MUTUAL FUNDS BASIC INFORMATION AND TUTORIALS

WHAT ARE MUTUAL FUNDS? HOW MUTUAL FUND WORKS?

Mutual Funds: A Popular Alternative to Individual Stocks and Bonds

Instead of investing directly in the stock market, you can buy mutual funds. An investment company creates a mutual fund by pooling investors’ money and using it to invest in an assortment of stocks, bonds, or cash. In a way, investing in a mutual fund is like hiring your own professional money manager.

The best part is that the fund manager who manages the mutual fund makes the buying and selling decisions for you. This is ideal for people who don’t have the time or knowledge to research individual companies and determine whether the stock is a good buy at its current price. This is one of the reasons that mutual funds have become so popular in the last few years.

For a relatively low fee, especially when compared with stock commissions, mutual funds give you instant diversification. For a minimum investment of $2500, or sometimes less, you can buy a slice of a whole basket of stocks. (Many mutual fund companies have raised their minimum from as little as $100 to $2500.)

If you are interested in mutual funds, you should begin by looking in the financial section of your local newspaper. There are well over 7000 mutual funds to choose from, each with its own style and strategy.

For example, you could buy a mutual fund that invests in stocks (called a stock fund), technology (a sector fund), or bonds (a bond fund), or one that invests in international stocks (an international fund).

No matter what kind of investment you’re interested in, there is a mutual fund that should meet your needs. When you find a mutual fund that meets your goals and fits your investment strategy, you send a check to the investment company.

Because there are so many mutual funds, you should take as much time to choose the correct mutual fund as you would take to choose a stock. Keep in mind that although most mutual funds did extremely well during the 1990s, many have faltered during the last few years. That’s why it’s important to find a fund that is successful even when the economy is doing poorly.

One of the smartest ways to invest in mutual funds is through a 401(k), a voluntary tax-deferred savings plan that is provided by a number of companies. The popular 401(k) plan is one of the reasons so many people became involved in the stock market to begin with.

The brilliant part of the 401(k) is that you don’t have to pay taxes on the money you earn until you are 591⁄2. If you leave the company before you’re 59 1⁄2, you can convert your 401(k) to an IRA, another type of tax deferred savings plan.

Why People Choose Mutual Funds
The main reason that people choose mutual funds is to allow diversification, which means that instead of investing all of your money in only one stock—a frequently risky move—you are able to buy a slice of hundreds of stocks.

For example, let’s say that most of your money was invested in WorldCom on the day it announced that it had misstated its earnings by $3.8 billion. The stock fell by over 90 percent in 1 day! If you had owned this stock directly, you would have lost 90 percent of your money.

On the other hand, if you owned a mutual fund that owned WorldCom, you might have lost no more than 3 percent of your money that day. Now do you see why mutual funds are a good idea for investors?

On the other hand, some people are looking for a whole lot more, which is what brings them to the stock market in the first place. If you owned a mutual fund that contained a stock that went up a lot in price in 1 day, you might make 1 or 2 percent on your fund that day. But if you owned the stock directly, you could make 10 or 20 percent, or perhaps more, in 1 or 2 days. (I’ve owned stocks that have gone up as much as 50 percent in 1 day.)

TIPS ON CHOOSING YOUR BANK - WHAT TO LOOK FOR IN A BANK

Evaluating a bank: What to look for

When looking for a bank that fits your needs, put on your detective hat and get ready to search for the best deals. You don’t want to pick a bank just because that’s where your parents or co-worker banked.

So what do you look for? You first want to look for a bank that participates in the U.S. government–operated Federal Deposit Insurance Corporation (FDIC) program. Otherwise, if the bank fails, your money isn’t protected.

The FDIC covers your deposits at each bank up to a cool quarter million dollars. Some online banks are able to offer higher interest rates because they’re based overseas and, therefore, don’t participate in the FDIC program. (Banks must pay insurance premiums into the FDIC fund, which, of course, adds to a bank’s costs.)

Another risk for you is noncovered banks that take excessive risks with their business to be able to pay depositors higher interest rates.

When considering doing business with an online bank or a smaller bank you haven’t heard of, you should be especially careful to ensure that the bank is covered under the FDIC. And don’t simply accept the bank’s word for it or the bank’s display of the FDIC logo in its offices or on its Web site.

Check the FDIC’s Web site database of FDIC-insured institutions to see whether the bank you’re considering doing business with is covered. Search by going to the FDIC’s “Bank Find” page (www2.fdic.gov/idasp/main_bankfind.asp). You can search by bank name, city, state, or zip code of the bank.

For insured banks, you can see the date it became insured, its insurance certificate number, the main office location for the bank (and branches), its primary government regulator, and other links to detailed information about the bank. In the event that your bank doesn’t appear on the FDIC list yet the bank claims FDIC coverage, contact the FDIC at 877-275-3342.

In addition to ensuring that a bank is covered by the FDIC, also seek answers to these questions:

✓ What’s the bank’s reputation for its services? This may not be easy to discern, but at a minimum, you should conduct an Internet search of the bank’s name along with the word “complaints” or “problems” and examine the results.

✓ How accessible and knowledgeable are customer service people at the bank? You want to be able to talk to a live, helpful person when you need help. Look for a phone number on the bank’s Web site and call it to see how difficult reaching a live person is. Ask the customer service representatives questions to determine how knowledgeable and service oriented they are.

✓ What’s the process and options for withdrawing your money? This issue is important to discuss with the bank’s customer service people because you want convenient, low-cost access to your money. For example, if a bank lacks ATMs, what do they charge you for using other ATMs?

✓ What are the fees for particular services? You can probably find this information on the bank’s Web site in a section called “accounts terms” or “disclosures.” Also, look for the Truth in Savings Disclosure, which answers relevant account questions in a standardized format.

BANK'S INVESTMENT OBJECTIVES BASIC INFORMATION AND TUTORIALS

WHAT ARE THE OBJECTIVE OF BANKS?

Pension funds, endowments, and insurance firms obtain virtually free funds for investment purposes. Not so with banks. To have funds to lend, they must attract investors in a competitive interest rate environment.

They compete against other banks and also against companies that offer other investment vehicles, from bonds to common stocks. A bank’s success relies primarily on its ability to generate returns in excess of its funding costs.

A bank tries to maintain a positive difference between its cost of funds and its returns on assets. If banks anticipate falling interest rates, they will try to invest in longer-term assets to lock in the returns while seeking short-term deposits, whose interest cost is expected to fall over time. 

When banks expect rising rates, they will try to lock in longer-term deposits with fixed-interest costs, while investing funds short term to capture rising interest rates. The risk of such strategies is that losses may occur should a bank incorrectly forecast the direction of interest rates. 

The aggressiveness of a bank’s strategy will be related to the size of its capital ratio and the oversight of regulators.

Banks need substantial liquidity to meet withdrawals and loan demand. A bank has two forms of liquidity. Internal liquidity is provided by a bank’s investment portfolio that includes highly liquid assets that can be sold to raise cash. 

A bank has external liquidity if it can borrow funds in the federal funds markets (where banks lend reserves to other banks), from the Federal Reserve Bank’s discount window, or by selling certificates of deposit at attractive rates.

Banks have a short time horizon for several reasons. 

First, they have a strong need for liquidity. 

Second, because they want to maintain an adequate interest revenue–interest expense spread, they generally focus on shorter-term investments to avoid interest rate risk and to avoid getting “locked in” to a long-term revenue source. 

Third, because banks typically offer short-term deposit accounts (demand deposits, NOW accounts, and such), they need to match the maturity of their assets and liabilities to avoid taking undue risks.

Banks are heavily regulated by numerous state and federal agencies. The Federal Reserve Board, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation all oversee various components of bank operations. 

The Glass-Steagall Act restricts the equity investments that banks can make. Unique situations that affect each bank’s investment policy depend on their size, market, and management skills in matching asset and liability sensitivity to interest rates. 

For example, a bank in a small community may have many customers who deposit their money with it for the sake of convenience. A bank in a more populated area will find its deposit flows are more sensitive to interest rates and competition from nearby banks.

REGIONAL DEVELOPMENT BANKS BASIC INFORMATION

Regional development banks are organized with goals similar to the World Bank, such as poverty reduction and promotion of economic growth. Rather than a global focus, however, these banks instead focus on a particular geographic region. They are owned and funded by the governments of the region and industrialized nations. These include:

■ African Development Bank The African Development Bank (AfDB), which began operations in 1963, is a major source of public financing in Africa. The member countries include 51 African states and 25 other countries, most of which are industrialized nations.

■ Arab Fund for Economic and Social Development Established in 1972, the Arab Fund for Economic and Social Development assists development in the member countries of the Arab League. The fund assists in financing of development projects.

■ Asian Development Bank The Asian Development Bank is a multilateral development finance institution that engages in mostly public sector lending for development purposes in its developing member countries in Asia and the Pacific. It pursues this goal by providing loans and technical assistance for a broad range of development activities.

ADB raises funds through bond issues on the world’s capital markets but also relies on members’ contributions. The ADB was established in 1966 and has its headquarters in Manila, Philippines. As of September of 2003, the ADB had 58 member countries. Although ADB historically focused on government level public agency lending with a governmental guarantee, the significant increase in privatizations in member countries has resulted in a private-sector mandate.


■ European Bank for Reconstruction and Development The European Bank for Reconstruction and Development (EBRD) began operations in 1991. It was organized to provide assistance to the nations of Central and Eastern Europe for transition to market based economies. There are over 50 member countries. The EBRD raises funds from member countries as well as the capital markets.

■ European Union The European Union, organized in 1993, is an organization of 25 industrialized European nations. It provides grant  to developing countries throughout the world, including Africa, Asia, the Caribbean, central and eastern Europe, Latin America and the former Soviet Union.

■ European Investment Bank Organized in 1958, the European Investment Bank (EIB) provides financial support for development. The members of the EIB are the members states of the European Union. Funds are raised by the EIB from member countries and also from the capital markets. Loans are generally made within the European Union, but are also made outside of the union.

■ Inter-American Development Bank The Inter-American Development Bank (IDB) was organized in 1959, and is a major lender to Latin American and Caribbean member countries. It is currently the principal source of external finance for most Latin American countries.

The 46 member countries include Latin American countries, the United States and other industrialized nations. Funds for loans are raised by the IDB from member countries as well as from the capital markets.

Loans are generally made to public agencies of member countries to finance specific projects. A government guarantee is required. Direct support to the private sector is made available by the bank through its affiliate, the Inter-American Investment Corporation (IIC).


■ Islamic Development Bank The Islamic Development Bank (IsDB), established in 1974, is a multilateral organization of 45 countries. Its purpose is to promote economic development in member countries and in Muslim communities in non-member countries.

The bank, operating within the principles of the Koran, provides interest-free loans for development projects, and also finances lease transactions and instalment sales, and makes equity investments.

■ Nordic Investment Bank The Nordic Investment Bank (NIB) was formed in 1975 by Denmark, Finland, Iceland, Norway and Sweden. Its purpose is to finance investments in which its member nations are interested, both within the Nordic countries and internationally.

■ Nordic Development Fund Since l989, the Nordic Development Fund (NDF) has provided credits to developing countries on concessional terms, primarily in Africa and Asia. It participates in co-financing arrangements with other multilateral agencies and regional banks.

■ OPEC Fund for International Development The OPEC Fund for International Development, established in 1976, provides financial assistance to developing countries. Its members are the countries that are members of the Organization of Petroleum Exporting Countries.