Economics for Life Real World Financial Literacy Chapter 14 Investing in Mutual Funds

14 . Investing in Mutual Funds Mutual Funds When you buy a mutual fund , you are pooling your money along with other investors . You put money into a mutual fund by buying units or shares of the fund . As more people invest , the fund issues new units or shares . The investments in a mutual fund are managed by a portfolio manager . All mutual funds have a stated goal for the assets they invest in and a philosophy for how they will invest . According to , there were approximately mutual funds in 2019 , and they managed over 21 trillion ( 2020 ) There are many mutual fund management companies , and each company offers many different types of mutual funds trying to make an informed choice can make you dizzy . There are four broad categories of mutual funds those that invest in stocks ( equity funds ) bonds ( funds ) debt ( money market funds ) or both stocks and bonds ( balanced or hybrid funds ) There are also many mutual funds that invest in specific sectors , such as technology , real estate , gold , or the bank sector . The Advantage of a Mutual Fund The overwhelming advantage of a mutual fund is diversification . The benefits of diversification include the following It minimizes the risk of loss to your overall portfolio . Risk is defined by the standard deviation ofthe returns ofyour portfolio ) It exposes you to more opportunities for return . It safeguards you against adverse market cycles . It reduces volatility in your portfolio . 247

Random Walk Down Wall Street , author Burton , explains these benefits By the time the portfolio contains close to 20 similarly weighted and issues , the total risk ( standard deviation of returns ) ofthe portfolio is reduced by 70 percent . Further increase in the number of holdings does not produce any significant further risk reduction ( 2019 ) Other investment advisors agree , saying that 20 to 30 stocks is good diversification . However , here the rub one share of Amazon on August 19 , 2020 , cost , and one share of Google on the same day costs . Meanwhile , Facebook costs 271 per share , and Netflix costs 486 per share . Along with Apple , these are known as the stocks ) For us mere mortals who are not billionaires , how can we diversify into 20 or more stocks ?

The answer is , of course , a mutual fund . Warren Buffet , Chairman and CEO of , once , eight percent or more of people who invest should extensively diversify and not trade . Specifically , these investors should buy a very index fund . By buying into an 843 500 Mutual fund , you can own shares of all the stocks in the 500 Index . You can also buy into diversified fund that owns a mix of 70 stocks and 30 bonds . Before we discuss what mutual fund you should buy , let explore whether you should choose an actively managed fund or an index fund . John Bogle , the founder of Vanguard Mutual Funds , became convinced from his research that not a single actively managed mutual fund consistently beat the market . That is , none had a better return than the index that was used to benchmark them . Benchmarks are indices of various stock market and stock market sector prices that can be compared on a day to day or annual basis . Below are the most watched stock markets indices . The Dow Jones Industrial Average ( DINA ) This is not actually an index but the daily sum of the 30 largest companies current stock prices of . Almost all of them are household names , like , Facebook , and Proctor and Gamble . The stocks are weighted in the sum according to their relative prices . For example , a 200 per share stock is weighted four times as much as a 50 per share stock . 248

The Standard and Poor 500 Index ( 500 ) Standard and Door is a credit rating company that created this stock index in 1957 . It is composed ofthe largest publicly listed companies . It further the US . economy into eleven sectors , and it then selectively chooses stocks from each of these sectors to match the total market capitalization ofall the public stocks in those sectors . In the chart below , you see these eleven sectors and their weights . Information Technology Health Care 14 122 Communication Services 107 Consumer Discretionary Consumer Staples Energy Utilities 35 Real Estate 31 Materials . The Composite ( Index ) The National Association of Securities Dealers Automated Quotation Index has over stocks in its index , all stocks , both domestic and international that are listed on the stock exchange . The stock exchange began operations on February as the first electronic stock market . The Composite Index is made up of 40 tech stocks , so it is a heavy tech index compared to public stocks overall ( which are only 20 tech stocks ) Let look at some examples of benchmarks . If the actively managed mutual fund had a broad range of hundreds of stocks in it , its annual returns would be measured against the 500 Index , tracking the performance of the overall stock . If the actively managed mutual fund had a broad range of international stocks , its annual returns would be measured against a stock index of international stocks , such as the Europe , Far East which is a broad index that represents the performance of foreign 249

stocks . This Index was created by Morgan Stanley Capital International ( to track foreign developed markets . Many of the largest mutual fund companies , such as Fidelity Investments and Charles Company have created mutual funds that mimic this index . Unfortunately , the number of actively managed funds that beat their benchmarks is well below 50 . In , reported on this Fund managers gave investors yet another reason to avoid their products last year Well below 50 of actively managed mutual funds beat their benchmark in it would have taken a stroke of luck to pick a winner . Just 29 of active US . stock fund managers beat their benchmark after fees in 2019 . That declined from 37 of funds beating their benchmarks in 2018 , the average success rate over the past 15 years ( 2020 ) In November 2019 , gave a similar report card to actively managed funds Fund flows continue to favor index funds over actively managed funds We found that 22 of active funds ( 182 out of 840 with records ) beat the 500 return for the last decade through 21 . The vast majority of them were growth funds ( Further , et al . summarize the research on whether investors can rely on past performance to predict future performance for a mutual fund It has long been stated that past performance is not indicative of future results , but many investors are still tempted to select mutual funds by recent performance . Philips ( 2012 ) confirms that past performance is no more reliable than a coin flip in identifying active managers who will outperform in the future . Not only is past performance an unreliable predictor , but according to significant research , most other quantitative measures of fund attributes or performance ( such as fund size , star ratings , active share , etc . are equally undependable when used to identify future ( 2013 ) The other issue to note here is the cost of actively managed funds . et al . report that the average annual fees of actively managed funds are 250

while the average annual fees of index funds is ( 2013 ) reported almost the same fee structure averages for 2020 . Vanguard states However , the traditional value proposition for many advisors has been primarily based on their investment acumen and their prospects for delivering better returns than those of the markets . No matter how skilled the advisor , the path to better investment results may not lie with the ability to pick investments or strategies . Historically , active management has failed to deliver on its promise over longer investment horizons . and , 2018 ) Can we as individual investors predict the funds that will best the indices each year ?

For the Wall Street Journal , Mark Halbert , a financial analyst who audits and reports on the advice of investment newsletters , says the answer is a resounding no rather , it is more dependent on luck than skill ( 2020 ) Halbert reports that similar studies by a number of prominent researchers come to remarkably similar conclusions . Bradford Cornell , a retired finance professor at UCLA , measures the role of luck by comparing the greater dispersion of versus returns of mutual funds . Halbert applied algorithm to analyze several hundred investment newsletters , many of which are popular with day traders When applying Cornell formula to this data , 92 of the differences in newsletters annual returns is due to luck . When he Cornell applied the same formula to a sample of equity mutual funds , he reached the conclusion ( 2020 ) Further , according to Halbert , Michael , a managing director at Counterpoint Global , a division of Morgan Stanley Investment Management , analyzed how quickly a manager falls back to the middle of the pack . rationale is that the faster this happens , the more luck is playing a role . Halbert applied algorithm to forty years of investment returns from the advice given by investment newsletters ( 1980 to 2020 ) He tracked newsletters whose returns put them in the top 10 of all newsletter returns in a given year . Halbert states that if skill were involved , the newsletters return should be in the top 10 again in the following year . Unfortunately , on average , the top performing newsletters for one year ended up on average at the percentile performance mark the next year . This is only slightly better than 25 '

chance . Finally , the Dow Jones ( owned by the company that owns the Wall Street Journal ) found that only of US . equity funds that were in the top half of performers in 2015 ( above 50 ofall funds ) were still in the top half of performers in 2019 . Halbert , 2020 ) So , this is the bottom line even the experts can not beat the indices on a regular basis . It is impossible to guess who will be the lucky few who do beat them in any particular year . The best path to riches is to invest your money in a diversified index mutual fund with a nonprofit mutual fund company like Vanguard or , reaping annual average returns of to 10 . Mutual Funds In the United States , there were mutual funds in 2019 , managing assets worth approximately 21 trillion US . dollars . The three largest mutual fund companies are , Vanguard , and Charles . As of the third quarter of 2019 , had approximately trillion in assets under management . As of the third quarter of 2019 , the Vanguard Group manages approximately trillion under management , while Charles managed trillion in assets as of the second quarter of 2019 . Almost all mutual fund companies are for profit , but there are a number of mutual fund companies that are , and these are worth considering . Nonprofit Mutual Funds Vanguard Vanguard was started by John Bogle , who had a cult following similar to Warren . research showed that no actively managed mutual funds beat their benchmark for more than two years in a row but were still charging or more per year to manage the mutual funds . Because of this , Bogle invented Index Funds that had all the same stocks as the benchmarks therefore , he did not need to actively manage them . Vanguard has employees worldwide and offers 170 mutual funds and 80 Exchange Traded 252 i

Funds ( There is a fund to meet every investor interest and risk tolerance . The good thing about Vanguard is that their average mutual fund fee is . The industry average mutual fund fee is . The owners ( that is , the customers ) of the Vanguard Funds own the company . The low fees at Vanguard are possible because the fees only have to cover the salaries of the Vanguard employees plus the overhead of the buildings , utilities , and other operating costs . Vanguard does not have to generate any profit over and above its expense to run the funds . The Teachers Insurance and Association ( and its sister organization , College Retirement Equities Fund ( both offer insurance , and mutual funds to individuals . used to be identified as but in the past few years has shortened its acronym to . It has employees and manages approximately trillion in accounts . Although started out as an insurance company and retirement fund manager for teachers , anyone can now use its services . Similar to Vanguard , offers over 100 mutual funds . However , reviews from some investment websites claim that mutual fund management fees are somewhat higher than Vanguard . Load and Open End Funds Closed End Funds Load and open closed end funds are technical terms in the mutual fund industry . No load mutual funds sell directly to investors . These are the types of funds you want . Load mutual funds charge a commission when you purchase them and are usually sold through Stockbrokers . Do not buy load mutual funds . All or almost all mutual funds from the top mutual fund companies ( Vanguard , Charles , are funds . funds are the ones you want . Open end funds sell shares directly to investors , and the funds will redeem the shares ( that is , buy back the shares ) 253

when the customer wants to sell them . All or almost all ofthe top mutual fund companies mutual funds are open end funds . Closed end funds sell shares to investors at the creation of the funds but do not redeem them when the customer wants to sell them . The closed end funds are listed on stock exchanges , and any buying and selling takes place on the stock exchange . A fund manager actively manages the closed end fund but , as I said , does not redeem the shares . Closed end mutual funds have been in existence for almost one hundred years . are relatively new but will have many advantages over closed end mutual funds . Therefore , you would do better with an than a closed end fund . Exchange Traded Funds ( An Exchange Traded Fund ( is a collection of tens , hundreds , or sometimes thousands or bonds in a single fund . are traded on major stock exchanges , like the New York Stock Exchange and . Of course , you will buy and sell them through a brokerage account at your mutual fund company . Although and mutual funds share many similarities , there are a couple of distinguishing characteristics that may make more attractive to some investors , including lower investment minimums when you first start investing and pricing every time you buy and sell . Mutual funds themselves are not traded on any stock market . The mutual fund owns stocks that are traded on the stock market ( and the value of the mutual fund is calculated at the end of each day based on the closing price of the mutual funds stocks . This is similar to owning a stock portfolio and calculating at the end of each day what your stocks are worth based on its closing prices . are listed stocks themselves , and the owns a portfolio of like a mutual fund . However , the price in the market fluctuates just like a listed stock , depending on the buying ( demand ) and selling ( supply ) of that . For example , Vanguard offers 80 with various portfolios of stocks and bonds and levels of risk . 254

Types of Mutual Funds Bond Mutual Funds Bond mutual funds invest their money in bonds . Bonds are basically and can be issued by governments , states , local municipalities , and corporations . Instead of these entities borrowing money from the bank , it is considerably cheaper to go directly to the investors themselves . I talked about bonds in the previous chapter , and we saw that the average annual return on bonds for 94 years was . Bond mutual funds tend to specialize in specific types of bonds , and these include the following International Government Bond Funds US . Treasury Bond Funds Mortgage Bond Funds Corporate Bond Funds Municipal Bond Funds International Bond Funds Index Bond Funds Stock Mutual Funds Stock mutual funds invest their money in stocks ( also called equities ) There are many types of stock mutual funds . Some of the more popular ones are below Growth Funds Capital Appreciation Funds Funds 255

Funds Funds Equity Income Funds Balance Growth and Income Funds Sector Funds International Stock Funds Index Funds Socially Responsible Stock Funds Real Estate Mutual Funds Real estate mutual funds invest the money in real estate stocks . The funds also tend to be specialized , so there are real estate stock mutual funds that invest exclusively in things like these examples Large Shopping Mall Stocks Industrial Building Stocks Office Building Stocks Apartment Building Stocks Mixed Mutual Funds Traditional , conservative investment advisors will tell you that you should have a mix of 70 stocks and 30 bonds in your portfolio . This is because stocks rise in price when the economy is in an expansion , and bonds rise in price when the economy is in a recession . There are plenty of mutual funds that offer a mix of stocks and bonds in various proportions , according to your risk tolerance . These 256 I

usually have Balanced Fund in their name to signify that they have a mix of stocks and bonds . Hedge Funds Many people have heard that hedge funds have been a great investment for and wealthy people and institutions . A recent article in the Wall Street Journal that while this may have been the case from 1990 to 2009 , hedge funds have seriously the 500 since 2010 ( Chung , 2019 ) Table . Percent Return Below 500 Average 1990 to 2009 Average 2010 to 2019 Outperform 500 by 500 by Hedge Funds 52 annually 89 Source , and A hedge fund is a mutual fund that by its mission and charter can invest in any multitude of assets . It can buy and hold stocks and bonds , but it can also sell short stocks and bonds that is , it can make a bet that stocks or bonds will drop in price . Some hedge funds invest in commodities like gas and oil or corn and wheat . Some use people to pick the assets , but increasingly more and more are using computers to analyze tons of data to find assets to invest in . The of the hedge funds hurts investors further by the exorbitant fees they charge . Normal mutual funds charge their investors or less of assets annually . Hedge funds typically charge their clients of assets annually plus keep 20 of the profits they make each year ( called and 20 ) Critics say this fee structure means that hedge funds are a vehicle to transfer all the fund money from the pockets ofthe investors to the pockets ofthe fund Indeed , there have been a lot of billionaires minted out of hedge fund managers . So what happened to hedge funds ?

Quants and Index Funds the increase in trading by computers and passive investing funds ( like Index Funds and ) have distorted the way stocks move . Currently , only about 15 of stocks traded are traded by humans . 257 The quants computers can spot small in stocks and take advantage of them . Competition there werejust hedge funds in 1990 , and they managed 39 billion . Now there are hedge funds managing trillion of investors money . Stock Correlations in recent years , stocks moved in correlation when financial news hit the market ( such as a Federal Reserve Bank action ) and this means less of individual stocks for hedge funds to take advantage of . Low Interest Rates low interest rates keep shaky companies alive that would have died in higher interest rate environments . These are the companies that hedge funds sell short . There seems to be no advantage to owning hedge funds now , so do not do it , even ifyou could . Domestic and International Stock Funds In the last chapter , I mentioned that a portfolio of international stocks appears to consistently show an annual return of about less than a portfolio of US . stocks . This means that there seems to be no advantage to diversifying internationally , especially in European stocks . You may , however , be enamored of emerging economies like the countries Brazil Russia India China South Africa There are mutual funds that in stocks ofthose countries . I would not , 258

however , put all of my investment in that one basket . Ten percent or twenty percent of your cash seems reasonable . But why does a domestic firm mutual fund outperform a European portfolio of stocks ?

First , Europe ( and the nations ) do not have the innovative , tech companies that we do . The top tech companies are often referred to as the Facebook , Apple , Amazon , Netflix , and ( now called Alphabet ) Some investment gurus put in this exclusive club ( the ) and some do not . Those who do not say that the recent growth of stock has not been as meteoric as the stocks . Twenty years ago it was a better idea to diversify with European stocks , as at the time the economies of the US . and Europe were . That is , when the US . was in a recession , Europe was not European companies were doing well when US . companies were slumping . This is no longer true . Globalization is so widespread that the US . and European economies are now . Finally , most ofthe largest European companies are listed on both a European stock exchange and the New York or stock exchange . If you buy a widely diversified stock mutual fund like an 500 Index Fund , you will still get stock of the largest European companies in the fund . Diversification Advice My advice is that , when you are investing ( especially for retirement ) put all your money into an 500 Index Fund . Of course , having said that , I am also going to make the case in the next section for investing in an Fund . In the last chapter , I showed you that this will return you an average annual return of per year . That return from 1926 to 2018 included both the bear and the bull markets . Of course , you must have the patience to endure and not panic and sell stocks when it enters a bear market . This panic is the hallmark mistake of amateur investors . However , are a short run phenomenon . We have had 12 ( and ) since the end of World War II , including the current Pandemic Recession . The average length of these has been 11 months . As long as you are not within five years of retirement , you have the time to ride out the recession and achieve your 101 annual return . One more note , if you want to be risky and own luck at the stock markets , do not invest any more than 259

ten percent ofyour current in the market . lfyou make a big mistake , you can recover from a ten percent loss . Social Investing Funds ( Funds ) What is loosely called Social Investing is the wave of the future . You should strongly consider investing in them instead of an 843 500 mutual fund . Companies that pollute , do not treat their stakeholders fairly , or engage in unethical behavior will not survive for long . The public and investors are demanding more and more that firms engage in behavior . An Fund is essentially an 500 mutual fund that filters out any company that is not Environmentally Responsible Socially Responsible Governance Responsible There are a number of different interpretations that mutual funds use to claim that their funds fulfill the above responsibilities . Therefore , you need to read about what the fund means by this to assure it is a true fund . However , here what these terms should mean , although this is not a complete list Environmentally Responsible This should mean that the firms in the portfolio , minimize greenhouse gas emissions , minimize air and water pollution , manage energy appropriately , and create recyclable packaging for their products . Socially Responsible This should mean that the firms in the portfolio respect human rights , exercise fair labor practices , promote diversity in hiring and promotion , insist on 260 i

fair labor standards in its supply chain , engage in good community relations , and treat their customers fairly . Governance Responsible This should mean that the firms in the portfolio engage in good safety and health practices for its workers , are transparent and honest in their financial reporting , have fair and equal compensation practices , are ethical in their business practices , source their materials from fair trade suppliers , and do not engage in behavior . Table . Examples of Authentic Funds Fund Name Investment Type Stocks or Bonds Global Select Stock Fund ( Mutual Fund 50 us . Stock ( Indexed ) International Stock ( to ( Indexed ) Social Index Fund ( Mutual Fund 500 ( Indexed ) zoo to 300 ( Indexed ) excludes companies that do the following Produce alcohol , tobacco , gambling , and adult entertainment Produce civilian , controversial , and conventional weapons Produce nuclear power Do not meet certain diversity criteria Have violations of labor rights , human rights , and environmental standards defined by UN Global Compact Principles Own proved or probable reserves in fossil fuels such as coal , oil , or gas 26 '

This excludes any company that determines has a primary business activity in the exploration and drilling for , as well as producing , refining , and supplying , oil and gas products the supply of equipment and services to oil fields and offshore platforms the operations of pipelines carrying oil , gas , or other forms of fuel integrated oil and gas companies that provide a combination of services listed in above , including the refining and marketing of oil and gas products or the exploration for or mining of coal . Here are a few examples of Funds . International Fund Invests at least 80 of its assets in equity securities or other financial instruments that are components of , or have market similar to , the securities included in the Index . Fund ) Invests in a portfolio of equity securities of companies with positive aggregate societal impact outcomes , as determined by . Emerging Markets Fund ) Invests at least 80 of its assets in equity securities or other financial instruments that are components of , or have market similar to , the securities included in the Emerging Index . ESO Aware Moderate Allocation Index The Aware Moderate Allocation Index is designed to measure the performance of a portfolio composed of equity and fixed income intended to represent a moderate risk profile strategy with a 60 allocation to fixed income and 40 allocation to equities . 262 i

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ock Growth Index The Aware Growth Allocation Index is designed to measure the performance of a portfolio composed of equity and fixed income intended to represent a growth risk profile with a 60 allocation to equities and 40 allocation to fixed income . ock Index The Aware Conservative Allocation Index is designed to measure the performance of a portfolio composed of equity and fixed income intended to represent a conservative risk profile with a 70 allocation to fixed income and 30 allocation to equities . Buy a Vanguard Fund because the fees are generally lower than funds . Research also shows that adding international stocks to a portfolio does not increase returns , nor does adding a greater number of stocks increase the return . My advice is to invest in the Social Index Fund ( a US . stock fund that has 500 stocks in it , like the 500 Index Mutual Fund but with an filter . The United Nations has 17 Sustainable Development Goals that can work as a framework for your investments . Every large American company ( and every large company in the world ) is now a global company , so the goals of the UN . have relevance here . You can evaluate how your fund meets each of these goals . Fuel Funds Since you are investing for the long term and not on the volatility ofthe stock market , you should avoid investing in companies whose business is in fossil fuels . Over the next twenty years ( and maybe sooner ) these companies will perform very poorly . A number of coal mining companies are declaring bankruptcy right now as electricity generating plants switch to natural gas , which is cheaper and pollutes less . Every automobile manufacturing company is adding electric vehicles to their lineups in anticipation of national and state 263

standards mandating cleaner vehicles . Finally , clean energy is becoming cheaper and competitive with fossil fuels . On top of this , the principal way to reduce greenhouse gasses is to eliminate fossil fuel burning . Divestment Movements The fossil fuel divestment movement began with student protests calling for their university endowments to divest from any company involved with fossil fuels . The movement was quite effective over time as university endowments pulled out of fossil fuels . In addition , the divestment movement has expanded to demand that mutual fund managers pull out of fossil fuel companies and that endowments and mutual funds invest in clean energy . A 2013 study mi bank found that between 40 and 60 of the market value , Royal Dutch Shell and other European fossil fuel companies could be wiped out because of stranded assets caused by carbon emission regulation . The reaction companies has been mixed in response . For example , announced they will be pivoting from fossil fuel exploration to become a clean energy company . on the other hand , has announced it will continue exploring fossil fuel and has committed to a massive new investment program in fossil fuel exploration ( Matthews , 2020 ) 264 i