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13
Investing in Mutual Funds
McGraw-Hill/Irwin
Focus on Personal Finance, 2e
Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
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Investment in Mutual Funds
Chapter Objectives
1. Describe the characteristics of mutual
fund investments
2. Classify mutual funds by investment
objectives
3. Evaluate mutual funds
4. Describe how and why mutual funds are
bought and sold
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What is a Mutual Fund?
 An investment chosen by people who pool
their money to buy stocks, bonds, and other
financial securities selected by professional
managers who work for investment
companies.
 An investment company is a firm that invests
the pooled funds of small investors in
securities appropriate to the fund’s stated
objective.
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What is a Mutual Fund?
(continued)
 There are over 9,200 funds to choose from.
 Many people choose mutual funds for their
retirement account investments.
– 401(k) or 403(b)
– IRA
– Roth IRA
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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. This variety provides often provides an
element of safety.
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Objective 1: describe the characteristics of mutual
fund investments
Characteristics of Mutual Funds
 Closed-end funds (7% of funds).
– Shares are issued by an investment company only when the
fund is organized.
– After all original shares are sold you can purchase shares only
from another investor who is willing to sell.
 Exchange-Traded Funds
– Invests in the stocks contained in a specific stock market
index, like the Standard and Poor’s 500 stock index.
– Performance of shares in the fund tend to mirror the
performance of the index.
– Low management fees since
there is less need for decisions
made by a portfolio manager.
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Characteristics of Mutual Funds
 Open-end funds (90% of funds).
– Shares are issued and redeemed by the investment
company at the request of investors.
– Investors are free to buy and sell shares at the net
asset value (NAV).
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Net Asset Value (NAV)
Value of the fund’s portfolio – Liabilities
Number of shares outstanding
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Load Funds compared to No-Load Funds
 Load Fund.
– Investors pay a commission (sales charge) up to
8.5% every time they purchase shares. This is
sometimes called an “A” fund.
– Average charge is 3-5% for which an investor
can get purchase advice and explanations.
 No-Load Fund.
– Investors pay no sales charge up front.
– You deal directly with the investment
company via 800 numbers or web sites, or from
discount brokers.
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Load Funds compared to No-Load Funds
 Contingent deferred sales load (back-end load
or “B” fund).
– Charged upon withdrawal of funds (1-5%).
– Generally decreases on a sliding scale depending on
the number of years shares are held.
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Management Fees and Other Charges
 Management fee.
– Charged yearly (.25%-1.5% average) based on a
percentage of the funds asset value.
 12b-1 fees.
– Annual fee to defray advertising and marketing costs
of the fund.
– Cannot exceed 1% of a fund’s assets per year.
 Expense ratio
– The total expenses associated with the management
fees and operating costs of the fund
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Objective 2: Classify mutual funds by investment
objectives
Classification of Mutual Funds
 STOCK FUNDS
– Aggressive growth funds buy stocks in small, fastgrowing companies.
– Equity income funds invest in stock of companies with a
long history of paying dividends.
– Global stock funds buy stock in companies in the U.S.
and other countries.
– Growth funds buy stock in companies with higher- thanaverage revenue and earnings growth.
– Index funds buys stocks that mirror an index.
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Classification of Mutual Funds
– International funds buy stock only in companies
outside the United States.
– Large cap funds buy stock in companies with total
capitalization of at least $5 billion or more.
– Lifecycle funds these
funds start as being risky and
become more conservative.
– Midcap funds invest in companies
with a capitalization of
$1 to $5 billion.
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Classification of Mutual Funds
– Regional funds invest in stock traded within one
specific region of the world.
– Sector funds buy stock in companies in a
particular sector such as biotechnology.
– Small cap funds buy stock in lesser-known
companies with a capitalization of less than 500
million.
– Socially responsible funds avoid investing in
companies that may cause harm.
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Classification of Mutual Funds
 BOND FUNDS.
– High-yield (junk) bond funds buy
corporate bonds that are higher risk.
– Intermediate corporate bond funds invest in
corporate debt that matures in 5-10 years.
– Intermediate U.S. bond funds buy treasury
securities with maturities of 5-10 years.
– Long-term corporate bond funds that invest in
corporate debt that matures in more than 10
years.
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Classification of Mutual Funds
 BOND FUNDS
– Long-term U.S. bond funds invest in U.S.
securities with maturities of greater than 10
years.
– Municipal bonds funds buy municipal bonds
with tax-free interest income.
– Short-term corporate bond funds invest in
corporate debt with maturities of 1-5 years.
– Short-term U.S. bond funds invest in U.S.
Treasury issues with maturities of 1-5 years.
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Classification of Mutual Funds
(continued)
 OTHER FUNDS.
– Asset allocation funds invest in various asset
classes, with precise amounts within each type.
– Balanced funds invest in both stocks and bonds
with the primary objective of conserving principal
and providing income.
– Money market funds invest in CDs, government
securities and other safe and liquid investments.
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Families of Funds
 A family of funds exists when one investment
company manages a group of mutual funds.
 Each fund in the family has a different financial
objective.
 Exchange privileges allow you to move your
money from one fund to another within the fund
family with low or no charge.
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Objective 3: Evaluate mutual funds
Managed Funds versus Index Funds
 A managed fund is a fund where managers
make the decisions about what securities are
included in the fund’s portfolio.
 An index fund is a fund that invests in the
securities contained in a specific index like the
S&P 500.
 The decision to invest in a managed versus an
index funds depends on your research
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Sources of Fund Information
INTERNET
 Use websites to find current values, research a fund.
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http://finance.yahoo.com
www.businessweek.com
www.morningstar.com
www.smartmoney.com
 Check mutual fund companies Internet sites.
– www.troweprice.com
– www.vanguard.com
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Sources of Fund Information
 Professional Advisory Services
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Lipper Analytical Services
Morningstar, Inc.
Value Line
Various mutual fund newsletters
Reports from the sources in the libraries and
brokerage firms
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Mutual Fund Prospectus
 Mutual fund prospectus tells the funds objective, plus…
– A statement describing the risk factors.
– A description of the fund’s past performance.
– A statement describing the type of investments in the fund’s portfolio.
– Information about dividends, distributions and taxes.
– Information about the fund’s management.
– Information about limitations or requirements for the fund.
– The process for investors to buy or sell shares.
– Services provided to investors.
– The turnover ratio of the fund’s investments.
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Other Sources of Fund Information
 Mutual fund annual report.
– Performance, investments, assets and liabilities.
 Financial Publications.
– Business Week, Forbes, Kiplinger's Personal
Finance and Money are sources of information.
– Business Week’s mutual fund survey includes
information such as the...
• 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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Sources of Fund Information
NEWSPAPER
 Net asset value and net change.
 The fund family and fund name.
 Total return over various time periods.
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Objective 4: Describe how and why mutual funds are
bought and sold
The Mechanics of Mutual Fund Transactions
 You can open an account from $250 to $3,000 and up depending
on the fund family and the fund.
 Open-end, no-load directly from the investment company by
phone, the Internet, through the mail, or from a discount broker.
 Closed-end or exchange-traded funds are purchased via a
broker through the stock exchange.
 In addition to just selling shares, there are numerous withdrawal
options.
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The Mechanics of Mutual Fund Transactions
RETURN ON INVESTMENTS
There are 3 ways to make money on different funds
Income Dividends
– Earnings a fund pays to the shareholders from its dividend and interest
income
Capital Gains Distribution
– Capital gain distributions are made to shareholders when the fund buys
and sells securities in the fund.
Capital Gains
– You have capital gains when you sell shares at a higher price than you
paid.
Note: Keep accurate records for tax purposes, as income distributions,
capital gain distributions, and capital gains are subject to taxation.
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The Mechanics of Mutual Fund Transactions
TAXES AND MUTUAL FUNDS
 Gains and losses from all types of mutual funds are subject to
taxation
 Guidelines on how mutual funds are taxed
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–
–
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Income dividends
Capital gains distributions
Capital gains or losses from you selling shares
Length of owning shares determines short-term or long-term
capital gains
 Turnover ratio measures the percentage of the fund’s holding
that has changed over a 12 month period
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The Mechanics of Mutual Fund Transactions
PURCHASE OPTIONS
 Shares of closed-end and exchange-traded funds can be bought
through a stock exchange or the over-the-counter market
 Shares of open-end no load fund can be bought by contacting
the company that manages the fund
 Shares of open-end load fund can be bought by contacting an
authorized agent
 Many types of funds can also be bought from mutual fund
supermarkets available through brokerage firms
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The Mechanics of Mutual Fund Transactions
 PURCHASE OF OPEN-END MUTUAL FUNDS
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–
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REGULAR ACCOUNT TRANSACTIONS
VOLUNTARY SAVINGS PLAN
CONTRACTUAL SAVINGS PLANS
REINVESTMENT PLANS
 All of the purchase plans allow you to use the
principle of dollar cost averaging
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The Mechanics of Mutual Fund Transactions
WITHDRAWAL OPTIONS
 Closed-end funds and exchange-traded funds can be
traded on the stock exchanges
 Shares in an open-end fund can be sold to the fund
sponsoring company
 Most funds allow 4 types of withdrawal
1.
2.
3.
4.
Withdraw a fixed dollar amount until the fund is exhausted
Liquidate or “sell off’ a certain number of shares each period
Withdraw a fixed percentage of asset growth
Withdraw all income dividends and capital gains distribution