Chapter 12
Mutual Funds:
Professionally
Managed Portfolios
Mutual Funds
• Learning Goals
1. Describe the basic features of mutual funds, and note
what they have to offer as investment vehicles.
2. Distinguish between open- and closed-end funds, as
well as other types of professionally managed
investment companies, and discuss the various types
of fund loads, fees, and charges.
3. Discuss the types of funds available and the variety
of investment objectives these funds seek to fulfill.
2
Mutual Funds
• Learning Goals (cont’d)
4. Discuss the investor services offered by mutual
funds and how these services can fit into an
investment program.
5. Gain an appreciation of the investor uses of mutual
funds, along with the variables to consider when
assessing and selecting funds for investment
purposes.
6. Identify the sources of return and compute the rate of
return earned on a mutual fund investment.
3
Mutual Funds
• Mutual Fund: an investment company that invests its
shareholders’ money in a diversified portfolio of
securities
– Investors own a share of the fund proportionate to the amount of
the investment
• First started in 1924
• Nearly 8,000 mutual funds available today
• More mutual funds in existence today than stocks listed
on NYSE and AMEX combined
• 54 million U.S. households own mutual funds
4
Attractions of Mutual Funds
• Portfolio Diversification
– Owning numerous securities reduces risk
• Professional management
• Ability to invest small amounts
• Service
– Automatic reinvestment of dividends
– Withdrawal plans
– Exchange privileges
• Convenience
– Easy to buy and sell; high liquidity
– Funds handle recordkeeping
– Easy to track prices
5
Drawbacks of Mutual Funds
• Substantial Transaction Costs
– Management fee
– Commission fees on load funds
• Lower-than-Market Performance
– Consistently beating the market is difficult
– Many mutual funds just keep even with overall
stock market index
6
Figure 12.1 The Comparative
Performance of Mutual Funds Versus
the Market
7
How Mutual Funds are Organized
• Management company runs the funds’ daily operations
• Investment advisor buys and sells stocks or bonds and
oversees the investment portfolio
• Distributor sells the fund shares
– Direct to the public
– Through brokers
• Custodian physically safeguards the securities
• Transfer agent keeps track of purchases and redemption
requests from shareholders
8
Open-End Investment Companies
• Investors buy and sell shares directly with the
mutual fund company without a secondary
market
• Have an unlimited number of shares
• Purchase and selling price is determined by the
Net Asset Value (NAV) of the fund
NAV  Value of all securities  Liabilities total shares outstanding
• All purchases and sales are completed at the
end of the day after the stock markets have
closed
9
Closed-End Investment Companies
• Sell only the initial offering
– Subsequent trades are done in a secondary market, similar to
the common stock market
• Have a limited number of shares
• Investment advisor doesn’t have to worry about cash
inflow or outflows
• Purchase and selling price is determined by supply
and demand
• Generally sell at premium or discount (usually discount)
to NAV
10
Exchange-Traded Funds (ETF)
• A basket of securities designed to track a specific
market index
• Similar to index mutual funds
• Trade like individual stocks on stock exchanges
• Can buy and sell ETFs any time of the day
• Low management expenses due to limited trading by
investment advisor
• Low turnover helps avoid taxes until ETF is sold
• Types of ETFs
– “Diamonds” (DIA) track DJIA
– “Spiders” (SPY) track S&P 500
– “Qubes (QQQ) track NASDAQ 100
11
Load and No-Load Funds
• Load Fund: a mutual fund that charges a commission
when shares are bought
– Typically sold through a broker
• No-load Fund: a mutual fund that does not charge a
commission when shares are bought
– Typically sold directly to investor by mutual fund
– Cost savings tend to give investors a head start in achieving
superior rates of return
• Low-load Fund: a mutual fund that charges a small
commission (2% to 3%) when shares are bought
12
Load and No-Load Funds
• Back-end load: a commission charged on
the sale of shares in a mutual fund
• 12(b)-1 fee: fee charged by some mutual
funds to cover management and other
operating costs; amounts to as much as
1% of the average net assets
13
Other Fees and Costs
• Management fee: compensation paid to professional
managers who administer the fund’s investment portfolio
– This fee is paid by all types of funds (load vs. no-load; open-end
vs. closed-end)
– Fee is charged annually on average net assets
• Administrative costs: the normal costs of doing
business, such as trading expenses
• Taxes on mutual funds
– Mutual funds do not pay taxes if income and capital gains are
passed on to shareholders
– Shareholders are taxed on their share of income and capital
gains annually
14
Figure 12.2 Fund Fees and
Charges on the Web
15
©2003 Morningstar, Inc. Used with permission.
Table 12.1 Mutual Fund Fee Table
(Required by Federal Law)
16
Unit Investment Trusts (UIT)
• Fixed pool of securities, normally bonds
• Not actively managed; securities in portfolio
remain static
• Have shares that represent a proportionate
share
of the trust
17
Real Estate Investment Trusts
(REIT)
• Closed-end investment company that invests in
mortgages and various types of real estate
investments
• Provide high dividends along with capital appreciation
potential
• Types of REITs
– Property/equity REITs invest in shopping centers, hotels,
apartments, office buildings and other real estate
– Mortgage REITs invest in mortgages
– Hybrid REITS invest in both properties and mortgages
18
Hedge Funds
• Not really mutual funds; private limited partnerships
• Not regulated by mutual fund regulations
• General partner runs fund and takes 10-20% of profits;
limited partners are investors
• Only sold to “accredited investors”—net worth greater
than $1,000,000 and/or annual income over $200,000
• Use arbitrage strategies, options, short sales and other
complex strategies
19
Types of Mutual Funds
• Growth Fund: primary goals are capital
gains and long-term growth
– Invest in large, well-established companies
with above-average growth potential
– Little or no dividend income
– Moderately risk investments for more
aggressive investors
20
Types of Mutual Funds (cont’d)
• Aggressive Growth Fund: highly speculative
mutual fund that seeks large profits from
capital gains
– Invest in small, unseasoned companies with high
price/earnings ratios
– Often look for turnaround situations
– Prices are often highly volatile
– High risk investments for very aggressive investors
21
Types of Mutual Funds (cont’d)
• Value Fund: seeks stocks that are undervalued
in the market
– Focus is on intrinsic value of stocks and requires
extensive fundamental analysis
– Invest in stocks with low P/E ratios, high dividend
yields and promising futures
– Looks for undiscovered companies with potential for
future growth
– Less risky investments for relatively conservative
investors looking for moderate growth
22
Types of Mutual Funds (cont’d)
• Equity-income Fund: emphasizes current income
and capital preservation
– Focus is on high current income with some long-term
capital appreciation
– Invest in high-yielding common stocks, convertible
securities or preferred stocks
– Invests in “blue chip” stocks and other
high-grade securities
– Typically less price volatility than overall stock market
– Less risky investments for relatively conservative
investors looking for moderate growth
23
Types of Mutual Funds (cont’d)
• Balanced Fund: generates a balanced return of
both current income and long-term capital gains
– Invest in blend of fixed-income securities and
common stocks, with 30% to 40% in fixed income
– Allocation between stocks and bonds typically
remains constant or varies very little
– Emphasis between fixed-income and common stocks
can be shifted as market conditions change
– Less risky investments for relatively conservative
investors looking for moderate growth
24
Types of Mutual Funds (cont’d)
• Growth-and-Income Fund: seeks both
long-term growth and current income, with
primary emphasis on capital gains
– Focus is on long-term capital appreciation with some
high income to provide limited stability
– Invest in blend of commons stocks and fixed-income
securities, with up to 90% in common stocks
– Moderate risk investments for investors who can
tolerate moderate price volatility
25
Types of Mutual Funds (cont’d)
• Bond Funds: invests in various kinds and
grades of bonds, with income as primary
objective
– Advantages of bond funds over individual bonds:
• More liquid
• Offer high diversification
• Bond funds automatically reinvest interest
– Lower risk investments for investors who are looking
for steady income
– Some price volatility occurs with changing
interest rates
26
Types of Bond Funds
• Government bond funds: invest in U.S. Treasury and
agency securities
• Mortgage-backed bond funds: invest in mortgagebacked securities of U.S. government, such as GNMA’s
• High-grade corporate bond funds: invest in corporate
bonds rated triple-B or better
• High-yield corporate bond funds: invest in lower rated
corporate bonds (junk bonds)
• Convertible bond funds: invest in securities that can be
converted into common stocks
27
Types of Bond Funds (cont’d)
• Municipal bond funds: invest in
tax-exempt securities issued by states and
political subdivisions
– Single-state fund: invests in municipal issues of only
one state to provide double tax-free income
• Intermediate-term bond funds: invest in bonds
with maturities of 7 to 10 years or less
• Short-term bond funds: invest in bonds with
maturities of 2 to 5 years
– Often used as alternative to money market funds when
interest rates are low
28
Money Market Funds
• Invest in short-term securities with maturities of less than
90 days
• Interest rates move up and down with market rates
• Trade at a constant net asset value of $1 per share
• Considered a safe, convenient investment to accumulate
capital and temporarily store idle funds
• Types of money market funds:
– General purpose: invests in all types of money market investments
– Government securities: invest only in U.S. Treasury bills and other
short-term government securities
– Tax-exempt: invest in very short-term tax-exempt
municipal securities
29
Types of Mutual Funds
• Index Funds: buys and holds a portfolio of
stocks (or bonds) equivalent to those in a
specific
market index
– Objective is to match, not beat, the specific index
– Strategy is buy-and-hold, which provides tax
advantages with very little taxable capital gains
– Operating costs are very low due to low turnover in
investment portfolio
30
Types of Mutual Funds (cont’d)
• Sector Funds: investments are restricted
to a particular segment of the market
– Investments are concentrated in one specific
industry sector
– Objective is to produce capital gains
– Considered speculative because limited
diversification can increase investment risks
31
Types of Mutual Funds (cont’d)
• Socially Responsible Funds: funds that actively and
directly incorporate ethics and morality into the
investment decision
– Specific stocks are evaluated on financial criteria and moral,
ethic or environmental tests
– Stocks that do not meet these tests are not considered for the
investment portfolio
– Examples of excluded companies:
• Tobacco or alcohol
• Gambling
• Nuclear energy
– Returns may be reduced due to limited investment opportunities
32
Types of Mutual Funds (cont’d)
• Asset Allocation Funds: funds that spread
investors’ money across stocks, bonds, and
money market securities
– Provides built-in asset allocation by professional
investment manager
– As market conditions change over time, the asset
allocation mix changes as well
– Provides convenience of “one-stop shopping” without
having to own several mutual funds
33
Types of Mutual Funds (cont’d)
• International Funds: funds that do all or most of their
investing in foreign securities
– Objective is to benefit from changes in:
• International market conditions
• Valuation of U.S. dollar
– Funds can specialize in international stocks, bonds or money
market securities
– Funds can specialize in growth, value, aggressive growth and
other types of stocks
– Funds can specialize in specific countries or regions of the world
– Considered fairly high-risk due to currency exchange risks
34
Mutual Fund Investor Services
• Automatic Investment Plans
– Regular investment from checking or savings
account or paycheck
– Monthly amounts as small as $25
– Excellent way to build up investment over
time
• Automatic Reinvestment of Interest,
Dividends, and Capital Gains
• Systematic Withdrawal Plans
35
Mutual Fund
Investor Services (cont’d)
• Conversion (Exchange) Privileges
– Load funds usually allow exchanges between
mutual funds in the same fund family without
paying additional sales loads
– Exchanges between funds can trigger capital
gains taxes in non-retirement accounts
• Phone Switching
• Easy Establishment of Retirement Plans
36
Investor Uses of Mutual Funds
• Accumulation of Wealth
• Storehouse of Value
• Speculation and Short-Term Trading
37
Selecting Mutual Funds
• Determine if you want to use mutual funds
in portfolio
– Mutual funds increase diversification
– Mutual funds offer expertise in areas where investor
may not be informed
– Can use stocks and mutual funds
• Compare mutual fund’s investment objective to
investor’s objective
• Compare range of services offered
38
Sources of Information
• Fund prospectus
• The Wall Street Journal
• Barron’s, Money, Fortune or Forbes
• Morningstar Mutual Funds
• Value Line Mutual Fund Survey
• Websites such as Yahoo.finance.com
39
Figure 12.5 Some Relevant
Information About Specific Mutual
Funds
©2003 Morningstar, Inc. Used with permission.
40
Factors in Comparing Mutual
Funds
• Fund’s investment performance
• Tax efficiency
• Fee structure
• How particular fund fits into your portfolio
• Investment skills of fund managers
• Load or No-Load funds
• Closed-End or Open-End funds
41
Comparing Closed-End and
Open-End Funds
• Brokerage commissions apply to closed-end
funds
• Open-end funds have greater liquidity
• Closed-end funds trade at premium (or discount)
to NAV
– Avoid closed-end funds trading at premium
– Look for closed-end funds trading at discount
Premium (or discount)  (Share price  NAV) / NAV
42
Sources of Return
from Mutual Funds
• Dividend income
• Capital gains distributions
• Change in price/NAV
– Unrealized capital gains (paper profits):
capital gain that has not been realized since
fund’s holdings have not been sold
43
Calculating Return:
Holding Period Return
• Returns include distributions of dividends,
distributions of capital gains, or NAV
appreciation
• Return for specific holding period
• Best for one year returns since does not use
present value
Holding period

return
 Number of
 shares at end
 of period
Number of



Ending
Initial
   shares at beginning 


price 
price 




of period
Number of shares
Initial

at beginning of period
price
44
Chapter 12 Review
• Learning Goals
1. Describe the basic features of mutual funds, and note
what they have to offer as investment vehicles.
2. Distinguish between open- and closed-end funds, as
well as other types of professionally managed
investment companies, and discuss the various types
of fund loads, fees, and charges.
3. Discuss the types of funds available and the variety
of investment objectives these funds seek to fulfill.
45
Chapter 12 Review (cont’d)
• Learning Goals (cont’d)
4. Discuss the investor services offered by mutual
funds and how these services can fit into an
investment program.
5. Gain an appreciation of the investor uses of mutual
funds, along with the variables to consider when
assessing and selecting funds for investment
purposes.
6. Identify the sources of return and compute the rate of
return earned on a mutual fund investment.
46
Chapter 12
Additional Chapter
Art
Figure 12.3 Mutual Fund Quotes
48
Figure 12.4 The Effects of
Reinvesting Income
49
Figure 12.6 Selected Performance
on CEFs
50
Table 12.2 A Report of Mutual Fund
Income and Capital Changes
(For a share outstanding throughout the year)
51