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Prentice-Hall, Inc. 1
Chapter 15
Mutual Funds: An Easy Way to Diversify
Prentice-Hall, Inc. 2
What Is a Mutual Fund?
Investment company that pools money from investors to buy stocks, bonds, and other investments. Investors own a share of the fund proportionate to the amount of the investment.
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Why Invest in Mutual Funds?
Benefit the small investor – diversification and reduced risk.
Level the playing field between corporations and the individual investor.
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Advantages of Mutual Fund Investing
Diversification -- owning numerous securities reduces risk
Professional management Minimal transaction costs Liquidity Flexibility Service Avoidance of bad brokers
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Disadvantages of Mutual Fund Investing
Lower-than-market performance– 1989-1998, average annual returns
» actively managed stock funds, 15.6%» S & P 500 stock index, 19.2%
CostsRisks -- Unsystematic risk Risk -- Systematic riskCapital gains taxes
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To Operate, Mutual Funds
Pool money from investors with similar goals.
Invest in numerous securities.
Hire a management company to run the fund.
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To Operate, Mutual Funds (cont’d)
Hire an investment advisor to manage the fund’s portfolio
Hire a– a custodian to safeguard fund holdings– a transfer agent to act as recordkeeper – an underwriter to sell new shares
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Ways of Making Money With Mutual Funds
Increases in market value (appreciation)
Dividends Capital gains
distribution
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Types of Investment Companies
Open-end investment companies or mutual funds
Closed-end investment companies or mutual funds
Unit investment trustsReal estate investment trusts (REITs)
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Open-End Investment Companies or Mutual Funds
Have an unlimited number of shares Buy and sell shares directly to investors
without a secondary market Purchase and selling price is determined by
the net asset value of the fund
NAV = value of all securities - liabilities total shares
outstanding
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Closed-End Investment Companies or Mutual Funds
Have a limited number of sharesSell only the initial offering. Subsequent
trades are done in a secondary market, similar to the common stock market.
Purchase and selling price is determined by supply and demand.
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Unit Investment Trusts
Fixed pool of securities, normally municipal bonds
Have shares that represent a proportionate share of the trust
Are passive investments that operate on a buy-and-hold strategy
Normally require $1,000 minimum investment Long time horizon recommended
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Real Estate Investment Trusts (REITs)
Professional managers invest pooled funds in a diversified portfolio of real estate.
Require that 75% of fund income is generated from real estate investments and must distribute 95% of income as dividends.
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Real Estate Investment Trusts (cont’d)
Have 3 types (equity; mortgage; hybrid).Lack the liquidity of most mutual funds,
but more liquidity than direct real estate investments.
Actively traded REITs recommended.Offer diversification independent of the
stock market.
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Equity REITs
Buy property directly Manage the
property Investors hope the
real estate appreciates in value
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Mortgage REITs
Buy mortgages. Do not have any
capital appreciation. Investors only
receive interest payments on the mortgages.
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Hybrid REITs
Invest in both properties and mortgages.
Investments result in both capital appreciation and interest income.
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The Costs of Mutual FundsLoad funds-- sales commissions
charged to the investor when purchasing fund shares.
Back-end load funds -- commissions charged to the investor when selling the shares; may be a sliding scale.
No-load funds -- no commission charged.
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The Costs of Mutual Funds (cont’d)
Management fees and expenses -- fees associated with the operation of the company.– expense ratio– turnover rate
12b-1 fees -- fees charged to cover the fund’s cost of advertising and marketing.
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Types and Objectives of Mutual Funds
Money market mutual fundsStock mutual fundsBalanced mutual fundsAsset allocation fundsLife-cycle fundsBond funds
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Money Market Mutual Funds (MMMFs)
Invest in short-term securities with maturities of less than 30 days
Trade at a constant net asset value of $1 per share
Work much like an interest bearing checking account with some limitations
Considered practically risk free
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Specialized Types of MMMFs
Tax-exempt MMMFs -- invest in only muni’s
Government securities MMMFs -- invest in government paper to reduce risk, but lower return
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Stock Mutual Funds
Aggressive growth fundsSmall-company growth fundsGrowth fundsGrowth-and-income fundsSector funds Index funds International funds
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Balanced Mutual Funds
Try to balance objectives of long-term growth, income, and stability of the capital invested
Invest in common stock, preferred stock, and bonds
Less volatile than stock funds
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Asset Allocation Funds
Are similar to balanced mutual funds in the mix of securities
Practice market timing to attempt to outperform the market
Risky due to the turnover rate and associated transaction costs
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Life-Cycle Funds
Are similar to asset allocation funds.
Tailor holdings to best meet the needs of investors in a certain stage of the life cycle, such as age or risk tolerance.
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Bond Funds
A small investment buys shares in a diversified bond portfolio.
More liquid than individual bonds.Provide professional management.Provide regular income.
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Bond Funds (cont’d)
Can incur more expenses than purchasing bonds directly.
Don’t mature to pay a guaranteed lump sum investment like individual bonds do.
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Types of Bond Funds
U.S. government and GNMA bond funds
Municipal bond fundsCorporate bond fundsSpecialized maturity length (short-,
intermediate-, and long-term) funds
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Services Offered by Mutual Funds
Automatic investment and withdrawal plans Automatic reinvestment of interest, dividends,
and capital gains Wiring and funds express options Phone switching Easy establishment of retirement plans Check writing Bookkeeping and help with taxes
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Buying a Mutual Fund
Step 1: Determine your investment goals.
Step 2: Identify funds that meet your objectives.
Step 3: Evaluate the fund.
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Step 1: Determine Your Investment Goals
Determine your time horizon for each goal
Determine your risk toleranceDetermine your personal investment
preferencesDetermine your tax planning strategies
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Step 2: Identify Funds That Meet Your Objectives
Look to third-party publications– Morningstar Mutual Funds
Determine the fund’s objectiveDetermine the fund’s investment style
– value– growth
Read the prospectus
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Information Contained in the Prospectus
The fund’s goal and investment strategyThe fund manager’s past experienceAny limitation on investments that the
fund may haveAny tax considerations of importance to
the investors
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Information Contained in the Prospectus (cont’d)
The redemption and investment process for buying and selling shares in the fund
Services provided investorsPerformance over the past 10 years or
since the fund has been in existenceFund fees and expensesThe fund’s annual turnover ratio
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Step 3: Evaluate the Fund
Always compare funds with the same objective.
Evaluate the fund’s long-term performance.
Look at returns in both up and down markets.
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Sources of Information The Wall Street Journal Forbes or Business Week Kiplinger’s Personal
Finance Smart Money or
Consumer Reports Wiesenberger Investment
Companies Service Morningstar Mutual Funds
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Mutual Fund Quotes in The Wall Street Journal
NAV – net asset value (price)NAV change – gain or loss from prior
day’s NAV Total return – NAV change plus
accumulated incomeTotal return – NAV change plus income
for different time periods, in percent.
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Mutual Fund Quotes (cont’d)
Ranking – Performance comparison among funds with same objective for different time periods.
Max initial sales com – the largest allowable sales commission charged
Annual Exp – covers all expenses associated with running and advertising the fund
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Calculating Fund Returns
Returns include distributions of dividends, distributions of capital gains, or NAV appreciation
Total return =
dividends + capital gains + (ending NAV – beginning NAV) beginning NAV
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Calculating Fund Returns
With reinvestment of all distributions, total return includes the NAV share increase and the increased number of shares
Total return =
(No. of ending shares x ending price) –
(No. of beginning shares x beginning price)
(No. of beginning shares x beginning price)
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Making the Purchase Buy through a
financial services broker, banker, planner– Probably a load
Buy directly from the mutual fund – – No load– 1-800…– Internet
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Making the Purchase (cont’d)
Buy through a “mutual fund supermarket”– 8 major players, 3 largest include:
» Fidelity Funds Network» Charles Schwab» Jack White
– Minimum account balances vary– Transaction fees vary
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SummaryWhat is a mutual fund and how does it
operate? Mutual fund advantages and
disadvantagesTypes of investment companies
– Open and closed end mutual funds– Unit investment trusts– REITs
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Summary (cont’d)
Costs of owning a mutual fund– Loads -- front-end and back-end– Fees -- management and 12b-1
Understand fund objectives and categories
Understand fund services
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Summary (cont’d)
Sources of mutual fund investment information– Newspapers, magazines, Internet– Investment company prospectus
How do you buy a mutual fund?Types of mutual fund returns
– Dividends or capital gains distributions– NAV appreciation
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