C 4 HAPTER Mutual Funds
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Transcript C 4 HAPTER Mutual Funds
CHAPTER 4
Mutual Funds
Chapter Sections:
Advantages and Drawbacks of Mutual Fund Investing
Investment Companies and Fund Types
Mutual Funds Operations
Mutual Funds Costs and Fees
Short-Term Funds
Long-Term Funds
Mutual Fund Performance
Closed-End Funds, Exchange Traded Funds, and Hedge Funds
Mutual Funds: Investments for the Masses
1
2
What is a Mutual Fund?
An investment company that invests its
shareholders’ money in a diversified portfolio
of securities
“Investment company” is the legal term
“Mutual fund” is the popular 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 (401k, 403b,
Traditional IRA, Roth IRA, etc.)
3
Mutual Funds
STOCKS
Stock
mutual
funds
“CASH”
BONDS
Balanced
mutual
funds
Bond
mutual
funds
Money
market
mutual
funds
a “mutual” fund
a.k.a. investment company
Professional Money Management
Diversification
4
Growth of Mutual Fund Industry
Year
1940
1970
1980
1990
2000
2011
Number of
Mutual Funds
70
350
600
2,000
9,000
10,664*
Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, and ETFs
5
Growth of Mutual Fund Industry
(continued)
In 1980, five million Americans owned funds
Holding 3% of their household financial assets
As of December 2011, 92 million Americans in
52 million households owned mutual funds
That is approximately 44% of all U. S. households
Mutual fund assets totaled $13.0 trillion dollars*
Holding 23% of their household financial assets
Mutual funds are now the nation’s largest financial
intermediary, followed by commercial banks (second
largest) and life insurance companies (third largest)
Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, ETFs, and UITs as of
December 2011. By the way, at the end of 2010, the amount was $13.1 trillion; at the end of 2009, the amount was
$12.16 trillion; at the end of 2008, it was $10.35 trillion, and at the end of 2007, it was $12.98 trillion dollars.
2008 was a very rough year.
6
Advantages of Mutual Funds
Pooled Diversification
A process whereby investors buy into a
diversified portfolio of securities for the collective
benefit of the individual investors
This variety provides some safety that is difficult for
an individual investor to obtain on their own
Professional management
The mutual fund managers are supposed to know
what they are doing
(They are certainly getting paid enough!)
Low initial outlay of capital
You can start with $25 to $50 per month
“PITA” factor is low –
The Wealthy Barber
7
Drawbacks of Mutual Funds
Transaction Costs
Some mutual funds charge sales fees called
“loads”
Front-end loads, back-end loads, etc.
Many others are “no-load” funds
But some “no-load” funds can wind up costing you
more than “load” funds over time
Annual Operating Expenses
Typically from 0.5% (or less) to 2.5% (or more)
Many mutual funds do not match the market’s
performance
What? Aren’t the mutual fund managers
supposed to know what they are doing?
8
Open-end versus Closed-end Funds
Open-end mutual funds (>90% of mutual funds)
A type of investment company in which investors
buy shares from, and sell them back to, the mutual
fund itself, with no limit on the number of shares
the fund can issue
Shares are issued and redeemed by the
investment company at the request of investors
Investors can buy shares from (purchase) and sell
shares to (redeem) the investment company at any
time
When people refer to a mutual fund, they are almost exclusively
referring to an open-end mutual fund. As of December ‘11, there were
8,684 open-end mutual funds totaling $11.6 trillion dollars in assets.
9
Open-end versus Closed-end Funds
(continued)
Closed-end mutual funds (<10% of mutual funds)
A type of investment company that operates with a
fixed number of shares outstanding
Shares are issued by an investment company only
when the fund is organized
After all original shares are sold you can only
purchase shares from another investor
Bought and sold like stocks on the open market
Incur brokerage commissions
Closed-end investment companies are not as popular with
individual investors as open-end investment companies. At the
end of December 2011, there were only 634 closed-end mutual
funds holding only $239 billion dollars in assets.
10
Open-end versus Closed-end Funds
(continued)
Net Asset Value
The underlying value of one share in a particular
mutual fund
Add up the value of the securities in the mutual fund
Subtract any liabilities (normally close to zero)
Divide by the number of shares
Open-end mutual funds are sold at net asset value (with a sales
load added to load funds). Since closed-end mutual funds are
bought and sold on the open market, their price usually either
reflects a premium or discount to the net asset value (usually a
discount). They are very rarely priced at their net asset value.
11
Open-end versus Closed-end Funds
(continued)
Net Asset Value =
Value of the fund’s portfolio - Liabilities
Number of shares outstanding
Example: $10,050,000 - $50,000 = $10 NAV
1,000,000 shares
Offering price = NAV + sales commission
Example: $10 + ($10 * 5%) = $10.50 Offering Price
12
Open-end versus Closed-end Funds
(continued)
Advantages / Disadvantages?
Open-end investment company
Always able to buy and sell – no market forces
Very popular – wide range of choices
Large purchases or redemptions can make
management of the fund more difficult
Mutual fund company can “close the fund” to new investors
Closed-end investment company
Must pay broker’s commission (like a stock)
Must be bought/sold via the marketplace
Often sold at premium or discount to NAV
Easier to manage assets for investment advisors
Which would (or do) you prefer?
13
A New Type of Mutual Fund: ETFs
Exchange-traded Funds
An open-end mutual fund that trades on the
exchanges like closed-end mutual funds
There is no limit to the number of shares
The mutual fund company issues shares as needed
But the investor must purchase the fund using a
brokerage account
Incurring brokerage transaction fees (commissions)
A recent entry to the industry, ETFs are becoming increasingly popular.
At the end of 2011, there were 1,166 ETFs totaling $1,048 billion.
At the end of 2010, there 950 ETFs totaling $992 billion in assets.
At the end of 2009, there were 820 ETFs totaling $777 billion. At the end of 2008, there
were 743 totaling $531 billion. At the end of 2007, there were 629 totaling $608 billion.
And at the end of 2006, there were 359 totaling $423 billion dollars.
Again, take note of the steep drop in value in 2008.
14
How are Mutual Funds Regulated?
Investment Company Act of 1940
Foundation of the modern mutual fund industry
Defined “regulated investment company”
a.k.a. “pass-through” investment vehicle
Does not pay taxes on its investment income
The shareholders pay the taxes
To qualify, an investment company must…
Hold almost all its assets as investments in stocks,
bonds, and other traditional securities, and
Very limited ability to use derivatives & other risky strategies
Use no more than 5% of its assets when acquiring a
particular security, and
Create an organization with “checks & balances”
15
(continued)
16
How are Mutual Funds Organized?
The Mutual Fund
A Corporation run by a Board of Directors
Board of Directors voted in by Shareholders
Sponsored the fund’s creator
(investors)
Investment Advisor (a.k.a. Management Company)
Portfolio Manager (sometimes a team or a committee)
Research Analysts (usually focus on a specific industry)
Distributors
Distributes the shares to the public or to dealers
Much the same role as an investment banker
Mutual funds are technically continuous Initial Public
Offerings – must have an annual prospectus & report
17
How are Mutual Funds Organized?
(continued)
Custodian
The company that actually holds the securities
Often a bank or trust company
Transfer Agent
Keeps track of purchase and redemption requests
from shareholders
Independent Public Accounting Firm
Certifies the fund’s financial reports
Why the large diversification of tasks and companies? Mutual
funds are highly regulated in order to protect shareholders’
investment from fraud and collapse. How often have you heard
of a scandal at a mutual fund company? Until 2003, never.
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
any of the shenanigans
Instead of losing $99,999 on a $100,000 account (example: Enron
or WorldCom), investors lost $1 on a $100,000 account.
18
Annual Operating Expenses
Management fees
Charged yearly (.25%-2% average) 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 – up to 1% per year
Accounting and other expenses
Trustee fee
Only for retirement accounts – typically $10 to
$30
19
Annual Operating Expenses
(continued)
Trading Costs
Not disclosed in the annual prospectus
So how does an investor know how much the
trading costs are?
You can ask the mutual fund or just look at the…
Annual Turnover
Measure of how much trading a mutual fund does
Measured in percentage of the amount a portfolio
“turns over” each year
100% turnover, 50% turnover, etc.
The higher the turnover, the higher the trading costs
Also gives you an idea how long they hold investments
100% turnover: They hold on average one year
50% turnover: They hold on average two years
20
21
Load versus No-load Funds
Load Fund
A mutual fund that charges a commission when
shares are bought
Typically 3% to 5%
Used to compensate the financial representative
Along with the fund distributor
No-load Fund
A mutual fund that does not charge a commission
when shares are bought
Traditionally sold directly to shareholders
The endless debate: Should you purchase a
Load Fund or No-load Fund?
22
Load versus No-load Funds
(continued)
Types of Load Funds
Front-end Load – a.k.a. Class A
Commission is paid when shares are purchased
Normally have lower annual operating expenses
Back-end Load – a.k.a. Class B
Commission is paid when shares are redeemed
Most back-end load funds have a Contingent
Deferred Sales Charge (CDSC)
The CDSC declines to zero over a period of 3 to 6 years
5% first year, 4% second year, 3% third year, etc.
Normally, the back-end load pay higher annual
operating expenses (12b-1 fees) until the CDSC
declines to zero
Eventually, the Class B shares revert to Class A shares
23
Load versus No-load Funds
(continued)
Types of Load Funds (continued)
No-load
Funds (Huh?) – a.k.a. Class C
No front-end nor back-end commissions
Except 1% back-end charge if redeemed within one year
However, many Class C funds have higher annual
operating expenses in perpetuity (or for a long time)
There are those 12b-1 fees again
Hence, they can wind up costing more than the
Class A or Class B shares over time
The SEC now says you can not call a mutual fund a
“no-load” fund if the 12b-1 fee is greater than 0.25%
So, Class C shares are now not allowed to be called “no-
load” funds even though many in the industry still do
24
Load versus No-load Funds
(continued)
Types of No-load Funds
Advisor No-load Funds – a.k.a. Class F, Class I
Held in advisor’s “wrap account”
a.k.a. “Management account,” “Wealth Management Account”
Advisor charges 1% to 2% to “manage the account”
“True” No-load Funds
Mutual fund company deals directly with public
May not have a 12b-1 fee greater than 0.25%
These are the darlings of the popular media
“Bypass the middleman! Who needs a financial advisor?”
But that does not mean the overall fees are low
Over time, a no-load fund can wind up costing you more
than a load fund
You must compare the annual operating expenses
25
Growth
Fund 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 Class F-1
Management Fees
0.28%
0.28%
0.28%
0.28%
Distribution and/or Service Fees
(a.k.a. 12b-1)
0.24%
1.00%
1.00%
0.25%
Other Expenses
0.19%
0.18%
0.21%
0.15%
0.71%
1.46%
1.49%
0.68%
Total:
This is a load fund.
26
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%
0.36%
0.32%
1.25%
2.18%
2.11%
1.07%
Total:
Another load fund.
Legg
Mason
Value Trust
Example of Shareholder Fees:
27
Transaction fees
Class A
Class C
FI
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
Annual Operating Expenses
Class A
Class C
FI
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%
1.01%
1.78%
1.10%
0.77%
Total:
This is a very famous, now infamous, mutual fund. They just recently changed
from “Primary Class” shares to “Class C” shares and added Class A shares.
28
Example of Shareholder Fees:
Vanguard
500 Index
Fund
Transaction fees
This is an index fund. This
Maximum sales charge
None
fund does no research. They
Maximum sales charge on
None simply buy all the 500 stocks
reinvested dividends
in the S&P 500 Index. The
Maximum deferred sales charge None
term for this is “passive
Redemption or exchange fees
None
management.” (More later)
Index funds are usually
Annual Operating Expenses
Class A “true” no-load mutual fund
Management Fees
0.14% and usually (but not always)
have very low fees.
Distribution and/or Service Fees
(a.k.a. 12b-1)
Other Expenses
0.03%
Total:
0.17%
There is a $20 annual fee if
your account value is less
than $10,000.
29
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
0.025%
Distribution and/or Service Fees
(a.k.a. 12b-1)
Other Expenses
0.07%
Total: 0.095%
Fidelity
Spartan 500
Index Fund
Vanguard pioneered low
fee mutual funds and was
able to overtake Fidelity as
the number #1 mutual fund
company for a short time.
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.
30
Examples of Dollar Costs:
Growth
Fund of
America
Hypothetical $10,000 Investment
with 5% Return
1
Year
3
Years
5
Years
10
Years
Class A
$643
$789
$947
$1,407
Class B (assuming no redemption)
149
462
797
1,543
Class C (assuming no redemption)
152
471
813
1,779
69
218
379
847
Class F-1 (excludes advisor fee)
Although it looks as though the F shares are the best deal,
this does not 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:
31
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 (formerly Primary Class)
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 does not 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?
32
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
5
16
28
64
The fees for passively-managed index funds will almost always be
less than actively-managed funds. The Admiral Class shares used
to be available with a minimum of only $100,000. Any takers?
(In the fall of 2010, they lowered the minimum to $10,000.)
Do you remember the exchange-traded funds (ETFs)? They often
have fees lower than the index funds! The Vanguard ETF that
tracks the total U. S. stock market has an expense ratio of 0.05%.
33
Breakpoint Sales Reductions:
Investment (either purchased or accumulated)
Growth
Fund 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?
34
CDSC Reduction over Time:
Growth
Fund 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.
35
10-Year Rates of Return:
as of December 31, 2012
Investment
So, Which
One Would
You Pick?
10-Year
Return
Growth of
$10,000
A
Growth Fund of America, Class A
7.60%*
$20,792
B
Alliance Large Cap Growth Fund, Class A
7.29%*
$20,211
C
Legg Mason Value Trust, Class C
2.22%
$12,455
D
Vanguard Index 500 Fund
6.99%
$19,644
Standard & Poor’s 500 Index
7.10%
$19,849
formerly
Primary Class
Fees are important, but they certainly 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.
*8.24% and 7.75%, respectively, without sales charge (a.k.a. NAV, net asset value)
36
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 eventually become
A shares after 6 to 8 years.
37
Mutual Funds Fees: What are __?
These shares do not have an up-front fee and
only a 1% back-end fee if redeemed within one
year. The advisor called them “no-load” but
you notice that their annual operating expense
is higher than other share classes (again, courtesy
of those ubiquitous 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.
38
Mutual Funds Fees: What are __?
Your financial advisor tells you that these
shares have no sales fees and 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.
39
Types of Mutual Funds
Aggressive Growth Funds
Highly speculative mutual funds that seek large
profits from capital gains
Dey Iz Rollin’ De’ Dice!
Growth Funds
Mutual funds whose primary goals are capital gains
and long-term growth
Typically invest in high-growth companies
Some fund companies now have a category or two more
speculative than Aggressive Growth. They are sometimes
called Ultra Funds or Momentum Funds. (Example: Janus 20)
What do you think about this strategy?
40
Types of Mutual Funds
(continued)
Capital Appreciation Funds
Mutual funds that seek long-term growth of capital
How does it differ from a growth fund?
Most growth funds have a provision that states they
will invest primarily in growth stocks, usually staying
between 80% & 100% invested in the market
Capital Appreciation Funds can often invest in
anything they like and anywhere they like
In general, they tend to be as risky as growth and
aggressive growth funds (although not always)
The well-known Fidelity Magellan Fund is a
Capital Appreciation Fund
41
Types of Mutual Funds
(continued)
Growth-and-Income Funds
Mutual funds that seek both long-term growth and
current income, with primary emphasis on capital
gains
Sometimes own bonds to augment the income
Sometimes referred to as “Blend” (of Growth & Value)
Value Funds
Mutual funds that seek stocks that are undervalued
in the market by investing in shares that have low
P/E multiples and high dividend yields
Often look for companies out-of-favor with investors
Some folks lump growth-and-income funds and
value funds together
42
Types of Mutual Funds
(continued)
Equity-Income Funds
Mutual funds that emphasize current income and
capital preservation by investing primarily in highyielding, income-producing common stocks
Railroads, Foods, Utilities, REITs, etc.
They will also invest in bonds to generate income
when the investment advisor believes that stock
prices have risen to levels that threaten
preservation of capital
Many Equity-Income Funds did very well during the 2000 to
2002 bear market after lagging the market badly during the late
1990’s bull market. Every type of fund was clobbered in 2008.
43
Types of Mutual Funds
(continued)
More Stock Fund Classifications
Large Cap – largest companies
Mid Cap – medium-sized companies
Which do you
think is the
riskiest?
Small Cap – smallest companies
Domestic – companies based in U.S.
Which do you
Global – based anywhere in globe
think is the
riskiest?
International – based outside U.S.
Regional – Japan, Far East, Latin America, etc.
Emerging Markets – India, Mexico, Brazil, Russia,
Philippines, China, Turkey, etc.
Sector – energy, technology, health care, etc.
Market Timing – dumb
44
Types of Mutual Funds
(continued)
Bond Funds – a.k.a. Fixed-income Funds
Mutual funds that invest in various kinds and
grades of bonds, with income as the primary
objective
High-Yield Bond Funds – a.k.a. Junk Bond Funds
Are often more correlated with stocks than bonds
Corporate Bond Funds
Convertible Bond Funds
Municipal and Insured Municipal Bond Funds
Popular with high net worth individuals
Income is free from Federal taxes
State-specific municipal bond funds
Income is free from state taxes as well
45
Types of Mutual Funds
(continued)
Bond Funds (continued)
U.S. Backed Bonds (Fannie Mae, etc.)
a.k.a. Mortgage-backed Bond Funds
Government Bond Funds – a.k.a. Treasury Bond
Funds, Government Securities Funds
Income is free from state and local taxes
Long-term Bond Funds
Intermediate-term Bond Funds
Short-term Bond Funds
Which do you think
is the riskiest?
Careful!
Global and International Bond Funds
46
Types of Mutual Funds
(continued)
Balanced Funds
Mutual funds whose objective is to generate a
balanced return of both current income and longterm capital gains
Invest in both stocks and bonds
Normally 60% stocks and 40% bonds
But allocation can change as the investment
environment changes
The prospectus of the American Balanced Fund states that the
fund is “managed as the complete U. S. investment program of
a prudent investor.” They can never be more than 75% stocks,
25% bonds or less than 50% stocks, 50% bonds.
47
Types of Mutual Funds
(continued)
Asset Allocation Funds
Mutual funds that spread investors’ money across
stocks, bonds, and money market securities
Very similar to Balanced Funds
However, the investment advisor often more
diligently tries to “fine-tune” the allocation as
market conditions change
Whereas a Balanced Fund usually stays around 60%
stocks / 40% bonds,
An Asset-Allocation Fund might try to move money
into cash when they thought the market might fall
For all their hype, the returns of many Asset Allocation Funds
are very close to Balanced Funds. Some trail Balanced Funds
considerably because they “timed the market” badly.
48
Types of Mutual Funds
(continued)
Money Market Mutual Funds (review)
Mutual funds that invest in short-term money
market instruments
Much the same as money market accounts at banks
and credit unions EXCEPT money market mutual
funds are not guaranteed
General Purpose – Treasury bills, commercial paper
Government Securities – Only Treasury bills
Tax-exempt – very short-term municipal securities
They are essentially as safe as guaranteed money market
accounts since they invest in exactly the same securities but
they are not guaranteed! (Did we already mention that?)
“Breaking the Buck”
49
Types of Mutual Funds
(continued)
Mutual Funds of Mutual Funds
a.k.a. Lifestyle Funds, Target-Date Funds
Choose the fund that matches your time horizon …
College 2020, Retirement 2035, etc.
The company will populate the mutual fund with
other mutual funds to match the time horizon
Often from the same company’s mutual fund choices
As the time horizon shortens, the mutual fund will
change the mix of mutual funds
Some are “Target-Risk” Funds
Choose your risk tolerance & they choose the funds
“A mutual fund of mutual funds? You are kidding, right?”
No. These are very popular now because of retirement plans
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Types of Mutual Funds
(continued)
Specialty Funds
Hedge Funds
Traditionally only open to “sophisticated investors”
But now available to those with as little as $5,000 to $10,000
No regulatory oversight – have become a major force
1% to 2% operating expense; take 20% of the profits
“Bear” Funds
Precious Metals / Hard Assets Funds
REIT Funds
Boutique / Exotic Funds
StockCar Stocks Fund
Pauze Tombstone Fund
The Chicken Little Growth Fund
(I am not making this up!)
The choices are endless. So are the fees…
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Types of Mutual Funds
(continued)
Index Funds – a.k.a. Passively-managed
Mutual funds that buy and hold a portfolio of stocks
or bonds equivalent to those in a specific market
index
No “active management” performed – no research
The mutual fund simply buys all the stocks in the S&P 500,
Dow Jones Industrial Average, Russell 2000, etc.
Why?
Can offer much lower annual fees (no research)
Many actively-managed mutual funds do not beat the market
Because of the annual fee, an index fund can not
actually match the market’s performance, but it
should come very close (providing the annual fee is not excessive)
Whereas, an actively-managed fund could substantially out
perform or under perform the market index
52
Types of Mutual Funds
(continued)
Index Funds (continued)
The rationale for index funds came from research
done in the early 1970’s that statistically showed
that many of the actively-managed funds did not
beat the market
“A monkey throwing darts at a dartboard…”
However, many actively-managed funds do beat
their respective indexes over time
Look for a fund family where most all funds have
consistently beaten their indexes over decades!
(Psst! There are only a few major companies)
In the late ’90’s, index funds became a victim of their own success.
53
Types of Mutual Funds
(continued)
Index Funds (continued)
Standard & Poor’s 500 (a.k.a. S&P 500)
Dow Jones Industrial Average (a.k.a. the Dow)
Dow Jones U.S. Total Stock Market Index
nee Dow Jones Wilshire 5000, nee Wilshire 5000
a.k.a. Total Market Index
NASDAQ Composite & NASDAQ 100
MSCI World (Global) & EAFE Index (International)
Countless other index funds available now
Index funds are the current “perfect investment.”
For the failsafe superlative treatment, visit www.ifa.com.
What, if any, are the downsides to index funds?
54
Types of Mutual Funds
(continued)
Index Funds (continued)
Indexes sometimes become skewed toward a
particular sector of the economy or region of the
world (more about this phenomenon later)
MSCI EAFE 12/31/1989
Japan, 59.8%
P/E: 51.9
All else, 40.2%
P/E: 13.0
S&P 500 3/31/2000
Info Tech, 33.3%
P/E: 59.2
All else, 66.7%
P/E: 19.3
55
Types of Mutual Funds
(continued)
Exchange-Traded Funds – a.k.a. ETFs
An open-end mutual fund that trades as a listed
security on a stock exchange
Trades like a stock as does a closed-end fund
But there is no limit on the number of shares
Becoming very popular because they can be
bought and sold throughout the day like stocks
Unlike open-end mutual funds, which always trade
at the end-of-day net asset value
Most all ETFs are passively-managed index funds
But there are also some actively-managed ETFs
And they have cool names like “Spider,” “Diamond,” and “Cube”
56
Types of Mutual Funds
(continued)
Socially Responsible Funds
Mutual funds that actively and directly incorporate
ethics and morality into the investment decisions
Started out with some funds refusing to invest in
companies that sold alcohol or tobacco
Moved to companies that pollute, build weapons or
nuclear power plants, destroy the rain forests, etc.
And then to companies that exploit labor
It is surprising that there any companies left to invest in …
Silliness aside, many Socially Responsible Funds have
done quite well for their investors
57
Types of Mutual Funds
(continued)
Socially Irresponsible Funds (???)
Possibly as a backlash to socially responsible
funds (and their perceived political overtones)
There is a mutual fund called The Vice Fund
Yep! You guessed it!
It invests in tobacco and alcohol …
(The manager says he simply loves Philip Morris!)
And all the other corporate nasties you can think of
Gambling, Defense firms
And although it is still a very small fund with high annual fees, it
has done very well for its investors (www.vicefund.com)
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59
Types of Mutual Funds
(continued)
Style
Value
Blend
Growth
Size
Large
Medium
Small
Morningstar, a company that analyzes mutual funds, designed the
“style box” to help investors identify investment alternatives. They say
they are fabulous. No one I know uses them; neither do I.
Now they have “ownership zones.” They say they are even better.
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 the fund is in a taxable account, you could
generate a taxable transaction
Recently, fees are being charged for “excessive”
transfers within the fund family
Done to discourage “market timing” by investors
Forbes sez, “Choose a Family, Not a Fund”
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Fund Families: Top Ten Families
Examples: Offerings from the top
Vanguard Group
three families
2. Fidelity Investments
3. American Funds (CR&M)
4. PIMCO Funds
5. J. P. Morgan Chase
6. Franklin Templeton Investments
7. BlackRock Funds
8. Federated Investors
9. T. Rowe Price
10. Bank of New York / Dreyfus Corporation
1.
Source: Investment Company Institute, http://www2.iii.org/financial/securities/mutualfunds Dec 2011
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62
Mutual Fund Investor Services
Automatic Investment Plans
Mutual fund service that allows shareholders to
automatically send fixed amounts of money from
their paychecks or bank accounts into the fund
a.k.a. Dollar-Cost Averaging (more later)
“Pay yourself first!”
In my humble opinion, this is the absolute best way to invest in
a mutual fund. You do not worry about whether or not it is a
good time to invest. Every month is a good time to invest $50
that comes right out of your paycheck or checking account.
P.S. It is practically the only way most people will ever invest!
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Mutual Fund Investor Services
(continued)
Automatic Reinvestment Plan
Mutual fund service that enables shareholders to
automatically buy additional shares in the fund
through the reinvestment of dividends, interest,
and capital gains
Automatic Reinvestment Plans allow an investor to earn
fully compounded rates of return. Unless an investor needs
the income, it is always a good idea to reinvest dividends
and capital gains received from a mutual fund.
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Mutual Fund Investor Services
(continued)
Systematic Withdrawal Plan
Mutual fund service that enables shareholders to
automatically receive a predetermined amount of
money monthly or quarterly
Sometimes annually
Normally electronically transferred directly to your
checking account
Conversion Privilege – a.k.a. Exchange Privilege
Allows shareholders to move money from one fund
to another within the same family of funds
May trigger tax consequences if not in a retirement
account
65
Mutual Fund Transactions
Purchase options
Closed-end & ETFs through the stock exchange
Open-end
Through a broker
Directly from the investment company
Best way is auto-contributions (payroll, checking)
Sell options
Closed-end & ETFs through the stock exchange
Open-end
Through a broker or through the mutual fund
Best way is auto-withdrawals (into your checking)
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Taxes and Mutual Funds
Two types of taxes for Regular Accounts
Income dividends
Taxed as income (20% max, 15% typical, 5% min)
Capital gains distributions
Taxed as capital gains (20% max, 15%, 5% min)
Reinvested dividends and capital gains are still
taxable transactions
Save your year-end statements
Congress may change this someday (doubtful!)
Unrealized capital gains (a.k.a. paper profits) would not be
taxed until you sell your mutual fund shares (forget it!)
Tax-deferred Retirement Accounts (401(k), etc.)
Pay no taxes until retirement
All proceeds taxed as income (except Roth tax-free)
67
Sources of Mutual Fund Information
Mutual Fund Prospectus
A statement describing the risk factors
A description of the fund’s past performance
A statement describing the type of investments in
the fund’s portfolio
Information about dividends, distributions & taxes
Information about the fund’s management
No one reads them!
Unless they have taken BUS-123
It was not that hard, was it?
Mutual Fund Annual Report
Performance, investments, assets and liabilities
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Sources of Mutual Fund Information
(continued)
Financial publications
Morningstar, Lipper, etc.
Business Week, Forbes, Kiplinger's Personal
Finance, and Money are sources of information
on mutual funds
Mutual fund surveys usually include:
Fund’s overall rating compared to other funds
Fund’s rating compared to funds in the same
category
Fund size, sales charge and expense ratio
Risk of loss factor and toll-free number
History for past three, five, and ten years
69
Sources of Mutual Fund Information
(continued)
Financial web sites
finance.yahoo.com
www.businessweek.com
www.morningstar.com
Mutual fund companies’ Internet sites
www.fidelity.com
www.troweprice.com
Hurray! The mutual
www.vanguard.com
fund web sites are again
promoting education.
www.americanfunds.com
www.dodgeandcox.com
www.franklintempleton.com
Investment Company Institute web site
www.ici.org
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“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
71
Is 79 years “long-term” enough for you?
6%, 8%, 9%, 10%? How about almost 12%?
“But stocks are very risky”
Short-term, Yes. Long-term, No!
“But now is not a good time to invest”
“Excuse me, when is it ever a good time to invest?”
Okay, so what if you had invested on the worst day
of the year for the past 20 years? How did you do?
“But what about market downturns?”
Keep a long-term perspective, and
Dollar Cost Average…
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
Your average cost-per-share should be
lower than your average price-per-share
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73
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
Must be approved by SEC and FINRA
And contain disclaimers about past versus future
performance
Let’s run some hypotheticals!
And That Ain’t the Only One!
As of December 31, 2012
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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 (once or twice a year?)
But make changes judiciously and sparingly
As you approach retirement, migrate from stock funds
to bond funds
But do not give up stocks entirely (ICA illustration)
Dollar-Cost Average
$50 a month, $100 a month, whatever is affordable…
For the most part, Forget About Them!
Do not be one of the mutual fund investors that does
worse than your mutual funds!
CHAPTER 4 – REVIEW
76
Mutual Funds
Chapter Sections:
Advantages and Drawbacks of Mutual Fund Investing
Investment Companies and Fund Types
Mutual Funds Operations
Mutual Funds Costs and Fees
Short-Term Funds
Long-Term Funds
Mutual Fund Performance
Closed-End Funds, Exchange Traded Funds, and Hedge Funds
Next week: Chapter 5, The Stock Market