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Chapter 13 Investing in Mutual Funds, ETFs, and Real Estate How Will This Affect Me? Having a financial plan, and being aware that diversification is crucial is a great start to the task of investment planning. The next step is figuring out how to implement your plan by deciding what to invest in. For most people, diversification is best achieved using mutual funds and exchange traded funds (ETFs). This chapter describes the key characteristics of each type of fund, sorts through the various options you have, shows how to calculate rates of return and evaluate performance, and explains how to choose among funds. The essential elements of investing in real estate and its role in diversifying your overall investment portfolio are also covered. After reading this chapter, you should be in a good position to invest in mutual funds, ETFs, and real estate in a way that will help you achieve your financial objectives. This is the last of the investment chapters of 11, 12, and 13. The chapter explains how Mutual Funds, Exchange Traded Funds, and Real Estate investment operate and the advantages of each. There are some problems that ask the student to find mutual funds, ETFs, and REITs and recommend one. It would be good to assign one of those problems; Financial Planning Exercises number 5 or 6 for example. Learning Objectives 13-1 Describe the basic features and operating characteristics of mutual funds and exchange traded funds. Terminology and understanding how things work drives this section. The Power Point Slides should be enough for coverage. I suggest using the Facts or Fantasies to get their attention. 13-2 Differentiate between open- and closed-end mutual funds as well as exchange traded funds and discuss the various types of fund loads and charges. Terminology and understanding how things work drives this section. The Power Point Slides should be enough for coverage. 13-3 Discuss the types of funds available to investors and the different kinds of investor services offered by mutual funds and exchange traded funds. OK, I am repeating myself, but these first three goals have similar purposes. Terminology and understanding how things work drives this section. The Power Point Slides should be enough for coverage. 13-4 Gain an understanding of the variables that should be considered when selecting funds for investment purposes. I would pick a fund and discuss why it is a good fund, or not. I suggest a growth stock fund or a small cap fund such as Fidelity Growth (FDGRX) or Fidelity Small Cap (FCPVX). Of course there are others that can be used. For this purpose, select whatever fund you want. 13-5 Identify the sources of return and calculate the rate of return earned on an investment in a mutual fund, as well as evaluate the performance of an exchange traded fund. Financial Planning Exercises 7 & 8 gives the student opportunities to compute approximate yields or use financial calculators. I suggest you assign these and go over in class. 13-6 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. Terminology and understanding how things work drives this section. The Power Point Slides should be enough for coverage. Also, Financial Planning Exercises 10 is worth discussion in class. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • When a mutual fund is open-ended, it means there’s no limit on the returns an investor can realize. Fantasy: In an open-end mutual fund there is no limit to the number of shares the fund can issue. While the upside return on a mutual fund is limited only by the overall market and the skill of its managers, investors cannot lose more than they invested. • Online and phone switching are services that enable you to move money from one fund to another, so long as you stay within the same family of funds. Fact: Online and phone switching are conversion (or exchange) privileges that allow you to sell one fund and buy another, with the only condition being that you confine your switches to the same family of funds. • While exchange traded funds (ETFs) offer many of the benefits of mutual funds, they have tax-timing disadvantages not present with otherwise comparable mutual funds. Fantasy: While ETFs offer many of the benefits of mutual funds, they also have tax-timing advantages over mutual funds. Most mutual funds regularly distribute taxable capital gains to investors. In contrast, ETFs rarely distribute them. Thus, ETF investors defer most all capital gains taxes until they choose to take them by selling shares. • In many types of real estate investments, appreciation in the value of the property affects return more than annual rental income. Fact: Like most forms of investing, the biggest bang for your buck usually comes from capital gains. You’ll find that’s the way the really big money is made, and real estate is certainly no exception to that rule. • A real estate investment trust (REIT) is a popular form of limited partnership that enables individuals to invest directly in income-producing property. Fantasy: A REIT is a type of closed-end investment company (like a mutual fund) that issues stocks and invests the proceeds in various kinds of real estate properties, including mortgages.
Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False When a mutual fund is open-ended, it means there’s no limit on the returns an investor can realize. 2. True False Online and phone switching are services that enable you to move money from one fund to another, so long as you stay within the same family of funds. 3. True False While exchange traded funds (ETFs) offer many of the benefits of mutual funds, they have tax-timing disadvantages not present with otherwise comparable mutual funds. 4. True False In many types of real estate investments, appreciation in the value of the property affects return more than annual rental income. 5. True False A real estate investment trust (REIT) is a popular form of limited partnership that enables individuals to invest directly in income- producing property. Answers: 1. False 2. True 3. False 4. True 5. False YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. YOU CAN DO IT NOW Objective Mutual Fund Resources Looking for information on mutual fund investing from a source that isn’t trying to sell you a particular financial product? Then try the Mutual fund Investor’s Center at http://mfea.com/. It’s sponsored by the Mutual Fund Education Alliance (MFEA), which is a national trade organization for mutual funds. You can do it now. YOU CAN DO IT NOW How to Choose the Best ETF for You Do ETFs sound right for you but you’re not sure how to find the best ETF? Check out the ETF Selector provided on the Seeking Alpha site: http://seekingalpha.com/page/etf-finder. It provides a list of ETFs by asset class, explains how to use them, and provides links to articles that discuss key investor issues. You can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Eliza Finds a Simple Retirement Investment Plan Eliza Myers, 27 years old, wants to get her retirement investing portfolio up and running. But she has a demanding job and little time to manage a portfolio closely. In doing some research, she read a short (16-page) booklet by William J. Bernstein, “If You Can” (www.etf.com/docs/IfYouCan.pdf). Bernstein argues that by age 25 it’s important to invest at least 15 percent of your income annually in a 401(k), an IRA, or a taxable account (or all three) in just three mutual funds or ETFs: • U.S. total stock market index fund • International total stock market fund • U.S. total bond market index fund These funds will earn different rates of return over time, so once a year it makes sense to rebalance the amount in each account so they’re equal. Bernstein convincingly argues that following this simple investment plan will beat most professional investors and would likely provide enough savings for Virginia to retire comfortably. Eliza was indeed convinced and estimated that keeping the plan in place would take about 30 minutes a year. So she invested equal amounts in the following ETFs: • Vanguard Total International Stock ETF (VXUS) • Vanguard Total Stock Market ETF (VXUS) • Vanguard Total Bond Market ETF (BND) Eliza will invest 15 percent of her income each year in these ETFs and rebalance them annually. Her research and simple, systematic approach will no doubt serve her well. Financial Planning Exercises 1. Choosing between a mutual fund and an ETF. Lily Hughes is considering whether she should invest some extra money in a mutual fund or an ETF. Explain the key factors that should influence her decision. An exchange traded fund (ETF) is an investment company whose shares trade on stock exchanges. Unlike mutual funds, ETF shares can be bought or sold (or sold short) throughout the day. The term mutual fund commonly denotes an open-end investment company. In an open-end investment company, investors actually buy their shares from, and sell them back to, the mutual fund itself. Buy and sell transactions in an open-end mutual fund are carried out at prices based on the current value of all the securities held in the fund’s portfolio. This is known as the fund’s net asset value (NAV); it is calculated at least once a day and represents the underlying value of a share of stock in a particular fund. Accordingly, all transactions are executed at the end of day price—there is no trading during the day, unlike the ETF. A decision to invest in an ETF is a decision to follow and buy or sell the fund throughout the day. If you are only going to review position once a day or even less frequently [one a month] the ETF does not provide an advantage. 2. Estimating cost of mutual fund investments. Using the mutual fund quotes in Exhibit 13.3, and assuming that you can buy these funds at their quoted NAVs, how much would you have to pay to buy each of the following funds? a. AEMMX b. ADCVX c. FCPAX d. FSTAX According to the quotes, which of these four funds have 12b-1 fees? Which have redemption fees? Are any of them no-loads? Which fund has the highest year-to-date return? Which has the lowest?
From Exhibit 13.3 Emerging Markets AEMMX ADCVX FCPAX FSTAX
Net Asset Value 1 25.27 19.56 11.99
12b-1 fees ? Yes No Yes No
Redemption fees? Yes No No No
No-load? No [front-end] Yes No [front-end load] Yes
Yield to date -13.5% 11.6% -1.0% -0.5%
Rank by yield 4 1 3 2
3. Building a mutual fund portfolio. Imagine that you’ve just inherited $40,000 from a rich uncle. Now you’re faced with the problem of deciding how to spend it. You could make a down payment on a condo—or better yet, on that BMW that you’ve always wanted; or you could spend your windfall more profitably by building a mutual fund portfolio. Let’s say that, after a lot of soul-searching, you decide to build a mutual fund portfolio. Your task is to develop a $40,000 mutual fund portfolio. Use actual funds and actual quoted prices, invest as much of the $40,000 as you possibly can, and be specific! Briefly describe the portfolio that you end up with, including the investment objectives that you’re trying to achieve. I would not be very risky, but some risk. You could divide into 4 $10,000 investments into four funds: Growth, Income, International, Index, for example. You could follow William J. Bernstein, “If You Can” advice discussed in the Financial impact of Personal Choices near the end of the chapter and above. His advice is to spread equally between three funds: 4. Comparing ETF with SPRD. Describe an ETF and explain how these funds combine the characteristics of open- and closed-end funds. In the Vanguard family of funds, which would most closely resemble a “Spider” (SPDR)? In what respects are the Vanguard fund (that you selected) and SPDRs the same, and how are they different? If you could invest in only one of them, which would it be? Explain. An ETF is like an open-end fund in that the number of shares outstanding can be increased or decreased as investors send in more money or redeem shares. An ETF is also like a closed-end fund in that it trades as a listed security on one of the stock exchanges, and it can be traded at any time of day by placing an order through a broker. The Vanguard 500 Index Fund would most closely resemble a Spider, as this fund tracks the performance of the S&P 500 Index just as a Spider does. For buy-and-hold investors, the two choices would be comparable, although the 500 Index Fund would not be quite as tax efficient as the Spider. Most ETFs are index funds that trade less than the average actively managed mutual fund, which means that they should generates fewer taxable gains. For investors who trade more frequently, the Spider would probably be the better choice, as it can be bought and sold during the day. 5. Comparing risks of different mutual fund types. For each pair of funds listed below, select the fund that would be less risky and briefly explain your answer. a. Growth versus growth-and-income The income fund would be less risky. The funds look for stable companies that pay consistent dividends—a slow and steady approach. b. Equity-income versus high-grade corporate bonds The corporate bonds will be less risky with consistent interest income. Equity-income would be more volatile. c. Intermediate-term bonds versus high-yield municipals This is a toss-up. High yield municipals may be from Orange County California or Detroit. Munis can be risky due primary to unfunded health and pension liabilities. Intermediate-term bonds should be less risky of the two and maybe a higher return, but on an after-tax basis, the municipal bond is most likely a higher return. d. International versus balanced Balanced funds have a portfolio of investments from bonds to small caps. International are all equities and from developed and undeveloped countries. The balanced fund would be less risky due to the portfolio approach. 6. Evaluating ETF performance. Do an online search for information on the Power Shares QQQ ETF. Discuss what information you need to evaluate the performance of the ETF and use what you find to evaluate the QQQ ETF. What kind of investor should invest in this ETF? The primary reason for investing in an index-based ETF, of course, is to replicate the performance of the index. It follows that an important aspect of ETF performance is how well it tracks the performance of the underlying index. You can determine this by checking the so-called R-Squared (R2) statistical measure, which shows how much of the variability in an ETF’s total returns is explained by the variability in the total returns of the underlying index. The R2 varies between 0 percent and a maximum of 100 percent. Obviously, the higher the R2, the closer the relationship between the ETF and the associated target index. It also makes sense to know how the ETF’s style is described and how consistently it pursues this style. Finally, it’s wise to check how the ETF’s performance compares to its peers and how the ETF’s expense ratio compares with reasonable benchmarks. In September 2018, Morningstar reported that the R2 of the QQQ ETF relative to the closely related, best-fitting Morningstar U.S. technology index over the last three years was 92.06 percent. This is a very tight fit. What type of investor? An investor wanting exposure to the large, nonfinancial, technology growth stock that characterize the NASDAQ 100 and Morningstar’s related index could rest assured that the QQQ ETF replicates the performance of these indices well, with relatively lost expenses. 7. Calculating approximate yield on mutual fund. About a year ago, Elliot Cox bought some shares in the Axix Fund. He bought the fund at $24.50 a share, and it now trades at $26. Last year, the fund paid dividends of 40 cents a share and had capital gains distributions of $1.83 a share. Using the approximate yield formula, what rate of return did Elliot earn on his investment? Repeat the calculation using a handheld financial calculator. Would he have made a 20 percent rate of return if the stock had risen to $30 a share? Trading at $26: Approximate yield = ($2.23 + [($26 – $24.50)/1] ) / {(24.5 + 26)/2] = 3.73 / 25.25 = 14.8% Trading at $30: Approximate yield = ($2.23 + [($30 – $24.50)/1] ) / [(24.50 + 30)/2] = 7.73 / 27.25 = 28.4% If the fund was trading at $30, he would have made an approximate return of 28.4%, more than 20%. When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year, a total of $2.23 per share ($0.40 + $1.83). The keystrokes on the left show the return if the value of his stock rises to $26 at the end of the year, while those on the right show the return if the value of his stock rises to $30 at the end of the year. 8. Calculating mutual fund approximate rate of return. A year ago, the Constellation Fund was being quoted at an NAV of $21.50 and an offer price of $23.35; today, it’s being quoted at $23.04 (NAV) and $25.04 (offer). Use the approximate yield formula or a handheld financial calculator to find the rate of return on this load fund; it was purchased a year ago, and its dividends and capital gains distributions over the year totaled $1.05 a share. (Hint: As an investor, you buy fund shares at the offer price and sell at the NAV.) Trading at $23.04: Approximate yield = ($1.05 + [($23.04 – $23.35)/1] ) / [(23.04 + 23.35/2] = 0.74 / 23.20 = 3.2% When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year. 9. Investing in residential income-producing property. Leah Reyes is thinking about investing in some residential income-producing property that she can purchase for $200,000. Leah can either pay cash for the full amount of the property or put up $50,000 of her own money and borrow the remaining $150,000 at 8 percent interest. The property is expected to generate $30,000 per year after all expenses but before interest and income taxes. Assume that Leah is in the 25 percent tax bracket. Calculate her annual profit and return on investment, assuming that she (a) pays the full $200,000 from her own funds or (b) borrows $150,000 at 8 percent. Then discuss the effect, if any, of leverage on her rate of return. By using leverage, she was able to increase her return on her investment. This is due to the fact that the rate of interest was less than her return on investment with no leverage. Note depreciation is not given in the problem, it will be the same amount for each investment. The impact would be to reduce taxes in the same amount for both options. 10. Different ways to invest in real estate. Assume that you’ve just inherited $100,000 and wish to use all or part of it to make a real estate investment. a. Would you invest directly in real estate, or indirectly through something like a REIT? Explain. One guiding principle of investing is to invest in what you know about and understand. If you live in Virginia, it will be risky to purchase a specific real estate property in Montana when you have never been to the state. So investing in local real estate makes sense. If you are going to invest in real estate outside your local area, better to do so indirectly through REIT or Mutual Fund. b. Assuming that you decided to invest directly, would you invest in income-producing property or speculative property? Why? Describe the key characteristics of the types of income producing or speculative property you would seek. One of the most popular forms of real estate investing is income (or income- producing) property, which includes commercial and residential properties. Investments in income properties offer both attractive returns and tax advantages for investors. The purchased real estate is leased to tenants to generate income from rent. One approach that’s popular with many investors is to speculate in raw land. In this approach, which is often viewed as highly risky, investors seek to generate high rates of return by investing in property that they hope will undergo dramatic increases in value. So, you have income property with a low risk compared to speculating with high risk. The choice will be based upon your risk tolerance. I can be aggressive, but not an investor in high risk opportunities. Thus, I most likely will never own a private jet. c. What financial and nonfinancial goals would you establish before beginning the search for suitable property? Basic goal income v appreciation. If you are buying real estate for income you look to property that is leased and will most like stay leased. You will plan to buy and hold. If you are looking for appreciation, you need to look for properties that can be “flipped” with rewarding increase in value. d. If you decide to invest in real estate indirectly, which type(s) of securities would you buy, and why? Options are a real estate investment trust (REIT), which is a type of closed-end investment company that invests money in various types of real estate and real estate mortgages. Another option is a special-purpose syndicates organized to invest in real estate are another type of real estate investment. These can be structured as limited partnerships (LPs) or limited liability companies (LLCs). The LLCs or LPs have a high unit cost, typically $100,000 or more. A third option is to invest in Mutual Fund that own real estate or that invest in businesses related to real estate. For a small investor, the mutual fund is best. Test Yourself 13-1 What is a mutual fund? Why are diversification and professional management so important to mutual funds? A mutual fund is a financial services organization that receives money from its shareholders and invests those funds on their behalf in a diversified portfolio of securities. When investors buy shares in a mutual fund or an ETF, they usually become part owners of a widely diversified portfolio of securities. The purchasers of mutual funds have turned over their investment funds to the mutual fund in order to obtain both diversification and professional management. The investors will go elsewhere if a mutual fund does not offer these services. 13-2 Who are the key players in a typical mutual fund organization? The primary players are the investors and the money managers who takes the investor’s money and invest it for them. Supporting the money managers are security analysts who investigates companies, traders who execute the purchases and sales for the money manager, custodians who keep the records of who owns the fund, and agents who takes the investor’s money and sets up the account. All of these people may work for the same company [such as Fidelity or T. Rowe Price] 13-3 What’s the difference between an open-end mutual fund and an ETF? An exchange traded fund (ETF) is an investment company whose shares trade on stock exchanges. Unlike mutual funds, ETF shares can be bought or sold (or sold short) throughout the day. The term mutual fund commonly denotes an open-end investment company. In an open-end investment company, investors actually buy their shares from, and sell them back to, the mutual fund itself. Buy and sell transactions in an open-end mutual fund are carried out at prices based on the current value of all the securities held in the fund’s portfolio. This is known as the fund’s net asset value (NAV); it is calculated at least once a day and represents the underlying value of a share of stock in a particular fund. Accordingly all transactions are executed at the end of day price—there is no trading during the day, unlike the ETF. 13-4 What types of ETFs are available to investors? Most all ETFs are structured as index funds, set up to match the performance of a certain market segment; they do this by owning all or a representative sample of the stocks (or bonds) in a targeted market segment or index (we’ll examine traditional index funds in more detail later in this chapter). Thus, ETFs offer the professional money management of traditional mutual funds and the liquidity of an exchange traded stock. However, the passive indexing of early ETFs is giving way to the creation of actively managed ETFs. The most common type tracks a major market index like the S&P 500 or the NASDAQ-100 index. Foreign market ETFs track non-U.S. market indexes, like Japan’s Nikkei index or the MSCI index for Germany. There are also sector and industry ETFs that allow investors access to specific segments of the market like high-tech or pharmaceuticals. ETFs also provide exposure to commodities like gold or oil. You can even buy ETFs that invest in real estate, or are composed of derivatives like options and futures. 13-5 What’s the difference between a load fund and a no-load fund? Most open-end mutual funds are so-called load funds because they charge a commission when the shares are purchased (such charges are often referred to as frontend loads). Some open-end investment companies charge you nothing at all to buy their funds; these are known as no-load funds. Even funds that don’t have frontend loads (and so may be categorized as no-loads) can have back-end load charges that you must pay when selling your fund shares—or something called a 12b-1 fee, which you’d pay for as long as you hold your shares. 13-6 What is a 12b-1 fund? Can such a fund operate as a no-load fund? Also known as hidden loads, 12b-1 fees have been allowed by the Securities and Exchange Commission (SEC) since 1980 and were originally designed to help no-load funds cover their distribution and marketing expenses. The fees are assessed annually and can amount to as much as 1 percent of assets under management. The SEC set a 1 percent cap on annual 12b-1 fees and, perhaps more significantly, stated that true no-load funds cannot charge more than 0.25 percent in annual 12b-1 fees (otherwise, they must drop the “no-load” label in their sales and promotional material). 13-7 Briefly describe a back-end load, a low load, and a hidden load. How can you tell what kind of fees and charges a mutual fund has? Funds that charge a commission—or a redemption fee—when you sell your shares are known as back-end load funds. These charges tend to decline over time and usually disappear altogether after five or six years. Funds that charge commissions of only 2 percent or 3 percent are known as low-load funds. The 12b-1 fees are also known as hidden fees. Mutual funds are required by the SEC to disclose fully all their fees and expenses in a standardized, easy-to-understand format. Every fund prospectus must contain, right up front, a fairly detailed fee table that has three parts: shareholders transaction costs, annual operating expenses, and total cost over time. 13-8 What’s the difference between a growth fund and a balanced fund? The objective of a growth fund is simple—capital appreciation. Long-term growth and capital gains are the primary goals of such funds, so they invest principally in common stocks with above-average growth potential. Balanced funds are so named because they tend to hold a balanced portfolio of both stocks and bonds, and they do so to generate a well-balanced return of current income and long-term capital gains 13-9 What’s an international fund, and how does it differ from a global fund? The term international fund is used to describe a type of fund that invests exclusively in foreign securities, often confining the fund’s activities to specific geographical regions (such as Mexico, Australia, Europe, or the Pacific Rim). Global funds invests not only in foreign securities but also in U.S. companies—usually multinational firms. As a rule, global funds provide more diversity and, with access to both foreign and domestic markets, can go wherever the action is. 13-10 What’s an asset allocation fund? How do these funds differ from other types of mutual funds? Asset allocation funds spread investors’ money across all different types of markets. That is, whereas most mutual funds concentrate on one type of investment—whether it be stocks, bonds, or money market securities—asset allocation funds put money into all these markets. Many of them also include foreign securities in their asset allocation scheme, and some may even include inflation-resistant investments such as gold or real estate. These funds are designed for people who want to hire fund managers not only to select individual securities for them, but also to make the strategic decisions concerning asset allocation over time. 13-11 If growth, income, and capital preservation are the primary objectives of mutual funds, why do we bother to categorize them by type? There is a mutual fund for any plan an investor wants to follow. Granted all have the same overall goal of growth, income and appreciation, but they plan to get there is different ways. The investor has seemingly unlimited choices with the 30,000 mutual funds. 13-12 What are fund families? What advantages do these families offer investors? Family of funds are offered by investment companies in order to offer the investor choices within their company, the hope to keep all of the investor’s funds in their house. Fund families—usually provide conversion privileges that enable shareholders to move easily from one fund to another; this can be done either by phone or online. The only limitation is that the investor must confine the switches to the same family of funds. 13-13 What are automatic reinvestment plans, and how do they differ from automatic investment plans? Automatic reinvestment is one of the real draws of mutual funds, and it’s offered by just about every open-ended mutual fund. Whereas automatic investment plans deal with money shareholders put into a fund, automatic reinvestment plans deal with the dividends and other distributions that the funds pay to their shareholders. The automatic investment plan allows fund shareholders to funnel fixed amounts of money from their paychecks or bank accounts automatically into a mutual fund. 13-14 What are the most common reasons for buying mutual funds? Individuals tend to use these investment vehicles for one or more of these reasons: (1) to achieve diversification in their investment holdings, (2) to obtain the services of professional money managers, (3) to generate an attractive rate of return on their investment capital, and (4) for the convenience that they offer. 13-15 Briefly describe the steps in the mutual fund selection process. The selection process itself (especially regarding the types of funds to purchase) obviously plays an important role in defining the amount of success you’ll have with mutual funds or ETFs. It means putting into action all you know about investing in order to gain as much return as possible at an acceptable level of risk. Given that you have an asset allocation strategy in place and that you’re trying to select funds compatible with your targeted mix, the selection process begins with an assessment of your own investment needs; this sets the tone for your investment program. Obviously, you’ll want to select from those thousands of funds the one or two (or three or four) that will best meet your investment needs. Fund selection becomes a process of elimination as you weigh your investment needs against the types of funds available. 13-16 Why does it pay to invest in no-load funds rather than load funds? Under what conditions might it make sense to invest in a load fund? With no-load funds, the cost are less. Load funds are charging more so you may expect to get more, that better returns or service. While it is not necessarily true that you get what you pay for, it may be true. 13-17 Identify three potential sources of return to mutual fund investors, and briefly discuss how each could affect total return to shareholders. Mutual funds pay dividends, have capital appreciation, and have gains [and losses] from buying and selling stock. All of these activities are incorporated in the Net Asset Value that is used to value the mutual fund. The dividends and gains [and losses] are pass through to the mutual funds owners who are responsible for paying the income taxes due on these transactions. 13-18 Which would you rather have: $100 in dividend income or $100 in capital gains distribution? $100 in realized capital gains or $100 in unrealized capital gains? Between capital gains and dividends in a mutual fund, there is little difference Both the gain and the dividend are available to the fund manager to reinvest as they manage the fund. The income tax is the same for both as long as the dividends are “qualified dividends”. Between a realized gain v an unrealized gain there is an income tax effect. The realized gain will result in a tax while the unrealized gain does not. True, the unrealized gain may disappear in the future, but the realized gain will be reinvested [that is the after tax gain] so it could disappear in the future as well. 13-19 Describe how to evaluate the attractiveness of investing in an index-based ETF. The primary reason for investing in an index-based ETF, of course, is to replicate the performance of the index. It follows that an important aspect of ETF performance is how well it tracks the performance of the underlying index. You can determine this by checking the so-called R-Squared (R2) statistical measure, which shows how much of the variability in an ETF’s total returns is explained by the variability in the total returns of the underlying index. The R2 varies between 0 percent and a maximum of 100 percent. Obviously, the higher the R2, the closer the relationship between the ETF and the associated target index. It also makes sense to know how the ETF’s style is described and how consistently it pursues this style. Finally, it’s wise to check how the ETF’s performance compares to its peers and how the ETF’s expense ratio compares with reasonable benchmarks. 13-20 How important is general market in affecting the price performance of mutual funds? 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. 13-21 Define and briefly discuss the role of each of these factors in evaluating a proposed real estate investment: a. Cash flow and taxes Cash flow and taxes: An investor’s cash flow, or annual after-tax earnings, depends not only on the revenues generated from a particular piece of property, but also on depreciation and taxes. Depreciation is an allocation of the total cost of property incurred in the past that is considered an expense for tax purposes even though it involves no actual current outflow of cash. Therefore, it reduces your current taxable income and your taxes. In this case, it is considered a tax shelter. b. Appreciation in value Appreciation in value: 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. c. Use of leverage 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 percent 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. 13-22 Why is speculating in raw land considered a high-risk venture? 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. On the other hand, the supply of land is fixed and if you are able to be patient and wait for some time, the value of your land will most likely increase. This may not be true if you bought a swamp or flood plain unless you are in New Orleans. 13-23 Describe the major categories of income property, and explain the advantages and disadvantages of investing in income property. How can a single-family home be used to generate income? The major categories of income property include commercial properties and multi-family residential rental 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. Owner occupied 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. 13-24 Describe how the following securities allow investors to participate in the real estate market. a. Stock in real estate–related companies If you buy stock in publicly traded real estate–related companies, you are investing indirectly in real estate. These include residential homebuilders, construction companies, mortgage lenders, home improvement retailers, property managers, real estate brokerage firms, and engineering companies. The performance of these types of stocks will mirror that of a direct investment in real estate. b. Real estate limited partnerships (LPs) or limited liability companies (LLCs) Most of these are local and not traded on exchanges. Some very large LPs or LLCs are listed on regional exchanges. Local investments in LLCs or LPs are true investments in real estate. Typically the partnership will own one real estate project such as an apartment complex or a shopping center. Large national partnerships invest in similar properties but do so in a wide variety of locations. They are riskier investments than REITs, and they appeal to more affluent investors who can afford the typical unit cost of $100,000 or more 13-25 Briefly describe the basic structure and investment considerations associated with a REIT. What are the three basic types of REITs? A real estate investment trust (REIT) is a type of closed-end investment company that invests money in various types of real estate and real estate mortgages. 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. REITs have become popular with investors seeking portfolio diversification because these trusts have relatively low correlations with other market sectors, such as common stocks and bonds. They also provide attractive dividend yields—well above the yields on common stocks. (In fact, about 65 percent of the total return from REITs comes from their dividends.) Critical Thinking Cases 13.1 Damon’s Dilemma: Common Stocks, Mutual Funds, or ETFs? Damon Bellamy has worked in the management services division of Niche Consultants for the past five years. He currently earns an annual salary of about $120,000. At 33, he’s still a bachelor and has accumulated about $100,000 in savings over the past few years. He keeps his savings in a money market account, where it earns about 3 percent interest. Damon wants to get “a bigger bang for his buck,” so he has considered withdrawing $50,000 from his money market account and investing it in the stock market. He feels that such an investment can easily earn more than 3 percent. Naomi Ladd, a close friend, suggests that he invest in mutual fund shares. Damon has approached you, his broker, for advice. Critical Thinking Questions 1. Explain to Damon the key reasons for purchasing mutual fund or ETF shares. Mutual funds offer professional management with substantial support from security analysts who investigates companies, traders who execute the purchases and sales for the money manager, custodians who keep the records of who owns the fund, and agents who takes the investor’s money and sets up the account. All of these people may work for the same company [such as Fidelity or T. Rowe Price] Funds within a family of funds offer conversion privileges as well as automatic reinvestment of returns from the fund. ETF are similar to mutual funds and offer the same advantages plus the ability to trade during the day rather than only at the end of the day. 2. What special fund features might help Damon achieve his investment objectives? There are mutual funds for all types of risk. If Damon wants to go for appreciation, there are mutual funds that invest in growth companies and small cap companies. Whatever his pleasure, there is a mutual fund. 3. What types of mutual funds or ETFs would you recommend to Damon? Given his age and income, I would go for growth funds and small caps. Tech stocks and health care may also be good for Damon, however, they are expensive and the growth may have already occurred for them. 4. What recommendations would you make regarding Damon’s dilemma about whether to go into stocks, mutual funds, or ETFs? Explain. The new investor needs the support of a mutual fund. ETFs are OK, but he does not need the flexibility they offer. I suggest a mutual fund. 5. Explain to Damon the rationale for choosing ETFs over mutual funds. ETFs offer trading during the day and a variety of index funds to match whatever interest Damon has. Also, since ETFs tend to buy and sell less often, the tax impact will be lower for ETFs than for mutual. Otherwise, ETFs and mutual funds are very similar. 13.2 Nichole Ponders Mutual Funds Nichole Whiting is the director of a major charitable organization in Charlotte, North Carolina. A single mother of one young child, she earns what could best be described as a modest income. Because charitable organizations aren’t known for their generous retirement programs, Nichole has decided it would be best for her to do a little investing on her own. She’d like to set up a program to supplement her employer’s retirement program and, at the same time, provide some funds for her child’s college education (which is still 12 years away). Although her income is modest, Nichole believes that with careful planning, she could probably invest about $250 a quarter, and she hopes to increase this amount over time. Nichole now has about $15,000 in a bank savings account, which she’s willing to use to kick off this program. In view of her investment objectives, she isn’t interested in taking a lot of risk. Because her knowledge of investments extends no further than savings accounts, series EE bonds, and a little bit about mutual funds, she approaches you for some investment advice. Critical Thinking Questions 1. In view of Nichole’s long-term investment goals, do you think mutual funds or ETFs are the more appropriate investment vehicle for her? I suggest mutual funds. ETFs have higher fees and she does not need the flexibility they provide. 2. Do you think that Nichole should use her $15,000 savings to start a mutual fund or an ETF investment program? Nichole needs to keep some funds for emergencies. The guide is to have 6 to 9 months of living costs in emergencies funds. These funds could be invested in a money market account that will provide more interest than a simple saving account. The $250 per month will give her $1,500 in six months. I advise her to set up an automatic investment to her money market account. Then every six months, she can move $1,500 to a mutual fund that invest in growth stocks and small caps. While they are volatile, if she is build an educational fund, she needs to take some risk. 3. What type of mutual fund or ETF investment program would you set up for Nichole? In your answer, discuss the types of funds you’d consider, the investment objectives you’d set, and any investment services (such as withdrawal plans) you’d seek. Would taxes be an important consideration in your investment advice? Explain. As before, I would use a money market for her emergency fund; move the $250 per month saving to a growth or small cap stock mutual fund; and make no withdrawals until kid goes to college. Taxes are not a major issue for her with the standard deduction, personal exemptions, and child tax credit. If she is concerned, she could start a ROTH IRA that is invested as stated. Then the withdrawals will be tax free when made. 4. Do you think some type of real estate investment would make sense for Nichole? If so, what type would you suggest? Explain. The major advantage is taxes and leverage. She should focus on purchasing her personal residence and not purchase real estate as an investment. Terms Found in the Chapter
12b-1 fee . A annual fee that’s supposed to be used to offset promotion and selling expenses
automatic investment plan An automatic savings program that enables an investor to channel a set amount of money systematically into a given mutual fund.
automatic reinvestment plan A plan that gives share owners the option of electing to have dividends and capital gains distributions reinvested in additional fund shares.
back-end load . A commission charged for redeeming fund shares
closed-end investment company An investment company that issues a fixed number of shares, which are themselves listed and traded like any other share of stock.
conversion (exchange) privileges A feature that allows investors to switch from one mutual fund to another within a family of funds.
exchange traded fund (ETF) An investment company whose shares trade on stock exchanges; unlike mutual funds, ETF shares can be bought or sold (or sold short) throughout the day. ETFs are usually structured as an index fund that’s set up to match the performance of a certain market segment.
general-purpose money fund A money fund that invests in virtually any type of short-term investment vehicle.
government securities money fund A money fund that limits its investments to short-term securities of the U.S. government and its agencies.
income (income- producing) property Real estate purchased for leasing or renting to tenants in order to generate ongoing monthly/annual income in the form of rent receipts.
international fund A mutual fund that does all or most of its investing in foreign securities.
load fund . A fund that charges a fee at time of purchase.
low-load fund A fund that has a low purchase fee
management fee A fee paid to the professional money managers who administer a mutual fund’s portfolio.
mutual fund A financial services organization that receives money from its shareholders and invests those funds on their behalf in a diversified portfolio of securities.
net asset value (NAV) The current market value of all the securities the fund owns, less any liabilities, on a per-share basis.
open-end investment company A firm that can issue an unlimited number of shares that it buys and sells at a price based on the current market value of the securities it owns; also called a mutual fund.
pooled diversification A process whereby investors buy into a diversified portfolio of securities for the collective benefit of individual investors.
real estate investment trust (REIT) An investment company that accumulates money by selling shares to investors, in order to invest that money in various forms of real estate, including mortgages; this type of fund is similar to a mutual fund, but a REIT invests only in specific types of real estate or real estate–related firms.
socially responsible fund (SRF) A fund that invests only in companies meeting certain moral, ethical, and/or environmental criteria.
systematic withdrawal plan A plan offered by mutual funds that allows shareholders to be paid specified amounts of money each period.
tax-exempt money fund A money fund that limits its investments to short-term, tax-exempt municipal securities.
Investing in Mutual Funds, ETFs, and Real Estate Chapter Outline Learning Objectives I. Mutual Funds and Exchange Traded Funds: Some Basics A. The Mutual Fund Concept 1. Pooled Diversification B. Why Invest in Mutual Funds or ETFs? 1. Diversification 2. Professional Management 3. Financial Returns 4. Convenience C. How Mutual Funds Are Organized and Run D. Open-End versus Closed-End Funds 1. Open-End Investment Companies 2. Closed-End Investment Companies E. ETFs F. Choosing between ETFs and Mutual Funds G. Some Important Cost Considerations 1. Load Funds 2. No-Load Funds 3. 12(b)-1 Fees 4. Management Fees 5. Keeping Track of Fund Fees and Loads H. Buying and Selling Funds II. Types of Funds and Fund Services A. Types of Funds 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 Mutual Funds 9. Index Funds 10. Sector Funds 11. Socially Responsible Funds 12. International Funds 13. Asset Allocation Funds B. Services Offered by Mutual Funds 1. Automatic Investment Plans 2. Automatic Reinvestment Plans 3. Regular Income 4. Conversion Privileges 5. Retirement Plans III. Making Mutual Fund and ETF Investments A. The Selection Process 1. Objectives and Motives for Using Funds 2. What Funds Have to Offer 3. Whittling Down the Alternatives 4. Stick with No-Loads or Low-Load Mutual Funds 5. Choosing between ETFs and Mutual Funds B. Getting a Handle on Mutual Fund Performance 1. Measuring Fund Performance a. Evaluating ETF Performance 2. What About Future Performance? IV. Investing in Real Estate A. Some Basic Considerations 1. Cash Flow and Taxes 2. Appreciation in Value 3. Use of Leverage B. Speculating in Raw Land C. Investing in Income Property 1. Commercial Properties 2. Residential Properties D. Other Ways to Invest in Real Estate 1. Real Estate Investment Trusts 2. Real Estate Limited Partnerships or Limited Liability Companies Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
