Transcript CHAPTER 13 Investing in Mutual Funds a.k.a. Investment Companies “Mutual Funds will bore you to wealth.” – Industry saying.

CHAPTER 13
Investing in Mutual Funds
a.k.a. Investment Companies
“Mutual Funds will bore you to wealth.”
– Industry saying
1
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
Stock
mutual
funds
BONDS
Balanced
mutual
funds
CASH
Bond
mutual
funds
Money
market
mutual
funds
a “mutual” fund
Professional Money Management
Diversification
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
Year
1940
1970
1980
1990
2000
2010
Number of
Mutual Funds
70
350
600
2,000
9,000
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?
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)
7
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
8
Load Funds versus
No-load Funds

9
(continued)
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
10
Investment
Company
of America
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
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%
0.61%
1.38%
1.42%
0.66%
Total:
Class F-1
This is a load fund.
11
Example of Shareholder Fees:
Alliance
Large Cap
Growth Fund
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
None
Annual 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%
1.25%
2.18%
2.13%
1.10%
Total:
Another load fund.
Example of Shareholder Fees:
Legg
Mason
Value Trust
Transaction fees
Class A
Class C
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
Annual Operating Expenses
Class A
Class C
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%
1.01%
1.78%
1.10%
0.77%
Total:
12
Financial Institutional
Financial Institutional
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.
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
None
Annual 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
None
Annual Operating Expenses
Class A
Management Fees
0.07%
Distribution and/or Service Fees
(a.k.a. 12b-1)
Other Expenses

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,
0.03%
Total:
Fidelity
Spartan 500
Index Fund
0.10%
there is a “low balance”
annual fee of $10 if your
account is below $10,000.
15
Examples of Dollar Costs:
Investment
Company
of America
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
67
211
368
822
Class F-1 (excludes advisor fee)
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?
Examples of Dollar Costs:
16
Legg
Mason
Value Trust
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
79
246
428
955
Institutional Class
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?
17
Examples of Dollar Costs:
Hypothetical $10,000 Investment
with 5% Return
Vanguard
500 Index
Fund
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%.
18
Breakpoint Sales Reductions:
Investment (either purchased or accumulated)
Investment
Company
of America
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?
19
CDSC Reduction over Time:
Investment
Company
of America
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.
20
10-Year Rates of Return:
So, Which
One Would
You Pick?
as of March 31, 2012
Investment
10-Year
Return
Growth of
$10,000
A
Investment Company of America, Class A
3.74%*
$14,437
B
Alliance Large Cap Growth Fund, Class A
3.74%*
$14,381
C
Legg Mason Value Trust, Primary (Class C)
0.37%
$10,376
D
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.
*4.36% ($15,323) and 4.19% ($15,079), respectively, without sales charge
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.
B.
C.
D.
A shares
B shares
C shares
F or I shares
The 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.
B.
C.
D.
A shares
B shares
C shares
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.
B.
C.
D.
A shares
B shares
C shares
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
Classification of Mutual Funds

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
These classifications are just some of the major types of
stock mutual funds. There are many, many more.
25
Classification of Mutual Funds
(continued)

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.
Which do
you think is
riskiest?
Which do
you think is
riskiest?
 Regional – Japan, Far East, Latin America, etc.
 Sector – energy, technology, health care, etc. – dumb
 Market Timing – dumber
26
Classification of Mutual Funds
(continued)

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
What are the
advantages /
disadvantages of
each of these types?
 Domestic, Global, and International
27
Classification of Mutual Funds
(continued)

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.
28
Classification of Mutual Funds
(continued)

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
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
Vanguard Group
Examples: Offerings from the
top three families
2. Fidelity Investments
Because of the mutual fund
3. American Funds (CR&M)
scandals of 2003, three of the
4. PIMCO Funds
companies that used to be amongst
the top ten are no longer here.
5. J. P. Morgan Chase
6. Franklin Templeton Investments
7. BlackRock Funds
8. Federated Investors
9. Bank of New York / Dreyfus Corporation
10. T. Rowe Price
1.
Source: Investment Company Institute, http://www2.iii.org/financial/securities/mutualfunds August 2010
Wait a minute, Paiano! Did you just say,
“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.
33
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
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
35
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”
Yippee!
 “The market is up! Good News!”
Huh?!
 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
36
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!
And That’s Not the Only One!
Do you remember this slide from chapter 1? As of December 31, 2011
38
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!