Section 10: Other Investments (Details)
Concepts you’ll learn
1. Mutual Funds
2. Mutual Fund Family
3. Open ended fund
4. Closed ended fund
5. Prospectus
6. Morningstar and Lipper Fund Ratings
7. NAV Value
8. Loads and fees
9. Annuities
10. 529s
11. Coverdell Education Savings Account -- ESAs
12. Tax Deferred Growth and Tax Free Growth
Problems you’ll solve
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Understand
Understand
Understand
Understand
Understand
mutual fund pros and cons
annuity pros and cons
tax advantages of Education IRAs
different types of Education IRAs
the benefits of tax deferred growth
©2014 D. M. Kaufman. All rights reserved
Other Investments – Definitions
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Mutual Fund: A mutual fund is a company that brings together money from many people and invests it in stocks,
bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its
portfolio. Each investor in the fund owns shares, which represent a part of these holdings.
Mutual Fund Family: A group of mutual funds supervised by the same investment company (e.g. Fidelity,
Vanguard, etc.). Funds can be moved easily from one type of fund to another if conditions (market or personal)
dictate a change.
Open Ended Fund: A type of mutual fund that does not have restrictions on the amount of shares the fund will
issue. If demand is high enough, the fund will continue to issue shares no matter how many investors there are.
Open-end funds also buy back shares when investors wish to sell.
Closed Ended Fund: A publicly traded investment company that raises a fixed amount of capital through an initial
public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange. Despite the
name similarities, a closed-end fund has little in common with a conventional or open ended mutual fund.
Prospectus: A formal legal document, which is required by and filed with the Securities and Exchange
Commission, that provides details about an investment offering for sale to the public. A prospectus should contain
the facts that an investor needs to make an informed investment decision. Specifically, a mutual fund prospectus
contains details on its objectives, investment strategies, risks, performance, distribution policy, fees and expenses,
and fund management.
NAV (Net Asset Value): A mutual fund's price per share or exchange-traded fund's (ETF) per-share value. In
both cases, the per-share dollar amount of the fund is derived by dividing the total value of all the securities in its
portfolio, less any liabilities, by the number of fund shares outstanding. In the context of mutual funds, NAV per
share is computed once a day based on the closing market prices of the securities in the fund's portfolio. All mutual
fund’s buy and sell orders are processed at the NAV of the trade date. However, investors must wait until the
following day to get the trade price. Mutual funds pay out virtually all of their income and capital gains. As a
result, changes in NAV are not the best gauge of mutual fund performance, which is best measured by annual total
return. Load: A sales charge or commission charged to an investor when buying or redeeming shares in a mutual
fund. The fee may be a one-time charge at the time the investor buys into the mutual fund (front-end load), when
the investor redeems the mutual fund shares (back-end load), or on an annual basis.
Management Fee: A charge levied by an investment fund for managing an investment fund. The management
fee is intended to compensate the managers for their time and expertise. It can also include other items such as
investor relations expenses and the administration costs of the fund. Management fee structures vary from fund to
fund, but they are typically based on a percentage of assets under management. For example, a mutual fund’s
management fee could be stated as 0.5% of assets under management.
Annuity: A financial product sold by financial institutions that is designed to accept and grow funds from an
individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time.
Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement
years.
529 Plan: A plan that allows for the prepayment of qualified higher education expenses at eligible educational
institutions.
Coverdell Education Savings Account (Coverdell ESAs): A type of tax-deferred trust account created by the
U.S. government to assist families in funding educational expenses for beneficiaries 18 years or younger. While
more than one ESA can be set up for a single beneficiary, the total maximum contribution per year for any single
beneficiary is $2,000.
Types of Mutual Funds
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Mutual funds can invest in any and all asset classes, in any nation or
region of the world
Value
Large
Blend
Growth
Bonds, Cash,
“blue chip”
stocks
Mid
Small
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Highest
Risk
Stocks
Any fund’s strategy (i.e. what assets or securities it trades, how it’s
managed, etc.) will be detailed in its prospectus. The fund will not be
able to deviate from the prospectus in any way as governed by federal
law.
Funds are rated by two independent organizations: Morningstar and
Lipper. The higher the rating, the better managed the fund is thought
to be (with respect to performance, fees, management, etc.) vs. funds
following a similar prospectus.
Researching and Investing in Mutual Funds
Most of the large mutual fund families will have a similar research tool available
(we’ll go through some usage examples)
Researching and Investing in Mutual Funds (cont.)
As you drill down into individual funds, you find information similar to that for
individual stocks (we’ll find even more details online). The NAV is the price you
pay per full share, but you can buy fractional shares to invest a set dollar amount.
An Interesting Note
• Remember the definition of a NAV?
– “...Mutual funds pay out virtually all of their income and capital gains. As a
result, changes in NAV are not the best gauge of mutual fund performance,
which is best measured by annual total return.”
• Egad. What the hell does that really mean?
• It means that increases in the NAV don’t reflect the total
return or performance of a mutual fund. Why...?
• Because every time a fund trades an asset, any profits
must be distributed to the investors’ accounts.
Sometimes this distribution affects the NAV, but at other
times it results in the distribution of additional shares to
account holders.
• Remember the very first section on taxes? Specifically
on capital gains?
– If you buy an individual stock, and it goes up, but you don’t sell it, you
don’t have to pay taxes on the unrealized gain. But...
– Profit distributions from mutual funds are taxable events. Hold that
thought ‘till the end of this section.
Annuities
• Annuities can be fiendishly complex, with a ton of
fine print, but here’s how they work at the highest
level:
1. You, as a purchaser of an annuity, pay either a lump sum or a
series of payments to an insurance company
• Accumulation period could be for one year or less (immediate annuity)
• Accumulation period could be for much longer than one year (deferred
annuity)
2. After an accumulation period, the insurance company makes
regular payments to you for a prescribed period of time.
• Could be for a set number of years
• Could be for the rest of your life
• Could be for the rest of you and your spouse’s life – whoever lives
longest
• Could include a minimum death benefit for your heirs, etc. ad
infinitum
• Annuities are known to carry high fee structures –
insurance companies don’t work for free.
Annuities can be a great tool to guarantee yourself a future income stream, but
beware the fine print, and beware the fees!
Saving for Higher Education
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At a high level, there are three options to create special,
tax sheltered accounts for education savings:
1. Coverdell ESA: You invest money and select investment assets – all assets
are available to you, and you manage your risk level. Your investment
can increase or decrease in value. If it decreases just before you need the
money to pay education expenses, that’s tough luck.
2. 529 Savings Plan: These are similar to the Coverdell ESAs in terms of
flexibility, risk, etc., but sometimes there are state income tax benefits
(varies by state).
3. 529 Pre-Paid Tuition Plan: As the name suggests, these plans cannot lose
value, because investments made in them are really advanced education
payments made at a discount. That is, the further out in time the student
is expected to matriculate, the more the cost of a given year’s tuition will
be discounted from today’s prices. So, pay 50% of the discounted rate for
one year’s tuition today, and you’ll have 50% of one year’s tuition paid for
in the future, no matter how much tuition levels increase during the
intervening time. The big trade-off: money in the plan that isn’t used for
education expenses at a “member” institution will be returned to you with
very little interest earned during the intervening time, and “member”
institutions tend to be limited to public colleges and universities within the
state administering the plan.
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One wrinkle: There is a plan called the Independent 529 Plan. Instead of the
member institutions being public and limited to a particular state, there are
200+ private member colleges and universities. Money invested today can be
used in the future at any member institution.
Saving for Higher Education (cont.)
Saving for Higher Education (cont.)
• A couple extra details regarding the Private College 529 Plan
– Prepaid plan for 200+ private member colleges and universities
– If the student matriculates at a non-member college, the principal investment is
returned along with interest, but the interest is capped at 2% per year.
Tax Deferred and Tax Free Growth
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If you hold a mutual fund in a
regular brokerage account,
you’ll be relegated to the gray
line, because all profit
distributions from mutual funds
are taxed – the compound effect
on your returns is severely
dampened.
Tax deferred growth allows you
to track the green line, but taxes
are paid upon withdrawal,
taking you back down to the
dotted line.
Tax free growth keeps you at
the green line, period.
The good news: money invested
in 529 Savings Plans and
Coverdell ESAs grows tax
deferred and is not taxed upon
withdrawal (provided it’s used
for valid education expenses).
And, note the following:
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The higher rate of return you earn,
the greater the deltas shown in the
chart become
The higher the tax rate, the higher
the deltas
The longer the time period, the
higher the deltas
You’ll hear a lot more about this
concept in the final section on
retirement planning
Section 10: Practice Problems
1. True or false?
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Mutual funds provide a quick easy path to a diversified portfolio
Mutual funds always charge a transaction fee
Mutual funds are a great way to reduce your taxes vs. buying and holding
individual stocks
NAV performance over time isn’t a good indicator of mutual fund
performance over time
Mutual funds can invest in any asset class worldwide as outlined in its
prospectus
Annuities always provide good value
Coverdell ESA and 529 plans always allow the contributor to retain control
of the account
2. Compare and contrast taxable growth, tax deferred
growth, and tax free growth.