Chapter 13
Investing in
Mutual Funds
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Investing in Mutual Funds
Chapter Learning Objectives
LO13.1
Explain the characteristics of
mutual fund investments.
LO13.2
Classify mutual funds by
investment objective.
LO13.3
Evaluate mutual funds.
LO13.4
Describe how and why mutual
funds are bought and sold.
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Learning Objective LO13.1
Explain the Characteristics of Mutual Fund
Investments
• Mutual Fund = an investment vehicle offered
by investment companies to those who wish
to:
– Pool money
– Buy stocks, bonds, and other financial securities
– Have buy/sell decisions made by a fund manager
• Many mutual funds chosen for inclusion in
retirement account investments
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Investment Company
• Pools the money of many investors –
its shareholders – to invest in a variety
of securities
• Employs the fund manager who is
compensated for selecting securities
appropriate to the fund’s stated
objective
• “Financial Intermediary”
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Why Investors Purchase
Mutual Funds
• Professional management
– Who is the fund’s manager?
– How has the fund performed
under the current managers?
• Diversification
– Investor’s funds are used to purchase a
variety of investments
– Risk reduction
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Advantages and Disadvantages of
Investing in Mutual Funds
13-6
Characteristics of Funds
• Closed-end funds (≈ 6% of funds)
– Fixed number of shares
– Trade like shares of common stock
– Actively managed
• Exchange-traded funds (≈ 9% of funds)
– Invests in securities contained in a specific
securities index
• Open-end mutual funds (≈ 85% of funds)
– Shares issued and redeemed on demand
– Actively managed
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Closed-End Funds
• Fixed number of shares issued when
the fund is organized
• Shares traded on stock exchanges or
the over-the-counter market.
• Trade price set by supply and demand
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Exchange Traded Funds
• Invests to replicate the composition of a
specific securities index
– Performance mirrors index performance
• Low management fees
• Trade on exchanges throughout the day
like stock
– Prices determined by supply and demand
• You can use limit orders and sell short
or use margin
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Open-End Funds
• Open-end funds ≈ 85% of all funds
– Shares issued and redeemed by the
investment company at the request of
investors
– Investors free to buy and sell shares at the
net asset value (NAV)
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Net Asset Value
• Net asset value (NAV):
The value of the fund’s portfolio minus
liabilities divided by the number of
outstanding shares
Net Assets
NAV 
Shares Outstanding
• NAV calculated at the close of
trading
13-11
Costs: Load Funds vs. No-Load Funds
• Load Fund
– Sometimes called an “A” fund
– Commission (sales charge) up to 8.5%
• Average = 3 to 5%
– Paid every time shares purchased
– Purchased through brokerage firms or
registered representatives
• Salespeople prepared to explain the fund and
help determine if it meets the investor’s
financial goals
13-12
Costs: Load Funds vs. No-Load Funds
• No-Load Fund
– No up-front sales charge
– No salespeople
– Investor deals directly with the investment
company via 800 numbers or web sites, or
from discount brokers
13-13
Costs: Load Funds vs. No-Load Funds
• Contingent deferred sales charge (CDSC)
– “Back-end load”
– “B” fund
– “Redemption fee”
– Charged upon withdrawal of funds (1-5%)
– Generally decreases on a sliding scale
depending on the number of years shares
are held
13-14
Costs: Management Fees and
Other Charges
• Management fee
– Charged yearly (.25%-1.5% average) based on a
percentage of assets
• 12b-1 fees (distribution fee)
– Annual fee to defray advertising and marketing costs
– Cannot exceed 1% of assets per year
• Cannot exceed 0.25% for a fund to be called “no load”
• Expense ratio
– Total expenses associated with the management
fees and operating costs of the fund
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Typical Mutual Fund Fees
13-16
Learning Objective LO13.2
Classify Mutual Funds by Investment Objective
Long-term
Funds
Stock Funds
Bonds Funds
Other Funds
13-17
Stock Funds
Long-term
Funds
Stock Funds
Bonds Funds
Other Funds
Aggressive Growth
Growth
Price growth vs.
Dividend Income
Equity income
Small-cap
Mid-cap
Company Size
Large-cap
Global
Regional
% U.S. vs.
International
International
Index funds
Match index holdings
Sector funds
Economic Sectors
Socially responsible
Invest in socially
responsible firms
13-18
Bond Funds
Long-term Funds
Stock Funds
Bonds Funds
Other Funds
High-yield
Intermediate
Corporate bonds
Intermediate U.S.
Gov't bonds
Long-term
corporate bonds
Long-term U.S.
gov't bonds
Municipal bonds
Short-term
corporate bonds
Short-term
U.S.gov't bonds
World Bond
Funds
13-19
Other Funds
Long-term
Funds
Stock Funds
Bonds Funds
Other Funds
Asset Allocation Funds
Balanced Funds
Fund of Funds
Lifecycle Funds
Money Market Funds
13-20
A Family of Funds
• One investment company manages a group of
mutual funds
– Each fund has a different financial objective
– Exchange privileges allow movement from one
fund to another within the family with low or no
charge
• Fidelity Investments
– http://personal.fidelity.com/products/funds/mut
ual_funds_overview.shtml.cvsr
• Franklin Templeton Funds
– https://www.franklintempleton.com/funds
13-21
Learning Objective LO13.3
Evaluate Mutual Funds
Managed Funds vs. Index Funds
• Managed fund  a fund manager
makes all decisions regarding what
securities are included in the fund’s
portfolio
• Index fund  securities held by the
fund replicate those contained in a
specific index like the S&P 500
13-22
Sources of Fund Information
1. Internet websites provide current values
–
http://finance.yahoo.com
–
www.valueline.com
–
www.morningstar.com
–
www.lipperweb.com
2. Check fund companies’ Internet sites
–
www.troweprice.com
–
www.vanguard.com
–
www.fidelity.com
13-23
Sources of Fund Information
3. Professional Advisory Services
–
–
–
–
–
Lipper Analytical Services
Morningstar, Inc.
Value Line
Mutual fund newsletters
Available in libraries and from
brokerage firms and online
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Mutual Fund Prospectus
–
–
–
–
–
–
–
–
–
–
Fund objective(s)
Statement describing the risk factors
The fund’s past performance
The type(s) of investments in the fund’s
portfolio
Information about dividends, distributions and
taxes
The fund’s management
Limitations or requirements for the fund
Procedure to buy or sell shares
Services provided to investors
Turnover ratio of the fund’s investments
13-25
Other Sources of Fund Information
• Mutual fund annual report
– Performance, investments, assets and liabilities
• Financial Publications
– Bloomberg Businessweek, Forbes, Kiplinger's
Personal Finance, Money, and The Wall Street
Journal
– A mutual fund’s information usually includes:
• Fund’s overall rating compared to all other funds,
and to funds in the same category
• Fund size, sales charge and expense ratio
• Historical returns for the past ten years
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Learning Objective LO13.4
The Mechanics of a Mutual Fund Transaction
• Open an account:
– $250 to $2,000 and up depending on the fund
family and the fund
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Return on Investment
3 Ways to Make Money on Mutual Funds
Income Dividends
– Earnings paid from dividend and interest income
– Taxed as ordinary income
Capital Gains Distribution
– Distributions when the fund buys and sells
securities
– Taxed as long-term gains
Capital Gains (or Losses)
– Capital gains (or losses) when you sell shares at a
price different than price you originally paid
– Taxed as short- or long-term gains
13-28
Taxes and Mutual Funds
Transaction
Taxed as:
Income dividend
Ordinary income
Capital gain
distribution
Long-term capital
gains regardless of
how long held
Capital gains or losses Short- or long-term
gains depending on
how long you held the
fund shares
13-29
Purchase Options
Fund Type
Purchase From
Closed End
Stock exchange or Over-the-counter
market
Exchange Traded
Open End
*
No Load
Fund Management Co.
Load
Authorized Agent
Fund
Supermarket*
* Investor may deal with one company, get one statement,
yet have a choice of a wide variety of funds
13-30
Purchasing Open-End Fund Shares
• Regular account transactions
– Easiest
– Simply buy shares in amount and when desired
• Voluntary savings plans
– Allows for smaller than usual purchases on a
recurring basis
• Contractual savings plans
– Require regular purchases over a specified period
– Sometimes called “Front-end Load Plans”
• Reinvestment plans
– Automatically reinvests dividends and capital gains
in the fund
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Withdrawal Options
• Closed-end funds & exchange-traded
funds
– Traded on stock exchanges and in the over
the counter market
– Sold like common stock shares
• Open-end fund
– Shares sold to the fund sponsoring
company
13-32
Mutual Fund Withdrawal Options
4 Options available if minimum balance ($5,000+)
1. Withdraw a fixed dollar amount each period
until account exhausted
2. Liquidate or “sell off’ a certain number of
shares each period
3. Withdraw a fixed percentage of asset growth;
principal untouched
4. Withdraw all income dividends and capital
gains distribution; principal untouched
13-33
Chapter Summary
Learning Objective LO13.1
• Major advantages of mutual funds are professional
management and diversification.
• Three types of funds:
– Closed-end funds = a fund whose shares are issued only
when the fund is organized
– Exchange-traded funds = a fund that invests in the stocks
contained in a specific stock index or securities index
– Open-end funds = a fund whose shares are sold and
redeemed by the investment company at the net asset
value (NAV) at the request of investors.
• Both closed-end and exchange-traded funds are
traded on a stock exchange or in the over-thecounter market
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Chapter Summary
Learning Objective LO13.1
• Mutual funds can also be classified as:
– A shares (commissions charged when shares
purchased)
– B shares (commissions charged when money is
withdrawn during the first five years)
– C shares (no commission to buy or sell shares,
but higher, ongoing fees).
• Other possible fees include management
fees and 12b-1 fees.
• Together all management fees and operating
costs are referred to as an expense ratio.
13-35
Chapter Summary
Learning Objective LO13.2
The major categories of stock mutual
funds, in terms of the types of
securities in which they invest, are:
- Aggressive growth
- Equity income
- Global
- Growth
- Index
- International
- Large Cap
- Midcap
- Regional
- Sector
- Small cap
- Socially responsible
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Chapter Summary
Learning Objective LO13.2
Bond funds include:
–
–
–
–
–
–
–
–
–
High-yield (junk)
Intermediate corporate
Intermediate U.S. government
Long-term corporate
Long-term U.S. government
Municipal
Short-term corporate
Short-term U.S. government
World bond funds
13-37
Chapter Summary
Learning Objective LO13.2
• Other funds invest in a mix of different
stocks, bonds, and other investment
securities that include:
–
–
–
–
–
Asset allocation funds
Balanced funds
Fund of funds
Lifecycle funds
Money market funds
• A family-of-funds concept allows
shareholders to switch among funds as
different funds offer more potential, financial
reward, or security.
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Chapter Summary
Learning Objective LO13.3
• Managed fund or an index fund?
– With a managed fund, a professional fund
manager (or team of managers) chooses the
securities that are contained in the fund.
– Over many years, index funds have outperformed
the majority of managed funds.
– Because an index mutual fund is a mirror image
of a specific index, the dollar value of a share in
an index fund also increases or decreases when
the index increases or decreases.
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Chapter Summary
Learning Objective LO13.3
• To help evaluate different mutual funds,
investors can use the information from:
– The Internet
– Professional advisory services
– The fund’s prospectus
– The fund’s annual report
– Financial publications
– Newspapers
13-40
Chapter Summary
Learning Objective LO13.4
•
Closed-end funds and ETFs
– The shares of a closed-end fund or exchangetraded fund are bought and sold on organized stock
exchanges or the over-the-counter market.
•
Open-end Funds
– Shares may be purchased through a salesperson
who is authorized to sell them, through an account
executive of a brokerage firm, from a mutual fund
supermarket, or from the investment company that
sponsors the fund.
– Open-end fund shares can be sold to the investment
company that sponsors the fund.
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Chapter Summary
Learning Objective LO13.4
• Shareholders in mutual funds can receive a return in
one of three ways:
– Income dividends
– Capital gain distributions when the fund buys and
sells securities in the fund’s portfolio at a profit
– Capital gains when the shareholder sells shares in
the mutual fund at a higher price than the price paid.
• To ensure having all of the documentation you need
for tax reporting purposes, it is essential that you
keep accurate records.
• A number of purchase and withdrawal options are
available for mutual fund investors.
13-42