Download Chapter 18

Chapter Eighteen
Mutual Funds
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McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Mutual Fund
Definition 
Security that gives small investors access to a
well diversified portfolio of
• Equities
• Bonds
• Other securities
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Shareholders participates in gain/loss of fund
Shares issued & redeemed as needed
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Mutual Fund cont.
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Net asset value (NAV) determined each day
Portfolio objective stated in prospectus
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Majority of mutual funds fail to beat the market
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Past performance is no
guarantee of future results
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Advantages and Disadvantages
of Mutual Funds
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Diversification
Professional Management
Time Savings
Performance
Expenses
Selection problems
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Diversification
 Chose securities from different industries
 Economy does not affect companies equally
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Advantages and Disadvantages
of Mutual Funds
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Alternatively diversify portfolio in different
kinds of assets such as
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Bonds
Preferred stock
Convertible securities
International securities
Real estate
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Mutual Funds cont.
Buy different types of mutual funds to achieve
diversification, e.g.
 Corporate
 U.S. government bond fund
 Domestic equity fund
 International equity fund
 Real estate investment trust
 Municipal bond fund
 Short-term money market fund
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Closed-End versus Open-End Funds

Close & Open refer to distribution &
redemption
Closed-end fund
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Fixed number of shares
Cannot buy the shares directly from the fund
(except at the inception of the fund)
Limitation on shares outstanding
Fund does not stand ready to buy shares back
Purchasers/sellers must trade with each other
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Closed-End versus Open-End Funds
Open-end fund
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Represents opposite of closed-end fund
Always ready to sell new shares
Always ready to buy back old shares
Shares of closed-end funds trade on security
exchanges or over-the-counter just as any
other stock might
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Total value of securities - Liabiliti es
Net asset valu e (NAV) 
Shares oustanding
Example
Total value of securities ……. $140 million
Liabilities ……………………… $5 million
Shares outstanding ………….. 10 million
$140 million - $5 million
NAV 
 $13.50
10 million shares
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Exchange Traded Funds (ETFs)
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Passively managed
Low-cost
Tax-efficient baskets of stocks
Focus on
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Countries
Sectors
Regions
Indices
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Exchange Traded Funds (ETFs)
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Best advancement for individual investors
in the past decade
No other development, with the possible
exception of the rise of Eliot Spitzer, New
York attorney-general, has inflicted greater
damage to the mutual fund industry that
has monopolized the investor market for
the past 50 years
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Exchange Traded Funds (ETFs)

Index-based funds imitate market indexes e.g.
• S&P 500 Index (SPDRs)
• Dow Jones Index (called DIAMONDS)
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Major advantage of ETFs:
Investor can buy “the market” or
“an industry” just like buying
a common stock
ETFs discussed more fully in the next chapter
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Investing in Open-Ended Funds
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Load versus No-Load Funds
No-Load Funds
Information on Mutual Funds
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More than 95% of the investment funds
in U.S. are open-ended
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Load versus No-Load Funds
Fund type
Commission in %
Load funds
7.25% or higher
Low-load funds
2 to 3%
Back-end load
Exit fee 2 to 3%
may decline with time
No Load
Zero
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No-Load Funds
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Do not charge commissions
Sold directly by investment company through
• Advertisements
• Prospectuses
• 800-number telephone orders
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About 50% of all mutual fund assets are no-load funds
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Account for approx. 50% of new sales
Why buy load funds when you can buy no-load
funds? (HOPE for a better return!)
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No-Load Funds
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How do no-load funds justify their existence?
Answer: charge assets management fee plus
expenses (12b-1 fees) - 0.75 to 1.25%
Load funds have similar management fees
Fund with a 12b-1 fee of .25% or less is still
considered a no-load fund
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Invest $1,000 in a load mutual fund
Pay a 7.25% commission
Only 92.75% go toward purchasing shares
$1,000 investment becomes $927.50
Fund must go up by $72.50 or 7.82% just
to break even
$72.50
 7.82%
$927.50
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Figure 18-2 Load and No-Load Fund Assets as a
Share of Fund Assets, 1984 -2003
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Figure 18-2 Load and No-Load Fund Assets as a
Share of Fund Assets, 1984 -2003
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Differing Objectives and the
Diversity of Mutual Funds
Matching Investment Objectives with Fund Types
 Money Market Funds
 Growth Funds
 Growth with Income
 Balanced Funds
 Index Funds
 Bond Funds
 Sector Funds
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Differing Objectives and the
Diversity of Mutual Funds
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Sector Funds (riskier)
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Energy
Medical Technology
Computer Technology
Leisure
Defense
Foreign Funds
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Differing Objectives and the
Diversity of Mutual Funds
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Specialty Funds - investing primarily in the
securities of a particular
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Industry
Sector
Type of security
Geographic region
Examples:
Underlined
hyperlinks
www.sbs.gov.uk/phoenix
www.calvertgroup.com
www.usfunds.com
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Differing Objectives and the
Diversity of Mutual Funds
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Hedge Funds
• The name is misleading
• Not restricted to hedging/reducing risk
• Neither bullish or bearish
• Highly leveraged
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Differing Objectives and the
Diversity of Mutual Funds
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Hedge Funds continued
• Engage in wide range of activities for superior return:
Buying (long)
 Short selling
 Buy/sell puts and calls at the same time in the
attempt to gain an edge
• Limited partnership
• Charge management fees only on profits (20%)
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Matching Investment Objectives
with Fund Types
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Volatility of return
Safety of principal
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Little deviation of returns
Choose money market funds
Intermediate-term bond funds
Expect lower returns
Aggressive growth stock funds
• Provide the highest expected return
• Biggest risk
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Matching
OBJECTIVES
FUND TYPES
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Almost all mutual funds allow
redemption at any time
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Bond funds provide
highest annual current yield
Aggressive growth
funds the lowest yield
Liquidity
Income
Growth-Income
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Balanced funds
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Example- Diversify by Fund Type
% Weight
Type of Fund
50%
U.S. Common Stocks
35%
Bonds
10%
Money Market Funds
5%
International Stock Fund
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The Prospectus
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Investment Objectives and Policies
Portfolio (or “Investment Holdings”)
Management Fees and Expenses
Turnover Rate
Expense ratio
Per share income
Capital changes
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Shareholder Services
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Automatic reinvestment
Safekeeping
Exchange privilege
Preauthorized check plan
Systematic withdrawal plan
Checking privileges
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Dollar Averaging
Investor buys
 Fixed dollar’s worth
 Given security
 Regular intervals
 Regardless of security’s price
 Ignores current market outlook
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 In January, low price $12, purchased
large numbers: 16.66 shares
 In April, high price $19, purchased
low numbers: 10.52 shares
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Computing Total Return on Your Investment
Assume invested in a fund for one year
Three potential sources of return:
 Change in net asset value (NAV)
 Dividends distributed
 Capital gains distributed
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Websites
www.morningstar.com
www.quicken.com
www.my.yahoo.com
Comments
Basic site containing
detailed information about
mutual funds, portfolio
tracking, & analysis
Provides mutual fund data
& quotes along with
portfolio tracking & financial
planning information
Permits tracking of mutual
funds in portfolios
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Websites
moneycentral.msn.com
www.ici.org
Comments
Provides information
about mutual funds
Investment Company
Institute
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Summary
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Investment funds allow investors to pool
their resources under professional managers
Closed-end a fixed number of shares, and
purchasers and sellers of shares must deal
with each other (via brokers)
Open-end fund are more prevalent
• Ready to sell new shares or buy back old shares
• Load fund up to 7.25% sales commissions
• No-Load fund
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Summary
Mutual funds specialize:
 Money market management
 Growth in common stocks
 Bond portfolio management
 Special sectors of the economy
• Energy
• Computers
• Foreign investments
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Funds with an international orientation have
enjoyed strong popularity in the last decade
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Summary
Examining a fund’s prospectus one can determine
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Investment objectives
Policies
Portfolio holdings
Turnover rate
Management fees (SEC 12b-1)
Special services
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Automatic reinvestment of distributions
Exchange privileges among different funds
Systematic withdrawal plans
Check writing privileges
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Summary
Return to fund holders may come from
 Capital appreciation
 Yield
 Over the long term, mutual funds have not
outperformed the popular market averages
 offer an opportunity for
• Low-cost
• Efficient diversification
• Normally have experienced management
Few funds have above-average returns
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