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Investing in Mutual Funds

Investing in Mutual Funds. Topic 11. A. Pooled Diversification. 1. Professional Money Managers 2. Combines the Funds of many people with similar investment goals 3. Receive shares of stock in the mutual fund; a pooled common investment. 4. An indirect investment.

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Investing in Mutual Funds

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  1. Investing in Mutual Funds Topic 11

  2. A. Pooled Diversification • 1. Professional Money Managers • 2. Combines the Funds of many people with similar investment goals • 3. Receive shares of stock in the mutual fund; a pooled common investment. • 4. An indirect investment

  3. B. Attractions and Drawbacks of Mutual Fund Ownership • 1. Diversification • 2. Full-time Professional Management • 3. Modest Capital Investment • 4. Services offered • a. Automatic reinvestment of dividends • b. Withdrawal plans • c. Exchange privileges • d. Check writing privileges

  4. B. Attractions and Drawbacks of Mutual Fund Ownership • 5. Convenience • a. Easy to acquire • b. Paperwork and record keeping • c. Prices are widely quoted • 6. Lack of liquidity • a. Normally must be sold back to the fund • b. No brokerage commissions • 7. Consistently average to below average performance

  5. C. Essential Characteristics • 1. Open-end Funds • a. Investors buy and sell shares back to the fund itself • b. There is no limit on the number of shares the fund can issue • c. NET ASSET VALUE (NAV) • Defined as the total market value of all securities held by the fund less liabilities, divided by the number of fund shares outstanding.

  6. Net Asset Value Example • Example: NAV • XYZ Mutual Fund owns assets totaling $10M and liabilities equal to $500,000 with 500,000 shares outstanding • Therefore, NAV is: $10,000,000 - $500,000 / 500,000 $19/share

  7. C. Essential Characteristics (continued) • 2. Closed-end Funds • a. A fixed number of shares outstanding • b. 100 Closed-end funds • c. $8 billion market value • 3. Investment Trusts • a. Interest is an unmanaged pool of investments • b. Usually consist of corporate, government, or municipal bonds

  8. C. Essential Characteristics (continued) • 4. Load or No Load • a. Load Fund • Charges a commission when shares are bought (7 - 8 1/2% or more) • b. No Load Fund • No sales charges are levied • 5. Other fees and Costs • a. Professional Management Fee • .25 to 1.75 percent of the average dollar amount of assets under management

  9. D. Types of Funds (Equity) • 1. Growth • Goal is capital appreciation • 2. Maximum Growth • Highly speculative, seeking large profits from capital gains • a. Often buy stocks of small, unseasoned companies • b. Highly speculative

  10. D. Types of Funds (continued) • 3. Income • CURRENT income is main objective • a. Interest income • b. Dividend income • 4. Balanced Funds • Objective is to earn both capital gains and current income • a. High-grade common stocks (60 - 75%) • b. Fixed income securities (25 - 40%)

  11. D. Types of Funds (continued) • 5. Small Company • Invest in small companies that usually have sales of $100 million or less. 6. International • Can invest in one region or area of the world • Can invest in specific country

  12. D. Types of Funds (continued) • Bond Funds • Objective is to invest in bonds • a. Income is primary objective • b. Two advantages • Liquidity • Diversification

  13. D. Types of Funds (continued) • 6. Money Market Funds • Offers the individual investor access to high-yielding money market instruments without having to pay $100,000 denominations • a. Bank CD’s • b. Treasury Bills • c. Commercial Paper

  14. D. Types of Funds (continued) • 7. Dual Funds • Closed-end Funds with two types of shares • a. INCOME shares (Senior) which receive two times income as Junior • b. CAPITAL shares (Junior) which receive two times the capital gains as Senior

  15. D. Types of Funds (continued) • 8. Specialty Funds - Single Industry • a. Option trading • b. Commodity funds • c. Oil drilling • d. Cattle funds • e. Electronics • f. Gold • g. Chemicals • h. Health

  16. E. Special Services • 1. Saving Plans • Investor adds funds on a regular basis • 2. Automatic Reinvestment Plans • Dividends and capital gains are reinvested in additional shares • 3. Regular Income • Through withdrawal plans, the investor can receive periodic repayment or income • Shares or Dollars

  17. E. Special Services (continued) • 4. Conversion Privileges • Allows the investor the right to switch from one fund to another • a. Must confine switches within the same family of funds • b. Usually no transfer charges

  18. E. Special Services (continued) • 5. Check Writing Privileges • a. Shareholders have the right to write checks drawn on the Mutual Fund account • b. Normally checks must be written for at least $500 • c. Almost all Money Funds have this privilege

  19. p Systematic  Market 5 30 Assets F. Risk • Because Mutual Funds are so well diversified (typically), the inherent risk is similar to that in the Market • However, Specialty Fund risk can vary significantly from overall Market risk

  20. Analyzing Mutual Funds • Assessment of your risk tolerance • Importance of diversification • Should hold six mutual funds • Should be able to earn 16% plus with a beta equivalent to 1.0 or slightly less

  21. Mutual Fund Analysis: • Style Analysis: Style analysis identifies the process of investing by fund managers that leads them to pick certain kinds of securities. • Three factors of style analysis: • Growth • Value • Company Size

  22. Mutual Fund Analysis: • Growth Managers buy stocks in companies whose earnings are growing rapidly. • Value Managers are bargain hunters seeking stocks with low prices compared to intrinsic value. • Company Size Managers specialize in small companies or large cos.

  23. Mutual Fund Style Analysis: • Style determines 85-90% of a fund portfolio’s return. • The technique looks at the way funds perform on a monthly basis against one of 12 different indexes. The mix of indexes that are most highly correlated determines the style of the mutual fund manager.

  24. Mutual Fund Style Analysis: • The mutual fund universe can be divided into six basic styles: • Small cap growth funds • Large cap growth funds • Small cap value • Large cap value • Foreign funds • Fixed income funds

  25. Mutual Fund Style Analysis: • Source of Information: Advisor Software Style Data 1-800-738-6369 http://www.advisorsw.com

  26. Mutual Fund Annual Reports • Two Reports a Year: Mutual funds typically issue two financial reports a year - the semiannual report, which is often dated June 30 or April 30, and the year-end or annual report, which is often dated December 31 or October 31. • Shareholder Letter: A shareholder letter is usually written by the fund’s president or investment manager and reviews the fund’s investment objectives and performance for the current period. • Top 10: By looking at a mutual fund’s top 10 holdings, you will get a sense of the type of investments in the portfolio and the degree to which the fund meets your investment objectives. Similarly, study the industry composition of the portfolio - the percent of the fund’s asset that is invested in a particular industry.

  27. Mutual Fund Annual Reports • Investment Portfolio: An investment portfolio comprises the assets (securities) held within a mutual fund. • Portfolio Turnover: Portfolio turnover is the percentage of the portfolio’s investment that are bought and sold in one year. A fund with a portfolio turnover rate of 100 percent means they effectively bought and sold every security in the portfolio. High portfolio turnover increases transaction expenses and often reduces your rate of return. • Charts and Graphs: Many mutual fund reports include charts and graphs. A line graph may compare the growth of a $10,000 investment in the fund to the growth of similar investments over five years, ten years, or over the life of the fund. Pie charts are used to show the % of each type of investment in the fund: C.S., bonds, and cash.

  28. Mutual Fund Annual Reports • Portfolio: Some mutual fund financial reports include a more in-depth discussion of the fund’s performance for the period than the shareholder’s letter. • Statement of Assets and Liabilities: A mutual fund’s statement of assets and liabilities reflects the fund’s financial position at the stock or bond market’s close on the date of the report. Assets typically include investments that are valued at market on the financial statement date. Other assets include collateral held for securities loaned and receivables. Two examples are dividends and interest income receivable, which represent income earned by the fund but not yet collected in cash. Liabilities primarily represent amounts the fund owes for the purchase of new securities.

  29. Mutual Fund Annual Reports • Footnotes to the Financial Statements: Mutual fund financial reports include footnotes similar to those found in other annual reports. Footnotes include significant accounting policies, and related party and affiliate transactions. • Significant Accounting Policies: Related party and affiliate transactions typically include three types of transactions. The first occurs when payment of fees is made to portfolio managers and financial advisors. The second occurs when a mutual fund accumulates an ownership stake of a least 5% of the company. The third occurs when one mutual fund sells some of its investments to another mutual fund sponsored by the same mutual fund family.

  30. Deadly Mutual Fund Myths - The Conventional Wisdom Myth • 1. The Conventional Wisdom Myth • This is the number one mistake most investors make. Investors look at historic trends reported by Forbes, Kiplinger’s Business Week and others tend to recommend funds that have already made big gains rather than identify funds that are positioned to make profits in the future.

  31. The Diversification Myth • 2. If you own at least 10 different mutual funds you’ll have a diversified portfolio. • Owning 10 mutual funds won’t assure you of anything but a lot of work trying to stay on top of them all. In fact, you can have a well diversified portfolio with just 4 to 6 funds or you can have a portfolio of 15 funds with very little diversification.

  32. The Momentum Myth • 3. The easiest way to beat the market is to buy last year’s top-performing funds. • The fact is that last year’s best funds are just as likely to be this year’s dogs. Blindly following this strategy is very dangerous for most investors. The very top-performing funds are usually those that took a lot of risk and happened to bet on the right market sector at the right time.

  33. The Five-Star Myth • 4. The best funds to buy are those rated 4 or 5 Stars by Morningstar. • The star system tells you which funds were good, not which ones will be good. Even Morningstar will tell you that their ratings are a measure of past (risk-adjusted) performance, not the potential for future profits. Relying on statistical ratings is no substitute for a thorough examination and analysis of what a fund is doing today.

  34. The Market Timing Myth • 5. The safest strategy is to move everything into money market funds when the market is declining and switch everything back into stock funds when the market is rising. • This is a loser’s game. It has been proven over and over that investors are incapable of timing the market or identifying major bull or bear markets.

  35. The Long-Term Performance Myth • 6. The best measure of a fund’s quality is its long-term performance. • There is a fair amount of truth to this statement, but too many investors follow some broker’s advice to “buy this fund, it has a great 10-year record,” without asking some key questions. Who earned that record? Is the manager responsible for its returns still at the helm? If not, the record could be meaningless.

  36. The New fund Myth • 7. You should wait until a fund has at least a 3-year track record before investing. • The fact is that brand new funds often enjoy superior gains. New funds from top fund families often show explosive gains in their rookie year. Montgomery Small Cap was up 98.8% in 1991, Oakmark was up 48.9% in 1992, DFA Pacific Rim Small Company was up 92.6% in 1993, and JanusOlympus was up 30% the first 9 months of 1996.

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