The Mutual Fund Concept:

A mutual fund is a type of financial services organization that receives money from a pool of shareholders and then invests those funds in a portfolio of securities. The mutual fund concept, therefore, revolves around diversification. Diversification, which reduces the overall risk borne by the investor, is available through a mutual fund. This, coupled with the fact that mutual funds have professional management, which frees the individual investor from managing his own portfolio, makes mutual funds attractive to individuals.

Mutual funds have a history over 85 years in the U.S. In 2008, there were more than 69,000 mutual funds in operation which held $19 trillion in assets worldwide.

There is a difference between buying into a mutual fund and investing directly in securities. First pooled diversification is one of the major benefits of investing in a mutual fund. Second are the additional benefits of professional management. Third is the modest start-up capital requirements make investing in mutual funds attractive, even for small investors. Drawbacks of mutual funds is that returns will be less than investing in individual stocks but so are the risks such as diversifiable risk.

The major advantage of mutual funds is that they provide diversification and full-time professional management. Investors with modest amounts of capital can invest in mutual funds and receive the advantages of these services. Also, mutual funds may offer several attractive services (like monthly withdrawal plans). They are relatively easy to acquire. They also handle all the paperwork and record keeping, deal in fractional shares, and automatically reinvest dividends.

There are several disadvantages, however. The funds can be quite expensive to acquire if they are load funds, or they may have other types of charges and fees. In terms of performance over the long run, mutual funds, on average, have not done all that well; indeed, only a handful have been able to outperform the market with some degree of regularity. Their performance, in general, has corresponded to the performance of the market as a whole. Of course, index-based mutual funds should provide the return of that market covered less mutual fund-related costs.

A management company runs the fund's daily operations. Money manager runs the portfolio and makes the buy and sell decisions. Security analysts analyze securities and look for viable investment candidates. Traders buy and sell big blocks of securities at the best possible price. A distributor sells the fund shares. A custodian physically safeguards the securities and other assets of the fund, without taking a role in the investment decision. A transfer agent keeps track of purchase and redemption requests from shareholders and maintains shareholder records.

Mutual funds are frequently open-ended investment companies. An open-end investment company is a mutual fund in which investors actually buy their shares from and sell them back to the mutual fund itself. There is no limit on the number of shares an open-end fund can issue, and this is by far the most common type of mutual fund.

A closed-end investment company is a fund that operates with a fixed number of outstanding shares and does not regularly issue new shares of stock. These funds, which are few in number relative to open-end funds, operate with a fixed capital structure and trade in the stock marketmost are listed on the NYSE.

An exchange-traded fund (ETF) is a type of open-end investment company that trades as a listed security on one of the stock exchanges. ETFs offer the professional money management of traditional mutual funds and the liquidity of an exchange-traded stock. ETFs combine the advantages of close-end funds with open-end funds. As with close-end funds, you can buy and sell ETFs at any time of the day by placing an order through your broker. ETFs can be bought on margin and can be sold short. They offer low cost, low portfolio turnover, and low taxes.

A load fund is a mutual fund that charges a commission to purchase shares in the fund. A no-load fund does not require any commissions on the part of the investors. The no-load fund offers an advantage to investors because, by avoiding the commission (often as high as 8.5%), they can buy more shares in the fund with a given amount of capital, and therefore, other things being equal, earn a higher rate of return.

A 12(b)-1 fund may appear to be a no-load fund, but in fact, it charges an annual fee, which replaces an up-front load charge. Many so-called no-load funds levy 12(b)-1 charges; they continue to refer to themselves as no-loads even though 12(b)-1 charges can add up over time.

In addition to 12(b)-1 fees, there are a number of other types of load fees and charges. A back-end load fund charges a (redemption) fee/commission when the investor sells the fund. Redemption fees often decline over time and disappear altogether after the first three to five years of ownership. A low-load fund is a type of front-end load fund, but it keeps the load charge very low, usually less than 2 or 3%, while a hidden load is a term used to describe a 12(b)-1 fee.

The easy way to distinguish between a load and a no-load fund is to look for a difference between the net asset value (NAV) and offer prices of a fund. If there's a difference, it's a load fund and the amount of the difference represents the size of the front-end load charge (the "commission" to buy the fund). In addition, the WSJ and other major papers use letters in their mutual fund quotes to identify various types of fees; for example, "r" means the fund has a redemption charge. Finally, every fund prospectus must contain a fee table that fully discloses the types and amounts of fees and charges.

A real estate investment trust (REIT) is a type of closed-end investment company that invests money in mortgages and various types of real estate investments. REITs allow investors to receive both the capital appreciation and current income from real estate ownership without having to manage the property.

Like mutual funds, hedge funds sell shares (or participation units) in a professionally managed portfolio of securities. However, hedge funds are private partnerships that tend to limit their clientele to rich individuals. The manager is a general partner, while the investors are limited partners. Hedge funds have very limited reporting requirements and are generally unregulated. Some hedge funds attempt to limit the downside risk through employment of options and futures, while others invest in any opportunity that has the potential of a positive return.

Types of Mutual Funds:

The objective of growth funds is "capital appreciation." Growth funds mainly seek to invest in companies with above-average growth in earnings that reinvest earnings into expansion, acquisitions, or research and development.

Aggressive growth funds are highly speculative funds that concentrate on obtaining large capital gains. These funds tend to be small and their portfolios consist of speculative common stocks. Returns on these funds generally move with the market, but in larger increments: when the market's up, these funds do great, but when the market falls, they do really poorly.

Value funds confine their investing to stocks considered to be undervalued by the market. The funds look for stocks that are fundamentally sound but overlooked by investors. They prefer undiscovered companies that offer the potential for growth.

Equity-income funds emphasize current income by investing primarily in high-yielding common stocks. In addition to high-grade common stocks, these funds also invest in convertible securities, preferred stocks, and even bonds. They like securities that provide high current yields, but also consider potential price appreciation over the longer haul. These funds are generally viewed as a fairly low risk way of investing in stocks.

Balanced funds tend to hold a balanced portfolio of both stocks and bonds for the purpose of generating a balanced return of both current income and long-term capital gains. They are much like equity-income funds, but they keep around 30% to 40% of their portfolios in bonds.

Growth-and-income funds seek a balanced return made up of both current income and long-term capital gains, with the greatest emphasis placed on growth of capital. Unlike balanced funds, growth and income funds have 80-90% of their capital in common stocks. They tend to invest in growth-oriented blue chips (for their capital gains) and high-yield common stocks (for their current income due to high dividends).

Bond funds come in all shapes and colors (from government bond funds to high-yield corporate bond funds), and they all have one thing in common: they invest principally (or exclusively) in some type(s) of fixed-income security. While current income is the primary objective of these funds, capital gains is not ignored altogether. There are three advantages of buying shares in bond funds rather than investing directly in bonds: (1) The bond funds are more liquid than direct investment in bonds; (2) They offer a cost-effective way of achieving a high degree of diversification; (3) Bond funds will automatically reinvest interest and other income. However, a disadvantage of investing in bond funds would be that the prices of the bonds held in the fund's portfolio fluctuate with changing interest rates. Different types of domestic bond funds are government bond funds, high-yield corporate bond funds, municipal bond funds, mortgage-backed bond funds, convertible bond funds, and intermediate-term bond funds.

Money market funds apply the mutual fund concept to the buying and selling of short-term money market instruments such as bank certificates of deposits and U.S. Treasury bills. These funds offer investors with modest amounts of capital access to the high-yielding money market, where many instruments require minimum investments of $100,000 or more. Different kinds of money market mutual funds are general-purpose money funds, government securities money funds, and tax-exempt money funds.

Index fund is a type of mutual fund that buys and holds a portfolio of stocks (or bonds) equivalent to those in a market index like the S&P 500.This approach is strictly buy-and-hold.

Sector funds are mutual funds that concentrate their holdings in one or more industries that make up a target sector. For instance, a health care sector fund may hold drug companies, medical suppliers, biotech companies, and hospital management companies. They are not widely diversified and therefore are riskier than diversified funds.

Socially responsible funds are mutual funds that actively and directly incorporate ethics and morality into the investment decision. These funds will consider only socially responsible companies for inclusion in their portfolios. For example, these funds generally will not invest

in companies that derive revenues from tobacco, alcohol, or gambling; companies that are weapons contractors; or companies that operate nuclear power plants.

In an asset allocation fund, the manager establishes a desired allocation mix and purchases securities for the fund in these proportions. Thus, as the market changes over time, so do these fundsthis is what separates allocation funds from other mutual funds.

International fund is a mutual fund that does all or most of its investing in foreign securities. In contrast, global funds invest in both foreign securities and U.S. companies. As a rule, global funds provide more diversity. These funds attempt to take advantage of international economic developments in two ways: (1) by capitalizing on changing market conditions, and (2) by positioning themselves to benefit form devaluation of the dollar.

Investor Services:

Mutual funds offer a variety of services to investors, including: savings and automatic reinvestment plans: investors are provided a way to accumulate capital and have returns systematically and automatically reinvested for the long haul (at little or no cost); withdrawal plans: investors receive regular payments from the mutual funds; and conversion privileges and phone switching: when the investment climate changes and/or an investor's goals change, he or she can quickly and easily switch from one kind of fund to another within the same family, using the conversion privilege. Some mutual funds (mostly money funds) are extremely liquid because they offer check writing privileges. Most mutual funds will also design and provide for individual retirement plans.

Past performance is important to the mutual fund selection processit's an indication of how well the fund and its fund managers have done over time. And in this regard, it's important to look at past performance over an extended (5- to 10-year) period of time, covering both good markets and bad. If a fund and its managers have done well in both up markets and down markets, that's a pretty good indication of what they're capable of doing in the future. Whether they actually will perform up to expectations is another matter and is dependent to a large extent on what the future behavior of the market holds. That's why it's so important to try to get a handle on the future direction of the market: if you think it's headed up, that should bode well for mutual funds. Combining these two variables (the past performance of the fund with the future expectations of the market) is an important method for selecting among funds.

Investing in Mutual Funds:

Investors tend to use these securities for one of the three reasons: (1) as a way to accumulate wealth; (2) as a storehouse of value, and (3) as a speculative vehicle for achieving high rates of return.

The major types of closed-end funds include those that specialize in municipal bonds, taxable bonds, various types of equity securities, international securities, and regional and single-country funds.

Key differences between closed-end (CEFs) and open-end (OEFs) mutual funds include:

(a) CEFs trade like stocks, while OEFs are traded directly with the fund operators.

(b) Large traders of CEFs affect the buy or sell price, while trading large amounts of OEFs typically does not affect the price; i.e., CEFs are much less liquid than OEFs.

(c) CEFs do not provide the full range of services provided by OEFs.

(d) CEFs typically have a relatively constant capitalization. Unlike OEFs, CEF investors do not continually buy new shares.

(e) Most importantly, although OEFs are traded (bought and sold) at net asset value, CEFs have two values, a market value and a net asset value, and these are rarely the same.

Premium (or discount) = (Share price - NAV) / NAV

The three sources of return for a mutual fund are (1) dividend income, (2) capital gains distributions, and (3) changes in the net asset value of the fund. Each of these components has an effect on the total return of a mutual fund. The greater the return from any of these components, the greater the total return to the investor. For closed-end investment companies, changes in price premiums or discount are another source of return. The premium or discount actually affects the market price (or net asset value) of the fund and hence investment returni.e., as discount or premium changes, it affects the changes in NAV and, therefore, total return.

Holding period return (HPR) is useful to calculate the measure the return on mutual funds with investment horizons of one year or less.

HPR = [(Number of shares at end period x Ending price) - (Number of shares at beginning of period x Initial price)] / (Number of shares at beginning of period x Initial price)

When holding period is longer than a year, then we can use the present-value-based internal rate of return (IRR).

Major risk for mutual funds is market risk (systematic risk) because a mutual fund is a large, diversified portfolio. Therefore, its fortunes are generally tied to the behavior of the market. A second kind of risk arises from management practices. If a mutual fund is managed aggressively, the probability of a loss in capital may be high. This is not to imply that a conservative strategy is the only feasible strategy for a mutual fund. Obviously, all funds are not subject to the same amount of risk. The more aggressive the fund management is, the greater the potential return and the greater the amount of risk. Moreover, since funds deal in different markets, their market risk may not be the same either.

Having reviewed these topics please answer the following questions:

A year ago, an investor bought 200 shares of a mutual fund of $8.50 per share. Over the past year, the fund has paid dividends of $0.90 per share and had a capital gains distribution of $0.75 per share.

a.Find the investor's holding period return, given that this no-load fund now has a net asset value of $9.10.

b.Find the holding period return, assuming all the dividends and capital gains distributions are reinvested into additional shares of the fund at an average price of $8.75 per share.