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1
CHAPTER 13Investing in Mutual Funds
a.k.a. Investment Companies
“Mutual Funds will bore you to wealth.” – Industry saying
2
What is a Mutual Fund? An investment chosen by people who pool
their money to buy stocks, bonds, and other financial securities a.k.a. Investment company (the legal term) Professional management Diversification
Each fund has a specific objective Over 10,000 funds to choose from Many people choose mutual funds for their
retirement account investments [401(k), 403(b), IRA and Roth IRA, etc.]
3
Mutual Funds
STOCKS BONDS CASH
Professional Money Management
Diversification
Stock mutual funds
Bond mutual funds
Money market mutual funds
Balanced mutual funds
a “mutual” fund
4
Why Investors Purchase Mutual Funds
Professional management Who is the fund’s manager? Managers change often (like professional athletes!)
Look for an experienced management team
Diversification Investors funds are pooled and used to purchase
a variety of investments This variety provides some safety that is difficult for
individual investors to obtain on their own
“PITA” factor is low – The Wealthy Barber
5
Growth of Mutual Fund Industry
YearNumber of
Mutual Funds
1940 70
1970 350
1980 600
1990 2,000
2000 9,000
2010 10,119 Source: Investment Company Institute, www.ici.org
6
Mutual Fund Transactions Purchase options
Through a broker Directly from the investment company Best way is auto-contribution (payroll, checking)
Dollar-cost averaging! Sell options
Through a broker or through the mutual fund Best way is auto-withdrawal (into your checking)
You automatically invest $50 or $100 per month for thirty years and then you automatically withdraw $2,000 or $3,000 per
month for the rest of your life! Sound interested? Uh, wait a minute. Did I mention that there are no guarantees.
Always be sure to read the fine print, okay?
7
Annual Operating Expenses Management fees
Charged yearly (0.2% to 2% or more) based on a percentage of the fund’s asset value
Paid to portfolio managers and analysts who make the investment decisions
12b-1 fees Annual fee to defray advertising, servicing, and
distribution costs of the fund Accounting and other expenses Trustee fee
For retirement accounts ($10-$30)
8 Load Funds versus No-load Funds Load Fund
Investors pay a sales commission (sales load) every time they purchase shares
Average fee is 3-5% for which an investor gets purchase advice and explanations
Often have lower annual operating expenses No-Load Fund
Investors pay no sales fee, because there are no sales people
You deal directly with the investment company via 800 numbers or web sites
Often have higher annual operating expenses
9
Types of Load Funds Front-end Load – a.k.a. Class A
Upfront fee – lower annual operating expense Back-end Load – a.k.a. Class B
Back-end fee – higher annual operating expense No-load Funds (Huh?) – a.k.a. Class C
No upfront nor back-end fee – higher annual fees Types of No-Load Funds
Advisor No-load Funds – a.k.a. Class F, Class I Advisor charges 1% to 2% to “manage the account”
“True” No-load Funds May not have a 12b-1 fee greater than 0.25% But that doesn’t mean the overall fees are low
Over time, a no-load fund can wind up costing more in fees than a load fund
(continued)
Load Funds versus No-load Funds
10
Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F-1
Maximum sales charge 5.75% None None None
Maximum sales charge on reinvested dividends
None None None None
Maximum deferred sales charge None 5.00% 1.00% None
Redemption or exchange fees None None None None
Annual Operating Expenses Class A Class B Class C Class F-1
Management Fees 0.24% 0.24% 0.24% 0.24%
Distribution and/or Service Fees (a.k.a. 12b-1)
0.23% 1.00% 1.00% 0.25%
Other Expenses 0.14% 0.14% 0.18% 0.17%
Total: 0.61% 1.38% 1.42% 0.66%
Investment Company
of America
This is a load fund.
11
Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F
Maximum sales charge 4.25% None None None
Maximum sales charge on reinvested dividends
None None None None
Maximum deferred sales charge
None 4.00% 1.00% None
Redemption or exchange fees None None None NoneAnnual Operating Expenses Class A Class B Class C Class F
Management Fees 0.75% 0.75% 0.75% 0.75%
Distribution and/or Service Fees (a.k.a. 12b-1)
0.30% 1.00% 1.00% 0.00%
Other Expenses 0.20% 0.43% 0.38% 0.35%
Total: 1.25% 2.18% 2.13% 1.10%
Alliance Large Cap
Growth Fund
Another load fund.
12
Example of Shareholder Fees:Transaction fees Class A Class C Financial Institutional
Maximum sales charge 5.75% None None None
Maximum sales charge on reinvested dividends
None None None None
Maximum deferred sales charge None 0.95% None None
Redemption or exchange fees None None None None
Legg Mason
Value Trust
This was a very famous no-load mutual fund. The class C shares were (and still are) the most popular. It just added class A shares. Many in the industry
still refer to it as a no-load fund.
Annual Operating Expenses Class A Class C Financial Institutional
Management Fees 0.67% 0.67% 0.67% 0.67%
Distribution and/or Service Fees (a.k.a. 12b-1)
0.25% 0.95% 0.25% 0.00%
Other Expenses 0.09% 0.16% 0.18% 0.10%
Total: 1.01% 1.78% 1.10% 0.77%
13
Example of Shareholder Fees:
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends
None
Maximum deferred sales charge
None
Redemption or exchange fees NoneAnnual Operating Expenses Class A
Management Fees 0.14%
Distribution and/or Service Fees (a.k.a. 12b-1)
Other Expenses 0.03%
Total: 0.17%
Vanguard 500 Index
Fund
This is an index fund. This fund does no research. They simply buy all the 500 stocks
in the S&P 500 Index. The term for this is “passive
management.” (More later)Index funds are usually “true” no-load mutual fund and usually have
very low fees.
There is a $20 annual fee if your account value is less
than $10,000.
14
Example of Shareholder Fees:
Transaction fees
Maximum sales charge None
Maximum sales charge on reinvested dividends
None
Maximum deferred sales charge
None
Redemption or exchange fees NoneAnnual Operating Expenses Class A
Management Fees 0.07%
Distribution and/or Service Fees (a.k.a. 12b-1)
Other Expenses 0.03%
Total: 0.10%
Fidelity Spartan 500 Index Fund
Vanguard pioneered low fee mutual funds and was
able to overtake Fidelity as the number #1 mutual fund
company.Fidelity responded by
eliminating all sales loads, creating their own index
funds, and lowering their fees below Vanguard.
Like the Vanguard fund, there is a “low balance” annual fee of $10 if your
account is below $10,000.
15
Examples of Dollar Costs:
Hypothetical $10,000 Investment with 5% Return
1 Year
3 Years
5 Years
10 Years
Class A $634 $759 $896 $1,293
Class B (assuming no redemption) 140 437 755 1,447
Class C (assuming no redemption) 145 449 776 1,702
Class F-1 (excludes advisor fee) 67 211 368 822
Although it looks as though the F shares are the best deal, this doesn’t include the advisor’s annual fee. Adding the
advisor’s typical fee of 1% to 2% per year would easily add an additional $1,200 to $2,400 to the total cost. Over the
long term, which is the best deal?
Investment Company
of America
16
Examples of Dollar Costs:
Hypothetical $10,000 Investment with 5% Return
1 Year
3 Years
5 Years
10 Years
Class A $672 $878 $1,101 $1,741
Class C 181 561 965 2,096
Financial Intermediary Class 112 350 607 1,341
Institutional Class 79 246 428 955
The class C shares of this “no load” fund wind up costing more than the class A shares! Again, the Financial Intermediary Class seems to be a
better deal but it doesn’t include the advisor’s annual fee. The Institutional Class looks great. How can I get them? Well, for starters,
are you a large pension fund, university endowment, or tax-exempt charity? Oh, and by the way, do you have at least $1 million to invest?
Legg Mason
Value Trust
17
Examples of Dollar Costs:
Hypothetical $10,000 Investment with 5% Return
1 Year
3 Years
5 Years
10 Years
Investor Class $17 $55 $96 $217
Admiral Class 6 19 34 77
The fees for passively-managed index funds will almost always be less than actively-managed funds. The Admiral Class shares were
available with a minimum of only $100,000 but now can be had with as little as $10,000. Any takers?
There is another type of mutual fund called an exchange-traded fund (ETF) that we will discuss later. They often have fees lower
than the index funds! The Vanguard ETF that tracks the S&P 500 has an expense ratio of 0.06%.
Vanguard 500 Index
Fund
18
Breakpoint Sales Reductions:
Investment (either purchased or accumulated) Sales Charge
Less than $25,000 5.75%
$25,000 but less than $50,000 5.00%
$50,000 but less than $100,000 4.50%
$100,000 but less than $250,000 3.50%
$250,000 but less than $500,000 2.50%
$500,000 but less than $750,000 2.00%
$750,000 but less than $1,000,000 1.50%
$1,000,000 or more None
Class A shares typically qualify for a sales reduction if you invest a larger amount or as your investment grows. Some brokers fail to
inform their clients of this feature. Instead, as the client approaches the breakpoint, the broker will advise them to start another fund. Why?
Investment Company
of America
19
Contingent Deferred Sales Charge (CDSC) on Class B Shares
Year of Redemption Contingent Deferred Sales Charge
1 5.0%
2 4.0%
3 4.0%
4 3.0%
5 2.0%
6 1.0%
7+ 0.0%
The back-end sales charge on Class B shares typically is reduced over time until it is eliminated. However, as we noted, the Class B shares
usually pay more in annual fees. This type of schedule is also typical of annuities, only usually it is worse.
CDSC Reduction over Time:Investment Company
of America
20
10-Year Rates of Return:
Investment10-Year Return
Growth of $10,000
Investment Company of America, Class A 3.74%* $14,437
Alliance Large Cap Growth Fund, Class A 3.74%* $14,381
Legg Mason Value Trust, Primary (Class C) 0.37% $10,376
Vanguard Index 500 Fund 4.02% $14,825
Standard & Poor’s 500 Index 4.12% $14,972
Fees are important, but they do not tell you the whole story. When comparing mutual funds, you must look at many
attributes, not the least of which are the rates of return, preferably over longer periods of time.
So, Which One Would You Pick?
*4.36% ($15,323) and 4.19% ($15,079), respectively, without sales charge
A
B
C
D
as of March 31, 2012
21
Mutual Funds Fees: What are __?
These shares do not have an up-front sales load. Instead, they assess a decreasing back-end load if you withdraw your money within 6 years. The annual operating expense is higher (courtesy of the 12b-1 fees).
A. A shares
B. B shares
C. C shares
D. F or I sharesThe correct answer is (B). They normally become A shares
after 6 to 8 years.
22
Mutual Funds Fees: What are __?
These shares do not have an up-front or back-end sales load. The advisor called them “no-load” but you notice that their annual operating expense is higher than other share classes (again, courtesy of 12b-1 fees).
A. A shares
B. B shares
C. C shares
D. F or I shares
The correct answer is (C). They sometimes revert to A or F shares after many years.
23
Mutual Funds Fees: What are __?
Your financial advisor tells you that these shares have a very low annual operating expense. She mumbles something about “wealth management.” These shares are:
A. A shares
B. B shares
C. C shares
D. F or I shares
The correct answer is (D). She also did her best not to explain that her brokerage firm will charge you an extra 2% each year.
24
Stock Mutual Funds Aggressive Growth – most risky
a.k.a. Momentum, Ultra Growth – invests primarily in growth stocks (risky) Capital Appreciation – very flexible, often very risky Growth and Income – blend of growth & dividends
a.k.a. Value, Blend Moderately risky
Equity Income – emphasizes dividends, least risky
Classification of Mutual Funds
These classifications are just some of the major types of stock mutual funds. There are many, many more.
25
Stock Mutual Funds (continued) Large Cap – largest companies
Mid Cap – medium-sized companies
Small Cap – smallest companies
Domestic – based in U.S.
Global – based anywhere in globe International – based outside U.S.
Regional – Japan, Far East, Latin America, etc. Sector – energy, technology, health care, etc. – dumb
Market Timing – dumber
(continued)
Which do you think is
riskiest?
Which do you think is
riskiest?
Classification of Mutual Funds
26
Bond Mutual Funds High-Yield Bonds (a.k.a. Junk Bonds) Corporate Bonds Municipal and Insured Municipal Bonds
State-specific municipal bond funds (exp: California)
U.S. Backed Bonds (Fannie Mae, etc.) U.S. Bonds (Treasuries) Long-term Intermediate-term Short-term Domestic, Global, and International
(continued)Classification of Mutual Funds
What are the advantages /
disadvantages of each of these types?
27
Classification of Mutual Funds Stock & Bond Funds (a.k.a. Balanced Funds)
Invest in both stocks and bonds Stock and Bond Blend Funds
a.k.a. Asset allocation funds Often marketed as “a complete investment
program for the prudent investor” Money Market Mutual Funds
Short-term investments (kinda’ like a checking acct) Mutual Funds of Mutual Funds – “Life-cycle”
“Huh? Sure, I don’t mind being charged twice!” Often marketed as a total mutual fund solution
Retirement (401k), College Education, etc.
(continued)
28
Classification of Mutual Funds Specialty Funds
Hedge Funds Traditionally only open to “sophisticated investors” Very risky and sky-high operating expenses
“Bear” Funds Expect market to go down
Precious Metals and Commodities Funds REIT Funds Boutique / Exotic Funds
StockCar Stocks Fund Pauze Tombstone Fund The Chicken Little Growth Fund
(continued)
The choices are endless. So are the fees…
29
The Buzz about Index Funds Index funds
No management (a.k.a. passively managed) The mutual fund simply buys all the stocks in a
specific index (S&P 500, “US Total Market”, EAFE) Why?
Usually much lower annual operating expenses Many actively managed funds don’t beat the indexes!
Unfortunately, index funds can become victims of their own success (Example: Vanguard Index 500)
Many funds do beat the indexes Look for a fund family where most all funds have
consistently beaten the indexes over decades! Psst! There are only a few companies!
30
The Buzz about ETF’s Exchange-Traded Funds
The success of index funds bred a whole new type of mutual fund Traded on the exchanges like stocks
Very low annual operating expenses Even lower than index funds
But you incur brokerage commissions
Most all are index funds (passively managed) But there are now actively-managed ETF’s
Which have higher fees (because of the active management)
Can be bought and sold throughout the trading day Unlike all other mutual funds which only trade at the
end-of-trading-day closing price
31
Fund Families
A family of funds exists when one investment company manages a group of mutual funds
Funds in the family vary in their objectives You can move your money from one fund to
another within a fund family Almost always with no charge But, if in a taxable account, you could and
probably will generate a taxable transaction
“Choose a Family, Not a Fund”
32
Fund Families: Top Ten Families
1. Vanguard Group2. Fidelity Investments 3. American Funds (CR&M)
4. PIMCO Funds5. J. P. Morgan Chase6. Franklin Templeton Investments7. BlackRock Funds8. Federated Investors9. Bank of New York / Dreyfus Corporation10. T. Rowe PriceSource: Investment Company Institute, http://www2.iii.org/financial/securities/mutualfunds August 2010
Because of the mutual fund scandals of 2003, three of the
companies that used to be amongst the top ten are no longer here.
Examples: Offerings from the top three families
33
“Mutual Fund Scandals?!” “You want me to invest in an industry that is
plagued with scandal?!” Since 1940, the mutual fund industry has been
regulated and escaped any hint of impropriety In 2003, some practices that were not quite illegal
but obviously unethical were uncovered Only a handful of funds and people were affected Strong, Janus, Bank of America, Putnum, Alliance
The vast majority of companies never engaged in the shenanigans
Instead of losing $99,999 on a $100,000 account (example: Enron), investors lost $1 on a $100,000 account.
Wait a minute, Paiano! Did you just say,
34
“So, How Do I Pick a Mutual Fund?”
Pick a Mutual Fund that… Invests in high-quality stocks or bonds Is well-diversified across several industries and
sectors of the economy Has a long-term perspective and a manager or
(better yet) a management team with many years of experience Avoid companies that “shuffle” their managers
every few years (which is virtually all of them!) Has been around for decades and performed
consistently well in both good and bad markets
35
A Sample Stock Mutual Fund
Is 78 Years “Long-term” Enough? 6%, 8%, 9%, 10%? How ‘bout almost 12%? “But stocks have been very risky, right?”
Short-term? Yes. Long-term? No!
“But now is not a good time to invest” What if you had invested on the worst day of the
year for the past 20 years?
“But what about market downturns?” Keep a long-term perspective, and Dollar Cost Average
36
Dollar Cost Averaging
A system of buying an investment at regular intervals with a fixed dollar amount
With Dollar Cost Averaging, there is always “Good News” “The market is up! Good News!”
Your account is worth more “The market is down! Good News!”
Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account
Yippee!
Huh?!
37
Hypotheticals Most mutual fund companies have a system for
running “hypotheticals” a.k.a. “Illustrations” “Hypothetical illustrations” Examples of returns of investments Lump sum principals, or Streams of investments
a.k.a. Dollar-Cost Averaging Or combinations of both lump sum & streams Must be approved by SEC and FINRA
And contain disclaimers about past versus future performance
Let’s run some hypotheticals!
38
And That’s Not the Only One!
Do you remember this slide from chapter 1? As of December 31, 2011
39
Bottom Line on Mutual Funds Choose a fund family and stick with them
“Most mutual fund investors do worse than the mutual funds they invest in”
Re-evaluate them periodically But make changes judiciously and sparingly As you approach retirement, migrate from stock
funds to bond funds But don’t give up on stocks entirely (ICA illustration)
Use Dollar Cost Averaging $50 a month, $100 a month, whatever… For the most part, Forget About Them!
I know. It makes investing boring, but it works!