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

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

 n   5. Convenience
     • a. Easy to acquire
     • b. Paperwork and record keeping
     • c. Prices are widely quoted
 n   6. Lack of liquidity
     • a. Normally must be sold back to the fund
     • b. No brokerage commissions
 n   7. Consistently average to below
     average performance
C. Essential Characteristics
 n   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
       – Defined as the total market value of all
         securities held by the fund less liabilities,
         divided by the number of fund shares
Net Asset Value Example
 n   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
C. Essential Characteristics

n   2. Closed-end Funds
    • a. A fixed number of shares outstanding
    • b. 100 Closed-end funds
    • c. $8 billion market value
n   3. Investment Trusts
    • a. Interest is an unmanaged pool of
    • b. Usually consist of corporate,
      government, or municipal bonds
C. Essential Characteristics
  n   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
  n   5. Other fees and Costs
      • a. Professional Management Fee
        – .25 to 1.75 percent of the average dollar
          amount of assets under management
D. Types of Funds (Equity)
 n   1. Growth
     • Goal is capital appreciation
 n   2. Maximum Growth
     • Highly speculative, seeking large profits
       from capital gains
        – a. Often buy stocks of small, unseasoned
        – b. Highly speculative
D. Types of Funds (continued)
 n   3. Income
     • CURRENT income is main objective
       – a. Interest income
       – b. Dividend income
 n   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%)
D. Types of Funds (continued)
 n   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
     • Can invest in specific country
D. Types of Funds (continued)
 n   Bond Funds
     • Objective is to invest in bonds
        – a. Income is primary objective
        – b. Two advantages
           • Liquidity
           • Diversification
D. Types of Funds (continued)
 n   6. Money Market Funds
     • Offers the individual investor access to
       high-yielding money market instruments
       without having to pay $100,000
       – a. Bank CD’s
       – b. Treasury Bills
       – c. Commercial Paper
D. Types of Funds (continued)
 n   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
D. Types of Funds (continued)
 n   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
E. Special Services
 n   1. Saving Plans
     • Investor adds funds on a regular basis
 n   2. Automatic Reinvestment Plans
     • Dividends and capital gains are reinvested
       in additional shares
 n   3. Regular Income
     • Through withdrawal plans, the investor can
       receive periodic repayment or income
       – Shares or Dollars
E. Special Services (continued)
 n   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
E. Special Services (continued)
 n   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
F. Risk
     n   Because Mutual Funds are so well
         diversified (typically), the inherent risk is
         similar to that in the Market

                Systematic  Market
           5                          30      Assets
     n   However, Specialty Fund risk can vary
         significantly from overall Market risk
Analyzing Mutual Funds
 n   Assessment of your risk tolerance
 n   Importance of diversification
 n   Should hold six mutual funds
 n   Should be able to earn 16% plus with a
     beta equivalent to 1.0 or slightly less
Mutual Fund Analysis:
 n   Style Analysis: Style analysis identifies
     the process of investing by fund
     managers that leads them to pick
     certain kinds of securities.
 n   Three factors of style analysis:
     • Growth
     • Value
     • Company Size
Mutual Fund Analysis:
 n   Growth Managers buy stocks in
     companies whose earnings are growing
 n   Value Managers are bargain hunters
     seeking stocks with low prices
     compared to intrinsic value.
 n   Company Size Managers specialize in
     small companies or large cos.
Mutual Fund Style Analysis:
 n   Style determines 85-90% of a fund
     portfolio’s return.
 n   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
Mutual Fund Style Analysis:
 n   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
Mutual Fund Style Analysis:
 n   Source of Information:
     Advisor Software
     Style Data
Mutual Fund Annual Reports
 n   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.
 n   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
 n   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
    Mutual Fund Annual Reports
n    Investment Portfolio: An investment portfolio comprises the
     assets (securities) held within a mutual fund.
n    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.
n    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.
Mutual Fund Annual Reports
 n   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.
 n   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.
Mutual Fund Annual Reports
 n   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.
 n   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.
Deadly Mutual Fund Myths - The
Conventional Wisdom Myth

 n   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.
The Diversification Myth
 n   2. If you own at least 10 different
     mutual funds you’ll have a diversified
     • 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.
The Momentum Myth
 n   3. The easiest way to beat the market
     is to buy last year’s top-performing
     • 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.
The Five-Star Myth
 n   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.
The Market Timing Myth
 n   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.
The Long-Term Performance Myth

 n   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.
The New fund Myth
 n   7. You should wait until a fund has at
     least a 3-year track record before
     • 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 Janus
       Olympus was up 30% the first 9 months of 1996.

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