Lecture # 24

Mutual Funds

Balanced Funds

• The basic objectives of balanced funds are to generate income as well as long-term growth of principal. These funds generally have portfolios consisting of bonds, preferred stocks, and common stocks. They have fairly limited price rise potential, but

• do have a high degree of safety, and moderate to high income potential. Investors who desire a fund with a combination of securities in a single portfolio, and who seek some current income and moderate growth with low-level risk, would do well to invest in balanced mutual funds.

• Balanced funds, by and large, do not differ greatly from the growth and income funds described above.

Growth Funds

• Growth funds are offered by every investment company. The primary objective of such funds is to seek long-term appreciation (growth of capital). The secondary objective is to make one's capital investment grow faster than the rate of inflation. Dividend income is considered an incidental objective of growth funds.

• Growth funds are best suited for investors interested primarily in seeing their principal grow and are therefore to be considered as long-term investments - held for at least three to five years. Jumping in and out of growth funds tends to defeat their purpose.

• However, if the fund has not shown substantial growth over a three - to five-year period, sell it (redeem your shares) and seek a growth fund with another investment company.

• Candidates likely to participate in growth funds are those willing to accept moderate to high risk in order to attain growth of their capital and those investors who characterize their investment temperament as "fairly aggressive.

Index Funds

• The intent of an index fund is basically to track the performance of the stock market. If the overall market advances, a good index fund follows the rise. When the market declines, so will the index fund. Index funds' portfolios consist of securities listed on the popular stock market indices.

• It is also the intent of an index fund to materially reduce expenses by eliminating the fund portfolio manager. Instead, the fund merely purchases a group of stocks that make up the particular index it deems the best to follow.

• The stocks in an index fund portfolio rarely change and are weighted the same way as its particular market index. Thus, there is no need for a portfolio manager. The securities in an index mutual fund are identical to those listed by the index it tracks, thus, there is little or no need for any great turnover of the portfolio of securities.

• The funds are "passively managed" in a fairly static portfolio. An index fund is always fully invested in the securities of the index it tracks.

• An index mutual fund may never outperform the market but it should not lag far behind it either. The reduction of administrative cost in the management of an index fund also adds to its profitability.

Sector Funds

• As was discussed earlier, most mutual funds have fairly broad-based, diversified portfolios. In the case of sector funds, however, the portfolios consist of investment from only one sector of the economy.

• Sector funds concentrate in one specific market segment; for example, energy, transportation, precious metals, health sciences, utilities, leisure industries, etc. In other words, they are very narrowly based.

• Investors in sector funds must be prepared to accept the rather high level of risk inherent in funds that are not particularly diversified. Any measure of diversification that may exist in sector funds is attained through a variety of securities, albeit in the same market sector.

• Substantial profits are attainable by investors astute enough to identify which market sector is ripe for growth - not always an easy task.

Special Funds

• Specialized funds resemble sector funds in most respects. The major difference is the type of securities that make up the fund's portfolio. For example, the portfolio may consist of common stocks only, foreign securities only, bonds only, new stock issues only, over - the - counter securities only, and so on.

• Those who are still novices in the investment arena should avoid both specialized and sector funds or the time being and concentrate on the more traditional, diversified mutual funds instead.

Islamic Funds

• In case of Islamic Funds, the investment made in different instruments is to be in line with the Islamic Shairah Rules. The Fund is generally to be governed by an Islamic Shariah Board.

• And then there is a purification process that needs to be followed, as some of the money lying in reserve may gain interest, which is not desirable in case of Islamic investments.

Risk Involving in Mutual Fund Investment

• There is some degree of risk in every investment. Although it is reduced considerably in mutual fund investing. Do not let the specter of risk stop you from becoming a mutual fund investor.

• However, it behaves all investors to determine for them the degree of risk they are willing to accept in order to meet their objectives before making a purchase. Knowing of potential risks in advance will help you avoid situations in which you would not be comfortable.

• Understanding the risk levels of the various types of mutual funds at the outset will help you avoid the stress that might result from a thoughtless or a hasty purchase.

• Let us now examine the risk levels of the various types of mutual funds.

LOW-LEVEL RISK

Mutual funds characterized as low-level risks fall into here categories

1. Money market funds

2. Treasury bill funds

3. Insured bond funds

MODERATE-LEVEL RISKS

• Mutual funds considered moderate-risk investments may be found in at least the eight types categorized below.

1. Income funds

2. Balanced funds

3. Growth and income funds

4. Growth funds

5. Short-term bond funds (taxable and tax-free)

6. Intermediate bond funds (taxable and tax-free)

7. Insured government/municipal bond funds

8. Index funds.

HIGH-LEVEL RISKS

• The types of funds listed below have the potential for high gain, but all have high risk levels as well.

1. Aggressive growth funds

2. International funds

3. Sector funds

4. Specialized funds

5. Precious metals funds

6. high-yield bond funds (taxable and tax-free)

7. Commodity funds

8. Option funds

MEASURING RISK

• As you become a more experienced investor, you may want to examine other, more technical, measures to determine risk factors in your choice of funds.

Beta Coefficient

• Beta coefficient is a measure of the fund’s risk relative to the overall market. For example, a fund with a beta coefficient of 2.0 means that it is likely to move twice as fast as the general market – both up and down. High beta coefficients and high risk go hand in hand.

Alpha Coefficient

• Alpha coefficient is a comparison of a fund’s risk (beta) to its performance. A positive alpha is good. For example, an alpha of 10.5 means that the fund manager earned an average of 10.5% more each year than might be expected, given the fund’s beta.

Interest Rates

• Interest rates and inflation rates are other factors that can be used to measure investment risks. For instance, when interest rates are going up, bond funds will usually be declining, and vice versa.

• The rate of inflation has a decided effect on funds that are sensitive to inflation factors; for example, funds that have large holdings in automaker stocks, real estate securities, and the like will be adversely affected by inflationary cycles.

R-Square Factor

• R-Square factor is a measure of the fund’s risk as related to its degree of diversification.

• The information is supplied here merely to acquaint you with the terminology in the event you should wish to delve more deeply into complex risk factors. The more common risk factors previously described are all you really need to know for now, and perhaps for years to come.

• One caveat is in order, however. There is no such thing as an absolutely 100% risk-free investment. Even funds with excellent 10 year past performance records must include in their literature and prospectuses the following disclaimer:

• “Past performance is no guarantee of future results.” However, by not exceeding your risk tolerance level, you can achieve a wide safety and comfort zone with mutual fund portfolios such as those shown.