XV. MUTUAL FUNDSXV. MUTUAL FUNDS

The Five Things to Know Before The Five Things to Know Before Investing in Mutual FundsInvesting in Mutual Funds

1.1. What is the fund sponsor’s reputation for:What is the fund sponsor’s reputation for:a.a. LeadershipLeadership

b.b. Clarity of CommunicationClarity of Communication

c.c. Transparency, andTransparency, and

d.d. Business Continuity;Business Continuity;

2.2. What is the tenure and experience of fund What is the tenure and experience of fund managers;managers;

3.3. What is the fund’s style;What is the fund’s style;

4.4. What is the fund’s expense ratio, andWhat is the fund’s expense ratio, and

5.5. Has the fund provided consistently strong Has the fund provided consistently strong returns relative to its peers?returns relative to its peers?

A. The Mechanics of Mutual FundsA. The Mechanics of Mutual Funds

1.1. Mutual funds pool money from many investorsMutual funds pool money from many investors

2.2. Mutual fund investors own a part of all of the Mutual fund investors own a part of all of the securities in the mutual fund “pool”securities in the mutual fund “pool”

3.3. The fund manager is responsible for tracking The fund manager is responsible for tracking the securities in the poolthe securities in the pool

4.4. Mutual funds provide diversification – mutual Mutual funds provide diversification – mutual fund investors can own a portion of a variety fund investors can own a portion of a variety of stocks and/or bonds for a relatively small of stocks and/or bonds for a relatively small investmentinvestment

A. The Mechanics of Mutual FundsA. The Mechanics of Mutual Funds5.5. Profits are paid in two ways:Profits are paid in two ways:

a.a. Income Distributions – Dividends and interest paid Income Distributions – Dividends and interest paid by the underlying securities are subsequently paid by the underlying securities are subsequently paid to investorsto investors

b.b. Capital Gains Distributions – Payment to investors Capital Gains Distributions – Payment to investors of profits obtained from sales of securitiesof profits obtained from sales of securities

6.6. Passive Funds – Primarily index fundsPassive Funds – Primarily index funds

7.7. Active Funds – Run by a professional manager Active Funds – Run by a professional manager – active funds have– active funds have::a.a. Professional managersProfessional managers

b.b. An investment objective, andAn investment objective, and

c.c. An investment program designed to meet the An investment program designed to meet the investment objectiveinvestment objective

A. The Mechanics of Mutual FundsA. The Mechanics of Mutual Funds

7.7. Open and Closed End FundsOpen and Closed End Fundsa.a. Open end – sold by brokerage firms and by Open end – sold by brokerage firms and by

fund distributors, issues or purchases shares fund distributors, issues or purchases shares depending upon demand, uses client funds depending upon demand, uses client funds to buy or sell securitiesto buy or sell securities

b.b. Closed end – raise money only once, invest Closed end – raise money only once, invest in a variety of securities, and offer a fixed in a variety of securities, and offer a fixed number of shares – traded Over the Counter number of shares – traded Over the Counter or on the market – price varies with the or on the market – price varies with the price of the underlying securities and with price of the underlying securities and with market demand (discount or premium from market demand (discount or premium from Net Asset Value)Net Asset Value)

B. TYPES OF MUTUAL FUNDSB. TYPES OF MUTUAL FUNDS

1.1. Stock Funds – invest in equity securities, can Stock Funds – invest in equity securities, can be growth, value, dividend, sector, market be growth, value, dividend, sector, market cap, etc.cap, etc.

2.2. Bond Funds – invest in Treasury bonds, Bond Funds – invest in Treasury bonds, municipal bonds, passive trading of securities, municipal bonds, passive trading of securities, active trading of securities, high yield bonds, active trading of securities, high yield bonds, corporate bonds, etc. corporate bonds, etc.

3.3. Commodity Funds – invest in stocks of Commodity Funds – invest in stocks of commodities firms or in commodity futurescommodities firms or in commodity futures

4.4. Balanced Funds – contain a mix of stocks and Balanced Funds – contain a mix of stocks and bonds (generally 60% stocks, 40% bonds)bonds (generally 60% stocks, 40% bonds)

B. TYPES OF MUTUAL FUNDSB. TYPES OF MUTUAL FUNDS

5.5. Target Date Funds – change investment Target Date Funds – change investment allocation as a target date approaches allocation as a target date approaches (ex. - §(ex. - §529 funds))

6.6. Money Market Funds – cash equivalent Money Market Funds – cash equivalent securities – like a savings accountsecurities – like a savings account

7.7. International Funds – invest in Europe, International Funds – invest in Europe, China, Asia, Far East, Latin America, China, Asia, Far East, Latin America, emerging markets, etc.emerging markets, etc.

8.8. Miscellaneous – socially responsible Miscellaneous – socially responsible funds, sin funds, green funds, etc.funds, sin funds, green funds, etc.

C. DEFINITIONSC. DEFINITIONS

1.1. Turnover Rate – the number of times per Turnover Rate – the number of times per year that the equivalent of all of the year that the equivalent of all of the underlying securities in the fund are underlying securities in the fund are purchased or soldpurchased or sold

2.2. Volatility – the historic deviation of rates of Volatility – the historic deviation of rates of return above and below the average rate of return above and below the average rate of returnreturn

3.3. Prospectus – similar to a stock prospectus, Prospectus – similar to a stock prospectus, explains fund objectives, investment explains fund objectives, investment strategy, fees, historic before and after tax strategy, fees, historic before and after tax returns, and fund risk profilereturns, and fund risk profile

C. DEFINITIONSC. DEFINITIONS4.4. Net Asset Value (NAV) – the value of the Net Asset Value (NAV) – the value of the

underlying securities in a fund - defined as: underlying securities in a fund - defined as:

(market cap of fund shares + accrued(market cap of fund shares + accrued

interest + accrued dividends – accruedinterest + accrued dividends – accrued expenses) expenses)

number of fund sharesnumber of fund shares

5.5. Premium – The price of a share of a closed Premium – The price of a share of a closed end mutual fund minus the share Net Asset end mutual fund minus the share Net Asset Value – exists where demand for fund shares Value – exists where demand for fund shares exceeds the value of the underlying holdingsexceeds the value of the underlying holdings

C. DEFINITIONSC. DEFINITIONS6.6. Discount – Where the shares of a closed end Discount – Where the shares of a closed end

fund trade below the fund’s net asset value, fund trade below the fund’s net asset value, exists where demand is less than the value of exists where demand is less than the value of the underlying holdingsthe underlying holdings

7.7. Liquidity – The ability to get “into” and “out Liquidity – The ability to get “into” and “out of” an investment (buy and sell) – ETFs are of” an investment (buy and sell) – ETFs are generally highly liquid, mutual funds are notgenerally highly liquid, mutual funds are not

8.8. Diversification – Where a fund holds a variety Diversification – Where a fund holds a variety of securitiesof securities

9.9. Fund Objectives – the management style Fund Objectives – the management style behind a mutual fund (large cap, small cap, behind a mutual fund (large cap, small cap, growth, value, junk bond, muni, etc.)growth, value, junk bond, muni, etc.)

C. DEFINITIONSC. DEFINITIONS10.10. Rating – An independent analyst’s opinion of Rating – An independent analyst’s opinion of

how the fund has performed compared to how the fund has performed compared to benchmarksbenchmarks

11.11. Ranking – The relative standing of a mutual Ranking – The relative standing of a mutual fund compared to others with similar fund compared to others with similar investment strategiesinvestment strategies

12.12. Sharpe Ratio – Calculated as a fund’s rate of Sharpe Ratio – Calculated as a fund’s rate of return – the rate of return on 3 month return – the rate of return on 3 month Treasury bills divided by the standard Treasury bills divided by the standard deviation of fund returnsdeviation of fund returns

Sharpe Ratio = Sharpe Ratio = (Fund Return – 3 mo. Treasury Yield)(Fund Return – 3 mo. Treasury Yield)Standard Deviation of Fund ReturnsStandard Deviation of Fund Returns

C. DEFINITIONSC. DEFINITIONS

13.13. Standard Deviation – The amount Standard Deviation – The amount by which the annual returns of a by which the annual returns of a fund vary above and below the fund vary above and below the fund’s average returnfund’s average return

14.14. Rating Firms:Rating Firms:a.a. Standard and PoorsStandard and Poors

b.b. MorningstarMorningstar

c.c. LipperLipper

C. DEFINITIONSC. DEFINITIONS15.15. Fund Style (See Style Box)Fund Style (See Style Box)

a.a. Growth/Blend/Value – Invests in growth stocks, a Growth/Blend/Value – Invests in growth stocks, a blend of growth and value stocks, and value stocksblend of growth and value stocks, and value stocks

b.b. Small Cap (less than $1.5 billion), Mid Cap ($1.5 Small Cap (less than $1.5 billion), Mid Cap ($1.5 billion to $9 billion), Large Cap ($9 billion +)billion to $9 billion), Large Cap ($9 billion +)

c.c. Dividend (Yield) – Invests in securities with the Dividend (Yield) – Invests in securities with the highest dividend paymentshighest dividend payments

d.d. Contrarian – Against the accepted (current trend) in Contrarian – Against the accepted (current trend) in managementmanagement

e.e. Style Drift – When a fund manager changes styles Style Drift – When a fund manager changes styles to make up for below market returnsto make up for below market returns

16.16. Portfolio Overlap – Where a holder of several Portfolio Overlap – Where a holder of several mutual funds owns duplicate underlying mutual funds owns duplicate underlying shares of stockshares of stock

D. FEES AND CHARGESD. FEES AND CHARGESFees have the greatest impact on fund Fees have the greatest impact on fund

returns other than the manager’s returns other than the manager’s performanceperformance

1.1. Sales Charges (Loads)Sales Charges (Loads)a.a. Front End Load – A sales charge on fund purchase, Front End Load – A sales charge on fund purchase,

reduces the number of shares purchasedreduces the number of shares purchased

b.b. Back End Load (Redemption Fee or Contingent Back End Load (Redemption Fee or Contingent Deferred Sales Charge) – Paid when shares are sold Deferred Sales Charge) – Paid when shares are sold – usually declines to 0 after 5-7 years – designed to – usually declines to 0 after 5-7 years – designed to prevent investor “churn”prevent investor “churn”

c.c. Level Load – sales charges are part of annual Level Load – sales charges are part of annual operating expensesoperating expenses

D. FEES AND CHARGESD. FEES AND CHARGES

2.2. Fund ClassesFund Classesa.a. A = Front end loadA = Front end loadb.b. B = Back end loadB = Back end loadc.c. C = Level load – no sales charges, but C = Level load – no sales charges, but

higher fees than A or B – higher annual higher fees than A or B – higher annual fees and charges instead of front end fees and charges instead of front end or back end loadsor back end loads

3.3. Exchange Fees – A charge for Exchange Fees – A charge for moving assets between different moving assets between different funds issued by the same groupfunds issued by the same group

D. FEES AND CHARGESD. FEES AND CHARGES

4.4. Early Redemption Charge – Exit fee, can Early Redemption Charge – Exit fee, can be 5 days to 1 yearbe 5 days to 1 year

5.5. Breakpoint – A point where more money Breakpoint – A point where more money is invested to reduce the front end loadis invested to reduce the front end load

a.a. Right of Accumulation – Where an investor Right of Accumulation – Where an investor can combine past and new investments to can combine past and new investments to reach a breakpointreach a breakpoint

b.b. Letter of Intent – A promise by the investor Letter of Intent – A promise by the investor to increase the amount invested to reach a to increase the amount invested to reach a breakpoint breakpoint

D. FEES AND CHARGESD. FEES AND CHARGES

6.6. Other Types of Fees – Total annual fees Other Types of Fees – Total annual fees are quoted as an “Expense Ratio” – are quoted as an “Expense Ratio” – must be listed in the fund prospectus, must be listed in the fund prospectus, generally range from 0.1% to 2.75%generally range from 0.1% to 2.75%

a.a. 12-b 1 Fees – Marketing and distribution 12-b 1 Fees – Marketing and distribution expenses – limited by NASD rule to 1% of expenses – limited by NASD rule to 1% of assets per year or less, with marketing fees assets per year or less, with marketing fees at 0.75% or less; and with shareholder at 0.75% or less; and with shareholder services capped at 0.25% of assetsservices capped at 0.25% of assets

b.b. Management Fees – Charge to pay the Management Fees – Charge to pay the advisory firm that invests fund assets advisory firm that invests fund assets

The Securities and Exchange Commission (SEC) maintains a mutual fund fee calculator to assist consumers - see

FINRA also has a tool for analyzing mutual funds, including fees - see

E. MEASURING FUND RETURNSE. MEASURING FUND RETURNS

1.1. Percentage change in share price Percentage change in share price (market value) is the measure of fund (market value) is the measure of fund returns for closed end fundsreturns for closed end funds

PercentagePercentage Closing Share Price Closing Share Price

Rate of Return= Opening Share Price -1Rate of Return= Opening Share Price -1

E. MEASURING FUND RETURNSE. MEASURING FUND RETURNS

2.2. Net Asset Value = Net Asset Value = Value of Fund InvestmentsValue of Fund Investments

Number of SharesNumber of Shares

PercentagePercentage Closing Net Asset Value Closing Net Asset Value

Change in NAV = Opening Net Asset Value -1Change in NAV = Opening Net Asset Value -1

E. MEASURING FUND RETURNSE. MEASURING FUND RETURNS

3.3. Distributions – Can be both interest Distributions – Can be both interest (dividends and interest on investments) (dividends and interest on investments) and capital gains (mutual fund’s gain and capital gains (mutual fund’s gain from sale of underlying investments)from sale of underlying investments)

4.4. Yield = Yield = Distribution per ShareDistribution per Share

Price per SharePrice per Share

E. MEASURING FUND RETURNSE. MEASURING FUND RETURNS

5.5. Total Return = Total Return = Change in NAV + DistributionsChange in NAV + Distributions

Cost of Initial InvestmentCost of Initial Investment

a.a. Reported as a geometric mean, taking into Reported as a geometric mean, taking into account annual compounding of account annual compounding of distributionsdistributions

b.b. Must be viewed in comparison with Must be viewed in comparison with standard indices or with indices of standard indices or with indices of competing funds with a similar investing competing funds with a similar investing stylestyle

F. ANNUITIESF. ANNUITIES

1.1. Defined as an investment contract between Defined as an investment contract between the purchaser and an insurance company, the purchaser and an insurance company, funded (money invested) either by a lump funded (money invested) either by a lump sum or by a series of scheduled paymentssum or by a series of scheduled payments

2.2. Types of AnnuitiesTypes of Annuitiesa.a. Fixed annuities – interest rate set upon purchaseFixed annuities – interest rate set upon purchase

b.b. Variable annuities – contain a selection of sub Variable annuities – contain a selection of sub accounts, with the yield on the annuity varying accounts, with the yield on the annuity varying depending upon the investment performance of the depending upon the investment performance of the types of securities represented in the sub account types of securities represented in the sub account

F. ANNUITIESF. ANNUITIES

3.3. Advantages of annuities over mutual Advantages of annuities over mutual fundsfunds

a.a. Income taxes – no income taxes are paid on Income taxes – no income taxes are paid on capital gains until the annuity matures capital gains until the annuity matures (presumably when the investor is retired (presumably when the investor is retired and in a lower tax bracket)and in a lower tax bracket)

b.b. Withdrawals from an annuity, unlike Withdrawals from an annuity, unlike withdrawals from a pension plan or an IRA, withdrawals from a pension plan or an IRA, can be postponed until after age 701/2, can be postponed until after age 701/2, allowing transfer of wealth to heirsallowing transfer of wealth to heirs

F. ANNUITIESF. ANNUITIES

c.c. Special types of annuities (ex. §403(B) Special types of annuities (ex. §403(B) annuities) are tax deferred for both annuities) are tax deferred for both contributions and interestcontributions and interest

d.d. Annuities may contain a death benefit, Annuities may contain a death benefit, which is a guaranteed payment upon which is a guaranteed payment upon death regardless of market conditions death regardless of market conditions – the death benefit is similar to life – the death benefit is similar to life insurance, funded by a mortality and insurance, funded by a mortality and expense (M&E) fee.expense (M&E) fee.

F. ANNUITIESF. ANNUITIES

4.4. Disadvantages of annuitiesDisadvantages of annuitiesa.a. Annual fees are generally higher than Annual fees are generally higher than

mutual fund annual fees as a mutual fund annual fees as a percentage of the amount investedpercentage of the amount invested

b.b. Surrender fees – a back end load, Surrender fees – a back end load, generally starting at 7% for the first generally starting at 7% for the first year, declining by 1% per year year, declining by 1% per year thereafterthereafter

F. ANNUITIESF. ANNUITIES

5.5. Annuity ratingsAnnuity ratingsa.a. As an insurance product, the state of As an insurance product, the state of

issue may guarantee the company’s issue may guarantee the company’s obligations, including annuities, in the obligations, including annuities, in the event that the company becomes event that the company becomes insolvent (goes bankrupt)insolvent (goes bankrupt)

b.b. The insurance companies issuing The insurance companies issuing annuities are rated by Standard and annuities are rated by Standard and Poors and MorningstarPoors and Morningstar