Planning Your Financial Future, 4e by: Boone, Kurtz & Hearth Mutual Funds Chapter 14

2 Understanding Mutual Funds  A pool of money from numerous investors used to invest in a portfolio of securities—managed by a professional portfolio manager  When you own shares in a mutual fund, you own a small part of the portfolio  Distributions of interest income, dividend income and capital gain/losses occur to investor in terms of the proportion of the total number of mutual fund shares owned

3 Understanding Mutual Funds  There are over 8,000 mutual funds today Compared to about 600 in 1980  The net assets of mutual funds is about $7.5 trillion  Why are they so popular? Bull market for stocks and bonds Growth of self-directed retirement plans

4 Figure 14.1: Growth of Mutual Funds Source: Based on data from the Investment Company Institute.

5 How a Mutual Fund Operates  A mutual fund raises money by selling shares of the fund to the investing public  The funds are used to purchase assets such as stocks, bonds, money market securities, etc.  The shareholder of the mutual fund is said to indirectly own the assets held by the mutual fund  AKA open-ended investment companies Constantly issues new shares and redeems existing shares

6 How a Mutual Fund Operates  The fund’s NET ASSET VALUE represents The market value of the fund’s assets, less any liabilities, divided by the number of shares outstanding

7 How To Buy Mutual Fund Shares  Can purchase either Through your stockbroker or Directly from the mutual fund  Check the fund’s Web site  Review the fund’s prospectus States the fund’s investment objectives, types of securities it can purchase, fees, recent performance  Send in your application along with a check

8 Services Offered  Automatic reinvestment of distributions Effectively increases the number of shares you own  Automatic investment plans Can be as little as $50 a month  Exchange privileges Transfer within fund family  Check writing Mostly money market funds (and a few others) allow minimum checks ($500+ each) Doesn’t replace a regular checking account

9 Regulation and Taxation  Regulated by SEC Must present certain types of information in prospectus and other reports Limits types of advertising  If mutual fund retains investment profit, it must pay taxes on it; therefore, most mutual funds distribute the gains to shareholders Shareholders must report these distributions for tax purposes, as well as any gain/loss on redemption of shares

10 Where to Get Mutual Fund Information  Internet  Money’s February issue is heavily devoted to mutual funds  The Wall Street Journal publishes a mutual fund section regularly

11 Classifying Mutual Funds  Can be classified based on Investment objectives Investment style Types of securities owned by fund  Stocks  Bonds (or income)  Hybrid (balanced)  Money market

12 Figure 14.2: Distribution of Mutual Fund Assets Source: Based on data from the Investment Company Institute.

13 Classifying Mutual Funds  Common subcategories for stock funds Aggressive growth Growth and income Long-term growth Small-company growth International  Common subcategories for bond funds Government High-yield corporate (junk bonds) Investment-grade corporate World income Mortgage-backed securities Municipal bond

14 Classifying Mutual Funds  Common subcategories for money market funds Government Taxable Tax-exempt

15 Mutual Fund ‘Styles’  Even mutual funds that fall into the same subcategory can have different management styles One fund may try to achieve growth by investing in stocks with potential for strong earnings growth; whereas Another fund may try to achieve same objective by selecting stocks it currently believes to be currently undervalued in the market

16 Different Fund Types  Some fairly new fund types Asset allocation funds  Invest in a mixture of stocks, bonds, and money market instruments, shifting allocation of money in an attempt to gain high returns with low risk Index funds  Attempt to replicate performance of a major stock index (most popular is S&P 500)  Why are these so appealing? Very low fees (not that much management to be done) Most mutual fund managers can’t consistently outperform the market Sector funds  Invest only in one industry

17 Advantages of Mutual Funds  Diversification Can increase your return without increasing your risk (or may even reduce your risk)  But doesn’t eliminate risk! Not all mutual funds are diversified—they’re not meant to be

18 Advantages of Mutual Funds  Smaller minimum investments Can purchase a piece of a well-diversified portfolio for a relatively small investment Money market mutual funds minimum investment  $1,000 Stock and bond mutual funds minimum investment  $1,000–$3,000 (less for IRAs)  Additional investments can be as little as $50–$100  Many funds offer automatic investment plans that require initial investments of as little as $50

19 Advantages of Mutual Funds  Professional management Do all mutual funds always beat the market?  Over the past 10 years, stock funds have had an average annual return about 1.5% less than the S&P 500 (9% vs. 10.5%)

20 Picking the Right Mutual Funds  Step 1: Choose your investment goals and assess your risk/return position You can then identify the types (group) of mutual funds that meet your criteria  Step 2: Assess the fees and performance of the mutual funds

21 Fees and Expenses  Several types of fees Load charges: fees associated with either buying or redeeming mutual fund shares  Front-end – paid when shares are purchased Cannot exceed 8.5% Example: You deposit $1000 in a fund with a 2% front-end load— only $980 goes toward purchase of shares, the remaining $20 is a fee Most funds use front-end loads with very few actually charging the maximum 8.5%  Redemption fee (back-end load) – paid when shares are sold Often depends on how long the shares were owned—with a lower fee charged for a longer holding period

22 Fees and Expenses  Trend is toward low front-end loads or no-loads No charges associated with buying or selling the mutual fund  Over half of all mutual funds are no-load  Annual operating expenses Includes fees paid to portfolio manager, transaction costs, printing costs Paid from investment income before it is distributed  Average is about 1.5% for stock funds; 1.1% for bond funds 12b-1 fees  Pays for distribution costs (such as advertising) in lieu of a load charge

23 Fees and Expenses  Evaluating fees and expenses Not all funds charge the same operating fee %—shop around Can range from 0.1% to 2.5+% Fees and expenses can have a dramatic impact on the value of your investment over time No definitive evidence shows that funds charging higher fees earn higher returns  Everything else being equal, you’re better off buying a no-load fund with low operating costs

24 Performance  Need to examine absolute performance AND relative performance as well as risk  When comparing fund to a benchmark, choose the right benchmark

25 The Relationship Between Past and Future Performance  Some funds beat the market some years and not others Should we try to predict which funds will beat the averages next year (or during the next 5 years) or not?  Randomly choosing funds will probably lead to the same results according to some people Others argue that superior funds may underperform some years, but over the long run produce superior returns

26 The Relationship Between Past and Future Performance  Results are mixed  Conclusion Don’t chase returns—the fees are too great and your results probably won’t be stellar Past performance in NO WAY GUARANTEES FUTURE PERFORMANCE

27 Performance and Taxes  Mutual funds pass investment income and realized capital gains to shareholders, so taxes must be paid on these distributions  The more distributions paid to you, the more taxes you’ll pay

28 When Not to Buy Mutual Fund Shares  Most mutual funds have regularly scheduled distribution dates  For tax purposes, you shouldn’t buy shares in a mutual fund right before a distribution You’d owe taxes on that immediate distribution

29 What About Index Funds  Designed to track performance of a broad stock or bond market index Most popular track the S&P500  Number of index funds has grown rapidly

30 Making Changes to Your Mutual Fund Investments  Will your goals remain the same for the next 30–40 years? No—the mix of your investments will need to change over time  You’ll also need to rebalance over time Adjusting investments periodically to return to the target asset allocation

31 When to Sell a Mutual Fund  One reason many people sell shares is due to poor performance BUT, selling shares based on poor short-term performance may be a bad idea  Are you chasing past returns? This rarely produces superior returns over the long run  Even the best funds have poor performance at times If you have a good fund, keep it even if it offers poor short-term performance

32 When to Sell a Mutual Fund  There are viable reasons for selling a fund Performance lags behind the benchmarks for an extended time period (three years or so) Fund gets very large very fast Expenses keep rising  Fund is trying to capitalize on its popularity Management turnover