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Chapter 14

Mutual Funds: An
Easy Way to
Diversify

Learning Objectives
1. Weigh the advantages and disadvantages
of investing in mutual funds.
2. Differentiate between types of mutual
funds, ETFs, and investment trusts.
3. Calculate mutual fund returns.
4. Classify mutual funds according to
objectives.
5. Select a mutual fund thats right for you.

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Introduction
A way of holding investments such as stocks
and bonds.
Mutual fundan investment that raises from
investors, pools the money, and invests it in
stocks, bonds, and other investments.
Each investor owns a share of the fund
proportionate to his/her investment.

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Why Invest in Mutual Funds?


Advantages of mutual funds:

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Diversification
Professional management
Minimal transaction costs
Liquidity
Flexibility
Service
Avoidance of bad brokers

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Why Invest in Mutual Funds?


Disadvantages of mutual funds:

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Lower-than-market performance
Costs
Risks
You cant diversity away a market crash
Taxes

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Mutual Fund-Amentals
A mutual fund pools money from investors
with similar financial goals.
You are investing in a diversified portfolio
thats professionally managed according to
set goals.
Investment objectives are clearly stated.

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Mutual Fund-Amentals
As the value of the securities in the fund
increases, the value of each mutual fund
share also rises.
Most pay dividends or interest to
shareholders.
Shareholders receive a capital gains
distribution when the fund sells a security
for more than originally paid.
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Mutual Fund-Amentals
Fund is set up as a corporation or trust.
Shareholders elect a board of directors.
Fund is run by a management company.
Each individual fund hires an investment advisor
to oversee the fund.
Contracts with a custodian, a transfer agent, and
an underwriter.
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Investment Companies
Invest the pooled money of a number of
investors in return for a fee
Most popular are the open-end investment
companies or mutual funds
Net asset value (NAV)dollar value of a
share in the mutual fund

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Investment Companies

Closed-End Investment Companiescant


issue new shares
Unit Investment Trustsfixed pool of securities
Real Estate Investment Trusts (REITs)
specializes in real estate
Hedge Fundsvery risky
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Calculating Mutual Fund Costs


and Returns
Commissions when you buy or sell your
holdings
Annual management fee
Marketing expenses

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Load Versus No-Load Funds


Loadcommission charged on a mutual fund
Load fundmutual fund on which a load is
charged.
Class A sharesfront-end sales load
Class B sharesback-end load
Class C sharespay coming and going
No-load funddoesnt charge commission

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Management Fees and Expenses


Expense ratiothe ratio of a mutual funds
expenses to its total assets
Invest in a fund with a low expense ratio
Turnover ratemeasures the level of the
funds trading activity.
Higher turnover rate, higher the funds
expenses.
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12b-1 Fees
Annual fee, generally ranging from 0.25 to
1% of a funds assets, that the mutual fund
charges its shareholders for marketing
costs.

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Calculating Mutual Fund Returns


Return can be in the form of dividends,
capital gains, or a change in net asset value.
Automatic reinvestments result in increases
in the NAV and number of shares.
Calculating returns can help you spot funds
that have consistent winners over time.

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Calculating Mutual Fund Returns

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Types and Objectives of Mutual


Funds
Fund managers classify their own funds
First, determine your objectives
Then, you can likely find a mutual fund to
meet your objectives

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Money Market Mutual Funds


Invest in Treasury bills, CDs, and other shortterm investments, less than 30 days
Carry no loads, trade at a constant $1 NAV,
and have minimal expense ratios
Tax-exempt money market fund
Government securities money market mutual
fund
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Stock Mutual Funds

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Aggressive growth funds


Small company growth funds
Growth funds
Growth-and-income funds
Sector funds
Index funds
International funds

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Balanced Mutual Funds


Tries to balance objectives of long-term
growth, income, and stability
Hold both common stock and bonds and
sometimes preferred stock
Aimed at those needing income to live on
and moderate stability in their investment
Less volatile than stock mutual funds

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Asset Allocation Funds


Invests in stocks, bonds, and money market
securities
Move money between stocks and bonds to
outperform the market
Balanced funds that practice market timing

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Life Cycle and Target Retirement


Funds
Mutual funds that try to tailor their holdings
to the investors individual characteristics,
such as age and risk
Target retirement funds are managed based
on when you plan to retire

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Bond Funds
Mutual funds that invest primarily in bonds
Fluctuate in value with market interest rates
Use for small amounts of money, to keep
investments liquid
Otherwise, use individual bonds where there
is no professional management or fees
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U.S. Government Bond Funds or


GNMA Bond Funds
Municipal Bond Funds
Corporate Bond Funds
Bond Funds and Their Maturities:
Short-term (1-5 years)
Intermediate-term (5-10 years)
Long-term (10-30 years)

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Exchange Traded Funds or ETFs


A hybrid between a mutual fund and an
individually traded stock or bond that trade
on an exchange like individual securities do
and can be bought and sold through the
trading day.

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Exchange Traded Funds or ETFs


Charge lower annual expenses but still pay
trading commissions.
More tax-efficient than most mutual funds.
Allow investors to stake out an investment
position in a sector, industry, or country.
Investors can make their move during the
markets trading hours.
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Mutual Fund Services


Automatic investment and withdrawal plans
Automatic reinvestment of interest,
dividends, and capital gains
Wiring and funds express options
Online and phone switching
Easy establishment of retirement plans
Check writing
Bookkeeping and help with taxes

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Buying a Mutual Fund


Step 1: Determining Your Goals

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Goals and time horizon


Why are you investing?
Tax-deferred investments?
Risk tolerance

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Buying a Mutual Fund


Step 2: Meeting Your Objectives
Look at classifications and objectives

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Buying a Mutual Fund


Step 3: Selecting the Fund
Evaluate past performance and scrutinize the
costs
Make sure it meets your objectives

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Buying a Mutual Fund


Step 4: Making the Purchase
Buy directuse phone or internet
Buy through a mutual fund supermarketsuch
as Fidelity or Charles Schwab & Co.

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Summary
When you buy a mutual fund, youre buying
a share of a very large portfolio which goes
up and down as the value of the mutual
funds investments goes up and down.
There are open-end and close-end
investment companies, unit investment
trusts, and real estate investment trusts.

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Summary
Be very wary of mutual fund expensesnoload mutual funds dont charge commission.
Funds are classified according to objective.
When selecting a mutual fund, determine
your goals, find funds that meet your
objectives, and evaluate.

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