chapter 12-mutual funds lawre.gitman.ppt

chapter 12-mutual funds lawrence git.ppt

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Chapter 12
Mutual Funds:
Professionally
Managed Portfolios

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12-2
Mutual Funds
•Mutual Fund: an investment company that invests its shareholders’
money in a diversified portfolio of securities
–Investors own a share of the fund proportionate to the amount of the
investment
•First started in 1924
•By 1940 there were 68 funds and by 1980 there were 564 funds
•By the end of 2008 there were more than 8,000 mutual funds available,
with more than $9.6 trillion under management
•More mutual funds in existence today than stocks listed on NYSE and
AMEX combined
•More 45% of all U.S. households own a mutual fund

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Attractions of Mutual Funds
•Portfolio Diversification
–Owning numerous securities reduces risk
•Professional management
•Ability to invest small amounts
•Service
–Automatic reinvestment of dividends
–Withdrawal plans
–Exchange privileges
•Convenience
–Easy to buy and sell; high liquidity
–Funds handle recordkeeping
–Easy to track prices

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Drawbacks of Mutual Funds
•Substantial Transaction Costs
»This term is relative; stocks have round trip commissions and frequently
there are other charges for research and advice and portfolio mgt
–Management fee
–Commission fees on load funds
•Lower-than-Market Performance
–Consistently beating the market is difficult
–Many mutual funds just keep even with overall stock
market index
•For a variety of reason this might be true; but there are many
funds that have beat the market on a consistent basis with
less risk

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Figure 12.1 The Comparative Performance of Managed
Mutual Funds Versus Market Benchmarks
Source: Standard & Poor’s, Standard & Poor’s Indices Versus Active Funds Scorecard, Year End 2008.

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The Comparative Performance of
Mutual Funds Versus the Market
Go to morningstar.com, fund screen 10 years > S&P500 200 hits

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How Mutual Funds are Organized
•Management company runs the funds’ daily operations
•Investment advisor buys and sells stocks or bonds and
oversees the investment portfolio
•Distributor sells the fund shares
–Direct to the public
–Through brokers
•Custodian physically safeguards the securities
•Transfer agent keeps track of purchases and redemption
requests from shareholders

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Open-End Investment Companies
•Investors buy and sell shares directly with the mutual
fund company without a secondary market
•Have an unlimited number of shares
•Purchase and selling price is determined by the Net
Asset Value (NAV) of the fund
•All purchases and sales are completed at the end of the
day after the stock markets have closedNAVValue of all securitiesLiabilities total shares outstanding

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Closed-End Investment Companies
•Sell only the initial offering
–Subsequent trades are done in a secondary market, similar to the
common stock market
•Have a limited number of shares
•Investment advisor doesn’t have to worry about cash
inflow or outflows
•Purchase and selling price is determined by supply and
demand
•Generally sell at premium or discount (usually discount)
to NAV

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Exchange-Traded Funds (ETF)
•A basket of securities designed to track a specific
market index
•Similar to index mutual funds
•Trade like individual stocks on stock exchanges
•Can buy and sell ETFs any time of the day
•Low management expenses due to limited trading by
investment advisor
•Low turnover helps avoid taxes until ETF is sold
•Types of ETFs
–“Diamonds” (DIA) track DJIA
–“Spiders” (SPY) track S&P 500
–“Qubes (QQQ) track NASDAQ 100

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Load and No-Load Funds
•Load Fund: a mutual fund that charges a commission when shares
are bought
–Typically sold through a broker
•No-load Fund: a mutual fund that does not charge a commission
when shares are bought
–Typically sold directly to investor by mutual fund
–Cost savings tend to give investors a head start in achieving superior
rates of return
•Low-load Fund: a mutual fund that charges a small commission (2%
to 3%) when shares are bought

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Load and No-Load Funds
•Back-end load: a commission charged on the
sale of shares in a mutual fund
•12(b)-1 fee: fee charged by some mutual funds
to cover management and other operating costs;
amounts to as much as 1% of the average net
assets

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Other Fees and Costs
•Management fee: compensation paid to professional managers who
administer the fund’s investment portfolio
–This fee is paid by all types of funds (load vs. no-load; open-end vs.
closed-end)
–Fee is charged annually on average net assets
•Administrative costs: the normal costs of doing business, such as
trading expenses
•Taxes on mutual funds
–Mutual funds do not pay taxes if income and capital gains are passed on
to shareholders
–Shareholders are taxed on their share of income and capital
gains annually

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Figure 12.2
Fund Fees and
Charges on the
Web
Source: Data from
www.morningstar.com,
September 10, 2009.
©2009 Morningstar, Inc.

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12-15
Table 12.1 Mutual Fund Fee Table (Required by
Federal Law)

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Unit Investment Trusts (UIT)
•Fixed pool of securities, normally bonds
•Not actively managed; securities in portfolio remain static
•Have shares that represent a proportionate share
of the trust

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Real Estate Investment Trusts (REIT)
•Closed-end investment company that invests in mortgages and
various types of real estate investments
•Provide high dividends along with capital appreciation potential
•Types of REITs
–Property/equity REITs invest in shopping centers, hotels,
apartments, office buildings and other real estate
–Mortgage REITs invest in mortgages
–Hybrid REITS invest in both properties and mortgages

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Hedge Funds
•Not really mutual funds; private limited partnerships
•Notregulated by mutual fund regulations
•General partner runs fund and takes 10-20% of profits;
limited partners are investors
•Only sold to “accredited investors”—net worth greater
than $1,000,000 and/or annual income over $200,000
•Use arbitrage strategies, options, short sales and other
complex strategies

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Types of Mutual Funds
•Growth Fund: primary goals are capital gains
and long-term growth
–Invest in large, well-established companies with
above-average growth potential
–Little or no dividend income
–Moderately risk investments for more aggressive
investors

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Types of Mutual Funds (cont’d)
•Aggressive Growth Fund: highly speculative mutual
fund that seeks large profits from
capital gains
–Invest in small, unseasoned companies with high price/earnings
ratios
–Often look for turnaround situations
–Prices are often highly volatile
–High risk investments for very aggressive investors

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Types of Mutual Funds (cont’d)
•Value Fund: seeks stocks that are undervalued
in the market
–Focus is on intrinsic value of stocks and requires
extensive fundamental analysis
–Invest in stocks with low P/E ratios, high dividend
yields and promising futures
–Looks for undiscovered companies with potential for
future growth
–Less risky investments for relatively conservative
investors looking for moderate growth

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Types of Mutual Funds (cont’d)
•Equity-income Fund: emphasizes current income and
capital preservation
–Focus is on high current income with some long-term capital
appreciation
–Invest in high-yielding common stocks, convertible securities or
preferred stocks
–Invests in “blue chip” stocks and other high-grade securities
–Typically less price volatility than overall stock market
–Less risky investments for relatively conservative investors looking
for moderate growth

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Types of Mutual Funds (cont’d)
•Balanced Fund: generates a balanced return of both
current income and long-term capital gains
–Invest in blend of fixed-income securities and common stocks,
with 30% to 40% in fixed income
–Allocation between stocks and bonds typically remains constant
or varies very little
–Emphasis between fixed-income and common stocks can be
shifted as market conditions change
–Less risky investments for relatively conservative investors
looking for moderate growth

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Types of Mutual Funds (cont’d)
•Growth-and-Income Fund: seeks both
long-term growth and current income, with
primary emphasis on capital gains
–Focus is on long-term capital appreciation with some
high income to provide limited stability
–Invest in blend of commons stocks and fixed-income
securities, with up to 90% in common stocks
–Moderate risk investments for investors who can
tolerate moderate price volatility

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Types of Mutual Funds (cont’d)
•Bond Funds: invests in various kinds and
grades of bonds, with income as primary
objective
–Advantages of bond funds over individual bonds:
•More liquid
•Offer high diversification
•Bond funds automatically reinvest interest
–Lower risk investments for investors who are looking
for steady income
–Some price volatility occurs with changing
interest rates

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Types of Bond Funds
•Government bond funds: invest in U.S. Treasury and
agency securities
•Mortgage-backed bond funds: invest in mortgage-
backed securities of U.S. government, such as GNMA’s
•High-grade corporate bond funds: invest in corporate
bonds rated triple-B or better
•High-yield corporate bond funds: invest in lower rated
corporate bonds (junk bonds)
•Convertible bond funds: invest in securities that can be
converted into common stocks

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Types of Bond Funds (cont’d)
•Municipal bond funds: invest in
tax-exempt securities issued by states and
political subdivisions
–Single-state fund: invests in municipal issues of only one state to
provide double tax-free income
•Intermediate-term bond funds: invest in bonds with
maturities of 7 to 10 years or less
•Short-term bond funds: invest in bonds with maturities of
2 to 5 years
–Often used as alternative to money market funds when interest
rates are low

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Money Market Funds
•Invest in short-term securities with maturities of less than
90 days
•Interest rates move up and down with market rates
•Trade at a constant net asset value of $1 per share
•Considered a safe, convenient investment to accumulate
capital and temporarily store idle funds
•Types of money market funds:
–General purpose: invests in all types of money market investments
–Government securities: invest only in U.S. Treasury bills and other
short-term government securities
–Tax-exempt: invest in very short-term tax-exempt municipal
securities

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Types of Mutual Funds
•Index Funds: buys and holds a portfolio of stocks (or
bonds) equivalent to those in a specific
market index
–Objective is to match, not beat, the specific index
–Strategy is buy-and-hold, which provides tax advantages with
very little taxable capital gains
–Operating costs are very low due to low turnover in investment
portfolio

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Types of Mutual Funds (cont’d)
•Sector Funds: investments are restricted to a
particular segment of the market
–Investments are concentrated in one specific industry
sector
–Objective is to produce capital gains
–Considered speculative because limited diversification
can increase investment risks

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Types of Mutual Funds (cont’d)
•Socially Responsible Funds: funds that actively and
directly incorporate ethics and morality into the
investment decision
–Specific stocks are evaluated on financial criteria and moral, ethic
or environmental tests
–Stocks that do not meet these tests are not considered for the
investment portfolio
–Examples of excluded companies:
•Tobacco or alcohol
•Gambling
•Nuclear energy
–Returns may be reduced due to limited investment opportunities

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Types of Mutual Funds (cont’d)
•Asset Allocation Funds: funds that spread
investors’ money across stocks, bonds, and
money market securities
–Provides built-in asset allocation by professional
investment manager
–As market conditions change over time, the asset
allocation mix changes as well
–Provides convenience of “one-stop shopping” without
having to own several mutual funds

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Types of Mutual Funds (cont’d)
•International Funds: funds that do all or most of their
investing in foreign securities
–Objective is to benefit from changes in:
•International market conditions
•Valuation of U.S. dollar
–Funds can specialize in international stocks, bonds or money
market securities
–Funds can specialize in growth, value, aggressive growth and
other types of stocks
–Funds can specialize in specific countries or regions of the world
–Considered fairly high-risk due to currency exchange risks

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Mutual Fund Investor Services
•Automatic Investment Plans
–Regular investment from checking or savings account
or paycheck
–Monthly amounts as small as $25
–Excellent way to build up investment over time
•Automatic Reinvestment of Interest, Dividends,
and Capital Gains
•Systematic Withdrawal Plans

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Mutual Fund Investor Services (cont’d)
•Conversion (Exchange) Privileges
–Load funds usually allow exchanges between mutual
funds in the same fund family without paying
additional sales loads
–Exchanges between funds can trigger capital gains
taxes in non-retirement accounts
•Not just load funds; any exchange of one fund (called selling)
and the purchase of another fund will trigger a taxable event
outside of retirement accounts
•Phone Switching
•Easy Establishment of Retirement Plans

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Investor Uses of Mutual Funds
•Accumulation of Wealth
•Storehouse of Value
•Speculation and Short-Term Trading
–By definition and law this is illegal.

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Selecting Mutual Funds
•Determine if you want to use mutual funds
in portfolio
–Mutual funds increase diversification
–Mutual funds offer expertise in areas where investor
may not be informed
–Can use stocks and mutual funds
•Compare mutual fund’s investment objective to
investor’s objective
•Compare range of services offered

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Sources of Information
•Fund prospectus
•The Wall Street Journal
•Barron’s,Money, Fortuneor Forbes
•Morningstar Mutual Funds
•Value Line Mutual Fund Survey
•Websites such as Yahoo.finance.com

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Figure 12.5
Some Relevant
Information
About Specific
Mutual Funds
Source: Morningstar, Inc.,
Principia, release date: August 31,
2009.

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Factors in Comparing Mutual Funds
•Fund’s investment performance
•Tax efficiency
•Fee structure
•How particular fund fits into your portfolio
•Investment skills of fund managers
•Load or No-Load funds
•Closed-End or Open-End funds

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Comparing Closed-End and
Open-End Funds
•Brokerage commissions apply to closed-end funds
•Open-end funds have greater liquidity
•Closed-end funds trade at premium (or discount) to NAV
–Avoid closed-end funds trading at premium
–Look for closed-end funds trading at discount

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Sources of Return from Mutual Funds
•Dividend income
•Capital gains distributions
•Change in price/NAV
–Unrealized capital gains (paper profits): capital gain
that has not been realized since fund’s holdings have
not been sold

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Calculating Return:
Holding Period Return
•Returns include distributions of dividends, distributions of
capital gains, or NAV appreciation
•Return for specific holding period
•Best for one year returns since does not use present
value