Mutual Funds

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Lecture 24

• Mutual Funds

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Balanced Funds
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• The basic objectives of balanced funds are to
  generate income as well as long-term growth of
  principal. These funds generally have portfolios
  consisting of bonds, preferred stocks, and common
  stocks. They have fairly limited price rise
  potential, but

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• do have a high degree of safety, and moderate to
  high income potential. Investors who desire a
  fund with a combination of securities in a single
  portfolio, and who seek some current income and
  moderate growth with low-level risk, would do
  well to invest in balanced mutual funds.

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• Balanced funds, by and large, do not differ
  greatly from the growth and income funds
  described above.

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Growth Funds
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• Growth funds are offered by every investment
  company. The primary objective of such funds is
  to seek long-term appreciation (growth of
  capital). The secondary objective is to make
  one's capital investment grow faster than the
  rate of inflation. Dividend income is considered
  an incidental objective of growth funds.

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• Growth funds are best suited for investors
  interested primarily in seeing their principal
  grow and are therefore to be considered as
  long-term investments - held for at least three
  to five years. Jumping in and out of growth funds
  tends to defeat their purpose.

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• However, if the fund has not shown substantial
  growth over a three - to five-year period, sell
  it (redeem your shares) and seek a growth fund
  with another investment company.

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• Candidates likely to participate in growth funds
  are those willing to accept moderate to high risk
  in order to attain growth of their capital and
  those investors who characterize their investment
  temperament as "fairly aggressive.

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Index Funds
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• The intent of an index fund is basically to track
  the performance of the stock market. If the
  overall market advances, a good index fund
  follows the rise. When the market declines, so
  will the index fund. Index funds' portfolios
  consist of securities listed on the popular stock
  market indices.

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• It is also the intent of an index fund to
  materially reduce expenses by eliminating the
  fund portfolio manager. Instead, the fund merely
  purchases a group of stocks that make up the
  particular index it deems the best to follow.

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• The stocks in an index fund portfolio rarely
  change and are weighted the same way as its
  particular market index. Thus, there is no need
  for a portfolio manager. The securities in an
  index mutual fund are identical to those listed
  by the index it tracks, thus, there is little or
  no need for any great turnover of the portfolio
  of securities.

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• The funds are "passively managed" in a fairly
  static portfolio. An index fund is always fully
  invested in the securities of the index it
  tracks.

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• An index mutual fund may never outperform the
  market but it should not lag far behind it
  either. The reduction of administrative cost in
  the management of an index fund also adds to its
  profitability.

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Sector Funds
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• As was discussed earlier, most mutual funds have
  fairly broad-based, diversified portfolios. In
  the case of sector funds, however, the portfolios
  consist of investment from only one sector of the
  economy.

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• Sector funds concentrate in one specific market
  segment for example, energy, transportation,
  precious metals, health sciences, utilities,
  leisure industries, etc. In other words, they are
  very narrowly based.

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• Investors in sector funds must be prepared to
  accept the rather high level of risk inherent in
  funds that are not particularly diversified. Any
  measure of diversification that may exist in
  sector funds is attained through a variety of
  securities, albeit in the same market sector.

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• Substantial profits are attainable by investors
  astute enough to identify which market sector is
  ripe for growth - not always an easy task.

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Special Funds
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• Specialized funds resemble sector funds in most
  respects. The major difference is the type of
  securities that make up the fund's portfolio. For
  example, the portfolio may consist of common
  stocks only, foreign securities only, bonds only,
  new stock issues only, over - the - counter
  securities only, and so on.

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• Those who are still novices in the investment
  arena should avoid both specialized and sector
  funds or the time being and concentrate on the
  more traditional, diversified mutual funds
  instead.

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Islamic Funds
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• In case of Islamic Funds, the investment made in
  different instruments is to be in line with the
  Islamic Shairah Rules. The Fund is generally to
  be governed by an Islamic Shariah Board.

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• And then there is a purification process that
  needs to be followed, as some of the money lying
  in reserve may gain interest, which is not
  desirable in case of Islamic investments.

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Risk Involving in Mutual Fund Investment
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• There is some degree of risk in every investment.
  Although it is reduced considerably in mutual
  fund investing. Do not let the specter of risk
  stop you from becoming a mutual fund investor.

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• However, it behaves all investors to determine
  for them the degree of risk they are willing to
  accept in order to meet their objectives before
  making a purchase. Knowing of potential risks in
  advance will help you avoid situations in which
  you would not be comfortable.

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• Understanding the risk levels of the various
  types of mutual funds at the outset will help you
  avoid the stress that might result from a
  thoughtless or a hasty purchase.
• Let us now examine the risk levels of the
  various types of mutual funds.

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LOW-LEVEL RISK
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• Mutual funds characterized as low-level risks
  fall into here categories
• Money market funds
• Treasury bill funds
• Insured bond funds

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MODERATE-LEVEL RISKS
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• Mutual funds considered moderate-risk investments
  may be found in at least the eight types
  categorized below.
• Income funds
• Balanced funds
• Growth and income funds
• Growth funds

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1. Short-term bond funds (taxable and tax-free)
2. Intermediate bond funds (taxable and tax-free)
3. Insured government/municipal bond funds
4. Index funds.

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HIGH-LEVEL RISKS
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• The types of funds listed below have the
  potential for high gain, but all have high risk
  levels as well.
• Aggressive growth funds
• International funds
• Sector funds
• Specialized funds

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1. Precious metals funds
2. high-yield bond funds (taxable and tax-free)
3. Commodity funds
4. Option funds

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MEASURING RISK
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• As you become a more experienced investor, you
  may want to examine other, more technical,
  measures to determine risk factors in your choice
  of funds.

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Beta Coefficient
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• Beta coefficient is a measure of the funds risk
  relative to the overall market. For example, a
  fund with a beta coefficient of 2.0 means that it
  is likely to move twice as fast as the general
  market both up and down. High beta coefficients
  and high risk go hand in hand.

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Alpha Coefficient
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• Alpha coefficient is a comparison of a funds
  risk (beta) to its performance. A positive alpha
  is good. For example, an alpha of 10.5 means that
  the fund manager earned an average of 10.5 more
  each year than might be expected, given the
  funds beta.

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Interest Rates
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• Interest rates and inflation rates are other
  factors that can be used to measure investment
  risks. For instance, when interest rates are
  going up, bond funds will usually be declining,
  and vice versa.

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• The rate of inflation has a decided effect on
  funds that are sensitive to inflation factors
  for example, funds that have large holdings in
  automaker stocks, real estate securities, and the
  like will be adversely affected by inflationary
  cycles.

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R-Square Factor
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• R-Square factor is a measure of the funds risk
  as related to its degree of diversification.

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• The information is supplied here merely to
  acquaint you with the terminology in the event
  you should wish to delve more deeply into complex
  risk factors. The more common risk factors
  previously described are all you really need to
  know for now, and perhaps for years to come.

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• One caveat is in order, however. There is no such
  thing as an absolutely 100 risk-free investment.
  Even funds with excellent 10 year past
  performance records must include in their
  literature and prospectuses the following
  disclaimer

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• Past performance is no guarantee of future
  results. However, by not exceeding your risk
  tolerance level, you can achieve a wide safety
  and comfort zone with mutual fund portfolios such
  as those shown.