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C
HAPTER 16
Personal Finance
Investing in Mutual Funds
Kapoor Dlabay Hughes
7e
© The McGraw-Hill Companies, Inc., 2004. All Rights Reserved. Irwin/McGraw-Hill
What is a Mutual Fund?
An investment chosen by people whose money is pooled with other investors to buy stocks, bonds, and other financial securities selected by professional managers
who work for investment companies.
An investment company is a firm, that for a management fee, invests the pooled funds of small investors
in securities appropriate to the fund’s stated
objective. 16-2
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What is a Mutual Fund?
(continued)There are over 8,000 funds to choose from.
Many people choose mutual funds for their retirement account investments.
401(k) or 403(b)
IRA
Roth IRA
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Why Investors Purchase Mutual Funds
Professional management.
Who is the fund’s manager?
Managers can change. Diversification.
Investors funds are used to purchase a variety of investments. This variety provides some safety.
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Closed- and Open-End Funds
Closed-end funds (6% of funds).
Shares are issued by an investment company only when the fund is organized.
After all original shares are sold you can purchase shares only from another investor who is willing to sell.
Open-end funds (93% of funds).
Shares are issued and redeemed by the investment company at the request of investors.
Investors are free to buy and sell shares at the
net asset value (NAV). 16-5
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Exchange-Traded Funds
Invests in the stocks contained in a specific stock market index, like the Standard and Poor’s 500 stock index.
Performance of shares in the fund tend to mirror the performance of the index. Low management fees since
there is less need for decisions made by a portfolio manager.
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Net Asset Value (NAV)
Value of the fund’s portfolio - Liabilities Number of shares outstanding
Offer price = NAV + sales commission
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Load Funds and No-Load Funds
Load Fund.
Investors pay a commission (sales charge) up to 8.5%every time they purchase shares. This
is sometimes called a front load.
Average charge is 3-5% for which an investor can get purchase advice and explanations.
No-Load Fund.
Investors pay no sales charge up front.
You deal directly with the investment
company via 800 numbers or web sites, or from
discount brokers. 16-8
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Management Fees
and Other Charges
Management fee.
Charged yearly (.25%-1.25% average) based on a percentage of the funds asset value.
Contingent deferred sales load (back-end load).
Charged upon withdrawal of funds (1-5%).
Generally decreases on a sliding scale depending on the number of years shares are held.
12b-1 fees.
Annual fee to defray advertising and marketing costs of the fund.
Approximately 1% of a fund’s assets per year.16-9
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Number of Mutual Funds by Type*
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 Equity Funds
Bond Funds Hybrid Funds Money Market, Taxable Money Market, Tax Exempt 16-10
*Source: Year 2000 data from the U.S. Bureau of the Census, Statistical Abstract of the United States, 2001, page 744.
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Classification of Mutual Funds
Stock funds.
Aggressive growth funds buy stocks in small, fast-growing companies.
Growth buy stock in companies with higher- than-average revenue and earnings growth.
Growth and income buy stock in growth companies, plus stock in companies with a predictable source of dividend income.
Equity income funds invest in stock of companies with a long history of paying dividends.
Index buys stocks that mirror an index. 16-11
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Classification of Mutual Funds
Global funds buy stock in companies in theU.S. and other countries, while international funds buy stock only in companies outside the United States.
Regional funds buy stock in companies in a specific region of the world.
16-12 (stock funds continued)
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Classification of Mutual Funds
Sector funds buy stock in companies in a particular sector such as biotechnology.
Large-cap funds buy stock in very large companies whose capitalization may be in the billions, while mid-cap funds buy stock in companies with a capitalization of 500 million or more.
Small cap funds buy stock in lesser-known companies with a capitalization of less than 500 million.
16-13 (stock funds continued)
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Classification of Mutual Funds
Bond funds.
Municipal bonds funds buy municipal bonds with tax-free interest income.
Insured municipal bonds provide tax-free income insured against default.
Long-term U.S. bonds with maturities of greater than 10 years.
Intermediate U.S. bond funds buy treasury notes with maturities of 5-10 years.
Short-term U.S. bond funds invest in U.S. Treasury issues of 1-5 years.
(continued)
16-14
Treasury Bond
Treasury Note
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Classification of Mutual Funds
Short-term corporate bonds with maturities of 1-5 years.
Intermediate corporate bonds (5-10 years).
Long-term corporate bonds (> 10 years).
High-yield (junk) bonds buy corporate bonds that are higher risk.
World bond funds buy bonds of foreign companies and governments.
(continued)
16-15
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Classification of Mutual Funds
Other funds.
Balanced funds.
yInvest in both stocks and bonds with the primary
objective of conserving principal.
Money market funds.
yInvest in CDs, government securities and other safe and liquid investments.
Asset allocation funds invest in various asset classes, with precise amounts within each type.
(continued)
16-16
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Families of Funds
A family of funds exists when one investment company manages a group of mutual funds.
Each fund in the family has a different financial objective.
Exchange privileges allow you to move your money from one fund to another within the fund family with low or no charge.
16-17
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Steps to Evaluate Mutual Funds
Perform a financial checkup to make sure you are ready to invest.
Determine your risk tolerance. Determine your investment objectives.
Obtain the money you need to purchase mutual funds.
Find a fund with an objective that matches your objective.
Evaluate, evaluate, and evaluate any mutual fund before buying or selling. 16-18
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Reading a Mutual Fund Quote
in the Newspaper
Net asset value and asset value change. The fund family and fund name.
Fund objective.
Total return over various time periods. Ranking among funds with the same
objective.
Sales load fees if any, or no load (NL). Annual expenses.
16-19
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Other Sources of Fund Information
Mutual fund prospectus tells the funds objective, plus..
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 on how to open an account.
Dividends, distributions and taxes.
Information about the fund’s management.
The process for investors to buy or sell shares.
Services provided to investors.
The turnover ratio of the fund’s investments. 16-20
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Other Sources of Fund Information
Mutual fund annual report.
Performance, investments, assets and liabilities.
Financial Publications.
Business Week, Forbes, Kiplinger's Personal Finance and Money are sources of information.
Business Week’s mutual fund survey includes information such as the...
yFund’s overall rating compared to all other funds, and to funds in the same category.
yFund size, sales charge and expense ratio.
yHistorical returns for the past ten years. 16-21
(continued)
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Internet Sources of Fund Information
Use web sites to research a fund.www.finance.yahoo.com
www.businessweek.com
www.morningstar.net
www.smartmoney.com
Check mutual fund companies Internet sites. www.troweprice.com
www.vanguard.com
16-22
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16-23
Who Owns Mutual Funds by Age
*2% 18%
28% 25%
27%
Less than age 25 25-34 years old 34-44 years old 45-54 years old Over 55 years old
*Source: Year 2000 data from the U.S. Bureau of the Census, Statistical Abstract of the United States, 2001, page 744.
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Mutual Fund Transactions
You can open an account from $250 to$3,000 and up depending on the fund family and the fund.
Open-end, no-load directly from the investment company by phone or through the mail, or from a discount broker.
Closed-end or exchange-traded funds are purchased via a broker through the stock exchange.
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Mutual Fund Transactions
There are several ways you can get a return on your investment.
You have capital gains when you sell shares at a higher price than you paid.
There may be income distributions when your fund sells securities.
Capital gain distributions are made.
Income and capital gain distributions can be automatically reinvested.
Keep accurate records for tax purposes, as gains and income are subject to taxation. 16-25
