IFYF Unit 6 Review Question Answers

• Introduction
• Unit 1: Basic Building Blocks of Successful Financial Management
• Unit 2: Investing Basics
• Unit 3: Finding Money to Invest
• Unit 4: Ownership Investments
• Unit 5: Fixed-Income Investing
• Unit 6: Mutual Fund Investing
• Unit 7: Tax-Deferred Investments
• Unit 8: Investing Small Dollar Amounts
• Unit 9: Getting Help: Investing Resources
• Unit 10: Selecting Financial Professionals
• Unit 11: Investment Fraud

• Study Guide
• Action Steps
• Monthly Investment Messages
• Glossary

Unit 6

Mutual Fund Investing Review Questions & Answers

1.Why is it important to learn about mutual funds?

Mutual funds are an important financial management topic because:

• They are popular with investors. Surveys show that mutual funds are widely owned by the American public.
• Many people don’t understand mutual funds! Research suggests that many investors are not knowledgeable about mutual funds.
• Purchases may be required or optional. Some people choose to invest bonus or other windfall money in mutual funds. But many must choose mutual funds for 401(k) plans or other investment programs.

2.What factors should always be considered prior to selecting a mutual fund, or other investment?

Before choosing any investment, you should match the mutual fund or other investment product to your:

• investment goal;
• time-frame, or time horizon, for needing the money to meet that goal; and
• risk tolerance, or the amount of risk you are willing to take with these funds. Be sure to review Figure 1. Risk and Return in this unit.

3.Describe a mutual fund. How does it make money for investors?

A mutual fund is an investment company that pools money from a large number of individual or institutional investors to buy and manage a portfolio of investments. The portfolio is purchased based on a given objective for the mutual fund that is stated in the fund prospectus. Typical objectives include growth, income, growth and income, or preservation of capital. Although the underlying portfolios may include some combination of investments, mutual funds fall into the three main categories of stock, bond, or money market.

Investors make money from mutual funds in two ways:

• Return to investors of dividends, interest, or capital gains generated from the investments in the portfolio.

• Capital gains from the sale of shares of the mutual fund that have appreciated, or increased in value. (Not all shares increase in value, and, consequently, the investor would lose money if the share price at the time of the sale was lower than the initial share purchase price.)

4.Compare and contrast open-end and closed-end mutual funds. Which are most widely available? Is a closed fund the same thing as a closed-end fund?

Open-end mutual funds are the subject of this unit and are the “mutual funds” commonly referenced in the media and other sources. Because of their widespread availability, the term mutual funds is used without the designation “open-end” in reference to the unlimited number of investors, or shares, in the individual fund. An open-end mutual fund may “close,” meaning it is no longer accepting new investors, but the fund remains open to the influx of investment dollars from the current shareholders. With time and changes in market conditions, a closed open-end fund may again open to new investors.

In contrast, closed-end mutual fund shares are traded similarly to common stock shares. A closed-end fund initially issues only “x” number of shares and all future sales of those shares must occur on the market exchanges.

5.How does a mutual fund investment company calculate net asset value (NAV)? Why is this important investor information?

In essence, NAV represents the net worth of the mutual fund divided by the number of outstanding shares held by the fund investors. The balance sheet calculation comparing company assets, liabilities, and expenses is updated at the close of every trading day to reflect current prices of the portfolio investments. The resulting NAV calculation represents (1) the price you will be paid if you are selling shares or (2) the price you will pay if you are purchasing shares, assuming no additional fees or commissions are assessed.

6.What disadvantages are associated with investing in individual stocks and bonds?

Disadvantages associated with individual stock and bond investments include the following:

• Significant time and expertise is required to analyze a company and it’s future prospects for financial success.
• Transaction costs to buy and sell individual stocks and bonds can be very expensive, unless a discount or online brokerage service is used.
• Diversification requires a significant amount to invest. To reduce risk, a minimum of 10 to 20 companies spanning different industries must be included in an individual portfolio.

7.When are mutual funds not a recommended investment choice?

Mutual funds are not needed if you (1) plan to buy Treasury securities or (2) have sufficient knowledge and money to select a diversified portfolio of individual stocks.

8.Briefly summarize the 10 advantages associated with mutual fund investing. Identify three that are most important to you.

Ten advantages to mutual fund investing include:

1. Professional money management of the portfolio.
2. Diversification
3. Competitive returns, and returns that essentially mirror the market if investing in index funds.
4. Small amounts are needed to start and maintain an investment plan.
5. Liquidity—easy access to money invested, when needed.
6. Commissions are avoidable and fees are low.
7. Convenient strategies for selecting, maintaining, and liquidating accounts.
8. Automatic withdrawal of investment account to help fund goals.
9. Highly regulated industry with less risk than others for company bankruptcy or fraud.
10. Information is easy to access through the newspaper, the Internet, or by telephone.

9. How is an automatic investment plan used to build a portfolio?

Building on the concept of dollar cost averaging, an automatic investment plan (AIP) establishes a periodic purchase agreement between an investor and a mutual fund company. On an established schedule (e.g., bi-weekly, monthly, quarterly), funds are automatically transferred from a bank account to the fund to purchase additional shares. Funds may allow an investor to make a smaller initial deposit or to make smaller periodic purchases, than typically advertised, if the investor establishes an AIP. Regardless, the investor benefits from the convenience and financial gain associated with disciplined investing.

10.Briefly summarize the four disadvantages associated with mutual fund investing. Identify one that is most important to you.

Four primary disadvantages to mutual fund investing include:

1. Some funds may outperform the market, but funds do not protect the investor from a bear market, or a broad market downturn.
2. Prices may fluctuate, depending on the fund, and there is no guaranteed return. You can lose money.
3. Annual distributions of dividends, interest and capital gains can increase your tax liability—even if you lost money in the fund that same year.
4. Keeping records documenting the actual cost basis for tax calculations can be difficult.

11.Define the cost basis of a mutual fund. How might a mutual fund supermarket be helpful when determining your cost basis?

The cost basis is the original price paid for an investment, including any commissions, plus all subsequent deposits and fund distributions (e.g., dividends and capital gains). Mutual fund share prices could change for every purchase made, whether by direct investor purchases or by reinvestments of dividends or capital gains. When shares are sold, the calculation of the capital gain (profit) or capital loss must be determined for income tax calculations. Consequently, it is important to keep every fund statement, or at least a detailed annual account summary statement, to document the share price for all purchases. Mutual fund supermarkets facilitate this effort by consolidating and reporting all fund activity as one account.

12.Review Worksheets 1, 2, 3, and 4 to identify the mutual fund categories that match the descriptions listed below.

a.Invest in companies that circle the globe, including the United States.

global funds

b.Funds with typically the lowest expense ratios.

index funds

c.The high potential for capital appreciation coupled with volatility suggests that these funds are riskier than others with this objective.

aggressive growth funds

d.Fund objective and name reflects the size of the companies whose stock make up the mutual fund portfolio.

small capitalization (“small cap”) funds and large capitalization (“large cap”) funds

e.Utilities are commonly found in both of these fund categories, although the rest of the portfolios are made up of either stocks or bonds and the fund objectives are different.

income funds and equity income funds

f.These two fund categories invest in a portfolio of corporate bonds but one significant criteria, bond rating, differentiates the two.

corporate bond funds and high-yield (junk) bond funds

g.Both fund categories combine stocks and bonds to meet their objectives, but only one matches the portfolio to a fixed ratio of the two securities.

income funds and balanced funds

h.Both of these funds use portfolios of municipal bonds, although their fund objectives and investment terms are different.

muncipal bond funds and tax-free money market funds

i.Although all funds maintain some cash in their portfolios, these fund portfolios are based on a combination of stocks, bonds, and cash.

lifestyle funds, asset allocation funds, and some funds of funds

j.Diversification is a hallmark of mutual funds, but these funds take that concept one step further by investing in mutual funds themselves.

funds of funds

13.Define no-load, load, and low-load funds. Explain the loads typically charged with Class A, B, and C shares.

No-load mutual funds charge no commissions, either up-front, back-end, or “perpetual” in the form of higher 12b-1 marketing and management fees. (Note: no-load funds may charge a 12b-1 fee for marketing or a contingent deferred sales charge; however, NASD regulations require those fees to be less than .25 of 1% of average net assets, if the term “no-load” is used to describe the fund.) No-load funds are typically purchased directly from the investment company, a mutual fund supermarket, or a fee-only financial planner.

Load mutual funds charge a commission to support the sales professionals who promote and provide these funds to the investing public. Commissions can vary with the “class” of share sold, as outlined below:

• Class A shares: Carry an up-front sales charge of 4% to 8.5% of the amount invested and may also include a 12b-1 fee. Are described as having a front-end load.

• Class B shares: Carry a contingent deferred sales charge, or initial fee of 5% to 6% the first year that declines by 1% each year until it disappears. This fee is only assessed if the fund shares are sold. A 12b-1 fee is usually assessed. Are described as having a back-end load. Usually have a higher management fee than Class A shares.

• Class C shares: Charge no commission on purchase, or fee upon sale of the shares, but do charge a higher 12b-1 fee for the life of the fund ownership. Are described as having a level load. Usually have a higher management fee than Class A and Class B shares.

Low-load funds typically carry an up-front sales charge this is lower than that associated with load funds (e.g., 1% to 3% as compared to 4% to 8.5%).

14.What are redemption fees? Are they unique to load or no-load funds?

Redemption fees are sometimes charged by both load and no-load mutual funds to discourage frequent trading in and out of a mutual fund. This fee may be assessed as 1% of the value of the shares sold, but usually disappears after the investment is held for a designated time, typically 6 months to 1 year. This fee is very different from a contingent deferred sales charge and should not dissuade a long-term investor from seriously considering a fund with a redemption fee.

15. Define expense ratio. What guidelines can you use to assess expense ratios?

The expense ratio reflects the percentage of fund assets paid for operating expenses and management fees, including, if applicable, 12b-1 fees for marketing, distribution, and compensation to the financial professional. Expense ratios are reported for both no-load and load funds, but are typically higher for the latter. Expense ratios may range from less than 0.5% to more than 2% of fund assets. Recall that expense ratios for index funds are typically lower because less “active” management is required to maintain the portfolio. Recommended guidelines for differentiating high and low expense ratios include the following:

• Stock funds: 1.4%

• Bond funds: 1.0%

• Money market funds: 0.5%

16.Summarize the seven-step mutual fund selection process. Is this approach unique to mutual funds or universally applicable to any investment?

The seven-step mutual fund selection process is applicable to any investment purchase and can be summarized in five steps, as follows:

• Determine your investment needs to match the mutual fund, or other investment product, to your goal, time horizon, and risk tolerance.
• Do your homework—read and learn about the mutual fund or other investment product, and perhaps the company or industries represented.
• Determine your selection criteria, gather information (including the prospectus), and analyze the investment options considered.
• Implement your investment plan—make your initial purchase and develop a plan for subsequent purchases.
• Monitor your future returns and/or account value.