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  1. 1. Chapter Fifteen Investing Through Mutual Funds
  2. 2. Learning Objectives <ul><li>Summarize the two types of investment returns that investors expect from mutual funds. </li></ul><ul><li>Classify mutual funds by investment objectives. </li></ul><ul><li>Describe the unique features of mutual funds that make them an attractive investment. </li></ul>
  3. 3. Learning Objectives (continued) <ul><li>Distinguish among load and no-load mutual funds and explain how to avoid some of their numerous charges and fees. </li></ul><ul><li>Explain how to evaluate mutual funds in which to invest. </li></ul>
  4. 4. Introduction <ul><li>Investment Company – a corporation, trust, or partnership in which investors with similar financial goals pool their funds so as to utilize professional management and to diversify their investments in securities and other investments. </li></ul>
  5. 5. Introduction (continued) <ul><li>Mutual Fund – an investment company that combines the funds of investors who have purchased shares of ownership in the investment company and then invests that money in a diversified portfolio of stocks and bonds issued by other corporations or governments. </li></ul><ul><li>Portfolio – consists of a collection of securities and other investment alternatives. </li></ul>
  6. 6. What Investors Expect from Mutual Funds <ul><li>Closed-End Investment Company – issues a limited and fixed number of shares and does not buy them back. </li></ul><ul><li>Open-End Mutual Fund – always ready to sell new shares of ownership and to buy back previously sold shares at the fund’s current share price. </li></ul>
  7. 7. Figure 15.1: How a Mutual Fund Works
  8. 8. Investors Expect Mutual Fund Dividend Income <ul><li>Mutual Fund Dividends – income paid to investors out of profits earned by the mutual fund from the investments it has made. </li></ul><ul><ul><li>Mutual funds dividends represent current income to mutual fund shareholders. </li></ul></ul>
  9. 9. Ordinary Income Dividend Distributions <ul><li>Ordinary Income Dividend Distributions – the fund pays out dividend income and interest it has received from securities it owns. </li></ul>
  10. 10. Capital Gains Distributions <ul><li>Capital Gains Distributions – represent the net gains that a fund realizes when it sells securities that were held in the fund’s portfolio. </li></ul>
  11. 11. Investors Expect Capital Gains Through Price Appreciation <ul><li>Mutual fund investors also expect to profit when they sell their shares. </li></ul><ul><li>Net Asset Value (NAV) – the per-share value of the mutual fund. </li></ul><ul><li>Unrealized Capital Gains – merely “paper profits” on the accounts of the mutual fund. </li></ul><ul><li>When such gains are “realized” by the mutual fund company, they are paid to fund investors as capital gains distributions. </li></ul>
  12. 12. Mutual Funds Have Different Investment Objectives <ul><li>Prospectus – a mutual fund’s investment objectives must be stated in this. </li></ul>
  13. 13. Funds with an Income Objective <ul><li>Bond Fund – aims to earn current income without incurring undue risk and to pay ordinary income dividend distributions. </li></ul><ul><li>Municipal Bond (Tax-Exempt) Fund – attempts to earn current tax-exempt income by investing solely in municipal bonds issued by cities, states, and various districts and political subdivisions. </li></ul><ul><li>Mortgage Fund – invests in mortgage-backed securities. </li></ul>
  14. 14. Funds with a Balanced Objective <ul><li>Balanced Funds – invest in a mixture of bonds, preferred stocks, and blue-chip common stocks. </li></ul>
  15. 15. Funds with a Growth Objective <ul><li>Growth Fund – seeks long-term capital appreciation by investing in the common stocks of companies whose values are expected to grow faster than usual. </li></ul><ul><li>Value Fund – specializes in growth stocks whose prices appear to be low, based on the logic that such stocks are currently out of favor and under-priced. </li></ul>
  16. 16. Funds with a Growth Objective (continued) <ul><li>Aggressive-Growth Fund (or Maximum Capital Gains Fund) – seeks the greatest long-term capital appreciation and incurs the greatest fluctuation in the price of its shares. </li></ul><ul><li>Small-Cap Fund (or Small-Capitalization Fund) – specializes in investing in lesser-known mid-sized companies with market capitalization of less than $1 billion that are expected to grow rapidly. </li></ul>
  17. 17. Funds with a Growth Objective (continued) <ul><li>Sector Fund – heavily invests in common stocks from one industry or one portion of the economy that are expected to grow, perhaps very rapidly. </li></ul><ul><li>Precious Metals and Gold Funds – seek long-term capital appreciation by investing in securities associated with gold, silver, and other precious metals. </li></ul><ul><li>Global Fund – invests primarily in growth stocks of companies listed on foreign exchanges. </li></ul>
  18. 18. Funds with a Growth Objective (continued) <ul><li>International Funds – hold only foreign stocks, and some such funds focus on a single country or geographic region. </li></ul>
  19. 19. Funds with a Growth and Income Objective <ul><li>Growth and Income Fund – objective is a combination of growth and income; invests in companies expected to show average or better growth and to pay steady or rising dividends. </li></ul><ul><li>Life-Cycle Funds – create a diversified, all-in-one portfolio for those individuals who do not wish to actively manage their own investments. </li></ul>
  20. 20. Funds with a Growth and Income Objective (continued) <ul><li>Socially Conscious Funds – usually invest in firms with good records on the environment, human rights and public safety. </li></ul><ul><li>Mutual Fund Funds – earn a return by investing in other mutual funds, thereby providing extensive diversification. </li></ul>
  21. 21. Unique Features of Mutual Funds <ul><li>Easy Purchase and Sale – after you have opened an account with a mutual fund company, you can easily buy and sell shares. </li></ul><ul><li>Check Writing and Wiring of Funds </li></ul><ul><li>Automatic Investment – Most funds allow investors to make periodic monthly or quarterly payments using money automatically transferred from their bank account to the mutual fund company. </li></ul>
  22. 22. Unique Features of Mutual Funds (continued) <ul><li>Automatic Reinvestment – allows for the automatic use of ordinary income dividend distributions, capital gains distributions, and interest to buy additional shares of the fund without paying any commissions. </li></ul>
  23. 23. Figure 15.2: The Wisdom of Automatic Reinvestment
  24. 24. Switching Privileges within a Mutual Fund Family <ul><li>Switching Privilege (or Exchange Privilege) – permits mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund within a mutual fund family. </li></ul><ul><li>Exchange Fee – a small charge, typically $5 or $10 per transaction, on a transfer from one fund to another. </li></ul><ul><li>Mutual Fund Family – exists when the same management company operates a variety of mutual funds, each with its own investment objectives. </li></ul>
  25. 25. Recordkeeping and Help with Taxes <ul><li>Confirmation Statements – indicate the number of shares owned and the value of the holdings. </li></ul><ul><li>Consolidated Statements – report all of the investor’s holdings and transactions in the mutual fund family. </li></ul>
  26. 26. Beneficiary Designation <ul><li>Beneficiary Designation – enables the shareholder to name one or more beneficiaries so that the proceeds to go them without going through probate. </li></ul>
  27. 27. Withdrawal Plans <ul><li>Withdrawal Plans (or Systematic Withdrawal Plans) – available to shareholders who want a periodic income from their mutual fund investments. </li></ul><ul><li>You can take your funds out of a mutual fund using one of four methods: </li></ul><ul><ul><li>By taking a set dollar amount each month. </li></ul></ul><ul><ul><li>By cashing in a set number of shares each month. </li></ul></ul><ul><ul><li>By taking the current income as cash. </li></ul></ul><ul><ul><li>By taking a portion of the asset growth. </li></ul></ul>
  28. 28. Mutual Fund Transaction Fees <ul><li>You may be required to pay a transaction fee when you purchase and sell your mutual fund shares </li></ul><ul><li>Load funds always charge transaction fees </li></ul><ul><ul><li>Sales Charge (or Commission or Load) – assessed by some mutual funds at the time of purchase. </li></ul></ul><ul><ul><li>Load Funds – mutual funds that levy sales charges. </li></ul></ul><ul><ul><li>Front-End Load – the commission paid to the salesperson. </li></ul></ul>
  29. 29. Mutual Fund Transaction Fees (continued) <ul><li>No-Load Funds Sometimes Charge Transaction Fees </li></ul><ul><ul><li>No-Load Fund – a mutual fund that does not assess a sales charge at the time of the investment purchase. </li></ul></ul><ul><ul><li>Note that the SEC allows funds to be called “no-load” if they assess a “service fee” of 0.25 percent or less when shares are purchased. </li></ul></ul>
  30. 30. Mutual Fund Transaction Fees (continued) <ul><li>Deferred Load (or Back-End Load) – a sales commission that is imposed only when shares are sold. </li></ul><ul><li>Redemption Charge (or Exit Fee) – typically disappears after the investment has been held for six months or a year. </li></ul>
  31. 31. Mutual Fund Expense Charges <ul><li>Management Fee – an annual assessment to pay the advisors who operate the mutual fund. </li></ul><ul><li>12b-1 Fee (or Distribution Fee) – an annual charge deducted by the fund company from a fund’s assets to pay for advertising, marketing, distribution, and promotional costs. </li></ul>
  32. 32. Disclosure of Fees <ul><li>Standardized Expense Table – describes and illustrates in an identical manner the effects of all of a mutual fund’s fees and other expenses projected over five years. </li></ul><ul><li>Expense Ratio – the combined percentage charged annually for expense charges including management fees, 12b-1 fees, and other expenses of the mutual fund company. </li></ul>
  33. 33. What’s Best: Load or No-Load? Low-Fee or High-Fee? <ul><li>Up-front load charges are costly to the investor in the short run (less than five years), whereas annual 12b-1 charges are very costly over the long run. </li></ul><ul><li>Over five-year periods, lower-cost funds always deliver returns better than those offered by higher-cost funds. </li></ul>
  34. 34. Managed Funds or Index Funds? <ul><li>Managed Funds – professional managers are constantly evaluating and choosing securities using a specific investment approach. </li></ul><ul><li>Index Fund – a mutual fund that simply buys and holds the stocks or bonds that constitute a market index. </li></ul><ul><li>Unmanaged Funds – managers do not evaluate and select individual securities, but rather buy and hold all the stocks in a particular index. </li></ul>
  35. 35. How to Evaluate Mutual Funds in Which to Invest <ul><li>Match your investment philosophy and financial goals to a mutual fund’s objectives </li></ul><ul><li>Read prospectuses and annual reports </li></ul><ul><ul><li>Annual Report – a published summary of the financial activities of a mutual fund company for the year. </li></ul></ul>
  36. 36. How to Evaluate Mutual Funds in Which to Invest (continued) <ul><li>Locate sources of comparative performance data </li></ul><ul><ul><li>The Financial Press </li></ul></ul><ul><ul><li>specialized mutual fund investment publications </li></ul></ul><ul><ul><li>magazines that rate mutual funds </li></ul></ul><ul><ul><li>internet sources on mutual funds </li></ul></ul>
  37. 37. Figure 15.3: Balancing Risk and Returns on Mutual Funds
  38. 38. Interpret Comparative Performance Information Over Time <ul><li>Consider a fund’s volatility – volatility characterizes a security’s or mutual fund’s tendency to rise or fall in price over a period of time. </li></ul><ul><li>Consider a fund’s long- and short-term performance </li></ul>
  39. 39. Interpret Comparative Performance Information Over Time (continued) <ul><li>Consider the size of the fund </li></ul><ul><li>Consider fund performance in up and down markets </li></ul>
  40. 40. Golden Rules of Investing in Mutual Funds <ul><li>Invest only in no-load mutual funds that have a low expense ratio and also do not assess a 12(b)1 fee. </li></ul><ul><li>When choosing mutual funds, always match your investment philosophy and financial goals to a mutual fund’s objectives by gathering information about fund volatility and performance. </li></ul><ul><li>When investing for long-term goals, definitely sign up for automatic reinvestment of your mutual fund dividends. </li></ul>
  41. 41. Golden Rules of Investing in Mutual Funds (continued) <ul><li>If you have a defined contribution retirement plan available at work, sign up for payroll withholding to automatically forward a portion of each paycheck to a mutual fund. </li></ul><ul><li>Invest most of your “serious” money – such as that to pay for your child’s education and your retirement – in one or more low-fee diversified index funds. </li></ul>
  42. 42. Golden Rules of Investing in Mutual Funds (continued) <ul><li>Don’t jump in and out of the mutual fund market; instead, keep it simple by investing in a few funds and leave your money alone. That’s all. </li></ul>