Chapter 12

Mutual Funds: Professionally Managed PortfoliosReporter: Ivory C. Brigino3BSA-2Mutual FundsMutual Fund: an investment company that invests its shareholders money in a diversified portfolio of securities Organizations that pool investor funds to purchase financial instruments and thus reduce risks through diversificationAre corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government unitsAttractions of Mutual FundsPortfolio DiversificationOwning numerous securities reduces riskProfessional managementAbility to invest small amountsServiceAutomatic reinvestment of dividendsWithdrawal plansExchange privilegesConvenienceEasy to buy and sell; high liquidityFunds handle recordkeepingEasy to track pricesDrawbacks of Mutual FundsSubstantial Transaction CostsManagement feeCommission fees on load fundsLower-than-Market PerformanceConsistently beating the market is difficultMany mutual funds just keep even with overall stock market indexHow Mutual Funds are OrganizedManagement company runs the funds daily operationsInvestment advisor buys and sells stocks or bonds and oversees the investment portfolioDistributor sells the fund sharesDirect to the publicThrough brokersCustodian physically safeguards the securitiesTransfer agent keeps track of purchases and redemption requests from shareholdersOpen-End Investment CompaniesInvestors buy and sell shares directly with the mutual fund company without a secondary marketHave an unlimited number of sharesPurchase and selling price is determined by the Net Asset Value (NAV) of the fundAll purchases and sales are completed at the end of the day after the stock markets have closed

Closed-End Investment CompaniesSell only the initial offering Subsequent trades are done in a secondary market, similar to the common stock marketHave a limited number of sharesInvestment advisor doesnt have to worry about cash inflow or outflowsPurchase and selling price is determined by supply and demandGenerally sell at premium or discount (usually discount) to NAVComparing Closed-End and Open-End FundsBrokerage commissions apply to closed-end fundsOpen-end funds have greater liquidityClosed-end funds trade at premium (or discount) to NAVAvoid closed-end funds trading at premiumLook for closed-end funds trading at discount

Exchange-Traded Funds (ETF)A basket of securities designed to track a specific market indexSimilar to index mutual fundsTrade like individual stocks on stock exchangesCan buy and sell ETFs any time of the dayLow management expenses due to limited trading by investment advisorLow turnover helps avoid taxes until ETF is soldTypes of ETFsDiamonds (DIA) track DJIASpiders (SPY) track S&P 500 Qubes (QQQ) track NASDAQ 100Load and No-Load FundsLoad Fund: a mutual fund that charges a commission when shares are boughtTypically sold through a brokerNo-load Fund: a mutual fund that does not charge a commission when shares are boughtTypically sold directly to investor by mutual fundCost savings tend to give investors a head start in achieving superior rates of return Low-load Fund: a mutual fund that charges a small commission (2% to 3%) when shares are boughtLoad and No-Load FundsBack-end load: a commission charged on the sale of shares in a mutual fund12(b)-1 fee: fee charged by some mutual funds to cover management and other operating costs; amounts to as much as 1% of the average net assetsOther Fees and CostsManagement fee: compensation paid to professional managers who administer the funds investment portfolioThis fee is paid by all types of funds (load vs. no-load; open-end vs. closed-end)Fee is charged annually on average net assetsAdministrative costs: the normal costs of doing business, such as trading expensesUnit Investment Trusts (UIT)Fixed pool of securities, normally bondsNot actively managed; securities in portfolio remain staticHave shares that represent a proportionate share of the trustReal Estate Investment Trusts (REIT)Closed-end investment company that invests in mortgages and various types of real estate investmentsProvide high dividends along with capital appreciation potentialTypes of REITsProperty/equity REITs invest in shopping centers, hotels, apartments, office buildings and other real estateMortgage REITs invest in mortgagesHybrid REITS invest in both properties and mortgagesHedge FundsNot really mutual funds; private limited partnershipsNot regulated by mutual fund regulationsGeneral partner runs fund and takes 10-20% of profits; limited partners are investorsOnly sold to accredited investorsnet worth greater than $1,000,000 and/or annual income over $200,000Use arbitrage strategies, options, short sales and other complex strategiesTypes of Mutual FundsGrowth Fund: primary goals are capital gains and long-term growthInvest in large, well-established companies with above-average growth potentialLittle or no dividend incomeModerately risk investments for more aggressive investorsTypes of Mutual Funds (contd)Aggressive Growth Fund: highly speculative mutual fund that seeks large profits from capital gainsInvest in small, unseasoned companies with high price/earnings ratiosOften look for turnaround situationsPrices are often highly volatileHigh risk investments for very aggressive investorsTypes of Mutual Funds (contd)Value Fund: seeks stocks that are undervalued in the marketFocus is on intrinsic value of stocks and requires extensive fundamental analysisInvest in stocks with low P/E ratios, high dividend yields and promising futuresLooks for undiscovered companies with potential for future growthLess risky investments for relatively conservative investors looking for moderate growthTypes of Mutual Funds (contd)Equity-income Fund: emphasizes current income and capital preservationFocus is on high current income with some long-term capital appreciationInvest in high-yielding common stocks, convertible securities or preferred stocksInvests in blue chip stocks and other high-grade securitiesTypically less price volatility than overall stock marketLess risky investments for relatively conservative investors looking for moderate growthTypes of Mutual Funds (contd)Balanced Fund: generates a balanced return of both current income and long-term capital gainsInvest in blend of fixed-income securities and common stocks, with 30% to 40% in fixed incomeAllocation between stocks and bonds typically remains constant or varies very littleEmphasis between fixed-income and common stocks can be shifted as market conditions changeLess risky investments for relatively conservative investors looking for moderate growthTypes of Mutual Funds (contd)Growth-and-Income Fund: seeks both long-term growth and current income, with primary emphasis on capital gainsFocus is on long-term capital appreciation with some high income to provide limited stabilityInvest in blend of commons stocks and fixed-income securities, with up to 90% in common stocksModerate risk investments for investors who can tolerate moderate price volatilityTypes of Mutual Funds (contd)Bond Funds: invests in various kinds and grades of bonds, with income as primary objectiveAdvantages of bond funds over individual bonds:More liquidOffer high diversificationBond funds automatically reinvest interestLower risk investments for investors who are looking for steady incomeSome price volatility occurs with changing interest ratesCopyright 2008 Pearson Addison-Wesley. All rights reserved.12-22Types of Mutual Funds (contd)Index Funds: buys and holds a portfolio of stocks (or bonds) equivalent to those in a specific market indexObjective is to match, not beat, the specific indexStrategy is buy-and-hold, which provides tax advantages with very little taxable capital gainsOperating costs are very low due to low turnover in investment portfolioTypes of Mutual Funds (contd)Sector Funds: investments are restricted to a particular segment of the marketInvestments are concentrated in one specific industry sectorObjective is to produce capital gainsConsidered speculative because limited diversification can increase investment risksTypes of Mutual Funds (contd)Socially Responsible Funds: funds that actively and directly incorporate ethics and morality into the investment decisionSpecific stocks are evaluated on financial criteria and moral, ethic or environmental testsStocks that do not meet these tests are not considered for the investment portfolioExamples of excluded companies:Tobacco or alcoholGamblingNuclear energyReturns may be reduced due to limited investment opportunitiesTypes of Mutual Funds (contd)Asset Allocation Funds: funds that spread investors money across stocks, bonds, and money market securitiesProvides built-in asset allocation by professional investment managerAs market conditions change over time, the asset allocation mix changes as wellProvides convenience of one-stop shopping without having to own several mutual fundsTypes of Mutual Funds (contd)International Funds: funds that do all or most of their investing in foreign securitiesObjective is to benefit from changes in:International market conditionsValuation of U.S. dollarFunds can specialize in international stocks, bonds or money market securitiesFunds can specialize in growth, value, aggressive growth and other types of stocksFunds can specialize in specific countries or regions of the worldConsidered fairly high-risk due to currency exchange risksMutual Fund Investor ServicesAutomatic Investment PlansRegular investment from checking or savings account or paycheckMonthly amounts as small as $25Excellent way to build up investment over timeAutomatic Reinvestment of Interest, Dividends, and Capital GainsSystematic Withdrawal PlansMutual Fund Investor Services (contd)Conversion (Exchange) PrivilegesLoad funds usually allow exchanges between mutual funds in the same fund family without paying additional sales loadsExchanges between funds can trigger capital gains taxes in non-retirement accountsPhone SwitchingEasy Establishment of Retirement PlansInvestor Uses of Mutual FundsAccumulation of WealthStorehouse of ValueSpeculation and Short-Term TradingSelecting Mutual FundsDetermine if you want to use mutual funds in portfolioMutual funds increase diversificationMutual funds offer expertise in areas where investor may not be informedCan use stocks and mutual fundsCompare mutual funds investment objective to investors objectiveCompare range of services offeredSources of Return from Mutual FundsDividend incomeCapital gains distributionsChange in price/NAV Unrealized capital gains (paper profits): capital gain that has not been realized since funds holdings have not been sold