Personal Finance Questions: Mutual Funds

Question: Why would someone want to give serious attention to investing in mutual funds? At the same time, why would you not invest in them?
Mutual funds on the whole serve to level the investment playing field between large and small investors
- They offer an inexpensive way to instant diversification, professional management guidance, minimal transaction costs, liquidity, flexibility, many services, avoidance of bad brokers.
Mutual funds perform lower than the market does
- Sales and annual expense fees can be very costly ? be selective
- Not all mutual funds are truly safe
- Systematic risk is still present and taxes are not deferred.

Question: What are the two broad types of risks that are associated with investing? Can you avoid them by investing in Mutual Funds?
The two broad types of risks associated with investing are systemic and unsystemic risks.
A broadly diversified Mutual Fund can protect you from unsystemic risk associated with an individual company, industry or country
- These funds invest in a broad spectrum of firms, industries and possibly countries to minimize the impact of specific unsystemic risks.
A narrowly focused sector fund invests in many firms in the same industry or country.
While the risk of a few firms failing is diversified away, the risk of a systemic event effecting the entire industry or country is not diversified away
- A new technology, political change, natural disaster or some other broad impact will effect all the investments in the fund.


Question: Do the advantages of investing in a Mutual Fund outweigh the disadvantages for the average small investor?
A case can be made that the advantages to the small investor far outweigh the disadvantages of investing in mutual funds
- The average investor does not have the time, expertise or desire to do the research necessary to invest in individual stocks
- They typically don't have the money to adequately diversify at realistic costs
- They are fairly naive when it comes to market trends, predatory Brokers, and economic impacts on the markets
- Mutual Fund Managers are much better suited to succeed in the markets than an individual investor
- The services funds provide are invaluable with record keeping and paying taxes
- The trick is to find a good Mutual Fund company that provides the selection and services that you need and dollar cost average your investments.

Question: Briefly explain the three ways to make money when you own shares in a mutual fund
First, as the value of all the securities held by the mutual fund increases, the value of each mutual fund share also goes up.
Second, if a fund receives interest or dividends from its holdings, this revenue is passed on to shareholders in the form of dividends.
Third, if the fund sells a security for more than it originally paid for the security, the shareholders receive this gain in the form of a capital gains distribution, generally paid annually.


Question: Compare and contrast open-end and closed-end mutual funds
Open-end funds can literally issue as many shares as investors want
- The fund grows and shrinks as shares are bought by investors and sold by the same
- The value of all the investments determines how much each share in the fund is worth
- On the other hand, a closed-end fund only sells shares once
- After that, investors must conduct trading among themselves
- This fund determines the value of each share by the value of the investments that the fund holds and investors' demand for the shares in the fund.


Question: In what ways do unit investment trusts and real estate investment trusts resemble mutual funds?
UITs are a pool of investments, generally municipal bonds, and REITs are also a pool of investments, in this case made up of a diversity of real estate holdings
- Investors buy shares just as they do in mutual funds
- Like mutual funds, these two investments are not limited only to the wealthy.


Question: Explain what the three 'classes' of a mutual fund shares are all about
There is actually only one mutual fund but you can purchase shares in this fund several different ways
- Depending on how you purchase the share, there may be different loads or sales commissions associated with the purchase or redemption of the share
- Class A shares can be purchased directly from the Fund itself or through an Agent like a Financial planner
- Class A shares have a front-end load or commission that comes right off the top of your purchase
- Class B shares are typically sold by a Stock Broker
- They do not have a front-end load so your entire investment is placed into your account
- If you withdraw money before a certain date, then there is a back-end load applied to your withdrawal.
Class C funds are the least attractive since they have both a front-end and back-end load plus higher fees.


Question: Explain how sales loads and fund expenses can negatively impact your return on investment in a mutual fund
The sales load and fund expenses are subtracted out of your account which means you have less of your money available or fewer shares available to grow and earn a return.
For example, if you invest $1,000 into a 5% front-end load fund, $50 is subtracted off the top leaving only $950 in the account
- If your account grows to $1,500 by the end of the year, and the fund expenses are 2%, then they will remove another $30 from your account balance
- With this example, if the total gross return on your money was 12%, after the load and expenses your net return would be much less.

Question: Briefly describe the cost involved in mutual funds.
A mutual fund has either a sales commission or no sales commission involved
- Funds are either a no-load fund, a load fund, or a back-end load, the load being the commission
- A mutual fund can also charge management, marketing, and trading fees.


Question: Explain how a dividend reinvestment plan is similar to compounding and the time value of money
With compounding, the interest you earned from previous periods earns interest in the current period
- As time progresses, the interest earning interest becomes a substantial part of your future value
- By reinvesting all dividend and capital gains distributions into additional shares of the fund, you are basically compounding these new shares which will earn more distributions, additional new shares, and this reinvesting will make up a substantial portion of the future value of your total investment.


Question: What are the tax liabilities concerning investing in a mutual fund?
There may be a tax liability due on the current dividend and capital gains distributions made during the current tax year
- Taxes on these distributions are due regardless if you received the distributions in cash or reinvested them in additional shares
- In addition to taxes on distributions, there is also a potential capital gains tax on the increase in NAV from the purchase to the sale
- One of the great benefits of investing in most large Mutual
Fund Companies is they provide shareholders with an end of the year 1099 tax statement that shows all distributions and capital gains for the previous tax year.


Question: Why are stock mutual funds so popular? Briefly outline the highlights of each type of fund
There is a stock mutual fund for almost every need ? about 6,000 in all
- They serve many purposes as follows:
- Aggressive growth funds try to maximize capital appreciation while ignoring income; they are risky with wide price swings.
- Small-company growth funds are aggressive funds in undiscovered companies with potentially unlimited future growth.
- Growth funds are similar to aggressive funds but pay more attention to strong firms that pay dividends.
- Growth-and-income funds attempt to provide a steady stream of income and have some potential for increasing value.
- Sector funds try to capture the advantage of a single industry; they are risky and lose the diversity advantage.
- Index funds buy stocks that make up the S&P 500, which is good for those who want to mimic the market rather than beat it at low cost.
- International funds seek to diversify and grow by focusing on general world regions or foreign companies with abnormal growth potential regardless of location.


Question: There are dissimilarities between U.S - government, GNMA, municipal, and corporate bond funds - Please point them out
The major difference stems from the bond vehicle
- U.S
- government bonds invest in securities issued by the federal government
- GNMA bonds specialize in pools of residential mortgages
- Municipal funds are generally exempt from some form of taxes and invest in municipalities, such as cities, counties, and states
- Corporate funds invest in various for-profit corporations and have the potential for defaulting.

Question: Compare the investment vehicles and tax treatment of tax-exempt and government securities money market mutual funds
The tax-exempt fund invests only in very short-term municipal debt, while the government securities fund invests solely in U.S - government securities
- The former is exempt from federal income taxes, while the latter is not.


Question: How is an asset allocation fund different from a balanced mutual fund?
Asset allocation funds seek to time the market by moving money between stocks and bonds
- These attempts may cost more and therefore diminish returns.

Question: Prepare a case for investing in a bond fund versus individual bonds.
A bond mutual fund suits the small investor as well as the large investor

- You can begin with as little as $1,000 and add more later in smaller amounts

- The funds offer more liquidity than individual bonds, and on top of that you get professional management.
Rather than receiving a semiannual check as with bonds, you can choose a monthly check or reinvest back into the fund

- The bond fund does not mature; it is virtually perpetual and carefree.


Question: Question: What is the purpose of a Target Retirement fund and who would benefit from it?
A target retirement fund is designed to make sure that an individual is properly diversified based on how much longer they have until retirement

- A younger person's fund would have a greater percentage of common stocks verses bonds because they have enough time remaining to be exposed to more risk

- As a person nears retirement age, the fund's managers automatically change the make-up of the investments in the fund to more conservative, less volatile investments more appropriate for someone needing their money fairly soon.
These types of funds are ideal for the average person who does not have the time, expertise or desire to put in the effort necessary to manage their own monies
- With these funds, a person just states what year they plan on retiring and then set up automatic payments and everything else is decided by professional investment managers.


Question: What are the advantages of index funds?
Index funds are set up to mimic or duplicate the stocks found in a market index like the S&P 500 or or Dow Jones Industrials
- They are called passively managed funds because it does not take any expertise to select the stocks from the index, these funds do not require high paid managers or have a lot of trading costs or other expenses associated with a actively traded fund
- Because of the low costs, most index funds are no-load funds with very low expense fees.
Because of the efficient markets, it is very difficult for an actively traded fund to consistently beat the market indexes over time
- For a typical, dollar cost averaging, buy and hold investor, the index funds are a very good choice for their important savings.


Question: What are ETFs and what are their advantages?
an ETF is a hybrid type investment that mimics the diversification of a mutual fund but enjoys the flexibility of an actively traded share of common stock
- Most ETFs follow an underlying index, similar to an index fund
- The main advantages of an ETF is that you don't need to open up a special account or have a minimum deposit for an account
- If you already have a trading account you can purchase shares of an ETF just like shares of any common stock
- You can actively trade the ETF anytime of the day taking advantages of market movements
- You can trade ETFs using margin and short selling
- Because of their nature, the tax liability for capital gains comes upon the trade only and is much less complex than the potential tax liability of mutual funds.


Question: Investment companies are required by law to offer a prospectus to prospective investors
- Let your instructor know which 5 parts you think are the most important and why
The fund's goal and investment strategy is important because I want it to align with my own personal goal and strategy
- The fund's manager must have a good track record of successful performance or I will not invest
- I must know what the distribution options are to see if they will meet my needs
- I want to take advantage of all of the services offered to get the most out of my mutual fund
- Last, I want to know the fund's performance since inception
- Let's face it, if it hasn't done well I don't need it.


Question: What are the four choices for purchasing a mutual fund?
- broker
- financial advisor
- buy direct
- mutual fund supermarket


Question: Provide a list of sources of information to evaluate mutual funds
- Morningstar Mutual Funds
- The Wall Street Journal
- Yahoo! Finance
- MoneyCentral
- The Mutual Fund Prospectus

Question: What steps would you advise someone to go through when buying a mutual fund?
First, determine your investment goals
- Second, identify funds that meet your objectives.
Third, evaluate the fund.

Question: Mutual funds are a great way to invest - Once you have the minimum amount saved–about $3,000 for most Vanguard mutual funds–it's time to start investing - What are a few factors to keep in mind?
Goals
- Set up your investment plan to meet your goals.
Put your plan on autopilot
- The easiest way to save is to never see the money in the first place
- Just about every mutual fund allows you to have money automatically pulled from your checking account each month and invested in the mutual fund of your choice.
Paying yourself first, as it's called, always makes sense.
Taxes
- As you invest, keep your tax situation in mind, because mutual funds pass along taxable income from their investments in the form of dividends and capital gains–and even if your money remains invested in the mutual funds, there might be taxes to pay.
Taxes when you move money
- When you move money from one fund to another, even within the same fund family, the IRS looks at the movement as a sale and a purchase and assesses taxes on any gain from the sale.
The losers
- While it's hard to pick winners, it's much easier to pick losers
- If a fund has done poorly in the past, chances are it will do poorly in the future
- Take the time to check out the past performance of a fund you are interested in.
Costs, costs, costs
- Keep your costs down, as lower-cost mutual funds tend to do better than higher-cost funds
- Read the fine print
- Watch for commissions, maintenance, and other fees that eat away at your money!