Investing in Mutual Funds

Chapter 17
Investing in Mutual Funds
Copyright 2004 Pearson Education, Inc. All rights reserved.
Chapter Objectives
Identify the types of stock funds
Present the types of bond funds Explain how to choose among mutual funds Describe quotations of mutual funds
Explain how to diversify among mutual funds

Copyright 2004 Pearson Education, Inc. All rights reserved. 17-2
Background on Mutual Funds

Stock mutual funds: funds that sell shares to individuals and invest the proceeds in stocks
Bond mutual funds: funds that sell shares to individuals and invest the proceeds in bonds All are managed by professional portfolio managers who decide what securities to purchase
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Motives for investing in mutual funds
Low initial investment Expertise of portfolio manager To meet specific investment goals
Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities owed
Usually reported on a per share basis

Open-end versus closed-end funds
Open-end mutual funds: funds that sell shares directly to investors and repurchase those shares whenever investors wish to sell them
Usually managed by investment companies that are subsidiaries of a large financial conglomerate Family: a group of separately managed open-end mutual funds held by one investment company

Closed-end mutual funds: mutual funds that sell shares to investors but do not repurchase them; instead fund shares are purchased and sold on stock exchanges
Premium: the amount by which a closed-end funds share price in the secondary market is above the funds NAV
Discount: the amount by which a closed-end funds share price in the secondary market is below the funds NAV

Load versus no-load funds
No-load mutual funds: funds that sell directly to investors and do not charge a fee Load mutual funds: funds whose shares are sold by a stockbroker who charges a fee (or load) for the transaction Loads can have significant impact on their investment performance
Exhibit 17.1: Comparison of Returns from a No-Load Fund and a Load Fund

Expense ratio: the annual expenses per share divided by the net asset value of a mutual fund
Average expense ratio is 1.5 percent
Reported components of expense ratios
Mutual funds incur expenses for administrative, legal, and clerical expenses as well as portfolio management fees

Relationship between expense ratios and performance
Funds with lower expense ratios then to outperform other funds
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Types of Mutual Funds

Types of stock mutual funds
Growth funds: mutual funds that focus on stocks that have potential for aboveaverage growth Capital appreciation funds: mutual funds that focus on stocks that are expected to grow at a very high rate
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Small capitalization (small-cap) funds: mutual funds that focus on funds that are relatively small
Mid-size capitalization (mid-cap) funds: mutual funds that focus on medium-size firms Equity income funds: mutual funds that focus on firms that pay a high level of dividends

Balanced growth and income funds: mutual funds that contain both growth stocks and stocks that pay high dividends
Sector funds: mutual funds that focus on a specific industry or sector, such as technology stocks
Technology funds: mutual funds that focus on stocks of Internet-based firms and therefore represent a particular type of sector fund

Index funds: mutual funds that attempt to mirror the movements of an existing stock index
International stock funds: mutual funds that focus on firms that are based outside the U.S. Socially responsible stock funds: mutual funds that screen out firms viewed as offensive by some
Financial Planning Online: Index Mutual Funds

Go to: http://www.indexfunds.com/
This Web site provides news and other information about index mutual funds that can guide your investment decisions.
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Example
You are considering investing in either a no-load mutual fund that focuses on growth stocks or an index mutual find. When ignoring expenses incurred by the mutual funds, you expect that the growth fund will generate an annual return of 9 percent versus an annual return of 8 percent for the index fund.
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The growth fund has an expense ratio of 1.5 percent versus an expense ratio of 0.2 percent for the index fund.
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Based on your expectations about the portfolio returns, you returns would be:
Growth Fund Index Fund Fund's portfolio return (exludes expenses) 9.00% 8.00% Expense ratio 1.50% 0.20% Your annual return 7.50% 7.80%
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Types of bond mutual funds
Treasury bond funds: mutual funds that focus on investment in Treasury bond Ginnie Mae funds: mutual funds that invest in bonds issued by the Government National Mortgage Association Corporate bond funds: mutual funds that focus on bonds issued by high-quality firms that tend to have a low degree of default risk
17-19

High-yield (junk) bond funds: mutual funds that focus on relatively risky bonds issued by firms that are subject to default risk
Municipal bond funds: mutual funds that invest in municipal bonds Index bond funds: mutual funds that are intended to mimic performance of a specified bond index

International bond funds: mutual funds that focus on bonds issued by non-U.S. firms or governments
Global bond funds: mutual funds that invest in foreign bonds as well as U.S. bonds
Maturity classifications some funds are also segmented by their maturities
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Return and Risk of a Mutual Fund

Return from investing in a mutual fund
Dividend distributions
Dividends received on stocks in the funds are distributed to shareholders
Capital gains distributions

Proceeds received from the sale of securities are distributed to shareholders
Capital gains from redeeming shares

If price received at redemption exceed price paid

Example
You invest in an equity income fund focused on large, well-established stocks that pay high dividends. You also invest in a growth fund focused on young firms that are attempting to expand and therefore pay no dividends. You are curious about your tax liabilities on distributions from these investments.

The equity income mutual fund distributes $1,000 of dividends over the year, while the growth fund distributes $1,000 of long-term capital gains.
Your marginal tax rate on ordinary income is about 40 percent. The capital gains tax rate is 20 percent.

Given this information, the taxes on the distribution are as follows:
Large Stock Fund Small Stock Fund Dividends $1,000 $0 Capital gains $0 $1,000 Total income $1,000 $1,000 Tax on divs (40%) $400 $0 Tax on cap gains (20% $0 $200 Total taxes $400 $200 After-tax income $600 $800

Comparing returns among stock mutual funds
Great variation among types of funds over a particular time period Not necessarily an indicator of future performance
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Risk from investing in a stock mutual fund
Market risk: the susceptibility of a mutual funds performance to general stock market conditions Focus on Ethics: Risk from investing in hedge funds
Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions
Exhibit 17.3: Comparison of Returns among Types of Mutual Funds (based on 1999 data)
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Tradeoff between expected return and risk of stock funds
Conservative stock index fund
Limited return and risk
Moderate growth stock fund

Moderate return and risk
High risk growth stock fund in one sector

High return and risk
Exhibit 17.4: Tradeoff between Expected Return and Risk
17-31

Risk from investing in a bond mutual fund
Interest rate risk: for a bond mutual fund, its susceptibility to interest rate movements Longer-term bonds most sensitive Must also consider default risk Bond funds can have either interest rate risk, default risk, or both
Exhibit 17.5: Classifying Bond Mutual Funds according to Interest Rates and Default Risk
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Tradeoff between expected return and risk of bond funds
Conservative short-term Treasury bond fund
No default risk and limited interest rate risk Low return
Moderate Ginnie Mae bond fund

Slight default risk and moderate interest rate risk Moderate return
High risk junk bond fund

High default risk and high interest rate risk Potentially high return
Exhibit 17.6: Tradeoff between Expected Return and Risk of Bond Mutual Funds
Deciding Among Mutual Funds

Determining your preferred characteristics of a mutual fund
Minimum initial investment
Investment objective (type of fund)

Investment company
Reviewing a mutual funds prospectus

Prospectus: a document that provides financial information about a mutual fund, including expenses and past performance

Investment objective: in a prospectus, a brief statement about the general goal of the mutual fund
Investment strategy: in a prospectus, a summary of the types of securities that are purchased by the mutual fund in order to achieve its objective Past performance 1 year, 3 years, 5 years
Decide Among Mutual Funds

Fees and Expenses
Maximum load Redemption fee or back-end load
Expenses, including management fees

Expense ratio
Risk
Distribution of dividends and capital gains
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Minimum investment and minimum balance
How to buy or redeem shares
Making the decision

Narrow down your choices to a small number and use a table for comparison
Consider the following tables comparing 4 stock funds and 4 bond funds

With $1,000 to invest in a stock mutual fund: Recent Annual Expense Ratio Performance 1.50% 13% 0.80% 12% 2.00% 14% 1.70% 11%
Internet Fund #1 #2 #3 #4
Load Status No-load No-load No-load 3% load
With $1,000 to invest in a bond mutual fund: High-Yield Bond Funds #1 #2 #3 #4 Typical Terms to Expense Ratio Maturity 1.00% 6 - 8 years 0.90% 15 - 20 years 0.80% 5 - 7 years 1.20% 5 - 7 years
Load Status 4% load No-load No-load No-load
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Financial Planning Online: Online Services by Mutual Funds

Go to: http://www.vanguard.com
This Web site provides an example of what an investment company that manages mutual funds can provide online to its customers. You can monitor your account online and transfer money from one fund to another within the same family.
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Quotations of Mutual Funds

Quotations available from financial publications
Open-end funds
Column 1 Investment company in bold type with funds listed beneath
Column 2 NAV
Column 3 Net change in NAV

Column 4 Return year to date
Exhibit 17.7: Open-End Mutual Fund Price Quotations

Copyright 2001 Dow Jones & Company, Inc. All Rights Reserved.
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Closed-end funds listed on the exchanges where they are traded
Column 1 Fund name and symbol
Column 2 Exchange where traded

Column 3 NAV Column 4 Market price
Column 5 Premium or discount

Column 6 return over the last year
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Exhibit 17.8: Closed-End Fund Price Quotations

Copyright 2001 Dow Jones & Company, Inc. All Rights Reserved. Copyright 2004 Pearson Education, Inc. All rights reserved. 17-45

Lipper indexes are useful for assessing the recent performance of a particular fund or funds with a specific objective
Column 1 type of index Column 2 preliminary closing Column 3 percent change from previous day Column 4 percent change from previous week Column 5 percent change since December 31
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Exhibit 17.9: The Lipper Indexes of Mutual Funds

Copyright 2001 Dow Jones & Company, Inc. All Rights Reserved.
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Diversification Among Mutual Funds

Diversify among several types of funds to lower risk
Best strategy is to diversify across stock and bond mutual funds Can also diversify among mutual funds representing different countries
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Diversification through mutual fund supermarkets: an arrangement offered by some brokerage firms that enables investors to diversify among various mutual funds and to receive a summary consolidated statement for these funds
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Exhibit 17.10: Diversifying among Mutual Funds That Are Primarily Affected by Different Factors
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Financial Planning Online: Diversifying among Mutual Funds

Go to: http://www.mfea.com
Click on: Asset Allocation This Web site provides suggested asset allocation models that fit your financial situation and your degree of risk tolerance.
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How Mutual Funds Fit within Your Financial Plan

Key decisions about mutual funds for your financial plan are:
Should you consider investing in mutual funds? What types of mutual funds would you invest in?
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Integrating Key Concepts
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Integrating Key Concepts

Part 1: Financial Planning Tools
Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Assets and Income
Part 5: Investing
In Chapter 13 we learned about investment fundamentals In Chapter 14 we learned about stock analysis and valuation In Chapter 15 we learned about investing in stocks
In Chapter 16 we learned about investing in bonds

In Chapter 17 we learned about investing in mutual funds In Chapter 18 we will cover asset allocation
Part 6: Retirement and Estate Planning

Investing in Mutual Funds

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Chapter 17

Investing in Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Explain how to diversify among mutual funds

Background on Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Background on Mutual Funds

Background on Mutual Funds

Background on Mutual Funds

Background on Mutual Funds

Background on Mutual Funds

Background on Mutual Funds

Background on Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Types of Mutual Funds

Types of Mutual Funds

Financial Planning Online: Index Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Copyright 2004 Pearson Education, Inc. All rights reserved.

Types of Mutual Funds

Types of Mutual Funds

Maturity classifications some funds are also segmented by their maturities

Copyright 2004 Pearson Education, Inc. All rights reserved.

Return and Risk of a Mutual Fund

Capital gains distributions

Capital gains from redeeming shares

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Copyright 2004 Pearson Education, Inc. All rights reserved.

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Copyright 2004 Pearson Education, Inc. All rights reserved.

Return and Risk of a Mutual Fund

Moderate growth stock fund

High risk growth stock fund in one sector

Return and Risk of a Mutual Fund

Exhibit 17.4: Tradeoff between Expected Return and Risk

Copyright 2004 Pearson Education, Inc. All rights reserved.

Return and Risk of a Mutual Fund

Return and Risk of a Mutual Fund

Copyright 2004 Pearson Education, Inc. All rights reserved.

Return and Risk of a Mutual Fund

Moderate Ginnie Mae bond fund

High risk junk bond fund

Return and Risk of a Mutual Fund

Deciding Among Mutual Funds

Investment objective (type of fund)

Reviewing a mutual funds prospectus

Deciding Among Mutual Funds

Decide Among Mutual Funds