Chapter 12


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Chapter 12

  1. 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 12 Mutual Funds and Other Pooling Arrangements
  2. 2. Major Topics <ul><li>Mutual Funds </li></ul><ul><li>Investment Trusts </li></ul><ul><li>Limited Partnerships and Investment Clubs </li></ul><ul><li>Constructing and Maintaining Your Personal Portfolio </li></ul>
  3. 3. Types of Pooling Arrangements <ul><li>Mutual Funds </li></ul><ul><ul><li>Closed End </li></ul></ul><ul><ul><li>Open End </li></ul></ul><ul><li>Investment Trusts </li></ul><ul><ul><li>Unit Investment Trusts (UITs) </li></ul></ul><ul><ul><li>Real Estate Investment Trusts (REITs) </li></ul></ul><ul><li>Limited Partnerships </li></ul><ul><li>Investment Clubs </li></ul>
  4. 4. What Is A Mutual Fund? <ul><li>Pools the Funds of Many Individuals to Invest in Stocks, Bonds, and Many Other Types of Assets </li></ul><ul><li>A Fund’s Net Asset Value (NAV) is the Total Value of All the Assets the Fund Owns (minus any liabilities) Divided by the Number of Shares Issued by the Fund </li></ul>
  5. 5. Fund X’s NAV <ul><li>Company # of Shares Price per Total </li></ul><ul><li>Owned Share Value </li></ul><ul><li>IBM 100 $120 $12,000 </li></ul><ul><li>Xerox 100 80 8,000 </li></ul><ul><li>GM 100 70 7,000 </li></ul><ul><li>Value of the fund’s portfolio $27,000 </li></ul><ul><li>Number of shares issued 1,000 </li></ul><ul><li>Fund X’s NAV $ 27.00 </li></ul>
  6. 6. Load Versus No-Load Funds <ul><li>A Load is a commission paid to buy or sell fund shares </li></ul><ul><ul><li>Loads range from 1% to over 9% of NAV </li></ul></ul><ul><ul><li>No-load funds have no commission to buy shares (called a “front-end” load), but some charge a commission to sell (called a “back-end” load) </li></ul></ul><ul><li>There is no evidence showing that load funds do better than no-load funds </li></ul>
  7. 7. Open-End Funds <ul><li>Most Popular Type of Fund </li></ul><ul><ul><li>They Advertise Extensively to Attract Investors </li></ul></ul><ul><ul><li>Large Funds Include Fidelity, Vanguard </li></ul></ul><ul><li>You Can Deal Directly with the Fund to Buy or Sell Shares </li></ul><ul><ul><li>Completing an Application Form is Easy </li></ul></ul><ul><ul><li>Shares Are Purchased/Sold at NAV (Plus a Load, if Applicable) </li></ul></ul><ul><ul><li>You Can Use Many Fund Services </li></ul></ul>
  8. 8. Closed-End Funds <ul><li>Shares Trade in the Securities Markets </li></ul><ul><ul><li>You Trade Shares As You Would the Shares of Any Company, such as Intel </li></ul></ul><ul><ul><li>While You Do Pay a Broker’s Commission, There Are No Loads </li></ul></ul><ul><li>Shares Trade at Premiums or Discounts to NAV </li></ul><ul><ul><li>Discounts Can Be Attractive; In Effect, You Buy $1.00 Worth of Securities for Less than $1.00 </li></ul></ul>
  9. 9. Fund Objectives <ul><li>Type of Fund Objective </li></ul><ul><li>___________ _______________________________ </li></ul><ul><li>Growth Price Appreciation over Time </li></ul><ul><li>Income High Current Return </li></ul><ul><li>Balanced Good Current Return with some Growth </li></ul><ul><li>Money Mkt. High Liquidity and Returns Better than </li></ul><ul><li>Bank Returns </li></ul><ul><li>Maximum Exploit Opportunities to Earn Very High </li></ul><ul><li>Appreciation Returns </li></ul>
  10. 10. Fund Objectives,Continued <ul><li>Type of Fund Fund Objective </li></ul><ul><li>____________ _______________________________ </li></ul><ul><li>Sector Invests in Only One Industry </li></ul><ul><li>International Earn Returns in Countries outside the </li></ul><ul><li>United States </li></ul><ul><li>Global Earn Returns in both the United </li></ul><ul><li>States and Foreign Countries </li></ul><ul><li>Index Earn Returns Equal to a Market Index </li></ul><ul><li>Returns </li></ul>
  11. 11. Mutual Fund Services <ul><li>Reinvestment Plans </li></ul><ul><ul><li>Can Reinvest Dividends and Capital Gains </li></ul></ul><ul><li>Transactions by Telephone and Internet </li></ul><ul><li>Fund Switching within a Fund Family </li></ul><ul><ul><li>Can Sell Shares of One Fund and Reinvest in Shares of Another Fund </li></ul></ul><ul><ul><li>Be Careful of Loads </li></ul></ul><ul><li>Adaptability to IRAs </li></ul>
  12. 12. Selecting a Mutual Fund <ul><li>Evaluate Performance </li></ul><ul><li>Review the Fund’s Current Portfolio </li></ul><ul><li>Examine Expenses and Turnover </li></ul><ul><li>Review Evaluations in Popular Magazines and Newspapers </li></ul><ul><li>Consult a Professional Evaluation Service, such as Morningstar </li></ul>
  13. 13. Performance Measurements <ul><li>Growth of $1,000 over Time </li></ul><ul><ul><li>Example: a cumulative total return of 259.45% means that $1,000 invested 10 years ago has earned $2,594.50 and the investment is now worth $3,594.50 </li></ul></ul><ul><ul><li>Assumes that All Dividends Are Reinvested as They Are Earned Each Quarter </li></ul></ul><ul><li>Average Annual Total Return (AATR) </li></ul><ul><ul><li>Expresses the Cumulative Return as a Yearly Average: 13.65% for the Above </li></ul></ul>
  14. 14. The Risk-Adjusted Rate of Return (RAROR) <ul><ul><li>Adjusts a Funds AATR by Its Beta Value and Compares this Adjusted Return to the Overall Market Return </li></ul></ul><ul><li>RAROR = (AATR/Beta) - S&P 500 Return </li></ul><ul><ul><li>Example: AATR = 13.65%, Beta = 0.86, S&P 500 Return = 14.39% </li></ul></ul><ul><ul><li>RAROR = (13.65%/0.86) - 14.39% </li></ul></ul><ul><ul><li>= 15.87% - 14.39% </li></ul></ul><ul><ul><li>= + 1.48% </li></ul></ul>
  15. 15. Interpreting RARORs <ul><li>A Positive RAROR Indicates Good Fund Management </li></ul><ul><li>A Negative RAROR Indicates Poor Fund Management </li></ul><ul><li>It is Important to Have + RARORS Consistently Over Time--Do Not Rely Too Heavily on One Year’s Number </li></ul>
  16. 16. Other Evaluation Items <ul><li>Review the Fund’s Current Portfolio </li></ul><ul><ul><li>Is There Adequate Diversification? </li></ul></ul><ul><li>Review the Fund’s Operating Expenses </li></ul><ul><ul><li>Usually Expressed as a % of Net Assets </li></ul></ul><ul><ul><li>Small %s Are Desirable </li></ul></ul><ul><li>Examine the Portfolio Turnover % </li></ul><ul><ul><li>Turnover % Measures the Trading Frequency: High Numbers = Much Trading </li></ul></ul>
  17. 17. Fund Evaluations <ul><li>The Popular Press </li></ul><ul><ul><li>Wall Street Journal--Each Friday Issue </li></ul></ul><ul><ul><li>Money Magazine </li></ul></ul><ul><ul><li>Business Week </li></ul></ul><ul><ul><li>Forbes </li></ul></ul><ul><li>Professional Evaluations </li></ul><ul><ul><li>Morningstar is An Example </li></ul></ul><ul><ul><li>You Pay for this Service BUT Check Out Morningstar’s Web Site for Free Info </li></ul></ul>
  18. 18. Unit Investment Trust <ul><li>Similar to an Open-End Fund </li></ul><ul><ul><li>Trust Units (Shares) Are Purchased from and Redeemed by the Fund Originator </li></ul></ul><ul><ul><li>Redemption is at Current Market Value </li></ul></ul><ul><li>Major Difference </li></ul><ul><ul><li>A Trust’s Portfolio is Unmanaged; i.e., Once Established It Is Left Virtually Unchanged </li></ul></ul><ul><ul><li>This Leads to Very Low Operating Costs </li></ul></ul><ul><ul><li>However, UITs Have Loads </li></ul></ul>
  19. 19. Creation of a UIT Trust Originator Buys a Portfolio of Bonds and Sells Trust Units to Individual Investors Investor A Investor B Investor C Who May Hold Their Units to Maturity or May Sell Back to Originator--at Current Market Value
  20. 20. Exchange Traded Funds <ul><li>UITs that trade in the securities markets, similar to closed-end funds </li></ul><ul><li>Relatively fixed portfolios </li></ul><ul><ul><li>Based on broad market (QQQs, Spiders, Diamonds, others) </li></ul></ul><ul><ul><li>Based on market segments (Industry ETFs, Holders, others) </li></ul></ul>
  21. 21. ETF Advantages (Disadvantage) <ul><li>Positions can be taken quickly, just as with any individual stock </li></ul><ul><li>Shares can be purchased on margin </li></ul><ul><li>Very low expense ratios </li></ul><ul><li>Tax advantage insofar as investors can avoid capital gains by simply not selling </li></ul><ul><li>But, commissions must be paid on trades </li></ul>
  22. 22. Real Estate Investment Trusts <ul><li>Similar to a Closed-End Fund </li></ul><ul><ul><li>Equity per Share (EqPS) of a REIT is Similar to NAV and Calculated as Follows: </li></ul></ul><ul><ul><li>(Assets - Liabilities)/REIT Shares Outstanding </li></ul></ul><ul><li>Types of REITs </li></ul><ul><ul><li>Equity Trust: Invest in Rental Properties </li></ul></ul><ul><ul><li>Mortgage Trust: Invests in Mortgages </li></ul></ul><ul><li>Investment Appeal: Easy Way to Include Real Estate in a Portfolio </li></ul>
  23. 23. Limited Partnerships (LPs) <ul><li>Formed by: </li></ul><ul><ul><li>General Partner Who Runs the Business </li></ul></ul><ul><ul><li>Limited Partners Who Put Up the Money </li></ul></ul><ul><li>Invest in a Various Activities, Such As: </li></ul><ul><ul><li>Real Estate </li></ul></ul><ul><ul><li>Energy Programs </li></ul></ul><ul><ul><li>Equipment Leasing </li></ul></ul>
  24. 24. Limited Partnerships (LPs) <ul><li>Unique Feature is the Pass Through of Business Profits and Losses to the Limited Partners </li></ul><ul><li>Losses Can Have Significant Advantages if Used to Offset Other Taxable Income </li></ul><ul><li>However, Current Tax Code Severely Limits Such Deductions </li></ul><ul><li>Making LPs an Undesirable Vehicle for Most Investors </li></ul><ul><li>Moreover, LP Interests Cannot be Sold Easily, Making Your Investment Highly Illiquid </li></ul>
  25. 25. Investment Clubs <ul><li>Characteristics </li></ul><ul><ul><li>Frequent Meetings, Usually Monthly </li></ul></ul><ul><ul><li>Low Monthly Contributions, $25 - $50 </li></ul></ul><ul><ul><li>Members Do Research on Specific Stocks </li></ul></ul><ul><li>Advantages </li></ul><ul><ul><li>Diversification </li></ul></ul><ul><ul><li>Help with Investing Workload </li></ul></ul><ul><ul><li>Fun and Fellowship </li></ul></ul>
  26. 26. Investment Clubs <ul><li>Disadvantage: </li></ul><ul><ul><li>Too Much Fun, Not Enough Research </li></ul></ul>
  27. 27. Portfolio Construction: Aggressive Investor <ul><li>Characteristics </li></ul><ul><ul><li>Risk Tolerance: High </li></ul></ul><ul><ul><li>Return Preference: Future Return </li></ul></ul><ul><ul><li>Priority of Specific Future Goals: Not Strong </li></ul></ul><ul><li>Investor Types </li></ul><ul><ul><li>Persons with No Dependents </li></ul></ul><ul><ul><li>Wealthy Investors </li></ul></ul>
  28. 28. Portfolio Construction: Cautious Investor <ul><li>Characteristics </li></ul><ul><ul><li>Risk Tolerance: Low </li></ul></ul><ul><ul><li>Return Preference: Future Return </li></ul></ul><ul><ul><li>Priority of Specific Future Goals: Very Strong </li></ul></ul><ul><li>Investor Types </li></ul><ul><ul><li>Anyone with Dependents </li></ul></ul><ul><ul><li>Investors Planning Retirement </li></ul></ul><ul><ul><li>Investors Planning a Major Purchase </li></ul></ul>
  29. 29. Portfolio Construction: Investor Who Needs Income <ul><li>Characteristics </li></ul><ul><ul><li>Risk Tolerance: Moderate </li></ul></ul><ul><ul><li>Return Preference: Current Return </li></ul></ul><ul><ul><li>Priority of Specific Future Goals: Moderately Strong </li></ul></ul><ul><li>Investor Types </li></ul><ul><ul><li>Retirees </li></ul></ul><ul><ul><li>Persons with Dependents to Support </li></ul></ul><ul><ul><li>Persons with No Major Future Expenses </li></ul></ul>
  30. 30. Investment Selection <ul><li>Aggressive Investor </li></ul><ul><ul><li>100% Stocks: 1/3 Large Company, 1/3 Small Company, 1/3 International </li></ul></ul><ul><li>Cautious Investor </li></ul><ul><ul><li>30% Large Company Growth Stocks, the Balance in Bonds, including Zero-Coupon </li></ul></ul><ul><li>Investor Who Needs Income </li></ul><ul><ul><li>50% High-Quality Corporate Bonds, 25% Medium-Quality Corporate Bonds, and 25% Income Stocks </li></ul></ul>
  31. 31. Maintaining a Portfolio <ul><li>Stocks Bonds </li></ul><ul><li>(1) Amount Invested </li></ul><ul><li>Initially $10,000 $10,000 </li></ul><ul><li>(2) Current Market </li></ul><ul><li>Values 15,000 9,000 </li></ul><ul><li>(3) Adjustment with </li></ul><ul><li>Constant Ratio Plan * - 3,000 + 3,000 </li></ul><ul><li>(4) Adjusted Balances 12,000 12,000 </li></ul><ul><li>____________ </li></ul><ul><li>* A Variable Ratio Plan Would Sell More Stocks and Buy More Bonds </li></ul>
  32. 32. 401(k) Plan Considerations <ul><li>Don’t Reject Participation </li></ul><ul><li>Diversify Broadly Using a Variety of Funds </li></ul><ul><li>Coordinate Out-of-Plan Investments with In-Plan Investments </li></ul><ul><li>Don’t Try to Time the Markets, Even Though Gains Are Not Taxed </li></ul><ul><li>Avoid Excessive Conservatism </li></ul>
  33. 33. Next Chapter 13 Property and Liability Insurance