Chapter 13: Investing in Mutual Funds

Investing in Mutual Funds
• 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 fund manager
• Many mutual funds chosen for inclusion in
retirement account investments (e.g., 401(k)s)
Objective 1
Explain the Characteristics of Mutual
Fund Investments
Investment Company
• Pools the money of many investors – its
shareholders – to invest in a variety of
• Employs fund manager who is
compensated for selecting securities
appropriate to the fund’s stated objective
• “Financial Intermediary”
How a Mutual Fund Works
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 (shares of many different companies)
– Risk reduction
Characteristics of Funds
• Closed-End Funds (7% of all Mutual Funds)
Fixed number of shares issued when the fund is organized
Trade like shares of common stock on stock exchanges
Trade price set by supply & demand
Actively managed
Most sell at a discount relative to their net asset value
• Exchange-Traded Funds (6% of all Mutual 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
Can be sold short and traded with limit orders
• Open-End Mutual Funds (87% of all Mutual Funds)
– Shares issued and redeemed on demand
– Actively managed
Net Asset Value
Net Asset Value (NAV):
Current market value of assets held by a fund
AUM = “Assets Under Management”
– Net Assets = Fund Assets (AUM) - Liabilities
– NAV calculated at the close of trading
Example: $52,500,000 value of fund net assets
3,500,000 number of shares = $15 per share
Open-End Funds
Open-End Funds ≈ Majority of funds
– Shares issued and redeemed by investment
company at the request of investors
– Investors free to buy and sell shares at the
net asset value (NAV)
– No broker or stock exchange required
– Wide variety of services
• Automatic deposit and withdrawal
• Exchanges among family of funds
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
• 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
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 number of years shares are held
• Disappears after about 5 years
• Knowing your holding period is key factor
Costs: Management Fees and
Other Charges
• Management Fee
– Charged yearly (.25%-1.5% of NAV average)
based on a percentage of AUM
• 12b-1 Fee
– Annual fee to defray advertising and
marketing costs
– Cannot exceed 1% of AUM per year
• Expense Ratio
– Total expenses associated with management
fees and operating costs of the fund
Typical Mutual Fund Fees
Objective 2
Classify Mutual Funds by Investment
Stock Funds
Bonds Funds
Other Funds
Stock Funds
Stock Funds
Bonds Funds
Other Funds
Aggressive Growth
Price growth vs.
Dividend Income
Equity income
Company Size
% U.S. vs.
Index funds
Sector funds
Socially responsible
Match index holdings
Economic Sectors
Invest in socially
responsible firms
Bond Funds
Long-term Funds
Stock Funds
Bonds Funds
Other Funds
Corporate bonds
Intermediate U.S.
Gov't bonds
corporate bonds
Long-term U.S.
gov't bonds
Municipal bonds
corporate bonds
Short-term't bonds
Other Funds
Stock Funds
Bonds Funds
Other Funds
Asset Allocation Funds
Balanced Funds
Fund of Funds
Lifecycle Funds
Money Market Funds
Balancing Risk and Returns on
Mutual Funds
A Family of Funds
One investment company manages a
group of mutual funds portfolios
– Each fund has a different financial objective
– Exchange privileges allow movement from
one fund to another within the family with low
or no charge
– Listed alphabetically in newspapers
Names of popular investment companies?
Objective 3
Evaluate Mutual Funds
Managed Funds vs. Index Funds
• Managed Fund  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
Sources of Fund Information
Internet sites provide current values
Check mutual fund companies’ Internet sites
Professional Advisory Services
Lipper Analytical Services
Morningstar, Inc.
Value Line
Mutual fund newsletters
Mutual Funds Have Different
Investment Objectives
Prospectus – a mutual fund’s
investment objectives and policies must
be stated in this document.
Two Types:
• Traditional prospectus (long)
• Profile prospectus (short)
Mutual Fund Prospectus Data
– Fund objective(s)
– Statement describing risk factors
– Description of fund’s past performance
– Statement describing type of investments in
fund’s portfolio
– Information about dividends, distributions, and
– Information about fund’s management
– Procedure to buy and sell shares
– Services provided to investors
– Turnover Ratio of the fund’s investments: how
often the fund’s portfolio changes
Other Sources of Fund Information
• Mutual Fund Annual Report
– Performance, investments, assets & liabilities
• Financial Publications
– Business Week, Forbes, Kiplinger's Personal
Finance, WSJ, and Money
– Business Week’s mutual fund survey
• 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
Objective 4
Describe How and Why Mutual Funds are
Bought and Sold
The Mechanics of a Mutual Fund
• Open an account:
– On Your Own: $250 to $3,000 and up
depending on the fund family and the fund
– At Work: Select mutual funds for a taxdeferred retirement savings account
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 Distributions
– 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
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
– Reinvestment Plans
• Automatically reinvests dividends and capital gains
in the fund
The Wisdom of Automatic
Withdrawal Options
Closed-End Funds and Exchange-Traded Funds
Traded on stock exchanges and in over the counter market
Sold like common stock shares
Open-End Funds
Shares sold to the fund sponsoring company
Systematic withdrawal methods
Withdraw fixed dollar amount each period until account is
Liquidate or “sell off” a certain number of shares each period
Withdraw a fixed percentage of asset growth; principal untouched
Withdraw all income dividends and capital gains distributions;
principal untouched
Wrap Up
• Chapter Quiz
• Concept Check 13-1- NAV Problem
• Concept Check 13-2- Importance of Fund
• Concept Check 13-3- Managed Fund vs.
Indexed Fund
• Concept Check 13-4- Purchasing ClosedEnd Funds and ETFs