BM410 Investments

Mutual Fund Basics

 Objectives

A. Understand the advantages and disadvantages

of mutual funds
B. Understand the major types of mutual funds
C. Understand how to calculate mutual fund
returns
D. Understand the process of how to buy a
mutual fund
E. Understand the costs of investing in mutual
funds
 A. Understand the Advantages and
Disadvantages of Mutual Funds
What is a Mutual Fund?
A way of holding financial and real investments
An Investment company that pools money from
investors to buy stocks, bonds, and other financial
investments
Investors own a share of the fund proportionate
to the amount of their investment divided by
the total value of the fund
Why were they developed?
To give smaller investors access to professional
management and to increase the assets of mutual
fund companies
 Mutual Funds (continued)

What are the advantages of Mutual Fund

Investing?
Diversification
While owning a single stock or bond is very
risky, owning a mutual fund which holds
numerous securities can reduce risk significantly
Professional management
Picking your own stocks and bonds to put in
your portfolio and beating your benchmarks is
difficult and time consuming. Hiring a mutual
fund to make those decisions for you can be
beneficial and save time
 Mutual Funds (continued)

Minimal transaction costs

Buying individual stocks and bonds is expensive in
terms of transactions costs. Mutual funds enjoy
economies of scale in purchases and sales due to
size
Liquidity
Buying and selling individual stocks and bonds
takes time. Money from open-end mutual funds can
be received in two business days
Flexibility
Individual stocks and bonds are not flexible. With
many mutual funds, you have more flexibility and
can often write checks on your account
 Mutual Funds (continued)

Low cost
No-load mutual funds are sold without a sales
charge and are redeemed without a charge as well
The ability to purchase and sell at Net Asset Value
Open-end mutual funds can be purchased and
sold each day at the funds Net Asset Value, which
is the funds assets less liabilities, divided by the
number of shares outstanding
Service
Mutual funds generally you have good service to
answer questions, help you open accounts, purchase
and sell funds, and to transfer funds as well.
 Mutual Funds (continued)

In addition, they may include:

Automatic investment and withdrawal plans
Automatic reinvestment of interest, dividends, and
capital gains
Wiring and funds express options
Phone switching
Easy establishment of retirement plans
Check writing
Bookkeeping and help with taxes
 Mutual Funds (continued)

What are the disadvantages of Mutual Fund

Investing?
Risk of lower-than-market performance
From 1989-1998, the average annual returns of
actively managed stock funds was 15.6% versus
the return of the S&P 500 stock index of 19.2%.
Not all mutual funds outperform their
benchmarks, and taxes take a significant part of
investor returns
High costs
Unless analyzed carefully, management and
other fees can be significant. Moreover, many
mutual funds have loads or sales charges and
12-b1 fees which reduce returns
 Mutual Funds (continued)

Other Risks
Mutual funds are subject to both market and stock
related risks, particularly in concentrated portfolios
Inability to plan taxes
Mutual funds pass through 95% of all capital gains
and dividends to the shareholders
Even if you do not sell your mutual fund, you
can have a significant tax bill each year if your
portfolio trades often and has a short-term gains
It is difficult to plan for taxes when the tax decision
is taken by the portfolio manager, not you
 Mutual Funds (continued)

Premiums or Discounts
Closed-end mutual funds may trade at a premium
to (more than) or discount (less than) the
underlying Net Asset Value (NAV). These
premiums or discounts may be based more on
investor demand than the underlying shares value
New investor bias
New investors dilute the value of existing investors
shares. Since new money comes into the fund at
Net Asset Value, and since this money must be
invested (at roughly 0.5% on average in the U.S.),
existing investors are subsidizing new investors
coming into the fund
 Mutual Funds (continued)

How do you make Money With Mutual Funds?

Capital gains (i.e. appreciation market value)
Capital gains are the best type of earnings as
capital gains at the share level are not taxed until
you sell your mutual fund shares. You decide
when to sell your shares and get taxed
Distributions (i.e., interest, dividends, realized
capital gains, etc.)
This is a less attractive type of earnings. Even
though you do not sell any mutual fund shares
and most investors reinvest earnings, you are
still liable to pay taxes on all distributions that
your mutual fund makes during the year
 Mutual Funds (continued)

Distributions are divided into 4 main types:

Stock dividends
Payment of a stock or cash amount to the
shareholder of a company. Taxes on stock
dividends are only 15%.
Short-term capital gains
These are capital gains where the fund has owned
the assets for less than 12 months. They are taxed
at your marginal tax rate
Long-term capital gains
These are capital gains where the fund has owned
the assets for more than a year. These are taxed at
15%.
 Mutual Funds (continued)

Bond dividends and interest

These are taxed at your marginal tax rate, which
may be as high as 35% for federal tax and 10% for
state
The key to after-tax returns is to understand the
investment policy of the mutual fund, and to invest in
funds which have the highest after-tax return
By looking at a funds turnover, you can get an idea
about how often the mutual funds managers turn
over the portfolio, generating capital gains at the
fund level. Remember that you are taxed on these
each year, even when your fund loses money.
 B. Major Types of Mutual Funds

What are the major types of Mutual funds?

These generally follow the major asset classes
Money market , stock, and bond mutual funds
Others specialty funds
Index funds
Exchange Traded Funds (ETFs)
Balanced funds
Asset allocation funds
Life-cycle funds
Hedge funds
 Types of Mutual Funds (continued)

Money market mutual funds

Money market mutual funds are funds which invest
the majority of their assets in short-term liquid
financial instruments such as commercial paper and
government treasury bills
Their goal is to obtain a higher return, after fees
and expenses, than traditional bank savings or
checking accounts
 Types of Mutual Funds (continued)

Stock mutual funds

Stock mutual funds are funds which invest a majority
of their assets in common stocks of listed companies.
These funds generally have a specific objective, i.e.
large-cap, small-cap, value, growth,, etc.
which relates to the types of stocks the mutual fund
invests in.
Their goal is either to outperform their relative
benchmarks or to have a consistently high total
return
 Types of Mutual Funds (continued)

Bond mutual funds

Bond mutual funds are funds which invest a
majority of their assets in bonds of specific types
of companies or institutions.
These funds generally have a specific objective, i.e.
corporate, government, municipals,
growth,, etc. which relates to the types of bonds
the mutual fund invests in.
In addition, most have a specific maturity objective
as well, which relates to the average maturity of the
bonds in the mutual funds portfolio
Their goal is to generally outperform their
relative benchmarks
 Types of Mutual Funds (continued)

Index funds
Index funds are mutual funds designed to match
the returns of a specific benchmark.
Index funds can track many different benchmarks,
including the S&P500 (Large-cap stocks), Russell
5000 (small-cap stocks), MSCI EAFE
(international stocks), Lehman Aggregate
(corporate bonds), DJ REIT (Real estate
investment trusts), etc.
Index funds are tax efficient since they do little in
buying and selling of securities
Their goal is to match the return of their relative
benchmarks
 Types of Mutual Funds (continued)

Exchange Traded Funds (ETFs)

Exchange traded funds are baskets of stocks similar
to mutual funds which trade on organized exchanges
ETFs trade more like stocks, as they are purchased
with all the transaction and custody costs of a stock,
are priced throughout the day (rather than at days
end like mutual funds), and can be shorted and
purchased on margin.
ETFs can be either in a unit investment trust (UIT)
format, or an open-end mutual fund structure. The
UIT structure does not allow for immediate
reinvestment of dividends
Their goal is to match the return of their relative
benchmarks
 Types of Mutual Funds (continued)

Balanced funds
Balanced funds are mutual funds which purchases
both stocks and bonds generally in a specific
percentage or relationship, i.e. 60% stocks and 40%
bonds.
Their benefit is that they perform the asset
allocation, stock selection, and rebalancing decision
for the investor in the fund.
Their goal is to exceed the return of their
percentage-weighted relative benchmarks
 Types of Mutual Funds (continued)

Asset allocation funds

Asset allocation funds are mutual funds which
rotate among stocks, bonds, and cash
Asset allocation funds invest the funds assets in the
asset classes expected to perform the best over the
coming period of time.
Their goal is to exceed the return of their
percentage-weighted relative benchmarks after
costs and fees
 Types of Mutual Funds (continued)

Life-cycle mutual funds

Life cycle mutual funds are funds which change
their allocation between stocks and bonds
depending on the age of the investor.
As an investor ages, life cycle funds reduce their
allocation to stocks and increase their allocation to
bonds, more consistent with the goals and
objectives of an older investor.
These funds seek to perform the asset allocation
decision normally done by the investor and to
reduce transactions costs as well.
Their goal is to exceed the return of their
percentage-weighted relative benchmarks after
costs and fees
 Types of Mutual Funds (continued)

Hedge Funds
Hedge funds are mutual funds which take much
more risk than normal with the expectation of
much higher returns.
Generally they can take both long positions (where
they buy assets) and short positions (where they
borrow assets and sell them.) They hope to later
buy back the assets at a lower price before they
must return them to the borrower.
Their goal is either to outperform their relative
benchmarks or to have a consistently high total
return
C. Know How to Buy a Mutual Fund

What are the steps to buying a mutual fund?

1. Determine your investment goals and your key
principles
2. Choose your appropriate investment benchmark
3. Identify funds that meet your objectives and
benchmark subject to your investment principles
4. Evaluate the funds and choose wisely based on
your key investment principles
5. Send money or purchase online
 Step 1. Determine your Investment
Objectives
What is the final purpose of the funds you will
be investing?
Know your personal goals and budget
Determine your risk tolerance and return
requirements for each goal
Determine your investment constraints for each
goal
Determine where you are now in your investment
program
Determine which key principles are most important
to this investment
 Step 2: Choose the appropriate
Benchmark for the asset class
What is the asset class you want to follow?
Do you want your performance to be broadly
based?
Choose a benchmark with many constituents
What type of performance are you looking for?
Choose the benchmark that most matches the
performance you are seeking
Why is benchmark choice the second step?
Tell me your asset class benchmark, and I will
tell you what your portfolio should look like
Choose your benchmark wisely
 Step 3: Identify Funds That
Meet Your Objectives
One of the easiest ways to identify funds is to
use financial publications and services.
You can access databases from which you can
input your objectives and which will give you lists
of possible funds. Examples include:
Morningstar Mutual Funds
Schwab One Source
Other fee based databases

Determine the funds objective, asset class, and

investment style
Identify funds that meet your criteria for
performance, size, fees, management, etc.
 Step 4: Evaluate the Funds

How do you evaluate funds (some advice from a

fund manager in a previous career)?
Always compare funds with the same objective
Compare them to a relevant index. Some funds
are not willing to be compared to an index as it
shows their poor performance. They may change
the index to look better
Evaluate the funds long-term performance versus
peers and the relevant index
Try to make sure they havent inflated returns by
buying outside their asset class.
Look at returns in both up and down markets
If they have historically under-performed peers
and the index, avoid both and buy an index fund
 Evaluate the Funds (continued)

Look to the managers

How long have they been managing the fund, and
were they managing the fund during the periods of
good performance?
Often good managers will leave when
performance has been good to start their own
firm, and others will come in later
Size
How much has the fund grown or shrunk? If a fund
is losing assets, it generally sells its liquid assets first
Often those left in a fund after liquidation are
stuck with illiquid stocks that are harder to sell
 Evaluate the Funds (continued)

History
How long has the fund been around? Has it changed
its style? How did it perform under previous names
and managers?
Often fund companies will rename poorly
performing funds and change investment objectives
to mask poor performance
Fees
Watch the fee structures
Sometimes funds will add additional fees, i.e. 12-b1
fees, or impose rear-end loads to help reduce costs
to themselves
12-b1 fees are paid by the shareholders and are
just marketing fees. Avoid them
 Evaluate the Funds (continued)

Once you have selected a few funds, read each

prospectus carefully
Information in the Prospectus
Fund information
Goals and investment strategy
Any limitations on investments that the fund
may have, i.e., asset class constraints
Any tax considerations of importance to the
investors
Services provided by the fund family
The redemption and investment process for
buying and selling shares in the fund
Services provided to investors
 Evaluate the Funds (continued)

Information in the Prospectus

Manager information
The fund managers past experience and how
long he/she had been managing the fund
Performance and fees
Performance over the past 10 years or since the
fund has been in existence
Fund fees and expenses
The funds annual turnover ratio
Minimum account size
 Evaluate the Funds (continued)

Printed Sources of Information

The Wall Street Journal
Morningstar Mutual Funds
Forbes or Business Week
Kiplingers Personal Finance
Smart Money or Consumer Reports
Wiesenberger Investment Companies Service
Electronic Sources of Information
www.fool.com Motley Fool
www.morningstar.com Morningstar
 Step 5: Make the Purchase

If you are planning to buy the fund through a

financial broker, banker, or planner:
There is likely to be a load, or at least he will sell a
class of share (i.e., R shares) which will rebate him
a commission or charge an annual custody fee.
Watch clearly for the class of shares he sells
Research has shown, on average, that there is no
statistical difference in performance between
load and no-load mutual funds
You will get all the services of the mutual fund
company
Check to make sure you can access your account
through Quicken or other computer software
 Make the Purchase (continued)

If you plan to buy the fund directly from the

mutual fund company:
Most of the time they are no-load funds and have no
custody cost
You will get all the services of the mutual fund
company, including an 800 number to call, internet
access, and internet account information and
servicing
Check to make sure you can access your account
through Quicken or other computer software
Make sure your assets to be invested are more
than the minimum account size
 Make the Purchase (continued)

If you plan to buy the fund through a mutual fund

supermarket i.e., Fidelity Funds Network, Charles
Schwab, or Jack White
You get all the benefits of the mutual fund company, plus
they are Quicken compatible
You get access to a whole range of mutual fund
companies
Mutual fund companies rebate part of their
management fees back each month to the mutual
fund supermarkets
Minimum account balances vary
Transaction fees vary, but generally no custody
fee
 Questions

Any questions on purchasing a mutual fund?

D. How do you Calculate Fund Returns

How do you calculate fund returns?

Mutual fund returns include distributions of
dividends, capital gains, and interest, and any NAV
appreciation
Total return:
(ending NAVbeginning NAV)+ distributions
beginning NAV

Make sure you adjust your beginning and ending

NAVs to take into account the cost of both front-
end and back-end loads!
 Calculating Fund Returns

Calculating before-tax returns

With reinvestment of all distributions, total return
includes the NAV share increase and the increased
number of shares
Total return:
(#ES x EP) (#BS x BP) + Distributions
(#BS x BP)
#BS = beginning shares owned BP= beginning price
#ES = ending shares owned EP = ending price
 Calculating Fund Returns (continued)

Calculating after-tax returns

With reinvestment of all distributions, total return
includes the NAV share increase and the increased
number of shares
After-tax (AT) Total return:

(#ES x EP) (#BS x BP) + ATSD+ATLCG+ATSCG+ATBDI

(#BS x BP)

ATSD = Stock dividends * (1-tax on stock dividends)

ATLCG = Long-term cap gains * (1-tax on LT Cap Gains)
ATSCG = Short-term cap gains * (1-tax on ST Cap Gains)
ATBDI = Bond dividends/interest * (1-tax rate on interest)
E. Understand the Costs of Mutual Funds

What are the costs of mutual funds?

Explicit costs
Front-end Loads
Sales commissions charged to the investor
when purchasing certain types of fund shares.
Back-end load funds
Commissions charged to the investor when
selling certain types of shares. This may be a
sliding scale.
No-load funds
Funds where there are no commission
charged
 Costs of Mutual Funds (continued)

Fees and expenses

Management fees: Fee charged by the advisor to a
fund generally on the basis of a percentage of
average assets, i.e. 75 basis points or .75% a year
12b-1 fees: Fees charged to cover the funds cost of
advertising and marketing (why should you pay to
market the funds to someone else?)
Total expense ratio: the total percentage of assets
that are spent each year to manage the fund
including management fee, overhead costs, and
12b-1 fees
 Costs of Mutual Funds (continued)

Explicit costs (continued)

Custody (or annual) fees
These are fees the brokerage house charges to
hold the mutual funds or ETFs in your account.
May be a minimum amount for small
accounts ($15 per year), a specific charge
per holding (8 basis points per security), or
a percentage of assets for large accounts (25
basis points on assets under management)
 Costs of Mutual Funds (continued)

Implicit costs
Taxes on Distributions:
Taxes must be taken into account to get the
true return of your portfolio but which are
not noted on your monthly reports
Bond dividends and interest
These are taxed at your marginal tax rate
Stock dividends
These are taxed at 15%.
Short-term capital gains
These are taxed at your marginal tax rate
Long-term capital gains
These are taxed at 15%.
 Costs of Mutual Funds (continued)

Hidden costs
Transaction costs
These are costs of the fund buying and selling
securities, which are not included in other costs
Mutual funds which turn over the portfolio often,
i.e. buy and sell a lot, will have higher
transactions costs.
A good proxy for this is the turnover ratio, a measure
of trading activity during the period divided by the
funds average net assets. A turnover ratio of 50%
means half the fund was bought and sold during the
period
Turnover not costs money, but it also incurs taxes
 Costs of Mutual Funds (continued)

Hidden Costs (at the account level)

Beyond the explicit and implicit costs, look for the
following hidden costs:
Account Transfer Fees
Charges for moving assets either into our out of
an existing account
Account maintenance fees
Fees for maintaining your account
Inactivity/Minimum balance fees
Fees because you did not trade or have account
activity during the period or because you failed
to keep a minimum balance in your account
 Review of Objectives

A. Do you understand the advantages and

disadvantages of mutual funds?
B. Do you understand the major types of mutual
funds?
C. Do you understand how to calculate mutual
fund returns?
D. Do you understand the process of how to buy
a mutual fund?
E. Do you understand the costs of investing in
mutual funds?