MUTUAL FUNDS

Benefits of investing in a mutual fund

Risks of a mutual fund
Advantages do mutual funds have over individual securities
Kind of income from a mutual fund
Best a! to "u! mutual funds
#ommon mistakes $eo$le make hen choosing mutual funds
Net asset value
Measuring the groth of a Mutual Fund
Factors res$onsi"le for the huge groth in mutual fund assets
T!$es of stock funds
%alue funds
&roth funds
'ncome funds( )*uit! income funds( Balanced funds
Sector funds
Mone! market funds
Munici$al "ond funds
'nde+ funds
Risk in Mutual Fund 'nvesting
MUTUAL FUNDS
Don't want to mess around with individual stocks or Bonds?
Don't have much money to invest?
Want diversification and professional management?
Seeking price appreciation or income?
Mutual funds are the answer, whether you're interested in stocks, bonds,
government securities, international securities, foreign currencies or options
!very imaginable investment ob"ective is included in the more than #,$$$ funds
with assets e%ceeding &' trillion Some have no minimum initial investment
re(uirements, while others re(uire a modest outlay of &)$$ or less *his gives
you access to the market and a chance to add to your holdings in small
increments
Mutual funds are investment companies that raise money from shareholders to
pool it for the purpose of investing in many securities Because they can buy and
sell large blocks, their brokerage costs are lower than commissions paid by
individuals
Mutual fund companies have professional management, with a portfolio manager
to monitor its holdings and decide which to buy, hold or sell Shares are sold to
the public at net asset value +,-./ price 0ow well your fund does will make the
difference between a rising or declining ,-. Most funds pay dividends every
(uarter and capital gains distributions annually
1und families, which offer many different types of funds, permit switching from
one fund to another within the family as the market or your goals change Most
offer free switching, although some impose small fees
Benefits of investing in a mutual fund
2ichard Shumway inherited a sum of &3$$,$$$ and wanted to put the money,
where it gives him the best and safe return *hough he has heard of investing in
stocks, he does not have the knowledge or the confidence to enter the market on
his own 0e therefore sought the advice of a friend who told him 45ou can en"oy
many benefits by investing in mutual funds6 -ccording to 7*he 8nvesting 9it7
+Dearborn 1inancial :ublishing, 8nc, ;hicago/, mutual funds offer 7professional
portfolio management, diversification, a wide variety of investment styles and
ob"ectives, easier access to foreign markets, dividend reinvestment, ease of
buying and selling shares and e%change privileges *his will save 2ichard the
ha<el of investing in risky market and en"oy the advantage of skilful investment
managers who can operate on a large scale and benefit from their research
Risks of a mutual fund
Being a newcomer in the market, 2ichard was scared to invest in the market,
which he has heard, is very risky 0ow safe are mutual fund investments he
wondered
*he main one is that the companies in which the fund has invested will
= perform poorly,
= suffer mismanagement or
= otherwise meet with misfortune
-nother big risk is that some economic, political or other development will cause
the overall market to fall, dragging down with it the holdings of your particular
fund *hese are risks you would face investing in individual stocks as well> at
least mutual funds can offer diversification 0owever, some risks are uni(ue to
mutual funds *he fund management, for instance, may be doing things you don?t
know about or wouldn?t like if you did What you think is a plain vanilla domestic
e(uity@income fund might, in order to boost returns, invest in derivatives, invest
overseas, or invest in growth companies that pay little or no dividend 8n a
downturn, he could be in for an unpleasant surprise *here is also the risk that
the fund will under perform a benchmark inde%, which means that management
fees aren?t buying any added value
2ichard was a worried man Would it be more advantageous investing in a
mutual fund than investing in the stock market? 0e met an investment counsellor
Advantages do mutual funds have over individual securities
*he counsellor said there are several advantages in investing in a mutual fund
rather than in individual securities Ane key advantage is that mutual funds are
generally more diversified 2ichard Shumway can en"oy the advantage of a
diversified portfolio and does not have to bother about studying investment
options, which takes a long time and re(uires some degree of skill *he 1und
Manager of the Mutual 1und takes this responsibility - typical fund invests in
do<ens of securities, which makes it possible for small investor like 2ichard
Shumway to achieve a level of diversification greater than they could on their
own or with less effort than they could on their own *here are bond funds for
every taste 8f you want safe investments, consider government bond funds> if
you're willing to gamble on high@risk investments, try high@yield +aka "unk/ bond
funds> and if you want to keep down your ta% bill, try municipal bond funds
*he funds are professionally managed, which logically should add to your
investment returns in the end 8nvesting in a mutual fund will also save you
paperwork headaches because the monthly and annual statements will
summari<e short@ and long@term gains, dividends and interest earned on your
account Most also offer telephone and online trading, which makes buying,
selling or switching funds a snap 8dle cash can be automatically invested at
competitive rates in a money market fund and many companies offer unlimited
checking privileges, debit cards and credit cards, much as a bank would 5ou can
even designate a beneficiary so that, when you die, there will be none of the
delays and e%penses of probate
'ncome from a mutual fund
Mutual funds provide a simple and convenient way to meet various income
needs 8t gives you a number of choices 8n many cases, dividends are paid
monthly Ather funds, whose ob"ective is growth of capital, generally pay much
lower income distributions 8f 2ichard?s first decision is seeking to develop current
income, he should determine whether he wants the income to be ta%@free or
ta%able *he after@ta% return on higher@yielding ta%able funds may provide him
with less money after ta%es than he will have from lower@yielding ta%@free funds
1or instance, if he is in a B#C ta% bracket, he will keep only DBC of his ta%able
income 8n addition, a ta%@free income, invest in a good municipal bond fund may
yield him much more *here is also a diverse group of funds whose investment
ob"ective is to pay a high level of current income that is not ta%@e%empt *hey fall
into two categoriesE those holding securities issued or backed by the FS
government +or its agencies/ and those holding securities issued by domestic
corporations or foreign companies and governments 2ichard was informed that
Mutual fund shares are not federally insured or backed by the FS government
Best a! to "u! mutual funds
2ichard was convinced that his investment has to be in a Mutual 1und as it
combines the best of returns of the stock market and the safety of an investment
in Bonds 0e was not sure how he would go about selecting a mutual fund and
he heard about no@load, load, front end, back end and trailing load funds 0e met
an investment counsellor who told him that one of the great opportunities
available to investors today is the ability to buy into diversified, professionally
managed portfolios of stocks and bonds with no commissions *his is easily done
by investing in no@load mutual funds
!%amples of mutual fund choices that can fit 2ichards personal goals for saving,
retirement or education includeE
3 ,igh-risk investment funds offer the greatest potential for capital
appreciation but also greatest risk and volatility, such as aggressive growth
funds, growth funds, small@capitali<ation stock funds and specialty funds
B Medium-risk funds invest in higher@(uality, safer instruments with
potential for capital growth, income or both, such as growth@and@income funds,
growth funds, balanced or e(uity@income funds and ta%@e%empt municipal bond
funds
G Lo-risk funds feature investments with safety, stability and little risk,
such as money@market funds, FS government money@market funds, fi%ed@
income funds and ta%@e%empt funds
*here are two basic types of fundsE
3 .No-load. /no sales charge0 funds generally sold directly when you
send a check in the mail
B .Load. /sales charge0 funds sold by brokers who receive a commission
-fter that, the plot thickens Some load funds come in more than one class of
shares, such as 7-7 shares with a front@end load and 7B7 shares with a back@end
load, paid when you sell your shares *here are also 7;7 shares with no front@end
or back@end fee, but an annual one@percent distribution fee on top of the typical
annual e%penses
No-"rainers
-nother type of fund, known as an inde% fund, doesn't try to beat the
performance of the overall market, but tries to e(ual it 8ts manager buys a
portfolio that is a mirror image of a popular inde% such as the Standard H :oor's
)$$ or about '$ other inde%es *hrough many periods, these funds outperform
the ma"ority of active fund managers -nother choice is a (uantitative fund, which
employs computers to buy stocks in industries or specific stocks likely to beat the
market
*hese funds sell shares directly to the public without a sales charge More than
D$$ no@load funds are priced daily in the mutual funds section of *he ,ew 5ork
*imes, *he Wall Street Iournal, Barron?s and other ma"or newspapers -lthough
there are no upfront charges, there are, of course, e%penses and management
fees
!%ampleE 2ichard Shumway buys 3$$ units of -merican Scandia -dvisor 1unds
at the ,-. of &B#)$ with a front load of )C *his will mark@up the price to
&BJJB), which includes the commission or load *he total cost of the investment
would be &BJJB)$
#hoosing a Mutual Fund
When e%amining a mutual fund's performance, look forE
;onsistency of returns year after year Buying the top funds of the prior year
can often be a dismal failure, since high flyers often come crashing down to
earth
*olerable risk and low e%penses
*a% efficiency, which can vary considerably between funds Many maga<ines
and newspapers publish the percentage of a fund's total return that an
investor in a B#@percent ta% bracket would have kept after paying ta%es on
income and capital gains distributed by the fund over the past three years
8nvesting in mutual funds re(uires homework, setting goals, selecting appropriate
funds and hanging in there for the long haul Daily returns are published in your
local newspaper Many maga<ines and advisory publications +such as
Morningstar Mutual 1unds and the .alue Kine Mutual 1und Survey/ present
longer@term results 8t's easy to determine whether your carefully chosen funds
are winning or losing the investment game
2ichard wasn?t sure how many funds he should invest in to reduce the risk
0e was told by the investment counsellor that the primary reason why many
people invest in a mutual fund is to diversity their portfolio Since funds typically
own do<ens or even hundreds of different stocks or bonds, they provide much
broader diversification than you could hope to get by investing in individual
securities by yourself Some investors take this farther and buy shares in many
different mutual funds While it?s usually wise to invest in different kinds of funds,
owning three or four with different investment goals probably is enough to
achieve sufficient diversification
2ichard had come into a lot of money at the young age of B#, and wanted a
mutual fund that will reinvest the interest so that the growth of his investment
would be rapid and the investment will grow to a large sum later 0e was told that
there is dividend reinvestment plan called D28:
*his plan, offered by a company or mutual fund, allows investors to reinvest their
regular dividends in the company?s stock or the mutual fund?s shares 8f you take
part in a dividend reinvestment plan, also known as a D28:, the company won?t
send you a regular dividend check 8nstead, the money will be used to purchase
additional shares on your behalf, commission@free, and sometimes at a discount
Net asset value
*he net asset value, or ,-., is the price at which you buy or sell shares of a
mutual fund *o determine the ,-., a mutual fund computes the value of its
assets daily by adding up the market value of all the securities it owns,
subtracting all liabilities, and then dividing the balance by the number of shares
the fund has outstanding *he ,-. is the figure you look at in the newspaper to
see how much your mutual fund investment rose or fell the previous day 8f a
mutual fund has a portfolio of stocks and bonds worth &3$ million and there are a
million shares, the ,-. would be &3$ - fund's ,-. changes every day,
depending on the price fluctuations of the fund's holdings
*he ,-. is the price at which you can buy and sell shares, as long as you don't
have to pay a sales commission, or 7load7 8f you're buying directly from a fund
NAV Calculation of a Mutual Fund
Company # of Shares Price per Total
Owned Share Value
IM !"" #!$" #!$%"""
&ero' !"" (" (%"""
)M !"" *" *%"""
Value of the fund+s portfolio #$*%"""
Num,er of shares issued !%"""
Fund &+s NAV # $*-""
)rowth of #!%""" o.er Time
/0'ample1 a cumulati.e total return of $23-425 means that
#!%""" in.ested !" years a6o has earned #$%234-2" and the
in.estment is now worth #7%234-2"
/Assumes that All 8i.idends Are 9ein.ested as They Are
0arned 0ach :uarter
A.era6e Annual Total 9eturn ;AAT9<
0'presses the Cumulati.e 9eturn as a =early A.era6e1 !7->25
for the A,o.e
American Scandia Ad.isor Funds
The 9is? Ad@usted 9ate of 9eturn ;9A9O9<
Ad@usts a Funds AAT9 ,y Its eta Value and Compares this
Ad@usted 9eturn to the O.erall Mar?et 9eturn
9A9O9 A ;AAT9Beta< C SDP 2"" 9eturn
0'ample1
AAT9 A !7->25% eta A "-(>% SDP 2"" 9eturn A !4-735
9A9O9 A ;!7->25B"-(>< C !4-735
A !2-(*5 C !4-735
A E !-4(5
A Positi.e 9A9O9 Indicates )ood Fund Mana6ement
A Ne6ati.e 9A9O9 Indicates Poor Fund Mana6ement
It is Important to Fa.e E 9A9O9S Consistently O.er
TimeCC8o Not 9ely Too Fea.ily on One =ear+s Num,er
company such as 1idelity or * 2owe :rice, you don't have to worry @@ loads
come up only when you buy from a broker, financial planner, insurance agent, or
other adviser
2eturns aren't everything @@ also consider the risk taken to achieve those returns
Measuring the groth of a Mutual Fund
Before buying a fund, look at how risky its investments are ;an you tolerate big
market swings for a shot at higher returns? 8f not, stick with low@risk funds *o
assess risk level, check these three factorsE the fund's biggest (uarterly loss,
which will help you brace for the worst> beta, which measures a fund's volatility
against the SH: )$$> and standard 8nde% funds track the performance of market
benchmarks, such as the SH: )$$ Such 7passive7 funds offer a number of
advantages over 7active7 fundsE 8nde% funds charge lower e%penses and be more
ta% efficient, and there's no risk the fund manager will make sudden changes that
throw off your portfolio's allocation deviation, which shows how much a fund
bounces around its average returns -ny fund can @@ and probably will @@ have an
off year *hough you may be tempted to sell a losing fund, first check to see
whether it has trailed comparable funds for more than two years 8f it hasn't, sit
tight But if earnings have been consistently below par, it may be time to move
on
Factors res$onsi"le for the huge groth in mutual fund assets
*here are now appro%imately D,$$$ actively managed mutual funds in the Fnited
States, with wide variations in si<e, age, purpose and policy *he oldest have
been in e%istence for more than L) years> many have been established in the last
) years Some have only several million dollars under management, while others
measure their assets in the tens of billions *he greatest growth of mutual funds
occurred after World War 88 and has continued since with only occasional pauses
8n 3J'L mutual fund companies managed "ust over &B billion in assets By 3J)L
this had grown to &3$) billion, and to more than &GJ billion in 3JLL 8n the 3J#$s
growth e%ploded, "umping from &L' billion in 3JD# to more than &3 trillion by the
end of 3JJ3 *oday, there are appro%imately &G trillion dollars invested in all types
of mutual funds While a great deal of this growth has derived from the return on
invested assets, most growth has come from new money going into the funds
1or e%ample, according to the 3JJL@JD Directory of Mutual 1unds +8nvestment
;ompany 8nstitute, Washington, D;/, the number of funds has grown from
3,)B# in 3J#) to about D,$$$ today *he number of shareholder accounts has
grown from ')3 million in 3J#L to about 3)$ million in B$$$
T!$es of stock funds
When searching for stock mutual funds, you're going to run into all sorts of
names and categories *hey are usually pretty broad, and funds don't always live
up to their names @@ but at least they give you an idea of what you are getting
yourself into 0ere are some of the most common categories and sub@categories
Type of Fund O,@ecti.e
GGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG
)rowth Price Appreciation o.er Time
Income Fi6h Current 9eturn
alanced )ood Current 9eturn with some )rowth
Money M?t- Fi6h HiIuidity and 9eturns etter than
an? 9eturns
Ma'imum 0'ploit Opportunities to 0arn Very Fi6h
Appreciation 9eturns
Value Value in.estin6
Sector SpecialiJe in one sector
Muni Municipal and )o.ernment onds with ta' e'emption
Inde' 9educe the cost of in.estin6 and ensures a.era6e returns
%alue funds
.alue fund managers look for stocks that they think are cheap on the basis of
earnings power +which means they often have low priceMearnings ratios/ or the
value of their underlying assets +which means they often have relatively low
priceMbook ratios/
Karge@cap value managers typically look for big battered behemoths whose
shares are selling at discounted prices Aften these managers have to hang on
for a long time before their picks pan out
Small@cap value managers typically bottom@fish for small companies +usually
ones with market value of less than &3 billion/ that have been shunned or beaten
down by other investors
1unds within the small@company category can differ dramatically -t the * 2owe
:rice ,ew 0ori<ons fund, for e%ample, the manager snaps up shares of small
and midsi<e companies with <ooming profits Meanwhile, the manager of the *
2owe :rice Small@;ap .alue fund is more likely to pass on such highfliers and
instead, fills his portfolio with shares of very small companies that are trading at
rock@bottom valuations
&roth funds
*here are many different breeds of growth funds Some growth fund managers
are content to buy shares in companies with mildly above@average revenue and
earnings growth, while others, shooting for monster returns, try to catch the
fastest growers before they crash
-ggressive growth fund managers are like drag@car racers who keep the pedal to
the metal while taking on some si<eable risk *he resultE *hese funds often lead
the pack over long periods of time @@ as well as over short periods when the stock
market is booming @@ but they also have some crack@ups along the way ;onsider
them only if you can afford to put away your money for at least five years and if
you won't bail out when faced with downdrafts of B$ percent or more
Nrowth funds also invest in shares of rapidly growing companies, but lean more
toward large established names :lus, growth managers are often willing to play
it safe with cash -s a result, growth funds won't <oom as high in bull markets as
their aggressive cousins, but they hold up a bit better when the market heads
south ;onsider them if you're seeking high long@term returns and can tolerate
the normal ups and downs of the stock market 1or most long@term investors, a
growth fund should be the core holding around which the rest of their portfolio is
built
'ncome funds( )*uit! income funds( Balanced funds
*hese three types of funds have a common goalE :roviding steady long@term
growth while simultaneously throwing off reliable income *hey all hold some
combination of dividend@paying stocks and income@producing securities, such as
bonds or convertible securities +bonds or special types of stocks that pay interest
but can also be converted into the company's regular shares/
Nrowth and income funds concentrate more than the other two on growth, so
they generally have the lowest yields Balanced funds strive to keep anywhere
from )$ to L$ percent of their holdings in stocks and the rest in interest@paying
securities such as bonds and convertibles, giving them the highest yields 8n the
middle is the e(uity@income class -ll three types hold up better than growth
funds when the market turns sour, but lag in a raging bull market
-ll of these are for risk@averse investors and anyone seeking current income
without forgoing the potential for capital growth
Sector funds
2ather than diversifying their holdings, sector and specialty funds concentrate
their assets in a particular sector, such as technology or health care *here's
nothing wrong with that approach, as long as you remember that one year's top
sector could crash the following year
Mone! market funds
*hese funds invest primarily in bonds issued by the FS *reasury or federal
government agencies, which means you don't have to worry about credit risk But
because of their higher level of safety, however, their yields and total returns tend
to be slightly lower than those of other bond funds
*hat's not to say government bonds funds don't fluctuate @@ they do, right along
with interest rates 8f you can't tolerate swings of more than a few percentage
points, stick to short@term government bond funds 8f fluctuations of five percent
or so don't cause you to break out in a cold sweat, then you can pick up a bit
more yield with intermediate government bond funds 8f you plan on holding on
for several years and can handle 3$ percent swings, long@term government bond
funds will provide even more yield
Ma+imum a$$reciation funds
Ket's spare the euphemisms *hese are "unk bond funds *hey invest in debt of
fledgling or small firms whose staying power is untested as well as in the bonds
of large, well known companies in weakened financial condition *he potential
that these companies will default on their interest payments is much higher than
on higher (uality bonds, but since these funds usually hold more than 3$$
issues, a default here and there won't capsi<e the fund
*here is more risk, however, and for that, you get higher yields @@ usually three to
3$ percentage points more than safer bond funds *hese funds tend to shine
when the economy is on a roll, and suffer when the economy is fading
+increasing the chance of default/
Who should buy themE 8nvestors who want to boost their income and total returns
and can tolerate losses of 3$ percent or so during periods of economic
turbulence
Munici$al "ond funds
*a%@e%empt bond funds @@ also known as muni bond funds @@ invest in the bonds
issued by cities, states, and other local government entities -s a result, they
generate dividends that are free from federal income ta%es *he income from
muni bond funds that invest only in the issues of a single state is also e%empt
from state and local ta%es for resident shareholders Ance you factor in the ta%
benefits, muni funds often offer better yields than government and corporate
funds
'nde+ funds
With the best business schools in the country churning out a steady supply of
e%pensively educated MB-s who go to work for fund companies, you'd think
funds would have no trouble posting above@average returns -fter all, fund
shareholders @@ that's you @@ are paying fund managers big bucks to find the best
stocks in the market
But the fact is, the ma"ority of funds don't beat the market in most years *hat is,
you're better off mindlessly buying all the stocks in the Standard H :oor's )$$
inde% or in the Wilshire )$$$ inde% +which includes "ust about every stock on the
,ew 5ork, -merican and ,asda( stock e%changes/ than paying someone to
select what he thinks are the best ones
*here are several reasons so many funds fall short 1irst, factor in investing costs
that fund companies incur @@ the cost of research, administration, managers'
salaries and so on *hat cost is borne by the shareholders and gets deducted
from returns - fund manager needs to pick a lot of great stocks to make up for
those costs 8nde% funds, meanwhile, are much lower maintenance, and tend to
have much lower costs
*here are some caveats 8nde%ing seems to work better in some areas than
others *he case is most solid for large FS stocks and bonds, largely because
there is so much information on these big securities that it is tough for a fund
manager to gain an edge
-ctive managers of small@cap funds have traditionally fared better against their
inde% @@ the 2ussell B$$$
8nde% funds track the performance of market benchmarks, such as the SH: )$$
Such 7passive7 funds offer a number of advantages over 7active7 fundsE 8nde%
funds tend to charge lower e%penses and be more ta% efficient, and there's no
risk the fund manager will make sudden changes that throw off your portfolio's
allocation
Risk in Mutual Fund 'nvesting
2eturns may vary, but funds that are risky tend to stay risky So 2ichard should
be sure to check out the route the fund took to rack up past gains and decide
whether he would be comfortable with such a ride 0ere are some risk measures
he should consider to gauge the risk
Beta measures how much a fund's value "umps around in relation to changes in
the value of the SH: )$$, which by definition has a beta of 3$ - stock fund with
a beta of 3B$ is B$ percent more volatile than the SH: @@ ie for every move in
the SH:, the fund will move B$ percent more in either direction
Standard deviation will tells him how much a fund fluctuates from its own average
returns - standard deviation of 3$ means the fund's monthly returns usually fall
within 3$ percentage points of their average *he higher the standard deviation,
the more volatile the fund
Worst (uarter performance should be studied *his is a very straightforward
measure of riskE 8t merely shows the fund's worst (uarterly return on record,
giving you a feel of what to brace yourself for