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  • 1. 16 INVESTING IN MUTUAL FUNDS CHAPTER OVERVIEW This chapter describes mutual funds as an investment alternative. We begin our discussion by considering why investors purchase mutual funds. Then, we examine the characteristics of closed-end mutual funds, exchange-traded funds, and open-end mutual funds. The differences between load funds and no-load funds are explained. We describe the major categories of mutual funds in terms of the types of securities they invest in. Finally, methods that can be used to evaluate mutual fund investments and the mechanics of mutual fund transactions are presented. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Describe the The major reasons why investors choose mutual funds are profes- characteristics of sional management and diversification. Mutual funds are also a mutual fund convenient way to invest money. There are three types of mutual investments. funds. A closed-end fund is a mutual fund whose shares are issued only when the fund is organized. An exchange-traded fund (ETF) is a fund that invests in the stock contained in a specific stock index like the Standard & Poor’s 500 stock index. Both closed-end funds and exchange-traded funds are traded on a stock exchange or the over-the-counter market. An open-end fund is a mutual fund whose shares are sold and redeemed by the investment company at the net asset value (NAV) at the request of investors. Mutual funds are also classified as load and no-load funds. Load funds charge a commission every time an investor purchases shares. No commission is charged to purchase shares in a no-load fund. Mutual funds can also be classified as “A” shares (commission charged when shares are purchased), “B” shares (commissions charged when money is withdrawn during the first five to seven years, and “C” shares (no commission to buy or sell shares, but higher, ongoing 12b-1 fees. Other possible fees include management fees, contingent deferred sales fees, and 12b-1 fees. Together all the different fees are reported as an expense ratio. Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 37
  • 2. LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 2 Classify mutual The major categories of stock mutual funds, in terms of the types funds by investment of securities in which they invest, are aggressive growth, equity objective. income, global, growth, index, international, large-cap, mid cap, regional, sector, small cap, and socially responsible. There are also bond funds that include high-yield, index, intermediate corporate, intermediate U.S. government, long-term corporate, long-term U.S. government, municipal, short-term corporate, short-term U.S. government and world. Finally, other funds invest in a mix of different stocks, bonds, and other investment securities that include asset allocation funds, balanced funds, and money-market funds. Today, many investment companies use a family of funds concept, which allows shareholders to switch their investments among funds as different funds offer more potential, financial reward, or security. Some investors even use a market timer to decide when to switch their investments from one fund to another fund. Obj. 3 Evaluate mutual The responsibility for choosing the “right” mutual fund rests with funds for investment you—the investor. One of the first questions you must answer is if purposes. you want a managed fund or an index fund. Most mutual funds are managed funds with a professional fund manager (or team of managers) that choose the securities that are contained in the fund. On the other hand, an index fund invests in the securities that are contained in an index like the Standard & Poor’s 500 stock index. Statistically, the majority of managed mutual funds have failed to outperform index funds over many years. The information on the Internet, from professional advisory services, in newspapers, in the prospectus and annual reports, and in financial publications can all help you evaluate a mutual fund. Obj. 4 Describe how and The advantages and disadvantages of mutual funds have made why mutual funds are mutual funds the investment of choice for many investors. For bought and sold. $250 to $3,000 or more, you can open an account and begin investing. The shares of a closed-end fund or exchange-traded fund are bought and sold on organized exchanges or the over-the- counter market. The shares of an open-end fund may be purchased through a salesperson who is authorized to sell them, through an account executive of a brokerage firm, from a mutual fund supermarket, or from the investment company that sponsors the fund. The shares in an open-end fund can be sold to the investment company that sponsors the fund. Shareholders in mutual funds can receive a return in one of three ways: income dividends, capital gain distributions when the fund buys and sells securities in the fund’s portfolio at a profit, and capital gains when the shareholder sells shares in the mutual fund at a higher price than the price paid. A number of purchase and withdrawal options are available. 38 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.
  • 3. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 513). • Point out the learning objectives (p. 512) in an effort to highlight the key points in the chapter. • Ask students to express opinions they may have about investing in mutual funds. • Discuss how different investment objectives can be achieved with various types of mutual funds. • Ask if investors need to evaluate mutual funds since they are professionally managed. CHAPTER 16 OUTLINE I. Why Investors Purchase Mutual Funds A. Characteristics of Mutual Funds 1. Closed-End, Exchange-Traded, or Open-End Mutual Funds 2. Load Funds and No-Load Funds 3. Management Fees and Other Charges II. Classifications of Mutual Funds A. Stock Funds B. Bond Funds C. Other Funds III. How to Make a Decision to Buy or Sell Mutual Funds A. Managed Funds Versus Indexed Funds B. The Internet C. Professional Advisory Services D. How to Read the Mutual Funds Section in the Newspaper E. Mutual Fund Prospectus F. Mutual Fund Annual Report G. Financial Publications IV. The Mechanics of a Mutual Fund Transaction A. Return on Investment B. Taxes and Mutual Funds C. Purchase Options D. Withdrawal Options CHAPTER 16 LECTURE OUTLINE • A mutual fund is an investment alternative chosen by individuals who pool their money to buy Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 39
  • 4. CHAPTER 16 LECTURE OUTLINE stocks, bonds, and other securities selected by professional managers who work for an investment company. • The Mutual Fund Education Alliance defines an investment company as a corporation, partnership, or trust that invests the pooled monies of many investors. For a fee, an investment company invests the pooled funds of small investors in securities appropriate to a fund’s statement investment objective. • Mutual funds are an excellent choice for many individuals. In many cases, they can also be used for retirement accounts, including 401(k), 403(b), traditional individual retirement accounts, and Roth IRAs. • Regardless if you are investing in an account subject to immediate taxation or in a retirement- type account with deferred taxation, you must be able to select the funds that will help you obtain your investment goals. • An investment in mutual funds is based on the concept of opportunity costs, which we have discussed throughout this text. • Simply put, you have to be willing to take some chances if you want to get larger returns on your investments. I. WHY INVESTORS PURCHASE MUTUAL FUNDS (p. 514) • The following statistics illustrate how important mutual funds investments are to both individuals and the nation’s economy. 1. An estimated 92 million individuals in 54 million households own mutual funds in the United States. 2. The number of mutual funds grew from 361 to over 8,000 in late 2004, and continue to increase each year. 3. At the end of 2004, the last year for which complete totals are available, the combined value of assets owned by mutual funds in the United States totaled just over $8 trillion. This amount is expected to continue to increase based on long-term performance. • The major reasons why investors purchase mutual funds are professional management and diversification, or investment in a wide variety of securities. • But be warned—even the best portfolio managers make mistakes. As an investor, you have to evaluate an investment in mutual funds just as you would evaluate any other potential investment. • The diversification of mutual funds spells safety, because an occasional loss incurred with one investment contained in a mutual fund is usually offset by gains from other investments in the fund. Characteristics of Mutual Funds (p. 516) • There are three ways to invest in the mutual funds offered by investment companies. 1. Approximately 7 percent of all mutual funds are closed-end funds offered by investment companies. A closed-end fund is a mutual fund whose shares are issued by an investment company only when the fund is organized. Shares of closed-end funds are traded on the floor of stock exchanges. 2. An exchange-traded fund (ETF) is a fund that invests in the stocks contained in a specific stock, like the Standard & Poor’s 500 stock index, the Dow Jones Industrial Average, or the Nasdaq 100 Index, and whose shares are traded on a stock exchange. Although exchanged- 40 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.
  • 5. CHAPTER 16 LECTURE OUTLINE traded funds are similar to closed-end funds, there is an important difference. Most closed- end funds are actively managed, while exchange-traded fund managers are passive and invest in the stocks included in a specific stock index. There are only about 150 exchange-traded funds. 3. Approximately 91 percent of all mutual funds are classified as open-end funds. An open-end fund is a mutual fund whose shares are issued and redeemed by the investment company at the request of investors. • Investors are free to buy and sell shares in an open-end fund at the net asset value. The net asset value (NAV) per share is equal to the current market value of the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the number of shares outstanding. • The investor should compare the cost of investing in a mutual fund with the cost of other investment alternatives. • With regard to cost, mutual funds are classified as 1. Load funds. 2. No-load funds. • The commission charge for load funds may be as high as 8 1/2 percent of the purchase price for investments under $10,000. • While many exceptions exist, the average load charge for mutual funds is between 3 and 5 percent. • No-load funds don’t charge commissions when you buy shares because they have no salespeople. Since no-load funds offer the same investment opportunities that load funds offer, you should investigate them further before deciding which type of mutual fund is best for you. • Some mutual funds charge a contingent deferred sales load of 1 to 5 percent that shareholders pay when they withdraw their investment from a mutual fund. These fees depend on how long the investor owns the fund. • Some mutual funds charge a management fee that ranges from 0.25 to 2 percent per year. While management fees vary, the average is 0.50 percent to 1.25 percent of the fund’s assets. • The investment company may also levy a 12b-1 fee to defray the costs of marketing and distributing a mutual fund. This annual fee is generally 1 percent or less of a fund’s assets per year. • When compared to Class A shares (commissions charged when shares are purchased) and Class B shares (commissions charged when withdrawals are made over the first five to seven years), Class C shares, with their ongoing, higher 12b-1 fees, may be more expensive over a long period of time. • Together, all the different management fees, 12b-1 fees, if any, and additional fund operating costs for a specific fund are referred to as an expense ratio. II. CLASSIFICATIONS OF MUTUAL FUNDS (p. 520) • The managers of mutual funds tailor their investment portfolios to the investment objectives of Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 41
  • 6. CHAPTER 16 LECTURE OUTLINE their customers. • The major categories of mutual funds, in terms of the types of securities they invest in, are as follows: Stock Funds (p. 520) 1. Aggressive growth funds 2. Equity income funds 3. Global stock funds 4. Growth funds 5. Index funds 6. International funds 7. Large-cap funds 8. Mid-cap funds 9. Regional funds 10. Sector funds 11. Small-cap funds 12. Socially-responsible funds Bond Funds (p. 522) 1. High-yield (junk) bond funds 2. Index bond funds 3. Intermediate corporate bond funds 4. Intermediate U.S. bond funds 5. Long-term corporate bond funds 6. Long-term U.S bond funds 7. Municipal bond funds 8. Short-term corporate bond funds 9. Short-term U.S. government bond funds 10. World bond funds Other Funds (p. 522) 1. Asset allocation funds 2. Balanced funds 3. Money-market funds • A family of funds exists when one investment company manages a group of mutual funds. Each fund has a different financial objective. And most investment companies offer exchange privileges that enable shareholders to readily switch among the mutual funds in a fund family. • To improve financial performance, some investors use a market timer. A market timer is an individual who helps investors decide when to switch their investment from one fund to another fund, usually within the same family of funds. III. HOW TO MAKE A DECISION TO BUY OR SELL MUTUAL FUNDS (p. 524) • The responsibility for choosing the right mutual funds rests with the individual investor. After all, they are the only ones who know how a particular mutual fund can help them achieve their financial objectives. Managed Funds Versus Indexed Funds (p. 524) • Most mutual funds are managed funds. In other words, there is a professional fund manager (or team of managers) that chooses the securities that are contained in the fund. • Instead of investing in a managed fund, some investors choose to invest in an index fund. Why? The answer to that question is simple: Over many years, the majority of managed mutual funds fail to outperform the Standard & Poor’s 500 stock index. Depending on the year, anywhere from 42 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.
  • 7. CHAPTER 16 LECTURE OUTLINE 50 percent to 80 percent of managed funds get beat by index funds. • Simply put: It’s hard to beat an index like the Standard & Poor’s 500. • If the individual securities included in an index increase, the index goes up. Because an index mutual fund is a mirror image of a specific index, the dollar value of a share in an index fund also increases when the index increases. • Unfortunately, the reverse is true. • Index funds, sometimes called “passive” funds, have managers, but they simply buy the stocks or bonds contained in the index. • A second reason why investors choose index funds is the lower expense ratio charged by these passively managed funds. Typical expense ratios for an index fund are 0.50 percent or less. The Internet (p. 525) • It is possible to use the Internet to obtain information about mutual funds. Not only is it possible to obtain current market values, you can also access home pages of the investment company sponsoring the mutual fund and different professional advisory services. Professional Advisory Services (p. 526) •A number of subscription services provide detailed information on mutual funds. Standard and Poor’s Corporation, Lipper Analytical Services, Morningstar, Inc., and Value Line are widely used sources of information. In addition, various mutual fund newsletters provide financial information to subscribers for a fee. How to Read the Mutual Funds Section in the Newspaper (p. 528) • Most large metropolitan newspapers, The Wall Street Journal, and Barron’s provide information about mutual funds. • The net asset value, change in net asset value and total return over selected time periods are reported in tables like that shown in Exhibit 16-6. • The letters beside the name of a specific fund can be very informative. You can find out what they mean by looking at the footnotes that accompany the newspaper’s mutual fund quotations. Generally, 1. “p” means that a 12b-1 distribution fee is charged. 2. “r” means that a redemption charge may be made. 3. “t” means that both the p and r footnotes apply. 4. “s” means the fund has had a stock split or paid a dividend. Mutual Fund Prospectus (p. 529) • An investment company sponsoring a mutual fund must give potential investors a prospectus. • The prospectus should provide the answers to a number of questions—see text page 529. Mutual Fund Annual Report (p. 529) • Once you are a shareholder, the investment company will send you annual reports. Financial Publications (p. 529) • Another source of information about mutual funds is investment-oriented magazines like Business Week, Forbes, Kiplinger’s Personal Finance Magazine, Money, and other finance- or consumer-oriented magazines and financial guidebooks. • A number of mutual fund guidebooks are available at your local bookstore or public library. IV. THE MECHANICS OF A MUTUAL FUND TRANSACTION (p. 532) Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 43
  • 8. CHAPTER 16 LECTURE OUTLINE • In this section, we discuss three important topics. 1. We examine how shareholders can make money by investing in closed-end, exchange-traded, or open-end mutual funds. 2. We look at the options that can be used to purchase shares in a mutual fund. 3. We look at the options that can be used to withdraw shares from a mutual fund. Return on Investment (p. 532) • As with other investments, the purpose of investing in a closed-end, exchange-traded, or an open- end fund is to earn a financial return. • Shareholders in such funds can receive a return in one of three ways. 1. All three types of funds pay income dividends. Income dividends are the earnings that a fund pays to shareholders after it has deducted expenses from its dividend and interest income. 2. Mutual funds also pay capital gain distributions. Capital gain distributions are the payments made to a fund’s shareholders that result from the sale of securities in the fund’s portfolio. Note: exchange-traded funds don’t usually pay end-of-the-year capital gain distributions. 3. As with stock investments, it is possible to buy shares in both types of funds at a low price and then to sell them after the price has increased. The profit that results from an increase in value is referred to as a capital gain. Of course, if the price of a fund’s shares goes down, the shareholder incurs a loss. 4. Note the difference between a capital gain distribution and a capital gain. Taxes and Mutual Funds (p. 533) • Financial gains and losses from the transactions of closed-end, exchange-traded, or open-end funds are subject to taxation. • At the end of each year, investment companies are required to send each shareholder a statement specifying how much he or she received in dividends and capital gain distributions. • Reminder: Be sure you understand the difference between capital gains distributions and capital gains. • Be sure to keep accurate records for tax purposes. Purchase Options (p. 535) • The shares of a closed-end or exchange-traded funds are traded on various stock exchanges. • The shares of an open-end fund may be purchased through a salesperson who is authorized to sell them, through an account executive of a brokerage firm, or directly from the investment company that sponsors the fund. • You can also purchase shares from a mutual fund supermarket. • You may also purchase shares in an open-end fund by using the fund’s reinvestment plan. • All four purchase options (regular accounts, voluntary savings plans, contractual savings plans, and reinvestment plans) allow investors to buy shares over a long period of time. As a result, they can use the principle of dollar cost averaging. Withdrawal Options (p. 536) • Because closed-end and exchange-traded funds are listed on securities exchanges, it is possible to sell shares in such a fund to another investor. • Shares in an open-end fund can be sold on any business day to the investment company that sponsors the fund. In this case, shares are redeemed at their net asset value. • In addition to just selling shares, the investor may use at least four options to systematically withdraw money from an open-end mutual fund. 1. Most funds have a provision that allows investors to systematically withdraw a specified, fixed dollar amount of money each month, quarter, or year. 2. A second option allows the investor to liquidate or “sell off” a certain number of shares each 44 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.
  • 9. CHAPTER 16 LECTURE OUTLINE month, quarter, or year. 3. A third option allows investors to withdraw a fixed percentage of asset growth. 4. A final option allows the investor to withdraw all asset growth that results from income, dividends, and capital gains earned by the fund during an investment period. Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 45