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
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
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
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.
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
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
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
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
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%)
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
D. TYPES OF FUNDS (CONTINUED)
 Bond Funds
 Objective is to invest in bonds
 a. Income is primary objective
 b. Two advantages

 Liquidity
 Diversification
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
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

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
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
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
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
F. RISK
 Because Mutual Funds are so well diversified (typically), the inherent risk is similar to that in the
Market

p However, Specialty Fund risk can vary significantly from overall Market risk


Systematic  Market
5 30 Assets
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
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
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.
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.
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
MUTUAL FUND STYLE ANALYSIS:
 Source of Information:
Advisor Software
Style Data
1-800-738-6369
http://www.advisorsw.com
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.
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.
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.
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.
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.
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.
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.
THE FIVE-STAR MYTH
 4. The best funds to buy are those rated 4 or 5 Stars
by Morningstar.
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
 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 isa 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
 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
 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 Janus Olympus was up 30% the first
9 months of 1996.