Mutual Funds
Chapter 14
Planning Your Financial Future, 4e
by: Boone, Kurtz & Hearth
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
5
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
6
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 own
 Automatic investment plans

Can be as little as $50 a month
 Exchange 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


 If
Must present certain types of information in prospectus
and other reports
Limits types of advertising
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
 Internet
 Money’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 mixed
 Conclusion


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
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