Investing in Mutual Funds

Mutual fund: pools the money of many investors — its shareholders — to invest in a variety of securities such as stocks, bonds, and other assets. Almost half of U.S. households invest in mutual funds.

  • Why invest?

    • Professional management

    • Diversificiation

    • Affordability

    • Liquidity

Characteristics of Funds

  • Open-end funds

    • Shares are issued and redeemed by the investment company at the request of investors

    • Investors can buy and sell shares at the net asset value (NAV)

    • Provide services such as payroll deduction programs, automatic reinvestment programs, automatic withdrawal programs

  • Closed-end funds

    • Shares in the fund are issued by an investment company only when the fund is organized. Only a certain number of shares are available to investors.

    • After all original shares are sold → shares are traded in the secondary market or in the OTC market

    • Shares trade at a discount or premium to NAV

  • Exchange-traded funds (ETFs)

    • Invest in the stocks or other securities contained in an index

    • Shares are traded of a securities exchange or in the OTC market

    • Generally lower fees since it is not actively managed

Net Asset Value

The market value of the securities contained in the fund’s portfolio minus the fund’s liabilities divided by the number of shares outstanding

Net Asset Value (NAV) = Value of the fund’s portfolio - Liabilities/Number of shares outstanding

Costs of Investing in Mutual Funds

  • Shareholder fees

    • Load fund - investors pay a commission (sales charge) every time they purchase shares

    • No-load fund - investors pay no sales charge up front

    • Contingent deferred sales load (back-end load) - charged upon withdrawal of funds

  • Fund operating expenses

    • Management fees - annual fees paid to the professional money managers as a fixed percentage of the fund’s NAV

    • 12b-1 fees (distribution fee) - annual fee to defray distribution and marketing costs and commissions paid to brokers that sell shares in the fund

    • Other expenses

  • Expense ratio

    • Consists of the different management fees, 12b-1 fees (if any), and additional operating costs for a specific mutual fund

    • This fee should be 1% or less

    • The investment company’s prospectus must provide all details relating to management fees, sales fees, 12b-1 fees, and other expenses

Classifications of Mutual Funds

  • Stock funds

    • Growth funds - invest in companies expecting higher-than-average revenue and earnings growth

    • Aggressive growth funds - invest in small, fast-growing companies

    • Equity income funds - invest in companies with a long history of paying dividends

    • Index funds - mirror an index such as the S&P 500 index

    • Sector funds - focus on a particular industry such as biotech

    • Large-cap funds - invest in large-cap stocks

    • Mid-cap funds - invest in mid-cap stocks

    • Small-cap funds - invest in small-cap stocks

    • Socially responsible funds - avoid investing in companies that produce harmful products

    • Regional funds - focus on specific region of the world

    • Global stock funds - invest in U.S. and foreign stocks

    • International funds - invest in foreign stocks

  • Bond funds

    • High-yield (junk) bond funds - invest in high-yield, high-risk corporate bonds

    • Long-term corporate bond funds - invest in investment-grade corporate bond issues with maturities in excess of 10 years

    • Intermediate corporate bond funds - invest in investment-grade corporate debt with maturities between 3 and 10 years

    • Short-term corporate bond funds - invest in investment-grade corporate bond issues with maturities of less than three years

    • Long-term U.S. gov’t - invest in U.S. Treasury securities with maturities in excess of 10 years

    • Intermediate U.S. gov’t - invest in U.S. Treasury securities with maturities between 3 and 10 years

    • Short-term U.S. gov’t - invest in U.S. Treasury securities with maturities of less than three years

    • Municipal bond funds - invest in municipal bonds that provide investors with tax-free interest income

    • World bond funds - invest in bonds and other debt securities offered by foreign companies and gov’t

  • Other funds

    • Asset allocation funds - invest in various asset classes, such as stocks and bonds, with precise amounts maintained within each type of asset

    • Balanced funds - invest in both stocks and bonds with the primary objectives of conserving principal, providing income, and providing long-term growth

    • Fund of funds - invest in shares of other mutual funds

    • Target-date funds (lifestyle funds) - popular with investors planning for retirement by a specific date

    • Money market funds - invest in CDs, gov’t securities, and other safe and highly liquid investments

Managed funds vs. Index Funds

  • Managed funds

    • Professional fund managers choose the securities that are contained in the fund, and decide when to buy and sell securities in the fund

  • Index funds (i.e. passive funds)

    • Not actively managed

    • Lower expense ratio than managed funds

Return on Investment

  • Investors receive a return in three ways

    • Income dividends - earnings a fund pays to shareholders from its dividend and interest income

    • Capital gain distributions - payments made to a fund’s shareholders that result from the sale of securities in the fund’s portfolio

    • Capital gains - the profits that results when investors buy shares in a fund at a low price and then sell the share after the price has increased

Total Return for Mutual Funds

  • Total dollar return = income dividends + capital gain distirbutions + capital gain (loss) due to change in price

  • Total percentage return = total dollar return/purchase price

    • Total % return = dividends distributed + capital gains distributed + (selling price - purchase price)/purchase price

Taxes and Mutual Funds

  • Two problems develop with taxation of mutual funds

    • Even if you choose to reinvest dividends/distributions, they are still taxed in a taxable account and must be reported on your federal tax return as current income

    • You have no control over when the mutual fund sells securities and when you will be taxed on capital gain distributions

  • Turnover ratio - measures the % of the fund that has been replaced during a 12-month period

    • Unless you are using these investments in a tax-deferred retirement account, a high turnover ratio can result in higher income tax bills and higher fund expenses

Evaluating Mutual Funds

  • Decide on fund characteristics

    • Mutual fund or ETF

    • Managed fund or index fund

  • Screen and select funds that meet your criteria

    • Read the fund prospectus

    • Investment objective and strategy

    • Fees and expenses

    • Fund performance and risk

Summary

  • The major reasons investors choose mutual funds are professional management and diversification. Mutual funds are also a convenient way to invest money, especially for retirement accounts

  • Mutual fund managers tailor their investment portfolios to the fund’s investment objectives

  • Some investors choose to invest in an index fund because over many years, index funds have outperformed the majority of managed funds