees as total percentage of assets

Custody (or Annual) Fees Brokerage house charges to hold mutual funds

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Costs of Mutual Funds

Implicit Costs: Taxes on Distributions Stock Dividends

15% or 5%. Short-Term Capital Gains

Marginal Tax Rate Long-Term Capital Gains

15% or 5%. Bond Dividends and Interest:

Marginal Tax Rate

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Costs of Mutual Funds

Hidden Costs: Transaction Costs Costs of the fund buying and selling

securities not included in other costs A good measure this is the turnover ratio, a

measure of trading activity during the period divided by the fund’s average net assets.

A turnover ratio of 50% means half the fund was bought and sold during the period

Turnover costs money and incurs taxes

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Costs of Mutual Funds

Other Hidden Costs: Account Transfer Fees

Charges for moving assets either into our out of an existing account

Account Maintenance Fees Fees for maintaining your account

Inactivity/Minimum Balance Fees Fees because you did not trade or failed to keep

a minimum balance in your account

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Front-, Back- and No Load Funds

Front-Load Funds Commissions charged when purchasing

shares. Investors pay a commission (sales charge) up

to 8.5% every time they purchase shares. This is sometimes called a front load. (Class A shares)

Average charge is 3-5% for which an investor can get purchase advice and explanations.

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Front-, Back- and No Load Funds

Back-Load Funds Commissions charged when selling shares. Contingent deferred sales load (back-end load)

(Class B shares). Charged upon withdrawal of funds (1-5%). Generally decreases on a sliding scale

depending on the number of years shares are held.

No-Load Funds Investors pay no sales charge up front. You deal directly with the fund with 800 numbers

or web sites, or from discount brokers.

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Open- versus Closed-End Funds Open-End Funds (91% of Funds).

Shares are issued and redeemed by the investment company at the request of investors.

Investors can buy and sell shares at the net asset value (NAV).

Closed-End Funds (7% of Funds). Shares are issued only when the fund is

organized. Only purchase shares only from another investor. Traded on exchanges and over-the-counter.

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Open-End Funds Investors buy and sell shares back to the

fund itself There is no limit on the number of shares the

fund can issue Net Asset Value (NAV)

Defined as the total market value of all securities held by the fund less liabilities, divided by the number of fund shares outstanding.

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Net Asset Value (NAV)

For most mutual funds, NAV is calculated at the close of trading each day.

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gOutstandin Shares

sLiabilitieAssetsNAV

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Net Asset Value Example Example: NAV

XYZ Mutual Fund owns assets totaling $10M and liabilities equal to $500,000 with 500,000 shares outstanding.

$19/share500,000

500,00010,000,000NAV

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Closed-End Funds

Closed-End Funds A fixed number of shares outstanding 100 Closed-end funds $8 billion market value

Investment Trusts Interest is an unmanaged pool of

investments Usually consist of corporate, government, or

municipal bonds

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Mutual Fund Prospectus

Mutual fund prospectus tells the funds objective and: A statement describing the risk factors. A description of the fund’s past performance. A statement describing the type of investments in the

fund’s portfolio. Information on how to open an account. Dividends, distributions and taxes. Information about the fund’s management. The process for investors to buy or sell shares. Services provided to investors. The turnover ratio of the fund’s investments.

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Mutual Fund Quotations Net asset value and asset value change. The fund family and fund name. Fund objective. Total return over various time periods. Ranking among funds with the same

objective. Sales load fees if any, or no load (NL). Annual expenses.

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Mutual Fund Quotation Example

Project Note

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Ethical Dilemma