Personal Finance: An Integrated Planning Approach

1. Personal Finance:An Integrated Planning Approach Winger and Frasca Chapter 12 Mutual Funds and Other Pooling Arrangements: Simplifying and (Maybe) Improving Your Investment Performance

2. Introduction • There are various types of pooling arrangements such as mutual funds, unit investment trusts, and limited partnerships. • Mutual funds are important investment choices for investors because they provide diversification and professional management for a fee. • Choosing a mutual fund involves the selection of the proper mix of risk and return. • The risk tolerance of investors must be factored into the investment decision when constructing a portfolio.

3. Chapter Objectives • To understand why pooling arrangements are important alternatives to direct investment • To identify the important characteristics of open-end and closed-end mutual funds • To be able to evaluate a mutual fund within a risk and return framework • To recognize the characteristics of unit investment trusts and real estate investment trusts and how each differs from mutual funds

4. Chapter Objectives (Continued) • To understand the basic framework of limited partnerships and why they appeal only to a limited number of investors • To learn the basics of portfolio construction and maintenance and appreciate why mutual funds simplify the process

5. Topic Outline • Mutual Funds • Other Pooling Arrangements • Constructing and Maintaining Your Personal Portfolio

6. Types of Pooling Arrangements • Mutual funds • Closed-end funds • Open-end funds • Investment trusts • Unit investment trusts (UITs) • Real estate investment trusts (REITs) • Limited partnerships • Investment clubs

7. Mutual Funds • A mutual fund is an investment company that pools the funds of many individuals to invest in stocks, bonds, and other investment securities. • Investors buy shares in the mutual fund. • The mutual fund buys: Shares in companies and/or, bonds of companies, municipalities, governments and/or, other investment securities • A fund’s net asset value (NAV) is the total value of all the assets the fund owns (minus any liabilities) divided by the number of shares issued by the fund.

8. Example: Fund X’s NAV Company # of Shares Price per Total Owned Share Value IBM 100 $120 $12,000 Xerox 100 80 8,000 GM 100 70 7,000 Value of the fund’s portfolio $27,000 Number of shares issued 1,000 Fund X’s NAV $ 27.00

9. Load Versus No-Load Funds • A load is a commission paid to buy or sell fund shares. • Loads range from 1% to over 9% of the NAV. • No-load funds have no commission to buy shares (called a “front-end” load) but some charge a commission to sell (called a “back-end” load). • The load pays the fund salesperson who should provide investment advice for this fee. • There is no evidence that load funds perform better than no-load funds.

10. Open-End Funds • These are the most popular types of funds. • They advertise extensively to attract investors. • The largest and best known are Fidelity and Vanguard. • You can deal directly with the fund or through a salesperson to buy and sell shares. • Completing an application form is easy. • Shares are purchased/sold at NAV (plus load, if applicable). • You can use many fund services.

11. Closed-End Funds • These fund shares trade in the securities markets. • You trade shares as you would the shares of any company. • While you do pay a broker’s commission, there are no loads. • Shares can trade at premiums or discounts to NAV. • Discounts can be attractive because you are, in effect, getting a bargain. • If you buy the share at a discount, you, in effect, buy $1.00 worth of securities for less than $1.00.

12. The Fund’s Objectives Type of Fund Fund Objective ___________ _______________________________ Growth Price appreciation over time Income High current return Balanced Good current return with some growth Money Mkt. High liquidity and returns better than bank returns Maximum Exploit opportunities to earn very high Appreciation returns

13. The Fund’s Objectives (Continued) Type of Fund Fund Objective ____________ ______________________________ Sector Invests in only one industry International Earn returns in countries outside the United States Global Earn returns in both the United States and foreign countries Index Earn returns equal to a market index return

14. Important Mutual Fund Services • Reinvestment plans: Can reinvest dividends and capital gains • Transactions by telephone and Internet • Fund switching within a fund family • Can sell shares of one fund and reinvest in shares of another fund within the fund family • Be careful of loads though • Adaptability to IRAs due to low costs and wide range of investment objectives

15. Selecting a Mutual Fund • Evaluate performance. • Review the fund’s current portfolio. • Examine expenses and turnover. • Review evaluations in popular magazines and newspapers. • Consult a professional evaluation service such as Morningstar or Lipper Analytical Services.

16. Performance Measurements • Growth of $10,000 over time • Example: A cumulative total return of 173.8% means that the $10,000 invested 10 years ago has earned $17,380 and the investment is now worth $27,380 • Assumes that all dividends are reinvested as they are earned each quarter • Average Annual Total Return (AATR) • Expresses the cumulative return as a yearly average • 10.62% for example above

17. Risk-Adjusted Rate of Return (RAROR) • Adjusts a fund’s AATR by its beta value and compares this adjusted return to the overall market return • RAROR = (AATR/Beta) – S&P 500 Return • Example: AATR = 10.62%; Beta = 0.94; S&P 500 Return = 11.07% • RAROR = (10.62%/0.94) – 11.07% = 11.30% – 11.07% = + 0.23% • This fund outperformed the S&P 500 return.

18. Interpreting RAROR • A positive RAROR indicates good fund management. • A negative RAROR indicates poor fund management. • It is important to have positive RAROR consistently over time – do not rely too heavily on one year’s number.

19. Other Evaluation Items • Review the fund’s current portfolio • Is there adequate diversification? • Review the fund’s operating expenses • Usually expressed as a percent of net assets • Low expense ratios are desirable • Compare to other funds with similar investment objectives • Examine the portfolio turnover percent • Turnover percent measures the trading frequency • High numbers = high trading

20. External Fund Evaluations • Popular business publications such as: • The Wall Street Journal – the Friday issue especially • Business Week • Forbes Magazine • Money Magazine • Professional Evaluations • Morningstar: Web site has free features • Lipper Analytical Services: Also check out their Web site Both sources have more extensive research for a fee

21. Unit Investment Trusts (UITs) • Similar to an open-end fund • Trust units (shares) are purchased from and redeemed by the fund originator. • Redemption is at current market value. • Major difference • A trust’s portfolio is unmanaged. Once it is established, it is left virtually unchanged. • This leads to very low operating costs. • However, they have loads.

22. Creation of a UIT Trust Originator Buys a Portfolio of Bonds and Sells Trust Units to Individual Investors Investor A Investor B Investor Z Who May Hold Their Units to Maturity or May Sell Back to Originator—at Current Market Value

23. Exchange-Traded Funds (ETFs) • These are a variation of the UIT. • These are similar to closed-end funds that trade in the securities markets. • They have relatively fixed portfolios. • The most popular ETFs are based on broad market indexes (QQQ, Spiders, Diamonds, etc.). • There are also some ETFs that are based on market segments such as sectors (iShares, Holders, etc.).

24. ETF Advantages and Disadvantages • Positions can be taken quickly—similarly to any individual stock. • ETF shares can be purchased on margin. • They have very low expense ratios. • Investors have more control over the recognition of capital gains/losses by determining when to sell shares. • Although commissions must be paid on every trade, they can be much less than on load funds.

25. Real Estate Investment Trusts (REITs) • Similar to a closed-end fund • Equity per share (EqPS) of a REIT is similar to NAV and is calculated as follows: • EqPS = (REIT assets – liabilities)/(REIT shares outstanding) • Types of REITs • Equity trusts: Invest in rental properties • Mortgage trusts: Invest in mortgages • The investment appeal is that this is an easy way to include real estate in an investment portfolio.

26. Limited Partnerships (LP) • These are formed by a general partner who runs the business. • Limited partners only invest money and not time. • LPs invest in various activities such as: • Real estate • Energy programs • Equipment leasing

27. LP Advantages and Disadvantages • The unique feature is the pass through of business profits and losses to limited partners. • Losses can have significant advantages if used to offset other taxable income. • The current tax code, however, severely limits such deductions. • This limitation makes LPs an undesirable investment vehicle for most investors. • Moreover, LP interests cannot be easily sold, making the investment highly illiquid.

28. Investment Clubs • Characteristics • Low monthly contributions such as $25 – $50 • Members do research on specific stocks • Frequent meeting, usually monthly • Advantages • Diversification • Help with investing research workload • Possibility of a profit • Fun and fellowship • Disadvantage • Too much fun, not enough research

29. Portfolio Construction:Aggressive Investor • Any portfolio construction should begin with an understanding of the investor’s risk tolerance. • The portfolio characteristics for aggressive investors, those with a high risk-tolerance, should be: • High risk tolerance and high future return preference • Priority of specific future goals is not strong • This type of portfolio is appropriate for wealth investors and those with no dependents.

30. Portfolio Construction:Cautious Investor • Those investors who would be considered cautious from a risk-tolerance standpoint are: • Anyone with dependents • Investors planning for retirement • Investors planning a major purchase • The characteristics of this portfolio are: • Low risk tolerance • High preference for future return • Strong priority of specific future goals

31. Portfolio Construction:Investor Who Needs Income • Investors that fit this type of portfolio are: • Retirees • Persons with dependents to support • Persons with no major future expenses • The characteristics of this type of portfolio are: • Moderate risk tolerance • Return preference for current return • Moderately strong priority of specific future goals

32. Investment Selection • Aggressive investor: • 100% stocks: 1/3 large company, 1/3 small company, 1/3 international • Cautious investor: • 30% large company growth stocks, the balance in bonds, including zero coupon • Investor who needs current income: • 50% high-quality corporate bonds, 25% medium-quality corporate bonds, and 25% income stocks

33. Maintaining a Portfolio(Portfolio Rebalancing) Stocks Bonds (1) Amount Invested Initially $10,000 $10,000 (2) Current Market Values 15,000 9,000 (3) Adjustment with Constant Ratio Plan * – 3,000 + 3,000 (4) Adjusted Balances 12,000 12,000 ____________ * A variable ratio plan would sell more stocks and buy more bonds.

34. 401 (k) Plan Considerations • Don’t reject participation because this is a disciplined way to save and it is free money if your employer matches any portion of your contribution. • Diversify broadly using a variety of funds. • Coordinate out-of-plan investments with in-plan investments. • Don’t try to time the market, even though gains are not taxed. • Avoid excessive conservatism.

35. Discussion Questions • What is a mutual fund? • Explain two advantages of investing in mutual funds. • Explain the differences between open-end and closed-end mutual funds. • Explain how to evaluate the risk and return characteristics of a mutual fund. • Exchange-traded funds are a very popular investment choice. Explain two advantages of these funds. • Explain the difference between no-load and load.

36. NEXT:Chapter 13Property and Liability Insurance