Mutual Funds: An Easy Way to

Diversify

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Learning Objectives

1. Weigh the advantages and disadvantages of investing in mutual funds.

2. Differentiate between types of mutual funds, ETFs, and investment trusts.

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Learning Objectives

3. Classify mutual funds according to objectives.

4. Select a mutual fund that is right for you.

5. Calculate mutual fund returns.

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Introduction

A way of holding investments such as stocks and bonds.

Mutual fund—an investment that raises from investors, pools the money, and invests it in stocks, bonds, and other investments.

Each investor owns a share of the fund proportionate to his/her investment.

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Why Invest in Mutual Funds?

Advantages of mutual funds:Professional managementMinimal transaction costs Liquidity FlexibilityServiceAvoidance of bad brokers

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Why Invest in Mutual Funds?

Disadvantages of mutual funds:Lower-than-market performance CostsRisksYou can’t diversity away a market crash.Taxes.

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Mutual Fund-Amentals

A mutual fund pools money from investors with similar financial goals.

You are investing in a diversified portfolio that’s professionally managed according to set goals.

Investment objectives are clearly stated.

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Mutual Fund-Amentals

As the value of the securities in the fund increases, the value of each mutual fund share also rises.

Most pay dividends or interest to shareholders.

Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid.

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Mutual Fund-Amentals

Fund is set up as a corporation or trust

Shareholders elect a board of directors.

Fund is run by a management company.

Each individual fund hires an investment advisor to oversee the fund.

Contracts with a custodian, a transfer agent, and an underwriter.

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Investment Companies

Invest the pooled money of a number of investors in return for a fee.

Open-End Investment Companies or Mutual Funds

Net asset value (NAV)

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Investment Companies

Closed-End Investment Companies

Unit Investment Trusts

Real Estate Investment Trusts (REITs)

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Load Versus No-Load Funds

Load—commission charged on a mutual fund

Load fund—mutual fund on which a load is charged.

Class A shares– front-end sales load

Class B shares– back-end load

Class C shares – pay coming and going

No-load fund—doesn’t charge commission.

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Management Fees and Expenses

Expense ratio—the ratio of a mutual fund’s expenses to its total assets

Invest in a fund with a low expense ratio

Turnover rate—measures the level of the fund’s trading activity.

Higher turnover rate, higher the fund’s expenses.

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12b-1 Fees

Annual fee, generally ranging from 0.25 to 1.00% of a fund’s assets, that the mutual fund charges its shareholders for marketing costs.

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Calculating Mutual Fund Returns

Return can be in the form of dividends, capital gains, or a change in net asset value

Automatic reinvestments result in increases in the NAV and number of shares.

Calculating returns can help you spot funds that have consistent winners over time.

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Money Market Mutual FundsInvest in Treasury bills, CDs, and other short-

term investments, less than 30 days.

Carry no loads, trade at a constant $1 NAV, and have minimal expense ratios.

Tax-exempt money market fund

Government securities money market mutual fund

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Stock Mutual Funds

Aggressive growth funds

Small company growth funds

Growth funds

Growth-and-income funds

Sector funds

Index funds

International funds

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Balanced Mutual Funds

Tries to balance objectives of long-term growth, income, and stability

Hold both common stock and bonds and sometimes preferred stock.

Aimed at those needing income to live on and moderate stability in their investment.

Less volatile than stock mutual funds.

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Asset Allocation Funds

Invest in stocks, bonds, and money market securities.

Move money between stocks and bonds to outperform the market.

Balanced funds that practice market timing.

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Life Cycle and TargetRetirement Funds

Mutual funds that try to tailor their holdings to the investor’s individual characteristics, such as age and risk

Target retirement funds are managed based on when you plan to retire.

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Bond Funds

Mutual funds that invest primarily in bonds.

Fluctuate in value with market interest rates

Use for small amounts of money, to keep investments liquid.

Otherwise, use individual bonds where there is no professional management or fees.

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Bond Funds

U.S. Government Bond Funds of GNMA Bond funds

Municipal Bond Funds

Corporate Bond Funds

Bonds and their maturities:Short-term (1-5 years)Intermediate-term (5-10 years)Long-term (10-30 years)

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ETFs or Exchange Traded Funds

A hybrid between a mutual fund and an individually traded stock or bond that trade on an exchange like individual securities do and can be bought and sold through the trading day.

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ETFs or Exchange Traded Funds

Charge lower annual expenses but still pay trading commissions.

More tax-efficient than most mutual funds.

Allow investors to stake out an investment position in a sector, industry, or country.

Investors can make their move during the market’s trading hours.

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Mutual Fund Services

Automatic investment and withdrawal plans

Automatic reinvestment of interest, dividends, and capital gains

Wiring and funds express options

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Mutual Fund Services

Phone and internet switching

Easy establishment of retirement plans

Check writing

Bookkeeping and help with taxes

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Buying a Mutual Fund

Step 1: Determining Your Goals

Goals and time horizon

Why are you investing?

Tax-deferred investments?

Risk tolerance

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Buying a Mutual Fund

Step 2: Meeting Your Objectives

Look at (sub)classifications and objectives.

Morningstar provides an investment style box to understand the investment style.

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Buying a Mutual Fund

Step 3: Evaluating the Fund

Where to look—sources of information

Mutual fund prospectus

Internet screening to find the right mutual fund

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Buying a Mutual Fund

Step 4: Making the Purchase

Buy direct – use phone or internet.

Buy through a mutual fund “supermarket”– such as Fidelity or Charles Schwab.

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Summary

When you buy a mutual fund, you’re buying a share of a very large portfolio which goes up and down as the value of the mutual fund’s investments goes up and down.

There are open-end and close-end investment companies, unit investment trusts and real estate investment trusts.

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Summary

Be very wary of mutual fund expenses—no-load mutual funds don’t charge commission.

Funds are classified according to objective.

When selecting a mutual fund, determine your goals, find funds that meet your objectives, and evaluate.