Exploring Mutual Fund Investments: Advantages, Drawbacks & Performance Analysis

1. CHAPTER4 Mutual Funds Chapter Sections: Advantages and Drawbacks of Mutual Fund Investing Investment Companies and Fund Types Mutual Funds Operations Mutual Funds Costs and Fees Short-Term Funds Long-Term Funds Mutual Fund Performance Closed-End Funds, Exchange Traded Funds, and Hedge Funds Mutual Funds: Investments for the Masses

2. What is a Mutual Fund? • An investment company that invests its shareholders’ money in a diversified portfolio of securities • “Investment company” is the legal term • “Mutual fund” is the popular term • Professional management • Diversification • Each fund has a specific objective • Over 11,000 funds to choose from • Many people choose mutual funds for their retirement account investments (401k, 403b, Traditional IRA, Roth IRA, etc.)

3. Mutual Funds STOCKS BONDS “CASH” Balanced mutual funds Bond mutual funds Stock mutual funds Money market mutual funds a “mutual” fund a.k.a. investment company Professional Money Management Diversification

4. Growth of Mutual Fund Industry Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, and ETFs

5. Growth of Mutual Fund Industry (continued) • In 1980, five million Americans owned funds • Holding 3% of their household financial assets • As of December 2015, 93.1 million Americans in 54.9 million households owned mutual funds • That is just over 44% of all U. S. households • Mutual fund assets totaled $18.1 trillion dollars* • Holding 22% of their household financial assets • Mutual funds are now the nation’s largest financial intermediary, followed by commercial banks (second largest) and life insurance companies (third largest) Source: Investment Company Institute, 2016 Investment Company Fact Book, www.ici.org, *Includes open-end, closed-end, and ETFs as of December 2015.

6. Growth of Mutual Fund Assets As we saw in chapter 1, 2008 was a very difficult year. Source: Investment Company Institute, www.ici.org, *Includes open-end, closed-end, and ETFs

7. Advantages of Mutual Funds • Pooled Diversification • A process whereby investors buy into a diversified portfolio of securities for the collective benefit of the individual investors • This variety provides some safety that is difficult for an individual investor to obtain on their own • Professional management • The mutual fund managers are supposed to know what they are doing • (They are certainly getting paid enough!) • Low initial outlay of capital • You can start with $25 to $50 per month • “PITA” factor is low –The Wealthy Barber

8. Drawbacks of Mutual Funds • Transaction Costs • Some mutual funds charge sales fees called “loads” • Front-end loads, back-end loads, etc. • Many others are “no-load” funds • But some “no-load” funds can wind up costing you more than “load” funds over time • Annual Operating Expenses • Typically from 0.5% (or less) to 2.5% (or more) • Many mutual funds do not match the market’s performance • What? Aren’t the mutual fund managers supposed to know what they are doing?

9. Open-end versus Closed-end Funds • Open-end mutual funds (>80% of mutual funds) • A type of investment company in which investors buy shares from, and sell them back to, the mutual fund itself, with no limit on the number of shares the fund can issue • Shares are issued and redeemed by the investment company at the request of investors • Investors can buy shares from (purchase) and sell shares to (redeem) the investment company at any time When people refer to a mutual fund, they are almost exclusively referring to an open-end mutual fund. As of December ‘15, there were 9,520 open-end mutual funds totaling $15.65 trillion dollars in assets.

10. Open-end versus Closed-end Funds (continued) • Closed-end mutual funds (<5% of mutual funds) • A type of investment company that operates with a fixed number of shares outstanding • Shares are issued by an investment company only when the fund is organized • After all original shares are sold you can only purchase shares from another investor • Bought and sold like stocks on the open market • Incur brokerage commissions Closed-end investment companies are not as popular with individual investors as open-end investment companies. At the end of December 2015, there were only 558 closed-end mutual funds holding only $261 billion dollars in assets. In recent years, both numbers have been shrinking.

11. Open-end versus Closed-end Funds (continued) • Net Asset Value • The underlying value of one share in a particular mutual fund • Add up the value of the securities in the mutual fund • Subtract any liabilities (normally close to zero) • Divide by the number of shares Open-end mutual funds are sold at net asset value (with a sales load added to load funds). Since closed-end mutual funds are bought and sold on the open market, their price usually either reflects a premium or discount to the net asset value (usually a discount). They are very rarely priced at their net asset value.

12. Open-end versus Closed-end Funds (continued) Net Asset Value = Value of the fund’s portfolio - Liabilities Number of shares outstanding Example: $10,050,000 - $50,000 = $10 NAV 1,000,000 shares Offering price = NAV + sales commission Example: $10 + ($10 * 5%) = $10.50 Offering Price

13. Open-end versus Closed-end Funds (continued) • Advantages / Disadvantages? • Open-end investment company • Always able to buy and sell – no market forces • Very popular – wide range of choices • Large purchases or redemptions can make management of the fund more difficult • Mutual fund company can “close the fund” to new investors • Closed-end investment company • Must pay broker’s commission (like a stock) • Must be bought/sold via the marketplace • Often sold at premium or discount to NAV • Easier to manage assets for investment advisors Which would (or do) you prefer?

14. A New Type of Mutual Fund: ETFs • Exchange-traded Funds (≈14% of mutual funds) • An open-end mutual fund that trades on the stock exchanges like closed-end mutual funds • There is no limit to the number of shares • The mutual fund company issues shares as needed • But the investor must purchase the fund using a brokerage account • Incurring brokerage transaction fees (commissions) • However, some mutual fund companies have found a way to eliminate the brokerage transaction fees • They have opened their own brokerage firms and if you purchase their ETFs through their brokerage firm, they waive the commission – Very smart marketing! A recent entry to the industry, ETFs are becoming very, very popular. We will discuss why later on.

15. Growth of ETF Industry Again, take note of the drop in value in 2008 even as the growth in the number of ETFs was continuing apace. Source: www.ici.org

16. How are Mutual Funds Regulated? • Investment Company Act of 1940 • Foundation of the modern mutual fund industry • Defined “regulated investment company” • a.k.a. “pass-through” investment vehicle • Does not pay taxes on its investment income • The shareholders pay the taxes • To qualify, an investment company must… • Hold almost all its assets as investments in stocks, bonds, and other traditional securities, and • Very limited ability to use derivatives & other risky strategies • Use no more than 5% of its assets when acquiring a particular security, and • Create an organization with “checks & balances”

17. (continued)

18. How are Mutual Funds Organized? • The Mutual Fund • A Corporation run by a Board of Directors • Board of Directors voted in by Shareholders (investors) • Sponsored the fund’s creator • Investment Advisor (a.k.a. Management Company) • Portfolio Manager (sometimes a team or a committee) • Research Analysts (usually focus on a specific industry) • Distributors • Distributes the shares to the public or to dealers • Much the same role as an investment banker • Mutual funds are technically continuous Initial Public Offerings – must have an annual prospectus & report

19. How are Mutual Funds Organized? (continued) • Custodian • The company that actually holds the securities • Often a bank or trust company • Transfer Agent • Keeps track of purchase and redemption requests from shareholders • Independent Public Accounting Firm • Certifies the fund’s financial reports Why the large diversification of tasks and companies? Mutual funds are highly regulated in order to protect shareholders’ investment from fraud and collapse. How often have you heard of a scandal at a mutual fund company? Until 2003, never.

20. Wait a minute, Paiano! Did you just say, “Mutual Fund Scandals?!” • “You want me to invest in an industry that is plagued with scandal?!” • Since 1940, the mutual fund industry has been regulated and escaped any hint of impropriety • In 2003, some practices that were not quite illegal but obviously unethical were uncovered • Only a handful of funds and people were affected • Strong, Janus, Bank of America, Putnum, Alliance • The vast majority of companies never engaged in any of the shenanigans Instead of losing $99,999.99 on a $100,000 account (example: Enron or WorldCom), investors lost $0.01 on a $100,000 account.

21. Annual Operating Expenses • Management fees • Charged yearly (.25%-2% average) based on a percentage of the fund’s asset value • Paid to portfolio managers and analysts who make the investment decisions • 12b-1 fees • Annual fee to defray advertising, servicing, and distribution costs of the fund – up to 1% per year • Accounting and other expenses • Trustee fee • Only for retirement and other tax-qualified accounts – typically $10 to $30 per year

22. Annual Operating Expenses (continued) • Trading Costs • Not disclosed in the annual prospectus • So how does an investor know how much the trading costs are? • You can ask the mutual fund or just look at the… • Annual Turnover • Measure of how much trading a mutual fund does • Measured in percentage of the amount a portfolio “turns over” each year • 100% turnover, 50% turnover, etc. • The higher the turnover, the higher the trading costs • Also gives you an idea how long they hold investments • 100% turnover: They hold on average one year • 50% turnover: They hold on average two years

23. Load versus No-load Funds • Load Fund • A mutual fund that charges a commission when shares are bought • Typically 3% to 5% • Used to compensate the financial representative • Along with the fund distributor • No-load Fund • A mutual fund that does not charge a commission when shares are bought • Traditionally sold directly to shareholders The endless debate: Should you purchase a Load Fund or No-load Fund?

24. Load versus No-load Funds (continued) • Types of Load Funds • Front-end Load – a.k.a. Class A • Commission is paid when shares are purchased • Normally have lower annual operating expenses • Back-end Load – a.k.a. Class B • Commission is paid when shares are redeemed • Most back-end load funds have a Contingent Deferred Sales Charge (CDSC) • The CDSC declines to zero over a period of 3 to 6 years • 5% first year, 4% second year, 3% third year, etc. • Normally, the back-end load pay higher annual operating expenses (12b-1 fees) until the CDSC declines to zero • Eventually, the Class B shares revert to Class A shares

25. Load versus No-load Funds (continued) • Types of Load Funds (continued) • No-load Funds (Huh?) – a.k.a. Class C • No front-end nor back-end commissions • Except 1% back-end charge if redeemed within one year • However, many Class C funds have higher annual operating expenses in perpetuity (or for a long time) • There are those 12b-1 fees again • Hence, they can wind up costing more than the Class A or Class B shares over time • The SEC now says you can not call a mutual fund a “no-load” fund if the 12b-1 fee is greater than 0.25% • So, Class C shares are now not allowed to be called “no-load” funds even though many in the industry still do

26. Load versus No-load Funds (continued) • Types of No-load Funds • Advisor No-load Funds – a.k.a. Class F, Class I • Held in advisor’s “wrap account” • a.k.a. “Management account,” “Wealth Management Account” • Advisor charges 1% to 2% to “manage the account” • “True” No-load Funds • Mutual fund company deals directly with public • May not have a 12b-1 fee greater than 0.25% • These are the darlings of the popular media • “Bypass the middleman! Who needs a financial advisor?” • But that does not mean the overall fees are low • Over time, a no-load fund can wind up costing you more than a load fund • You must compare the annual operating expenses

27. Example of Shareholder Fees: AMCAP Fund This is a load fund. All data on next 9 slides of as December 31, 2016

28. AB Large Cap Growth Fund* Example of Shareholder Fees: This is another load fund. *nee Alliance Large Cap Growth Fund †nee Class F

29. Legg Mason Value Trust Example of Shareholder Fees: This was a very famous (now infamous) no-load mutual fund. The class C shares were and still are the most popular. They added class A shares a few years ago. They have since changed the name to ClearBridge Value Trust.

30. Example of Shareholder Fees: Vanguard 500 Index Fund This is an index fund. This fund does no research. They simply buy all the 500 stocks in the S&P 500 Index. The term for this is “passive management.” (More later) Index funds are usually “true” no-load mutual funds and usually (but not always) have very low fees. There is a $20 annual fee if your account value is less than $10,000 unless you enroll in electronic delivery of financial communications.

31. Example of Shareholder Fees: Fidelity 500 Index Fund Vanguard pioneered low fee mutual funds and was able to overtake Fidelity as the number #1 mutual fund company. Fidelity responded by eliminating all sales loads, creating their own index funds, and lowering their fees below Vanguard. Like the Vanguard fund, there is a “low balance” annual fee of $12 if your account is below $2,000 unless you enroll in automatic purchases.

32. AB Large Cap Growth Fund Examples of Dollar Costs: Although it looks as though the Advisor shares (Class F) are the best deal, this does not include the advisor’s annual fee. Adding the advisor’s typical fee of 1% to 2% per year would easily add an additional $1,200 to $2,400 to the total cost. Over the long term, which is the best deal?

33. Legg Mason Value Trust Examples of Dollar Costs: The class C shares of this “no load” fund wind up costing more than the class A shares! Again, the Financial Intermediary Class seems to be a better deal but it does not include the advisor’s annual fee. The Institutional Class looks great. How can I get them? Well, for starters, are you a large pension fund, university endowment, or tax-exempt charity? Oh, and by the way, do you have at least $1 million to invest?

34. Vanguard 500 Index Fund Examples of Dollar Costs: The fees for passively-managed index funds will almost always be less than actively-managed funds*. The Admiral Class shares used to be available with a minimum of only $100,000. Any takers? (In the fall of 2010, they lowered the minimum to $10,000.) Do you remember the exchange-traded funds (ETFs)? They often have fees lower than the index funds! The Vanguard ETF that tracks the total U. S. stock market has an expense ratio of 0.05%. *Careful! Some 401(k) plans have high-fee index funds! Huh? Why? Because they can.

35. Breakpoint Sales Reductions: AMCAP Class A shares qualify for a sales reduction if you invest a larger amount or as your investment grows. Some brokers failed to inform their clients of this feature. Instead, as the client approaches the breakpoint, the broker would advise them to start another fund. Why?

36. CDSC Reduction over Time: AB Large Cap Growth Fund The back-end sales charge on Class B shares typically is reduced over time until it is eliminated. However, as we noted, the Class B shares pay more in annual fees. Annuities from life insurance companies usually have this type of “surrender charge” schedule. However, they often start at 20% or 25%!

37. So, Which One Would You Pick? 10-Year Rates of Return: as of December 31, 2016 A B formerly Primary Class C D Fees are important, but they certainly do not tell you the whole story. When comparing mutual funds, you must look at many attributes, not the least of which are the rates of return, preferably over longer periods of time. *7.60% and 9.52%, respectively, without sales charge (a.k.a. NAV, net asset value)

38. Mutual Funds Fees: What are __? These shares do not have an up-front sales load. Instead, they assess a decreasing back-end load if you withdraw your money within 6 years. The annual operating expense is higher (courtesy of the 12b-1 fees). • A shares • B shares • C shares • F or I shares The correct answer is (B). They normally eventually become A shares after 6 to 8 years.

39. Mutual Funds Fees: What are __? These shares do not have an up-front fee and only a 1% back-end fee if redeemed within one year. The advisor called them “no-load” but you notice that their annual operating expense is higher than other share classes(again, courtesy of those ubiquitous 12b-1 fees). • A shares • B shares • C shares • F or I shares The correct answer is (C). They sometimes revert to A or F shares after many years.

40. Mutual Funds Fees: What are __? Your financial advisor tells you that these shares have no sales fees and a very low annual operating expense. She mumbles something about “wealth management.” These shares are: • A shares • B shares • C shares • F or I shares The correct answer is (D). She also did her best not to explain that her brokerage firm will charge you an extra 2% each year.

41. Types of Mutual Funds • Aggressive Growth Funds • Highly speculative mutual funds that seek large profits from capital gains • Dey Iz Rollin’ De’ Dice! • Growth Funds • Mutual funds whose primary goals are capital gains and long-term growth • Typically invest in high-growth companies Some fund companies now have a category or two more speculative than Aggressive Growth. They are sometimes called Ultra Funds or Momentum Funds. (Example: Janus 20) What do you think about this strategy?

42. Types of Mutual Funds (continued) • Capital Appreciation Funds • Mutual funds that seek long-term growth of capital • How does it differ from a growth fund? • Most growth funds have a provision that states they will invest primarily in growth stocks, usually staying between 80% & 100% invested in the market • Capital Appreciation Funds can often invest in anything they like and anywhere they like • In general, they tend to be as risky as growth and aggressive growth funds (although not always) The well-known Fidelity Magellan Fund is a Capital Appreciation Fund

43. Types of Mutual Funds (continued) • Growth-and-Income Funds • Mutual funds that seek both long-term growth and current income, with primary emphasis on capital gains • Sometimes own bonds to augment the income • Sometimes referred to as “Blend” (of Growth & Value) • Value Funds • Mutual funds that seek stocks that are undervalued in the market by investing in shares that have low P/E multiples and high dividend yields • Often look for companies out-of-favor with investors Some folks lump growth-and-income funds and value funds together

44. Types of Mutual Funds (continued) • Equity-Income Funds • Mutual funds that emphasize current income and capital preservation by investing primarily in high-yielding, income-producing common stocks • Railroads, Foods, Utilities, REITs, etc. • They will also invest in bonds to generate income when the investment advisor believes that stock prices have risen to levels that threaten preservation of capital Many Equity-Income Funds did very well during the 2000 to 2002 bear market after lagging the market badly during the late 1990’s bull market. Every type of fund was clobbered in 2008.

45. More Stock Fund Classifications Large Cap– largest companies Mid Cap– medium-sized companies Small Cap– smallest companies Domestic – companies based in U.S. Global – based anywhere in globe International – based outside U.S. Regional – Japan, Far East, Latin America, etc. Emerging Markets – India, Mexico, Brazil, Russia, Philippines, China, Turkey, etc. Sector – energy, technology, health care, etc. Market Timing– dumb Types of Mutual Funds (continued) Which do you think is the riskiest? Which do you think is the riskiest?

46. Types of Mutual Funds (continued) • Bond Funds – a.k.a. Fixed-income Funds • Mutual funds that invest in various kinds and grades of bonds, with income as the primary objective • High-Yield Bond Funds – a.k.a. Junk Bond Funds • Are often more correlated with stocks than bonds • Corporate Bond Funds • Convertible Bond Funds • Municipal and Insured Municipal Bond Funds • Popular with high net worth individuals • Income is free from Federal taxes • State-specific municipal bond funds • Income is free from state taxes as well

47. Types of Mutual Funds (continued) • Bond Funds (continued) • U.S. Backed Bonds (Fannie Mae, etc.) • a.k.a. Mortgage-backed Bond Funds • Government Bond Funds – a.k.a. Treasury Bond Funds, Government Securities Funds • Income is free from state and local taxes • Long-term Bond Funds • Intermediate-term Bond Funds • Short-term Bond Funds • Global and International Bond Funds Which do you think is the riskiest? Careful!

48. Types of Mutual Funds (continued) • Balanced Funds • Mutual funds whose objective is to generate a balanced return of both current income and long-term capital gains • Invest in both stocks and bonds • Normally 60% stocks and 40% bonds • But allocation can change as the investment environment changes Example: The prospectus of the American Balanced Fund states that the fund is “managed as the complete U. S. investment program of a prudent investor.” They can never be more than 75% stocks, 25% bonds or less than 50% stocks, 50% bonds.

49. Types of Mutual Funds (continued) • Asset Allocation Funds • Mutual funds that spread investors’ money across stocks, bonds, and money market securities • Very similar to Balanced Funds • However, the investment advisor often more diligently tries to “fine-tune” the allocation as market conditions change • Whereas a Balanced Fund usually stays around 60% stocks / 40% bonds, • An Asset-Allocation Fund might try to move money into cash when they thought the market might fall For all their hype, the returns of many Asset Allocation Funds are very close to Balanced Funds. Some trail Balanced Funds considerably because they “timed the market” badly.

50. Types of Mutual Funds (continued) • Money Market Mutual Funds (review) • Mutual funds that invest in short-term money market instruments • Much the same as money market accounts at banks and credit unions EXCEPT money market mutual funds are not guaranteed • General Purpose – Treasury bills, commercial paper • Government Securities – Only Treasury bills • Tax-exempt – very short-term municipal securities They are essentially as safe as guaranteed money market accounts since they invest in exactly the same securities but they are not guaranteed! (Did we already mention that?) “Breaking the Buck”