XV. MUTUAL FUNDS

1. XV. MUTUAL FUNDS

2. The Five Things to Know Before Investing in Mutual Funds • What is the fund sponsor’s reputation for: • Leadership • Clarity of Communication • Transparency, and • Business Continuity; • What is the tenure and experience of fund managers; • What is the fund’s style; • What is the fund’s expense ratio, and • Has the fund provided consistently strong returns relative to its peers?

3. A. The Mechanics of Mutual Funds • Mutual funds pool money from many investors • Mutual fund investors own a part of all of the securities in the mutual fund “pool” • The fund manager is responsible for tracking the securities in the pool • Mutual funds provide diversification – mutual fund investors can own a portion of a variety of stocks and/or bonds for a relatively small investment

4. A. The Mechanics of Mutual Funds • Profits are paid in two ways: • Income Distributions – Dividends and interest paid by the underlying securities are subsequently paid to investors • Capital Gains Distributions – Payment to investors of profits obtained from sales of securities • Passive Funds – Primarily index funds • Active Funds – Run by a professional manager – active funds have: • Professional managers • An investment objective, and • An investment program designed to meet the investment objective

5. A. The Mechanics of Mutual Funds • Open and Closed End Funds • Open end – sold by brokerage firms and by fund distributors, issues or purchases shares depending upon demand, uses client funds to buy or sell securities • Closed end – raise money only once, invest in a variety of securities, and offer a fixed number of shares – traded Over the Counter or on the market – price varies with the price of the underlying securities and with market demand (discount or premium from Net Asset Value)

6. B. TYPES OF MUTUAL FUNDS • Stock Funds – invest in equity securities, can be growth, value, dividend, sector, market cap, etc. • Bond Funds – invest in Treasury bonds, municipal bonds, passive trading of securities, active trading of securities, high yield bonds, corporate bonds, etc. • Commodity Funds – invest in stocks of commodities firms or in commodity futures • Balanced Funds – contain a mix of stocks and bonds (generally 60% stocks, 40% bonds)

7. B. TYPES OF MUTUAL FUNDS • Target Date Funds – change investment allocation as a target date approaches (ex. - §529 funds) • Money Market Funds – cash equivalent securities – like a savings account • International Funds – invest in Europe, China, Asia, Far East, Latin America, emerging markets, etc. • Miscellaneous – socially responsible funds, sin funds, green funds, etc.

8. C. DEFINITIONS • Turnover Rate – the number of times per year that the equivalent of all of the underlying securities in the fund are purchased or sold • Volatility – the historic deviation of rates of return above and below the average rate of return • Prospectus – similar to a stock prospectus, explains fund objectives, investment strategy, fees, historic before and after tax returns, and fund risk profile

9. C. DEFINITIONS • Net Asset Value (NAV) – the value of the underlying securities in a fund - defined as: (market cap of fund shares + accrued interest + accrued dividends – accrued expenses) number of fund shares • Premium – The price of a share of a closed end mutual fund minus the share Net Asset Value – exists where demand for fund shares exceeds the value of the underlying holdings

10. C. DEFINITIONS • Discount – Where the shares of a closed end fund trade below the fund’s net asset value, exists where demand is less than the value of the underlying holdings • Liquidity – The ability to get “into” and “out of” an investment (buy and sell) – ETFs are generally highly liquid, mutual funds are not • Diversification – Where a fund holds a variety of securities • Fund Objectives – the management style behind a mutual fund (large cap, small cap, growth, value, junk bond, muni, etc.)

11. C. DEFINITIONS • Rating – An independent analyst’s opinion of how the fund has performed compared to benchmarks • Ranking – The relative standing of a mutual fund compared to others with similar investment strategies • Sharpe Ratio – Calculated as a fund’s rate of return – the rate of return on 3 month Treasury bills divided by the standard deviation of fund returns Sharpe Ratio = (Fund Return – 3 mo. Treasury Yield) Standard Deviation of Fund Returns

12. C. DEFINITIONS • Standard Deviation – The amount by which the annual returns of a fund vary above and below the fund’s average return • Rating Firms: • Standard and Poors • Morningstar • Lipper

13. C. DEFINITIONS • Fund Style (See Style Box) • Growth/Blend/Value – Invests in growth stocks, a blend of growth and value stocks, and value stocks • Small Cap (less than $1.5 billion), Mid Cap ($1.5 billion to $9 billion), Large Cap ($9 billion +) • Dividend (Yield) – Invests in securities with the highest dividend payments • Contrarian – Against the accepted (current trend) in management • Style Drift – When a fund manager changes styles to make up for below market returns • Portfolio Overlap – Where a holder of several mutual funds owns duplicate underlying shares of stock

16. D. FEES AND CHARGES Fees have the greatest impact on fund returns other than the manager’s performance • Sales Charges (Loads) • Front End Load – A sales charge on fund purchase, reduces the number of shares purchased • Back End Load (Redemption Fee or Contingent Deferred Sales Charge) – Paid when shares are sold – usually declines to 0 after 5-7 years – designed to prevent investor “churn” • Level Load – sales charges are part of annual operating expenses

17. D. FEES AND CHARGES • Fund Classes • A = Front end load • B = Back end load • C = Level load – no sales charges, but higher fees than A or B – higher annual fees and charges instead of front end or back end loads • Exchange Fees – A charge for moving assets between different funds issued by the same group

18. D. FEES AND CHARGES • Early Redemption Charge – Exit fee, can be 5 days to 1 year • Breakpoint – A point where more money is invested to reduce the front end load • Right of Accumulation – Where an investor can combine past and new investments to reach a breakpoint • Letter of Intent – A promise by the investor to increase the amount invested to reach a breakpoint

19. D. FEES AND CHARGES • Other Types of Fees – Total annual fees are quoted as an “Expense Ratio” – must be listed in the fund prospectus, generally range from 0.1% to 2.75% • 12-b 1 Fees – Marketing and distribution expenses – limited by NASD rule to 1% of assets per year or less, with marketing fees at 0.75% or less; and with shareholder services capped at 0.25% of assets • Management Fees – Charge to pay the advisory firm that invests fund assets

20. The Securities and Exchange Commission (SEC) maintains a mutual fund fee calculator to assist consumers - see FINRA also has a tool for analyzing mutual funds, including fees - see

21. E. MEASURING FUND RETURNS • Percentage change in share price (market value) is the measure of fund returns for closed end funds Percentage Closing Share Price Rate of Return= Opening Share Price -1

22. E. MEASURING FUND RETURNS • Net Asset Value = Value of Fund Investments Number of Shares Percentage Closing Net Asset Value Change in NAV = Opening Net Asset Value -1

23. E. MEASURING FUND RETURNS • Distributions – Can be both interest (dividends and interest on investments) and capital gains (mutual fund’s gain from sale of underlying investments) • Yield = Distribution per Share Price per Share

24. E. MEASURING FUND RETURNS • Total Return = Change in NAV + Distributions Cost of Initial Investment • Reported as a geometric mean, taking into account annual compounding of distributions • Must be viewed in comparison with standard indices or with indices of competing funds with a similar investing style

25. F. ANNUITIES • Defined as an investment contract between the purchaser and an insurance company, funded (money invested) either by a lump sum or by a series of scheduled payments • Types of Annuities • Fixed annuities – interest rate set upon purchase • Variable annuities – contain a selection of sub accounts, with the yield on the annuity varying depending upon the investment performance of the types of securities represented in the sub account

26. F. ANNUITIES • Advantages of annuities over mutual funds • Income taxes – no income taxes are paid on capital gains until the annuity matures (presumably when the investor is retired and in a lower tax bracket) • Withdrawals from an annuity, unlike withdrawals from a pension plan or an IRA, can be postponed until after age 701/2, allowing transfer of wealth to heirs

27. F. ANNUITIES • Special types of annuities (ex. §403(B) annuities) are tax deferred for both contributions and interest • Annuities may contain a death benefit, which is a guaranteed payment upon death regardless of market conditions – the death benefit is similar to life insurance, funded by a mortality and expense (M&E) fee.

28. F. ANNUITIES • Disadvantages of annuities • Annual fees are generally higher than mutual fund annual fees as a percentage of the amount invested • Surrender fees – a back end load, generally starting at 7% for the first year, declining by 1% per year thereafter

29. F. ANNUITIES • Annuity ratings • As an insurance product, the state of issue may guarantee the company’s obligations, including annuities, in the event that the company becomes insolvent (goes bankrupt) • The insurance companies issuing annuities are rated by Standard and Poors and Morningstar