Course Outline Part XI (Mutual Funds)

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Course Outline Part XI (Mutual Funds)

  1. 1. X. MUTUAL FUNDS
  2. 2. A. The Mechanics of Mutual Funds <ul><li>Mutual funds pool money from many investors </li></ul><ul><li>Mutual fund investors own a part of all of the securities in the mutual fund “pool” </li></ul><ul><li>The fund manager is responsible for tracking the securities in the pool </li></ul><ul><li>Profits are paid in two ways: </li></ul><ul><ul><li>Income Distributions – Dividends and interest paid by the underlying securities are subsequently paid to investors </li></ul></ul><ul><ul><li>Capital Gains Distributions – Payment to investors of profits obtained from sales of securities </li></ul></ul>
  3. 3. A. The Mechanics of Mutual Funds <ul><li>Passive Funds – Primarily index funds </li></ul><ul><li>Active Funds – Run by a professional manager – active funds have: </li></ul><ul><ul><li>Professional managers </li></ul></ul><ul><ul><li>An investment objective, and </li></ul></ul><ul><ul><li>An investment program designed to meet the investment objective </li></ul></ul>
  4. 4. A. The Mechanics of Mutual Funds <ul><li>Open and Closed End Funds </li></ul><ul><ul><li>Open end – sold by brokerage firms and by fund distributors, issues or purchases shares depending upon demand, uses client funds to buy or sell securities </li></ul></ul><ul><ul><li>Closed end – raise money only once, invest in a variety of securities, and offer a fixed number of shares – traded Over the Counter or on the market – price varies with the price of the underlying securities and with market demand (discount or premium from Net Asset Value) </li></ul></ul>
  5. 5. B. TYPES OF MUTUAL FUNDS <ul><li>Stock Funds – invest in equity securities, can be growth, value, dividend, sector, market cap, etc. </li></ul><ul><li>Bond Funds – invest in Treasury bonds, municipal bonds, passive trading of securities, active trading of securities, high yield bonds, corporate bonds, etc. </li></ul><ul><li>Commodity Funds – invest in stocks of commodities or in commodity futures </li></ul><ul><li>Balanced Funds – contain a mix of stocks and bonds (generally 60% stocks, 40% bonds) </li></ul>
  6. 6. B. TYPES OF MUTUAL FUNDS <ul><li>Target Date Funds – change investment allocation as a target date approaches (ex. - §529 funds) </li></ul><ul><li>Money Market Funds – cash equivalent securities – like a savings account </li></ul><ul><li>International Funds – invest in Europe, China, Asia, Far East, Latin America, emerging markets, etc. </li></ul><ul><li>Miscellaneous – socially responsible funds, sin funds, green funds, etc. </li></ul>
  7. 7. C. DEFINITIONS <ul><li>Turnover Rate – the number of times per year that the equivalent of all of the underlying securities in the fund are purchased or sold </li></ul><ul><li>Volatility – the historic deviation of rates of return above and below the average rate of return </li></ul><ul><li>Prospectus – similar to a stock prospectus, explains fund objectives, investment strategy, fees, historic before and after tax returns, and fund risk profile </li></ul>
  8. 8. C. DEFINITIONS <ul><li>Net Asset Value (NAV) – </li></ul><ul><li>(market cap of fund shares + accrued </li></ul><ul><li>interest + accrued dividends – accrued expenses) </li></ul><ul><li>number of fund shares </li></ul><ul><li>Premium – The price of a share of a closed end mutual fund minus the share Net Asset Value – exists where demand for fund shares exceeds the value of the underlying holdings </li></ul>
  9. 9. C. DEFINITIONS <ul><li>Discount – Where the shares of a closed end fund trade below the fund’s net asset value, exists where demand is less than the value of the underlying holdings </li></ul><ul><li>Liquidity – The ability to get “into” and “out of” an investment (buy and sell) – ETFs are generally highly liquid, mutual funds are not </li></ul><ul><li>Diversification – Where a fund holds a variety of securities </li></ul>
  10. 10. C. DEFINITIONS <ul><li>Rating – An independent analyst’s opinion of how the fund has performed compared to benchmarks </li></ul><ul><li>Ranking – The relative standing of a mutual fund compared to others with similar investment strategies </li></ul><ul><li>Sharpe Ratio – Calculated as a fund’s rate of return – the rate of return on 3 month Treasury bills divided by the standard deviation of fund returns </li></ul><ul><li>Sharpe Ratio = (Fund Return – 3 mo. Treasury Yield) </li></ul><ul><li>Standard Deviation of Fund Returns </li></ul>
  11. 11. C. DEFINITIONS <ul><li>Standard Deviation – The amount by which the annual returns of a fund vary above and below the fund’s average return </li></ul><ul><li>Rating Firms: </li></ul><ul><ul><li>Standard and Poors </li></ul></ul><ul><ul><li>Morningstar </li></ul></ul><ul><ul><li>Lipper </li></ul></ul>
  12. 12. C. DEFINITIONS <ul><li>Fund Style </li></ul><ul><ul><li>Growth/Blend/Value – Invests in growth stocks, a blend of growth and value stocks, and value stocks </li></ul></ul><ul><ul><li>Dividend (Yield) – Invests in securities with the highest dividend payments </li></ul></ul><ul><ul><li>Contrarian – Against the accepted (current trend) in management </li></ul></ul><ul><ul><li>Style Drift – When a fund manager changes styles to make up for below market returns </li></ul></ul><ul><li>Portfolio Overlap – Where a holder of several mutual funds owns duplicate underlying shares of stock </li></ul>
  13. 13. D. FEES AND CHARGES <ul><li>Fees have the greatest impact on fund returns other than the manager’s performance </li></ul><ul><li>Sales Charges (Loads) </li></ul><ul><ul><li>Front End Load – A sales charge on fund purchase, reduces the number of shares purchased </li></ul></ul><ul><ul><li>Back End Load (Redemption Fee or Contingent Deferred Sales Charge) – Paid when shares are sold – usually declines to 0 after 5-7 years – designed to prevent investor “churn” </li></ul></ul>
  14. 14. D. FEES AND CHARGES <ul><li>Fund Classes </li></ul><ul><ul><li>A = Front end load </li></ul></ul><ul><ul><li>B = Back end load </li></ul></ul><ul><ul><li>C = Level load – no sales charges, but higher fees than A or B – higher annual fees and charges instead of front end or back end loads </li></ul></ul><ul><li>Exchange Fees – A charge for moving assets between different funds issued by the same group </li></ul>
  15. 15. D. FEES AND CHARGES <ul><li>Early Redemption Charge – Exit fee, can be 5 days to 1 year </li></ul><ul><li>Breakpoint – A point where more money is invested to reduce the front end load </li></ul><ul><ul><li>Right of Accumulation – Where an investor can combine past and new investments to reach a breakpoint </li></ul></ul><ul><ul><li>Letter of Intent – A promise by the investor to increase the amount invested to reach a breakpoint </li></ul></ul>
  16. 16. D. FEES AND CHARGES <ul><li>Other Types of Fees – Total annual fees are quoted as an “Expense Ratio” – must be listed in the fund prospectus, generally range from 0.1% to 2.75% </li></ul><ul><ul><li>12-b 1 Fees – Marketing and distribution expenses – limited by NASD rule to 1% of assets per year or less, with marketing fees at 0.75% or less; and with shareholder services capped at 0.25% of assets </li></ul></ul><ul><ul><li>Management Fees – Charge to pay the advisory firm that invests fund assets </li></ul></ul>
  17. 17. E. MEASURING FUND RETURNS <ul><li>Percentage change in share price (market value) is the measure of fund returns for closed end funds </li></ul><ul><li>Percentage Closing Share Price </li></ul><ul><li>Rate of Return= Opening Share Price -1 </li></ul>
  18. 18. E. MEASURING FUND RETURNS <ul><li>Net Asset Value = Value of Fund Investments </li></ul><ul><li> Number of Shares </li></ul><ul><li>Percentage Closing Net Asset Value </li></ul><ul><li>Change in NAV = Opening Net Asset Value -1 </li></ul>
  19. 19. E. MEASURING FUND RETURNS <ul><li>Distributions – Can be both interest (dividends and interest on investments) and capital gains (mutual fund’s gain from sale of underlying investments) </li></ul><ul><li>Yield = Distribution per Share </li></ul><ul><li>Price per Share </li></ul>
  20. 20. E. MEASURING FUND RETURNS <ul><li>Total Return = Change in NAV + Distributions </li></ul><ul><li>Cost of Initial Investment </li></ul><ul><ul><li>Reported as a geometric mean, taking into account annual compounding of distributions </li></ul></ul><ul><ul><li>Must be viewed in comparison with standard indices or with indices of competing funds with a similar investing style </li></ul></ul>
  21. 21. F. ANNUITIES <ul><li>Defined as an investment contract between the purchaser and an insurance company, funded (money invested) either by a lump sum or by a series of scheduled payments </li></ul><ul><li>Types of Annuities </li></ul><ul><ul><li>Fixed annuities – interest rate set upon purchase </li></ul></ul><ul><ul><li>Variable annuities – contain a selection of sub accounts, with the yield on the annuity varying depending upon the investment performance of the types of securities represented in the sub account </li></ul></ul>
  22. 22. F. ANNUITIES <ul><li>Advantages of annuities over mutual funds </li></ul><ul><ul><li>Income taxes – no income taxes are paid on capital gains until the annuity matures (presumably when the investor is retired and in a lower tax bracket) </li></ul></ul><ul><ul><li>Withdrawals from an annuity, unlike withdrawals from a pension plan or an IRA, can be postponed until after age 701/2, allowing transfer of wealth to heirs </li></ul></ul>
  23. 23. F. ANNUITIES <ul><ul><li>Special types of annuities (ex. §403(B) annuities) are tax deferred for both contributions and interest </li></ul></ul><ul><ul><li>Annuities may contain a death benefit, which is a guaranteed payment upon death regardless of market conditions </li></ul></ul>
  24. 24. F. ANNUITIES <ul><li>Disadvantages of annuities </li></ul><ul><ul><li>Annual fees are generally higher than mutual fund annual fees as a percentage of the amount invested </li></ul></ul><ul><ul><li>Surrender fees – a back end load, generally starting at 7% for the first year, declining by 1% per year thereafter </li></ul></ul>
  25. 25. F. ANNUITIES <ul><li>Annuity ratings </li></ul><ul><ul><li>As an insurance product, the state of issue may guarantee the company’s obligations, including annuities, in the event that the company becomes insolvent (goes bankrupt) </li></ul></ul><ul><ul><li>The insurance companies issuing annuities are rated by Standard and Poors and Morningstar </li></ul></ul>

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