Mutual Funds Background on Mutual Funds • Stock mutual funds: funds that sell shares to individuals and invest the proceeds in stocks • Bond mutual funds: funds that sell shares to individuals and invest the proceeds in bonds • All are managed by professional portfolio managers who decide what securities to purchase Background on Mutual Funds (cont’d) • Motives for investing in mutual funds: – Low initial investment – Expertise of portfolio manager – To meet specific investment goals • Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities owed – Usually reported on a per share basis Background on Mutual Funds (cont’d) • Open-end versus closed-end funds – Open-end mutual funds: funds that sell shares directly to investors and repurchase those shares whenever investors wish to sell them • Usually managed by investment companies that are subsidiaries of a large financial conglomerate • Family: a group of separately managed open-end mutual funds held by one investment company Background on Mutual Funds (cont’d) – Closed-end mutual funds: mutual funds that sell shares to investors but do not repurchase them; instead fund shares are purchased and sold on stock exchanges • Premium: the amount by which a closed-end fund’s share price in the secondary market is above the fund’s NAV • Discount: the amount by which a closed-end fund’s share price in the secondary market is below the fund’s NAV Background on Mutual Funds (cont’d) • Load versus no-load funds – No-load mutual funds: funds that sell directly to investors and do not charge a fee – Load mutual funds: funds whose shares are sold by a stockbroker who charges a fee (or load) for the transaction – Loads can have significant impact on their investment performance Background on Mutual Funds (cont’d) • Expense ratio: the annual expenses per share divided by the net asset value of a mutual fund – Average expense ratio is 1.5 percent – Reported components of expense ratios • Mutual funds incur expenses for administrative, legal, and clerical expenses as well as portfolio management fees Background on Mutual Funds (cont’d) – Relationship between expense ratios and performance • Funds with lower expense ratios tend to outperform other funds Types of Mutual Funds • Types of stock mutual funds – Growth funds: mutual funds that focus on stocks that have potential for above-average growth – Capital appreciation funds: mutual funds that focus on stocks that are expected to grow at a very high rate Types of Mutual Funds (cont’d) – Small capitalization (small-cap) funds: mutual funds that focus on firms that are relatively small – Mid-size capitalization (mid-cap) funds: mutual funds that focus on mediumsize firms – Equity income funds: mutual funds that focus on firms that pay a high level of dividends Types of Mutual Funds (cont’d) – Balanced growth and income funds: mutual funds that contain both growth stocks and stocks that pay high dividends – Sector funds: mutual funds that focus on a specific industry or sector, such as technology stocks • Technology funds: mutual funds that focus on stocks of Internet-based firms and therefore represent a particular type of sector fund Types of Mutual Funds (cont’d) – Index funds: mutual funds that attempt to mirror the movements of an existing stock index – International stock funds: mutual funds that focus on firms that are based outside the U.S. – Socially responsible stock funds: mutual funds that screen out firms viewed as offensive by some Financial Planning Online: Index Mutual Funds • Go to: http://www.fool.com/mutualfunds/indexfu nds/indexfunds01.htm • This Web site provides news and other information about index mutual funds that can guide your investment decisions Types of Mutual Funds (cont’d) • Example: – You are considering investing in either a noload mutual fund that focuses on growth stocks or an index mutual find. When ignoring expenses incurred by the mutual funds, you expect that the growth fund will generate an annual return of 9 percent versus an annual return of 8 percent for the index fund. Types of Mutual Funds (cont’d) The growth fund has an expense ratio of 1.5 percent versus an expense ratio of 0.2 percent for the index fund. Types of Mutual Funds (cont’d) Based on your expectations about the portfolio returns, you returns would be: Fund's portfolio return (exludes expenses) Expense ratio Your annual return Growth Fund 9.00% 1.50% 7.50% Index Fund 8.00% 0.20% 7.80% Types of Mutual Funds (cont’d) • Types of bond mutual funds – Treasury bond funds: mutual funds that focus on investment in Treasury bonds – Ginnie Mae funds: mutual funds that invest in bonds issued by the Government National Mortgage Association – Corporate bond funds: mutual funds that focus on bonds issued by high-quality firms that tend to have a low degree of default risk Types of Mutual Funds (cont’d) – High-yield (junk) bond funds: mutual funds that focus on relatively risky bonds issued by firms that are subject to default risk – Municipal bond funds: mutual funds that invest in municipal bonds – Index bond funds: mutual funds that are intended to mimic performance of a specified bond index Types of Mutual Funds (cont’d) – International bond funds: mutual funds that focus on bonds issued by non-U.S. firms or governments • Exchange rate risk: realized when the value of a bond drops because the currency denominating the bond weakens against the dollar • Global bond funds: mutual funds that invest in foreign bonds as well as U.S. bonds – Maturity classifications—some funds are also segmented by their maturities Return and Risk of a Mutual Fund • Return from investing in a mutual fund – Dividend distributions • Dividends received on stocks in the funds are distributed to shareholders – Capital gains distributions • Proceeds received from the sale of securities are distributed to shareholders – Capital gains from redeeming shares • If price received at redemption exceed price paid Return and Risk of a Mutual Fund (cont’d) • Example: – You invest in an index fund that produces a small amount of capital gains distribution and a significant amount of tax-favored dividend income. You also invest in a technology fund that attempts to take advantage of short-term price swings, producing mostly short-term capital gains. What are the tax liabilities? Return and Risk of a Mutual Fund (cont’d) The equity income mutual fund distributes $1,000 of dividends over the year, while the growth fund distributes $1,000 of long-term capital gains. Your marginal tax rate on ordinary income is about 40 percent. The capital gains tax rate is 20 percent. Return and Risk of a Mutual Fund (cont’d) Return and Risk of a Mutual Fund (cont’d) • Risk from investing in a stock mutual fund – Market risk: the susceptibility of a mutual fund’s performance to general stock market conditions • Exposure of mutual funds to the credit crisis – Even though a stock mutual fund is diversified, it is still susceptible to major losses during a weak economy Return and Risk of a Mutual Fund (cont’d) • Focus on Ethics: Risk from investing in hedge funds – Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions – Hedge funds are not regulated by the SEC – Fees can be very high and the hedge fund management can be suspect • Bernard Madoff is an example of this Financial Planning Online: Return from Investing in Mutual Funds • Go to: http://www.bloomberg.com/ markets/mutualfunds/index.html • This Web site provides information on the top 25 mutual funds in the United States as well as several foreign countries Return and Risk of a Mutual Fund (cont’d) • Tradeoff between expected return and risk of stock funds – Conservative—stock index fund • Limited return and risk – Moderate—growth stock fund • Moderate return and risk – High risk—growth stock fund in one sector • High return and risk Return and Risk of a Mutual Fund (cont’d) Return and Risk of a Mutual Fund (cont’d) • Risk from investing in a bond mutual fund – Interest rate risk: for a bond mutual fund, its susceptibility to interest rate movements – Longer-term bonds most sensitive – Must also consider default risk – Bond funds can have either interest rate risk, default risk, or both Return and Risk of a Mutual Fund (cont’d) Return and Risk of a Mutual Fund (cont’d) • Tradeoff between expected return and risk of bond funds – Conservative—short-term Treasury bond fund • No default risk and limited interest rate risk • Low return – Moderate—Ginnie Mae bond fund • Slight default risk and moderate interest rate risk • Moderate return – High risk—junk bond fund • High default risk and high interest rate risk • Potentially high return Return and Risk of a Mutual Fund (cont’d) Selecting Mutual Funds • Determining your preferred characteristics of a mutual fund – Minimum initial investment – Investment objective (type of fund) – Investment company • Reviewing a mutual fund’s prospectus – Prospectus: a document that provides financial information about a mutual fund, including expenses and past performance Selecting Mutual Funds (cont’d) – Investment objective: in a prospectus, a brief statement about the general goal of the mutual fund – Investment strategy: in a prospectus, a summary of the types of securities that are purchased by the mutual fund in order to achieve its objective – Past performance—1 year, 3 years, 5 years Selecting Mutual Funds (cont’d) – Fees and Expenses • • • • Maximum load Redemption fee or back-end load Expenses, including management fees Expense ratio – Risk – Distribution of dividends and capital gains Selecting Mutual Funds (cont’d) – Minimum investment and minimum balance – How to buy or redeem shares • Making the decision – Narrow down your choices to a small number and use a table for comparison • Consider the following tables comparing 4 stock funds and 4 bond funds Selecting Mutual Funds (cont’d) With $1,000 to invest in a stock mutual fund: Internet Fund Load Status #1 No-load #2 No-load #3 No-load #4 3% load Recent Annual Expense Ratio Performance 1.50% 13% 0.80% 12% 2.00% 14% 1.70% 11% With $1,000 to invest in a bond mutual fund: High-Yield Bond Funds #1 #2 #3 #4 Load Status 4% load No-load No-load No-load Typical Terms to Expense Ratio Maturity 1.00% 6 - 8 years 0.90% 15 - 20 years 0.80% 5 - 7 years 1.20% 5 - 7 years Financial Planning Online: Mutual Fund Reports • Go to: http://moneycentral.msn.com/home.asp • Click on: Fund Research • This Web site provides a report for a mutual fund you specify. This report allows you to review key character-istics about the fund, including its performance and expenses Quotations of Mutual Funds • Quotations available from financial publications – Open-end funds • Column 1—Investment company in bold type with funds listed beneath • Column 2—NAV • Column 3—Net change in NAV • Column 4—Return year to date Quotations of Mutual Funds (cont’d) Quotations of Mutual Funds (cont’d) – Closed-end funds listed on the exchanges where they are traded • • • • • • Column 1—Fund name and symbol Column 2—Exchange where traded Column 3—NAV Column 4—Market price Column 5—Premium or discount Column 6—Return over the last year Exhibit 17.7 Example of Closed-End Fund Price Quotations INSERT EXHIBIT 17.7 HERE Quotations of Mutual Funds (cont’d) – Lipper indexes are useful for assessing the recent performance of a particular fund or funds with a specific objective • • • • Column 1—Type of index Column 2—Preliminary closing Column 3—Percent change from previous day Column 4—Percent change from previous week • Column 5—Percent change since December 31 Financial Planning Online: Online Services by Mutual Funds • Go to: https://personal.vanguard.com • This Web site provides Vanguard history, philosophy and news information about investing, research on Funds and Stocks, Account types and Services, Opening an Account, Planning, and Education, Daily Fund Quotes, articles, brochures, and online tools to help users with investment planning Diversification Among Mutual Funds • Diversify among several types of funds to lower risk • Best strategy is to diversify across stock and bond mutual funds • Can also diversify among mutual funds representing different countries Diversification Among Mutual Funds (cont’d) • Diversification through mutual fund supermarkets: an arrangement offered by some brokerage firms that enables investors to diversify among various mutual funds and to receive a summary consolidated statement for these funds Diversification Among Mutual Funds (cont’d) Financial Planning Online: Diversifying among Mutual Funds • Go to: http://www.mfea.com • Click on: Allocate Your Assets • This Web site provides suggested asset allocation models that fit your financial situation and your degree of risk tolerance Diversification Among Mutual Funds (cont’d) • Impact of the Credit Crisis – Diversification among different types of mutual funds had limited effectiveness during 2008-2009 – Most stock mutual funds performed poorly – Mutual funds containing Treasury bonds performed well – Other bond mutual funds performed poorly How Mutual Funds Fit within Your Financial Plan • Key decisions about mutual funds for your financial plan are: – Should you consider investing in mutual funds? – What types of mutual funds would you invest in? 
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