When you put money in a mutual fund, you pool it together with other people's money. The fund manager invests the money in stocks or bonds or both. Returns or losses on these investments are due to dividends or a change in value or the maturing of bonds. The fund makes money through fees you pay for services.
Students who did the stock market module should remember that the market is divided into sectors. One place that lists the sectors is Yahoo's sector browser.
Some funds have stocks in all sectors, other funds concentrate on a single sector.
Students should discuss the relative merits of these two strategies. Which provides more diversification? In what circumstances would you prefer a sector fund?
Here is a fund concentration in automotive stock.
Here is one concentration in high tech stock.
You can see from the charts that their performances are quite different. If you knew which sector was going to do better, you would invest in it. But if you don't, then a more diverse fund will even out the result.
Have students offer suggestions as to how the NAV is calculated. It is the Net Assets divided by the number of shares of the mutual fund that are held. On the summary page for the fund, such as this one, we can see the NAV and the Net Assets and divide one by the other to see how many shares there are altogether in this fund.
But how are the net assets calculated? Students should figure out that this would be the sum of the values of all stocks and bonds held by the fund. Since stock prices change every minute, which numbers are used to calculate net assets of the fund? It turns out that the NAV is updated at the close of every day based on the closing price of its assets.
Although a lot of mutual funds have human managers, it is still possible to conduct most transactions online. Often the fee for a transaction is much lower online than in person.
What are the fees paying for? They are supposed to pay for the expertise of the manager who presumably is smarter than you. They also cover the company's expenses. Fees negatively affect your return. In periods when the market drops and the fund loses money, you will still be paying fees.
Some funds have figured out other ways to charge you for their services in addition to the three on this slide. It could be an interesting research project for a student to find out what these are and explain them. For example, there are such things as redemption fees, exchange fees, account fees, purchase fees and operating expenses. These may or may not be rolled into the “expense ratio” on this slide.
One point of debate is whether mutual funds can actually do any better than the market at large. This article describes a period during which one in six funds managed to do better than the market as a whole.
Have the following discussion with your students. If 10 monkeys ran funds and invested in the market as a whole, about how many would do better than the market? Worse? This is a discussion about randomness. You would expect about half to do better. Yet the article cited here showed only one in six beating the market. It then proceeds to give reasons why those might be better. The monkey example shows that reasons are not required. It would be pretty unlikely for all of them to do worse.
People should invest in funds in order to diversify, but not with the expectation of beating the market. As one popular finance book points out, the funds basically are the market. That is, most stocks are held by mutual funds.
Once students find the numbers, ask them approximately how many shares are in this fund.
Have students jot down the price on May 2 and July 15. They need to read this off the graph.
When you find these graphs up online, there is usually a popup box that gives the exact closing price on the day you choose with the cursor.
This slide describes how expenses are calculated when you buy and sell. Have the students repeat this calculation with a second example of your choice.
Along the way, you will also have lost some of your gains due to the expense ratio, but this is reflected in the NAV on the day you sell.
This is how we compare investments with each other: percent gain (or loss) per unit time. Students can do mental arithmetic to estimate the percent loss over this period. It's about a 3% loss.
Ask students to redo this problem and calculate the gain or loss without a front-end load or a deferred load. Notice that without loads we end up with a reasonable profit (4%). Normally, people use mutual funds with high loads over a longer investment period.
How does this investment compare to the savings account or stock market examples from previous modules (if you have done those)?
After doing this calculation, students should see that the front load and the deferred charge have a much smaller impact on the gain or loss over longer periods. Some funds do not have a deferred charge if you keep them for a certain length of time. Challenge your students to find this length of time.
We were going to use this as an example of exponential growth of an investment, but WHAT happened in 2008? Maybe your students remember.
This graph is a fine illustration of the comment that mutual funds are the market.
You can also discuss what investors ought to have done at the low point or the high point.
You and your students should have a look at the top 70 funds. Each can pick one to track for a period, and then everybody can compare performance. Clicking on the symbol for the fund takes you to CNN Money's information portal.
The video shows a pitch for Fidelity. What messages are being conveyed? Are the messages correct?
Here is an example of an actively managed fund. It is one of the ones on the Money Magazine list. It has done particularly well, but students should pick some of the other actively managed funds and compare performances.
What if you suspect a fund is actually managed by monkeys? You could instead invest in an “index fund,” which follows an algorithm that a computer can carry out.
It might be good to look at some of the indices mentioned to get an idea of what the fund does. It is designed to mirror whatever the part of the market represented by that index is doing.
Because all exchanges and decisions are carried out by computer, the fees for such funds are minimal.
Students should notice that this fund did not do as well as the previous one. However the starting dates are different! Moving the managed fund forward two weeks causes it to have about the same performance as the index fund. Snap judgments should be avoided, and you can do this by checking out the other actively managed and indexed funds mentioned in Money Magazine.
Students can invent ways to compare how all of these did over the last year. Average, variance, rank ordering of all funds, etc. can provide a variety of representations of this data.
Students should notice that if you compare the graphs of the two fund examples that they performed about the same over the period of a year. Why does it appear from the individual graphs that one fund has done better than the other? Because of choice of starting dates—basically a software issue, as these were retrieved the same day. But the comparison graph has to use the same time frame for both.
The index fund, VOO, has an expense ratio of .06% whereas the managed fund VWNFX has an expense ratio of .35%. If you believe that the chance of VWNFX consistently outperforming VOO is fifty-fifty, then you might conclude that you would sacrifice the chance of doing better with the managed fund for the lower fees of the index fund. The monkeys working for the VWNFX will not have your bananas. But if you believe that VWNFX will consistently outperform VOO, then it might be worth it to pay for their bananas.
ETF fund shares are traded throughout the day like stocks, in contrast to traditional Mutual Funds where the price of the fund is not set until the end of the day when the NAV is determined. ETFs create flexibility for short-term traders.
Students could research the differences and advantages or disadvantages to ETFs and traditional Mutual Funds. These might include expenses, tax benefits, the trading process or the legal structure.
The slide lists the options in order of increasing risk (more or less). Can the students explain the ordering? Or, under what assumptions is this the correct ordering?
Which of these options ought to include an element of randomness? Why?
The spreadsheet includes random noise for investments the mutual fund columns, reflecting the random noise, which students should have observed in the charts in this module. This means that every run of the spreadsheet will produce a different answer in those columns. This is an opportunity for students to cooperate in running multiple numerical experiments and graphing the outcomes.
Note that if you want to use a different amount of money, or play with allocations, the spreadsheet allows you to do that also.
The spreadsheets have randomness built-in in two places:
Note that, instead of the spreadsheet, students can pick particular funds and use the online sources to find out what would have happened in the last four years of investment. Comparing the results to the spreadsheet provides an object lesson in simulations.
Look at page 2 of the spreadsheet for the thirty year projection. It might be a good idea to talk about “error” and projected average return rates. The thirty-year spreadsheet includes an average APR table so students can compare the results of various simulations.