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Chapter 14

Mutual Funds: An Easy Way to

Diversify

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Learning Objectives

1. Weigh the advantages and disadvantages of investing in mutual funds.

2. Differentiate between types of mutual funds, ETFs, and investment trusts.

3. Calculate mutual fund returns.

4. Classify mutual funds according to objectives.

5. Select a mutual fund that’s right for you.

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Introduction

• A way of holding investments such as stocks and bonds.

• Mutual fund—an 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.

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Why Invest in Mutual Funds?

• Advantages of mutual funds:

– Diversification

– Professional management

– Minimal transaction costs

– Liquidity

– Flexibility

– Service

– Avoidance of bad brokers

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Why Invest in Mutual Funds?

• Disadvantages of mutual funds:

– Lower-than-market performance

– Costs

– Risks

– You can’t diversity away a market crash

– Taxes

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Mutual Fund-Amentals

• A mutual fund pools money from investors with similar financial goals.

• You are investing in a diversified portfolio that’s professionally managed according to set goals.

• Investment objectives are clearly stated.

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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.

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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.

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Investment Companies

• Invest the pooled money of a number of investors in return for a fee

• Most popular are the open-end investment companies or mutual funds

• Net asset value (NAV)—dollar value of a share in the mutual fund

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Investment Companies

• Closed-End Investment Companies—can’t issue new shares

• Unit Investment Trusts—fixed pool of securities

• Real Estate Investment Trusts (REITs)—specializes in real estate

• Hedge Funds—very risky

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Calculating Mutual Fund Costs and Returns

• Commissions when you buy or sell your holdings

• Annual management fee

• Marketing expenses

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Load Versus No-Load Funds

• Load—commission charged on a mutual fund

• Load fund—mutual 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 fund—doesn’t charge commission

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Management Fees and Expenses

• Expense ratio—the ratio of a mutual fund’s expenses to its total assets

• Invest in a fund with a low expense ratio

• Turnover rate—measures the level of the fund’s trading activity.

• Higher turnover rate, higher the fund’s expenses.

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12b-1 Fees

• Annual fee, generally ranging from 0.25 to 1% of a fund’s assets, that the mutual fund charges its shareholders for marketing costs.

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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.

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Calculating Mutual Fund Returns

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Types and Objectives of Mutual Funds

• Fund managers classify their own funds

• First, determine your objectives

• Then, you can likely find a mutual fund to meet your objectives

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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

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Stock Mutual Funds

• Aggressive growth funds

• Small company growth funds

• Growth funds

• Growth-and-income funds

• Sector funds

• Index funds

• International funds

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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

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Asset Allocation Funds

• Invests in stocks, bonds, and money market securities

• Move money between stocks and bonds to outperform the market

• Balanced funds that practice market timing

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Life Cycle and Target Retirement Funds

• Mutual funds that try to tailor their holdings to the investor’s individual characteristics, such as age and risk

• Target retirement funds are managed based on when you plan to retire

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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

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U.S. Government Bond Funds or GNMA Bond Funds

• Municipal Bond Funds

• Corporate Bond Funds

• Bond Funds and Their Maturities:

– Short-term (1-5 years)

– Intermediate-term (5-10 years)

– Long-term (10-30 years)

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Exchange Traded Funds or ETFs

• 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.

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Exchange Traded Funds or ETFs

• 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 market’s trading hours.

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Mutual Fund Services

• Automatic investment and withdrawal plans

• Automatic reinvestment of interest, dividends, and capital gains

• Wiring and funds express options

• Online and phone switching

• Easy establishment of retirement plans

• Check writing

• Bookkeeping and help with taxes

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Buying a Mutual Fund

• Step 1: Determining Your Goals

– Goals and time horizon

– Why are you investing?

– Tax-deferred investments?

– Risk tolerance

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Buying a Mutual Fund

• Step 2: Meeting Your Objectives

– Look at classifications and objectives

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Buying a Mutual Fund

• Step 3: Selecting the Fund

– Evaluate past performance and scrutinize the costs

– Make sure it meets your objectives

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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 & Co.

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Summary

• When you buy a mutual fund, you’re buying a share of a very large portfolio which goes up and down as the value of the mutual fund’s investments goes up and down.

• There are open-end and close-end investment companies, unit investment trusts, and real estate investment trusts.

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Summary

• Be very wary of mutual fund expenses—no-load mutual funds don’t charge commission.

• Funds are classified according to objective.

• When selecting a mutual fund, determine your goals, find funds that meet your objectives, and evaluate.