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Mutual fundinvestment primer
Alan PalmiterAhmed Taha
© 2008
What is a mutual fund?
FundFund
FundFund
FundFundFund
Investors
ManagementCompany
InvestmentAdviser
DistributionCompany
Owners
services
Board
Mutual Fund Ownership - US stocks
0%
5%
10%
15%
20%
25%
30%
1950 1960 1970 1980 1990 2000 2005
Source: Bogle / Federal Reserve Flow of Funds Accounts
A pop quiz …
1. Mutual funds are primarily owned by:a. Individuals on their own
(through fund group, broker) b. Individuals with retirement
accounts (401(k), IRA)
2. Mutual funds mostly invest in:a. Stocksb. Bondsc. Notes (money market)
3. What have been annual returns on stock funds (last 20 years: 1987-2007):a. 17.8%b. 11.8%c. 9.3%d. 4.3%
4. Warren Buffet predicts that annual stock returns over the next 10 years will be:a. 6.5%b. 9.6%c. 12.3%d. 21.7%
5. Past performance of stock funds generally predicts future returns. a. Yesb. Noc. Only low-performing funds
6. Mutual fund investors say they pay attention more to fees than to performance.a. Trueb. False
7. As a mutual fund investor, you are entitled to:a. Prospectus (before you invest)b. Annual report (showing fund
performance)c. Statements (showing breakdown
of expenses / fees / trading costs)
8. Mutual funds only impose a sales charge at the time you invest. a. Trueb. False
9. Rate that average stock fund sells and replaces stock (“turnover”) in its portfolio:a. 6%b. 56%c. 90%d. 153%
10. What is a no-load fund? a. An unleveraged fundb. A fund without sales chargesc. A fund without trading costsd. A fund without withdrawal fees
11. Think about your own largest mutual fund:a. Your current balanceb. Fund’s investment objectivesc. Fund’s sales charges, expense
ratio, trading costs d. Fund’s performance last year
12. Consider your car/vehicle: a. Its make, model, yearb. Its cost, total miles, safety
rating, gas efficiencyc. You get our point.
1. Mutual funds are primarily owned by:a. Individuals on their own
(through fund group, broker) b. Individuals with retirement
accounts (401(k), IRA)
2. Mutual funds mostly invest in:a. Stocksb. Bondsc. Notes (money market)
3. What have been annual returns on stock funds (last 20 years: 1987-2007):a. 17.8% b. 11.8% [stock market]c. 9.3% [average fund]d. 4.3% [average fund investor]
4. Warren Buffet predicts that annual stock returns over the next 10 years will be:a. 6.5%b. 9.6%c. 12.3%d. 21.7%
5. Past performance of stock funds generally predicts future returns. a. Yesb. Noc. Only low-performing funds
6. Mutual fund investors say they pay attention more to fees than to performance.a. Trueb. False
7. As a mutual fund investor, you are entitled to:a. Prospectus (before you invest)b. Annual report (showing fund
performance)c. Statements (showing breakdown
of expenses / fees / trading costs)
8. Mutual funds only impose a sales charge at the time you invest. a. Trueb. False
9. Rate that average stock fund sells and replaces stock (“turnover”) in its portfolio:a. 6%b. 56%c. 90%d. 153%
10. What is a no-load fund? a. An unleveraged fundb. A fund without sales chargesc. A fund without trading costsd. A fund without withdrawal fees
11. Think about your own largest mutual fund:a. Your current balanceb. Fund’s investment objectivesc. Fund’s sales charges, expense
ratio, trading costs d. Fund’s performance last year
12. Consider your car/vehicle: a. Its make, model, yearb. Its cost, total miles, safety
rating, gas efficiencyc. You get our point.
Who is averagemutual fund investor?
• Knowledge of basic fund characteristics– Asset class? – Fund risk? – Fund expenses?
• Investment acumen: relevance of past returns– Morningstar *****– Asset classes?
US Households(112 million)
Retirementaccount
51%
55 million own mutual funds(90% have Internet access)
79%(broker)
Own fundon own
49%
29%(direct)
48%(IRAs)
52%(DC plans)
Mutual funds ($10.5 T)Stocks 40% Money Mkt 40%Bonds 20%
A graphical look at business model …
Stock Returns (1987-2007)($10,000 investment)
$0
$20,000
$40,000
$60,000
$80,000
$100,000
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
S&P 500 Index [11.8%]
Avg Mutual Fund [9.3%]
Dollar-weighted Returns [4.3%]
$93,304
$59,034
$22,852
Investor profilesaccording to …
(1) Industry
(2) SEC
(3) Finance literature
Information before purchasing Fund investors (outside retirement plans)
47%
52%
55%
57%
57%
58%
61%
69%
74%
0% 10% 20% 30% 40% 50% 60% 70% 80%
Tax consequences
Sales charge (if any)
Performance vs. index
Minimum investment
Types of securities
Net asset value
Fund risks
Historical performance
Fees / expenses
ICI Investor Preferences (2006)
Prospectus VFINX
• Disseminated– after investment / then once
annually– Including electronically / filed SEC
• Disclosure– Investment strategies – Risks (narrative)– Performance (1/5/10 years)– Expenses (sales charge, 12b-1
fees, mgmt fees)– Turnover rate
• Effect– Omissions in fund literature not
fraudulent, if info in prospectus
Fund comparer(SEC website / NASD)
Statement ofAdditional Information
• Not disseminated– Available to investors (incorporated
by ref into prospectus) / file SEC– No fraud liability if in SAI
• Disclosure– Fund organization – Investment policies / limitations– Management of fund– Proxy voting policies– Financial statements
• Can cover multiple funds
Only place thatdisclosestrading costs(commissions)
Annual and semi-annual statements
• Disseminated– Send semi-annually to all investors – Available on SEC website
• Disclosure– Annually, MDFP (what’s affecting
performance, line graph comparison to relevant index)
– Financials (including expenses, turnover rate)
– List of portfolio holdings (now summary of significant holdings, chart of category breakdown)
Focus of statementIs on performance,not expenses/costs
Advertising
• Regulated– SEC Rule 482 – must state where
can get prospectus– NASD Rule 2210 – must file with
Advertising Reg Dept
• Disclosure– Can include performance data
(standardized format)– Info beyond prospectus
• Required disclaimer– “Consider investment objectives,
risks, charges, expenses”– “Past performance does not
guarantee future results”
No longer does ad info have to comefrom prospectus
Investors’ Cognitive Biases
• Representativeness heuristic
• Endowment effect
• Anchoring heuristic
• Affect heuristic
Definition: People believe that experience is representative of reality (“past is prologue”)
Implications: • You believe a fund’s historical
returns will continue – you “buy high and sell law”
• You pour money into the latest “hot funds”
Reality: Little evidence that returns are
persistent for high-performing mutual funds (see)
Investors’ Cognitive Biases
• Representativeness heuristic
• Endowment effect
• Anchoring heuristic
• Affect heuristic
Definition: People value something more when they already own it
Implication: You believe your funds are better than funds you don’t own.
Reality:• Investors overestimate their
funds’ returns• Investors exhibit brand and
fund loyalty (staying in poor-performing funds).
Investors’ Cognitive Biases
• Representativeness heuristic
• Endowment effect
• Anchoring heuristic
• Affect heuristic
Definition: People rely on “anchor values” in making number estimates
Implication: You pay attention to fund advertising with “big numbers” (distorting your risk-return perceptions)
Reality: Just changing fund name affects investors’ estimates of expected returns
“Euro Star 100 fund” = 11.8%“Euro Star 500 fund” = 22.6%
Investors’ Cognitive Biases
• Representativeness heuristic
• Endowment effect
• Anchoring heuristic
• Affect heuristic
Definition: People’s current affect (e.g., fear, pleasure) influences their decisions
Implication: You are influenced by nice images of the future and lavish investment dinners
Reality: Ads evoking positive emotions
cause investors to not consider risk
A proposal …
(1) Point of sale
(2) Statements
(3) Confirmations
Asset returns / risk(1926-2004)
Average Return Standard Deviation
Small Company Stocks 12.7% 33.1%
Large Company Stocks 10.4% 20.3%
Long-Term Corporate Bonds 5.4% 9.3%
Treasury Bills 3.7% 3.1%
$10,000 (invested over 20 years)
Small Company Stocks, $109,264
Large Company Stocks, $72,340
Long-Term Corporate Bonds, $28,629
$10,000Treasury Bills, $20,681
0
20,000
40,000
60,000
80,000
100,000
120,000
Fund XYZ performance
Inv return Expenses/costs Net return
1-year 4.5% 2.1% 2.4%
5-years 7.6% 2.4% 5.2%
10-years 11.5% 1.9% 9.6%
20-years 8.9% 1.6% 7.3%
Comparison
Fund XYZ vs.
Asset Class
0.00% 5.00% 10.00% 15.00%
Fund
Asset class
Fund
Asset class
Fund
Asset class
Fund
Asset class1
-ye
ar5
-ye
ar
10
-
ye
ar
20
-
ye
ar
Your statement (Fund XYZ)
Beginning balance $10,000
Investments $ 2,000
Withdrawals $ --
Investment return $ 850 7.7%
Expenses
Sales charge $ 60 0.5%
Adm/advisory fees $ 140 1.3%
Trading costs $ 80 0.7%
TOTAL $ 280 2.5%
Net return $ 570 5.2%
Ending balance $12,570
66% - lower expenses 34% - higher expenses
Expenses (compare to other comparable funds)
2.5%XYZ
6.3%0.3%
Your fund has about average expenses, but 40% of other similar funds have lower expenses.
You could be saving up to 2.2% on fund expenses.
The end
