Ln14 keown 856526_pf_07_ln14

Chapter 14
Mutual Funds:
An Easy Way to
Diversify

© 2016 Pearson Education, Inc. All rights reserved.14-2
Learning Objectives
1. Weigh the advantages and disadvantages
of investing in mutual funds.
2. Differentiate between types of mutual
funds, ETFs, and investment trusts.
3. Calculate mutual fund returns.
4. Classify mutual funds according to
objectives.
5. Select a mutual fund that’s right for you.

Introduction
• A way of holding investments such as stocks
and bonds.
• Mutual fund—an investment that raises from
investors, pools the money, and invests it in
stocks, bonds, and other investments.
• Each investor owns a share of the fund
proportionate to his/her investment.

Why Invest in Mutual Funds?
• Advantages of mutual funds:
– Diversification
– Professional management
– Minimal transaction costs
– Liquidity
– Flexibility
– Service
– Avoidance of bad brokers

Why Invest in Mutual Funds?
• Disadvantages of mutual funds:
– Lower-than-market performance
– Costs
– Risks
– You can’t diversity away a market crash
– Taxes

Mutual Fund-Amentals
• A mutual fund pools money from investors
with similar financial goals.
• You are investing in a diversified portfolio
that’s professionally managed according to
set goals.
• Investment objectives are clearly stated.

• As the value of the securities in the fund
increases, the value of each mutual fund
share also rises.
• Most pay dividends or interest to
shareholders.
• Shareholders receive a capital gains
distribution when the fund sells a security
for more than originally paid.

• Fund is set up as a corporation or trust.
• Shareholders elect a board of directors.
• Fund is run by a management company.
• Each individual fund hires an investment
advisor to oversee the fund.
• Contracts with a custodian, a transfer agent,
and an underwriter.

Investment Companies
• Invest the pooled money of a number of
investors in return for a fee
• Most popular are the open-end investment
companies or mutual funds
• Net asset value (NAV)—dollar value of a
share in the mutual fund

Investment Companies
• Closed-End Investment Companies—can’t issue
new shares
• Unit Investment Trusts—fixed pool of securities
• Real Estate Investment Trusts (REITs)—
specializes in real estate
• Hedge Funds—very risky

Calculating Mutual Fund Costs
and Returns
• Commissions when you buy or sell your
holdings
• Annual management fee
• Marketing expenses

Load Versus No-Load Funds
• Load—commission charged on a mutual
fund
• Load fund—mutual fund on which a load is
charged.
• Class A shares—front-end sales load
• Class B shares—back-end load
• Class C shares—pay coming and going
• No-load fund—doesn’t charge commission

Management Fees and Expenses
• Expense ratio—the ratio of a mutual fund’s
expenses to its total assets
• Invest in a fund with a low expense ratio
• Turnover rate—measures the level of the
fund’s trading activity.
• Higher turnover rate, higher the fund’s
expenses.

12b-1 Fees
• Annual fee, generally ranging from 0.25 to
1% of a fund’s assets, that the mutual fund
charges its shareholders for marketing
costs.

Calculating Mutual Fund Returns
• Return can be in the form of dividends,
capital gains, or a change in net asset value.
• Automatic reinvestments result in increases
in the NAV and number of shares.
• Calculating returns can help you spot funds
that have consistent winners over time.

Calculating Mutual Fund Returns

Types and Objectives of Mutual
Funds
• Fund managers classify their own funds
• First, determine your objectives
• Then, you can likely find a mutual fund to
meet your objectives

Money Market Mutual Funds
• Invest in Treasury bills, CDs, and other
short-term investments, less than 30 days
• Carry no loads, trade at a constant $1 NAV,
and have minimal expense ratios
• Tax-exempt money market fund
• Government securities money market
mutual fund

Stock Mutual Funds
• Aggressive growth funds
• Small company growth funds
• Growth funds
• Growth-and-income funds
• Sector funds
• Index funds
• International funds

Balanced Mutual Funds
• Tries to balance objectives of long-term
growth, income, and stability
• Hold both common stock and bonds and
sometimes preferred stock
• Aimed at those needing income to live on
and moderate stability in their investment
• Less volatile than stock mutual funds

Asset Allocation Funds
• Invests in stocks, bonds, and money market
securities
• Move money between stocks and bonds to
outperform the market
• Balanced funds that practice market timing

Life Cycle and Target Retirement
Funds
• Mutual funds that try to tailor their holdings
to the investor’s individual characteristics,
such as age and risk
• Target retirement funds are managed based
on when you plan to retire

Bond Funds
• Mutual funds that invest primarily in bonds
• Fluctuate in value with market interest rates
• Use for small amounts of money, to keep
investments liquid
• Otherwise, use individual bonds where there
is no professional management or fees

U.S. Government Bond Funds or
GNMA Bond Funds
• Municipal Bond Funds
• Corporate Bond Funds
• Bond Funds and Their Maturities:
– Short-term (1-5 years)
– Intermediate-term (5-10 years)
– Long-term (10-30 years)

Exchange Traded Funds or ETFs
• A hybrid between a mutual fund and an
individually traded stock or bond that trade
on an exchange like individual securities do
and can be bought and sold through the
trading day.

Exchange Traded Funds or ETFs
• Charge lower annual expenses but still pay
trading commissions.
• More tax-efficient than most mutual funds.
• Allow investors to stake out an investment
position in a sector, industry, or country.
• Investors can make their move during the
market’s trading hours.

Mutual Fund Services
• Automatic investment and withdrawal plans
• Automatic reinvestment of interest,
dividends, and capital gains
• Wiring and funds express options
• Online and phone switching
• Easy establishment of retirement plans
• Check writing
• Bookkeeping and help with taxes

Buying a Mutual Fund
• Step 1: Determining Your Goals
– Goals and time horizon
– Why are you investing?
– Tax-deferred investments?
– Risk tolerance

• Step 2: Meeting Your Objectives
– Look at classifications and objectives

• Step 3: Selecting the Fund
– Evaluate past performance and scrutinize the
costs
– Make sure it meets your objectives

• Step 4: Making the Purchase
– Buy direct—use phone or internet
– Buy through a mutual fund “supermarket”—such
as Fidelity or Charles Schwab & Co.

Summary
• When you buy a mutual fund, you’re buying
a share of a very large portfolio which goes
up and down as the value of the mutual
fund’s investments goes up and down.
• There are open-end and close-end
investment companies, unit investment
trusts, and real estate investment trusts.

Summary
• Be very wary of mutual fund expenses—no-
load mutual funds don’t charge commission.
• Funds are classified according to objective.
• When selecting a mutual fund, determine
your goals, find funds that meet your
objectives, and evaluate.

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