Bond rating

15 Investing through Mutual Funds

YOU MUST BE KIDDING, RIGHT?

Twins Huan-yue and and Hao Wang invest in mutual funds. Huan-yue majored in English in college. For more than 20 years, she invested in managed funds, counting on professional financial advisers to select the winning companies more often than not. Hao majored in Finance; he invested in unmanaged index mutual funds that achieve the same return as a particular market index by buying and holding all or a representative selection of securities in the index. After 20 years of investing, what are the odds that Huan-yue's investment portfolio balance will be better than Hao's?

A. zero

B. 10%

C. 20%

D. 30%

The answer is A. Managed mutual funds generally do not earn returns for investors that exceed the overall market indexes. The fact is the average mutual fund manager earns a lower return at least 90 percent of the time over 5-year time periods. Finding a mutual fund investment manager who can consistently beat the market is very challenging!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Describe the features, advantages, and unique services of investing through mutual funds.

 Differentiate mutual funds by investment objectives.

 Summarize the fees and charges involved in buying and selling mutual funds.

 Establish strategies to evaluate and select mutual funds that meet your investment goals.

WHAT DO YOU RECOMMEND?

Tyler and Samantha Gent, a couple in their early 30s, have a 2-year-old child and enjoy living in a moderately priced downtown apartment. Tyler, a library director, earns $60,000 annually. Samantha earns $69,000 as a merchandise buyer for a specialty store. They are big savers: together they have been putting $1000 to $2000 per month into CDs, and the couple now has a portfolio worth $120,000 paying about 2 percent annually. The Gents are conservative investors and want to retire in about 20 years.

What do you recommend to Tyler and Samantha on the subject of investing through mutual funds regarding:

1. Redeeming their CDs and investing their retirement money in mutual funds?

2. Investing in growth and income mutual funds instead of income funds?

3. Buying no-load rather than load funds?

4. Buying mutual funds through their employers' 401(k) retirement accounts rather than saving through a taxable account as they have been doing?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to investing through mutual funds:

1. Match your investment philosophy and financial goals to a mutual fund's objectives.

2. Save regularly, pick an asset mix of mutual funds that matches your goals, and keep investment costs low by avoiding 12b-1 fees and high management fees.

3. Use your criteria to screen mutual fund investments using free online software.

4. Invest regularly in mutual funds through your employer's retirement plan.

5. Sign up for automatic reinvestment of your mutual fund dividends.

Most investors prefer to avoid buying individual stocks and bonds because of the high financial risk associated with owning too few investments like two or three stocks or bonds. The average investor usually cannot accumulate a portfolio diversified enough to minimize the risk linked to the failure of a one or two holdings. They often also lack both the ability and the time required to research individual securities and manage such a portfolio. In an effort to avoid these problems, many people invest in the stock and bond markets through mutual funds, which typically buy hundreds of different stocks and bonds. Mutual funds make it easy and convenient for investors to open an account and continue investing throughout their lives. Half of all households invest through mutual funds.

15.1 WHY SHOULD YOU INVEST IN MUTUAL FUNDS?

A  mutual fund  is an investment company that pools funds obtained by selling shares to investors and makes investments to achieve the financial goal of income or growth, or both. Mutual funds invest in a diversified portfolio of stocks, bonds, short-term money market instruments, and other securities or assets.

mutual fund Investment company that pools funds by selling shares to investors and makes diversified investments to achieve financial goals of income or growth, or both.

The fund might own common stock and bonds in such companies as AT&T, IBM, Google, or Running Paws Cat Food Company (our fictional example from Chapter 14). The combined holdings are known as a portfolio, as we noted in Chapter 13 and as shown graphically in Figure 15-1. The mutual fund company owns the investments it makes and the mutual fund investors own the mutual fund company. Unlike corporate shareholders, holders of mutual funds have no say in running the company, although they have equity interest in the pool of assets and a residual claim on the profits.

LEARNING OBJECTIVE 1

Describe the features, advantages, and unique services of investing through mutual funds.

15.1a The Net Asset Value Is the Price You Pay for a Mutual Fund Share

One measure of the investor's claim on assets is the net asset value. The  net asset value (NAV)  is the price one pays (excluding any transaction costs) to buy a share of a mutual fund. It is the per-share net worth of the mutual fund. It is calculated by summing the values of all the securities in the fund's portfolio, subtracting liabilities, and then dividing by the total number of shares outstanding.

net asset value (NAV) Per-share value of a mutual fund.

Figure 15-1  How a Mutual Fund Works

For example, a mutual fund has 10 million shares outstanding and a portfolio worth $100 million, and its liabilities are $5 million. The net asset value of a single share is

The NAV rises or falls to reflect changes in the market value of the investments held by the mutual fund company. This value is calculated daily after the U.S. stock exchanges close, and a new NAV is posted in the financial media. If the stocks and bonds held in a mutual fund increase in value, the NAV will rise. For example, if a mutual fund owns IBM and General Electric common stocks and the prices of those stocks increase, the increased value of the underlying securities is reflected in the NAV of fund shares. This is price appreciation. Some time later when investors sell shares at a net asset value higher than that paid when they purchased the shares (after transaction costs), they will have a capital gain.

The type of mutual fund that is the focus in this chapter is an  open-end mutual fund . Accounting for more than 90 percent of all funds, open-end mutual funds issue redeemable shares that investors purchase directly from the fund (or through a broker for the fund). They are always ready to sell new shares of ownership and to buy back previously sold shares at the fund's current NAV. Open-end mutual funds, numbering more than 13,000, total more than the stocks listed on the New York Stock Exchange (approximately 2800). Table 15-1 lists advantages of investing through mutual funds.

open-end mutual fund Investment that issues redeemable shares that investors purchase directly from the fund (or through a broker for the fund).

15.1b Dividend Income and Capital Gains Distributions Result from the Mutual Fund's Earnings

A  mutual fund dividend  is income paid to investors out of profits that the mutual fund has earned from its investments. The dividend represents both ordinary income dividend distributions and capital gains distributions.  Ordinary income dividend distributions  occur when the fund pays out dividends from the stock and interest from the bonds it hold in its portfolio. These are passed onto the investor quarterly.  Capital gains distributions  represent the net gains (capital gains minus capital losses) that a fund realizes when it sells securities that were held in the fund's portfolio. Mutual funds distribute capital gains once a year, even though the gains occur throughout the year whenever securities are sold at a profit. When a fund pays out these distributions, the NAV drops by the amount paid.

mutual fund dividend Income paid to investors out of profits earned by the mutual fund from its investments.

ordinary income dividend distributions Distributions that occur when the fund pays out dividends from the stock and interest from the bonds it hold in its portfolio; these are passed onto the investor quarterly.

capital gains distributions Distributions representing the net gains (capital gains minus capital losses) that a fund realizes when it sells securities that were held in the fund's portfolio.

DO IT IN CLASS

Table 15-1 Advantages of Investing Through Mutual Funds

Diversification	Many investors find it easier to achieve diversification through ownership of mutual funds that own hundreds of stocks and bonds rather than picking and then owning individual stocks and bonds.
Affordability	Individuals can invest in mutual funds with relatively low dollar amounts for initial purchases, such as $250 or $1000. Subsequent purchases can be as little as $50.
Professional Management	The fund's investment advisers have access to excellent research, and they select, buy, sell, and monitor the performance of the securities purchased; they oversee the portfolio.
Liquidity	You can very easily convert mutual fund shares into cash without loss of value because the investor sells (or  redeems ) the shares back to the investment company by using a telephone, wire, fax, mail, or online.
Low Transaction costs	Because mutual funds trade in large quantities of shares, they pay far less in brokerage commissions than stock investors. Shares bought and sold are at the NAV plus any fees and charges that the fund imposes, and these are often quite low.
Uncomplicated Investment choices	Selecting a mutual fund is easier than selecting specific stocks or bonds because mutual funds state their investment objectives, allowing investors to select funds that almost perfectly match their own objectives.

redeems When an investor sells mutual fund shares.

15.1c Capital Gains Can Result When You Sell Mutual Fund Shares

When you sell your shares in the mutual fund, you receive the NAV of the share at its current market price. If the price is higher than the price you originally paid, you have a capital gain due to the increase in the NAV although your gain is reduced by transaction costs.

Reinvesting income greatly compounds share ownership. Figure 15-2 illustrates the positive results obtained by reinvesting dividends.

15.1d Unique Mutual Fund Services

A  mutual fund family  is an investment management company that offers a large number of different mutual funds to the investing public, each with its own investment objectives. There are more than 400 mutual fund families (see biz.yahoo.com/p/fam/a-b.xhtml).

mutual fund family Investment management company that offers a number of different funds to the investing public, each with its own investment objectives or philosophies of investing.

Mutual funds, as shown in Table 15-2, offer a number of valuable services that are unique to this type of investment and that are helpful and appealing to investors. More than 40 percent of the total return of the S&P 500 over the past 80 years has come from reinvested dividends. Enrolling in an automatic reinvestment program is a smart and easy way of accumulating wealth over time.

Figure 15-2  The Wisdom of Automatic Dividend Reinvestment

The initial $10,000 investment in S&P 500 Index Fund grew to $58,000 over 20 years, instead of $40,000, because of the reinvestment of dividends.

DO IT IN CLASS

Table 15-2 Unique Mutual Fund Services

Convenience	Funds make it easy to open an account and invest in and sell shares. Fund prices are widely quoted. Services include toll-free telephone numbers, detailed records of transactions, checking and savings alternatives, and the paperwork and record keeping, including accounting for fractional shares.
Ease of Buying and Selling Shares	Opening an account with a mutual fund company is as simple as opening a checking account. After making your initial investment, you can easily buy more shares. Shares can be bought or sold at any time. Each is redeemed at the closing price—the NAV—at the end of the trading day.
Check Writing and Electronic Transfers	Mutual funds often offer interest-earning, check-writing money market mutual funds in which investors can accumulate cash, accept dividends, or hold their money. Investors can electronically transfer funds to and from mutual funds and banks.
Automatic Reinvestment of Income and Capital Gains	Mutual funds allow investors to choose to receive current income payments or have them automatically reinvested to purchase additional fund shares (often without paying any commissions). This is  automatic reinvestment , as illustrated in Figure 15-2.
Exchange Privileges	An  exchange privilege  permits mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund managed by the same mutual fund family, usually at no cost.
Automatic Investment Program (AIP)	Funds often allow investors to make periodic monthly or quarterly payments using money automatically transferred from their bank accounts or paychecks to the mutual fund company. You can invest as little as $25 monthly or quarterly.
Effortless Establishment of Retirement Plans	An employee can fill out a one-page form that directs his or her employer to transfer a specified dollar amount from every paycheck to a mutual fund to buy shares for a 401(k) plan. Similarly, individuals can fill out a one-page form to buy shares for their individual retirement accounts.
Beneficiary Designation	A  beneficiary designation  enables the shareholder to name one or more beneficiaries so that the proceeds go to them without going through probate.
Withdrawal Options	Mutual funds offer  withdrawal options  (also called  systematic withdrawal plans ) to shareholders who want to receive income on a regular basis from their mutual fund investments. The minimum withdrawal amount is $50 at regular intervals. You may make regular withdrawals by (1) taking a set dollar amount each month, (2) cashing in a set number of shares each month, (3) taking the current income as cash, or (4) taking a portion of the asset growth.

automatic reinvestment Investor's option to choose to automatically reinvest any interest, dividends, and capital gains payments to purchase additional fund shares.

exchange privilege Allowance for mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund within a mutual fund family. Also called switching, conversion, or transfer privilege.

beneficiary designation Allowance of fund holder to name one or more beneficiaries so that the proceeds bypass probate proceedings if the original shareholder dies.

withdrawal options (systematic withdrawal plans) Arrangements with a mutual fund company for shareholders who want to receive income on a regular basis from their mutual fund investments.

DID YOU KNOW 

Types of Investment Companies

The federal Investment Company Act distinguishes among investment companies. Open-end mutual funds are by far the most widely owned investment companies. Four other types exist:

1.  Closed-end mutual funds. Closed-end mutual funds  issue a limited and fixed number of shares at inception and do not buy them back. These companies operate with a fixed amount of capital. Closed-end shares are bought and sold on a stock exchange or in the over-the-counter market. After the original issue is sold, the price of a share depends primarily on the supply and demand in the market rather than the performance of the investment company assets. Closed-end shares of about 600 companies are actively traded like common stocks and bonds, primarily on the New York Stock Exchange.

2.  Real estate investment trusts. A special kind of closed-end investment company is a  real estate investment trust (REIT) . REITs invest in a portfolio of assets as defined in the trust agreement, such as properties, like office buildings and shopping centers (called an equity REIT), or mortgages (a mortgage REIT). Hybrid REITs invest in both. REITs have no predetermined life span. There are about 160 REITs traded on the New York Stock Exchange.

3.  Unit investment trusts. A  unit investment trust (UIT)  is a closed-end investment company that makes a one-time public offering of only a specific, fixed number of units. A UIT buys and holds an unmanaged fixed portfolio of fixed-maturity securities, such as municipal bonds, for a period of time. This could be a few months or perhaps 50 years. Each unit represents a proportionate ownership interest in the specific portfolio of perhaps 10 to 50 securities. Sold by brokers for perhaps $250 to $1000 a unit, there is no trading of these securities, although brokers may repurchase and resell them. There are about 5800 UITs.

4.  Exchange-traded funds. An  exchange-traded fund (ETF)  is a basket of passively managed securities structured like an index fund as it owns all or a representative set of securities that duplicate the performance of a market segment or index. In effect, ETFs ditch the fund manager and pass the savings on to the investor. There are ETFs for the S&P 500, called Spiders; the Dow Jones Industrial Average, called Diamonds; and Qubes based on the NASDAQ 100. There are about 1200 ETFs, and their prices are set by market forces since they are listed on securities markets (primarily on the American Stock Exchange) and traded throughout the day. ETFs give investors an easy way to track an index without buying an index fund. ETFs are available for nearly every index, from large U.S. companies to health care and foreign bonds.

 CONCEPT CHECK 15.1

1. Explain how net asset value is calculated and how it is used by mutual funds.

2. List five advantages of investing in mutual funds.

3. Name five services that are unique to mutual funds.

LEARNING OBJECTIVE 2

Differentiate mutual funds by investment objectives.

15.2 MUTUAL FUND OBJECTIVES

Most mutual funds are managed funds, meaning that professional managers are constantly evaluating and choosing securities using a specific investment approach. On a daily basis, active managers select the stocks and bonds in which to invest and sell them when they deem appropriate. The managers earn a fee often up to 2 percent, for their services, and ultimately their choices are responsible for the performance of the fund.

These also are index mutual funds (or index funds) whose investment objective is to achieve the same return as a particular market index by buying and holding all or a representative selection of securities in it. Index funds are called unmanaged funds because their managers do not evaluate or select individual securities. An S&P 500 index fund would effectively mirror the companies in the index, which are primarily large-cap U.S. stocks. Annual management fees are extremely low, perhaps only 0.07 to 0.30 percent.

index mutual funds (or index funds) are those funds whose investment objective is to achieve the same return as a particular market index by buying and holding all or a representative selection of securities in it.

DID YOU KNOW 

Money Websites on Mutual Funds

Informative websites for investing through mutual funds, including online screens to compare funds are:

Business Week Online on funds (www.businessweek.com/markets-and-finance/mutual-funds-and-etfs)

CNNMoney.com on funds (money.cnn.com/pf/funds/index.xhtml)

Kiplinger's Personal Finance (www.kiplinger.com/fronts/special-report/mutual-funds/index.xhtml)

Kiplinger's model portfolio (www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml)

MarketWatch (www.marketwatch.com/investing/mutual-funds?link=MW_Nav_INV)

Motley Fool (www.foolfunds.com)

Vanguard (www.vanguard.com)

Wikipedia (en.wikipedia.org/wiki/Mutual_fund)

Yahoo! Finance (finance.yahoo.com/funds)

Yahoo! Finance's fund screener (screener.finance.yahoo.com/funds.xhtml)

Before investing in any specific mutual fund, you need to decide whether the fund's investment objectives are a good fit for your own investment philosophy and financial goals. The SEC requires funds to disclose their investment objective. Mutual funds may be classified in one of three categories: (1) income, (2) growth, and (3) growth and income. Each type has different features, risks, and reward characteristics, and the name of a fund gives a clue to its objectives.

15.2a Income Objective

A mutual fund with an income objective, such as money market and bond funds, invests in securities that pay regular income in dividends or interest.

Money Market Funds Mutual fund companies and brokerage firms offer  money market funds (MMFs) . They invest in highly liquid, relatively safe securities with very short maturities (always less than one year), such as CDs, Treasury bills, and commercial paper (i.e., short-term obligations issued by corporations). To enhance liquidity, regulations require that MMFs keep 10 percent of their assets in cash or investments that can be converted easily to cash within one day. You can write checks or use an ATM card to access a money market fund account. Issuers keep the NAV (the price of each share of the fund) at $1.

money market funds are those that invest in highly liquid, relatively safe securities with very short securities, always less than one year.

Money market funds (and there are about 580 of them) pay a higher rate of return than accounts offered through banks and credit unions. They are considered extremely safe.  Tax-exempt money market funds  limit their investments to tax-exempt municipal securities with maturities of less than 60 days, and their earnings are tax free to investors. Government securities money market funds appeal to investors' concerns about safety by investing solely in Treasury bills and other short-term securities backed by the U.S. government.

tax-exempt money market funds Funds that limit their investments to tax-exempt municipal securities with maturities of 60 days or less.

Bond Funds  Bond funds  (also called fixed-income funds) aim to not incur undue risk while earning current income higher than a money market fund by investing in a portfolio of bonds and other investments, such as preferred stocks and common stocks that pay high dividends. They also earn some capital gains because bond fund prices fluctuate with changing interest rates. Today's nearly 2000 bond funds are categorized by what they own and the maturities of their portfolio holdings.

bond funds (fixed-income funds) Fixed-income funds that aim to earn current income higher than a money market fund without incurring undue risk by investing in a portfolio of bonds and other low-risk investments that pay high dividends and offer capital appreciation.

• Short-term corporate bond funds invest in securities maturing in one to five years.

• Short-term U.S. government bond funds invest in Treasury issues maturing in one to five years.

• Intermediate corporate bond funds invest in investment-grade corporate securities with five- to ten-year maturities.

• Intermediate government bond funds invest in Treasuries with five- to ten-year maturities.

• Long-term corporate bond funds specialize in investment-grade securities maturing in 10 to 30 years.

• Long-term U.S. government bond funds invest in Treasury and zero-coupon bonds with maturities of ten years or longer.

• Mortgage-backed funds invest in mortgage-backed securities issued by agencies of the U.S. government, such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).

• Junk bond funds invest in high-yield, high-risk corporate bonds.

• Municipal bond (tax-exempt) funds invest in municipal bonds that provide taxfree income. Both investment-grade and high-yield municipal bond funds exist.

• Single-state municipal bond funds invest in debt issues of only one state.

• World bond funds invest in debt securities offered by foreign corporations and governments.

15.2b Growth Objective

A mutual fund that has a growth objective seeks capital appreciation. It invests in the common stock of companies that have above average growth potential, firms that may not pay a regular dividend but have the potential for large capital gains. Growth funds carry a fair amount of risk exposure, and this is reflected in substantial price volatility. Growth funds are categorized by what they own and their investment goals.

Aggressive growth funds  (also known as maximum capital gains funds) seek the greatest long-term capital appreciation. Also known as capital appreciation funds, they make investments in speculative stocks with volatile price swings. They may employ high-risk investment techniques, such as borrowing money for leverage, short selling, hedging, and options. Lots of buying and selling occurs to enhance returns.

aggressive growth funds (maximum capital gains funds) Funds that invest in speculative stocks with volatile price swings, seeking the greatest long-term capital appreciation possible. Also known as maximum capital gains funds and capital appreciation funds.

Growth funds  seek long-term capital appreciation by investing in the common stocks of companies with higher-than-average revenue and earnings growth, often the larger and well-established firms. Such companies (like Walmart, Microsoft, and Coca-Cola) tend to reinvest most of their earnings to facilitate future growth.

growth funds Funds that seek long-term capital appreciation by investing in common stocks of companies with higher-than-average revenue and earnings growth, often the larger and well-established firms.

Growth and income funds  invest in companies that have a high likelihood of both dividend income and price appreciation.

growth and income funds Funds that invest in companies that have a high likelihood of both dividend income and price appreciation; less risk-oriented than aggressive growth funds or growth funds.

Value funds  specialize in stocks that are fundamentally sound and whose prices appear to be low (low P/E ratios), based on the logic that such stocks are currently out of favor and undervalued by the market.

value funds Funds specializing in stocks that are fundamentally sound whose prices appear to be low (low P/E ratios) based on the logic that such stocks are currently out of favor and undervalued by the market.

DID YOU KNOW 

Bond Funds Drop in Value When Interest Rates Rise

Extremely low interest rates—like those during and following an economic recession—are eventually replaced by rising interest rates because subsequent economic growth eventually results in inflation. When inflation goes up, the value of a bond mutual fund decreases. For every 1 percentage point change in interest rates, the value of the bond fund changes by the amount of the duration of maturity. For example, if a bond fund has an average duration of seven years and interest rates rise 1 percentage point, the value of the bond fund will drop by 7 percent. Should today's interest rates rise 3 percent over the next few years, the net asset value of a bond mutual fund is likely to decline in value by 21 percent.

Large-cap funds invest in the stocks of companies with a market capitalization of more than $10 billion.

Midcap funds invest in the stocks of midsize companies with a market capitalization of $2 to $10 billion in size that are expected to grow rapidly.

Small-cap funds (or small company growth funds) invest in lesser-known companies with a market capitalization of $300 million to $2 billion in size that offer strong potential for growth.

Microcap funds invest in high-risk companies with a market capitalization of $50 to $300 million.

Sector funds concentrate their investment holdings in one or more industries that make up a targeted part of the economy that is expected to grow, perhaps very rapidly, such as energy, biotechnology, health care, and financial services.

Regional funds invest in securities listed on stock exchanges in a specific region of the world, such as the Pacific Rim, Australia, or Europe.

Precious metals and gold funds invest in securities associated with gold, silver, and other precious metals.

Global funds invest in growth stocks of companies listed on foreign exchanges as well as in the United States, usually multinational firms.

International funds invest only in foreign stocks throughout the world.

Emerging market funds seek out stocks in countries whose economies are small but growing. Fund prices are volatile because these countries tend to be less stable politically.

15.2c Growth and Income Objective

A mutual fund that has a combined growth and income objective seeks a balanced return made up of current income and capital gains. Such funds primarily invest in common stocks. They seek a return not as low as offered by funds with an income objective but not as high as that offered by funds with a growth objective. They invite less risk than growth funds. There are a variety of growth and income funds.

Growth and income funds invest in companies expected to show average or better growth and pay steady or rising dividends.

ADVICE FROM A PROFESSIONAL

Invest Only “Fun Money” Aggressively

Once the investor has his or her financial plan in place, taking on more risk is acceptable—but only within the limits of the individual's “fun money.” Fun money is a sum of investment money that you can afford to lose without doing serious damage to your total portfolio. You might, for example, resolve to trade with a specific sum, such as $5000, or perhaps no more than 2 or 3 percent of your portfolio. Keep such fun money in a separate account from your long-term investments. Decide mentally that if and when the money is gone, it has been spent on an activity that you enjoyed trying, but accept that the money lost is lost forever. Avoid the temptation to “throw good money after bad” by investing more money in an effort to try to recover your losses.

Speculative investing is not much different from gambling. The biggest danger of fun-money investing is that you might be successful. Success can give you the confidence— albeit probably false confidence—that you are a great investor. While you might be the next billionaire investor like Warren Buffett, such success is likely to tempt you to aggressively invest even more of the assets in your total portfolio. That approach can result in disaster. As financial columnist Jane Bryant Quinn observes, “The money you really need for life is better off in broadly diversified mutual funds, where a mistake is not forever.”

Robert O. Weagley

University of Missouri–Columbia

Figure 15-3  Balancing Risk and Returns on Mutual Funds

ADVICE FROM A PROFESSIONAL

Stable-Value Funds Are Available Only through Employers

Stable-value funds  are only available through employer-sponsored retirement plans.

They offer attractive returns and liquidity without market risk to defined contribution plan participants (and some 529 tuition savings plans) because they have contracts with banks and insurance companies designed to permit redemption of shares at book value regardless of market prices. Over the past ten years, stable-value funds returned 3.0 to 5.0 percent annually. GIC funds increased in value during the worst of the Great Recession while virtually all others declined. Stable-value funds invest in high-quality, intermediate-term bond funds, including guaranteed investment contracts (GICs) offered by insurance companies. A GIC guarantees the owner a fixed or floating interest rate for a predetermined period of time, and the return of principal is guaranteed.

Dana Wolff

Southeast Technical Institute, Sioux Falls, SD

Stable-value fund Mutual fund that offers attractive returns and liquidity without market risk to defined contribution plan participants (and some 529 tuition savings plans) because they have contracts with banks and insurance companies designed to permit redemption of shares at book value regardless of market prices.

Equity-income funds invest in well-known companies with a long history of paying high dividends as they emphasize income and capital preservation.

Socially responsible funds invest in companies that meet some predefined standard of moral and ethical behavior. Criteria could be progressive employee relations, strong records of community involvement, an excellent record on environmental issues, respect for human rights, and safe products, as well as no “sinful” products such as tobacco, guns, alcohol, and gambling. See examples at The Forum for Sustainable and Responsible Investment (www.ussif.org/).

DID YOU KNOW 

Bias toward Inertia in Investment Decisions

People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward inertia or the tendency to not change. Once an employee selects a 401(k) plan contribution rate many never increase it, and only 20 percent of employees ever rebalance their investments. What to do? One day there will be a lot of money for you to manage in your 401(k) retirement account so regularly ratchet up your savings contribution, perhaps when you get a raise each year, and rebalance at least annually.

Balanced funds  (or hybrid funds) keep a set mix of stocks and bonds, often 60 percent stocks and 40 percent bonds, in order to earn a well-balanced return of income and long-term capital gains.

balanced funds Funds that keep a set mix of stocks and bonds, often 60 percent stocks and 40 percent bonds, in order to earn a well-balanced return of income and long-term capital gains.

Blend funds invest in a combination of stocks and money market securities, but no fixed-income securities, such as bonds.

Asset allocation funds  invest in a mix of assets (usually stocks, bonds, and cash equivalents and sometimes international assets, gold, and real estate), and they buy and sell regularly to reduce risk while trying to outperform the market. The asset mix may be based on risk tolerance (aggressive, moderate, and conservative).

asset allocation funds Investments in a mix of assets (usually stocks, bonds, and cash equivalents and sometimes international assets, gold, and real estate); they buy and sell regularly to reduce risk while trying to outperform the market.

Target-date retirement funds (life-cycle funds)  are asset allocation funds that offer investors premixed portfolios of stocks, bonds, and cash that investors of a certain age and risk tolerance might prefer. They are often named for the year one plans to retire, for example, the “Fidelity Freedom Fund 2030.” These are targeted to people in their 30s, 40s, and 50s. Target-date funds shift assets from aggressive to moderate to a more conservative mix of securities as the retirement target date approaches. They seek to first grow and then preserve the portfolio assets. This is a no-hassle, “set-it-and-forget-it” approach to investing for retirement. Regulations require target-date funds to provide investors with information that shows the projected allocations over the life of the fund.

target-date retirement funds (life-cycle funds) Asset allocation funds that offer investors premixed portfolios of stocks, bonds, and cash that investors of a certain age and risk tolerance might prefer, and they are often named for the year one plans to retire.

Mutual fund funds earn a return by investing in other mutual funds. This provides extensive diversification, but expenses and fees are higher than average.

DID YOU KNOW 

For the Lowest Fees Invest in ETFs and Index Mutual Funds

Instead of looking for a needle in a haystack when investing—finding the best mutual fund—why not buy the whole haystack? The lowest costs in investing can be found among the nation's 373 index funds and 1200 exchange traded funds (ETFs). These are unmanaged baskets of passively managed securities that own a representative set of securities that duplicate the performance of an index or market segment. ETFs trade throughout the day and index funds close after the end of the business day.

One in four investors has ETFs in their portfolios partly because of the extremely low costs (0.36% annual management fee on average), which are lower than similar index mutual funds (0.76% on average). The lowest annual fee of all ETFs is Vanguard Total Stock Market ETF (VTSAX), only 0.07 percent, which tracks 3000 stocks, while Schwab's U.S. Broad Market ETF (SCHB) tracks 2500 stocks with an annual fee of 0.08 percent.

The average annual gain of 9.6 percent on stock investments over the long-term is measured by the MSCI USA equity index from 1970 forward. It consists of 3.37 percent from dividends and 6.23 percent in capital gains. Stock pickers who are employed by managed funds have to actively trade and as a result they must obtain a return of 11 percent on average to achieve the same result as unmanaged index investment, because their fees and expenses often add up to 2 percent.

There is absolutely no scientific evidence that active fund management outperforms index funds and ETFs. Beating an unmanaged index investment may be remotely possible, but in reality it is highly unlikely.

 CONCEPT CHECK 15.2

1. What are the three basic types of mutual fund objectives?

2. Distinguish among mutual funds with an income objective, growth objective, and growth and income objective.

3. Explain why investors like index mutual funds and exchange traded funds.

LEARNING OBJECTIVE 3

Summarize the fees and charges involved in buying and selling mutual funds.

15.3 MUTUAL FUND INVESTING FEES AND CHARGES

Individuals who invest through mutual funds pay transaction costs that often are less than those associated with buying individual stocks, bonds, and cash equivalent securities. However, the fees and charges associated with investing in mutual funds are many, and they can be confusing.

15.3a Load Versus No-Load Funds

All mutual funds are classified as either load or no-load funds. This refers to whether or not they assess a sales charge, or load, when shares are purchased. There are also other fees assessed on load and no-load funds that can be avoided through careful research.

Load Funds Are “Sold” and Always Charge Transaction Fees Funds that levy a sales charge for purchases are called  load funds . Load funds are generally “sold” by stock brokerage firms, banks, and financial planners rather than marketed directly to investors by a mutual fund company. The load is the commission used to compensate sellers for their time and expertise in recommending appropriate funds for clients.

load funds Mutual funds that always charge a “load” or sales charge upon purchase; the load is the commission used to compensate brokers.

This commission, often called a  front-end load , typically amounts to a level sales charge of 3 to 8.5 percent of the amount invested. This reduces the amount available to purchase fund shares. For example, assume that you and your stockbroker have discussed the investment potential of the Conglomerate Cat and Dog Food Mutual Fund and you decide to invest $10,000. Because this load fund charges a commission of 8.5 percent (the maximum permitted by the SEC), the stockbroker receives $850 ($10,000 × 0.085). As a result, only $9150 of your money is actually available to purchase shares.

front-end load A sales charge paid when an individual buys an investment, reducing the amount available to purchase fund shares.

The sales charge may be shown either as the stated commission or as a percentage of the amount invested. The  stated commission  (8.5 percent in our example) is always somewhat misleading. The “percentage of the amount invested” is a more accurate figure because it is based on the actual money invested and working. A stated commission of 8.5 percent actually amounts to 9.3 percent of the amount invested: $10,000 − $9150 = $850; $850 ÷ $9150 = 9.3%. If you want to invest a full $10,000 in this load fund, you will need to pay out $10,930 [$10,930 − ($10,930 × 8.5%) = of $10,000]. Investments of $10,000 or more often receive a discount on the load.

stated commission The sales charge as a percentage of the amount invested.

So-called  low-load funds  may carry a sales charge of perhaps 1 to 3 percent. These funds may also be sold by brokers and are sometimes sold via mail and through mutual fund retailers located in shopping centers.

low-load funds Funds carrying sales charges of perhaps 1 to 3 percent; sold by brokers, via mail, and sometimes through mutual fund retailers located in shopping centers.

Many No-Load Funds Also Assess Back-end Loads and Redemption Fees A  back-end load  (or contingent deferred sales charge) is a sales commission that is imposed only when shares are sold. Deferred loads are often on a sliding scale. The fee may decline 1 percentage point for each year the investor owns the fund. For example, a fund might charge a 6 percent fee if an investor redeems the shares within one year of purchase, and then the fee declines on an annual basis, until it reaches zero after six more years.

back-end load (contingent deferred sales charge) A sales commission that is imposed only when shares are sold; often charges are on a sliding scale, with the fee dropping 1 percentage point per year that the investor stays in the fund.

A  redemption charge  (or  exit fee ) is lower and is usually 1 percent of the value of the shares redeemed. A fund assesses such a charge to reduce excessive trading of fund shares. The fee disappears after the investment has been held for six months or a year. Long-term investors for retirement do not need to be concerned about paying about back-end loads and exit fees, as these largely disappear over time.

redemption charge (exit fee) Similar to a deferred load but often much lower; used to reduce excessive trading of fund shares.

All No-Load Funds Assess Fees A  no-load fund  sells shares at the net asset value without the addition of sales charges. These mutual fund companies let people purchase shares directly from the mutual fund company without the services of a broker, banker, or financial planner. Interested investors simply seek out advertisements for these funds in financial newspapers, magazines, and the Internet and make contact through toll-free telephone numbers, online, or mail. However, the SEC does allow funds to be called “no-load” even though they assess a service fee of 0.25 percent or less when shares are purchased. No-load funds are usually the best mutual funds in which to invest.

no-load funds Funds that allow investors to purchase shares directly at the net asset value (NAV) without the addition of sales charges.

About One-half of No-Load Funds Also Assess Expensive 12b-1 Fees A  12b-1 fee  (named for the SEC rule that permits the charge) is an annual charge deducted by the fund company from a fund's assets to compensate underwriters and brokers for fund sales as well as to pay for advertising, marketing, distribution, and promotional costs. A 12b-1 fee is also known as a  distribution fee . This fee also pays for  trailing commissions , which is compensation paid to salespeople for months or years in the future.

12b-1 fees (distribution fees) Annual fees that some “no-load” fund companies deduct from a fund's assets to compensate salespeople and pay other expenses.

trailing commission Compensation paid to salespeople for months or years in the future.

Although the funds do not call 12b-1 fees “loads” because they are not charged up front, they have the same effect as loads—that is, they reduce the investor's return, often quite dramatically. Over 60 percent of funds assess 12b-1 fees, including many no-load funds.

These fees are hidden and they decrease a shareholder's earning power each year without being described as a sales commission. A 12b-1 fee is actually a “perpetual sales load” because it is assessed on the initial investment as well as on reinvested dividends, every year, forever. The SEC caps 12b-1 fees at 0.75 percent, although recall that the SEC also permits a 0.25 percent service fee, which brings the total to 1 percent. Some funds stop assessing 12b-1 fees after four to eight years. The 12b-1 fee is supposed to be replaced in 2017 with a 12b-2 fee to pay for “distribution activities, again capped at 0.25 percent annually.

DID YOU KNOW 

Bias toward Worrying about the Wrong Things

People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward worrying about the wrong things. Many investors focus on returns and passively ignore high investment fees associated with active account management, especially when they are automatically deducted from an account. What to do? Realize that high fees—which can be totally avoided— will reduce the growth of your assets 30 percent or more over many years, so steer clear of them!

FINANCIAL POWER POINT  

Avoid Managed Funds because Low Fees and Expenses Mean Higher Returns

The investment balances 20 years later if an investment earns a 7 percent annual return on a $10,000 investment are as follows:

• Actively managed mutual fund (1.9 percent; $29,190)

• Index mutual fund (0.70 percent; $33,936)

• Index ETF (0.07 percent; $38,193)

Over 20 years that is $9,003 or a 31 percent higher return ($38,193 − $29,190 = $9,003/$29,190) for investing in an Index ETF compared to an actively managed mutual fund. Smart investors avoid managed funds!

15.3b Mutual Fund Share Classes—Designed to Confuse—Are Sold to You

A single mutual fund may be available to investors in more than one class of shares: Class A, B, or C, and they all are falsely sold as “no load” funds. They all invest in the same portfolio of securities and have the same investment objectives but have different fee and expense patterns. Class A shares normally have a front-end sales charges paid at the time of the initial purchase. Class B shares have back-end sales charges paid when selling the shares within a specified number of years, and they might (if held long enough) allow automatic conversion to share with a lower 12b-1 fee. Class C shares might have a 12b-1 fee and a redemption charge.

Moreover, the performance results for each class will differ depending on how long you hold the shares. These shares are sold by brokers and financial planners and can be avoided by investors who choose to invest in no-load funds.

15.3c Use FINRA's Website to Compare Mutual Fund Fees

To compare the costs of various funds and share classes for your expected holding period and estimated returns, see the Financial Industry Regulatory Authority's Mutual Fund Expense Analyzer (www.apps.finra.org/fundanalyzer/1/fa.aspx). This tool estimates the value of the funds and impact of fees and expenses on your investment and also allows you to look up applicable fees and available discounts for thousands of funds.

The SEC requires that mutual funds provide investors with a summary prospectus— in plain English—of information needed to help make investment decisions, and it appears at the front of a fund's full prospectus. It must include a  standardized expense table  that describes and illustrates in an identical manner the effects of all of its fees and other expenses. Look for the fund's  expense ratio , the expense per dollar of assets under management. Expense ratios average 1.26 percent for managed diversified stock funds (which is way too expensive) and easily as low as 0.25 percent for index funds (much lower costs).

standardized expense table SEC-required information that describes and illustrates mutual fund charges in an identical manner so that investors can accurately compare the effects of all of a fund's fees and other expenses relative to other funds.

expense ratio Expense per dollar of assets under management.

FINANCIAL POWER POINT  

High Fees Will Cost You a Fortune

Mutual funds found in 401(k) plans can vary greatly in expense ratio fees. Here is how much the fees will be on $50,000 invested in certain lifecycle funds often found in 401(k) plans, as stated in Consumer Reports: Vanguard Target Retirement 2030 Investor, $3,531; TIAA-CREF Lifecycle 2030 Institutional, $9,416; Fidelity Freedom K 2030, $12,199; Blackrock LifePath 2030 Portfolio Class K, $13,104; T. Rowe Price Retirement 2030 Class R, $14,529. Be certain to find out how much the fees are before investing!

15.3d What's Best: Load or No Load? Low Fee or High Fee?

The best choice is to invest in no-load mutual funds or ETFs with low fees. Investors can almost guarantee a poorer return than others if they put their money into a load fund with high management fees. Experts agree that “If you pick your own funds, sales charges and high management fees are a total waste of money.” The SEC says that for a long-term investor a 1 percent fee that increases at 4 percent a year will devour one-third of your total return! And 1 percent is much less than the average set of fees.

Sales Commissions Reduce Returns The sales commissions charged by load funds indisputably reduce total returns. When investment results are adjusted to account for the effects of sales charges, no-load mutual funds always have an initial advantage because the investor has more money at work. Many are perplexed at the stubbornness of actively managed funds that have not reduced their fees in years, even though countless investors have moved to low- or no-load funds.

12b-1 Fees Kill Long-Term Returns Annual 12b-1 charges are very costly over the long run. If you pay 1 percent per year in 12b-1 fees for a mutual fund in which you invest for ten years, you will be giving up nearly 10 percent of your investment amount in trailing commissions. Yikes!

DID YOU KNOW 

Learn More about Mutual Funds

Information on mutual fund investing is vast, especially on the Internet, and excellent information about mutual funds is available from numerous sources.

Personal Finance Magazines

Kiplinger's Personal Finance, Money, Business Week, Consumer Reports, Forbes, Fortune, and Worth. comprehensive examinations of the performance of numerous mutual funds are featured every year in the late August issue of Forbes, the October issue of Money, a late February issue of Business Week, and the September issue of Kiplinger's Personal Finance.

Financial Press

The Wall Street Journal Barron's, Investor's Business Daily, and the business sections of newspapers such as The New York Times and USA Today.

Online News and Quote Services

CompuServe, Dow Jones News/Retrieval-Private Investor Edition, Farcast, Personal Journal, Quote.com, and Reuters Money Network.

Mutual Fund Investment Publications and Websites

Morningstar Mutual Funds, Morningstar No-Load Funds, Mutual Funds Update, Investment Companies Yearbook, IBC/IDonoghue's Mutual Funds Almanac, Standard & Poor's, Lipper Mutual Fund Profiles, Moody's, and The Value Line Mutual Fund Survey. Dozens of newsletters that specialize in mutual funds are available, too. Morningstar (www.morningstar.com) and the Investment Company Institute (www.ici.org) provide information on thousands of funds. Some charge fees, and others are free.

Avoiding High Fees Is Critical to Investment Success Research has found that over five-year periods, lower-cost funds always deliver returns better than those offered by higher-cost funds. It's even harder if you're paying 1.9 percentage points a year for active management. That's like carrying a couple of heavy barbells during a marathon. The equally fast runner without the barbells is going to win over the long run.

 CONCEPT CHECK 15.3

1. Give three examples of fees or charges associated with load funds.

2. Which is better for most investors, load or no-load funds? Why?

3. Summarize the effects of loads and fees on investment returns.

15.4 HOW TO SELECT THE FUNDS IN WHICH YOU SHOULD INVEST

Selecting mutual funds in which to invest is a do-it-yourself effort for no-load investors and it is easy to do. Brokers are not needed because a tremendous amount of objective information is available to help investors evaluate and select funds. To explain the process of selecting funds, let's follow Catalina Garcia's decision making. She is in her late twenties, lives in San Jose, California, and earns $51,000 annually in her sales management job. Figure 15-4 illustrates the process of selecting mutual fund investments, and Table 15-3 contains performance data for a number of large-cap mutual funds from Kiplinger's Personal Finance.

LEARNING OBJECTIVE 4

Establish strategies to evaluate and select mutual funds that meet your investment goals.

Figure 15-4  The Process of Selecting Mutual Funds

DO IT IN CLASS

Table 15-3 Mutual Fund Performance

15.4a Review Your Investment Philosophy and Investment Goals

Catalina began by reviewing her investment philosophy and financial goals. These topics were examined in Chapter 13. Catalina has a moderate investment philosophy, and she has a written investment plan (Figure 13-7 on page 405). The investment goal she is interested in investing for now is retirement, and her investment time horizon is the next 30 years or longer. She anticipates an annual return of at least 4 to 5 percent. She does not care about income taxes because these investments will be made within Catalina's tax-deferred 401(k) retirement plan at work, where her earnings will grow tax-free.

Catalina does not have any lump sums available in a savings or money market account to use for investing. To help fund her retirement plan, she decided to have $200 a month withheld from her paycheck to invest in a mutual fund with a growth investment objective. Catalina's employer's 401(k) plan offers about 20 funds as well as company stock.

DID YOU KNOW 

Your Worst Financial Blunders in Investing Through Mutual Funds

Based on others' financial woes, you will make mistakes in personal finance when you:

1. Buy funds with high fees and expenses.

2. Withdraw cash dividends rather than reinvesting.

3. Chase short-term performance by investing in “hot” funds.

15.4b Eliminate Funds Inappropriate for Your Investment Goals

Catalina began by reviewing all fund classifications (pages 459–463) and balancing the risks and returns of various funds as illustrated in Figure 15-3 on page 464. She aims to eliminate mutual funds inappropriate for her retirement investment goal.

DID YOU KNOW 

Turn Bad Habits into Good Ones

Do You Do This?

Have only a few investments like stocks and bonds

Find it difficult to reinvest dividends and interest

Buy load funds or those with 12b-1 fees

Seem confused about the right funds in which to invest

Find it difficult to monitor your investments

Do This Instead!

Diversify by investing in mutual funds

Invest in funds that reinvest automatically

Invest in no-load funds or ETFs

Use a free online fund-screening tool

Manage your fund portfolio free online

Catalina recognizes that increasing the potential for higher returns also increases the risk to the investor's capital. Therefore, she eliminated the following types of funds: sector funds, emerging markets funds, and aggressive growth funds, as well as stock in the company where she works. She also realizes that investing too conservatively invites the risk of failure to achieve her goal of a financially successful retirement. Therefore, Catalina eliminated money market funds.

15.4c Create a Portfolio of Funds in Which to Invest

Instead of simply investing in “this and that” funds, Catalina smartly decided to create a portfolio of mutual funds tailored to her needs. At www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml she found 25 portfolios recommended by Kiplinger's Personal Finance editors and writers. They are customized for different situations and stages of life. On that website, she can get updated returns and track the performance of her investments with the benchmark portfolios.

15.4d Choose No-Load Funds with Low Fees

The sales commissions charged by load funds indisputably reduce total returns. Catalina reasoned that since no-load mutual funds have an initial advantage—the investor has more money at work—she preferred no-load funds. Because her $200 a month was going into investment for retirement, she also thought that 12b-1 fees would be very costly over the long term. For the same reason, she wanted to avoid high management fees. She did not care about back-end loads and exit fees, as these largely disappear over time. Catalina decided to invest in one or more no-load mutual funds with no 12b-1 fees and very low management expense ratios. Catalina will have to look up some of this information on the Internet since data in Table 15-3 is quite limited.

15.4e Obtain Investment Information and Advice

Because Catalina is going to invest in no-load funds, she figured she did not need the services of a broker or financial planner. Instead, she plans to use the tremendous resources that are available via the Vanguard website (www.vanguard.com)—information, education, and professional advice. Vanguard is the largest mutual fund family in the country. Catalina's employer offers investing and retirement planning seminars and workshops provided by Ernst & Young, Vanguard, T. Rowe Price, and other companies. Significant others are welcome to attend. Employer-sponsored financial advice may cover an employee's entire financial situation, including debt reduction, college planning, spousal assets, real estate, and other investments. Once Catalina's retirement assets build up to a substantial amount, perhaps $50,000 or more, she would be wise to seek professional financial advice.

Catalina's employer offers retirement plan participants access to services that automatically rebalance their retirement assets known as a  limited management account , first discussed in chapter 13. For an annual fee of perhaps as little as $20 annually, the firm sells and buys her mutual fund assets on a quarterly basis to rebalance her portfolio back to her specific standards.

limited management account An account at an investment firm whereby, for a fee, they sell and buy your mutual fund assets, usually quarterly, on your behalf to automatically rebalance your portfolio back to your specific standards.

DID YOU KNOW 

How to Ease into Investing Cautiously

Investors who are fearful of investing in the stock market can try these techniques: (1) Start by buying shares of a diversified stock mutual fund using monthly purchases for 12 months or (2) Purchase a life cycle or target date mutual fund that contains a premixed allocation of stocks and bonds.

15.4f Screen and Compare Funds That Meet Your Criteria

When comparing the track records of mutual funds, there are a number of criteria to consider. These may include expenses; net asset value; minimum initial purchase; size of fund; ratings; past performance (perhaps one, three, five, and ten years); best and worst performance in up and down markets (volatility); fund manager tenure; and services. Catalina is interested in stock funds, international funds and global funds, low management fees, and no 12b-1 fees.

DID YOU KNOW 

Sean's Success Story

Sean's superb financial life continues. He increased his 401(k) contributions from 6 to 8 percent so the $90,000 in mutual funds in the account will total over $100,000 by December. That figure will be a milestone for Sean's retirement planning. While the return on his mutual fund portfolio was only 2 percent between 2007 and 2009, it did not decline; it more than doubled since then. Sean figures that the stock market is bound to go up even more as the economy grows and unemployment declines. Therefore, he has decided to move his investments completely into stock mutual funds.

Since today's share prices go up and down quite considerably during any one year, Catalina checked the volatility ratings of funds. Volatility characterizes a mutual fund's (or any security's) tendency to rise or fall in price over a period of time. A measure of volatility is the standard deviation, which gauges the degree to which a security's historical return rises above or falls below its own long-term average return— and therefore may be likely to do so again in the future. A standard deviation is a probability indicator, not an economic forecast. The bigger an investment's standard deviation, the more volatile its price may be in the future. High volatility suggests greater long-term rewards but a greater-than-normal risk of short-term losses during economic downturns. Other common measures of risk are beta, the Sharpe Ratio, and R-squared. Publications like Kiplinger's Personal Finance and Money provide volatility ratings for mutual funds.

Catalina started searching for mutual fund investments at Vanguard (www.personal.vanguard.com/us/FundsMFSIntro?%20FROM=VAN), which is considered one of the best mutual fund screening websites, and she began by typing in the fund symbols in “search.” A  fund screener  or  fund-screening tool  permits an individual to screen all of the mutual funds in the market. Other mutual fund screening tools are available at the following websites:

fund screener (fund-screening tool) Permits investors to screen all of the mutual funds in the market to gauge performance.

• Yahoo! Finance (www.screener.finance.yahoo.com/funds.xhtml)

• Kiplinger.com (www.kiplinger.com/tool/investing/T052-S001-search-and-com-pare-stocks-equities/index.php)

• Fidelity (www.fidelity.com/fund-screener/evaluator.shtml#!&ntf=Y)

• Vanguard (www.personal.vanguard.com/us/FundsMFSBasicSearch?FROM=VAN)

Catalina focused on large-cap funds, including those shown in Table 15-3. She researched funds using the Vanguard fund screener. She obtained online a profile prospectus from Vanguard on each of the funds she liked. A  profile prospectus  (or  fund profile ) describes the mutual fund, its investment objectives, and how it tries to achieve its objectives. Written in lay language, it offers a two- to four-page summary presentation of information contained in an SEC-required legal prospectus that answers 11 key investor questions, including risks, fees, and details about the fund's ten-year performance record.

profile prospectus (fund profile) Publication that describes the mutual fund, its investment objectives, and how it tries to achieve its objectives in lay terms rather than the legal language used in a regular prospectus.

After reading fund details, looking at the numbers, and comparing performance, Catalina decided to split her monthly $200 investment between Vanguard Total Stock Market Index (VTSMX) and Vanguard Emerging Markets Stock Index (VEIEX), partly because of their low to nil expense ratios. (In addition, any minimum initial investment fees are waived for investments via her employer's retirement plan.) Catalina thinks the fund managers will beat the average market returns, such as a S&P 500 index like Vanguard's 500 Index (VFINX). Catalina might be right, or she might be wrong, but she is probably correct.

DID YOU KNOW 

The Tax Consequences of Mutual Fund Investing

Ordinary income dividend distributions, capital gains distributions, and realized gains from the sale of mutual funds are generally subject to taxation.

1. In regular investment accounts:

• When you buy and hold mutual fund shares, you owe income taxes on any ordinary income dividends and on the fund's capital gains in the year you receive or reinvest them.

• When you sell shares, you owe taxes on the capital gains earned on the difference between what you paid for the shares and the selling price (less transaction costs).

• Before purchasing a mutual fund toward the end of the year, like in December, determine whether the fund has already made its end-of-year capital gains distribution. If you buy the fund before the record date (the date established by an issuer to determine who is eligible to receive a dividend or distribution), you will receive the income but you also will owe capital gains taxes for the whole year. Buying after the record date avoids that tax because you will not have received the distribution.

2. Interest from a tax-exempt municipal bond fund is exempt from federal income taxes.

3. In retirement accounts (such as a 401[k] or traditional IRA account), all taxes are deferred until funds are withdrawn from the account.

The next step is for Catalina to contact the human resources department at her employer and sign the documents to withhold $200 a month from her paycheck and invest $100 into each of the two funds. Catalina also knows that for every dollar invested, she gets an immediate 50 percent return because her employer's policy is to match 401(k) contributions 50 cents on the dollar for the first 6 percent of earnings. Catalina's 401(k) balance in 12 months, therefore, will show $2400 in contributions and $1200 in employer matching contributions (that's an immediate 50 percent return on her $2400!), plus whatever gain occurs (hopefully not a loss) in NAV. Catalina's 401(k) balance this time next year is likely to be more than $3600.

It is easy to research mutual funds on the Internet.

15.4g Monitor Your Portfolio of Mutual Fund Investments

Tracking your portfolio is imperative because investors do not want to keep any underperforming mutual funds in their portfolio for very long. If Catalina wants to invest outside of her 401(k) plan in the same or other no-load funds, she can purchase funds directly from mutual fund investment companies, such as family fund companies like Fidelity, T. Rowe Price, or any other mutual fund, like Gabelli, Neuberger, or Calvert.

Use Portfolio Monitoring on the Internet Monitoring a mutual fund portfolio is easy using any of the top-rated mutual fund websites cited earlier. Some services charge nominal fees.

Check Fund Quotations in Newspapers You can check closing prices online any time on the financial websites cited earlier or read quotes in newspapers. See Figure 15-5 for an illustration. Newspapers' quotations for no-load mutual funds list the name of the fund followed by columns for its net asset value, net change from the previous day, and year-to-date percentage return.

Figure 15-5  How Mutual Funds Are Quoted

For example, within the group listing for Fidelity Investments mutual funds, the Balanced Fund (abbreviated as Balanc) has a net asset value (NAV) of $15.14, a change in the net asset value (NET CHG) of —$0.20 from the closing price of the previous trading day, and a year-to-date percentage return (YTD %RET) of 1.1 percent.

DO IT NOW!

You know more about personal finance after reading this chapter, so get started right now by:

1. Identifying five unique services provided by mutual funds (see page 459) that appeal to you.

2. Identifying two of your long-term financial goals and determining whether you would seek a fund with a growth objective or growth and income objective for each goal.

3. Selecting one mutual fund from those listed in  Table 15-3  on page 470 to follow for two or three months, then reassessing your selection if warranted.

Mutual Fund Bid Price  In mutual funds, the NAV is also known as the  mutual fund bid price . Shareholders receive this amount per share when they redeem their shares—that is, the company is willing to pay this amount to buy the shares back. Also, the NAV is the amount per share an investor will pay to purchase a fund, assuming it is a no-load fund. A no-load fund is indicated as such by the alphabetic letter n at the end of the fund's name.

mutual fund bid price Shareholders receive this amount per share when they redeem their shares, which is the same dollar amount as the NAV.

Mutual Fund Ask Price  The  mutual fund ask price  (or  offer price ) is the price at which a mutual fund's share can be purchased by investors. It equals the current NAV per share plus sales charges, if any. If you wanted to buy or sell shares of Fidelity Balanced Fund, a no-load (note the superscript n in Figure 15-5) mutual fund, the price would be $15.14 per share. The funds listed without an n are load funds. The SEC requires that appropriate footnotes appear in newspaper listings of mutual funds to indicate other expenses and charges.

mutual fund ask (or offer) price Price at which an investor can purchase a mutual fund's shares; current NAV per share plus sales charges.

 CONCEPT CHECK 15.4

1. Explain why it is important to review your investment philosophy and goals when selecting mutual fund investments.

2. Explain how you would eliminate funds inappropriate for your investment goals.

3. How might you go about monitoring your mutual fund investments?

WHAT DO YOU RECOMMEND NOW?

Now that you have read the chapter on mutual funds, what do you recommend to Tyler and Samantha Gent in the case at the beginning of the chapter regarding:

1. Redeeming their CDs and investing their retirement money in mutual funds?

2. Investing in growth and income mutual funds instead of income funds?

3. Buying no-load rather than load funds?

4. Buying mutual funds through their employers' 401(k) retirement accounts, rather than saving through a taxable account as they have been doing?

BIG PICTURE SUMMARY OF LEARNING OBJECTIVES

LO1 Describe the features, advantages, and unique services of investing through mutual funds.

A mutual fund is an investment company that pools funds obtained by selling shares to investors and makes investments to achieve the financial goal of income or growth, or both. The net asset value (NAV) is the per-share value of the fund. Advantages of mutual funds include diversification, affordability, and professional management. Unique services include ease of buying and selling, check writing, and easy establishment of retirement plans.

LO2 Differentiate mutual funds by investment objectives.

A mutual fund with an income objective invests in securities that pay regular income in dividends or interest. A fund that has a growth objective seeks capital appreciation. A fund that has a combined growth and income objective seeks a somewhat balanced return made up of current income and capital gains. The name of a fund, such as aggressive growth fund, typically gives a clue to its objectives.

Index funds and ETFs are popular because they earn almost exactly the same return as a particular market index.

LO3 Summarize the fees and charges involved in buying and selling mutual funds.

Individuals who invest through mutual funds pay annual fund operating expenses—management fees—that are deducted from fund assets before earnings are distributed to shareholders. Investors must make decisions on load and no-load funds, 12b-1 fees, deferred load, and redemption fees.

LO4 Establish strategies to evaluate and select mutual funds that meet your investment goals.

The process of selecting no-load mutual funds in which to invest is a do-it-yourself effort. The steps are (1) review investment philosophy and investment goals, (2) eliminate funds inappropriate for your investment goals, (3) create a portfolio of funds in which to invest, (4) choose no-load funds with low fees, (5) obtain investment information and advice, (6) screen and compare funds that meet your investment criteria, and (7) monitor your mutual fund investments.

LET's TALK ABOUT IT

1. Investing in Tough Economic Times. Comment on this statement: “A great time to invest is during times of economic turmoil when assets are undervalued.”

2. One Fund of Interest. Review the three objectives of mutual funds. Based on your investment philosophy, which one type of fund would be of most interest to you if you were saving to buy a home several years from now? Give reasons why.

3. Two Funds. Assume you graduated from college a few years ago, have a job paying $75,000 annually, and want to invest $300 per month in mutual funds for retirement. Which combination of two or more mutual funds (see pages 468–469) would you think appropriate? Give reasons for each of your selections.

4. Spread Your Money into Funds. Assume that your uncle gave you $50,000 to invest solely in mutual funds. Based on your point in the life cycle and your investment philosophy, identify your investment goals and explain how you would spread your money among different funds. (See pages 469–469.)

5. Good Choices. Identify the types of mutual funds that would be good choices to meet the following four investment objectives: emergency fund, house down payment, college fund for 2-year-old child, and retirement fund for a 25-year-old. (See pages 469–469.) Give two reasons why each one of your recommendations would be appropriate.

6. Load or No-Load. Which is a better choice for you, load or no-load mutual funds? Give some reasons.

7. Review Table 15-1 on the “Advantages of Investing in Mutual Funds” on page 457, and select two that would be important to you as an investor. Explain why.

DO THE MATH

1. Profits and Taxes. A year ago, George Jetson, from Orbit City, Texas, invested $1000 by buying 100 shares of the Can't Lose Mutual Fund, an aggressive growth no-load mutual fund. George reinvested his dividends, so he now has 112 shares. So far, the NAV for George's investment has risen from $10 per share to $13.25.

(a) What is the percentage increase in the NAV of George's mutual fund?

(b) If George redeemed the first 100 shares of his mutual fund investment for $13.25 per share, what would be his capital gain over the amount invested?

(c) Assuming George pays income taxes at the 25 percent rate, how much income tax will he have to pay if he sells those first 100 shares?

2. Mutual Fund Sales. Two years ago, Izabella Martinez, from Denver, Colorado, invested $1000 by buying 125 shares ($8 per share NAV) in the Can't Lose Mutual Fund, an aggressive growth no-load mutual fund. Last year, she made two additional investments of $500 each (50 shares at $10 and 40 shares at $12.50). Izabella reinvested all of her dividends. So far, the NAV for her investment has risen from $8 per share to $13.25. Late in the year, she sold 60 shares at $13.25.

(a) What were the proceeds from Izabella's sale of the 60 shares?

(b) To use the Internal Revenue Service's “average-cost basis method” of determining the average price paid for one share, begin by calculating the average price paid for the shares. In this instance, the $2000 is divided by 215 shares (125 shares 1 50 shares + 40 shares). What was the average price paid by Izabella?

(c) To finally determine the average-cost basis of shares sold, you multiply the average price per share times the number of shares sold—in this case, 60. What is the total cost basis for Izabella's 60 shares?

(d) Assuming that Izabella has to pay income taxes on the difference between the sales price for the 60 shares and their cost, how much is this difference?

FINANCIAL PLANNING CASES

CASE 1

The Johnsons Decide to Invest Through Mutual Funds

After learning about mutual funds, the Johnsons are confident that they are a great way to invest, especially because of the diversification and professional management that funds offer. The couple has a financial nest egg of $9500 to invest through mutual funds. They also want to invest another $300 per month on a regular basis.

DO IT IN CLASS PAGE 469–471

Although not yet completely firm, Harry and Belinda's goals at this point are as follows:

• They want to continue to build their retirement income to retire in about 36 years.

• They will need about $10,000 in six to eight years to use as supplemental income if Belinda has a baby and does not work for six months.

• They might buy a luxury automobile requiring a $10,000 down payment if they decide not to have a child.

Knowing that the Johnsons have a moderate investment philosophy, that they live on a reasonable budget, and that they have a well-established cash-management plan, advise them on their mutual fund investments by responding to the following questions:

(a) Some comparable mutual fund performance data on stock funds are shown in Table 15-3. Using only that information and assuming that you are recommending some funds for the Johnsons' retirement needs, which two funds would you recommend? Why?

(b) How would you divide the $9500 between the two stock funds? Why?

(c) How much of the $300 monthly investment amount would you allocate to each of the stock funds? Why?

(d) Assume that both funds increase in value over the next ten years. Another bear market then occurs, causing the NAVs to drop 25 percent from the previous year. Would you recommend that the Johnsons sell their accumulated shares in the funds? Why or why not?

(e) Determine the value of the shares purchased with their $9500 original investment in ten years, assuming that the two funds' NAVs increase 6 percent annually for the ten years. (Hint: Use Appendix A.1 or the Garman/Forgue companion website.)

CASE 2

Victor and Maria Invest for Retirement

Victor and Maria Hernandez plan to retire in less than 15 years. Their current investment portfolio is distributed as follows: 40 percent in growth mutual funds, 40 percent in corporate bonds and bond mutual funds, and 20 percent in cash equivalents. They have decided to increase the amount of risk in their portfolio by taking 10 percent from their cash equivalent investments and investing in some mutual funds with strong growth possibilities.

DO IT IN CLASS PAGE 469–471

(a) Of the stock mutual funds listed in Table 15-3, which two would you recommend to meet the Hernandezes' goals? Why?

(b) Would you recommend that the Hernandezes remain invested in those two funds during their retirement years? Why or why not?

CASE 3

Julia Price Is Going to Invest Big in Mutual Funds

It has been over 25 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career as well as in managing her personal finances. She has moved up the career ladder, earns a high salary, has $50,000 in equity in her condo, and has an investment portfolio valued at $300,000 that includes $200,000 in retirement assets through her employer's 401(k) plan. She wants to liquidate her $300,000 investment portfolio now invested in stocks, bonds, and gold and put everything into mutual funds. Julia is optimistic about the future of investing. After serious research, Julia has decided to invest $300,000 into ETFs and index mutual funds rather than actively managed funds. Offer your opinions about her thinking.

CASE 4

Matching Mutual Fund Investments to Economic Projections

Joshua Wickler, an automobile salesperson for the past ten years in Albuquerque, New Mexico is divorced and contributes to the support of his two children. He is interested in investing in mutual funds. Joshua wants to put $20,000 of accumulated savings into a stock index mutual fund and then continue to invest $200 monthly for the foreseeable future, perhaps using the money for retirement starting in about 25 years. Joshua has limited his choices solely to the index mutual funds listed in Table 15-3.

DO IT IN CLASS PAGE 469–471

(a) In Table 15-3, note that there are two index funds based on the S&P 500 Index. Suggest a reason why Joshua should invest in one or the other, noting that the returns for the Vanguard 500 Index Fund slightly lagged the Fidelity Spartan Index Fund.

(b) Given that Joshua plans to invest $2400 annually for the next 25 years, which of the other two index funds (Vanguard Total Stock Market Index Fund or Vanguard Emerging Markets Stock Fund) would you recommend, and why?

CASE 5

Selection of a Mutual Fund as Part of a Retirement Plan

Lola Garcia, a single mother of a 6-year-old child, works for a utility company in Chestertown, Maryland, and is willing to invest $3000 per year in a mutual fund. She wants the investment income to supplement her retirement pension starting in approximately 30 years, and she has a moderate investment philosophy. Lola is concerned about not investing too conservatively because she expects to live a long life, given that her eldest relatives lived well into their 80s and early 90s. Advise Lola by responding to the following questions:

(a) If Lola invests $3000 annually into two growth mutual funds, which two types would you recommend and why? See the list on pages 460–461.

(b) Alternatively, if Lola invests $3000 annually into two growth and income funds, which two would you recommend and why? See the list on pages 461–463.

(c) Summarize why these four types of mutual funds might be suitable for Lola.

BE YOUR OWN PERSONAL FINANCIAL MANAGER

1. Your Mutual Fund Preferences. Review the section “Mutual Fund Objectives” and then complete Worksheet 61: My Mutual Fund Preferences from “My Personal Financial Planner.” For each of the types of mutual funds listed, identify which are of interest to you and one characteristic you like about them, and note those in which you might invest during your own investing life.

2. Comparing Mutual Fund Investments. Learn about three stock mutual funds that might be of interest to you, such as Vanguard Target Retirement 2055 Fund (VFFVX), Vanguard Target Retirement 2050 Fund (VFIFX), and Spartan 500 Index - Investor Class (FUSEX), by going online. Then complete Worksheet 62: Comparing Mutual Funds as Investments from “My Personal Financial Planner” by recording the facts requested.

3. Calculating Mutual Fund Returns. Use the information for the exercises immediately above and complete Worksheet 63: Calculating the Return on Mutual Fund Investments from “My Personal Financial Planner,” which will help you deter mine the return from income and capital gains after you make some assumptions, such as a 5-year holding period and the like.

4. Evaluating My Investment Returns. Complete Work sheet 64: Evaluating the Performance (Gain or Loss) of My Investments from “My Personal Financial Planner” using one example for which you make the assumptions. Perhaps you can use the Spartan 500 Index – Investor Class (FUSEX) in which you invested $3000 two years ago for $66.50 and its present price of $7.90.

ON THE NET

Go to the Web pages indicated to complete these exercises.

1. Low Cost Mutual Funds. Visit the Kiplingers website for low-cost mutual funds (www.kiplinger.com/tool/investing/T041-S000-kiplingers-25-favorite-fund/index.php). Summarize why they think these are good investments.

2. Which ETFs for You? Visit the website for Vanguard Investments and read its section on exchange-traded funds (ETFs) (www.personal.vanguard.com/us/funds/etf). Summarize why you think ETFs might or might not be a good investment for you.

3. Mutual Fund Information. Visit the website for CNNMoney. Go to the page titled “What Is a Mutual Fund” at www.money.cnn.com/retirement/guide/investing_mutualfunds.moneymag/index.htm. Review the dozen or so short articles and compare what you read there with what you read in this chapter. List two things that are new to your understanding.

4. FINRA on Mutual Funds. Visit the website for the Financial Industry Regulatory Authority (FINRA) at www.finra.org/Investors/SmartInvesting/ChoosingInvestments/MutualFunds/, where you will find a section titled “Mutual Funds.” Review the several paragraphs there and compare what you read with what you read in this chapter. List two things that are new to your understanding.

ACTION INVOLVEMENT PROJECTS

1. Review Some Mutual Fund Portfolios. Go to Kiplinger's article on model portfolios at www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml?si=1 and review the three illustrative portfolios that might fit your needs. Summarize your findings.

2. Using a Fund Screener. Go to the fund screener of Yahoo! Finance (finance.yahoo.com/funds) and look up three funds of interest to you, perhaps using some of the names of funds you found in the exercise immediately above. Summarize your findings.

3. Reviewing ETFs. Go to Fidelity's ETF fund screener website (www.research2.fidelity.com/fidelity/screeners/etf/landing.asp?) and click on the “Learn More” section of “ETF Portfolio Builder.” Compare what you learn there with what is in this book.

4. Unique Mutual Fund Services. Review Table 15-2 on “Unique Mutual Fund Services” on page 459 and select 2 that would be important to you as a mutual fund investor. Explain why.

DO IT IN CLASS PAGE 459

Visit the Garman/Forgue companion website at  www.cengagebrain.com .