chapter 15: investing through mutual funds

Chapter Fifteen

Investing Through Mutual Funds

Copyright ©Houghton Mifflin Company. All rights reserved. 15 - 2

Learning Objectives

1. Summarize two types of investment returns that investors expect from mutual funds.

2. Classify mutual funds by investment objectives.

3. Describe unique features of mutual funds that make them attractive.

4. Distinguish among load and no-load mutual funds

5. Explain how to avoid various charges and fees.

6. Explain how to evaluate mutual funds to invest in.


Introduction

Investment Company – corporation, trust, or partnership in which investors with similar financial goals pool their money to...

• utilize professional management

• diversify their investments

What are some large mutual fund investment companies?


Introduction (Continued)

Mutual Fund – an investment company that

• combines the funds of investors who have purchased shares of ownership

• invests that money in a diversified portfolio of stocks and bonds issued by other corporations or governments.

• Portfolio – consists of a collection of securities and other investment alternatives.


Types of Investment Companies

• Closed-End Investment Company – issues a limited and fixed number of shares and does not buy them back.– Shares trade like stock on stock exchanges

• Open-End Mutual Fund – always ready to sell new shares of ownership and buy back previously sold shares at the fund’s current share price.– More than 90% of all mutual funds


Figure 15.1: How a Mutual Fund Works


Investors Expect Mutual Fund Dividend and Capital Gains Income

• Mutual Fund Dividends – income paid to investors out of profits earned by the mutual fund from the investments it has made.

– Mutual funds dividends represent current income to mutual fund shareholders.

• Capital Gains Distributions – represent net gains that a fund realizes when it sells securities held in the fund’s portfolio.

Recommended strategy: reinvest dividends and capital gains into additional shares.


Investors Expect Capital Gains Through Price Appreciation

• Mutual fund investors also expect to profit when they sell their shares.

• Net Asset Value (NAV) – the per-share value of a mutual fund.

Example: $52,500,000 value of fund

3,500,000 number of shares = $15 per share

• Unrealized Capital Gains – merely “paper profits” on securities in the mutual fund.

• When such gains are “realized” by the fund, they are paid to investors as capital gains distributions.


Mutual Funds Have Different Investment Objectives

Prospectus – a mutual fund’s investment objectives must be stated in this.

Two Types:

• Traditional prospectus (long)

• Profile prospectus (short)


Funds with an Income Objective

• Bond Fund – aims to earn current income without incurring undue risk and to pay ordinary income dividend distributions.

• Municipal Bond (Tax-Exempt) Fund – attempts to earn current tax-exempt income by investing solely in municipal bonds issued by cities, states, and political subdivisions.

• Mortgage Fund – invests in mortgage-backed securities (e.g., Ginnie Maes)


Funds with a Balanced Objective

Balanced Funds – invest in a mixture of bonds, preferred stocks, and blue-chip common stocks.

• Often 60% stocks, 40% bonds

• Often have the word “balanced” in fund name


Funds with a Growth Objective

• Growth Fund – seeks long-term capital appreciation by investing in the common stocks of companies whose values are expected to grow faster than usual.

• Value Fund – specializes in growth stocks whose prices appear to be low, based on the logic that such stocks are currently out of favor and under-priced.


Funds with a Growth Objective (Continued)

• Aggressive-Growth Fund (or Maximum Capital Gains Fund) – seeks greatest long-term capital appreciation and incurs greatest fluctuation in price.

• Small-Cap Fund (or Small-Capitalization Fund) – specializes in investing in smaller companies with market capitalization less than $1 billion.

• Sector Fund – heavily invests in common stocks from one industry or one portion of the economy.

• Precious Metals and Gold Funds – seek long-term capital appreciation by investing in securities associated with gold, silver, other precious metals.

•


Funds with a Growth Objective (Continued)

• Global Fund – invests primarily in growth stocks of companies listed on foreign and U.S. exchanges.

• International Funds – hold only foreign stocks, and some such funds focus on a single country or geographic region.


Funds with a Growth and Income Objective

• Growth and Income Fund – objective is a combination of growth and income; invests in companies expected to show average or better growth and pay steady or rising dividends.

• Life-Cycle Funds – create a diversified, all-in-one (stocks, bonds, and cash assets) portfolio for those individuals who do not wish to actively manage their investments.


Other Types of Funds

• Socially Conscious Funds – funds that aim to invest in firms with good records on the environment, human rights, and public safety. – Screen for various negative factors (e.g.,

smoking, alcohol, polluters, gambling)

• “Funds of Funds” – funds that earn a return by investing in other mutual funds, thereby providing extensive diversification.


Unique Features of Mutual Funds

• Easy Purchase and Sale – after opening an account, you can easily buy and sell shares

• Easy Access- check Writing and wiring of funds

• Automatic Investment – Most funds allow investors to make periodic (monthly or quarterly) payments using money automatically transferred from a bank account

• Automatic Reinvestment – allows automatic use of dividend and capital gains distributions and interest to buy additional shares of the fund without paying any commissions.


Figure 15.2: The Wisdom of Automatic Reinvestment


Switching Privileges within a Mutual Fund Family

• Switching Privilege (or Exchange Privilege) – permits mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund within a mutual fund family.

• Exchange Fee – a small charge, typically $5 or $10 per transaction, on transfers from one fund to another.

• Mutual Fund Family – when the same management company operates a variety of mutual funds, each with its own investment objectives.


Withdrawal Plans

• Withdrawal Plans (or Systematic Withdrawal Plans) – available to shareholders who want a periodic income from their mutual fund investments.

• You can take your funds out of a mutual fund using one of four methods:

– By taking a set dollar amount each month.

– By cashing in a set number of shares each month.

– By taking the current income as cash.

– By taking a portion of the asset growth.


Mutual Fund Expenses

• Management Fee – annual assessment to pay advisors who operate the mutual fund.

• 12b-1 Fee (or Distribution Fee) – annual charge deducted by a fund company from fund’s assets to pay for advertising, marketing, distribution, and promotion costs.

– Ongoing expenses that increases fund costs

– Avoid funds with this charge (see prospectus)


Disclosure of Fees• Standardized Expense Table – illustrates in an

identical manner the effects of a mutual fund’s fees and other expenses (hypothetical scenario)

• Expense Ratio – the combined percentage (of fund assets) charged annually for expenses including management fees, 12b-1 fees, and other expenses of the mutual fund company.


What’s Best: Load or No-Load? Low-Fee or High-Fee?

• Up-front load charges are costly to investors in the short run (less than five years),

• Annual 12b-1 charges are very costly over the long run (increase expense ratio)

• Over five-year periods, lower-cost funds always deliver better returns than those offered by higher-cost funds.– Funds with no 12b-1 fees– Index funds


Managed Funds or Index Funds?

• Managed Funds – professional managers are constantly evaluating and choosing securities using a specific investment approach.

• Index Fund – a mutual fund that buys and holds stocks or bonds that constitute a market index.

– Managers do not evaluate and select individual securities, but rather buy and hold all the stocks in a particular index.

– Examples of market indexes?


How to Evaluate Mutual Funds in Which to Invest

• Match your investment philosophy and financial goals to a mutual fund’s objectives

• Read prospectuses and annual reports– Annual Report – a published summary of

the financial activities of a mutual fund company for the year.


How to Evaluate Mutual Funds in Which to Invest (Continued)

Locate sources of comparative performance data:

– The “Financial Press” (Examples?)

– Specialized mutual fund investment publications (e.g., Morningstar Mutual Funds)

– Magazines that rate mutual funds

– Internet sources on mutual funds

• www.ici.org

• www.morningstar.org


Figure 15.3: Balancing Risk and Returns on Mutual Funds


Interpret Comparative Performance Information Over Time

• Consider a fund’s volatility – a security’s or mutual fund’s tendency to rise or fall in price over a period of time.

• Consider a fund’s long- and short-term performance

• Consider a fund’s size

• Consider a fund’s performance in up and down markets


Golden Rules of Investing in Mutual Funds

1. Invest only in no-load mutual funds that have a low expense ratio and do not assess a 12(b)1 fee.

2. When choosing mutual funds, always match your investment philosophy and financial goals to a mutual fund’s objectives

3. When investing for long-term goals, definitely sign up for automatic reinvestment of your mutual fund dividends.


Golden Rules of Investing in Mutual Funds (Continued)

4. If you have a defined contribution retirement plan available at work, sign up for payroll withholding to automatically forward a portion of each paycheck to a mutual fund.

5. Invest most of your “serious” money – such as to pay for a child’s education and retirement – in one or more low-fee diversified index funds.

6. Don’t jump in and out of the mutual fund market; instead, keep it simple by investing in a few funds and leave your money alone.

chapter 15: investing through mutual funds

Economy & Finance

gambling funds of funds

conscious funds funds

funds of investors

mutual funds dividends

noload mutual funds

types of funds

funds portfolio

gold funds