Mutual Funds—Investment Companies



Mutual Funds—Investment Companies (Mutual Fund Revised February 2015)

Advantages of mutual funds: Professional management, diversification, and convenience.

Disadvantages of mutual funds: Fees, professionals don’t always do better, and investors cannot time gains and losses for taxes purposes.

Types of investment trusts:

1. Open-ended. They have an unlimited number of shares. When an investor buys and sells shares, the investor is dealing with the investment company, perhaps through a broker.

• Open-ended investment trusts can be either load or no load. The three types of loads are front-end, back-end and 12b-1 fees. The latter are sometimes called sideways loads.

• The price (Net Asset Value) of a share is determined after the close of the market at the end of the day.

• Many funds have different classes of shares:

o Class A shares typically have a front-end load and lower management fees.

o Class B shares have contingent back-end loads. The load is typically reduced 1% a year, until after five or six years it disappears. Class B shares have higher management fees.

o Class C shares often have a small back-end load for the first year, but they have the highest management fees. They also have the highest 12b-1 fees (also called distribution fees or sideways loads).

o Many funds have a class of shares for institutions (e.g., pension funds, insurance companies) and/or for certain investors. These have lower fees. A portion of the load money is typically used to pay sales agents and/or advertise the fund.

• Open-ended investment trusts are found under the name mutual funds. There are thousands more of these than there are closed-ended investment trusts.

2. Closed-ended. They have a fixed number of shares. When an investor buys and sells shares, the investor is dealing with another investor or market maker through brokers, not the fund.

• Since these types of funds are purchased on a stock exchange (NYSE) or on the over-the-counter market (NASDAQ), the funds cannot be classified as load or no load. An investor will pay his stockbroker a commission, but the commission won’t be a load because the commission money goes to the stockbroker, not the mutual fund company. Closed-ended funds trade during the hours that the financial markets are open.

• Closed-ended investment trusts sell for a premium or discount to net asset value (NAV).

• Exchange traded funds (ETFs), although technically classified as open-ended investment trusts, are more like closed-ended investment trusts because they trade on stock exchanges or on the NASDAQ. Most ETFs are index funds. They buy a portion of the market such as the 500 stocks that make up the Standard and Poors 500 index or the 25 largest stocks in China (i.e., ishares China 25). These are unmanaged funds. The managers don’t attempt to pick the best stocks. They simply buy a cross-section of the market and hold on. However, the managers balance the fund when the value of some securities in the fund becomes greater than other securities in the fund. Since most ETFs are unmanaged, their management fees are lower. For several reasons, the ETFs rarely trade for large premiums or discounts. In addition, the number of shares is not fixed. Fund holdings are more readily accessible than open-ended investment trusts. Management fees can run as low as .10%. = 10 basis points.

• Closed-ended funds and ETFs can easily be sold short.

All mutual funds, both open-ended and closed-ended, charge management fees. The typical management fee for a fund that buys American stocks is between 1.3% and 1.5% of the assets in the fund (NAV on a per share basis). Funds that invest in foreign stocks charge more on average, since it costs more for a fund to research and purchase foreign stocks. Bond funds have generally have lower management fees and this especially true for index funds.

Investors make money in mutual funds from:

• Capital gains—the value of an investor’s shares increases, and the investor sells them for a profit (a realized capital gain) or holds on (an unrealized capital gain).

• Distributions

o Dividend distributions are from the income the fund earns (e.g., interest on bonds, dividends on stock, rent on rental properties in the fund).

o Capital gain distributions are from the profits on the sale of assets in the fund

(e.g., profits from the sale of stocks, bonds, commodities, rental properties).

Funds are required to pay out 90% of the income they earn and capital gains that they realize to maintain their tax-free status. These distributions can be paid out in different ways

(e.g., monthly, quarterly, yearly). Many funds make their largest distributions in December.

The three most important things to look for in a mutual fund:

• Good performance, preferably over a period of 5 or 10 years. Performance is typically measured by total return. For example, an investor buys a share in a fund at $20 and it increases in price to $24 in one year. In addition, the fund makes dividend and capital gain distributions of 25 cents and 75 cents respectively per share during the year. The total return is $5 divided by $20 = 25%. Total return is an annual rate (a percentage).

• Low management fees. For a fund that invests in stocks, the management fees should be 1% of the assets per year or less. Index funds typically have lower management fees and tax adv.

• True no loads for open-ended investment trusts. In the case of closed-ended funds, investors should try to buy a fund when its discount is larger than normal.

Funds can be classified by what they invested in:

• Stock funds invest in stocks; however, there are many types of stock funds. Some examples are: International stock funds buy only foreign stocks. Global stock funds buy stocks from all over the world including U.S. companies. Income funds buy stocks that pay dividends, usually good dividends. The term income fund can also refer to bond funds. Aggressive growth funds buy small growth stocks. Index funds buy a cross section of the market (e.g., the 30 stocks that make up the DJIA). These are just a few of the ways that stock funds are classified.

• Bond funds buy bonds. There are many types of bond funds (e.g., municipal, corporate, U.S. government, international, investment grade, and high yield, also called junk bond funds).

• Balanced funds buy stocks and bonds, although not necessarily an equal amount of each.

• Real estate investment trusts (REIT) buy office buildings, apartment houses, shopping malls etc. They are usually closed-ended. There are different types of REITs.

• Money market mutual funds buy money market instruments: U.S. Treasury-Bills, commercial paper (the promissory notes of blue chip companies), and commercial or jumbo certificates of deposits from banks, etc. There are several types of money market funds.

• Money market mutual funds:

o Are safe, although not insured like C.D.s at a bank.

o Pay a competitive rate of interest, usually about what a 6-month C.D. pays.

o Are liquid. Investors can redeem shares by writing checks, although checks must be written for large amounts (usually $500 or more).

Most money market mutual funds are open-ended and no load. They pay daily dividends; this keeps the value of a share at a constant $1.00. Money market mutual funds prior to 2008 were often been a good place for students and others to park their money and emergency cash reserves until they need them. Bank accounts have been marginally better since 2008.

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