Planning Your Financial Future, 4eby: Boone, Kurtz & Hearth

Mutual Funds

Chapter 14

2

Understanding Mutual Funds

A pool of money from numerous investors used to invest in a portfolio of securities—managed by a professional portfolio manager

When you own shares in a mutual fund, you own a small part of the portfolio

Distributions of interest income, dividend income and capital gain/losses occur to investor in terms of the proportion of the total number of mutual fund shares owned

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Understanding Mutual Funds

There are over 8,000 mutual funds today Compared to about 600 in 1980

The net assets of mutual funds is about $7.5 trillion

Why are they so popular? Bull market for stocks and bonds Growth of self-directed retirement plans

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Figure 14.1: Growth of Mutual Funds

Source: Based on data from the Investment Company Institute.

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How a Mutual Fund Operates

A mutual fund raises money by selling shares of the fund to the investing public

The funds are used to purchase assets such as stocks, bonds, money market securities, etc.

The shareholder of the mutual fund is said to indirectly own the assets held by the mutual fund

AKA open-ended investment companies Constantly issues new shares and redeems

existing shares

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How a Mutual Fund Operates

The fund’s NET ASSET VALUE represents The market value of the fund’s assets,

less any liabilities, divided by the number of shares outstanding

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How To Buy Mutual Fund Shares

Can purchase either Through your stockbroker or Directly from the mutual fund

Check the fund’s Web site

Review the fund’s prospectus States the fund’s investment objectives, types

of securities it can purchase, fees, recent performance

Send in your application along with a check

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Services Offered

Automatic reinvestment of distributions Effectively increases the number of shares you

ownAutomatic investment plans

Can be as little as $50 a monthExchange privileges

Transfer within fund family Check writing

Mostly money market funds (and a few others) allow minimum checks ($500+ each)

Doesn’t replace a regular checking account

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Regulation and Taxation

Regulated by SEC Must present certain types of information in

prospectus and other reports Limits types of advertising

If mutual fund retains investment profit, it must pay taxes on it; therefore, most mutual funds distribute the gains to shareholders Shareholders must report these distributions

for tax purposes, as well as any gain/loss on redemption of shares

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Where to Get Mutual Fund Information

InternetMoney’s February issue is heavily

devoted to mutual funds The Wall Street Journal publishes a

mutual fund section regularly

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Classifying Mutual Funds

Can be classified based on Investment objectives Investment style Types of securities owned by fund

Stocks Bonds (or income) Hybrid (balanced) Money market

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Figure 14.2: Distribution of Mutual Fund Assets

Source: Based on data from the Investment Company Institute.

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Classifying Mutual Funds

Common subcategories for stock funds Aggressive growth Growth and income Long-term growth Small-company growth International

Common subcategories for bond funds Government High-yield corporate (junk bonds) Investment-grade corporate World income Mortgage-backed securities Municipal bond

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Classifying Mutual Funds

Common subcategories for money market funds Government Taxable Tax-exempt

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Mutual Fund ‘Styles’

Even mutual funds that fall into the same subcategory can have different management styles One fund may try to achieve growth by

investing in stocks with potential for strong earnings growth; whereas

Another fund may try to achieve same objective by selecting stocks it currently believes to be currently undervalued in the market

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Different Fund Types

Some fairly new fund types Asset allocation funds

Invest in a mixture of stocks, bonds, and money market instruments, shifting allocation of money in an attempt to gain high returns with low risk

Index funds Attempt to replicate performance of a major stock index

(most popular is S&P 500) Why are these so appealing?

Very low fees (not that much management to be done) Most mutual fund managers can’t consistently outperform

the market Sector funds

Invest only in one industry

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Advantages of Mutual Funds

Diversification Can increase your return without

increasing your risk (or may even reduce your risk) But doesn’t eliminate risk!

Not all mutual funds are diversified—they’re not meant to be

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Advantages of Mutual Funds

Smaller minimum investments Can purchase a piece of a well-diversified

portfolio for a relatively small investment Money market mutual funds minimum

investment $1,000 Stock and bond mutual funds minimum

investment $1,000–$3,000 (less for IRAs) Additional investments can be as little as $50–$100 Many funds offer automatic investment plans that

require initial investments of as little as $50

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Advantages of Mutual Funds

Professional management Do all mutual funds always beat the

market? Over the past 10 years, stock funds have

had an average annual return about 1.5% less than the S&P 500 (9% vs. 10.5%)

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Picking the Right Mutual Funds

Step 1: Choose your investment goals and assess your risk/return position You can then identify the types (group)

of mutual funds that meet your criteria

Step 2: Assess the fees and performance of the mutual funds

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Fees and Expenses

Several types of fees Load charges: fees associated with either

buying or redeeming mutual fund shares Front-end – paid when shares are purchased

Cannot exceed 8.5% Example: You deposit $1000 in a fund with a 2% front-

end load—only $980 goes toward purchase of shares, the remaining $20 is a fee

Most funds use front-end loads with very few actually charging the maximum 8.5%

Redemption fee (back-end load) – paid when shares are sold

Often depends on how long the shares were owned—with a lower fee charged for a longer holding period

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Fees and Expenses

Trend is toward low front-end loads or no-loads No charges associated with buying or selling the mutual

fund

Over half of all mutual funds are no-load Annual operating expenses

Includes fees paid to portfolio manager, transaction costs, printing costs

Paid from investment income before it is distributed Average is about 1.5% for stock funds; 1.1% for bond funds

12b-1 fees Pays for distribution costs (such as advertising) in lieu of a

load charge

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Fees and Expenses

Evaluating fees and expenses Not all funds charge the same operating fee %

—shop around Can range from 0.1% to 2.5+% Fees and expenses can have a dramatic impact

on the value of your investment over time No definitive evidence shows that funds

charging higher fees earn higher returns Everything else being equal, you’re better off buying

a no-load fund with low operating costs

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Performance

Need to examine absolute performance AND relative performance as well as risk

When comparing fund to a benchmark, choose the right benchmark

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The Relationship Between Past and Future Performance

Some funds beat the market some years and not others Should we try to predict which funds will beat

the averages next year (or during the next 5 years) or not? Randomly choosing funds will probably lead to the

same results according to some people Others argue that superior funds may

underperform some years, but over the long run produce superior returns

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The Relationship Between Past and Future Performance

Results are mixedConclusion

Don’t chase returns—the fees are too great and your results probably won’t be stellar

Past performance in NO WAY GUARANTEES FUTURE PERFORMANCE

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Performance and Taxes

Mutual funds pass investment income and realized capital gains to shareholders, so taxes must be paid on these distributions

The more distributions paid to you, the more taxes you’ll pay

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When Not to Buy Mutual Fund Shares

Most mutual funds have regularly scheduled distribution dates

For tax purposes, you shouldn’t buy shares in a mutual fund right before a distribution You’d owe taxes on that immediate

distribution

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What About Index Funds

Designed to track performance of a broad stock or bond market index Most popular track the S&P500

Number of index funds has grown rapidly

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Making Changes to Your Mutual Fund Investments

Will your goals remain the same for the next 30–40 years? No—the mix of your investments will

need to change over time

You’ll also need to rebalance over time Adjusting investments periodically to

return to the target asset allocation

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When to Sell a Mutual Fund

One reason many people sell shares is due to poor performance BUT, selling shares based on poor short-term

performance may be a bad idea Are you chasing past returns?

This rarely produces superior returns over the long run

Even the best funds have poor performance at times

If you have a good fund, keep it even if it offers poor short-term performance

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When to Sell a Mutual Fund

There are viable reasons for selling a fund Performance lags behind the

benchmarks for an extended time period (three years or so)

Fund gets very large very fast Expenses keep rising

Fund is trying to capitalize on its popularity Management turnover