Chapter 13

Mutual Funds:
Professionally
Managed
Portfolios

Mutual Funds
Learning Goals
1. Describe the basic features of mutual funds, and note
what they have to offer as investment vehicles.
2. Distinguish between open- and closed-end funds, as
well as other types of professionally managed
investment companies, and discuss the various types
of fund loads, fees, and charges.
3. Discuss the types of funds available and the variety of
investment objectives these funds seek to fulfill.

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Mutual Funds
Learning Goals (contd)
4. Discuss the investor services offered by mutual
funds and how these services can fit into an
investment program.
5. Gain an appreciation of the investor uses of mutual
funds, along with the variables to consider when
assessing and selecting funds for investment purposes.
6. Identify the sources of return and compute the rate of
return earned on a mutual fund investment.

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Mutual Funds
Mutual Fund: an investment company that invests its
shareholders money in a diversified portfolio of securities
Investors own a share of the fund proportionate to the amount of
the investment

First started in 1924

Nearly 8,300 mutual funds available today
More mutual funds in existence today than stocks listed on
NYSE and AMEX combined
Nearly half of all U.S. households own mutual funds

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Attractions of Mutual Funds

Diversification

Owning numerous securities reduces risk

Professional management
Ability to invest small amounts
Service

Automatic reinvestment of dividends

Withdrawal plans
Exchange privileges

Convenience

Easy to buy and sell; high liquidity

Funds handle recordkeeping
Easy to track prices

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Drawbacks of Mutual Funds

Substantial transaction costs
Management fee
Commission fees on load funds

Lower-than-market performance
Consistently beating the market is difficult
Many mutual funds just keep even with overall
stock market index

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Figure 13.2
Mutual Fund Performance

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How Mutual Funds are Organized

Management company runs the funds daily operations
Investment advisor buys and sells stocks or bonds and
oversees the investment portfolio
Distributor sells the fund shares
Direct to the public
Through brokers

Custodian physically safeguards the securities

Transfer agent keeps track of purchases and redemption
requests from shareholders

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Open-End Investment Companies

Investors buy and sell shares directly with the
mutual fund company without a secondary market
Have an unlimited number of shares
Purchase and selling price is determined by the Net
Asset Value (NAV) of the fund
NAV Valueofallsecurities Liabilitiestotalsharesoutstanding

All purchases and sales are completed at the end of

the day after the stock markets have closed
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Closed-End Investment Companies

Sell only the initial offering
Subsequent trades are done in a secondary market, similar to the
common stock market

Have a limited number of shares

Investment advisor doesnt have to worry about cash
inflow or outflows
Purchase and selling price is determined by supply
and demand
Generally sell at premium or discount (usually discount)
to NAV

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Exchange-Traded Funds (ETF)

A basket of securities designed to track a specific
market index
Similar to index mutual funds
Trade like individual stocks on stock exchanges
Can buy and sell ETFs any time of the day
Low management expenses due to limited trading by
investment advisor
Low turnover helps avoid taxes until ETF is sold
Types of ETFs
Diamonds (DIA) track DJIA
Spiders (SPY) track S&P 500
Qubes (QQQ) track NASDAQ 100

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Load and No-Load Funds

Load fund: a mutual fund that charges a commission when
shares are bought.
Typically sold through a broker

No-load fund: a mutual fund that does not charge a

commission when shares are bought.
Typically sold directly to investor by mutual fund
Cost savings tend to give investors a head start in achieving
superior rates of return

Low-load fund: a mutual fund that charges a small

commission (2% to 3%) when shares are bought.

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Load and No-Load Funds

Back-end load: a commission charged on the sale
of shares in a mutual fund.
12(b)-1 fee: fee charged by some mutual funds to
cover management and other operating costs;
amounts to as much as 1% of the average
net assets.
Multiple-class sales charge: different shares
classes of the same mutual fund are offered with
different fee structures.
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Other Fees and Costs

Management fee: compensation paid to professional
managers who administer the funds investment portfolio
This fee is paid by all types of funds (load vs. no-load; open-end
vs. closed-end)
Fee is charged annually on average net assets

Administrative costs: the normal costs of doing business,

such as trading expenses
Taxes on mutual funds
Mutual funds do not pay taxes if income and capital gains are
passed on to shareholders
Shareholders are taxed on their share of income and capital
gains annually

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Figure 13.4 Fund Fees

Copyright 2005 Pearson

2003 Morningstar, Inc. Used with permission.

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Table 13.2 Fund Fees

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Unit Investment Trusts (UIT)

Fixed pool of securities, normally bonds
Not actively managed; securities in portfolio
remain static
Have shares that represent a proportionate share
of the trust
Tend to be very costly due to high sales
commissions and high management fees

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Hedge Funds
Not really mutual funds; private limited partnerships
Not regulated by mutual fund regulations
General partner runs fund and takes 10-20% of profits;
limited partners are investors
Only sold to accredited investorsnet worth greater
than $1,000,000 and/or annual income over $200,000
Use arbitrage strategies, options, short sales and other
other complex strategies

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Types of Mutual Funds

Growth Fund: primary goals are capital
gains and long-term growth
Invest in large, well-established companies with
above-average growth potential
Little or no dividend income
Moderately risk investments for more
aggressive investors

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Types of Mutual Funds (contd)

Aggressive Growth Fund: highly speculative
mutual fund that seeks large profits from
capital gains
Invest in small, unseasoned companies with high
price/earnings ratios
Often look for turnaround situations
Prices are often highly volatile
High risk investments for very aggressive investors

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Types of Mutual Funds (contd)

Value Fund: seeks stocks that are undervalued in
the market
Focus is on intrinsic value of stocks and requires
extensive fundamental analysis
Invest in stocks with low P/E ratios, high dividend
yields and promising futures
Looks for undiscovered companies with potential for
future growth
Less risky investments for relatively conservative
investors looking for moderate growth

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Types of Mutual Funds (contd)

Equity-income Fund: emphasizes current income and
capital preservation
Focus is on high current income with some long-term capital
appreciation
Invest in high-yielding common stocks, convertible
securities or preferred stocks
Invests in blue chip stocks and other
high-grade securities
Typically less price volatility than overall stock market
Less risky investments for relatively conservative investors
looking for moderate growth

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Types of Mutual Funds (contd)

Balanced Fund: generates a balanced return of
both current income and long-term capital gains
Invest in blend of fixed-income securities and common
stocks, with 25% to 30% in fixed income
Allocation between stocks and bonds typically remains
constant or varies very little
Emphasis between fixed-income and common stocks can
be shifted as market conditions change
Less risky investments for relatively conservative
investors looking for moderate growth

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Types of Mutual Funds (contd)

Growth-and-Income Fund: seeks both
long-term growth and current income, with
primary emphasis on capital gains
Focus is on long-term capital appreciation with some
high income to provide limited stability
Invest in blend of commons stocks and fixed-income
securities, with up to 90% in common stocks
Moderate risk investments for investors who can
tolerate moderate price volatility

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Types of Mutual Funds (contd)

Bond Funds: invests in various kinds and grades
of bonds, with income as primary objective
Advantages of bond funds over individual bonds:
More liquid
Offer high diversification
Bond funds automatically reinvest interest

Lower risk investments for investors who are looking

for steady income
Some price volatility occurs with changing
interest rates
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Types of Bond Funds

Government bond funds: invest in U.S. Treasury and
agency securities.
Mortgage-backed bond funds: invest in mortgage-backed
securities of U.S. government, such as GNMAs.
High-grade corporate bond funds: invest in corporate
bonds rated triple-B or better.
High-yield corporate bond funds: invest in lower rated
corporate bonds (junk bonds).
Convertible bond funds: invest in securities that can be
converted into common stocks.
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Types of Bond Funds (contd)

Municipal bond funds: invest in
tax-exempt securities issued by states and
political subdivisions
Single-state fund: invests in municipal issues of only one
state to provide double tax-free income

Intermediate-term bond funds: invest in bonds with

maturities of 7 to 10 years or less
Short-term bond funds: invest in bonds with
maturities of 2 to 5 years
Often used as alternative to money market funds when
interest rates are low

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Money Market Funds

Invest in short-term securities with maturities of less than 90
days
Interest rates move up and down with market rates
Trade at a constant net asset value of $1 per share
Considered a safe, convenient investment to accumulate
capital and temporarily store idle funds
Types of money market funds:
General purpose: invests in all types of money market investments
Government securities: invest only in U.S. Treasury bills and other
short-term government securities
Tax-exempt: invest in very short-term tax-exempt
municipal securities

Types of Mutual Funds

Index Funds: buys and holds a portfolio of stocks
(or bonds) equivalent to those in a specific
market index
Objective is to match, not beat, the specific index
Strategy is buy-and-hold, which provides tax
advantages with very little taxable capital gains
Operating costs are very low due to low turnover in
investment portfolio

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Types of Mutual Funds (contd)

Sector Funds: investments are restricted to a
particular segment of the market
Investments are concentrated in one specific
industry sector
Objective is to produce capital gains
Considered speculative because limited
diversification can increase investment risks

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Types of Mutual Funds (contd)

Socially Responsible Funds: funds that actively and
directly incorporate ethics and morality into the
investment decision
Specific stocks are evaluated on financial criteria and moral, ethic
or environmental tests
Stocks that do not meet these tests are not considered for the
investment portfolio
Examples of excluded companies:
Tobacco or alcohol
Gambling
Nuclear energy

Returns may be reduced due to limited investment opportunities

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Types of Mutual Funds (contd)

Asset Allocation Funds: funds that spread
investors money across stocks, bonds, and money
market securities
Provides built-in asset allocation by professional
investment manager
As market conditions change over time, the asset
allocation mix changes as well
Provides convenience of one-stop shopping without
having to own several mutual funds

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Types of Mutual Funds (contd)

International Funds: funds that do all or most of their
investing in foreign securities
Objective is to benefit from changes in:
International market conditions
Valuation of U.S. dollar

Funds can specialize in international stocks, bonds or money

market securities
Funds can specialize in growth, value, aggressive growth and
other types of stocks
Funds can specialize in specific countries or regions of the world
Considered fairly high-risk due to currency exchange risks

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Mutual Fund Investor Services

Automatic investment plans
Regular investment from checking or savings
account or paycheck
Monthly amounts as small as $25
Excellent way to build up investment over time

Automatic reinvestment of interest,

dividends, and capital gains
Systematic withdrawal plans
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Mutual Fund
Investor Services (contd)
Conversion (exchange) privileges
Load funds usually allow exchanges between
mutual funds in the same fund family without
paying additional sales loads

Phone switching
Easy establishment of retirement plans

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Investor Uses of Mutual Funds

Accumulation of Wealth
Storehouse of Value
Speculation and Short-Term Trading

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Selecting Mutual Funds

Determine if you want to use mutual funds
in portfolio
Mutual funds increase diversification
Mutual funds offer expertise in areas where investor
may not be informed
Can use stocks and mutual funds

Compare mutual funds investment objective to

investors objective
Compare range of services offered
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Sources of Information
Fund prospectus
The Wall Street Journal
Barrons, Money, Fortune or Forbes
Morningstar Mutual Funds
Wiesenberger Investment Companies Service
Value Line Mutual Fund Survey

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Factors in Comparing Mutual Funds

Funds investment performance
Tax efficiency
Fee structure
How particular fund fits into your portfolio
Investment skills of fund managers
Load or No-Load funds
Closed-End or Open-End funds
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Comparing Closed-End and

Open-End Funds
Brokerage commissions apply to closed-end funds
Open-end funds have greater liquidity
Closed-end funds trade at premium (or discount)
to NAV
Avoid closed-end funds trading at premium
Look for closed-end funds trading at discount
Premium(ordiscount) (Shareprice NAV) / NAV

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Sources of Return
from Mutual Funds
Dividend income
Capital gains distributions
Change in price/NAV
Unrealized capital gains (paper profits): capital
gain that has not been realized since funds
holdings have not been sold

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Calculating Return:
Holding Period Return
Returns include distributions of dividends,
distributions of capital gains, or NAV appreciation
Return for specific holding period
Best for one year returns since does not use
present value
Holdingperiod

return

Numberof
sharesatend
ofperiod

Numberof

Initial

sharesatbeginning
price

ofperiod

Numberofshares
Initial

atbeginning ofperiod
price

Ending

price

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Chapter 13 Review
Learning Goals
1. Describe the basic features of mutual funds, and note
what they have to offer as investment vehicles.
2. Distinguish between open- and closed-end funds, as
well as other types of professionally managed
investment companies, and discuss the various types of
fund loads, fees, and charges.
3. Discuss the types of funds available and the variety of
investment objectives these funds seek to fulfill.

Copyright 2005 Pearson

13-43

Chapter 13 Review (contd)

Learning Goals (contd)
4. Discuss the investor services offered by mutual
funds and how these services can fit into an
investment program.
5. Gain an appreciation of the investor uses of mutual
funds, along with the variables to consider when
assessing and selecting funds for investment purposes.
6. Identify the sources of return and compute the rate of
return earned on a mutual fund investment.

Copyright 2005 Pearson

13-44