Mutual fund investment primer Alan Palmiter Ahmed Taha

Mutual fund investment primer Alan Palmiter Ahmed Taha © 2008

What is a mutual fund?

Investors Owners Board Fund Fund Management Company services Investment Adviser Distribution Company

Source: Bogle / Federal Reserve Flow of Funds Accounts

A pop quiz …

1. Mutual funds are primarily owned by: a. Individuals on their own (through fund group, broker) b. Individuals with retirement accounts (401(k), IRA) 2. Mutual funds mostly invest in: a. Stocks b. Bonds c. Notes (money market) 3. What have been annual returns on stock funds (last 20 years: 1987 -2007): a. b. c. d. 17. 8% 11. 8% 9. 3% 4. Warren Buffet predicts that annual stock returns over the next 10 years will be: a. b. c. d. 6. 5% 9. 6% 12. 3% 21. 7% 5. Past performance of stock funds generally predicts future returns. a. Yes b. No c. Only low-performing funds 6. Mutual fund investors say they pay attention more to fees than to performance. a. True b. False

7. As a mutual fund investor, you are entitled to: a. Prospectus (before you invest) b. Annual report (showing fund performance) c. Statements (showing breakdown of expenses / fees / trading costs) 8. Mutual funds only impose a sales charge at the time you invest. a. True b. False 10. What is a no-load fund? a. b. c. d. An unleveraged fund A fund without sales charges A fund without trading costs A fund without withdrawal fees 11. Think about your own largest mutual fund: a. Your current balance b. Fund’s investment objectives c. Fund’s sales charges, expense ratio, trading costs d. Fund’s performance last year 9. Rate that average stock fund sells and replaces stock (“turnover”) in 12. Consider your car/vehicle: its portfolio: a. b. c. d. 6% 56% 90% 153% a. Its make, model, year b. Its cost, total miles, safety rating, gas efficiency c. You get our point.

1. Mutual funds are primarily owned by: a. Individuals on their own (through fund group, broker) b. Individuals with retirement accounts (401(k), IRA) 2. Mutual funds mostly invest in: a. Stocks b. Bonds c. Notes (money market) 3. What have been annual returns on stock funds (last 20 years: 1987 -2007): a. b. c. d. 4. Warren Buffet predicts that annual stock returns over the next 10 years will be: a. b. c. d. 6. 5% 9. 6% 12. 3% 21. 7% 5. Past performance of stock funds generally predicts future returns. a. Yes b. No c. Only low-performing funds 17. 8% 6. Mutual fund investors say they 11. 8% [stock market] pay attention more to fees than 9. 3% [average fund] to performance. 4. 3% [average fund investor] a. True b. False

7. As a mutual fund investor, you are entitled to: a. Prospectus (before you invest) b. Annual report (showing fund performance) c. Statements (showing breakdown of expenses / fees / trading costs) 8. Mutual funds only impose a sales charge at the time you invest. a. True b. False 10. What is a no-load fund? a. b. c. d. An unleveraged fund A fund without sales charges A fund without trading costs A fund without withdrawal fees 11. Think about your own largest mutual fund: a. Your current balance b. Fund’s investment objectives c. Fund’s sales charges, expense ratio, trading costs d. Fund’s performance last year 9. Rate that average stock fund sells and replaces stock (“turnover”) in 12. Consider your car/vehicle: its portfolio: a. b. c. d. 6% 56% 90% 153% a. Its make, model, year b. Its cost, total miles, safety rating, gas efficiency c. You get our point.

Who is average mutual fund investor?

• Knowledge of basic fund characteristics – Asset class? – Fund risk? – Fund expenses? • Investment acumen: relevance of past returns – Morningstar ***** – Asset classes?

US Households (112 million) 55 million own mutual funds (90% have Internet access) Own fund on own 49% 79% (broker) Retirement account 51% 29% (direct) 48% (IRAs) 52% (DC plans) Mutual funds ($10. 5 T) Stocks 40% Bonds 20% Money Mkt 40%

A graphical look at business model …

$93, 304 $59, 034 $22, 852

Investor profiles according to … (1) Industry (2) SEC (3) Finance literature

ICI Investor Preferences (2006)

William O. Douglas: ”The investors’ advocate”

Prospectus • VFINX Disseminated – after investment / then once annually – Including electronically / filed SEC • Disclosure – – Investment strategies Risks (narrative) Performance (1/5/10 years) Expenses (sales charge, 12 b-1 fees, mgmt fees) – Turnover rate • Effect – Omissions in fund literature not fraudulent, if info in prospectus Fund comparer (SEC website / NASD)

Statement of Additional Information • Not disseminated – Available to investors (incorporated by ref into prospectus) / file SEC – No fraud liability if in SAI • Disclosure – – – • Fund organization Investment policies / limitations Management of fund Proxy voting policies Financial statements Can cover multiple funds Only place that discloses trading costs (commissions)

Annual and semi-annual statements • Disseminated – Send semi-annually to all investors – Available on SEC website Focus of statement Is on performance, not expenses/costs • Disclosure – Annually, MDFP (what’s affecting performance, line graph comparison to relevant index) – Financials (including expenses, turnover rate) – List of portfolio holdings (now summary of significant holdings, chart of category breakdown)

Advertising • Regulated – SEC Rule 482 – must state where can get prospectus – NASD Rule 2210 – must file with Advertising Reg Dept No longer does ad info have to come from prospectus • Disclosure – Can include performance data (standardized format) – Info beyond prospectus • Required disclaimer – “Consider investment objectives, risks, charges, expenses” – “Past performance does not guarantee future results”

Investors’ Cognitive Biases • Representativeness heuristic • Endowment effect • Anchoring heuristic • Affect heuristic Definition: People believe that experience is representative of reality (“past is prologue”) Implications: • You believe a fund’s historical returns will continue – you “buy high and sell law” • You pour money into the latest “hot funds” Reality: Little evidence that returns are persistent for high-performing mutual funds (see)

Investors’ Cognitive Biases • Representativeness heuristic Definition: People value something more when they already own it • Endowment effect Implication: You believe your funds are better than funds you don’t own. • Anchoring heuristic • Affect heuristic Reality: • Investors overestimate their funds’ returns • Investors exhibit brand fund loyalty (staying in poorperforming funds).

Investors’ Cognitive Biases • Representativeness heuristic • Endowment effect • Anchoring heuristic • Affect heuristic Definition: People rely on “anchor values” in making number estimates Implication: You pay attention to fund advertising with “big numbers” (distorting your riskreturn perceptions) Reality: Just changing fund name affects investors’ estimates of expected returns “Euro Star 100 fund” = 11. 8% “Euro Star 500 fund” = 22. 6%

Investors’ Cognitive Biases • Representativeness heuristic • Endowment effect • Anchoring heuristic • Affect heuristic Definition: People’s current affect (e. g. , fear, pleasure) influences their decisions Implication: You are influenced by nice images of the future and lavish investment dinners Reality: Ads evoking positive emotions cause investors to not consider risk

A proposal … (1) Point of sale (2) Statements (3) Confirmations

Asset returns / risk (1926 -2004) Average Return Standard Deviation Small Company Stocks 12. 7% 33. 1% Large Company Stocks 10. 4% 20. 3% Long-Term Corporate Bonds 5. 4% 9. 3% Treasury Bills 3. 7% 3. 1%

Fund XYZ performance 1 -year 5 -years 10 -years 20 -years Inv return 4. 5% 7. 6% 11. 5% 8. 9% Expenses/costs 2. 1% 2. 4% 1. 9% 1. 6% Net return 2. 4% 5. 2% 9. 6% 7. 3%

Your statement (Fund XYZ) Beginning balance Investments Withdrawals Investment return Expenses Sales charge Adm/advisory fees Trading costs TOTAL Net return Ending balance Your fund has about average expenses, but 40% of other similar funds have lower expenses. $10, 000 $ 2, 000 $ -$ 850 7. 7% $ $ 60 140 80 280 0. 5% 1. 3% 0. 7% 2. 5% $ 570 $12, 570 5. 2% You could be saving up to 2. 2% on fund expenses. Expenses (compare to other comparable funds) 66% - lower expenses 0. 3% 34% - higher expenses 2. 5% XYZ 6. 3%

The end