Fundamentals of investing

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13.1 What Is a Mutual Fund? LEARNING OBJECTIVE 13.1 LEARNING OBJECTIVE 13.1 Distinguish different types of investment companies based on key characteristics.

In the Feature Story, José and Maria were able to invest in stocks and bonds without having to make the individual investment selections themselves. You can do this by purchasing shares of an investment company that pools small dollar amounts from many investors and invests those funds in a wide variety of assets. Each investment company must provide detailed background information for potential buyers, including the company's investment objectives, holdings, and track record. Investors like José and Maria buy shares in the investment company, and the company uses the dollars to make investments on behalf of the investment pool. The term mutual fund is often used to refer to all types of investment companies, but technically, a mutual fund is a specific type called an open- end investment company, which we explain later. Although the mechanism can differ across funds, the cash flows generated by the securities in the investment pool are later distributed to the investors. As with stock investments, this distribution can take the form of dividends or an increase in the value of investment shares. Investors who purchase shares in mutual funds are like other corporate shareholders—they have an equity interest in the pool of assets and a residual claim on the profits, but they have no say in day-to-day decisions about buying and selling the financial assets. Until the enactment of comprehensive securities laws in the 1930s, investors didn't have a lot of confidence in this type of investment. Today, however, mutual fund shares are considered securities under the legal definition of the word, and shareholders are therefore entitled to all the protections afforded to owners of other financial assets. That means the investment company must provide all potential investors with detailed disclosure information, much like the information you'd get for a stock or bond investment. The company also must make regular reports to the Securities and Exchange Commission, which regulates mutual funds. In this section, we first take a closer look at the mutual fund investor's ownership interest, usually measured as net asset value. You'll learn about the various types of investment companies and the advantages and costs associated with mutual fund investing. What Does a Mutual Fund Investor Actually Own? One measure of the value of an investor's claim on a mutual fund's assets is called the net asset value. This is calculated as assets minus liabilities, per share, as defined in Equation 13.1:

(13.1)

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For example, suppose you own one share of a mutual fund that has 5 million shares outstanding. The fund portfolio is currently worth $100 million, and its liabilities include $2 million owed to investment advisors and $1 million in rent, wages, and other expenses. Your net asset value is therefore:

() If the securities that are held in a mutual fund increase in value or pay dividends, the net asset value of the shares of the mutual fund should also increase in value, even though these increases are technically unrealized capital gains. The objective of fund managers is therefore to invest in assets that will continue to grow in value over time. This is an important point to keep in mind as you learn more about this type of investment—mutual fund values will tend to track the performance of the assets they invest in. So if the stock market is down, mutual funds that invest in stock will typically decline in value as well, because the assets they have invested in will have lower market values. Demonstration Problem 13.1 shows how to calculate net asset value. DEMONSTRATION PROBLEM 13.1 Calculating Net Asset Value Problem You want to calculate the net asset value for the Acme Balanced Growth and Income mutual fund. You have the following information from the January 1 balance sheet: Assets: $150 million Liabilities: $10 million Shares: 12.3 million Strategy Use Equation 13.1 to calculate net asset value.

A mutual fund investor earns a return on their investment in the same way as stock and bond investors. They are paid dividends on their shares, and they benefit from an increase in the net asset value of their shares over time. As you learned in previous chapters, the rate of return on investment will be

. Suppose you bought the shares described in Demonstration Problem 13.1 for $11.38 per share and received a dividend during the year of $0.50 per share. If the shares are worth $12.50 one year later, you have earned a return of

or 14.24%.

Types of Investment Companies Although different types of investment companies are often lumped together in a discussion of mutual funds, the Investment Company Act of 1940 identifies several distinct types that provide pooling opportunities for individual investors. Types of investment companies include open-end funds,

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closed-end funds, exchange-traded funds, unit investment trusts, and real estate investment trusts.

Open-End Funds By far the most common type of investment company, an open-end fund is different from the other types discussed in this section in that: (1) it is required to buy back shares any time an investor wants to sell, and (2) it continuously offers new shares for sale to the public. As mentioned above, the term mutual fund typically refers to this type of investment company. With open-end funds, the share price for purchases and sales is usually the net asset value plus trading costs. The issuing company provides the only market for the shares, and there is no secondary market for trading between investors. The investment company is free to issue new shares at any time to raise additional funds for investment and to meet investor demand for the shares. Open-end funds can be very large, with many billions of dollars under management. This is the type of fund that is commonly available through employer-sponsored retirement plans. As more dollars flow into an open-end fund from retirement plan sponsors, the fund creates more shares and invests in more securities.

Closed-End Funds A closed-end fund is an investment company that issues a fixed number of shares that trade on a stock exchange or in the over-the-counter market. The process of issuing shares is very similar to that discussed in Chapter 12 for stocks. The initial public offering of shares is sold directly to investors, after which the shares trade between investors in the secondary market. Like open-end funds, closed-end funds hire professional managers to use investor's money to buy a diversified portfolio of assets that will meet the investment objectives described in the fund prospectus. Closed-end funds trade primarily on major stock exchanges, such as the New York Stock Exchange and the NASDAQ. The market values of shares traded on the secondary market fluctuate with supply and demand and may be greater or less than the net asset value per share. Closed-end funds make up only a small proportion of the total number of investment companies (around 500 in the United States, compared with more than 9,000 open-end mutual funds) and are declining in popularity relative to their close cousin, the exchange-traded fund.

Exchange-Traded Funds An exchange-traded fund (ETF) combines some of the characteristics of open-end and closed-end funds. It is technically an open-end fund because the company is free to issue new shares or redeem old shares to increase or decrease the number of shares outstanding. But like a closed-end fund, an ETF is traded on an organized exchange, and share prices are determined by market forces. Investors buy ETF shares through a broker just as they would purchase shares of common stock of any publicly traded company. Although the number of ETFs is still small relative to the numbers of open-end funds and unit investment trusts (discussed below), their size and popularity are growing rapidly. In fact, the number of ETFs has more than doubled to nearly 2,000 in the last decade. Many ETFs are designed as index funds, investing in a set of securities that mimic the performance of a particular market index such as the S&P 500 Index, but with lower expenses and a lower minimum required investment than for actively managed funds. For these reasons, the financial press has been strongly recommending this type of

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fund, since it originated, for individual investors seeking diversification and low costs. Investors who buy shares of an ETF based on the S&P 500 (called a “Spider” because its ticker is SPY) will see an increase in the value of their shares when the S&P 500 Index increases in value. Similarly, investors in a “Diamond” (ticker DIA), an ETF based on the Dow Jones Industrial Average, will benefit when the Dow goes up. For investors who want their portfolio to track large company stocks with low expenses, either of these ETFs is a good choice. Not all ETFs today are simple index funds. Specialized versions include ETFs that use different trading strategies, such as leverage, to magnify returns (or losses), and those that track returns of much riskier asset classes, such as cryptocurrencies or precious metals. As with other investment company types, the return and risk characteristics of ETFs are totally dependent on the underlying portfolio.

Unit Investment Trusts Another type of investment company is a unit investment trust (UIT). A UIT buys and holds a fixed portfolio of securities for a period of time that's determined by the life of the investments in the trust (which usually are fixed-maturity debt securities). Because there isn't any change in the portfolio over the period of investment, this type of fund is essentially unmanaged. The manager of the pool, called the trustee, initially purchases the pool of investments and deposits them in a trust. Owners are issued redeemable trust certificates, which entitle them to proportionate shares of any income and principal payments received by the trust and a distribution of their proportionate share of the proceeds at the termination of the trust. The investors in a unit investment trust generally pay a premium over what it costs the trustee to purchase the underlying assets, providing the equivalent of a commission to the trustee for his or her services (pooling the funds and distributing the income and principal). Because the funds are unmanaged, the fee should be lower than that for a comparable managed fund, but it still can be as high as 3 to 5 percent. Why would an investor be willing to incur such a high cost? The answer lies in the type of securities that make up unit investment trusts. About 90 percent of these assets are fixed-income securities, primarily municipal bonds. Each trust specializes in a certain type of security, so one might hold only municipal bonds and another only high-yield corporate bonds. The high cost of individual bonds (usually $1,000 minimum) makes it otherwise difficult for individual investors to include these investment classes in their portfolios. The availability of unit investment trust shares means that small investors can still participate in a relatively diversified pool of specialized debt securities. Although there isn't an active secondary market for the trust certificates, the trustee will usually buy them back on request. A unit investment trust continues in existence only as long as assets remain in the trust. Thus, a trust invested in short-term securities might exist for only a few months, whereas a trust holding municipal bonds might have a life of 20 years or more, depending on the maturities of the bonds held. The number of unit investment trusts and the total dollars invested in them have remained relatively stable over the last decade.

Real Estate Investment Trusts A real estate investment trust (REIT) is a special type of closed-end fund that invests in real estate and mortgages. By law, a REIT must have a buy-and- hold investment strategy, a professional manager (the trustee), and at least 100 shareholders. The trustee initially issues shares and then uses the investors' money to buy real estate assets according to the terms of the trust, much like a unit investment trust. The difference is that the REIT doesn't have a limited life span, because most real estate investments don't have fixed maturities. An important factor for individual investors is that REITs must

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distribute 90 percent of their profits to shareholders each year, and this income will be taxable as ordinary income unless the shares are held in a tax- deferred account. REITs offer individual investors the opportunity to diversify their investment portfolios into real estate. Many investors wouldn't otherwise have access to this investment class because of the high initial investment required and the liquidity risk involved. In many respects, REITs are similar to stock investments and closed-end mutual funds, trading on national exchanges and distributing profits to the investors through dividends. REITs often specialize in particular types of real estate investments. Equity REITs, which make up a large share of the market, specialize in making direct investments in income-producing real estate, such as office buildings and shopping centers. Mortgage REITs focus on mortgage investments, such as residential and construction loans. REITs can provide diversification for your portfolio because their prices do not tend to go up and down at the same time as stock and bond prices. However, they aren't as liquid as stocks and are highly sensitive to the real estate market environment. In the early 2000s, REIT investors benefited from the real estate bubble, earning higher returns than investors in most other asset classes. But when real estate prices plummeted later in the decade, contributing to the 2008 financial crisis, REIT investors were badly affected. As shown in Figure 13.1, the average equity REIT lost about two-thirds of its value between April 2007 and February 2009, much more than the decline in the stock market over that period. Fortunately for investors, as the economy recovered and real estate prices stabilized, REIT shares returned to their pre-2008 values.

Figure 13.1Equity REIT Total Return IndexREIT investors were hard hit by the financial crisis, but the real estate market rebounded strongly from 2009 to 2019. Source: FTSE NAREIT U.S. Real Estate Index Series for Equity REITs, nareit.com.

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Growth in the Market Mutual fund investing by individuals has dramatically increased over the last several decades. In 1980, fewer than 6 percent of households owned mutual fund shares. In 2018, as shown in Figure 13.2, nearly 44 percent were mutual fund investors, in large part due to the growth in defined- contribution retirement plans and IRAs. When asked why they invest in mutual funds, 94 percent say they are saving for retirement, and 48 percent say they are saving for emergencies. Although the number of mutual funds hasn't changed much, total investments have experienced tremendous growth since 1995, as shown in Table 13.1.

Figure 13.2Percentage of U.S. Households Owning Mutual FundsAfter growing fast for several decades, the proportion of households owning mutual funds has stabilized. Source: Data from Investment Company Institute, 2019 Fact Book, www.ici.org. Table13.1Growth in Number and Total Assets of U.S. Funds, by Type of Investment Company

Open-end Funds Closed-end Funds Exchange-traded Funds Unit Investment Trusts Number of FundsAssets ($ billions)Number of FundsAssets ($ billions)Number of FundsAssets ($ billions)Number of FundsAssets ($ billions)

1995 5,761 $2,811 499 $143 2 $1 12,979 $73 2000 8,370 6,965 481 143 80 66 10,072 74 2005 8,449 8,891 634 276 204 301 6,019 41 2010 8,536 11,833 624 238 950 992 5,971 51

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2015 9,517 15,652 559 261 1,644 2,101 5,188 94 2018 9,599 17,707 506 250 1,057 3,371 4,917 70 Source: Data from Investment Company Institute 2019 Factbook, www.ici.org.

Fund Classifications Mutual funds are usually classified based on investment objectives and portfolio composition. As the competition for investors' dollars has grown, mutual fund companies have attempted to distinguish themselves from competitors, creating so much diversity that it isn't always easy to categorize funds. The classifications suggested in this section aren't uniformly applied, but will familiarize you with the terms commonly used to describe mutual funds. In general, you'll find that the most important distinctions among funds are the type of investment (equity versus debt) and the investment objective (income versus capital gain).

Classification by Investment Objective Each mutual fund has a specific investment policy, which is described in the fund's prospectus. For example, money market mutual funds, introduced in Chapter 3, consider the preservation of capital to be an important investment objective. To achieve this objective, the fund managers must invest in short-term, low-risk debt securities. Investors know this in advance and therefore have specific expectations about the performance of this type of fund based on its objective. The most common general investment policy categories are capital appreciation (growth), income, and preservation of capital, but the objectives of a given fund may include more than one of these.

Growth Funds The primary objective of a growth fund is capital appreciation. Managers attempt to select assets that will experience above-average growth in value over time. Because growing companies tend to be riskier than stable companies, growth mutual funds are more appropriate for investors who are willing to bear a little more risk to achieve a higher long-run return. Growth funds are often placed in subcategories depending on the level and type of risk represented by the investment portfolio. For example, an aggressive growth fund invests only in risky companies that pay no dividends, whereas a moderate growth fund, while still focused on capital appreciation, might invest in larger companies that pay stable dividends but have the potential for good appreciation in value. Aggressive growth funds, as you'd expect, are much riskier and expose you to greater potential losses in the event of a market downturn.

Income Funds In contrast to a growth fund, an income fund holds stock and bond investments that provide high current income, either in dividends or interest. These funds tend to be viewed as less risky than growth funds, because the investor is realizing immediate gains rather than taking the risk of waiting for future

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gains. As with growth funds, there are various subcategories within this group, most commonly based on the source of the income (interest versus dividends) and the risk level (high-quality debt versus junk bonds).

Growth and Income Funds Some funds try to straddle the fence, providing reasonable income to investors while still investing in companies that have good potential for growth in value. Primarily invested in growth-oriented blue chip stocks, these funds have generated respectable returns over time and have been more stable than the market as a whole.

Balanced Funds A balanced fund, sometimes called a hybrid fund, provides investors with the opportunity to benefit from investments in both stocks and bonds. Because they are better diversified than funds that are entirely invested in stocks and because they tend to focus on high-grade securities, balanced funds tend to have stable returns over time. These funds are similar to income funds but focus more on reducing investment risk.

Value Funds A value fund invests in companies that its managers believe to be currently undervalued by the market—companies with good fundamentals whose stock prices are low relative to their perceived potential. As there are always many other investors seeking these same undiscovered gems, the risk of being wrong is fairly high. Value funds are a little less risky than aggressive growth funds but still offer fairly good returns.

Life-Cycle and Target-Date Funds A life-cycle fund allocates fund assets based on the age of the investor. A fund for 30-year-olds will be invested in riskier assets than a fund for 60-year- olds. A target-date fund adjusts the portfolio allocation to meet objectives related to a particular future need for cash, such as retirement or education funding. Funds of this type often have names like “Retirement 2040.” Generally, life-cycle and target-date funds attempt to rebalance the portfolio to gradually reduce risk as the investor gets older. If you're 30 years old, you could select a life-cycle fund that is designed for your age group. However, if you plan to retire earlier or later than average for your age group, you might prefer a target-date fund instead. Given the financial planning emphasis on changing needs over the life cycle, the idea behind the design of these types of funds is sound, although there isn't always agreement on the optimal asset mix. The number and variety of life-cycle and target-date funds increased substantially after the passage of the Pension Protection Act of 2006, which requires employers to offer a reasonable option to employees who are automatically enrolled in an employer-sponsored retirement plan. Because of their simplicity for the investor, these funds have become very popular choices for 401(k) plan assets. More than two-thirds of 401(k) plans now offer target- date and life-cycle funds as investment options, and more than 50% of plan participants allocate at least some of their savings to these funds.

Classification by Portfolio Composition

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In addition to being classified by investment objective, funds are also commonly categorized based on portfolio composition. This can involve some combination of asset class, industry representation, and index benchmark.

Asset Class Mutual funds commonly confine their investments to certain asset classes, such as stocks versus bonds, although as we've seen, some funds hold both stocks and bonds. Within each broad asset class, funds may be further classified according to such features as size of company (large-cap, mid-cap, or small-cap) or type of asset (long-term Treasury bonds, high-grade corporate bonds, or municipal bonds). When you invest in a mutual fund that is concentrated in a particular asset class, the performance of your fund is likely to mimic the overall performance of that asset class. Your share values will respond to economic conditions in much the same way as do investments in individual stocks and bonds.

Industry or Sector A sector fund specializes in a particular industry or business sector, such as technology, financial services, telecommunications, or health care. These funds tend to focus on growth rather than income, and they enable investors to allocate more of their money to the sector believed to offer the most attractive returns. Because this strategy results in less diversification, sector funds tend to be riskier over time than those that cover more industry groups. For example, we saw earlier how REITs were stars in the early 2000s but had bigger losses than investments in other sectors during the financial crisis.

Geographical Focus When the U.S. stock market is down, investors can benefit from global diversification. An international fund invests exclusively in securities from other countries. Some funds include securities from a particular region, such as Latin America or Asia. Others, commonly referred to as country funds, specialize in securities from a particular country. In contrast, a global fund attempts to diversify globally, investing in U.S. as well as foreign securities.

Index Funds Many managed funds try to mimic the performance of a particular index, such as the S&P 500 Index, without necessarily buying every stock that is included in the index. The performance of such a fund is judged by how well it compares with the performance of its benchmark index. Many academic studies, however, have shown that it's difficult for an actively managed fund to beat its benchmark. As an alternative, index funds attempt to buy and hold a selection of stocks that can mimic the market more exactly and at lower cost. If the index fund is targeting the Dow Jones Industrial Average or the S&P 500 Index, for example, it will usually buy all the stocks in that index in about the same proportions and will therefore be able to track the index almost exactly. For indexes that include a much larger number of stocks, such as the New York Stock Exchange Index, the index fund might try to buy a smaller selection of representative stocks. Because index funds buy and hold, trading costs and fund expenses are minimized.

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Socially Responsible Funds If the “bottom line” is not your primary focus, you might be interested in a socially responsible investing (SRI) fund. The manager of an SRI fund is charged with selecting stocks issued by companies that meet some predefined ethical and moral standards. Although the objectives of various funds differ, common issues that are considered are a company's policies toward employees and the environment. For this reason, companies are commonly rated based on ESG criteria (environmental, social, and governance), making it easier for investors to identify qualifying investments. SRI funds also commonly avoid securities of companies that are involved in “sin industries” such as tobacco, alcohol, and gambling. Note that there are also socially irresponsible funds (like the VICE Fund) that specifically invest in such industries. Reflection Question 1 Is being a socially responsible investor important to you? Why or why not?

You can use Interactive: Mutual Fund Classifications to review the various types of mutual funds. INTERACTIVE See Interactive: Mutual Fund Classifications in WileyPLUS.