an introduction to mutual funds (2)

8/3/2019 An Introduction to Mutual Funds (2)

1/36

An Introduction to Mutual

FundsBhuwaneshwar mandal

PGDM 1ST SEMRoll-12


2/36

What r mutual funds?

Mutual funds are a type of investment thattakes money from many investors anduses it to make investments based on a

stated investment objective.

Each shareholder in the mutual fundparticipates proportionally (based upon the

number of shares owned) in the gain orloss of the fund.


3/36

Why do People Invest in MutualFunds?

Mutual funds offer investors an affordable way todiversify their investment portfolios.

Mutual funds allow investors the opportunity to have afinancial stake in many different types of investments.

These investments include: stocks, bonds, moneymarkets, real estate, commodities, etc

Individually, an investor may be able to own stock in afew companies, a few bonds, and have money in a

money market account. Participation in a mutual fund,however, allows the investor to have much greaterexposure to each of these asset classes.


4/36

Continued

Most mutual funds are professionally managedby an investment expert known as a portfoliomanager.

This individual makes all of the buying andselling decisions for the fund.

There are thousands of different mutual funds inthe United States.

This provides investors with many options tohelp them achieve their investment objectives.


5/36

Basic Mutual Fund Categories

Mutual Funds can be divided into fourbasic categories based upon the fundsinvestment objective.

These categories are:

Money Market Mutual Funds

Stock Mutual Funds Bond Mutual Funds

Balanced Mutual Funds


6/36

Money Market Mutual Funds

This is the most conservative type of mutual fund.

The goal is to maintain the $1 value of its shares whileproviding income.

Invests in high-quality, short-term securities such as

certificates of deposit, U.S. Treasury Bills, and U.S.Treasury Notes.

MMMFs are an appropriate place for savings.

These funds have typically offered higher interest rates

than bank savings accounts. Money market mutual funds are not insured by the FDIC.


7/36

Stock Mutual Funds

Type of fund that invests in stocks.

These funds are also known as equity funds.

There are many different types of stock mutual

funds.

Some of the most common include:

Large-cap funds, mid-cap funds, small-cap

funds, income funds, growth funds, value funds,blend funds, international funds, and sectorfunds.


8/36

Bond Mutual Funds

Type of mutual fund that invests in bonds.

There are different types of bond mutualfunds.

Typically, bond mutual funds have theobjective of providing stable income withminimal risk.


9/36

Types of Bond Mutual Funds

Short, Intermediate, and Long-Term U.S. Bond Funds

Short, Intermediate, and Long-Term Corporate Bond Funds

Municipal Bond Funds High-Yield (junk) Bond Funds


10/36

Balanced Mutual Funds

These are also known as hybrid funds.

These mutual funds invest in stocks,bonds, and money markets.

These are very diversified mutual funds.The stock portion of the fund provides thepotential for capital appreciation, while thebond and money market portion provideincome.


11/36

The Mutual Fund Prospectus

This is a legal document which describesthe investment objective of the fund, themanner in which the fund is administered

and operated, the fees and other pertinentinformation.

The prospectus should be read thoroughly

before making an investment decision.


12/36

Load v. No Load Mutual Funds

A mutual fund that charges a commissionto cover its administrative costs is called aload fund.

A front-end load charges the load whenthe shares are purchased, while a back-end load charges the load when theshares are sold.

A no-load mutual fund doesnt charge apurchase or sales commission.


13/36

What are the advantages of MutualFund Investing?

Diversification

While owning a single stock or bond is veryrisky, owning a mutual fund which holdsnumerous securities can reduce risksignificantly Professional management

Picking your own stocks and bonds to put in yourportfolio and beating your benchmarks is difficult

and time consuming. Hiring a mutual fund to makethose decisions for you can be beneficial and savetime


14/36

Minimal transaction costs Buying individual stocks and bonds is expensive in

terms of transactions costs. Mutual funds enjoyeconomies of scale in purchases and sales due tosize

Liquidity Buying and selling individual stocks and bonds takes

time. Money from open-end mutual funds can bereceived in two business days

Flexibility Individual stocks and bonds are not flexible. With

many mutual funds, you have more flexibility and canoften write checks on your account


15/36

Low cost

No-load mutual funds are sold without a salescharge 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 soldeach day at the funds Net Asset Value, which is thefunds assets less liabilities, divided by the number ofshares outstanding

Service Mutual funds generally offer service to answer questions,help you open accounts, purchase and sell funds, and totransfer funds as well.


16/36

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


17/36

What are the disadvantages ofMutual Fund Investing?

Risk of lower-than-market performance

From 1989-1998, the average annual returns ofactively managed stock funds was 15.6% versusthe 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


18/36

High costs

Unless analyzed carefully, management and otherfees can be significant. Moreover, many mutualfunds have loads or sales charges and 12-b1fees which reduce returns


19/36

Other Risks

Mutual funds are subject to both market and stockrelated risks, particularly in concentrated portfolios

Inability to plan taxes

Mutual funds pass through 95% of all capital gains anddividends to the shareholders

Even if you do not sell your mutual fund, you canhave a significant tax bill each year if your mutualfund trades often and has dividends, interest orcapital gains

It is difficult to plan for taxes when the tax decision istaken by the portfolio manager, not you


20/36

Premiums or Discounts Closed-end mutual funds may trade at a premium to

(more than) or discount (less than) the underlying NetAsset Value (NAV). These premiums or discountsmay be based more on investor demand than theunderlying shares value

New investor bias New investors dilute the value of existing investors

shares. Since new money comes into the fund at NetAsset Value, and since this money must be invested(at roughly 0.5% on average in the U.S.), existinginvestors are subsidizing new investors coming intothe fund


21/36

Understand the Major Classes ofMutual Fund Shares?

Mutual funds are divided into classesdepending on the loads and managementfees paid.

Loads are sales charges to compensate the salesforce for selling the fund. Loads directly reducethe amount of money invested by the amount ofthe load

Generally, research has found that theperformance of load funds and no-load funds isidentical. When the sales charges are included,no-load funds significantly outperform load funds.


22/36

While there are differences in classes of sharesamong investment management companies whichcharge loads, they generally are:

Class A Shares: These shares commonly have a

front-end or back-end load to compensate for thesales persons commissions. Because of the front-end loads, they usually have lower management fees

Class B Shares: These shares commonly only havea back-end load that is paid only when the shares are

sold. This load traditionally declines over time.Class B shares generally have higher expense ratioswhen compared to Class A shares.


23/36

Class C Shares: These shares generally have alower front- and back-end load fees, but highermanagement fees.

Class R Shares: These shares are generally for

retirement purposes. Check the loads andmanagement fees which may be substantial.

No-Load Shares: These are shares sold without acommission or sales charge. Generally, these sharesare distributed directly by the investment

management company, instead of going through asales channel. They may have higher managementfees to compensate for the lack of a front- or back-end load.


24/36

Class Y Shares: These are shares with veryhigh minimum investments, i.e., $500,000, butwhich have lower management fees and

waived or limited load charges. These aregenerally for institutional investors

Class Z Shares: These are shares onlyavailable for employees of the fund

management company


25/36

Know How to Buy a Mutual Fund

What are the steps to buying a mutual fund?

1. Determine your investment goals and your keyprinciples

2. Choose your appropriate investment benchmark

3. Identify funds that meet your objectives andbenchmark subject to your investment principles

4. Evaluate the funds and choose wisely based on

your key investment principles 5. Send money or purchase online


26/36

Step 1. Determine your InvestmentObjectives

What is the final purpose of the funds you will beinvesting?

Know your personal goals and budget

Determine your risk tolerance and returnrequirements for each goal

Determine your investment constraints for each goal

Determine where you are now in your investmentprogram

Determine which key principles are most important tothis investment


27/36

Step 2: Choose the appropriateBenchmark 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 theperformance you are seeking

Why is benchmark choice the second step? Tell me your asset class benchmark, and I will tell youwhat your portfolio should look like

Choose your benchmark wisely


28/36

Step 3: Identify Funds ThatMeet Your Objectives

One of the easiest ways to identify funds is to usefinancial publications and services.

You can access databases from which you can input yourobjectives 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 investmentstyle

Identify funds that meet your criteria for performance, size,fees, management, etc.


29/36

Step 4: Evaluate the Funds

How do you evaluate funds (some advice from a fundmanager in a previous career)?

Always compare funds with the same objective

Compare them to a relevant index. Some funds arenot willing to be compared to an index as it showstheir poor performance. They may change the indexto look better

Evaluate the funds long-term performance versus peers andthe 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


30/36

F. Understand the Costs of MutualFunds

What are the costs of mutual funds?

Explicit costs Front-end Loads

Sales commissions charged to the investor whenpurchasing certain types of fund shares. Back-end load funds

Commissions charged to the investor when sellingcertain types of shares. This may be on a slidingscale

No-load funds

Funds where there are no commission charged


31/36

Fees and expenses

Management fees: Fee charged by the advisor to afund generally on the basis of a percentage ofaverage assets, i.e. 75 basis points or .75% a year

12b-1 fees: Fees charged to cover the funds cost ofadvertising and marketing (why should you pay tomarket the funds to someone else?)

Total expense ratio: the total percentage of assets

that are spent each year to manage the fund includingmanagement fee, overhead costs, and 12b-1 fees


32/36

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 peryear), a specific charge per holding (8 basis points persecurity), or a percentage of assets for large accounts(25 basis points on assets under management)


33/36

Implicit costs Taxes on Distributions:

Taxes must be taken into account to get the true return ofyour 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% or 5%.

Short-term capital gains

These are taxed at your marginal tax rate

Long-term capital gains

These are taxed at 15% or 5%.


34/36

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 transactionscosts.

A good proxy for this is the turnover ratio, a measure of

trading activity during the period divided by the fundsaverage net assets. A turnover ratio of 50% means halfthe fund was bought and sold during the period

Turnover costs money and incurs taxes


35/36

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 existingaccount

Account maintenance fees

Fees for maintaining your account

Inactivity/Minimum balance fees

Fees because you did not have account activityduring the period or because you failed to keep aminimum balance in your account


36/36

Review of Objectives

mutual fundsPeople Invest in Mutual Funds

Mutual Fund Categories

The Mutual Fund ProspectusAdvantages and disadvantages of Mutual Fund

Investing

Major Classes of Mutual Fund Shares

steps to buying a mutual fund

Costs of Mutual Funds

an introduction to mutual funds (2)

Documents