PART 4: MANAGING YOUR INVESTMENTS Chapter 15 Mutual Funds: An Easy Way to Diversify

15-2 Mutual Funds Pool investors’ money, investing in stocks, bonds, and various short-term securities. Pool investors’ money, investing in stocks, bonds, and various short-term securities. Professional managers tend to the investments. Professional managers tend to the investments. Allow investors to diversify, even with a small investment. Allow investors to diversify, even with a small investment.

15-3 Why Invest in Mutual Funds? Advantages of mutual funds: Advantages of mutual funds: Professional management Professional management Access to the best research to evaluate investment alternatives. Access to the best research to evaluate investment alternatives. Minimal transaction costs Minimal transaction costs Low commissions because of volume, which may translate into higher returns. Low commissions because of volume, which may translate into higher returns. Liquidity Liquidity Easy to buy and sell on phone or online. Easy to buy and sell on phone or online.

15-4 Why Invest in Mutual Funds? Advantages of mutual funds: Advantages of mutual funds: Flexibility – over 8,000 funds to choose from, covering many objectives and risk levels. Flexibility – over 8,000 funds to choose from, covering many objectives and risk levels. Service – provide bookkeeping, checking accounts, automatic additions or withdrawals. Service – provide bookkeeping, checking accounts, automatic additions or withdrawals. Avoidance of bad brokers – avoid potentially bad advice, high sales commissions, and churning. Avoidance of bad brokers – avoid potentially bad advice, high sales commissions, and churning.

15-5 Why Invest in Mutual Funds? Disadvantages of mutual funds: Disadvantages of mutual funds: Lower than market performance – mutual funds underperform the market on average. Lower than market performance – mutual funds underperform the market on average. Costs – sales fee or load can be as high as 8.5% in addition to annual expense ratio at 3%. Costs – sales fee or load can be as high as 8.5% in addition to annual expense ratio at 3%. Risks – not all mutual funds are safe; specialized funds may lack diversification outside a specific industry. Risks – not all mutual funds are safe; specialized funds may lack diversification outside a specific industry.

15-6 Why Invest in Mutual Funds? Disadvantages of mutual funds: Disadvantages of mutual funds: Systematic risk - mutual funds do not diversify away systematic risk. Even mutual funds will suffer in a crash. Systematic risk - mutual funds do not diversify away systematic risk. Even mutual funds will suffer in a crash. Taxes – mutual funds trade frequently, so investors may pay taxes on capital gains. You cannot defer taxes. Taxes – mutual funds trade frequently, so investors may pay taxes on capital gains. You cannot defer taxes.

15-7 Mutual Fund-Amentals A mutual fund pools money from investors with similar financial goals. 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. You are investing in a diversified portfolio that’s professionally managed according to set goals. Investment objectives are clearly stated. Investment objectives are clearly stated.

15-8 Mutual Fund-Amentals Make money 3 ways in a mutual fund: Make money 3 ways in a mutual fund: As the value of the securities in the fund increases, the value of each mutual fund share also rises. 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. Most pay dividends or interest to shareholders. Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid. Shareholders receive a capital gains distribution when the fund sells a security for more than originally paid.

15-9 Mutual Fund-Amentals Organization of a mutual fund: Organization of a mutual fund: Fund is set up as a corporation or trust, owned by shareholders. Fund is set up as a corporation or trust, owned by shareholders. Shareholders elect a board of directors. Shareholders elect a board of directors. Fund is run by a management company. Fund is run by a management company. Each individual fund hires an investment advisor to oversee the fund. Each individual fund hires an investment advisor to oversee the fund. Contracts with a custodian, a transfer agent, and an underwriter. Contracts with a custodian, a transfer agent, and an underwriter.

15-10 Mutual Fund-Amentals Custodian – acts as a third party safeguarding the fund’s assets; makes payments for the fund’s securities and receives money when securities are sold. Custodian – acts as a third party safeguarding the fund’s assets; makes payments for the fund’s securities and receives money when securities are sold. Is often a bank. Is often a bank. Transfer agent – is a record keeper; keeps track of purchases and redemptions and distributing dividends and capital gains. Transfer agent – is a record keeper; keeps track of purchases and redemptions and distributing dividends and capital gains. Underwriter – is responsible for selling new shares in the mutual fund. Underwriter – is responsible for selling new shares in the mutual fund.

15-11 Investment Companies A firm that invests the pooled money of a number of investors in return for a fee. A firm that invests the pooled money of a number of investors in return for a fee. Types of investment companies: Types of investment companies: Open-End Investment Companies Open-End Investment Companies Closed-End Investment Companies Closed-End Investment Companies Unit Investment Trusts Unit Investment Trusts Real Estate Investment Trusts Real Estate Investment Trusts

15-12 Open-End Investment Companies These mutual funds are the most popular form of investment companies. These mutual funds are the most popular form of investment companies. Open-end means the investment company can issue an unlimited number of ownership shares. Open-end means the investment company can issue an unlimited number of ownership shares. Shares do not trade in the secondary market, must buy or sell through the fund. Shares do not trade in the secondary market, must buy or sell through the fund. Price based on net asset value (NAV). Price based on net asset value (NAV). [Total market value of all securities less liabilities] ÷ total shares outstanding [Total market value of all securities less liabilities] ÷ total shares outstanding

15-13 Closed-End Investment Companies Has a fixed number of shares, cannot issue new shares. Has a fixed number of shares, cannot issue new shares. Shares sold initially by investment company, afterwards they trade like a common stock. Shares sold initially by investment company, afterwards they trade like a common stock. Price based on demand, not NAV. Price based on demand, not NAV.

15-14 Unit Investment Trusts A fixed pool of securities with each unit representing a proportionate ownership in the pool. A fixed pool of securities with each unit representing a proportionate ownership in the pool. They are not managed. They are not managed. Fund purchases a fixed amount of bonds, holds them until maturity, then the trust dissolves. Fund purchases a fixed amount of bonds, holds them until maturity, then the trust dissolves.

15-15 Real Estate Investment Trusts Like a mutual fund specializing in real estate. Like a mutual fund specializing in real estate. Has a professional manager. Has a professional manager. Uses pooled funds. Uses pooled funds. Is actively managed. Is actively managed. Must collect 75% of its income from real estate and distribute 95% of that income in the form of dividends. Must collect 75% of its income from real estate and distribute 95% of that income in the form of dividends.

15-16 Real Estate Investment Trusts Types of REITs: Types of REITs: Equity – buys property directly and manages it. Investors look for appreciation in value. Equity – buys property directly and manages it. Investors look for appreciation in value. Mortgage – investment is limited to mortgages. Investors receive interest payments only. Mortgage – investment is limited to mortgages. Investors receive interest payments only. Hybrid – a combination of the two. Invests in both property and mortgages, receiving both interest and capital appreciation. Hybrid – a combination of the two. Invests in both property and mortgages, receiving both interest and capital appreciation.

15-17 Load Versus No-Load Funds A load mutual fund charges a sales commission. They are sold through brokers, financial advisors and financial planners. A load mutual fund charges a sales commission. They are sold through brokers, financial advisors and financial planners. Class A – front-end sales load Class A – front-end sales load Class B – back-end load Class B – back-end load Class C – pay coming and going Class C – pay coming and going A no-load fund doesn’t charge a commission. A no-load fund doesn’t charge a commission.

15-18 Management Fees and Expenses Invest in a fund with a low expense ratio Invest in a fund with a low expense ratio Ratio compares funds expenses to total assets (expense ratio = expenses ÷ assets). Ratio compares funds expenses to total assets (expense ratio = expenses ÷ assets). This ratio typically ranges from 0.25% to 2.0%. This ratio typically ranges from 0.25% to 2.0%. Look at the turnover rate Look at the turnover rate Measures the level of the fund’s trading activity. Measures the level of the fund’s trading activity. The higher the turnover rate, the higher the fund’s expenses. The higher the turnover rate, the higher the fund’s expenses. 12b-1 Fees 12b-1 Fees Marketing expenses for advertising and sales promotion. Marketing expenses for advertising and sales promotion.

15-19 Money Market Mutual Funds Invest in Treasury bills, CDs, and other short- term investments, less than 30 days. Invest in Treasury bills, CDs, and other short- term investments, less than 30 days. Regarded as practically risk-free. Regarded as practically risk-free. Carry no loads, trade at a constant $1 NAV, and have minimal expenses. Carry no loads, trade at a constant $1 NAV, and have minimal expenses. Tax-exempt money market fund invests only in short-term municipal debt (which is exempt from federal taxes). Tax-exempt money market fund invests only in short-term municipal debt (which is exempt from federal taxes).

15-20 Stock Mutual Funds Aggressive Growth Funds – maximize capital appreciation while ignoring income. Have wider price swings than other funds. Aggressive Growth Funds – maximize capital appreciation while ignoring income. Have wider price swings than other funds. Small-Company Growth Funds – similar to aggressive growth funds but limited to investments in small companies. Look to uncover and invest in undiscovered companies with unlimited growth potential. Small-Company Growth Funds – similar to aggressive growth funds but limited to investments in small companies. Look to uncover and invest in undiscovered companies with unlimited growth potential.

15-21 Stock Mutual Funds Growth and Income Funds – provide a steady stream of income with the potential for increasing value. Less risky, stable dividends, less price movement. Growth and Income Funds – provide a steady stream of income with the potential for increasing value. Less risky, stable dividends, less price movement. Sector Funds – specialized mutual fund investing 65% of its assets in securities from a specific industry. Less risky than an individual stock, but more risky than a traditional mutual fund. Sector Funds – specialized mutual fund investing 65% of its assets in securities from a specific industry. Less risky than an individual stock, but more risky than a traditional mutual fund.

15-22 Stock Mutual Funds Index Funds – try to track a market index, such as the S&P 500, by buying stocks in that index. Provide diversification at a low cost. Index Funds – try to track a market index, such as the S&P 500, by buying stocks in that index. Provide diversification at a low cost. International Funds – concentrate on securities from other countries, may have political and currency risks. International Funds – concentrate on securities from other countries, may have political and currency risks.

15-23 Balanced Mutual Funds Hold both common stock and bonds. Hold both common stock and bonds. Objective is to earn steady income and some capital gains. Objective is to earn steady income and some capital gains. Aimed at those needing income to live on and moderate stability in their investment. Aimed at those needing income to live on and moderate stability in their investment. Ratio of stocks to bonds varies. Ratio of stocks to bonds varies.

15-24 Asset Allocation Funds Similar to a balanced fund, invest in stocks, bonds, and money market securities. Similar to a balanced fund, invest in stocks, bonds, and money market securities. Differ in that they move money between stocks and bonds to outperform the market. Differ in that they move money between stocks and bonds to outperform the market. It is a balanced fund practicing market timing. It is a balanced fund practicing market timing. Likely to produce additional transaction costs rather than additional returns. Likely to produce additional transaction costs rather than additional returns.

15-25 Life Cycle and Target Retirement Funds Life cycle is the newest type of funds. An asset allocation fund that tailors holdings to investor’s characteristics, such as age and risk tolerance. Life cycle is the newest type of funds. An asset allocation fund that tailors holdings to investor’s characteristics, such as age and risk tolerance. Target retirement funds are managed based on when you plan to retire. Target retirement funds are managed based on when you plan to retire.

15-26 Bond Funds $1000 investment buys a diversified portfolio. $1000 investment buys a diversified portfolio. More liquidity More liquidity Professional management Professional management Have automatic reinvestment Have automatic reinvestment Individual Bonds Save mutual fund expenses Bond funds do not mature, individual bonds do

15-27 Bond Funds Bond funds can be differentiated by the type of bond and by maturity. Type of Bond U.S. Government U.S. Government Municipal Municipal Corporate Corporate Maturity Short-term Intermediate-term Long-term

15-28 Bond Funds U.S. Government Bond Funds or GNMA Funds U.S. Treasury Bond Funds Specialize in Treasury securities. Specialize in Treasury securities. No default risk, but will fluctuate with changes in interest rates. No default risk, but will fluctuate with changes in interest rates. GNMA Funds Specialize in mortgage-backed securities. Carry interest rate risk and prepayment risk.

15-29 Bond Funds Municipal Bond Funds – interest is generally tax- exempt from federal taxes. Municipal Bond Funds – interest is generally tax- exempt from federal taxes. Aimed at those looking to avoid taxes. Aimed at those looking to avoid taxes. Corporate Bond Funds – invest in various types of corporate bonds, including high quality and junk bonds. Corporate Bond Funds – invest in various types of corporate bonds, including high quality and junk bonds. As interest rates rise, NAV goes down. As interest rates rise, NAV goes down.

15-30 Bond Funds Bond funds and their maturities: Bond funds and their maturities: Short-term – 1-5 years in maturity Short-term – 1-5 years in maturity Intermediate-term – 5-10 years in maturity Intermediate-term – 5-10 years in maturity Long-term – years in maturity Long-term – years in maturity As interest rates change, long-term bonds fluctuate more than short-term. As interest rates change, long-term bonds fluctuate more than short-term.

15-31 ETFs or Exchange Traded Funds First issued in 1993, these are hybrids between a mutual fund and an individual stock or bond. First issued in 1993, these are hybrids between a mutual fund and an individual stock or bond. Trade on an exchange just like securities and can be bought or sold throughout the day. Trade on an exchange just like securities and can be bought or sold throughout the day. 2 ETFs dominate the market 2 ETFs dominate the market Qubes (QQQ) tracks the NASDAQ 100 Index. Qubes (QQQ) tracks the NASDAQ 100 Index. Spiders (SPDRS) tracks the S&P 500. Spiders (SPDRS) tracks the S&P 500.

15-32 ETFs or Exchange Traded Funds Advantages of ETFs: Advantages of ETFs: Trade on an exchange and can be bought and sold throughout the day. Trade on an exchange and can be bought and sold throughout the day. Can be sold short or bought on margin. Can be sold short or bought on margin. Low annual expenses. Low annual expenses. More tax efficient than mutual funds. More tax efficient than mutual funds. Most trading is between shareholders so that the funds do not have to sell stocks to meet redemption demands of investors. Most trading is between shareholders so that the funds do not have to sell stocks to meet redemption demands of investors.

15-33 ETFs or Exchange Traded Funds Disadvantages of ETFs: Disadvantages of ETFs: Pay a commission because they trade like stocks. Pay a commission because they trade like stocks. Don’t necessarily trade at NAV. Don’t necessarily trade at NAV. Bid-ask spread because buying from another investor. Bid-ask spread because buying from another investor. Expensive for those who trade often, incur brokerage costs. Expensive for those who trade often, incur brokerage costs.

15-34 Mutual Fund Services Automatic investment and withdrawal plans Automatic investment and withdrawal plans Automatic reinvestment of interest, dividends, and capital gains Automatic reinvestment of interest, dividends, and capital gains Wiring and funds express options Wiring and funds express options Phone switching Phone switching Easy establishment of retirement plans Easy establishment of retirement plans Check writing Check writing Bookkeeping and help with taxes Bookkeeping and help with taxes

15-35 Buying a Mutual Fund Step 1: Determining Your Goals Buying a mutual fund involves determining your investment goals and time horizon. Buying a mutual fund involves determining your investment goals and time horizon. Understand why you are investing: Understand why you are investing: To receive additional income To receive additional income Supplement your retirement income Supplement your retirement income Save for a child’s education Save for a child’s education

15-36 Buying a Mutual Fund Step 2: Meeting Your Objectives Identify the fund’s objectives by looking at objective classifications. Identify the fund’s objectives by looking at objective classifications. Don’t assume the fund’s name reflects the strategy or objectives. Don’t assume the fund’s name reflects the strategy or objectives. Morningstar provides an investment style box to understand the investment style. Morningstar provides an investment style box to understand the investment style.

15-37 Buying a Mutual Fund Step 2: Meeting Your Objectives Look in the prospectus for: Look in the prospectus for: Fund’s goals and investment strategy Fund’s goals and investment strategy Fund manager’s past experience Fund manager’s past experience Any investment limitations the fund may have Any investment limitations the fund may have Tax considerations of importance to investors Tax considerations of importance to investors Redemption and investment process Redemption and investment process Services provided Services provided Performance over past 10 years Performance over past 10 years Fund fees and expenses Fund fees and expenses Fund’s annual turnover rate Fund’s annual turnover rate

15-38 Buying a Mutual Fund Step 3: Evaluating the Fund Look closely at past performance and scrutinize their costs. Look closely at past performance and scrutinize their costs. Past performance does not predict future results, but it does give insight. Past performance does not predict future results, but it does give insight. Limit comparisons to funds with similar objectives. Limit comparisons to funds with similar objectives. Investigate how the fund did during upturns and downturns. Investigate how the fund did during upturns and downturns.

15-39 Buying a Mutual Fund Step 3: Evaluating the Fund Sources of Information: Sources of Information: Wall Street Journal Wall Street Journal Forbes – annual mutual fund survey Forbes – annual mutual fund survey Kiplinger’s Personal Finance magazine Kiplinger’s Personal Finance magazine Morningstar Morningstar

15-40 Buying a Mutual Fund Making the Purchase: Making the Purchase: Buy direct – use phone or internet. Buy direct – use phone or internet. Buy through a mutual fund supermarket – such as Fidelity or Schwab. Buy through a mutual fund supermarket – such as Fidelity or Schwab.