Chapter 17

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Chapter 17
Investing in Mutual
Funds
Copyright ©2004 Pearson Education, Inc. All rights reserved.
Background on Mutual Funds
• Stock mutual funds: funds that sell shares to
individuals and invest the proceeds in stocks
• Bond mutual funds: funds that sell shares to
individuals and invest the proceeds in bonds
• All are managed by professional portfolio
managers who decide what securities to
purchase
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Background on Mutual Funds
• Motives for investing in mutual funds
– Low initial investment
– Expertise of portfolio manager
– To meet specific investment goals
• Net asset value (NAV): the market value
of the securities that a mutual fund has
purchased minus any liabilities owed
– Usually reported on a per share basis
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Background on Mutual Funds
• Open-end versus closed-end funds
– Open-end mutual funds: funds that sell
shares directly to investors and repurchase
those shares whenever investors wish to sell
them
• Usually managed by investment companies that
are subsidiaries of a large financial conglomerate
• Family: a group of separately managed open-end
mutual funds held by one investment company
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Background on Mutual Funds
– Closed-end mutual funds: mutual funds
that sell shares to investors but do not
repurchase them; instead fund shares are
purchased and sold on stock exchanges
• Premium: the amount by which a closed-end
fund’s share price in the secondary market is
above the fund’s NAV
• Discount: the amount by which a closed-end
fund’s share price in the secondary market is
below the fund’s NAV
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Background on Mutual Funds
• Load versus no-load funds
– No-load mutual funds: funds that sell
directly to investors and do not charge a
fee
– Load mutual funds: funds whose shares
are sold by a stockbroker who charges a
fee (or load) for the transaction
– Loads can have significant impact on their
investment performance
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Background on Mutual Funds
• Expense ratio: the annual expenses per
share divided by the net asset value
of a mutual fund
– Average expense ratio is 1.5 percent
– Reported components of expense ratios
• Mutual funds incur expenses for administrative,
legal, and clerical expenses as well as portfolio
management fees
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Background on Mutual Funds
– Relationship between expense ratios and
performance
• Funds with lower expense ratios then to
outperform other funds
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Types of Mutual Funds
• Types of stock mutual funds
– Growth funds: mutual funds that focus on
stocks that have potential for aboveaverage growth
– Capital appreciation funds: mutual funds
that focus on stocks that are expected to
grow at a very high rate
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Types of Mutual Funds
– Small capitalization (small-cap) funds:
mutual funds that focus on funds that are
relatively small
– Mid-size capitalization (mid-cap) funds:
mutual funds that focus on medium-size
firms
– Equity income funds: mutual funds that
focus on firms that pay a high level of
dividends
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Types of Mutual Funds
– Balanced growth and income funds: mutual
funds that contain both growth stocks and
stocks that pay high dividends
– Sector funds: mutual funds that focus on a
specific industry or sector, such as
technology stocks
• Technology funds: mutual funds that focus on
stocks of Internet-based firms and therefore
represent a particular type of sector fund
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Types of Mutual Funds
– Index funds: mutual funds that attempt
to mirror the movements of an existing
stock index
– International stock funds: mutual funds that
focus on firms that are based outside the
U.S.
– Socially responsible stock funds: mutual
funds that screen out firms viewed as
offensive by some
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Financial Planning Online: Index
Mutual Funds
• Go to: http://www.indexfunds.com/
• This Web site provides news and other
information about index mutual funds
that can guide your investment
decisions.
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Types of Mutual Funds
• Example
– You are considering investing in either a no-load
mutual fund that focuses on growth stocks or an
index mutual find. When ignoring expenses
incurred by the mutual funds, you expect that the
growth fund will generate an annual return of 9
percent versus an annual return of 8 percent for
the index fund.
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Types of Mutual Funds
The growth fund has an expense ratio of 1.5
percent versus an expense ratio of 0.2
percent for the index fund.
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Types of Mutual Funds
Based on your expectations about the
portfolio returns, you returns would be:
Growth Fund Index Fund
Fund's portfolio return (exludes expenses)
9.00%
8.00%
Expense ratio
1.50%
0.20%
Your annual return
7.50%
7.80%
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Types of Mutual Funds
• Types of bond mutual funds
– Treasury bond funds: mutual funds that focus on
investment in Treasury bond
– Ginnie Mae funds: mutual funds that invest in
bonds issued by the Government National
Mortgage Association
– Corporate bond funds: mutual funds that focus on
bonds issued by high-quality firms that tend to
have a low degree of default risk
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Types of Mutual Funds
– High-yield (junk) bond funds: mutual funds
that focus on relatively risky bonds issued
by firms that are subject to default risk
– Municipal bond funds: mutual funds that
invest in municipal bonds
– Index bond funds: mutual funds that are
intended to mimic performance of a
specified bond index
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Types of Mutual Funds
– International bond funds: mutual funds that
focus on bonds issued by non-U.S. firms or
governments
• Global bond funds: mutual funds that invest in
foreign bonds as well as U.S. bonds
– Maturity classifications — some funds are
also segmented by their maturities
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Return and Risk of a Mutual
Fund
• Return from investing in a mutual fund
– Dividend distributions
• Dividends received on stocks in the funds
are distributed to shareholders
– Capital gains distributions
• Proceeds received from the sale of securities
are distributed to shareholders
– Capital gains from redeeming shares
• If price received at redemption exceed price
paid
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Return and Risk of a Mutual
Fund
• Example
– You invest in an equity income fund
focused on large, well-established stocks
that pay high dividends. You also invest in
a growth fund focused on young firms that
are attempting to expand and therefore pay
no dividends.
– You are curious about your tax liabilities
on distributions from these investments.
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Return and Risk of a Mutual
Fund
The equity income mutual fund
distributes $1,000 of dividends over
the year, while the growth fund
distributes $1,000 of long-term capital
gains.
Your marginal tax rate on ordinary
income is about 40 percent. The
capital gains tax rate is 20 percent.
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Return and Risk of a Mutual
Fund
• Given this information, the taxes on the
distribution are as follows:
Large Stock Fund Small Stock Fund
Dividends
$1,000
$0
Capital gains
$0
$1,000
Total income
$1,000
$1,000
Tax on divs (40%)
$400
$0
Tax on cap gains (20%
$0
$200
Total taxes
$400
$200
After-tax income
$600
$800
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Return and Risk of a Mutual
Fund
• Comparing returns among stock mutual
funds
– Great variation among types of funds over
a particular time period
– Not necessarily an indicator of future
performance
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Return and Risk of a Mutual
Fund
• Risk from investing in a stock mutual
fund
– Market risk: the susceptibility of a mutual
fund’s performance to general stock market
conditions
– Focus on Ethics: Risk from investing in
hedge funds
• Hedge funds: limited partnerships that manage
portfolios of funds for wealthy individuals and
financial institutions
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Return and Risk of a Mutual
Fund
Exhibit 17.3: Comparison of Returns among Types of Mutual Funds (based on 1999 data)
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Return and Risk of a Mutual
Fund
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Return and Risk
of a Mutual Fund
• Tradeoff between expected return and
risk of stock funds
– Conservative — stock index fund
• Limited return and risk
– Moderate — growth stock fund
• Moderate return and risk
– High risk — growth stock fund in one
sector
• High return and risk
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Return and Risk
of a Mutual Fund
Exhibit 17.4: Tradeoff between Expected Return and Risk
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Return and Risk
of a Mutual Fund
• Risk from investing in a bond mutual
fund
– Interest rate risk: for a bond mutual fund,
its susceptibility to interest rate movements
– Longer-term bonds most sensitive
– Must also consider default risk
– Bond funds can have either interest rate
risk, default risk, or both
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Return and Risk
of a Mutual Fund
Exhibit 17.5: Classifying Bond Mutual Funds according to Interest Rates and Default Risk
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Return and Risk of a Mutual
Fund
• Tradeoff between expected return
and risk of bond funds
– Conservative — short-term Treasury bond fund
• No default risk and limited interest rate risk
• Low return
– Moderate — Ginnie Mae bond fund
• Slight default risk and moderate interest rate risk
• Moderate return
– High risk — junk bond fund
• High default risk and high interest rate risk
• Potentially high return
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Return and Risk
of a Mutual Fund
Exhibit 17.6: Tradeoff between Expected Return and Risk of Bond Mutual Funds
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Deciding Among Mutual Funds
• Determining your preferred characteristics of
a mutual fund
– Minimum initial investment
– Investment objective (type of fund)
– Investment company
• Reviewing a mutual fund’s prospectus
– Prospectus: a document that provides financial
information about a mutual fund, including
expenses and past performance
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Deciding Among Mutual Funds
– Investment objective: in a prospectus, a
brief statement about the general goal of
the mutual fund
– Investment strategy: in a prospectus, a
summary of the types of securities that are
purchased by the mutual fund in order to
achieve its objective
– Past performance — 1 year, 3 years, 5
years
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Decide Among Mutual Funds
– Fees and Expenses
• Maximum load
• Redemption fee or back-end load
• Expenses, including management fees
• Expense ratio
– Risk
– Distribution of dividends and capital gains
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Deciding Among Mutual Funds
– Minimum investment and minimum
balance
– How to buy or redeem shares
• Making the decision
– Narrow down your choices to a small
number and use a table for comparison
• Consider the following tables comparing
4 stock funds and 4 bond funds
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Deciding Among Mutual Funds
With $1,000 to invest in a stock mutual fund:
Internet Fund
#1
#2
#3
#4
Load Status
No-load
No-load
No-load
3% load
Recent
Annual
Expense Ratio Performance
1.50%
13%
0.80%
12%
2.00%
14%
1.70%
11%
With $1,000 to invest in a bond mutual fund:
High-Yield
Bond Funds
#1
#2
#3
#4
Load Status
4% load
No-load
No-load
No-load
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Typical
Terms to
Expense Ratio Maturity
1.00%
6 - 8 years
0.90%
15 - 20 years
0.80%
5 - 7 years
1.20%
5 - 7 years
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Financial Planning Online:
Online Services by Mutual Funds
• Go to: http://www.vanguard.com
• This Web site provides an example of what
an investment company that manages mutual
funds can provide online to its customers.
You can monitor your account online and
transfer money from one fund to another
within the same family.
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Quotations of Mutual Funds
• Quotations available from financial
publications
– Open-end funds
• Column 1 — Investment company in bold type
with funds listed beneath
• Column 2 — NAV
• Column 3 — Net change in NAV
• Column 4 — Return year to date
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Quotations of Mutual Funds
– Closed-end funds listed on the exchanges
where they are traded
• Column 1 — Fund name and symbol
• Column 2 — Exchange where traded
• Column 3 — NAV
• Column 4 — Market price
• Column 5 — Premium or discount
• Column 6 — return over the last year
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Quotations of
Mutual Funds
Exhibit 17.8: Closed-End Fund Price Quotations
Copyright © 2001 Dow Jones & Company, Inc. All Rights
Reserved.
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Quotations of Mutual Funds
– Lipper indexes are useful for assessing
the recent performance of a particular fund
or funds with a specific objective
• Column 1 — type of index
• Column 2 — preliminary closing
• Column 3 — percent change from previous day
• Column 4 — percent change from previous week
• Column 5 — percent change since December 31
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Quotations of Mutual Funds
Exhibit 17.9: The Lipper Indexes of Mutual Funds
Copyright © 2001 Dow Jones & Company, Inc. All Rights
Reserved.
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Diversification Among Mutual
Funds
• Diversify among several types of funds
to lower risk
• Best strategy is to diversify across stock
and bond mutual funds
• Can also diversify among mutual funds
representing different countries
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Diversification Among Mutual
Funds
• Diversification through mutual fund
supermarkets: an arrangement offered
by some brokerage firms that enables
investors to diversify among various
mutual funds and to receive a summary
consolidated statement for these funds
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Diversification
Among Mutual Funds
Exhibit 17.10: Diversifying among Mutual Funds That Are Primarily Affected by Different Factors
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Financial Planning Online:
Diversifying among Mutual Funds
• Go to: http://www.mfea.com
• Click on: Asset Allocation
• This Web site provides suggested asset
allocation models that fit your financial
situation and your degree of risk
tolerance.
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How Mutual Funds Fit
within Your Financial Plan
• Key decisions about mutual funds for
your financial plan are:
– Should you consider investing in mutual
funds?
– What types of mutual funds would you
invest in?
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