10 LECTURE INVESTING IN MUTUAL FUNDS & REAL ESTATE
CC3152 Principles of Financial Planning
(I) Mutual Fund Basics
[LG1,2] INVESTORS pool their money and buy shares in the MUTUAL FUND. FUND MANAGER selects and purchases a variety of investment instruments.
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ABC MUTUAL FUND
The Mutual Fund Concept
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Advantages of Mutual Funds
Diversificationrisk is lowered; one share buys a slice of everything in the fund. Professional managementpay someone else to make investing decisions. Financial returnsrelatively attractive returns over the long term. Convenienceeasy in and out, small 4 outlays, help with record keeping.
Disadvantages of Mutual Funds
No choice in securities selection if you dont agree with choices, you must change funds. No control over sale of securities within fundtiming of sales has implications for investor.
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How Mutual Funds are Organized and Run
Each fund is a separate corporation or trust and is owned by the shareholders. Other main players include: Management companyruns the daily operations, usu. also serves as investment advisor; e.g. Fidelity, Jardine Fleming Investment advisoroversees portfolio Money manager: runs portfolio and makes buy and sell decisions Security analyst: look for attractive investments Traders: buy & sell big blocks of securities at best possible price Distributorsells fund shares, directly to public or through dealers (e.g. brokerage firm, commercial banks) Custodianphysically safeguards funds assets independently Transfer agentexecutes transactions and maintains 6 shareholder records
Types of Fund Companies
Open-End Investment Companies (mutual funds) Dominant type of investment company Shares purchased from and sold back to company. Shares are not traded among individual investors. New shares issued as money flows in. No limit to the no. of shares issued. NAV is usually the quoted closing price.
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Net Asset Value (NAV)
Current value of all securities held in funds portfolio. Calculated at least once a day Represent the selling and buying price of a share in the open-end fund
NAV = Current market price of all fund assets (Less any liabilities) Divided by the number of outstanding shares
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Closed-End Investment Companies Operate with a fixed number of shares outstanding and do not regularly issue new shares of stock. All trading is done between investors on the open market (e.g. NYSE, AMEX, NASDAQ) Shares frequently trade at a discount or premium to net asset value as price depends on market outlook (demand & supply)& investor 9 expectations
Exchange-Traded Funds (EFT)
Trade on listed exchanges like closed-end funds. Numbers of shares outstanding can be increased or decreased, depending on demand, like open-end funds. Typically structured as index funds. Spiders based on S&P 500 - biggest & oldest (1993)
Standards & Poors Includes stock of 500 large cap/blue (capitalization over approximately $10 billion) chip shares in US
Diamonds based DJIA
(Dow-Jones Industrial Average
Qubes based on Nasdaq 100
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Mutual Fund Cost Considerations
Load Funds Load = sales commission Front-end load funds (or simply "load funds") charge a commission when shares are purchased. Low-load funds hold commissions to 2 3% when shares are purchased. Back-end load funds charge a commission when shares are sold.
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No-Load Fundsno fee to purchase or redeem shares and low or no 12(b)-1 fees. 12(b)-1 Fees (hidden loads)annual fees for covering distribution & marketing expenses. Management Feesannual fees charged by all funds to pay the fund manager, range from 0.5%-4% of assets under management.
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Maximum allowable fees: Total sales charges and fees cannot exceed 8 1/2%. Of this amount, 12(b)-1 fees cannot exceed 1%. Funds cannot call themselves no-load if their 12(b)-1 fees exceed 0.25%.
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Keeping Track of Fund Fees and Loads
Funds are required to disclose all fees in their prospectus.
Even no-load funds can have high annual expense ratios and/or 0.25% 12(b)-1 fees. Fees affect your return, and annual fees will be collected regardless of the performance of the fund.
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(II) Types of Funds
[LG3] Growth Objective is capital appreciation Invest in common stocks with above-average growth potential Fair amount of risk exposure Aggressive Growth Also called performance fund Highly speculative which seek large profits from capital gains Invest in stocks of small companies whose prices are highly volatile
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Value Stocks undervalued by market, with relatively low p/Es, high dividend yield and moderate amounts of financial leverage Competitive return but reduced risk exposure Equity-Income Emphasize current income so invest in highyielding common stocks, convertible securities and preferred stock Fairly low risk because of high grade securities Balanced Hold a balanced portfolio of both stocks & bonds Generate a well-balanced return of current income and long-term capital gains Provide competitive return without a lot of price 16 volatility
Growth & Income Seek a balanced return of current and income long-term capital gains but greater emphasis on growth of capital Put most money into equities, 80-90% in common stocks Provide fairly substantial return involve fair amounts of risk subject to ups and downs of market interest rates Money Market Portfolio of short-term money market instruments Allow investors access to higher-yielding money market with modest amounts of capital Highly liquid with low risk returns subject to ups and downs of market interest rates E.g. General-purpose money funds, Tax-exempt money funds, Government securities money 17 funds
Bond Invest in various kinds of bonds Primary investment objective is income, yet not ignore capital gains Advantages:
Cost-effective to achieve a high degree of diversification (min. denominations of US$1,000 to $5,000, or more) Automatically reinvest interest and other income to earn fully compounded rates of return Fairly conservative but not totally without risk, as bond prices fluctuate with changing interest rates
E.g. Government bond funds, Convertible bond funds, Municipal bond funds
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Index
Buy and hold a portfolio of stock or bonds equivalent to those in a market index like HIS Produce modest amount of dividend income plus highly competitive returns which may be better than other stock funds Restrict investments in a particular sectors, e.g. real estate (REITs), technology, financial services, etc. Idea behind is the really attractive returns come from small segments Underlying investment objective is capital gains so speculative Invest exclusively in foreign securities to specific regions, e.g. Europe, Asia, etc Global funds
invest not only on foreign securities but also in U.S. companies which are usually multinational firms Provide more diversity with access to both markets Hedging strategies such as foreign currency options and futures to protect investors from currency exchange risks
Sector
International
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Automatic Investment Planmutual fund periodically drafts money from investor's bank account. Automatic Reinvestment Planfund earnings and distributions automatically reinvested in additional shares of fund. Regular Incomefund automatically pays out to investor predetermined amount periodically. Conversion Privilegesallow shareholders to easily move from one fund to another within the fund family. 20
Services Offered by Mutual Funds
(III) Making Mutual Fund Investments [LG4,5]
The Selection Process:
Match the fund's objectives with your investment objectives. Consider your tolerance for risk and your investment time horizon. Read the prospectus. Assess the funds services. Check the fees charged. Consider the fund's longer-term returns as well as its shorter-term returns.
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Mutual Fund Performance
Returns consist of : 1) dividend/interest income earned by the fund assets; 2) realized capital gains distributions from sale of assets within the fund; 3) change in mutual fund's share price. Past performance reveals success of fund managers but does not guarantee future returns Stick with No Loads or Low Loads load funds that produce superior returns are the exception rather than the rule. 22
Future Performance
Consider the future direction of the market as a whole
A well diversified mutual fund tends to reflect general tone of market
Take a good look at the past performance of the mutual fund.
Not guarantee but success largely rests on investment skills of fund manager
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(VI) Investing in Real Estate
[LG6]
Investing in real estate provides greater diversification properties than does holding just stocks or bonds. Typically exhibits less volatility than stocks, and it doesnt move in tandem with stocks.
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Investing in Income Property
Commercial property
E.g. office buildings, industrial spaces, warehouses, retail space, hotels Risks & returns tied to business conditions & locations Factors affecting profitability include: purchase and financial cost considerations, occupancy rates, maintenance & management costs, neighborhood where units are located, supply & demand trends Interests deductible for tax purpose, potential capital gain Flipping house: buying and selling quickly for 25 profits, use renovations to increase value
Residential property
Single-family homes
Speculating in Raw Land
Highly risky Investors hope the property will undergo dramatic increases in value Often purchased by land speculators Often occurs near an area where some types of new development is anticipated
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Other Ways to Invest in Real Estate Real Estate Investment Trusts (REITs)
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Closed-end investment companies whose trust assets are limited to real estate investments. Offer a more diverse and marketable way to invest in real estate.
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Equity REITs invest in income properties z Produce both attractive current yields & potential to earn attractive capital gains as properties increase in value Mortgage REITs invest in mortgage loans to property investors
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High current yields generated by investing in debts
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Hybrid REITs invest in both
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Reading: Chapter 13
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