 Personal Finance PowerPoint Presentation. Mutual fund part number three. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Mutual Fund, which you can find online. Take a look at the references, resources, continue your research from there. This by Adam Hayes, updated March 7th, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, what stock is, and then we started discussing mutual funds. We're continuing the discussion of mutual funds here. Quick recap of that. We had the corporations, remember that corporations are separate legal entities, and we, as human beings, attribute the corporation the capacity to own property from kind of a natural law kind of perspective, the ability to own the property. Then we then can own the shares of the corporation, which can be useful because the shares of the corporation we can think of as basically fixed units. So every one share has the same kind of rights related to it as another share. We then thought about these corporations being on an exchange, whereas most people think about when they're investing in corporations, investing in them that are on a publicly traded exchange, typically larger corporations. The benefit to the corporation is they have the exposure to the capital for more people to make investments into it. The benefit for us as investors is that the exchanges require the corporations to be more transparent and uniform about their reporting requirements, building the level of trust for the typical investor. But we still have a difficulty in investing in one stock at a time or in a particular corporation. The mutual funds is one of the tools that allowed us to pool our money together from multiple investors so that that pooled resource can then be allocated in various different ways in whatever ways that we determine, or the mutual fund determines, allowing diversification to the average investor, allowing more funds to go into the market, which of course would be beneficial to the corporations and the exchanges as well. So now we've been digging into different kinds of mutual funds that might be put together. And here we go. Mutual fund shares come in several classes. Their differences reflect the number and size of fees associated with them. Currently, most individuals investors purchase mutual funds with A shares through A broker. This purchase includes a front-end load of up to 5% or more plus management fees and ongoing fees for distributions, also known as 12B1 fees. To top it off, loads on A shares vary quite a bit, which can create a conflict of interest. Financial advisors selling these products may encourage clients to buy higher load offerings to bring in bigger commissions for themselves. With front-end funds, the investor pays these expenses as they buy into the fund. So if you're dealing with a financial advisor, you've got to think about how they're getting paid. If they're getting paid by commission, how might that influence their recommendations to you? You might also use other kind of tools like a Vanguard account or something like that and do more of kind of your own research in any way that you pursue this. You do want to do your own research and make sure that the people that you're working with you understand what their at least financial incentives are as you're going through the process. To remedy these problems and meet fiduciary rule standards, investment companies have started designing new share classes, including, quote, a level load in, quote, C shares, which generally don't have a front-end load, but carry a 12B1 annual distribution fee of up to 1%. Funds that charge management and other fees when an investor's sale they're holding are classified as class B shares. A new class of fund shares, a relatively new share class developed in 2016, consists of clean shares. Clean shares do not have front-end sales loads or annual 12B1 fees for fund services. American funds and MFS are some fund companies currently offering clean shares. By standardizing fees and loads, the new classes enhance transparency for mutual fund investors and most likely save them money. So clearly when we're a typical type of investor, we would like to see basically the transparency. We were looking kind of for more uniformity, typically oftentimes, because that's going to simplify the investment process, the investment decision. And if companies are able to do that, you would think then they might draw in more money overall, given that transparency and the trust that might be built from that. Advantages of mutual funds. There are a variety of reasons that mutual funds have been the retail investor's vehicle of choice for decades. The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds. So when you're putting money into the market, you're typically doing so under a mutual fund. Oftentimes, most people doing that through their work with a 401K or a 403B, for example, those are retirement accounts that are using typically tools such as mutual funds in order to fund them. So multiple mergers have acquitted to mutual funds over time. Diversification. Diversification or the mixing of investment and assets within a portfolio to reduce risk is one of the advantage of investing in mutual funds. So clearly we can have less money and still be diversified possibly through an appropriate tool or an appropriate use of mutual funds. Experts advocate diversification as a way of enhancing a portfolio's returns while reducing its risk by an individual company stock and offsetting them with industrial sector stocks, for example, offers some diversification. However, a truly diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. So you can get a whole lot more realm of diversification. You would think generally for the common investor through the use of the mutual funds than possibly by buying individual stocks, even if you're able to buy some different kind of individual stocks. So buying a mutual fund can achieve diversification cheaper and faster than by buying individual securities. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be practical for an investor to build this kind of portfolio with a small amount of money. So easy access trading on the major stock exchange mutual funds can be bought and sold with relative ease making them highly liquid investments. So they're kind of like stocks in that way, meaning you can get access to your money fairly easily. Now remember if they're under the umbrella of a 401k or an IRA, there's restrictions to it. Tax consequences, you could have penalties related to it, but if it's just in the mutual fund outside of like an IRA or a retirement account, then you can get access to it fairly quickly. Not as fast as getting access to the bank account but fairly quickly. However, you are subject to the increases and decreases of the market. Also, when it comes to certain types of assets like foreign equities or exotic commodities, mutual funds are often the most feasible way, in fact, sometimes the only way for individual investors to participate. Economies of scale. Mutual funds also provide economies of scale. Buying one spares the investor of the numerous commission charges needed to create a diversified portfolio, meaning if you buy individual stocks, you might have to buy or pay someone for each of those trades, which can get quite costly, whereas if you buy the mutual fund, then you're being charged for the pool as a whole, lowering hopefully the cost of the buying process just to facilitate the trade. Buying only one security at a time leads to large transaction fees, which will eat up a good chunk of the investment. So also the $100 to $200 an individual investor might be able to afford is usually not enough to buy a round lot of the stock, but it will purchase many mutual fund shares. The smaller denominations of mutual funds allows investors to take advantage of dollar cost averaging because a mutual fund buys and sells large amounts of securities at a time its transaction costs are lower than what an individual would pay for securities transactions. Moreover, a mutual fund, since it pools money from many smaller investors, can invest in certain assets or take larger positions than a smaller investor could. For example, the fund may have access to IPO placements or certain structured products only available to institutional investors. So you get some of the benefits from being the big investor, even though you're not a big investor. You're investing in a mutual fund that has a whole big pool of assets due to the fact that a lot of people are invested in the mutual fund. Professional management, a primary advantage of mutual funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all this using careful research and skillful trading. Again, you might bulk at that a little bit. You might say, I don't know if I fully trust the professional manager. It depends on the manager, of course, but your question of how much leeway do you have in the mutual fund? You could invest in mutual funds that are tied to basically indexes, which you would think have less management, and then you're betting on the market itself possibly having lower fees to take a strategy such as that. So investors purchase funds because they often do not have the time or experience to manage their own portfolios. So it's quite likely that you on your own are not going to outperform a professional stock manager. That's most likely the case unless you spend a significant amount of time or are really good at one particular, you know, some area. However, so you might put the money into the mutual fund. But you can make the same argument for the mutual fund. Is the mutual fund manager going to actually beat the market questionable? And then if you don't think so, you'd be putting your money possibly into like more of an index fund. If you think you have a skilled manager that you think can perform better than the market average, then you'd be paying the manager more to do so, giving them more leeway, most likely paying them more to get those higher returns if you think that possible. Or they don't have access to the same kind of information that a professional fund has. So a mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. So most private non-institutional money managers deal only with high net worth individuals, people with at least six figures to invest. However, mutual funds as noted above require much lower investment minimums. So these funds provide a low-cost way for individual investors to experience and hopefully benefit from professional money management. And again, how much management do you want? How much leeway do you want to give the money management? You could still have some control over that depending on the types of mutual funds that you're putting in place. Variety and freedom of choice. Investors have the freedom to research and select from managers with a variety of styles and management goals. For instance, a fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or microeconomic investing. Many, many other styles. So you might say, I want to get a market manager that's specializing in particular areas. And so they're going to be an expert in that area. And then you might have other mutual funds that are in other areas in an attempt to do your own diversification. And again, you might look at these individual areas like emerging markets and so on and try to invest just in an index fund, which is trying to measure the average of the emerging markets, for example, which gets less leeway to a manager and possibly being cheaper. So one manager may also oversee funds that employ several different styles. So this variety allows investors to gain exposures to not only stocks and bonds, but also commodities, foreign assets, and real estate through specialized mutual funds. Some mutual funds are even structured to profit from a falling market known as bear funds. Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors. So transparency, mutual funds are subject to industry regulations that ensure accountability and fairness to investors. So one of the benefits of investing in often the U.S. markets and things that are traded on the public exchange is the fact that the regulations for a company to choose to be on the exchange and so on means that they need to show transparency. And it's just like a government, right? If you're a public servant, if you're the government and you're serving the people, you should be transparent. Everything that you're doing for in relation to that job should be transparent. If you're a private company, then you don't need to be asked that that chance because you're not asking anybody for money. But if you're if you're on the public exchange and you're asking people to invest private investors, individual investors to invest, you need to be transparent with how it is that you're making money, right? So that's one of the and that's one of the things that the U.S. stock market is typically pretty good at, which again, it's why that trust is built up and why a lot of capital could be gained due to just trust, transparency. So if you lose the transparency, not good over the long run. So pros, liquidity, diversification, minimal investment requirements, professional management, variety of offerings on the cons side of things, high fees, commission and other expenses, large cash presence in portfolios, no FDIC coverage, difficulty in comparing funds, lack of transparency and holdings. Disadvantages of Mutual Funds. Liquidity, diversification and professional management all make up Mutual Funds attractive options for younger novice and other individual investors who don't want to actually manage their money. However, no asset is perfect and Mutual Funds have drawbacks too. So fluctuating returns like many other investments without a guaranteed return, there's always the possibility that value of your Mutual Fund will depreciate. So in other words, even if you have a diversified portfolio, clearly that doesn't mean that the economy is not going to, that it might not go down because you're going to have fluctuations in the market. The whole market could go into a recession and then all the equity stocks or a good portion of them may go down bringing basically the Mutual Fund down as opposed to if you had your money in a savings account or bonds are less likely to go down at least that much, right? Equity Mutual Funds experience price fluctuations along with the stock that make up the fund. The Federal Deposit Insurance Corporation, the FDIC does not back up Mutual Fund investments and there is no guarantee of performance with any fund. So you don't have like if you put your money into a bank or something like that and the bank goes bankrupt, you're going to say, well, what if the bank loses all their money? Am I going to get my money? Well, usually, hopefully you have federal insurance on that. So that's supposed to give us some safeguard. You don't have that same kind of thing, putting your money into the Mutual Fund. So of course, almost every investment carries risk. It is especially important for investors in money market funds to know that unlike their bank counterparts, these will not be insured by the FDIC. Mutual Fund pools money from thousands of investors. So every day people are putting money into the fund as well as withdrawing it to maintain the capacity to accommodate withdrawals. Funds typically have to keep a large portion of their portfolio in cash. So it's kind of like when a bank makes money by you putting money into your checking account, but you can withdraw the money anytime. But the bank is taking the excess reserve and investing it and trying to get a return on it. But obviously they need enough money to account for any cash that's being pulled out, which means that reserve can't be used to invest on the bank's side of things. So having ample cash is excellent for liquidity, but money that is sitting around as cash and not working for you is not very advantageous. Mutual funds require a significant amount of their portfolios to be held in cash in order to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a quote, cash drag in quote. High costs, mutual funds provide investors with professional management, but it comes at a cost. Those expense ratios maintain mentioned earlier. The fees reduce the funds overall payout and they're assessed to mutual fund investors, regardless of the performance of the fund. As you can imagine in years when the fund doesn't make money, these fees only magnify losses, creating, distributing and running a mutual fund in an expensive is an expensive undertaking. So obviously doing all the work to put together the mutual fund can be can be a costly thing that they've got to make money on it. Everything from the portfolio manager salary to the investor's quarterly statement costs money. Those expenses are passed to the investors since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long term consequences. So you want to think about what those fees are, make your comparisons from fund to fund. You would think again index funds would have less active management therefore possibly being cheaper betting in essence on the market instead of the performance of the manager. Actively managed funds incur transaction costs that accumulate over each year. Remember every dollar spent on fees is a dollar that is not invested to grow over time. Dowersification and dilution. Dowersification a play on words is an investment or portfolio strategy that implies too much complexity can lead to worse results. Many mutual fund fund investors tend to over complicate matters. That is they acquire too many funds that are highly related and as a result don't get the risk reducing benefits of diversification. So notice we've got all these kind of mutual funds that have these combinations of things and you might be looking at mutual funds that have a targeted goal and so on. And you might say well I can't just put money into that one mutual fund that doesn't make sense does it but that one mutual fund is now diversified within the mutual fund. So then we as investors say well it's got to be more complicated than that so we start to invest in other mutual funds. And if we don't have a portfolio or some tool and there are tools that are good now like the personal capital tool basically that can kind of break out these mutual funds to give you some idea of how much is invested. How much is invested in your overall portfolio so that you can possibly buy multiple mutual funds. But we might buy multiple mutual funds that are basically investing in overlapping in the same areas and not really maximizing our diversification that way. So these investors may have have made their portfolio more exposed at the other extreme just because you own mutual funds doesn't mean you are automatically diversified. For example a fund that invests only in a particular industry or sector or region is still relatively risky. In other words it's possible to have poor returns due to too much diversification because mutual funds can have small holdings in many different companies. High returns from a few investors often don't make much difference on the overall return. Dilution is also the result of successful fund growing too big when when new money pours into funds that have had strong track records. The manager often has trouble finding suitable investments for all the new capital to be put to good use. So again if you have active management as the as the money fluctuates the manager the manager strategy might differ. If you go outside of their expertise which again if you put your money on something like an index fund then that might not be a less of a problem. But one thing that can lead to diversification is the fact that a fund's purpose or makeup isn't always clear. Fund advertisements can guide investors down the wrong path. The Securities and Exchange Commission the SEC requires that funds have at least 80% of assets in the particular type of investment implied in their names. So how the remaining assets are invested is up to the fund manager. However the different categories that qualify for the required 80% of the assets may be vague and wide ranging. A fund can therefore manipulate perspective investors via its title. A fund that focuses narrowly on conjolese stocks for example could be sold with a fair ranging title like quote international high tech fund end quote. So active fund management many investors debate whether or not the professionals are any better better than you or I at picking stock. So in other words can the professional beat the market. They're probably better than you or I but still professionals often might be taking more risk which again the different types of investors that are more aggressive or less aggressive. May have in the short run a better performance because whatever their style might match the market for that particular time period. It's really over their whole life that you have to kind of look at it and say well how did they do over their whole life. And by that point in time it's too late to invest with them. You know so it's kind of hard to see which of the stock pickers are actually really beating the market consistently you know over their whole over their whole career. So management is by no means infallible and even if the fund loses money the manager still gets paid. Actively managed funds incurred higher fees but increasingly passive index funds have gained popularity. These funds track an index such as the S&P 500 and are much less costly to hold. So you might just say I'm not going to deal with the active investment because I you know I don't really know who exactly the active investor. You know who's managing the fund right if I'm a passive investor so maybe I just invest in the averages is what I typically do. So the index funds so actively managed funds offer several time periods have fold to outperform benchmark indexes especially after accounting for taxes and fees. So they're kind of the active managers are kind of at a disadvantage to outperform because they have to clear at least the taxes and fees that they're that they're going to incur. As they do their active management process as opposed to the index funds which has less fees that has to be cleared. So lack of liquidity a mutual fund allows you to request that your shares be converted into cash at any time. However unlike stock that trades throughout the day many mutual fund redemptions take place only at the end of each trading day. Usually not an issue for most like normal investors but if you're actively trading then then that lag mean that can cause a lag. When a fund manager sells a security a capital gains tax is triggered. So it's kind of like when you sell stocks if they sell the security and it went up in value now you've got a game could have tax implications. Investors who are concerned about the impact of taxes need to keep those concerns in mind when investing in mutual funds. Taxes can be mitigated by investing in tax sensitive funds or by holding a non tax sensitive mutual funds in a tax deferred account such as a 401k or IRA. So if you put money under the umbrella of our 401k or an IRA it's still typically in mutual funds oftentimes. But now you can't take it out as easily because it's under the restrictions of the IRA and you got to be make sure you're following the rules. Evaluating funds researching and comparing funds can be difficult unlike stocks mutual funds do not offer investors the opportunity to juxtapose the price to earnings. The PE ratio sales growth earnings per share EPS or other important data a mutual funds net asset value can offer some base basis for comparison. But given the diversity of portfolios comparing the proverbial apples to apples can be difficult even among funds with similar names or stated objectives. So so it's kind of more difficult in some ways to do the side by side comparison given the different natures of the mutual fund. Only index fund tracking the same markets tend to be genuinely comparable which is nice for the index funds. So example of a mutual fund. So one of the most famous mutual funds in the investment universe is Fidelity Investments Magalene Fund. That's the FMAGX established in 1963. The fund had an investment objective of capital appreciation via investment in common stock. The funds glory days were between 1977 and 1990 when Peter Lynch served as its portfolio manager. Lender Lynch's tenure Magalene's assets under management increased from 18 million dollars to 14 billion dollars. Even after Lynch left Fidelity's performance continued strong in assets under management. A U.M. grew to nearly 110 billion dollars in 2000 by 1997. The fund had become so large that Fidelity closed it to new investors and would not reopen it until 2008. As of March 2022 Fidelity Magalene has nearly 28 billion dollars in assets and has been managed by Sammy Semeger since February 2019. The fund's performance has pretty much tracked or slightly surpassed that of the S&P 500.