23. Investing 6: Understanding Mutual Funds

Chapter 23. Investing 6: Mutual Fund Basics

23. Investing 6: Understanding Mutual Funds

Introduction

Mutual funds are collections of stocks, bonds, and other financial assets that are owned by a group of investors and managed by a professional investment management company. As an investor in a mutual fund, you own a share of the fund that is equal to the amount of your investment divided by the total value of the fund.

Mutual funds provide many important benefits to investors; these benefits particularly apply to investors who are just beginning to invest. Since a mutual fund can include hundreds of different securities, the performance of the fund is not dependent on any single security: the risk is spread among the various securities. In most cases, a portfolio manager is assigned to monitor the performance of securities in the fund. Well-chosen mutual funds can help you achieve your financial goals.

Objectives

When you have completed this chapter, you should be able to do the following:

A. Explain the advantages, disadvantages, types and classes of mutual fund shares. B. Understand how to calculate mutual fund returns. C. Understand the costs of investing in mutual funds and how to purchase a mutual fund. D. Understand plans and strategies for mutual funds.

Explain the Advantages, Disadvantages, Types and Classes of Mutual Fund Shares

There are both advantages and disadvantages to investing in mutual funds. The following is a discussion of some of these advantages and disadvantages.

Advantages of Mutual Funds

One of the main reasons for the creation of mutual funds was to give investors who wanted to make smaller investments access to professional management. However, mutual funds offer many advantages to investors of all types, such as:

Diversification: Investing in a single stock or bond is very risky, but owning a mutual fund that holds numerous securities reduces risk significantly. Mutual funds provide diversification, which is crucial to a well-balanced portfolio. Diversification is particularly crucial in small accounts.

Professional management: It is difficult and time consuming to pick the best stocks and bonds

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for your portfolio and to try to beat the benchmarks on these stocks and bonds. Allowing a professional mutual fund manager to make decisions about stocks and bonds for you can save you time and frustration.

Minimal transaction costs: Buying individual stocks and bonds is expensive in terms of transaction costs. Mutual funds offer the advantage of economies of scale in purchases because mutual fund transactions are typically large. Economies of scale refers to the fact that mutual fund costs may decrease as the mutual fund's asset size increases, since brokers may charge lower fees to try to get more of the mutual fund's business.

Liquidity: Money invested in mutual funds is generally liquid. You can sell your shares and collect money from open-ended funds (funds that can create and redeem shares on demand), usually within two business days. If the open-end funds are no-load funds, investors are not required to pay transaction costs when they buy or redeem shares.

Flexibility: Owning individual stocks and bonds does not allow for much flexibility in terms of liquidity, or the ability to access your money. You cannot write checks on the value of individual stocks and bonds. However, many mutual funds allow for more flexibility by allowing you to write checks on your account.

Low up-front costs: Certain types of mutual funds have financial benefits that make them less expensive than individual stocks and bonds. For example, no-load mutual funds can be sold and redeemed without incurring any sales charges, and open-ended mutual funds can be purchased at the fund's net asset value (NAV). A fund's NAV is calculated daily by subtracting the fund's liabilities from its assets and dividing the resulting amount by the number of outstanding shares. The benefit of open-ended funds is that you do not need to pay a premium or a sales charge to purchase or sell the shares.

Service: Mutual fund companies generally have good customer service representatives who can answer your questions and help you open accounts, purchase funds, and transfer funds. Mutual fund companies may also offer other services, including automatic investment and withdrawal plans; automatic reinvestment of interest, dividends, and capital gains; wiring funds to and from your accounts; account access via phone; optional retirement plans; check-writing privileges; bookkeeping services; and help with taxes.

Disadvantages of Mutual Funds

Although there are many advantages to investing in mutual funds, there are also some disadvantages.

Below market performance: Generally, most actively managed mutual funds have not beaten their benchmarks over the long term. While in some years actively managed funds outperform their index fund counterparts, the support for actively managed funds for longer periods of time is low.

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For the period from 1962 to 1997, the average actively managed fund, or a fund whose purpose is to outperform a specific index by the active buying and selling of securities, failed to outperform their benchmarks. In 22 of 35 years, less than half of all actively managed funds beat their benchmarks.1

Another paper that examined mutual fund performance on both a total return and after-tax basis reported:

In general, we find that index funds outperform actively managed funds for most equity and all bond fund categories on both a total return and after-tax total return basis, with the exception of actively managed small company equity and international funds. These results should be viewed with caution, however, as there is evidence that actively managed funds outperform the index funds during periods when the economy is either going into or out of a recession.2

Recent experience is not much different. In the last 10 years, 60?65 percent of actively managed funds failed to beat their benchmarks, depending on asset class (see Chart 1).

Chart 1. Percentage of Actively Managed Funds That Failed to Beat Their Benchmarks3

High costs: Unless you analyze funds carefully before you buy them, you may inadvertently choose a mutual fund that charges significant management, custodial, and transfer fees. Each of

these fees reduces your total amount of return. Moreover, many mutual funds charge loads (sales

charges) and 12b-1 fees, which is are paid by shareholders to cover the cost of marketing the fund to other investors. These charges and fees also reduce your total amount of return.4

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Risks: Mutual funds are subject to both market-related risks and asset-related risks, particularly in very concentrated portfolios, which are not as well diversified.

Inability to plan for taxes: Mutual funds are considered pass through vehicles for tax purposes and are required to distribute 95 percent of all capital gains and dividends to shareholders at the end of each year. Even if shareholders do not sell their mutual fund shares, if they are in taxable vehicles they may be required to pay a significant tax bill each year, particularly if the fund trades often and has a lot of short-term interest, dividends, or capital gains. It is difficult to plan for taxes because the decisions that affect the amount of taxes you will pay are made by the portfolio manager, not you.

Premiums or discounts: Closed-end mutual funds may be traded at a premium or discount to the fund's underlying net asset value. These premiums and discounts are based on investor demand more than they are based on actual share value; therefore, premiums and discounts are not constant over time.

New investor bias: Shares purchased by new investors dilute the value of the shares owned by current investors. When new money enters the mutual fund at net asset value, the money must be invested, which costs roughly 0.5 percent in an average U.S. stock fund. Thus, the funds of current investors are used to subsidize the purchase of the new investors' shares.

Describe the Different Types of Mutual Funds

There are three major types of mutual funds that parallel the major asset classes: money market, stock, and bond mutual funds.

Major Types of Mutual Funds

Money market mutual funds invest primarily in short-term, liquid financial assets, such as commercial paper and U.S. Treasury bills. The goal of these funds is to obtain a higher return than traditional savings or checking accounts.

Stock mutual funds invest primarily in common stocks listed on the major securities exchanges discussed in the previous section. Each type of stock mutual fund has a particular emphasis or objective, such as large-cap stocks, small-cap stocks, value stocks, growth stocks, and so on.

Bond mutual funds invest primarily in the bonds offered by companies or institutions. Each of these bond mutual funds has a particular emphasis or objective, such as corporate, government, municipal, and agency bonds. Most of these funds have specific maturity objectives, which relate to the average maturity of the bonds in the fund's portfolio. Bond mutual funds can either be taxable or tax-free, depending on the types of bonds the fund owns.

Specialty Mutual Funds

Index funds are mutual funds that are designed to match the returns of a specific benchmark.

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Since these funds buy and sell securities infrequently (i.e., they have a low turnover), they are very tax-efficient investment vehicles. Index funds have the option of following many different benchmarks, including the S&P 500 (large-cap stocks), Russell 5000 (small-cap stocks), MSCI EAFE (international stocks), Barclays Aggregate (corporate bonds), and DJ REIT (real estate investment trusts). As of March 9, 2017, there were 1,185 different index funds listed in the Morningstar database (Morningstar is one of the largest and best private data providers of mutual fund information).

Exchange-traded funds (ETFs) are similar to mutual funds in that they comprise groups of stocks; however, ETFs are different because they are traded in an organized exchange. Because ETFs are purchased on an exchange, they incur all the transaction fees and custody costs that stocks do. They are also similar to stocks in that they are priced throughout the day rather than at the end of the day like mutual funds. ETFs can be both shorted and purchased on margin. ETFs can be structured as either unit investment trusts (UITs), whose money is invested in a portfolio where the composition is fixed for the life of the fund, or open-end mutual funds, where money is invested in a portfolio that can change over time. The UIT structure does not allow for immediate reinvestment of dividends. As of March 9, 2017, there were 1,750 different ETFs listed in the Morningstar database.

Balanced funds are mutual funds that purchase both stocks and bonds, usually in a set ratio (e.g., 60 percent stocks and 40 percent bonds). The benefit of these funds is that the fund manager makes both the asset-allocation decisions and the stock-selection decisions for the investor.

Asset-allocation funds are mutual funds that rotate investments among stocks, bonds, and cash, with the goal of beating the return of a specific benchmark after all expenses have been accounted for. These funds invest in the asset classes that the portfolio managers expect to perform the best during the coming quarter.

Life-cycle mutual funds change their allocations of stocks and bonds depending on the age of the investor. As an investor ages, life-cycle funds reduce their allocations in stocks and increase their allocations in bonds, which typically makes the fund more consistent with the goals of an older investor. These funds make asset-allocation decisions for the investor and aim to reduce transaction costs.

Hedge funds are mutual funds that assume much more risk than normal mutual funds in the expectation of higher returns. Sometimes the managers of these funds take long positions, in which they buy and hold assets; sometimes the fund managers take short positions, in which they borrow assets and sell them. The managers of hedge funds hope they will later be able to buy back the assets at a lower price before they must return them to the lender.

Describe the Different Classes of Mutual Fund Shares

Mutual funds may be divided into classes depending on the loads, or sales charges. There are two

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types of loads, front-end and back-end. Front-end loads are commissions charged at purchase of the fund; they directly reduce the amount of money invested by the amount of the load. Back end loads are sales charges to compensate the sales force for selling the fund.

While there are differences of opinion as to the choice of load versus no-load funds, research has found that the performance of load funds and no-load funds is generally identical over the periods analyzed. However, when the sales charges are included in the calculation of returns, noload funds significantly outperform load funds.5

While there are differences in classes of shares among investment management companies which charge loads, they generally include the following.

Class A shares commonly have a front-end or back-end load to compensate for the sales person's commissions. Because of the high loads, they usually have lower management fees.

Class B shares commonly have a back-end load that is paid when the shares are sold. The amount of this back-end load traditionally declines over time. Class B shares generally have higher expense ratios when compared to Class A shares.

Class C shares generally have lower front- and back-end load fees but higher management fees.

Class R shares are generally for retirement purposes. Check the loads and management fees, which may be substantial.

No-load shares are sold without a commission or sales charge. Generally, this type of mutual fund share is distributed directly by the investment management company instead of through a sales channel. These shares may have higher management fees to compensate for the lack of a front- or back-end load.

Class Y shares have very high minimum investments (i.e., $500,000) but have lower management fees and waived or limited load charges. These are generally for institutional investors.

Class Z shares are only available for employees of the fund management company.

Understand How to Calculate Mutual Fund Returns

There are two ways to make money on mutual fund holdings: capital appreciation and distributions.

Capital Gains

One way to earn money on mutual fund shares is to purchase shares and hold them for an extended period of time. Then, when the market value of the shares increases, you can sell the shares and collect capital gains. Capital gains are generally the preferred type of earnings

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because they are not taxed until you sell your mutual fund shares and you get to decide when to sell those shares. In addition, capital gains are taxed at a preferential rate by the federal government whereas ordinary income may be taxed at a rate of up to 38.6 percent.

Distributions

Distributions are the second way you can make money on mutual funds. They are a less attractive type of earnings than capital gains because you do not have control over the taxes associated with distributions. Even if you do not sell any mutual fund shares, you must still pay taxes on your mutual fund's annual distributions. There are five main types of distributions: short-term capital gains, long-term capital gains, qualified stock dividends, ordinary (nonqualified) dividends, and bond interest and bond fund distributions.

Short-term capital gains: Short-term capital gains are earnings on assets you owned for less than 366 days. Short-term capital gains are taxed at your marginal tax rate, which can be up to 39.6 percent for federal taxes and 10 percent for state taxes.

Long-term capital gains: Long-term capital gains are earnings on assets the fund has owned for 366 days or more. In 2018, long-term capital gains are taxed at a federal rate depending on your taxable income and AGI. There is also an added Medicare tax on long term capital gains of 3.8 percent if your adjusted gross income (AGI) is $250,000 or higher (Married Filing Jointly).

Qualified stock dividends: A qualified dividend is a dividend paid by a U.S. corporation whose stock you held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (see Taxes on Securities Earnings Including Qualified Dividends (LT32)). In 2018, qualified stock dividends are taxed at the same rate as capital gains.

Ordinary (or non-qualified) stock dividends: Ordinary stock dividends are cash earnings paid to investors that have not held the stocks for the necessary amount of time. These dividends are taxed as ordinary income at both the federal and state levels.

Bond dividends and interest: Bond dividends and interest are distributions from bonds and bond mutual funds. These earnings are taxed at your marginal tax rate, which may be as high as 39.6 percent for federal taxes and 10 percent for state taxes.

The key to making money on mutual fund holdings is to invest in funds with high after-tax returns. The higher the after-tax returns on a fund, the more quickly you will be able to achieve your personal and financial goals.

Calculating Mutual Fund Returns

Calculating mutual fund returns is not as easy as it sounds. Too often investors only account for the explicit costs of trading and they forget about the implicit tax costs. These costs can significantly reduce the amount of a fund's return. Remember to invest wisely and to account for

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after-tax returns.

Calculating total returns: Mutual fund returns include dividends and distributions as well as any net asset value (NAV) appreciation. The basic equation for total return is as follows:

([ending NAV ? beginning NAV] + distributions) / beginning NAV

Before using this equation, be sure to adjust your beginning and ending net asset values to account for the costs of both front-end and back-end loads. These costs will significantly decrease your return.

Calculating before-tax returns: Before-tax returns are the same as total returns if all distributions are reinvested. The before-taxes total return includes the increase in the net asset value and the increase in the number of shares. The total return before taxes is calculated as follows:

([#ES * EP] ? [#BS * BP] + distributions) / (#BS * BP)

In the before-tax returns equation, the variables are defined as follows:

#BS = number of beginning shares owned BP = beginning price of the shares #ES = number of ending shares owned EP = ending price of the shares

Calculating after-tax returns is more difficult because you must know your marginal tax rate at the federal, state, and local levels and the tax rate for the different types of distributions. If all distributions are reinvested, the after-tax total return includes the increase in the net asset value, the increase in the number of shares, and the after-tax impact of distributions. The after-tax (AT) total return is calculated as follows:

([#ES * EP] ? [#BS * BP] + ATSD + ATLCG + ATSCG + ATBDI) / (#BS * BP)

In this equation, the variables are defined as follows:

#BS = number of beginning shares owned BP = beginning price of the shares #ES = number of ending shares owned EP = ending price of the shares ATSD = after tax stock distributions, or stock dividend distributions * (1 ? the tax rate on stock dividends) ATLCG = after tax long-term capital gains distributions, or long-term capital gains distributions * (1 ? tax rate on long-term capital gains) ATSCG = after tax short-term capital gains distributions, or short-term capital gains distributions * (1 ? tax rate on short-term capital gains)

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