Building a Stock Portfolio ?You have $50,000 to invest in stocks. Choose 4 COMPANIES to invest in,?and??using the knowledge gained?from the text and from watching this week’s videos,

MG105 – Personal Finance

Chapter 13-Investintg in Mutual Funds, Exchange- Traded Funds, and Real Estate

Learning Objectives and Lecture Notes

After reading this chapter, you should be able to: • Describe the basic features and operating characteristics of mutual funds • Differentiate between open- and closed-end funds as well as exchange-traded funds, and

discuss the various types of fund loads and charges • Discuss the types of funds available to investors and the different kinds of investor services

offered by mutual funds • Explain the variables that should be considered when selecting funds for investment

purposes • Identify the sources of return and calculate the rate of return earned on an investment in a

mutual fund • Define the role that real estate plays in a diversified investment portfolio along with the

basics of investing in real estate, either directly or indirectly

Why Is This Chapter Important for you?

The stock market is a very attractive option for investors to use in hopes of higher return on investment. There are many stories about fortunes made in the stock market and even more stories about fortunes lost. Where you find your place in this vast investing world is very important. Even more important is the ability to understand how the stock market works and how investing in stocks and bonds is an essential element in every investor’s portfolio.

This chapter introduces you to mutual funds, one of the most popular investment vehicles today. Mutual funds offer attractive levels of return from professionally managed, diversified portfolios of securities. The number of funds increases each year, and the many different fund types available can make selecting the right fund for an investor's particular needs a confusing process. This chapter also helps you understand the role that real estate plays in a diversified investment portfolio, along with the basics of investing in real estate, either directly or indirectly. Therefore, this chapter guides investors to wise choices by covering the following topics:

• The basic character of mutual funds, and how diversification and professional management are the cornerstones of the industry.

• The advantages and disadvantages of owning mutual funds.

• The five major types of investment companies. • Cost considerations when buying mutual funds. • The kinds of funds available and the variety of investment objectives these funds seek to

fulfill. • The array of special services offered by mutual funds and how these services can fit into an

investment program. • How to assess and select funds that are compatible with the investment needs of the

individual. • How to measure mutual fund performance. • Understanding real estate investments.

Chapter 13 Outline

Mutual funds A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors; mutual funds represent ownership in a managed 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 or her own portfolio, makes mutual funds attractive to individuals.

Individual mutual funds are created by management companies, like Fidelity, Dreyfus, and Vanguard. They also run the fund’s daily operations and usually serve as the investment advisor. The investment advisor buys and sells securities and otherwise oversees the fund’s portfolio. This is normally carried out by the money manager, who actually runs the portfolio; security analysts, who look for viable investment candidates; and traders, who attempt to trade large blocks of securities at the best possible price. In addition, there are fund distributors, who actually buy and sell the fund shares; custodians, who take physical possession of the fund's securities and other assets; and the transfer agent, who keeps track of fund shareholders.

Open-ended Fund 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.

Exchange-traded fund An exchange-traded fund is a type of open-end mutual fund that trades as a listed security on one of the stock exchanges. The number of shares outstanding can be increased or decreased in response to market demand like other open-end mutual funds. However, unlike open-end funds, investors can buy and sell ETFs at any time of the day by placing an order through their broker. Thus they offer all the advantages of any index fund: low costs, low portfolio turnover, and low taxes.

Load Fund A load fund is a mutual fund which must be purchased through a broker or other investment advisor. The seller is paid a commission by the mutual fund company for selling its funds. With a front-end load, the commission is assessed when purchases are made into the fund. With a back-end load, the commission is assessed when redemptions are made.

No-Load Funds Some load funds appear to be no-load funds but actually carry "hidden loads"— no front- or back-end loads, but they have higher annual expenses. Through time, funds with "hidden loads" may prove to be more expensive for the investor to hold than either front- or back-end load funds.

A no-load fund does not pay commissions to brokers or investment advisors and may be purchased directly from the mutual fund company. The no-load fund offers an advantage to investors because, by avoiding the commission (which can be 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.

Back End Load fund A back-end load fund charges a redemption fee/commission when the investor sells the fund. (Redemption fees often decline over time and may disappear all together after the first 3–6 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 the 12(b)-1 fee and higher annual expenses mentioned in the previous question.

Types of Funds – by investments

Growth Funds The objective of a growth fund is long-term growth and capital gains are the primary goals of such funds, and as a result they invest principally in common stocks that have above-average growth potential. They are usually viewed as long-term investment vehicles that are most suitable for the more aggressive investor who wants to build capital and has little interest in current income.

Balanced Funds Balanced Funds are so named because they tend to hold a balanced portfolio of both stocks and bonds, and they do so for the purpose of generating a well-balanced return of current income and long-term capital gains. For the most part, they confine their investing to high-grade securities, and are therefore usually considered a relatively safe form of investing.

International Funds International funds invest most or all of their assets in foreign securities. Some limit their portfolio to a particular country or geographical region—Japan, Mexico, Europe, Asia—while others have a broader base of investments. Another type of fund that invests in foreign securities is the global fund, which includes U.S. multinational companies as well as foreign corporations. There are many categories of both international and global funds: stock, bond, money market, growth, aggressive growth, balanced, etc. In general, these funds seek higher returns by capitalizing on changing market conditions abroad and the changing value of the dollar against foreign currencies. International and global funds provide a

good way for investors who lack extensive knowledge of international economics to diversify internationally.

Asset Allocation funds Unlike other mutual funds that invest primarily in one asset category, asset allocation funds invest in several markets. For example, a fund may invest 50% in common stocks, 25% in fixed income securities, 15% in money market securities, and 10% in foreign securities. These funds simplify the task of dividing an investor's assets among the various classifications. Instead of buying separate funds to achieve asset allocation, an investor can find one fund that matches his or her desired allocation plan. Whereas other types of mutual funds have a prescribed distribution among asset classes, asset allocation funds adapt their mix as market conditions change. Investors should monitor these changes to be sure the fund continues to match their personal objectives.

Fund Objectives Even though growth, income, and capital preservation are primary mutual fund objectives, each fund concentrates on one or more particular goal(s). Thus, for people who rely heavily on current income, an investment in an income fund would be the right choice. Investors who do not require the current income and are content with waiting for capital appreciation can benefit from growth funds. These classifications of mutual funds are helpful in determining whether or not the goal of the mutual fund is compatible with one's own investment objective. The SEC requires that the specific objective of a fund be stated in its prospectus, along with how it intends to meet its objective.

A fund family consists of the different funds offered by the same investment company, like Fidelity, Kemper, or Vanguard. The major advantage of these families is the right to switch among them for little or no charge as investment objectives change or as the investment environment changes.

Automatic reinvestment Plans Automatic reinvestment plans allow the shareowners to elect to have interest, dividends, and capital gains realized on their holdings automatically reinvested in additional shares. Fractional shares are issued, if necessary, and usually there is no charge on the reinvestment transaction. This keeps investors' capital fully invested, allowing it to earn compounded rates of return. Automatic investment plans, on the other hand, are programs by which investors channel a fixed amount from their bank account directly into a mutual fund at regular intervals, usually monthly or quarterly. These plans provide investors a convenient way to build up their mutual fund holdings over time. Also, many funds offer lower minimum initial investments to investors who enroll in automatic investment plans.

Benefits of Investing in Mutual Funds The most common motives for purchasing mutual fund shares are diversification, professional management, financial return, and convenience. The primary motive for investing in mutual fund shares is the ability to diversify and diminish risk by indirectly investing in a number of different types of securities and/or companies. The fact that a professional manager is paid to make investment decisions is expected to improve the owners' returns. Mutual funds also provide a way to invest in areas that an investor may not fully understand, and in reality, many people do not have the time or inclination to track their own investments. Convenience, provided by the fact that investment company shares can be purchased through a variety of sources, also adds to their appeal. In addition, mutual funds provide their

investors with a variety of services, like automatic reinvestment plans, phone or online switching, and conversion privileges.

Mutual funds also offer the small investor a way to invest with little start-up capital. In fact, some funds require only a very low or even no minimum initial investment if an automatic monthly draft is made from the investor’s bank account. To keep expenses low, the investor can pick a quality no-load fund and bypass the broker entirely. These funds are easy to get into, easy to get out of, and the investor doesn’t have to worry about whether to take physical possession of the securities or not.

How to Select a Mutual Fund The mutual fund selection process begins with an assessment of your investment objectives. Key factors to consider include: your reasons for investing, your risk tolerance, the use of the fund (capital accumulation, speculation, conservation of principal), what types of return you require, and services desired. Clearly, answering these questions is essential if you are to select from the universe of thousands of funds those with the investment objectives, operations, and services that meet your particular needs. Research comes next: financial publications (The Wall Street Journal, Investor's Business Daily, Barron’s, Forbes, Fortune, Kiplinger's, and SmartMoney, for example) regularly publish mutual fund reports and rankings, many of which are available online. Other valuable research sources are Morningstar and Weisenberger mutual fund report services, Value Line, and similar companies.

The next step is to narrow the field by choosing several types of funds that match your investment and asset allocation objectives and then apply other constraints (load versus no-load, services offered, etc.) to further define potential investment candidates. The final decision should be based on the fund's investment performance.

A load fund charges a fee, usually up front, to invest in the fund. This fee does not go to the manager to reward him or her for superior performance, but rather it goes to the sales person or broker who sold you the fund. Therefore, the only reasons you would ever want to invest in a load fund is if the sales person or broker adds value to your investment decisions or if the fund offers superior performance above that which can be found in any no-load funds.

A no-load fund does not charge the investor a fee, so every dollar gets fully invested. Also, a no-load fund does not have to take as high a risk to earn the same return as a load fund because of its lower expenses. Research has shown that, indeed, load funds do not outperform no-load funds, so that there is generally no advantage to buying load funds. Beware, however, some funds do not charge a front-end load but do charge hefty annual fees, 12(b)-1 fees, and/or redemption fees, and in this case, you might truly do better with a well-managed load fund with low annual fees. Also be careful when you see performance rankings, because many times the load is not reflected in the return. In reality, if you had actually held that load fund, you would not have earned the stated return after adjusting for the load.

Returns from Mutual Funds There are three potential sources of return to mutual fund investors: (1) current income (from the dividends and interest earned by the fund); (2) capital gains distribution (from the realized capital gains earned by the fund); and (3) change in the fund's share price. Each of these components has an effect on the total return of a mutual fund. Both dividends and realized capital gains are accumulated and then distributed to fund shareholders. Unrealized capital gains affect return because when the fund's

holdings increase or decrease in price, the NAV moves as well. The greater the return from any of these components, the greater the total return to the investor.

Your preferences for dividends, realized capital gains, or unrealized capital gains will depend on several factors. Dividend and realized capital gain income can be reinvested to achieve fully compounded returns. However, there are tax consequences from each distribution: current income (interest) and short-term capital gains are taxed at the taxpayer’s marginal tax rate; long-term capital gains and dividends are taxed at lower, more favorable rates. Unrealized capital gains (increases in NAV) have no tax implications until the shares of the fund are sold, so payment of taxes on this portion can be delayed. As the taxpayer gets into the higher marginal tax brackets, the tax implications become more and more of a consideration.

Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a whole, or a given segment of the market (as bond funds would relate to bond markets). In general, when economic conditions are good and the stock market moves up, mutual funds do well. When the market takes a plunge, mutual funds do poorly, although some portfolio managers do better than others at managing downside risk.

Real Estate Most types of real estate – including everything from raw land to various forms of income-producing properties – have experienced significant growth in value over time. Therefore, an investment evaluation should include expected changes in property value (that is, price appreciation). Price appreciation should be treated as capital gains and included as part of the return from the investment, minus the capital gain taxes paid.

Use of leverage: Leverage involves the use of borrowed money to magnify returns, which is a big attraction to investing in real estate. Because real estate is a tangible asset, investors are able to borrow as much as 75 to 90% of its cost. As a result, if the profit rate is greater than the cost of borrowing, then the return on a leveraged investment will be proportionally greater than the return generated from an unleveraged investment.

Speculation Speculating in raw land is considered a high-risk venture because the key to such speculation is to isolate areas of potential population growth and/or real estate demand (ideally before anyone else does) and purchase the property in these areas in anticipation of their eventual development. This involves a high degree of uncertainty.

The major categories of income property include commercial properties and residential properties. The advantages of investing in income properties is that they provide both attractive returns and tax advantages for investors. Disadvantages include the owner of the property being responsible for leasing the units and maintaining the property. Single-family homes can be used to generate income by the ability to deduct interest paid on a mortgage from taxes, capital gains exemption when you sell the home, renting out of a second residence, and “flipping houses”. “Flipping houses” involves buying a house, upgrading the property and then selling it for a higher price than you paid, including the cost of upgrades.

Stocks in Real Estate Related Companies Stock in real estate related companies offers investors the benefits of real estate ownership – both capital appreciation and current income – without the headaches of property management. These are investment companies that invest money in various types of real estate and real estate mortgages. It is like a mutual fund in that is sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments.

Real estate limited partnerships or limited liability companies are organized to invest in real estate. The managers assume the role of general partner, which means their liability is unlimited, and the other investors are limited partners who are legally liable only for the amount of their initial investment. Investors buy units in an LP or LLC, a unit represents an ownership position. These are riskier investment categories than the others discussed above, and appeal to more affluent investors who can afford the typical unit cost of $100,000 or more.

The basic structure of a REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. The investment consideration associated with a REIT is that income earned by the REIT is not taxed, but the income distributed to owners is designated and taxed as ordinary income while dividends on common stocks normally are taxed at preferential rates of 15% or less.

The three basic types of REITs are:

1. Equity REITs

2. Mortgage REITs

3. Hybrid REITs

MG105 – Personal Finance Chapter 12-Investing in Stocks and Bonds

Learning Objectives

After reading this chapter, you should be able to:

• Describe the various types of risks to which investors are exposed as well as the sources of return

• Explain how to search for an acceptable investment on the basis of risk, return, and yield • Discuss the merits of investing in common stock and be able to distinguish among the

different types of stocks • List the various measures of performance and how to use them in placing a value on stocks • Describe the basic issue characteristics of bonds as well as how these securities are used as

investment vehicles • Distinguish between the different types of bonds, gain an understanding of how bond prices

behave, and know how to compute different measures of yield.

Why Is This Chapter Important for you?

The stock market is a very attractive option for investors to use in hopes of higher return on investment. There are many stories about fortunes made in the stock market and even more stories about fortunes lost. Where you find your place in this vast investing world is very important. Even more important is the ability to understand how the stock market works and how investing in stocks and bonds is an essential element in every investor’s portfolio.

The financial rewards from investing can be great. However, investors first need to understand the features of the various types of investments and the risks inherent in each. The major topics in this chapter include:

• The risks associated with investing include business risk, financial risk, market risk, interest rate risk, purchasing power risk, and liquidity risk and event risk.

• Interest-on-interest underlies all elements of total return and is the basic assumption in estimations of future return.

• The risk-return trade-off is an important element of investing. • Common stock is a rewarding type of investment security. • The valuation of common stock provides a means of specifying the risks and rewards

associated with common stock investing. • Bond investing provides current income from interest.

Chapter 12 Outline

In studying investments, one must understand the jargon of the investment world. This chapter explains basic investment terminology and explores the features of the various types of investments. Key concepts in this chapter include the following:

Risk Investors are exposed to business risk, the possibility that the firm will fail, due to factors affecting the firm, such as economic or industry factors or poor management decisions. Business risk may be thought of as the degree of uncertainty associated with the firm's earnings and consequent ability to pay dividends and interest. There is financial risk, which is the risk associated with the mix of debt and equity financing used by the issuing company. Too much debt could also lead to financial failure. Market risk is reflected in the price volatility of a security and is associated with factors such as changes in political, economic and social conditions and in investor tastes and preferences. Purchasing power risk is the risk resulting from possible changes in price levels that can have a significant effect on investment returns. In times of rising prices, the purchasing power of the dollar declines. Interest rate risk results from changing market interest rates that mainly affect fixed-income securities. The prices of these securities decrease with rising interest rates and increase with falling rates. Liquidity risk is associated with the inability to liquidate an investment conveniently and at a reasonable price. Finally, there is event risk, which is the risk that something totally unexpected will happen (like a corporate takeover) to cause the market price of a security to drop dramatically.

Risk –Return Tradeoff The risk-return trade-off refers to the universal rule of investing that the amount of risk associated with an investment is directly related to the expected return of the investment. If you want a higher return, you must be willing and able to accept a higher level of risk. The risk-free rate of return is the positive level of return that you can earn even though there is virtually no risk of default involved in the security. This rate is usually identified as the return on short-term government securities, such as Treasury bills. (Even though this is referred to as the “risk-free” rate, bear in mind that these low rates of safe return are very susceptible to purchasing power risk—the risk that the growth in the value of the investment will not keep pace with inflation. In addition, if these investments are held outside a tax-sheltered environment, they are also subject to taxes.)

Returns from Stock Investing The two basic sources of return are current income and capital gains. Current income is the amount of return generated annually from an investment and takes the form of dividends, interest, or rent. A capital gain, in contrast, reflects the price behavior of an investment over time and is captured through capital appreciation (or loss).

Interest-on-interest is one of the most important, yet most overlooked, sources of return. Interest-on- interest means keeping your capital fully invested—it means reinvesting the current income and realized

capital gains into other investment products. It is through interest-on-interest that we are able to earn fully compounded rates of return (over the long haul) on our investments. Indeed, over extended (lengthy) periods of time, interest-on-interest may account for as much as 40–60% of total return.

An investor's desired rate of return is the minimum rate of return acceptable for the amount of risk that the investor must bear. An investment should be considered acceptable only if it is expected to generate a rate of return that meets or exceeds the investor's desired rate of return.

Capital Gains Yes, tax-wise, it makes a difference to investors whether they receive a return on stocks in the form of dividends or capital gains. Short-term capital gains (gains on property held less than one year) are taxed as regular income to the taxpayer at rates which currently go up to over 30% (rates are scheduled to go down through time). Dividends and capital gains on property held longer than one year are taxed more favorably. For taxpayers in the 10% and 15% tax brackets, the rate is 5%. For taxpayers in brackets higher than 15%, the rate is 15%. Also, an even more favorable 5-year capital gains rate has recently come into effect.

Dividends Dividends can take two forms. Cash dividends are just what the name implies. The most common form of dividend, they are typically paid on a quarterly basis in cash. Stock dividends pay existing shareholders in new shares of stock. However, the shareholder's proportion of ownership and investment value remain the same. The price generally falls in direct proportion to the size of the stock dividend. Investors should prefer to receive cash dividends. Cash dividends provide additional return, while stock dividends do not represent additional value. When a company issues a stock dividend, the price of its shares falls accordingly, and each shareholder holds the same proportion of the company's total outstanding stock as before.

Evaluation Measures Book value represents the accounting value of a firm. The book value is determined by subtracting the firm's liabilities and preferred stock value from its assets. The resulting amount would be the book value of the common stock.

Return on Equity (ROE) relates the amount of profits that the firm is generating relative to the firm's equity base, and it reflects the overall profitab

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