chapter 13 investing in mutual funds copyright © 2013 by the mcgraw-hill companies, inc. all rights...

Chapter 13

Investing in Mutual Funds

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

13-13-22

Investing in Mutual FundsChapter Learning Objectives

LO13.1 Explain the characteristics of mutual fund investments.

LO13.2 Classify mutual funds by investment objective.

LO13.3 Evaluate mutual funds.

LO13.4 Describe how and why mutual funds are bought and sold.

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Learning Objective LO13.1Explain 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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Advantages and Disadvantages of Investing in Mutual Funds

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Characteristics of Funds

• Closed-end funds (≈ 6% of funds)– Fixed number of shares– Trade like shares of common stock– Actively managed

• Exchange-traded funds (≈ 9% of funds)– Invests in securities contained in a specific

securities index

• Open-end mutual funds (≈ 85% of 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 or

the over-the-counter market.

• Trade price set by supply and demand

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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

• You can use limit orders and sell short or use margin

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Open-End Funds

• Open-end funds ≈ 85% 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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Net Asset Value

• Net asset value (NAV):

The value of the fund’s portfolio minus liabilities divided by the number of outstanding shares

gOutstandin Shares

Net AssetsNAV

• NAV calculated at the close of trading

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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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• 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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• 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 assets

• 12b-1 fees (distribution fee)– Annual fee to defray advertising and marketing costs– Cannot exceed 1% of assets per year

• Cannot exceed 0.25% for a fund to be called “no load”

• 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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Learning Objective LO13.2Classify Mutual Funds by

Investment Objective

Long-term Funds

Stock Funds Bonds Funds Other Funds

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Stock FundsLong-term

Funds


Company Size

Regional

Index funds Match index holdings

% U.S. vs. International

Small-cap

Mid-cap

Global

International

Large-cap

Socially responsibleInvest in socially responsible firms

Economic SectorsSector funds

Growth

Equity income

Price growth vs. Dividend Income

Aggressive Growth

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Bond FundsLong-term 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

World Bond Funds

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Other Funds

Long-term 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_f

unds_overview.shtml.cvsr

• Franklin Templeton Funds– https://www.franklintempleton.com/funds

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Learning Objective LO13.3Evaluate 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.valueline.com

– www.morningstar.com

– www.lipperweb.com

2. Check fund companies’ Internet sites

– www.troweprice.com

– www.vanguard.com

– www.fidelity.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 and online

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Mutual Fund Prospectus– Fund objective(s)– Statement describing the risk factors– The fund’s past performance– The type(s) of investments in the fund’s

portfolio– Information about dividends, distributions and

taxes– The fund’s management– Limitations or requirements for the fund– Procedure to buy or sell shares– Services provided to investors– Turnover ratio of the fund’s investments

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Other Sources of Fund Information

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

• Financial Publications– Bloomberg Businessweek, Forbes, Kiplinger's

Personal Finance, Money, and The Wall Street Journal

– A mutual fund’s information usually 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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Learning Objective LO13.4The Mechanics of a Mutual Fund

Transaction

• Open an account:– $250 to $2,000 and up depending on the fund

family and the fund

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Return on Investment3 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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Taxes and Mutual Funds

Transaction Taxed as:

Income dividend Ordinary income

Capital gain distribution

Long-term capital gains regardless of how long held

Capital gains or losses Short- or long-term gains depending on how long you held the fund shares

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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– Sometimes called “Front-end Load Plans”

• 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

4 Options available if minimum balance ($5,000+)

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Chapter SummaryLearning Objective LO13.1

• Major advantages of mutual funds are professional management and diversification.

• Three types of funds: – Closed-end funds = a fund whose shares are issued only

when the fund is organized– Exchange-traded funds = a fund that invests in the stocks

contained in a specific stock index or securities index– Open-end funds = a fund whose shares are sold and

redeemed by the investment company at the net asset value (NAV) at the request of investors.

• Both closed-end and exchange-traded funds are traded on a stock exchange or in the over-the-counter market

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• Mutual funds can also be classified as:– A shares (commissions charged when shares

purchased)– B shares (commissions charged when money is

withdrawn during the first five years)– C shares (no commission to buy or sell shares,

but higher, ongoing fees).

• Other possible fees include management fees and 12b-1 fees.

• Together all management fees and operating costs are referred to as an expense ratio.

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The major categories of stock mutual funds, in terms of the types of securities in which they invest, are:

- Aggressive growth- Large Cap

- Equity income - Midcap

- Global - Regional

- Growth - Sector

- Index - Small cap

- International - Socially responsible

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Bond funds include: – High-yield (junk)– Intermediate corporate– Intermediate U.S. government– Long-term corporate– Long-term U.S. government– Municipal– Short-term corporate– Short-term U.S. government– World bond funds

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• Other funds invest in a mix of different stocks, bonds, and other investment securities that include:– Asset allocation funds– Balanced funds– Fund of funds– Lifecycle funds– Money market funds

• A family-of-funds concept allows shareholders to switch among funds as different funds offer more potential, financial reward, or security.

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• Managed fund or an index fund?– With a managed fund, a professional fund

manager (or team of managers) chooses the securities that are contained in the fund.

– Over many years, index funds have outperformed the majority of managed funds.

– Because an index mutual fund is a mirror image of a specific index, the dollar value of a share in an index fund also increases or decreases when the index increases or decreases.

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• To help evaluate different mutual funds, investors can use the information from:– The Internet– Professional advisory services– The fund’s prospectus – The fund’s annual report– Financial publications– Newspapers

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• Closed-end funds and ETFs– The shares of a closed-end fund or exchange-

traded fund are bought and sold on organized stock exchanges or the over-the-counter market.

• Open-end Funds– Shares may be purchased through a salesperson

who is authorized to sell them, through an account executive of a brokerage firm, from a mutual fund supermarket, or from the investment company that sponsors the fund.

– Open-end fund shares can be sold to the investment company that sponsors the fund.

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• Shareholders in mutual funds can receive a return in one of three ways: – Income dividends

– Capital gain distributions when the fund buys and sells securities in the fund’s portfolio at a profit

– Capital gains when the shareholder sells shares in the mutual fund at a higher price than the price paid.

• To ensure having all of the documentation you need for tax reporting purposes, it is essential that you keep accurate records.

• A number of purchase and withdrawal options are available for mutual fund investors.

chapter 13 investing in mutual funds copyright © 2013 by the mcgraw-hill companies, inc. all rights...

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