Investing in
Mutual Funds
Topic 11
A. Pooled Diversification
1. Professional Money Managers
 2. Combines the Funds of many people
with similar investment goals
 3. Receive shares of stock in the
mutual fund; a pooled common
investment.
 4. An indirect investment

B. Attractions and Drawbacks of
Mutual Fund Ownership
1.
 2.
 3.
 4.

•
•
•
•
Diversification
Full-time Professional Management
Modest Capital Investment
Services offered
a.
b.
c.
d.
Automatic reinvestment of dividends
Withdrawal plans
Exchange privileges
Check writing privileges
B. Attractions and Drawbacks of
Mutual Fund Ownership

5. Convenience
• a. Easy to acquire
• b. Paperwork and record keeping
• c. Prices are widely quoted

6. Lack of liquidity
• a. Normally must be sold back to the fund
• b. No brokerage commissions

7. Consistently average to below
average performance
C. Essential Characteristics

1. Open-end Funds
• a. Investors buy and sell shares back to
the fund itself
• b. There is no limit on the number of
shares the fund can issue
• c. NET ASSET VALUE (NAV)
– Defined as the total market value of all
securities held by the fund less liabilities,
divided by the number of fund shares
outstanding.
Net Asset Value Example

Example: NAV
• XYZ Mutual Fund owns assets totaling
$10M and liabilities equal to $500,000 with
500,000 shares outstanding
• Therefore, NAV is:
$10,000,000 - $500,000 / 500,000
$19/share
C. Essential Characteristics
(continued)

2. Closed-end Funds
• a. A fixed number of shares outstanding
• b. 100 Closed-end funds
• c. $8 billion market value

3. Investment Trusts
• a. Interest is an unmanaged pool of
investments
• b. Usually consist of corporate,
government, or municipal bonds
C. Essential Characteristics
(continued)

4. Load or No Load
• a. Load Fund
– Charges a commission when shares are
bought (7 - 8 1/2% or more)
• b. No Load Fund
– No sales charges are levied

5. Other fees and Costs
• a. Professional Management Fee
– .25 to 1.75 percent of the average dollar
amount of assets under management
D. Types of Funds (Equity)

1. Growth
• Goal is capital appreciation

2. Maximum Growth
• Highly speculative, seeking large profits
from capital gains
– a. Often buy stocks of small, unseasoned
companies
– b. Highly speculative
D. Types of Funds (continued)

3. Income
• CURRENT income is main objective
– a. Interest income
– b. Dividend income

4. Balanced Funds
• Objective is to earn both capital gains and
current income
– a. High-grade common stocks (60 - 75%)
– b. Fixed income securities (25 - 40%)
D. Types of Funds (continued)

5. Small Company
• Invest in small companies that usually
have sales of $100 million or less.
6. International
• Can invest in one region or area of the
world
• Can invest in specific country
D. Types of Funds (continued)

Bond Funds
• Objective is to invest in bonds
– a. Income is primary objective
– b. Two advantages
• Liquidity
• Diversification
D. Types of Funds (continued)

6. Money Market Funds
• Offers the individual investor access to
high-yielding money market instruments
without having to pay $100,000
denominations
– a. Bank CD’s
– b. Treasury Bills
– c. Commercial Paper
D. Types of Funds (continued)

7. Dual Funds
• Closed-end Funds with two types of shares
– a. INCOME shares (Senior) which receive two
times income as Junior
– b. CAPITAL shares (Junior) which receive two
times the capital gains as Senior
D. Types of Funds (continued)

8. Specialty Funds - Single Industry
•
•
•
•
•
•
•
•
a. Option trading
b. Commodity funds
c. Oil drilling
d. Cattle funds
e. Electronics
f. Gold
g. Chemicals
h. Health
E. Special Services

1. Saving Plans
• Investor adds funds on a regular basis

2. Automatic Reinvestment Plans
• Dividends and capital gains are reinvested
in additional shares

3. Regular Income
• Through withdrawal plans, the investor can
receive periodic repayment or income
– Shares or Dollars
E. Special Services (continued)

4. Conversion Privileges
• Allows the investor the right to switch from
one fund to another
– a. Must confine switches within the same family
of funds
– b. Usually no transfer charges
E. Special Services (continued)

5. Check Writing Privileges
• a. Shareholders have the right to write
checks drawn on the Mutual Fund account
• b. Normally checks must be written for at
least $500
• c. Almost all Money Funds have this
privilege
F. Risk

p
Because Mutual Funds are so well
diversified (typically), the inherent risk is
similar to that in the Market
Systematic  Market

5
30
Assets
However, Specialty Fund risk can vary
significantly from overall Market risk
Analyzing Mutual Funds
Assessment of your risk tolerance
 Importance of diversification
 Should hold six mutual funds
 Should be able to earn 16% plus with a
beta equivalent to 1.0 or slightly less

Mutual Fund Analysis:
Style Analysis: Style analysis identifies
the process of investing by fund
managers that leads them to pick
certain kinds of securities.
 Three factors of style analysis:

• Growth
• Value
• Company Size
Mutual Fund Analysis:
Growth Managers buy stocks in
companies whose earnings are growing
rapidly.
 Value Managers are bargain hunters
seeking stocks with low prices
compared to intrinsic value.
 Company Size Managers specialize in
small companies or large cos.

Mutual Fund Style Analysis:
Style determines 85-90% of a fund
portfolio’s return.
 The technique looks at the way funds
perform on a monthly basis against one
of 12 different indexes. The mix of
indexes that are most highly correlated
determines the style of the mutual fund
manager.

Mutual Fund Style Analysis:

The mutual fund universe can be
divided into six basic styles:
•
•
•
•
•
•
Small cap growth funds
Large cap growth funds
Small cap value
Large cap value
Foreign funds
Fixed income funds
Mutual Fund Style Analysis:

Source of Information:
Advisor Software
Style Data
1-800-738-6369
http://www.advisorsw.com
Mutual Fund Annual Reports



Two Reports a Year: Mutual funds typically issue two financial
reports a year - the semiannual report, which is often dated June
30 or April 30, and the year-end or annual report, which is often
dated December 31 or October 31.
Shareholder Letter: A shareholder letter is usually written by
the fund’s president or investment manager and reviews the
fund’s investment objectives and performance for the current
period.
Top 10: By looking at a mutual fund’s top 10 holdings, you will
get a sense of the type of investments in the portfolio and the
degree to which the fund meets your investment objectives.
Similarly, study the industry composition of the portfolio - the
percent of the fund’s asset that is invested in a particular
industry.
Mutual Fund Annual Reports



Investment Portfolio: An investment portfolio comprises the
assets (securities) held within a mutual fund.
Portfolio Turnover: Portfolio turnover is the percentage of the
portfolio’s investment that are bought and sold in one year. A
fund with a portfolio turnover rate of 100 percent means they
effectively bought and sold every security in the portfolio. High
portfolio turnover increases transaction expenses and often
reduces your rate of return.
Charts and Graphs: Many mutual fund reports include charts
and graphs. A line graph may compare the growth of a $10,000
investment in the fund to the growth of similar investments over
five years, ten years, or over the life of the fund. Pie charts are
used to show the % of each type of investment in the fund: C.S.,
bonds, and cash.
Mutual Fund Annual Reports


Portfolio: Some mutual fund financial reports include a more
in-depth discussion of the fund’s performance for the period than
the shareholder’s letter.
Statement of Assets and Liabilities: A mutual fund’s
statement of assets and liabilities reflects the fund’s financial
position at the stock or bond market’s close on the date of the
report. Assets typically include investments that are valued at
market on the financial statement date. Other assets include
collateral held for securities loaned and receivables. Two
examples are dividends and interest income receivable, which
represent income earned by the fund but not yet collected in
cash. Liabilities primarily represent amounts the fund owes for
the purchase of new securities.
Mutual Fund Annual Reports


Footnotes to the Financial Statements: Mutual fund financial
reports include footnotes similar to those found in other annual
reports. Footnotes include significant accounting policies, and
related party and affiliate transactions.
Significant Accounting Policies: Related party and affiliate
transactions typically include three types of transactions. The
first occurs when payment of fees is made to portfolio managers
and financial advisors. The second occurs when a mutual fund
accumulates an ownership stake of a least 5% of the company.
The third occurs when one mutual fund sells some of its
investments to another mutual fund sponsored by the same
mutual fund family.
Deadly Mutual Fund Myths - The
Conventional Wisdom Myth

1. The Conventional Wisdom Myth
• This is the number one mistake most
investors make. Investors look at historic
trends reported by Forbes, Kiplinger’s
Business Week and others tend to
recommend funds that have already made
big gains rather than identify funds that are
positioned to make profits in the future.
The Diversification Myth

2. If you own at least 10 different
mutual funds you’ll have a diversified
portfolio.
• Owning 10 mutual funds won’t assure you
of anything but a lot of work trying to stay
on top of them all. In fact, you can have a
well diversified portfolio with just 4 to 6
funds or you can have a portfolio of 15
funds with very little diversification.
The Momentum Myth

3. The easiest way to beat the market
is to buy last year’s top-performing
funds.
• The fact is that last year’s best funds are
just as likely to be this year’s dogs. Blindly
following this strategy is very dangerous for
most investors. The very top-performing
funds are usually those that took a lot of
risk and happened to bet on the right
market sector at the right time.
The Five-Star Myth

4. The best funds to buy are those
rated 4 or 5 Stars by Morningstar.
• The star system tells you which funds were
good, not which ones will be good. Even
Morningstar will tell you that their ratings
are a measure of past (risk-adjusted)
performance, not the potential for future
profits. Relying on statistical ratings is no
substitute for a thorough examination and
analysis of what a fund is doing today.
The Market Timing Myth

5. The safest strategy is to move
everything into money market funds
when the market is declining and switch
everything back into stock funds when
the market is rising.
• This is a loser’s game. It has been proven
over and over that investors are incapable
of timing the market or identifying major
bull or bear markets.
The Long-Term Performance Myth

6. The best measure of a fund’s quality
is its long-term performance.
• There is a fair amount of truth to this
statement, but too many investors follow
some broker’s advice to “buy this fund, it
has a great 10-year record,” without asking
some key questions. Who earned that
record? Is the manager responsible for its
returns still at the helm? If not, the record
could be meaningless.
The New fund Myth

7. You should wait until a fund has at
least a 3-year track record before
investing.
• The fact is that brand new funds often enjoy
superior gains. New funds from top fund families
often show explosive gains in their rookie year.
Montgomery Small Cap was up 98.8% in 1991,
Oakmark was up 48.9% in 1992, DFA Pacific Rim
Small Company was up 92.6% in 1993, and Janus
Olympus was up 30% the first 9 months of 1996.