Investing In Mutual Funds and ETFs

Chapter 3 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University

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Indirect Investing

Alternative to direct investment in or ownership of securities Refers to buying and selling the shares of intermediaries that hold securities in portfolio

Shares are ownership interest in portfolio entitled to portfolio income Shareholders also pay expenses

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Investment Companies

Financial firm that sells shares to the public and uses the proceeds to invest in marketable securities

Acts as conduit for distribution of dividends, interest, and realized gains Can elect to pay no federal taxes on distributions Offers professional management

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Company Types

Unit investment trusts: Typically holds an unmanaged, fixed-income portfolio

Assets not actively traded once purchased Trust ceases to exist when securities mature Passive investment

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Company Types

Exchange Traded Funds: portfolio of assets that offer diversification over a sector, region, or market

Trade like individual equities on exchange Management fees low Investor controls realization of capital gains, losses

Tax implications

ETFs on equities, bonds, commodities

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Company Types

Closed-end investment companies: No additional shares sold after initial public offering

Share prices determined and trade in a secondary market Price may not equal Net Asset Value of the shares

Net Asset Value: Total market value of the security portfolio divided by total shares

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Company Types

Open-end investment companies: Shares continue to be sold to the public at NAV after initial sale that capitalizes the company

Shares may be sold back to company at NAV Company size constantly changes Popularly called mutual funds

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Mutual Fund Categories

Money market mutual funds invest in portfolio of money market securities

Taxable or tax-exempt Commercial paper important investment Average maturity limit: 90 days Investors pay a management fee but not a sales or redemption charge (load) Not insured by the federal government

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Mutual Fund Categories

Equity, bond, and income mutual funds invest in portfolio of securities consistent with the objectives of the fund

Objectives set by the companys board Disclosure of objectives to investors 18 major categories of investment objectives

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Equity Funds

Most assets in equity funds rather than bond or income funds Most equity funds are either:

Value funds, which invest in undervalued stocks as determined by fundamental financial analysis Growth funds, which invest in stocks of firms expected to show future rapid earnings growth
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Cost Considerations

Closed-end fund prices may be at a discount or premium to NAV

Liquidation value different than price

Load funds charge a front-end fee to cover the costs of selling the fund to investors

May also be a redemption (back-end) fee or distribution fee (called 12b-1 fee)

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Cost Considerations

All fees must be stated in the mutual fund prospectus No-load funds are purchased at NAV directly from the investment company

No sales force expense to cover Investors must seek out funds Still an annual operating expense paid out of fund income

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Performance

Reported on a regular basis in the popular press Measured over a given time period as a percent of initial investment

Total returns include reinvested dividends and capital gains Average annual return reflects the mean compound growth rate of investment over a given time period
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International Funds

Some mutual funds specialize in international securities

US investors can participate in emerging market economies International funds or global funds emphasize international stocks Single-country funds concentrate assets

Actively or passively managed

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New Directions

Mutual fund supermarkets

Various mutual fund families can be purchased through a single source Brokerage account may provide access Supermarket managers earn fee
Largely unregulated investment companies available to private investors

Hedge Funds

May use leverage, strategies not available to mutual fund managers Substantial initial investment required
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