 Hello and welcome to this session. This is Professor Farhad in which we would look at mutual funds. Mutual fund is a type of investment companies. We talked about investment companies in the prior session, but since mutual funds are a large proportion of investment companies in the US, therefore I'm devoting actually two to three recordings about mutual funds. What are they, the different types, the expenses and costs associated with them and how they are taxed. So these topics are typically covered in an essentials or principles of investment, whether it's undergraduate or graduate. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlist. If they benefit you, it means they might benefit other people connect with me on Instagram. On my website farhadlectures.com you will find additional resources to complement and supplement your accounting as well as your finance courses. I strongly suggest you check it out, especially if you're studying for your CPA or CFA exam. So let's talk about mutual fund. The first thing we want to know about mutual fund, they are open-end investment companies. What does it mean open-end investment companies? It means they are redeemed at net asset value. If you don't know what open-end is, you don't know what NAV is, please view the prior lecture. It means you can redeem them from the fund at something called net asset value. Now, how do you compute net asset value? I did that in the prior session. They account for 88% of investment company assets. It means they basically, the large majority of investment companies are mutual funds and the remainders are different types like hedge fund, commingle funds, REITs. This is what I talked about in the prior session, but in the session I'm devoting to the major investment companies, which is mutual fund. To learn about a mutual fund, you have to look at their fund's prospectus. So when they're advertising the mutual fund on TV or on radio, they would say, check out the fund's perspective, which would basically what it tells you the investment policies. What are they invested in? Are they invested in money market fund, mutual fund, bonds, corporate bond, US bond, so on and so forth. Management companies such as Fidelity, Vanguard, Tiro, Price, they manage a wide range or a family of mutual fund. And what they do by doing, so they make it easy for investors to allocate assets across market sectors and to switch assets across funds while still maintaining centralized record keeping company. So what you do when you buy a mutual fund with fidelity, let's assume you invested in technology and you want to switch to some other sector or you want to switch to an index fund. So it's easy to switch with the same company. The record keeping is centralized with one single company fidelity. That's the beauty of it. In 2017, there was about 8,000 different mutual fund in the US offered by 850 fund complexes. So it's a pretty common theme in the US when you are dealing with investments, you hear about mutual funds. There are many types of mutual funds. We're going to talk about first money market funds. These funds, they have an average maturity rate of a little bit more than a month and basically the offer check writing feature. So if you have a money market fund, you might be able to write a check against those funds, then that asset value is fixed at a dollar. So here if you have one unit or one share, it's equal to a dollar. Now some funds, they might change. I will talk about this in a little bit, but generally speaking, we can say they have an NAV of a dollar. It means there's no tax implication if they stay at a dollar, such as capital gains or capital losses associated with redeeming. So if you sell your money market mutual fund, you should not have a gain or a loss, although that might be changing a little bit. Money market funds are classified as either prime versus government. So we need to know the difference between government and prime. Basically as the word government suggests, it means it holds short-term US Treasury, agency securities and repurchase agreement collateralized or collateralized by such securities. So here you are putting your money in some government related investment. It's a money market fund, but it's a government related investment. Usually it's short-term US Treasury, the majority of the US short-term Treasury. Prime funds, they also are considered also money market, but they invest in commercial paper or bank CDs. When we talk about commercial papers, we're talking about corporations. So here you are dealing with corporation and obviously banks, it means you are buying banks. It means private, not public, private, not government institution. So the money market fund, it could be composed of prime versus government. And obviously which one is safer? Obviously government fund is safer. They're both supposed to be safe. So the prime funds, they're supposed to be safe because only high credit or safe companies with good credit, they can issue commercial paper. So on the safe side of the credit risk spectrum with the prime fund, nevertheless, they are still riskier than government securities and they could suffer reduced liquidity in times of market crisis. And this happens when the financial crisis hit and what happened is now they have policies, if everybody wants to look with their prime fund all at once, they can put a hold to it. Why? Because the fund may not have enough cash to be able to redeem your fund and that's why and as a result, what happens is if everybody redeeming at once, the NAV might go down below one. So basically you're not getting your money back. This is why they put a gate. So that's why there was a large shift from obviously from prime to government fund since the financial crisis. And now the prime, the prime institutional funds, they have to compute an NAV. And what does that mean? It means they could be more or less than a dollar. If that's the case, you could have small capital gain or a capital loss. Again, that's another reason to go from prime to government because you don't want to worry about computing and paying taxes on those NAVs. This is one type of mutual fund. Another type of mutual fund is equity funds. Obviously, as the word equity suggests, those that money is primarily invested in various stocks. Primarily, it doesn't have to be 100%. They also have to hold cash in case of liquidation, in case of redemption because they need the liquidity. If you want your money back, they have to liquidate at net asset value. Therefore, they have to have some cash on hand. And here the stocks are traditionally classified as either capital appreciation or growth appreciation. Another word for appreciation is growth versus current income or simply income funds. So when you invest your money, are you looking for income? If you're a retiree, you're looking for income because you want to live off that income. If you are young, starting your career, you want to invest in an equity fund where it has growth stocks. So it will be growth stocks, a typical growth stocks. For example, Tesla. If you invest in Tesla today, Tesla barely making any profit. They just reported a small profit yesterday, or 2020, July 23, 2020. But Tesla stock has the potential of growth. Same thing with Amazon. Amazon is a growth company. They don't give you any dividend. But you have stocks like AT&T or Verizon. That gives you dividend. They pay dividend. So they give you current income. So income funds tend to hold shares with high dividend yield that provide high current income. So your advisor will ask you, are you interested in income? Are you interested in growth? If you're interested in income, they put your money in an equity fund that's income funds. And if you're interested in growth or capital gain, you don't want the income now. You focus instead on capital gain. You would buy stocks and capital gains, stocks that have a lot of potential to grow down the road. Now, which one is riskier? Obviously, to be an income fund, it means you have to have cash on hand. It means you are a well-established company because companies don't pay dividend until they are well-established. Because once you pay dividend, you cannot just stop. I mean, you can stop, but your stock will suffer. Therefore, stocks invested in income funds, they have plenty of cash on hand and the prospect of plenty of cash to survive in the future. So therefore, growth funds are typically riskier, riskier to income fund. Why? Because if the market goes down, Tesla and Amazon will be affected more negatively than companies with plenty of cash, like for example, Walmart. So they are riskier. Also, you can have a sector funds. Basically, what is a sector? It means you are concentrated in one industry. So you are buying stocks, but they're concentrated in a particular industry. For example, Fidelity, they market dozens of select funds, each with invest in a specific industry. So you can buy a fund that track the biotech or only in biotech, utilities, energy, software, telecommunication, you name it. So you just want to invest in that sector. Other funds, they can specialize, but in different things, they can specialize geographically in particular countries or particular areas or particular continent, like you could invest in something that represent all of the EU market or a country, Mexico. So it doesn't have to be country. It could be geographical area, Southeast Asia. There's either some funds they can track if you're interested in tracking the growth in Africa. So that's a sector funds. And obviously, we have bond funds. Well, as the name suggests, you invest in bonds or what's called fixed income sector. Here you could also within this fixed income sector, you can concentrate further. For example, you could only have corporate bonds or treasury bonds or mortgage backed securities or municipal bonds. And some bond funds, they specialize in bonds of a particular state. And why would they do that? That's for tax purposes, because if you live in a state and you buy the bond, well, guess what? You may be off. You don't have to pay federal taxes. So that's what they do. They only buy bonds in your state that qualify you for the tax-free, their tax-free treatment. And some fund, some bond fund, they specialize by maturity. Remember, bonds mature. If you want the short-term investments to intermediate to long-term or by credit risk, you want to buy high-risk bond or low-risk bond or junk bond or safe high-yield bond. So there are bonds that tracks this. Also, we have international bonds. Obviously, bonds that have international focus. Now, we have to differentiate between international and global. When we say the word global in the mutual fund, it includes the U.S. When we say international, we're talking about firms outside the U.S., located outside the U.S. And they could be immersion market funds. Now, there is, for example, sometime you might confuse yourself, is this an international or focused on a particular country? Although I said country, it could also be, I would say, when we say country, we should take out EU and Southeast Asia and Africa. Because sector funds could be a country, but also sector fund could also be an area, like a geographical area. But also international funds could also be international area. So they kind of, yeah, there's some overlap between the two. Also, we have what's called balance funds or funds of funds. Those are the best. Those funds, you buy them. And obviously, the fund itself is your portfolio. So they're designed to be your entire portfolio. So you buy a fund and that fund will hold both equity, which is stocks and fixed income securities bond in relatively stable proportion. So basically, it's your portfolio, but it's represented by one mutual fund. It's called funds of funds. There's something called life cycle funds, which I do have this in my retirement, are balance funds in which the asset mix can range from aggressive, like primarily marketed to younger people to conservative. When you're younger, you'll have more equity than bonds. When as you get closer to retirement, they'll start to switch from bonds to from equity to bonds. Okay. As you get older, those are called life cycle bonds. There's also static allocation maintains stable mix across stocks and bonds. For example, you want 60% stocks, 40% bond. And what they do is they maintain that mix. So if the stocks went up to high, they will sell it and buy bonds. Or if the bonds went up to high, they will sell it and they buy stocks to keep that mix. Okay. Also, you could have a target date funds to gradually become more conservative as the investor age. So you might have 60, 40 for now. And 10 years later, you'll switch to 50, 50. And as you get older, you would reduce the stocks and you will increase the bond. That's what you want to do. And we have also called what's something called funds of funds. These mutual funds primarily invest in shares of other mutual funds. So you'll take, so mutual funds that invest in other mutual funds. So just basically, you're trying to kind of put your money in different baskets. Don't put your X in one basket. Those balance funds invest in equity and bonds funds and proportion suited to your investment goals. And I do have those funds of funds in my 401k as well. I have some in real estate, some in international, some in medium-sized companies, some in large caps. So I just want to make sure I have my money everywhere in all sorts of different funds. Okay. Also, we have index fund and obviously index funds, they try to track, they try to try to match the performance of a broad market index like the NASDAQ 100, S&P 500, so on and so forth or the Dow. The fund by share and securities included in a particular index in proportion to the securities representation of that index. So we're talking about the, for example, the Vanguard 500 index fund is a mutual fund that replicate the composition of the S&P 500. So rather than trying to figure out which stock are the best in S&P 500 by the whole index through a fund in this way, your fate is connected to the fate of the S&P 500. You don't have to worry about making any investment decision, doing any research. Basically, you are totally diversified because the S&P is a value weighted index, the fund by shares in each S&P company in proportion to the market value of that company outstanding equity. And if you don't know what a value weighted index, please go to the prior session or to the course to find out what the value index is. So investment in index funds is low cost. Why it's a low cost? Because you don't have to worry about switching back and forth and making any research. It's increasingly popular way for small investors to pursue a passive investment. You just invested in S&P 500. Whatever happened to the S&P 500 will happen to you. Simply put, you're invested in the whole U.S. market. That's basically what it is. About 25% of assets held in equity funds were index funds. And this fraction is considerably still growing. For example, Warren Buffett advised all people, just don't pay a large fee for an advisor. If you want to invest, invest in the S&P 500. Find the fund that tracks the S&P 500 and let them worry about it. You could also have an index fund that doesn't have to be tied to a specific equity index. For example, we have Vanguard offer a bond index and a real estate index. So bond index means it followed the bond market. Real estate index followed the real estate market. When the real estate goes up, when the real estate market goes up based on some measurement, then your mutual fund goes up and vice versa. So you're invested in real estate. In the next session, since we looked at mutual funds, we want to know the terminology cost of investing in mutual funders are different terms. We need to be familiar with them. If you like this recording, please like it, share it, put it in playlist. If it benefits you, it means it might benefit other people. And don't forget to visit my website for head lecturers.com for additional resources for this session, as well as other courses, especially accounting and finance. Good luck and study hard.