Chapter 13 Investing in Mutual Funds Mc GrawHillIrwin

Chapter 13 Investing in Mutual Funds Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Investing in Mutual Funds Chapter Objectives 1. Explain the characteristics of mutual fund investments. 2. Classify mutual funds by investment objective. 3. Evaluate mutual funds. 4. Describe how and why mutual funds are bought and sold. 13 -2

Objective 1 Explain the Characteristics of Mutual Fund Investments • Mutual Fund = an investment vehicle offered by investment companies to those who wish to: – Pool money – Buy stocks, bonds, and other financial securities – Have buy/sell decisions made by a fund manager • Many mutual funds chosen for inclusion in retirement account investments 13 -3

Investment Company • Pools the money of many investors – its shareholders – to invest in a variety of securities • Employs the fund manager who is compensated for selecting securities appropriate to the fund’s stated objective • “Financial Intermediary” 13 -4

Why Investors Purchase Mutual Funds • Professional management – Who is the fund’s manager? – How has the fund performed under the current managers? • Diversification – Investor’s funds are used to purchase a variety of investments – Risk reduction 13 -5

Characteristics of Funds • Closed-end funds – Fixed number of shares – Trade like shares of common stock – Actively managed • Exchange-traded Funds – Invests in securities contained in a specific securities index • Open-end mutual funds – Shares issued and redeemed on demand – Actively managed 13 -6

Closed-End Funds • Fixed number of shares issued when the fund is organized • Shares traded on stock exchanges • Trade price set by supply & demand • Most sell at a discount relative to their net asset value • Discount is sometimes substantial 13 -7

Exchange Traded Funds • Invests to replicate the composition of a specific securities index – Performance mirrors index performance • Low management fees • Trade on exchanges throughout the day like stock – Prices determined by supply and demand • Can be sold short and traded with limit orders 13 -8

Net Asset Value • Net asset value (NAV): – Assets under Management (AUM) • The current market value of the assets held by the fund – Net Assets = AUM - Liabilities • NAV calculated at the close of trading 13 -9

Open-End Funds • Open-end funds ≈ 90% of all funds – Shares issued and redeemed by the investment company at the request of investors – Investors free to buy and sell shares at the net asset value (NAV) 13 -10

Costs: Load Funds vs. No-Load Funds • Load Fund – Sometimes called an “A” fund – Commission (sales charge) up to 8. 5% • Average = 3 to 5% – Paid every time shares purchased – Purchased through brokerage firms or registered representatives • Salespeople prepared to explain the fund and help determine if it meets the investor’s financial goals 13 -11

Costs: Load Funds vs. No-Load Funds • No-Load Fund – No up-front sales charge – No salespeople – Investor deals directly with the investment company via 800 numbers or web sites, or from discount brokers 13 -12

Costs: Load Funds vs. No-Load Funds • Contingent deferred sales charge (CDSC) – “Back-end load” – “B” fund – “Redemption fee” – Charged upon withdrawal of funds (1 -5%) – Generally decreases on a sliding scale depending on the number of years shares are held 13 -13

Costs: Management Fees and Other Charges • Management fee – Charged yearly (. 25%-1. 5% average) based on a percentage of AUM • 12 b-1 fees – Annual fee to defray advertising and marketing costs – Cannot exceed 1% of AUM per year • Expense ratio – Total expenses associated with the management fees and operating costs of the fund 13 -14

Typical Mutual Fund Fees 13 -15

Objective 2 Classify Mutual Funds by Investment Objective 13 -16

Stock Funds 13 -17

Bond Funds 13 -18

Other Funds 13 -19

A Family of Funds • One investment company manages a group of mutual funds – Each fund has a different financial objective – Exchange privileges allow movement from one fund to another within the family with low or no charge • Fidelity Investments – http: //personal. fidelity. com/products/fu nds/mutual_funds_overview. shtml. cvsr 13 -20

Objective 3 Evaluate Mutual Funds Managed Funds vs. Index Funds • Managed fund a fund manager makes all decisions regarding what securities are included in the fund’s portfolio • Index fund securities held by the fund replicate those contained in a specific index like the S&P 500 13 -21

Sources of Fund Information 1. Internet websites provide current values – http: //finance. yahoo. com – www. businessweek. com – www. morningstar. com – www. smartmoney. com 2. Check fund companies’ Internet sites – www. troweprice. com – www. vanguard. com 13 -22

Sources of Fund Information 3. Professional Advisory Services – – – Lipper Analytical Services Morningstar, Inc. Value Line Mutual fund newsletters Available in libraries and from brokerage firms 13 -23

Mutual Fund Prospectus – Fund objective(s) – Statement describing the risk factors – Description of the fund’s past performance – Statement describing the type of investments in the fund’s portfolio – Information about dividends, distributions and taxes – Information about the fund’s management – Information about limitations or requirements for the fund – Procedure to buy or sell shares – Services provided to investors – Turnover ratio of the fund’s investments 13 -24

Other Sources of Fund Information • Mutual fund annual report – Performance, investments, assets & liabilities • Financial Publications – Business Week, Forbes, Kiplinger's Personal Finance and Money – Business Week’s mutual fund survey includes: • Fund’s overall rating compared to all other funds, and to funds in the same category • Fund size, sales charge and expense ratio • Historical returns for the past ten years 13 -25

Objective 4 Describe How and Why Mutual Funds are Bought and Sold The Mechanics of a Mutual Fund Transaction • Open an account: – $250 to $3, 000 and up depending on the fund family and the fund 13 -26

Return on Investment 3 Ways to Make Money on Mutual Funds Income Dividends – Earnings paid from dividend and interest income – Taxed as ordinary income Capital Gains Distribution – Distributions when the fund buys and sells securities – Taxed as long-term gains Capital Gains (or Losses) – Capital gains (or losses) when you sell shares at a price different than price you originally paid – Taxed as short- or long-term gains 13 -27

Purchase Options * * Investor may deal with one company, get one statement, yet have a choice of a wide variety of funds 13 -28

Purchasing Open-End Fund Shares – Regular account transactions • Easiest • Simply buy shares in amount and when desired – Voluntary savings plans • Allows for smaller than usual purchases on a recurring basis – Contractual savings plans • Require regular purchases over a specified period – Reinvestment plans • Automatically reinvests dividends and capital gains in the fund 13 -29

Withdrawal Options • Closed-end funds & exchange-traded funds – Traded on stock exchanges and in the over the counter market – Sold like common stock shares • Open-end fund – Shares sold to the fund sponsoring company 13 -30

Mutual Fund Withdrawal Options 1. Withdraw a fixed dollar amount each period until account exhausted 2. Liquidate or “sell off’ a certain number of shares each period 3. Withdraw a fixed percentage of asset growth; principal untouched 4. Withdraw all income dividends and capital gains distribution; principal untouched 13 -31

END OF CHAPTER 13 13 -32

Additional Video Mutual Fund Awards Business. Week and S&P’s Best Fund Picks (Instructors see the notes section for directions. ) SYNOPIS: Helpful information about how Business. Week and Standard & Poor’s evaluate mutual funds is provided in this video. In addition, specific funds that are highly rated in the Business. Week survey are recommended. 1. Explain why investors still need to evaluate mutual funds when there is a professional manager or team of managers that choose the investments for a mutual fund. 2. What factors did Business. Week and Standard & Poor’s use to evaluate mutual funds? Would these same factors help you evaluate a mutual fund for your investment portfolio? 3. Specific small-cap, technology, and growth funds were described in this video. How would you research one of these funds to determine if the fund could help you obtain your investment goals? 13 -33