Mutual Funds - Key Concepts

Why Investors Purchase Mutual Funds

• Estimated 100 million individuals own mutual funds.
• Over 59 million U.S. households own mutual funds.
• Typical mutual fund investor owns shares in four different funds.
• Mutual funds pool money from many investors to invest in a variety of securities.
• Reasons for investing in mutual funds:
  • Easy way to invest.
  • Professional management.
  • Diversification.

Psychology of Investing in Funds

• Major reasons: professional management and diversification.
• Even the best portfolio managers make mistakes.
• Diversification offers some safety; losses in one investment can be offset by gains in another.

Characteristics of Mutual Funds

• Closed-End Funds:
  • Shares issued only when the fund is organized.
  • Purchased from other investors after initial offering.
  • Actively managed.
• Exchange-Traded Funds (ETFs):
  • Invest in stocks or securities of a specific index.
  • Not actively managed; mirror index performance.
• Open-End Funds:
  • Shares issued and redeemed by the investment company.
  • Investors buy and sell shares at net asset value (NAV).

Net Asset Value (NAV)

• NAV = \frac{\text{Value of fund's portfolio} - \text{Liabilities}}{\text{Number of shares outstanding}}
• Example: NAV = \frac{$655 \text{ million} - $5 \text{ million}}{30 \text{ million}} = $21.67 \text{ per share}

Load Funds and No-Load Funds

• Load Fund:
  • Commission (sales charge) up to 8.5% when purchasing shares.
  • Average load charge is 2-5%.
• No-Load Fund:
  • No sales charge up front.

Contingent Deferred Sales Load

• Charged upon withdrawal of funds (back-end fund).
• Fees range from 1 to 5%.
• Deferred charge declines, potentially to zero after five years.

Management Fees and Other Charges

• Management Fees:
  • Average is 0.5 to 2% of fund’s assets.
• 12b-1 Fees (Distribution Fee):
  • Annual fee to cover distribution and marketing costs.
  • Cannot exceed 0.25% of a fund’s assets per year.
• Expense Ratio:
  • Includes management fees, 12b-1 fees, and operating costs.
  • Should be 1% or less.

Typical Fees Associated with Mutual Fund Investments

• Load fund: Up to 8.5% of purchase; average 2-5%.
• No-load fund: No sales charge.
• Contingent deferred sales load: 1-5% of withdrawals.
• Management fee: 0.5-2% per year of fund’s assets.
• 12b-1 fee: Cannot exceed 1% of fund’s assets per year.
• Expense ratio: Amount investors pay for all fees and operating costs.

Classification of Mutual Funds

• Stock Funds:
  • Aggressive growth funds: small, fast-growing companies.
  • Equity income funds: companies with a long history of paying dividends.
  • Global stock funds: US and other countries.
  • Growth funds: companies with higher-than-average revenue and earnings growth.
  • Index funds: stocks that mirror an index.
  • International funds: foreign stocks.
  • Large-cap funds: capitalization of >$10 billion.
  • Midcap funds: capitalization of 2-$10 billion.
  • Regional funds: specific region of the world.
  • Sector funds: particular industry.
  • Small-cap funds: capitalization of <$1 billion.
  • Socially responsible funds: avoid harmful products.
• Bond Funds:
  • High-yield (junk) bond funds: high-risk, high-yield corporate bonds.
  • Intermediate corporate bond funds: investment-grade, 3-10 year maturities.
  • Intermediate U.S. bond funds: U.S. Treasury securities, 2-10 year maturities.
  • Long-term corporate bond funds: investment-grade, >10 year maturities.
  • Long-term U.S. bond funds: U.S. Treasury securities, >10 year maturities.
  • Municipal bond funds: tax-free interest income.
  • Short-term corporate bond funds: investment-grade, <3 year maturities.
  • Short-term U.S. government bond funds: U.S. Treasury securities, <2 year maturities.
  • World bond funds: foreign companies and governments.
• Other Funds:
  • Asset allocation funds: various asset classes.
  • Balanced funds: stocks and bonds.
  • Funds of funds: shares of other mutual funds.
  • Target-date funds (lifestyle funds): Risk-oriented to conservative as retirement approaches.
  • Money Market funds: CDs, government securities, safe, highly liquid.

Family of Funds

• One investment company manages a group of mutual funds.
• Each fund has a different financial objective.
• Exchange privileges allow moving money between funds with little or no charge.

Benefits of Portfolio Construction

• Choosing different investments to get larger returns while reducing risk.

Managed Funds Versus Indexed Funds

• Managed funds: professional fund manager chooses investments.
• Index mutual fund: mirror image of a specific index, lower expenses.
• Index funds have lower expense ratios (typical expense ratios for index fund are 0.50% or less).

Professional Advisory Services

• Access information through the internet or the library; use the fund family and fund name.
• Fund Analysis.
• Performance.
• Risk.
• Price.
• Portfolio.
• People.
• Parent.

Mutual Fund Prospectus and Annual Report

• Mutual Fund Prospectus:
  • Fund’s objective and fees.
  • Risk factors and past performance.
  • Type of investments.
  • Dividends and capital gains.
  • Fund’s management.
  • Process to buy or sell shares.
  • Limitations or requirements for choosing investments.
  • Frequency of portfolio changes and tax consequences.
  • How to open an account.
• Annual Report:
  • Detailed financial information.
  • Letter from President and independent auditors.

Mechanics of a Mutual Fund Transaction

• May be part of retirement account (401(k), 403(b), SEP-IRA, Roth IRA, traditional IRA).
• May be owned in a taxable account.
• Open an account from $250 to over $3,000.

Advantages of Investing in Mutual Funds

• Ease of buying and selling shares.
• Professional management.
• Diversification.
• Multiple withdrawal options.
• Distribution or reinvestment of income and capital gain distributions.
• Switching privileges within the same fund family.
• Services that include online traders, toll-free telephone numbers, complete records of all transactions, and savings and checking accounts.

Disadvantages of Investing in Mutual Funds

• Purchase/withdrawal costs.
• Ongoing management fees and 12b-1 fees.
• Poor performance.
• Inability to control when capital gain distributions occur and complicated tax-reporting issues.
• Potential market risk.
• Some sales personnel are aggressive or unethical.

Return on Investment

• Income dividends: taxed as regular income.
• Capital gain distributions: taxed as long-term capital gains.
• Capital gains when selling shares: taxed on a short-term or long-term basis.

Taxes and Mutual Funds

• Income dividends and capital gain distributions can be automatically reinvested but may still be taxable.
• Turnover ratio measures the percentage of the fund that has been replaced during a 12-month period.
• High turnover ratio can result in higher income tax bills and higher fund expenses.

Withdrawal Options

• Closed-end fund or ETF can be sold in over-the-counter market to another investor.
• Open-end fund can be sold to sponsoring investment company.
• Minimum NAV value of shares of $5,000 allows four withdrawal options during investment period.
  • Withdraw specified, fixed dollar amount.
  • Liquidate or “sell off” a certain number of shares.
  • Withdraw a fixed percentage of asset growth.
  • Withdraw all asset growth earned (principal remains untouched).