Topic 20–Mutual Funds Lawrence Schrenk, Instructor FIN 200: Personal Finance Topic 20–Mutual Funds Lawrence Schrenk, Instructor

Learning Objectives Define a mutual fund. ▪ Outline the main types of funds. Describe the returns from and costs of a mutual fund. ▪

Mutual Funds: Overview

What and Why? What is a mutual fund? Why were they developed? Investment company that pools money Investors own a proportionate share of the fund to the amount of their investment divided by the total value of the fund Why were they developed? To give smaller investors access to professional management and to increase the assets of mutual fund companies

Advantages of Mutual Funds Diversification Full-Time Professional Management Modest Capital Investment Minimal Transaction Costs Services Offered Convenience/Liquidity

Disadvantages of Mutual Funds Lack of Liquidity Normally must be sold back to the fund Average to below average performance Average Annual Returns 1989-1998 Actively managed stock funds 15.6% S&P 500 stock index 19.2%. Fees and taxes can take a significant part of investor returns

Disadvantages of Mutual Funds Percentage of Actively Management Funds that failed to beat their benchmarks Source: John Bogle, Common Sense on Mutual Funds: New Imperative for the Intelligent Investor, John Wiley & Sons, USA, 1999, p. 119)

Mutual Funds: Types

Number of Mutual Funds by Type

Major Types of Mutual Funds Major Asset Classes Money Market Funds Stock Funds Bond Funds Specialty Funds Index Funds Exchange Traded Funds (ETFs) Balanced Funds Etc.

Stock Funds: Payout Approach Income Funds Goal: Current income Dividend income Growth Funds Goal: Capital Appreciation Higher-than-average revenue/earnings growth Aggressive/Maximum Growth Funds Goal: Extreme Capital Appreciation Highly speculative, seeking large profits from capital gains Often buy stocks of small, untested companies

Stock Funds: Geographic Approach Domestic Funds U.S. Equities Only Global Funds U.S. and International Equities International Funds International Equities Only Country/Regional Funds Specific Country/Region of the World

Stock Funds: Firm Size Large-Cap(italization) Funds Capitalization $5 billion or more Mid-Cap(italization) Funds Capitalization between $1 and $5 billion Small-Cap(italization) Funds Capitalization $1 billion or less

Stock Funds: Other Sector Funds Socially Responsible Funds Index Funds Particular industry such as biotechnology. Socially Responsible Funds Companies that don’t produce harmful products. Index Funds Mirror an index, like the S&P 500

Bond Funds: Yield High-Yield (Junk) Bond Funds Index Bond Funds Corporate bonds that are higher risk and higher yield. Index Bond Funds Sampling of bonds included in an index.

Bond Funds: Maturity Long Term Bond Funds Intermediate Term Bond Funds Maturities > 10 Years Intermediate Term Bond Funds Maturities 5-10 Years Short Term Bond Funds Maturities 1-5 Years Note: Can be either Government or Corporate Bond Funds

Bond Funds: Issuer Corporate Bond Funds Treasury Bond Funds Municipal Bond Funds International Bond Funds

Asset Allocation Funds Various asset classes, such as stocks, and bonds, with precise amounts within each type Rotate among stocks, bonds, and cash Goal: Invest in the asset classes expected to perform the best over the coming period of time (‘Timing’)

Balanced Funds Goal: Balance between Capital Gains and Current Income Stocks and bonds High-Grade Common Stocks (60-75%) Fixed Income Securities (25-40%)

Mutual Funds: Other Money Market Funds Goal: Higher return (after fees and expenses) than traditional bank savings or checking accounts Short-term liquid financial instruments such as commercial paper and government treasury bills Access to high-yielding money market instruments without having to pay $100,000 denominations

Mutual Funds: Other Single Industry Specialty Funds Option Trading Commodity Funds Oil Drilling Cattle Funds Electronics Gold Chemicals Health

Life-Cycle Funds Change allocation depending on the age of the investor. Reduce their allocation to stocks and increase their allocation to bonds These funds seek to perform the asset allocation decision normally done by the investor and to reduce transaction costs as well.

Mutual Funds: Returns and Costs

Mutual Fund Returns Capital Gains Distributions Market Value Appreciation Capital gains at the share level are not taxed until you sell your mutual fund shares. Distributions Interest, dividends, realized capital gains, etc. Taxable even if you do not sell any mutual fund shares

Mutual Fund Returns: Types Qualified Stock Dividends Short-Term Capital Gains Long-Term Capital Gains Bond Dividends and Interest

Costs of Mutual Funds Explicit Costs Management Fees 12b-1 Fees Charged by the Advisor Percentage of average assets, e.g. .75% 12b-1 Fees To cover cost of advertising and marketing Total Expense Ratio Fees as total percentage of assets Custody (or Annual) Fees Brokerage house charges to hold mutual funds

Costs of Mutual Funds Implicit Costs: Taxes on Distributions Stock Dividends 15% or 5%. Short-Term Capital Gains Marginal Tax Rate Long-Term Capital Gains Bond Dividends and Interest:

Costs of Mutual Funds Hidden Costs: Transaction Costs Costs of the fund buying and selling securities not included in other costs A good measure this is the turnover ratio, a measure of trading activity during the period divided by the fund’s average net assets. A turnover ratio of 50% means half the fund was bought and sold during the period Turnover costs money and incurs taxes

Costs of Mutual Funds Other Hidden Costs: Account Transfer Fees Charges for moving assets either into our out of an existing account Account Maintenance Fees Fees for maintaining your account Inactivity/Minimum Balance Fees Fees because you did not trade or failed to keep a minimum balance in your account

Front-, Back- and No Load Funds Front-Load Funds Commissions charged when purchasing shares. Investors pay a commission (sales charge) up to 8.5% every time they purchase shares. This is sometimes called a front load. (Class A shares) Average charge is 3-5% for which an investor can get purchase advice and explanations.

Front-, Back- and No Load Funds Back-Load Funds Commissions charged when selling shares. Contingent deferred sales load (back-end load) (Class B shares). Charged upon withdrawal of funds (1-5%). Generally decreases on a sliding scale depending on the number of years shares are held. No-Load Funds Investors pay no sales charge up front. You deal directly with the fund with 800 numbers or web sites, or from discount brokers.

Open- versus Closed-End Funds Open-End Funds (91% of Funds). Shares are issued and redeemed by the investment company at the request of investors. Investors can buy and sell shares at the net asset value (NAV). Closed-End Funds (7% of Funds). Shares are issued only when the fund is organized. Only purchase shares only from another investor. Traded on exchanges and over-the-counter. 16-5

Open-End Funds Investors buy and sell shares back to the fund itself There is no limit on the number of shares the fund can issue Net Asset Value (NAV) Defined as the total market value of all securities held by the fund less liabilities, divided by the number of fund shares outstanding.

Net Asset Value (NAV) For most mutual funds, NAV is calculated at the close of trading each day. 16-7

Net Asset Value Example Example: NAV XYZ Mutual Fund owns assets totaling $10M and liabilities equal to $500,000 with 500,000 shares outstanding.

Closed-End Funds Closed-End Funds Investment Trusts A fixed number of shares outstanding 100 Closed-end funds $8 billion market value Investment Trusts Interest is an unmanaged pool of investments Usually consist of corporate, government, or municipal bonds

Mutual Fund Prospectus Mutual fund prospectus tells the funds objective and: A statement describing the risk factors. A description of the fund’s past performance. A statement describing the type of investments in the fund’s portfolio. Information on how to open an account. Dividends, distributions and taxes. Information about the fund’s management. The process for investors to buy or sell shares. Services provided to investors. The turnover ratio of the fund’s investments. 16-20

Mutual Fund Quotations Net asset value and asset value change. The fund family and fund name. Fund objective. Total return over various time periods. Ranking among funds with the same objective. Sales load fees if any, or no load (NL). Annual expenses. 16-19

Mutual Fund Quotation Example

Project Note

Ethical Dilemma