Chapter 2 Securities Markets and Transactions 15
Chapter 12
Mutual Funds and Exchange-Traded Funds
Outline
Learning Goals
I. The Mutual Fund Concept
A. An Overview of Mutual Funds
1. Pooled Diversification
2. Active versus Passive Management
3. Attractions and Drawbacks of Mutual Fund Ownership
4. Performance of Mutual Funds
5. How Mutual Funds Are Organized and Run
6. Open- or Closed-End Funds
7. Closed-End Investment Companies
B. Exchange-Traded Funds
C. Some Important Considerations
1. Load and No-Load Funds
2. Other Fees and Costs
D. Other Types of Investment Companies
1. Real Estate Investment Trusts
2. Hedge Funds
Concepts in Review
II. Types of Funds and Services
A. Types of Mutual Funds
©2017 Pearson Education, Inc.
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
1. Growth Funds
2. Aggressive-Growth Funds
3. Value Funds
4. Equity-Income Funds
5. Balanced Funds
6. Growth-and-Income Funds
7. Bond Funds
8. Money Market Funds
9. Index Funds
10.Sector Funds
11. Socially Responsible Funds
12.Asset Allocation Funds
13.International Funds
B. Investor Services
1. Automatic Investment Plans
2. Automatic Reinvestment Plans
3. Regular Income
4. Conversion Privileges
5. Retirement Programs
Concepts in Review
III. Investing in Mutual Funds
A. Investor Uses of Mutual Funds
1. Accumulation of Wealth
2. Storehouse of Value
3. Speculation and Short-Term Trading
B. The Selection Process
1. Objectives and Motives for Using Funds
2. What the Funds Offer
3. Whittling Down the Alternatives
4. Stick with No-Loads or Low-Loads
C. Investing in Closed-End Funds
1. Some Key Differences between Closed-End and Open-End Funds
2. What to Look for in a Closed-End Fund
D. Measuring Performance
1. Sources of Return
2. Measures of Return
a. HPR with Reinvested Dividends and Capital Gains
b. Measuring Long-Term Returns
c. Return on Closed-End Funds
3. The Matter of Risk
Concepts in Review
Summary
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
Key Terms
Discussion Questions
Problems
Case Problems
12.1 Reverend Mark Thomas Ponders Mutual Funds
12.2 Calvin Jacobs Seeks the Good Life
Excel@Investing
Chapter-Opening Problem
Key Concepts
1. The basic characteristics of mutual funds and how diversification and professional management
are the cornerstones of the industry
2. The advantages and disadvantages of owning mutual funds
3. The kinds of funds available and the variety of investment objectives these funds seek to fulfill;
recent additions to the assortment covered include hedge funds and exchange-traded funds
4. The array of special services offered by mutual funds and how these services can fit into an
investment program
5. Investor uses of mutual funds and ways of assessing and selecting funds that are compatible with
the investment needs of the individual
6. Aspects of investing in closed-end mutual funds
7. Sources of return in mutual funds and ways to calculate rate of return
Overview
This chapter focuses on mutual funds.
1. The chapter begins with an overview of the major features and characteristics of mutual funds. At
the outset, the difference between buying into a mutual fund and investing directly in securities
should be clarified by the instructor; it’s also helpful to emphasize early on that pooled diversification
is one of the major benefits of investing in a mutual fund. The instructor might also mention that the
additional benefits of professional management and modest start-up capital requirements make
investing in mutual funds attractive, even, or perhaps especially, for small investors. Drawbacks of
mutual funds are pointed out.
2. Closed-end (CEFs) and open-end mutual funds (OEFs) are introduced. Other types of pooled
investments, such as investment (unit) trusts and load versus no-load funds are also described, along
with the various types of mutual fund fees and charges. The instructor should indicate the types of
investments these funds represent. The class may be shown how to read mutual fund quotations from
sources such as Morningstar.com or the finance sections of free websites, like Yahoo!.
©2017 Pearson Education, Inc.
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
3. In the next section, mutual funds are classified according to investment objectives. Growth funds,
aggressive growth value funds, equity-income funds, balanced funds, growth and income funds,
bond funds, money market funds, index funds, sector funds, socially responsible funds, asset
allocation funds, and international funds are defined. The instructor should explain how such funds
choose the investments that enable them to meet their prescribed objectives. How and why investors
might choose one type of fund rather than another should be explored, and the various investor
services offered by these funds need to be briefly discussed in class.
4. Given their popularity and hybrid nature, exchange-traded funds should be covered. Discussion of
advantages and disadvantages of exchange-traded funds puts some of the comparative advantages
and disadvantages of open-end mutual funds into perspective.
5. Next, a discussion of how to invest in closed-end funds follows. Some key differences between
investing in closed-end versus open-end funds are explored.
6. A mutual fund’s performance may be measured by rate of return. It might be helpful at this point
to discuss the sources of return and how investors can get a handle on the future performance of a
mutual fund; with that background out of the way, the instructor can work out examples in class
showing holding period return (HPR) and yield calculations similar to those in the text. Consideration
of risk should also be emphasized when comparing the return of two funds. The instructor might
point out that beta and other risk measures apply to funds as well as individual stocks and perhaps
discuss the various risk measures available from Morningstar.com and similar websites.
7. There is an abundance of information on mutual funds, including the Wall Street Journal’s
monthly mutual funds report, which is typically published on the first day of the month. Instructors
should provide information on recent mutual fund returns whenever possible.
Answers to Concepts in Review
1. 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
2. The major advantage of mutual funds is that they provide diversification and professional
There are several disadvantages, however. For one thing, the funds can be quite expensive to
acquire if they are load funds, or they may have other types of charges and fees (like 12(b)-1 fees). In
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 19
3. Mutual funds are frequently open-ended investment companies; investors in mutual funds are
Individual mutual funds are created by management companies, like Fidelity, Dreyfus, and
Vanguard. They also run the funds’ daily operations and usually serve as the investment advisers. The
4. a. An open-end investment company is a mutual fund in which investors actually buy
b. 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
d. 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
e. Like mutual funds, hedge funds sell shares (or participation units) in a professionally managed
portfolio of securities. However, hedge funds are private partnerships that are not regulated and
5. 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
A 12(b)-1 fund may appear to be a no-load fund, but in fact, it charges an annual fee, which
©2017 Pearson Education, Inc.
20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
6. 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
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
7. Mutual funds come in a wide variety.
a. Aggressive growth funds are highly speculative funds that concentrate on obtaining large capital
b. 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,
c. 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,
d. Bond funds come in all shapes and colors (from government bond funds to high-yield [junk]
corporate bond funds), and they all have one thing in common: They invest principally (or
e. Sector funds are mutual funds that concentrate their holdings in one or more industries that make
f. Socially responsible funds are mutual funds that actively and directly incorporate ethics and
8. Asset allocation funds spread investors’ money across different types of markets. Most other
In an asset allocation fund, the manager establishes a desired allocation mix and purchases
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 21
A target date is a kind of asset allocation fund in which the mix of assets automatically adjusts as
9. 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
10. Fund families are simply investment management companies that offer a number of different kinds of
mutual funds to the investing public. The two largest fund families—Fidelity and Vanguard—each
have over two trillion dollars in assets. Fidelity has over 450 different funds in its family. The big
11. Mutual funds offer a variety of services to investors, including the following: savings and automatic
reinvestment plans: investors are provided a way to accumulate capital and have returns
Automatic investment plans allow shareholders to send amounts of money automatically from their
paychecks or bank accounts into the fund. Automatic reinvestment plans enable mutual fund investors
to keep their capital fully employed; this is important because that’s the way investors earn fully
compounded rates of return. Normally, dividends and capital gains distributions are paid in the form
©2017 Pearson Education, Inc.
22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
12. Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a
The future performance of the market is difficult to predict, and therefore is of limited importance
13. 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. Of
these, more CEF assets are typically invested in bonds.
Key differences between closed-end (CEFs) and open-end (OEFs) mutual funds include the
following:
14. 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
15. 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
Suggested Answers to Discussion Questions
1. Arguments for mutual fund ownership:
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 23
2. An ETF is created when a portfolio of securities is placed in a trust and then shares are sold to the
3. a. Growth versus growth and income funds: Growth funds have more risk due to
b. Equity-income versus high-grade corporate bond funds: Bonds are less risky since they are rated
c. Balanced versus sector funds: Sector funds lack diversification and therefore may contain higher
d. Global versus Value funds: This depends on what type of global fund is used, but in most cases
e. Intermediate-term bonds versus high-yield municipal bond funds: Assuming the intermediate
f. The target date focused on 2020 is likely to be less risky than the fund focused on 2040. As such
4. Exchange-traded funds are similar to index mutual funds but trade like stocks. Each share
SPDRs are a specific type of ETF based on the S&P 500 Index. The Vanguard family of funds
contains a fund, known as the Vanguard 500 Index Fund, which is similar to a SPDR; that is, they
©2017 Pearson Education, Inc.
24 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
5. You can buy open-ended funds at their net asset value because you are dealing directly with the
fund. Why closed-end funds should sell at discounts or premiums is something of a puzzle.
6. Answers will vary with each student.
©2017 Pearson Education, Inc.