Mutual Funds: An Easy Way to Diversify

Learning Objectives
1. Weigh the advantages and

disadvantages of investing in mutual funds.

2. Differentiate between types of

mutual funds, ETFs, and investment trusts.

15-2

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Learning Objectives
3. Classify mutual funds according to

objectives.

4. Select a mutual fund that is right for

you.

5. Calculate mutual fund returns.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-3

Introduction
A way of holding investments such as

stocks and bonds.

Mutual fundan 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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-4

Figure 15.1

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-5

Why Invest in Mutual Funds?

Advantages of mutual funds:
Professional management
Minimal transaction costs Liquidity Flexibility Service Avoidance of bad brokers

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-6

Table 15.1

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-7

Why Invest in Mutual Funds?

Disadvantages of mutual funds:
Lower-than-market performance Costs Risks You cant diversity away a market crash. Taxes.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-8

Mutual Fund-Amentals
A mutual fund pools money from investors

with similar financial goals.

You are investing in a diversified portfolio

thats professionally managed according to set goals.

Investment objectives are clearly stated.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-9

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.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-10

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.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-11

Figure 15.2

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-12

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)

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-13

Investment Companies
Closed-End Investment Companies Unit Investment Trusts Real Estate Investment Trusts (REITs)

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-14

Load Versus No-Load Funds

Loadcommission charged on a mutual fund

Load fundmutual 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 funddoesnt charge commission.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-15

Management Fees and Expenses

Expense ratiothe ratio of a mutual funds expenses to its total assets
Invest in a fund with a low expense ratio Turnover ratemeasures the level of the funds trading activity. Higher turnover rate, higher the funds expenses.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-16

12b-1 Fees
Annual fee, generally ranging from 0.25 to 1.00% of a funds assets, that the mutual fund charges its shareholders for marketing costs.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-17

Table 15.2

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-18

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-19

Money Market Mutual Funds

Invest 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
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-20

Stock Mutual Funds

Aggressive growth funds Small company growth funds Growth funds

Growth-and-income funds
Sector funds Index funds International funds
15-21

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Figure 15.3

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-22

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-23

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-24

Life Cycle and Target Retirement Funds

Mutual funds that try to tailor their holdings to the investors individual characteristics, such as age and risk Target retirement funds are managed based on when you plan to retire.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-25

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.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-26

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)
15-27

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-28

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 markets trading hours.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-29

Table 15.3

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-30

Mutual Fund Services

Automatic investment and withdrawal plans Automatic reinvestment of interest, dividends, and capital gains Wiring and funds express options

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-31

Mutual Fund Services

Phone and internet switching Easy establishment of retirement plans

Check writing
Bookkeeping and help with taxes

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-32

Buying a Mutual Fund

Step 1: Determining Your Goals
Goals and time horizon Why are you investing? Tax-deferred investments?

Risk tolerance

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-33

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-34

Figure 15.4

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-35

Buying a Mutual Fund

Step 3: Evaluating the Fund
Where to looksources of information

Mutual fund prospectus

Internet screening to find the right

mutual fund

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-36

Table 15.4

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-37

Figure 15.5

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-38

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-39

Table 15.5

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-40

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-41

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-42

Table 15.6

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-43

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.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-44

Summary
When you buy a mutual fund, youre

buying a share of a very large portfolio which goes up and down as the value of the mutual funds investments goes up and down.

There are open-end and close-end

investment companies, unit investment trusts and real estate investment trusts.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-45

Summary
Be very wary of mutual fund expenses no-load mutual funds dont charge commission. Funds are classified according to objective. When selecting a mutual fund, determine your goals, find funds that meet your objectives, and evaluate.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

15-46