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CHAPTER 4Mutual FundsChapter Sections:Advantages and Drawbacks of Mutual Fund InvestingInvestment Companies and Fund TypesMutual Funds OperationsMutual Funds Costs and FeesShort-Term FundsLong-Term FundsMutual Fund PerformanceClosed-End Funds, Exchange Traded Funds, and Hedge Funds

Mutual Funds: Investments for the Masses

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What is a Mutual Fund? An investment company that invests its

shareholders’ money in a diversified portfolio of securities “Investment company” is the legal term “Mutual fund” is the popular term Professional management Diversification

Each fund has a specific objective Over 10,000 funds to choose from Many people choose mutual funds for their

retirement account investments (401k, 403b, Traditional IRA, Roth IRA, etc.)

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Mutual Funds

STOCKS BONDS “CASH”

Professional Money Management

Diversification

Stock mutual funds

Bond mutual funds

Money market mutual funds

Balanced mutual funds

a “mutual” fund

a.k.a. investment company

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Growth of Mutual Fund Industry

YearNumber of

Mutual Funds

1940 70

1970 350

1980 600

1990 2,000

2000 9,000

2012 10,593*

Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, and ETFs

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Growth of Mutual Fund Industry(continued)

In 1980, five million Americans owned funds Holding 3% of their household financial assets

As of December 2012, 92.4 million Americans in 53.8 million households owned mutual funds That is just over 44% of all U. S. households Mutual fund assets totaled $16.7 trillion dollars*

Holding 23% of their household financial assets Mutual funds are now the nation’s largest financial

intermediary, followed by commercial banks (second largest) and life insurance companies (third largest)

Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, and ETFs as of November 2013. Looking back a few years, at the end of 2012, the amount was $14.7 trillion, at the end of 2011, the amount was $13.0 trillion; 2010, $13.1 trillion; 2009, $12.16 trillion. At the end of 2008, it was $10.35 trillion, and at the

end of 2007, it was $12.98 trillion dollars. As we discussed in chapter 1, 2008 was a very rough year.

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Advantages of Mutual Funds Pooled Diversification

A process whereby investors buy into a diversified portfolio of securities for the collective benefit of the individual investors This variety provides some safety that is difficult for

an individual investor to obtain on their own Professional management

The mutual fund managers are supposed to know what they are doing (They are certainly getting paid enough!)

Low initial outlay of capital You can start with $25 to $50 per month

“PITA” factor is low – The Wealthy Barber

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Drawbacks of Mutual Funds Transaction Costs

Some mutual funds charge sales fees called “loads” Front-end loads, back-end loads, etc.

Many others are “no-load” funds But some “no-load” funds can wind up costing you

more than “load” funds over time Annual Operating Expenses

Typically from 0.5% (or less) to 2.5% (or more)

Many mutual funds do not match the market’s performance What? Aren’t the mutual fund managers

supposed to know what they are doing?

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Open-end versus Closed-end Funds Open-end mutual funds (>80% of mutual funds)

A type of investment company in which investors buy shares from, and sell them back to, the mutual fund itself, with no limit on the number of shares the fund can issue

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

Investors can buy shares from (purchase) and sell shares to (redeem) the investment company at any timeWhen people refer to a mutual fund, they are almost exclusively

referring to an open-end mutual fund. As of December ‘12, there were 8,752 open-end mutual funds totaling $13.0 trillion dollars in assets. (At the end of November ’13, it was $14.8 trillion. 2013 was a very good

year for stock mutual funds.)

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Open-end versus Closed-end Funds Closed-end mutual funds (≈5% of mutual funds)

A type of investment company that operates with a fixed number of shares outstanding

Shares are issued by an investment company only when the fund is organized

After all original shares are sold you can only purchase shares from another investor Bought and sold like stocks on the open market Incur brokerage commissions

(continued)

Closed-end investment companies are not as popular with individual investors as open-end investment companies. At the end of December 2012, there were only 602 closed-end mutual funds holding only $265 billion dollars in assets. (By the end of

November 2013, there were 604 funds holding $277 billion.)

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Open-end versus Closed-end Funds

Net Asset Value The underlying value of one share in a particular

mutual fund Add up the value of the securities in the mutual fund Subtract any liabilities (normally close to zero)

Divide by the number of shares

(continued)

Open-end mutual funds are sold at net asset value (with a sales load added to load funds). Since closed-end mutual funds are bought and sold on the open market, their price usually either

reflects a premium or discount to the net asset value (usually a discount). They are very rarely priced at their net asset value.

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Net Asset Value =

Value of the fund’s portfolio - Liabilities

Number of shares outstanding

Example: $10,050,000 - $50,000 = $10 NAV

1,000,000 shares

Offering price = NAV + sales commissionExample: $10 + ($10 * 5%) = $10.50 Offering Price

Open-end versus Closed-end Funds(continued)

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Open-end versus Closed-end Funds

Advantages / Disadvantages? Open-end investment company

Always able to buy and sell – no market forces Very popular – wide range of choices Large purchases or redemptions can make

management of the fund more difficult Mutual fund company can “close the fund” to new investors

Closed-end investment company Must pay broker’s commission (like a stock) Must be bought/sold via the marketplace Often sold at premium or discount to NAV Easier to manage assets for investment advisors

(continued)

Which would (or do) you prefer?

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A New Type of Mutual Fund: ETFs Exchange-traded Funds (<12% of mutual funds)

An open-end mutual fund that trades on the stock exchanges like closed-end mutual funds

There is no limit to the number of shares The mutual fund company issues shares as needed

But the investor must purchase the fund using a brokerage account Incurring brokerage transaction fees (commissions)

However, some mutual fund companies have found a way to eliminate the transaction fees

They have opened their own brokerage firms and if you purchase their ETFs through their brokerage firm, they waive the commission

A recent entry to the industry, ETFs are becoming very, very popular. We will discuss why later on.

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Growth of ETF Industry

Again, take note of the steep drop in value in 2008.* End of November 2013. All others end of December.

End of Year

Number of Funds

Billions of Dollars

2013* 1,285 $1,643

2012 1,239 $1,337

2011 1,166 $1,048

2010 950 $992

2009 820 $777

2008 743 $531

2007 629 $608

2006 359 $423

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How are Mutual Funds Regulated? Investment Company Act of 1940

Foundation of the modern mutual fund industry Defined “regulated investment company”

a.k.a. “pass-through” investment vehicle Does not pay taxes on its investment income

The shareholders pay the taxes

To qualify, an investment company must… Hold almost all its assets as investments in stocks,

bonds, and other traditional securities, and Very limited ability to use derivatives & other risky strategies

Use no more than 5% of its assets when acquiring a particular security, and

Create an organization with “checks & balances”

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(continued)

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How are Mutual Funds Organized? The Mutual Fund

A Corporation run by a Board of Directors Board of Directors voted in by Shareholders (investors)

Sponsored the fund’s creator Investment Advisor (a.k.a. Management Company)

Portfolio Manager (sometimes a team or a committee) Research Analysts (usually focus on a specific industry)

Distributors Distributes the shares to the public or to dealers

Much the same role as an investment banker Mutual funds are technically continuous Initial Public

Offerings – must have an annual prospectus & report

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How are Mutual Funds Organized? Custodian

The company that actually holds the securities Often a bank or trust company

Transfer Agent Keeps track of purchase and redemption requests

from shareholders Independent Public Accounting Firm

Certifies the fund’s financial reports

(continued)

Why the large diversification of tasks and companies? Mutual funds are highly regulated in order to protect shareholders’

investment from fraud and collapse. How often have you heard of a scandal at a mutual fund company? Until 2003, never.

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“Mutual Fund Scandals?!” “You want me to invest in an industry that is

plagued with scandal?!” Since 1940, the mutual fund industry has been

regulated and escaped any hint of impropriety In 2003, some practices that were not quite illegal

but obviously unethical were uncovered Only a handful of funds and people were affected Strong, Janus, Bank of America, Putnum, Alliance

The vast majority of companies never engaged in any of the shenanigans

Instead of losing $99,999 on a $100,000 account (example: Enron or WorldCom), investors lost $1 on a $100,000 account.

Wait a minute, Paiano! Did you just say,

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Annual Operating Expenses Management fees

Charged yearly (.25%-2% average) based on a percentage of the fund’s asset value

Paid to portfolio managers and analysts who make the investment decisions

12b-1 fees Annual fee to defray advertising, servicing, and

distribution costs of the fund – up to 1% per year Accounting and other expenses

Trustee fee Only for retirement accounts – typically $10 to

$30 per year

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Annual Operating Expenses Trading Costs

Not disclosed in the annual prospectus So how does an investor know how much the

trading costs are? You can ask the mutual fund or just look at the…

Annual Turnover Measure of how much trading a mutual fund does Measured in percentage of the amount a portfolio

“turns over” each year 100% turnover, 50% turnover, etc. The higher the turnover, the higher the trading costs Also gives you an idea how long they hold investments

100% turnover: They hold on average one year 50% turnover: They hold on average two years

(continued)

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Load versus No-load Funds Load Fund

A mutual fund that charges a commission when shares are bought

Typically 3% to 5% Used to compensate the financial representative

Along with the fund distributor No-load Fund

A mutual fund that does not charge a commission when shares are bought Traditionally sold directly to shareholders

The endless debate: Should you purchase a Load Fund or No-load Fund?

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Load versus No-load Funds

Types of Load Funds Front-end Load – a.k.a. Class A

Commission is paid when shares are purchased Normally have lower annual operating expenses

Back-end Load – a.k.a. Class B Commission is paid when shares are redeemed Most back-end load funds have a Contingent

Deferred Sales Charge (CDSC) The CDSC declines to zero over a period of 3 to 6 years 5% first year, 4% second year, 3% third year, etc.

Normally, the back-end load pay higher annual operating expenses (12b-1 fees) until the CDSC declines to zero Eventually, the Class B shares revert to Class A shares

(continued)

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Types of Load Funds (continued)

No-load Funds (Huh?) – a.k.a. Class C No front-end nor back-end commissions

Except 1% back-end charge if redeemed within one year However, many Class C funds have higher annual

operating expenses in perpetuity (or for a long time) There are those 12b-1 fees again

Hence, they can wind up costing more than the Class A or Class B shares over time

The SEC now says you can not call a mutual fund a “no-load” fund if the 12b-1 fee is greater than 0.25% So, Class C shares are now not allowed to be called “no-

load” funds even though many in the industry still do

(continued)

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Types of No-load Funds Advisor No-load Funds – a.k.a. Class F, Class I

Held in advisor’s “wrap account” a.k.a. “Management account,” “Wealth Management Account”

Advisor charges 1% to 2% to “manage the account” “True” No-load Funds

Mutual fund company deals directly with public May not have a 12b-1 fee greater than 0.25% These are the darlings of the popular media

“Bypass the middleman! Who needs a financial advisor?” But that does not mean the overall fees are low

Over time, a no-load fund can wind up costing you more than a load fund

You must compare the annual operating expenses

(continued)

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Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F-2

Maximum sales charge 5.75% None None None

Maximum sales charge on reinvested dividends

None None None None

Maximum deferred sales charge

None 5.00% 1.00% None

Redemption or exchange fees None None None NoneAnnual Operating Expenses Class A Class B Class C Class F-2

Management Fees 0.28% 0.28% 0.28% 0.28%

Distribution and/or Service Fees (a.k.a. 12b-1)

0.24% 1.00% 1.00% 0.0%

Other Expenses 0.18% 0.18% 0.22% 0.16%

Total: 0.70% 1.46% 1.50% 0.44%

This is a load fund.

Growth Fund of America

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Example of Shareholder Fees:Transaction fees Class A Class B Class C Class F



None None None None

Maximum deferred sales charge None 4.00% 1.00% None

Redemption or exchange fees None None None None

Annual Operating Expenses Class A Class B Class C Class F

Management Fees 0.75% 0.75% 0.75% 0.75%


0.30% 1.00% 1.00% 0.00%

Other Expenses 0.20% 0.34% 0.30% 0.28%

Total: 1.25% 2.09% 2.05% 1.03%

Alliance Large Cap

Growth Fund

Another load fund.

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Example of Shareholder Fees:Transaction fees Class A Class C FI Institutional



None None None None

Maximum deferred sales charge None 0.95% None None

Redemption or exchange fees None None None None

Annual Operating Expenses Class A Class C FI Institutional

Management Fees 0.68% 0.68% 0.68% 0.68%


0.25% 0.95% 0.25% 0.00%

Other Expenses 0.11% 0.17% 0.14% 0.13%

Total: 1.04% 1.80% 1.07% 0.81%

Legg Mason

Value Trust

This is a very famous, now infamous, mutual fund. Some time ago, they changed the “Primary Class” shares to “Class C” shares and added Class A shares.

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Example of Shareholder Fees:

Transaction fees

Maximum sales charge None


None


None

Redemption or exchange fees None

Annual Operating Expenses Class A

Management Fees 0.14%


Other Expenses 0.03%

Total: 0.17%

Vanguard 500 Index

Fund

This is an index fund. This fund does no research. They simply buy all the 500 stocks

in the S&P 500 Index. The term for this is “passive

management.” (More later)Index funds are usually

“true” no-load mutual funds and usually (but not always)

have very low fees.

There is a $20 annual fee if your account value is less

than $10,000 unless you enroll in electronic delivery of

financial communications.

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Example of Shareholder Fees:

Transaction fees

Maximum sales charge None


None


None

Redemption or exchange fees None

Annual Operating Expenses Class A

Management Fees 0.025%


Other Expenses 0.07%

Total: 0.095%

Fidelity Spartan 500 Index Fund

Vanguard pioneered low fee mutual funds and was

able to overtake Fidelity as the number #1 mutual fund

company.Fidelity responded by

eliminating all sales loads, creating their own index

funds, and lowering their fees below Vanguard.

Like the Vanguard fund, there is a “low balance” annual fee of $12 if your account is below $2,000.

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Examples of Dollar Costs:

Hypothetical $10,000 Investment with 5% Return

1 Year

3 Years

5 Years

10 Years

Class A $642 $786 $942 $1,395

Class B (assuming no redemption) 149 462 797 1,543

Class C (assuming no redemption) 153 474 818 1,791

Class F-1 (excludes advisor fee) 45 141 246 555

Although it looks as though the F shares are the best deal, this does not include the advisor’s annual fee. Adding the

advisor’s typical fee of 1% to 2% per year would easily add an additional $1,200 to $2,400 to the total cost. Over the

long term, which is the best deal?


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1 Year

3 Years

5 Years

10 Years

Class A $674 $886 $1,115 $1,771

Class C (formerly Primary Class) 182 566 974 2,115

Financial Intermediary Class 109 340 589 1,304

Institutional Class 82 258 449 1,002

The class C shares of this “no load” fund wind up costing more than the class A shares! Again, the Financial Intermediary Class seems to be a

better deal but it does not include the advisor’s annual fee. The Institutional Class looks great. How can I get them? Well, for starters,

are you a large pension fund, university endowment, or tax-exempt charity? Oh, and by the way, do you have at least $1 million to invest?

Legg Mason

Value Trust

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1 Year

3 Years

5 Years

10 Years

Investor Class $17 $55 $96 $217

Admiral Class 5 16 28 64

The fees for passively-managed index funds will almost always be less than actively-managed funds. The Admiral Class shares used

to be available with a minimum of only $100,000. Any takers? (In the fall of 2010, they lowered the minimum to $10,000.)

Do you remember the exchange-traded funds (ETFs)? They often have fees lower than the index funds! The Vanguard ETF that

tracks the total U. S. stock market has an expense ratio of 0.05%.

Vanguard 500 Index

Fund

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Breakpoint Sales Reductions:

Investment (either purchased or accumulated) Sales Charge

Less than $25,000 5.75%

$25,000 but less than $50,000 5.00%

$50,000 but less than $100,000 4.50%

$100,000 but less than $250,000 3.50%

$250,000 but less than $500,000 2.50%

$500,000 but less than $750,000 2.00%

$750,000 but less than $1,000,000 1.50%

$1,000,000 or more None

Class A shares typically qualify for a sales reduction if you invest a larger amount or as your investment grows. Some brokers fail to

inform their clients of this feature. Instead, as the client approaches the breakpoint, the broker will advise them to start another fund. Why?


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Contingent Deferred Sales Charge (CDSC) on Class B Shares

Year of Redemption Contingent Deferred Sales Charge

1 5.0%

2 4.0%

3 4.0%

4 3.0%

5 2.0%

6 1.0%

7+ 0.0%

The back-end sales charge on Class B shares typically is reduced over time until it is eliminated. However, as we noted, the Class B shares

usually pay more in annual fees.

CDSC Reduction over Time:Growth Fund of America

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10-Year Rates of Return:

Investment10-Year Return

Growth of $10,000

Growth Fund of America, Class A 7.67%* $20,933

Alliance Large Cap Growth Fund, Class A 8.47%* $23,457

Legg Mason Value Trust, Class C 1.76% $11,905

Vanguard Index 500 Fund 7.29% $20,206

Standard & Poor’s 500 Index 7.40% $20,424

Fees are important, but they certainly do not tell you the whole story. When comparing mutual funds, you must look at many

attributes, not the least of which are the rates of return, preferably over longer periods of time.

So, Which One Would You Pick?

*8.31% and 8.94%, respectively, without sales charge (a.k.a. NAV, net asset value)

A

B

C

D

as of December 31, 2013

formerly Primary Class

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Mutual Funds Fees: What are __?

These shares do not have an up-front sales load. Instead, they assess a decreasing back-end load if you withdraw your money within 6 years. The annual operating expense is higher (courtesy of the 12b-1 fees).

A. A shares

B. B shares

C. C shares

D. F or I sharesThe correct answer is (B). They normally eventually become

A shares after 6 to 8 years.

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These shares do not have an up-front fee and only a 1% back-end fee if redeemed within one year. The advisor called them “no-load” but you notice that their annual operating expense is higher than other share classes (again, courtesy

of those ubiquitous 12b-1 fees). A. A shares

B. B shares

C. C shares

D. F or I sharesThe correct answer is (C). They sometimes revert to A or F

shares after many years.

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Your financial advisor tells you that these shares have no sales fees and a very low annual operating expense. She mumbles something about “wealth management.” These shares are:

A. A shares

B. B shares

C. C shares

D. F or I shares

The correct answer is (D). She also did her best not to explain that her brokerage firm will charge you an extra 2% each year.

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Types of Mutual Funds Aggressive Growth Funds

Highly speculative mutual funds that seek large profits from capital gains Dey Iz Rollin’ De’ Dice!

Growth Funds Mutual funds whose primary goals are capital gains

and long-term growth Typically invest in high-growth companies

Some fund companies now have a category or two more speculative than Aggressive Growth. They are sometimes

called Ultra Funds or Momentum Funds. (Example: Janus 20) What do you think about this strategy?

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Capital Appreciation Funds Mutual funds that seek long-term growth of capital How does it differ from a growth fund?

Most growth funds have a provision that states they will invest primarily in growth stocks, usually staying between 80% & 100% invested in the market

Capital Appreciation Funds can often invest in anything they like and anywhere they like In general, they tend to be as risky as growth and

aggressive growth funds (although not always)

(continued)

The well-known Fidelity Magellan Fund is a Capital Appreciation Fund

Types of Mutual Funds

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Growth-and-Income Funds Mutual funds that seek both long-term growth and

current income, with primary emphasis on capital gains Sometimes own bonds to augment the income Sometimes referred to as “Blend” (of Growth & Value)

Value Funds Mutual funds that seek stocks that are undervalued

in the market by investing in shares that have low P/E multiples and high dividend yields Often look for companies out-of-favor with investors

(continued)

Some folks lump growth-and-income funds and value funds together


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Equity-Income Funds Mutual funds that emphasize current income and

capital preservation by investing primarily in high-yielding, income-producing common stocks Railroads, Foods, Utilities, REITs, etc.

They will also invest in bonds to generate income when the investment advisor believes that stock prices have risen to levels that threaten preservation of capital

(continued)

Many Equity-Income Funds did very well during the 2000 to 2002 bear market after lagging the market badly during the late 1990’s bull market. Every type of fund was clobbered in 2008.


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More Stock Fund Classifications Large Cap – largest companies Mid Cap – medium-sized companies Small Cap – smallest companies Domestic – companies based in U.S. Global – based anywhere in globe International – based outside U.S. Regional – Japan, Far East, Latin America, etc. Emerging Markets – India, Mexico, Brazil, Russia,

Philippines, China, Turkey, etc. Sector – energy, technology, health care, etc. Market Timing – dumb

Which do you think is the

riskiest?

Which do you think is the

riskiest?

Types of Mutual Funds(continued)

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Bond Funds – a.k.a. Fixed-income Funds Mutual funds that invest in various kinds and

grades of bonds, with income as the primary objective

High-Yield Bond Funds – a.k.a. Junk Bond Funds Are often more correlated with stocks than bonds

Corporate Bond Funds Convertible Bond Funds

Municipal and Insured Municipal Bond Funds Popular with high net worth individuals Income is free from Federal taxes State-specific municipal bond funds

Income is free from state taxes as well

(continued)Types of Mutual Funds

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Bond Funds (continued) U.S. Backed Bonds (Fannie Mae, etc.)

a.k.a. Mortgage-backed Bond Funds Government Bond Funds – a.k.a. Treasury Bond

Funds, Government Securities Funds Income is free from state and local taxes

Long-term Bond Funds Intermediate-term Bond Funds Short-term Bond Funds

Global and International Bond Funds


Which do you think is the riskiest?

Careful!

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Balanced Funds Mutual funds whose objective is to generate a

balanced return of both current income and long-term capital gains

Invest in both stocks and bonds Normally 60% stocks and 40% bonds

But allocation can change as the investment environment changes

(continued)

Example: The prospectus of the American Balanced Fund states that the fund is “managed as the complete U. S. investment

program of a prudent investor.” They can never be more than 75% stocks, 25% bonds or less than 50% stocks, 50% bonds.


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Asset Allocation Funds Mutual funds that spread investors’ money across

stocks, bonds, and money market securities Very similar to Balanced Funds However, the investment advisor often more

diligently tries to “fine-tune” the allocation as market conditions change Whereas a Balanced Fund usually stays around 60%

stocks / 40% bonds, An Asset-Allocation Fund might try to move money

into cash when they thought the market might fall

(continued)

For all their hype, the returns of many Asset Allocation Funds are very close to Balanced Funds. Some trail Balanced Funds

considerably because they “timed the market” badly.


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Money Market Mutual Funds (review)

Mutual funds that invest in short-term money market instruments Much the same as money market accounts at banks

and credit unions EXCEPT money market mutual funds are not guaranteed

General Purpose – Treasury bills, commercial paper Government Securities – Only Treasury bills Tax-exempt – very short-term municipal securities

(continued)

They are essentially as safe as guaranteed money market accounts since they invest in exactly the same securities but

they are not guaranteed! (Did we already mention that?)“Breaking the Buck”


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Mutual Funds of Mutual Funds a.k.a. Lifestyle Funds, Target-Date Funds Choose the fund that matches your time horizon …

College 2020, Retirement 2035, etc. The company will populate the mutual fund with

other mutual funds to match the time horizon Often from the same company’s mutual fund choices

As the time horizon shortens, the mutual fund will change the mix of mutual funds

Some are “Target-Risk” Funds Choose your risk tolerance & they choose the funds


“A mutual fund of mutual funds? You are kidding, right?”No. These are very popular now because of employer-sponsored

retirement plans such as 401(k) plans.

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Specialty Funds Hedge Funds

Traditionally only open to “sophisticated investors” But now available to those with as little as $5,000 to $10,000

No regulatory oversight – have become a major force 1% to 2% operating expense; take 20% of the profits

“Bear” Funds Precious Metals / Hard Assets Funds REIT Funds Boutique / Exotic Funds

StockCar Stocks Fund Pauze Tombstone Fund The Chicken Little Growth Fund (I am not making this up!)


The choices are endless. So are the fees…

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Index Funds – a.k.a. Passively-managed Mutual funds that buy and hold a portfolio of stocks

or bonds equivalent to those in a specific market index No “active management” performed – no research

The mutual fund simply buys all the stocks in the S&P 500, Dow Jones Industrial Average, Russell 2000, etc.

Why? Can offer much lower annual fees (no research) Many actively-managed mutual funds do not beat the market

Because of the annual fee, an index fund can not actually match the market’s performance, but it should come very close (providing the annual fee is not excessive) Whereas, an actively-managed fund could substantially out

perform or under perform the market index


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Index Funds (continued)

The rationale for index funds came from research done in the early 1970’s that statistically showed that many of the actively-managed funds did not beat the market “A monkey throwing darts at a dartboard…”

However, many actively-managed funds do beat their respective indexes over time

Look for a fund family where most all funds have consistently beaten their indexes over decades! (Psst! There are only a few major companies)

In the late ’90’s, index funds became a victim of their own success


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Standard & Poor’s 500 (a.k.a. S&P 500) Dow Jones Industrial Average (a.k.a. the Dow) Dow Jones U.S. Total Stock Market Index

nee Dow Jones Wilshire 5000, nee Wilshire 5000 a.k.a. Total Market Index

NASDAQ Composite & NASDAQ 100 MSCI World (Global) & EAFE Index (International) Countless other index funds available now

Index funds are the current “perfect investment.” For the failsafe superlative treatment, visit www.ifa.com.

What, if any, are the downsides to index funds?


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Indexes sometimes become skewed toward a particular sector of the economy or region of the world (more about this phenomenon later)


Japan, 59.8% P/E: 51.9

All else, 40.2% P/E: 13.0

MSCI EAFE 12/31/1989

Info Tech, 33.3% P/E: 59.2

All else, 66.7% P/E: 19.3

S&P 500 3/31/2000

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Types of Mutual Funds Exchange-Traded Funds – a.k.a. ETFs

An open-end mutual fund that trades as a listed security on a stock exchange Trades like a stock as does a closed-end fund But there is no limit on the number of shares

Becoming very popular because they can be bought and sold throughout the day like stocks Unlike open-end mutual funds, which always trade

at the end-of-day net asset value Most all ETFs are passively-managed index funds

But there are also some actively-managed ETFs

(continued)

And they have cool names like “Spider,” “Diamond,” and “Cube”

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Socially Responsible Funds Mutual funds that actively and directly incorporate

ethics and morality into the investment decisions Started out with some funds refusing to invest in

companies that sold alcohol or tobacco Moved to companies that pollute, build weapons or

nuclear power plants, destroy the rain forests, etc. And then to companies that exploit labor

It is surprising that there any companies left to invest in …

(continued)

Silliness aside, many Socially Responsible Funds have done quite well for their investors


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Socially Irresponsible Funds (???)

Possibly as a backlash to socially responsible funds (and their perceived political overtones)

There is a mutual fund called The Vice Fund Yep! You guessed it! It invests in tobacco and alcohol …

(The manager says he simply loves Philip Morris!)

And all the other corporate nasties you can think of Gambling, Defense firms

(continued)

And although it is still a very small fund with high annual fees, it has done very well for its investors (www.vicefund.com)


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(continued)

Morningstar, a company that analyzes mutual funds, designed the “style box” to help investors identify investment alternatives. They say

they are fabulous. No one I know uses them; neither do I.Now they have “ownership zones.” They say they are even better.


GrowthBlendValue

Large

Medium

Small

Size

Style

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Fund Families

A family of funds exists when one investment company manages a group of mutual funds

Funds in the family vary in their objectives You can move your money from one fund to

another within a fund family Almost always with no charge But, if the fund is in a taxable account, you could

generate a taxable transaction Recently, fees are being charged for “excessive”

transfers within the fund family Done to discourage “market timing” by investors

Forbes sez, “Choose a Family, Not a Fund”

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Fund Families: Top Ten Families

Source: Investment Company Institute, http://www2.iii.org/financial/securities/mutualfunds Dec 2011

Examples: Offerings from the top three families

1. Vanguard Group2. Fidelity Investments 3. American Funds (CR&M)4. PIMCO Funds5. J. P. Morgan Chase6. Franklin Templeton Investments7. BlackRock Funds8. Federated Investors9. T. Rowe Price 10. Bank of New York / Dreyfus Corporation

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Mutual Fund Investor Services Automatic Investment Plans

Mutual fund service that allows shareholders to automatically send fixed amounts of money from their paychecks or bank accounts into the fund

a.k.a. Dollar-Cost Averaging (more later)

“Pay yourself first!”

In my humble opinion, this is the absolute best way to invest in a mutual fund. You do not worry about whether or not it is a

good time to invest. Every month is a good time to invest $50 that comes right out of your paycheck or checking account.

P.S. It is practically the only way most people will ever invest!

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Mutual Fund Investor Services Automatic Reinvestment Plan

Mutual fund service that enables shareholders to automatically buy additional shares in the fund through the reinvestment of dividends, interest, and capital gains

(continued)

Automatic Reinvestment Plans allow an investor to earn fully compounded rates of return. Unless an investor needs

the income, it is always a good idea to reinvest dividends and capital gains received from a mutual fund.

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Mutual Fund Investor Services Systematic Withdrawal Plan

Mutual fund service that enables shareholders to automatically receive a predetermined amount of money monthly or quarterly Sometimes annually

Normally electronically transferred directly to your checking account

Conversion Privilege – a.k.a. Exchange Privilege Allows shareholders to move money from one fund

to another within the same family of funds May trigger tax consequences if not in a retirement

account

(continued)

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Mutual Fund Transactions Purchase options

Closed-end & ETFs through the stock exchange Open-end

Through a broker Directly from the investment company Best way is auto-contributions (payroll, checking)

Sell options Closed-end & ETFs through the stock exchange Open-end

Through a broker or through the mutual fund Best way is auto-withdrawals (into your checking)

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Taxes and Mutual Funds Two types of taxes for Regular Accounts

Income dividends Taxed as income (20% max, 15% typical, 5% min)

Capital gains distributions Taxed as capital gains (20% max, 15%, 5% min)

Reinvested dividends and capital gains are still taxable transactions Save your year-end statements Congress may change this someday (doubtful!)

Unrealized capital gains (a.k.a. paper profits) would not be taxed until you sell your mutual fund shares (forget it!)

Tax-deferred Retirement Accounts (401(k), etc.) Pay no taxes until retirement All proceeds taxed as income (except Roth tax-free)

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Sources of Mutual Fund Information

Mutual Fund Prospectus 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 about dividends, distributions & taxes Information about the fund’s management No one reads them!

Unless they have taken BUS-123 It was not that hard, was it?

Mutual Fund Annual Report Performance, investments, assets and liabilities

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Financial publications Morningstar, Lipper, etc. Business Week, Forbes, Kiplinger's Personal

Finance, and Money are sources of information on mutual funds

Mutual fund surveys usually include: Fund’s overall rating compared to other funds Fund’s rating compared to funds in the same

category Fund size, sales charge and expense ratio Risk of loss factor and toll-free number History for past three, five, and ten years

(continued)Sources of Mutual Fund Information

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Sources of Mutual Fund Information Financial web sites

finance.yahoo.com www.businessweek.com www.morningstar.com

Mutual fund companies’ Internet sites www.fidelity.com www.troweprice.com www.vanguard.com www.americanfunds.com www.dodgeandcox.com www.franklintempleton.com

Investment Company Institute web site www.ici.org

(continued)

Hurray! The mutual fund web sites are again

promoting education.

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“So, How Do I Pick a Mutual Fund?”

Pick a Mutual Fund that… Invests in high-quality stocks or bonds Is well-diversified across several industries and

sectors of the economy Has a long-term perspective and a manager or

(better yet) a management team with many years of experience Avoid companies that “shuffle” their managers

every few years (which is virtually all of them!) Has been around for decades and performed

consistently well in both good and bad markets

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A Sample Stock Mutual Fund Is 80 years “long-term” enough for you? 6%, 8%, 9%, 10%? How about 12%? “But stocks are very risky”

Short-term, Yes. Long-term, No! “But now is not a good time to invest”

“Excuse me, when is it ever a good time to invest?” Okay, so what if you had invested on the worst day

of the year for the past 20 years? How did you do? “But what about market downturns?”

Keep a long-term perspective, and Dollar Cost Average…

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Dollar-Cost Averaging A system of buying an investment at regular

intervals with a fixed dollar amount With Dollar-Cost Averaging, there is always

“Good News” “The market is up! Good News!”

Your account is worth more “The market is down! Good News!”

Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account

Your average cost-per-share should be lower than your average price-per-share

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Hypotheticals Most mutual fund companies have a system for

running “hypotheticals” a.k.a. “Illustrations” “Hypothetical illustrations” Examples of returns of investments Lump sum principals, or Streams of investments

a.k.a. Dollar-Cost Averaging Or combinations of both Must be approved by SEC and FINRA

And contain disclaimers about past versus future performance

Let’s run some hypotheticals!

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And That Ain’t the Only One!

As of December 31, 2013

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Bottom Line on Mutual Funds Choose a fund family and stick with them

“Most mutual fund investors do worse than the mutual funds they invest in”

Re-evaluate them periodically (once or twice a year?) But make changes judiciously and sparingly As you approach retirement, migrate from stock funds

to bond funds But do not give up stocks entirely (ICA illustration)

Dollar-Cost Average $50 a month, $100 a month, whatever is affordable… For the most part, Forget About Them!

Do not be one of the mutual fund investors that does worse than your mutual funds!

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CHAPTER 4 – REVIEW

Mutual Funds

Next week: Chapter 5, The Stock Market

Chapter Sections:Advantages and Drawbacks of Mutual Fund InvestingInvestment Companies and Fund TypesMutual Funds OperationsMutual Funds Costs and FeesShort-Term FundsLong-Term FundsMutual Fund PerformanceClosed-End Funds, Exchange Traded Funds, and Hedge Funds

c hapter 4

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