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Chapter 13.doc

  1. 1. Part Five Portfolio Management Part Four Includes Chapter 13 Mutual Funds: Professionally Managed Portfolios Chapter 14 Managing Your Own Portfolio
  2. 2. Chapter 13 Mutual Funds: Professionally Managed Portfolios   Outline Learning Goals I. The Mutual Fund Phenomenon A) An Overview of Mutual Funds 1. Pooled Diversification 2. Attractions and Drawbacks of Mutual Fund Ownership 3. How Mutual Funds Are Organized and Run 4. Mutual Fund Regulations B) Open- or Closed-End Funds 1. Open-End Investment Companies 2. Closed-End Investment Companies C) Exchange-Traded Funds D) Some Important Considerations 1. Load and No-Load Funds 2. Other Fees and Costs 3. Keeping Track of Fund Fees and Loads E) Other Types of Investment Companies 1. Unit Investment Trusts 2. Hedge Funds Concepts in Review II. Types of Funds and Services A) Types of Mutual 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 Funds 9. Index Funds
  3. 3. 240  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 10. Sector Funds 11. Socially Responsible Funds 12. Asset Allocation Funds 13. International Funds B) Investor Services 1. Automatic Investment Plans 2. Automatic Reinvestment Plans 3. Regular Income 4. Conversion Privileges and Phone Switching 5. Retirement Programs Concepts in Review III. Investing in Mutual Funds A) Investor Uses of Mutual Funds 1. Accumulation of Wealth 2. Storehouse of Value 3. Speculation and Short-Term Trading B) The Selection Process 1. Objectives and Motives For Using Funds 2. What the Funds Offer 3. Whittling Down the Alternatives 4. Stick with No-Loads or Low-Loads C) Investing in Closed-End Funds 1. Some Key Differences Between Closed-End and Open-End Funds 2. What to Look for in a Closed-End Fund D) Measuring Performance 1. Sources of Return 2. What About Future Performance? 3. Measures of Return a. HPR with Reinvested Dividends and Capital Gains b. Measuring Long-Term Returns c. Return on Closed-End Funds 4. The Matter of Risk Concepts in Review Summary Putting Your Investment Know-How to the Test Discussion Questions Problems Case Problems 13.1. Reverend Robin Ponders Mutual Funds 13.2. Tom Yee Seeks the Good Life Excel with Spreadsheets
  4. 4. Chapter 13 Mutual Funds: Professionally Managed Portfolios  241   Key Concepts 1. The basic characteristics of mutual funds, and how diversification and professional management are the cornerstones of the industry. 2. The advantages and disadvantages of owning mutual funds. 3. The kinds of funds available and the variety of investment objectives these funds seek to fulfill. Recent additions to the assortment covered include hedge funds and exchange-traded funds. 4. The array of special services offered by mutual funds and how these services can fit into an investment program. 5. Investor uses of mutual funds, and ways of assessing and selecting funds that are compatible with the investment needs of the individual. 6. Aspects of investing in closed-end mutual funds. 7. Sources of return in mutual funds and ways to calculate rate of return.   Overview This chapter focuses on mutual funds. 1. The chapter begins with an overview of the major features and characteristics of mutual funds. At the outset, the difference between buying into a mutual fund and investing directly in securities should be clarified by the instructor; it’s also helpful to emphasize early on that pooled diversification is one of the major benefits of investing in a mutual fund. The instructor might also mention that the additional benefits of professional management and modest start-up capital requirements make investing in mutual funds attractive, even for small investors. Drawbacks of mutual funds are pointed out. The opening section ends with a discussion about how mutual funds are managed and regulated. 2. Closed-end and open-end mutual funds are introduced. Other types of pooled investments, such as investment (unit) trusts, and load versus no-load funds are also described, along with the various types of mutual fund fees and charges. The instructor should indicate the types of investments these funds represent. The class may be shown how to read mutual fund quotations from the financial pages. 3. In the next section, mutual funds are classified according to investment objectives. Growth funds, aggressive growth value funds, equity-income, balanced funds, growth and income, bond funds, money market funds, index funds, sector funds, socially responsible funds, asset allocation funds, and international funds are defined. The instructor should explain how such funds choose the investments that enable them to meet their prescribed objectives. How and why investors might choose one type of fund rather than another should be explored, and the various investor services offered by these funds needs to be briefly discussed in class. 4. Given their popularity and hybrid nature, exchange-traded funds should be covered. Discussion of advantages and disadvantages of exchange-traded funds puts some of the comparative advantages and disadvantages of open-end mutual funds into perspective. 5. Next, a discussion of how investing in closed-end funds follows. Some key differences between investing in closed-end versus open-end funds are made.
  5. 5. 242  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 6. A mutual fund’s performance may be measured by rate of return. It might be helpful at this point to discuss the sources of return and how investors can get a handle on the future performance of a mutual fund; with that background out of the way, the instructor can work out examples in class showing holding period return (HPR) and yield calculations similar to those in the text. Consideration of risk should also be emphasized when comparing the return of two funds. 7. There is an abundance of information on mutual funds, including the Wall Street Journal’s monthly Mutual Funds report, which is typically published on the first day of the month. Instructors should provide information on recent mutual fund returns whenever possible.   Answers to Concepts in Review 1. A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors; mutual funds represent ownership in a managed portfolio of securities. The mutual fund concept, therefore, revolves around diversification. Diversification, which reduces the overall risk borne by the investor, is available through a mutual fund. This, coupled with the fact that mutual funds have professional management which frees the individual investor from managing his own portfolio, makes mutual funds attractive to individuals. 2. The major advantage of mutual funds is that they provide diversification and full-time professional management. Investors with modest amounts of capital can invest in mutual funds and receive the advantages of these services. Also, mutual funds may offer several attractive services (like monthly withdrawal plans). They also handle all the paperwork and record keeping, deal in fractional shares, and automatically reinvest dividends, if the investor so desires. There are several disadvantages, however. For one thing, the funds can be quite expensive to acquire if they are load funds, or have other types of charges and fees (like 12(b)–1 fees). In terms of performance over the long run, mutual funds, on average, have not done all that well; indeed, only a handful have been able to outperform the market with some degree of regularity. Their performance, in general, has corresponded to the performance of the market as a whole. Of course, index-based mutual funds should provide the return of that market covered less mutual fund-related costs. 3. Mutual funds are frequently open-ended investment companies; investors in mutual funds are essentially buying a small piece of a large, well-diversified portfolio of securities. A mutual fund is a financial services organization that receives money from its shareholders and invests those funds in a portfolio of securities. The investors in a given mutual fund are all part-owners of that portfolio. Individual mutual funds are created by management companies, like Fidelity, Dreyfus, and Vanguard. They also run the funds’ daily operations and usually serve as the investment advisor. The investment advisor buys and sells securities and otherwise oversees the fund’s portfolio. This is normally carried out by: the money manager, who actually runs the portfolio; security analysts, who look for viable investment candidates; and traders, who attempt to trade large blocks of securities at the best possible price. In addition, there are fund distributors, who actually buy and sell the fund shares; custodians, who take physical possession of the fund’s securities and other assets; and the transfer agent, who keeps track of fund shareholders. (Note: All these participants are part of open-end mutual funds; however, closed-end investment companies do not require a distributor. Shares in these funds trade in the open markets.)
  6. 6. Chapter 13 Mutual Funds: Professionally Managed Portfolios  243 4. (a) An open-end investment company is a mutual fund in which investors actually buy their shares from and sell them back to the mutual fund itself. There is no limit on the number of shares an open-end fund can issue, and this is by far the most common type of mutual fund. (b) A closed-end investment company is a fund that operates with a fixed number of outstanding shares and does not regularly issue new shares of stock. These funds, which are few in number relative to open-end funds, operate with a fixed capital structure and trade in the stock market— most are listed on the NYSE (c) Exchange-traded funds (ETF) is a type of open-end mutual fund that trades as a listed security on one of the stock exchanges. (d) A unit investment trust represents an interest in an unmanaged pool of investments, which generally have a given term or life. Once a portfolio of securities is put together for a UIT, it is simply held in safekeeping for investors under conditions set out in the trust agreement. Traditionally, these portfolios were made up of various types of fixed-income securities, with long-term municipal bonds being the most popular by far. There is no trading in the portfolios, so the returns, or yields, are fixed and fairly predictable. There is no trading in the portfolio, so management fees are low. Various sponsoring brokerage houses put these diversified pools of investments together and then sell “units” to investors. (e) Like mutual funds, hedge funds sell shares (or participation) units in a professionally managed portfolio of securities. However, hedge funds are private partnerships that tend to limit their clientele to the rich individuals. The manger is a general partner, while the investors are limited partners. Hedge funds have very limited reporting requirements and are generally unregulated. Some hedge funds attempt to limit the downside risk through employment of options and futures, while others invest in any opportunity that has the potential of a positive return. 5. A load fund is a mutual fund that charges a commission to purchase shares in the fund. A no-load fund does not require any commissions on the part of the investors. The no-load fund offers an advantage to investors because, by avoiding the commission (often as high as 8.5 percent), they can buy more shares in the fund with a given amount of capital, and therefore, other things being equal, earn a higher rate of return. A 12(b)–1 fund may appear to be a no-load fund, but in fact, it charges an annual fee which replaces an up-front load charge. Many so-called no-load funds levy 12(b)–1 charges; they continue to refer to themselves as no-loads even though 12(b)–1 charges can add up over time. 6. In addition to 12(b)–1 fees, there are a number of other types of load fees and charges. A back-end load fund charges a (redemption) fee/commission when the investor sells the fund. (Redemption fees often decline over time and disappear all together after the first 3–5 years of ownership). A low-load fund is a type of front-end load fund but it keeps the load charge very low, usually less than 2 or 3%, while a hidden load is a term used to describe a 12(b)–1 fee. The easy way to distinguish between a load and a no-load fund is to look for a difference between the net asset value (NAV) and offer prices of a fund. If there’s a difference, it’s a load fund and the amount of the difference represents the size of the front-end load charge (the “commission” to buy the fund). In addition, the WSJ and other major papers use letters in their mutual fund quotes to identify various types of fees; for example, “r” means the fund has a redemption charge. Finally, every fund prospectus must contain a fee table that fully discloses the types and amounts of fees and charges.
  7. 7. 244  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 7. There is a wide variety of mutual funds.
  8. 8. Chapter 13 Mutual Funds: Professionally Managed Portfolios  245 (a) Aggressive growth funds are highly speculative funds that concentrate on obtaining large capital gains. These funds tend to be small and their portfolios consist of speculative common stocks. Returns on these funds generally move with the market, but in larger increments: when the market’s up, these funds do great, but when the market falls, they do really poorly. (b) Equity-income funds emphasize current income by investing primarily in high yielding common stocks. In addition to high-grade common stocks, these funds also invest in convertible securities, preferred stocks and even bonds. They like securities that provide high current yields, but also consider potential price appreciation over the longer haul. These funds are generally viewed as a fairly low risk way of investing in stocks. (c) Growth-and-income funds seek a balanced return made up of both current income and long-term capital gains, with the greatest emphasis placed on growth of capital. Unlike balanced funds, growth and income funds have 80–90% of their capital in common stocks). They tend to invest in growth-oriented blue chips (for their capital gains) and high-yield common stocks (for their current income due to high dividends). (d) Bond funds come in all shapes and colors (from the government bond funds to high yield [junk] corporate bond funds) and they all have one thing in common: they invest principally (or exclusively) in some type(s) of fixed-income security. While current income is the primary objective of these funds, capital gains is not ignored all together. Today, there’s a full range of bond funds, ranging from the very conservative to the very risky. (e) Sector funds are mutual funds that concentrate their holdings in one or more industries that make up a target sector. For instance, a health care sector fund may hold drug companies, medical suppliers, biotech companies, and hospital management companies. They are not widely diversified and therefore are riskier than diversified funds. (f) Socially responsible funds are mutual funds that actively and directly incorporate ethics and morality into the investment decision. These funds will consider only socially responsible companies for inclusion in their portfolios. For example, these funds generally will not invest in companies that derive revenues from tobacco, alcohol, or gambling; companies that are weapons contractors; or that operate nuclear power plants. 8. Asset allocation funds spread investors’ money across different types of markets. Most other mutual funds focus on one particular type of investment such as portfolio of stocks, a portfolio of bonds, or money market securities—asset allocation funds allocate money to all of these markets. In an asset allocation fund, the manager establishes a desired allocation mix and purchases securities for the fund in these proportions. Thus, as the market changes over time, so do these funds—this is what separates allocations funds from other mutual funds. 9. Even though growth, income, and capital preservation are primary mutual fund objectives, each fund concentrates on one or more particular goal(s). Thus, for people who rely heavily on current income, an investment in an income fund would be the right choice. Investors who do not require the current income and are content with waiting for capital appreciation can benefit from growth funds. These classifications of mutual funds are helpful in determining whether or not the goal of the mutual fund is compatible with one’s own investment objective. The SEC requires that the specific objective of a fund be stated in its prospectus, along with how it intends to meet its objective.
  9. 9. 246  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 10. Fund families are simply investment management companies that offer a number of different kinds of mutual funds to the investing public. The two largest fund families—Fidelity and Vanguard—each have over a trillion dollars in assets. Fidelity has over 300 different funds in its family. The big fund families offer a full menu of different types of funds—everything from growth, equity-income, and sector funds to a variety of bond funds and money market funds. And that, of course, is the big advantage of investing in a fund family: i.e., the investor can fully manage his portfolio of funds by easily and inexpensively moving from one fund to another as the market dictates. On the downside, all the trading has to be confined to the same family of funds; if the funds aren’t in some type of tax- sheltered vehicle (like an IRA or Keogh account), then every time a trade is made, a tax liability is created. (For tax purposes, moving money from one fund to another is regarded as a sale followed by a subsequent purchase of a new security—the fact that it was done in the same family of funds is totally irrelevant). 11. Mutual funds offer a variety of services to investors. These include: Savings and automatic reinvestment plan: Investors are provided a way to accumulate capital and have returns systematically and automatically reinvested for the long haul (at little or no cost); Withdrawal plans: Investors receive regular payments from the mutual funds; and conversion privileges and phone switching: When the investment climate changes and/or an investor’s goals change, he or she can quickly and easily switch from one kind of fund to another within the same family, using the conversion privilege. Some mutual funds (mostly money funds) are extremely liquid because they offer check writing privileges. Most mutual funds also will design and provide for individual retirement plans. Automatic investment plans allow shareholders to automatically send amounts of money from their paycheck or bank accounts into the fund. Automatic reinvestment plans enable mutual fund investors to keep their capital fully employed; this is important because that’s the way investors earn fully- compounded rates of return. Normally, dividends and capital gains distributions are paid in the form of cash; in an automatic reinvestment plan, however, those dividends and capital gains distributions are used to buy additional shares in the fund. Thus, the number of shares owned by the investor will grow over time. Phone switching is a type of conversion privilege which enables fund owners to simply pick up the phone to move their money from one fund to another (such a move, of course, must be confined to the same family of funds). Investors would use such a service as a way to meet their changing investment goals: i.e., when the investment environmental/outlook changes, investors can move between funds as the situation dictates. 12. 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). 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. Some funds, such as sector funds, may not move with the overall market at all. That is one reason these funds are attractive to some investors. Past performance is important to the mutual fund selection process—it’s an indication of how well the fund and its fund managers have done over time. And in this regard, it’s important to look at past performance over an extended (5–10 year) period of time, covering both good markets and bad. If a fund and its managers have done well in both up markets and down markets, that’s a pretty good indication of what they’re capable of doing in the future. Whether they actually will perform up to expectations is another matter and is dependent to a large extent on what the future behavior of the market holds. That’s why it’s so important to try to get a handle on the future direction of the market: if you think it’s headed up, that should bode well for mutual funds. Combining these two variables (the past performance of the fund with the future expectations of the market) is an important method for selecting among funds.
  10. 10. Chapter 13 Mutual Funds: Professionally Managed Portfolios  247 13. The major types of closed-end funds include those that specialize in municipal bonds, taxable bonds, various types of equity securities, international securities, and regional and single-country funds. Regional funds focus on a group of countries within a broad geographic area, such as Europe or Latin America. In contrast, single-country funds will target either emerging markets or developed markets. Key differences between closed-end (CEFs) and open-end (OEFs) mutual funds include: (1) CEFs trade like stocks while OEFs are traded directly with the fund operators. (2) Large traders of CEFs affect the buy or sell price, while trading large amounts of OEFs typically do not affect the price, i.e., CEFs are much less liquid than OEFs. (3) CEFs do not provide the full range of services provided by OEFs. (4) CEFs typically have a relatively constant capitalization. Unlike OEFs, CEF investors do not continually buy new shares. (5) Most importantly, although OEFs are traded (bought and sold) at net asset value, CEFs have two values, a market value and a net asset value, and these are rarely the same. 14. The three sources of return for a mutual fund are (1) dividend income, (2) capital gains distributions, and (3) changes in the net asset value of the fund. Each of these components has an effect on the total return of a mutual fund. The greater the return from any of these components, the greater the total return to the investor. For closed-end investment companies, changes in price premiums or discount are another source of return. The premium or discount actually affects the market price (or net asset value) of the fund and hence investment return—i.e., as discount or premium changes, it affects the changes in NAV and, therefore, total return. 15. Major risk for mutual funds is market risk (systematic risk) because a mutual fund is a large, diversified portfolio. Therefore, its fortunes are generally tied to the behavior of the market. A second kind of risk arises from management practices. If a mutual fund is managed aggressively, the probability of a loss in capital may be high. This is not to imply that a conservative strategy is the only feasible strategy for a mutual fund. Obviously, all funds are not subject to the same amount of risk. The more aggressive is the fund management, the greater the potential return and the greater the amount of risk. Moreover, since funds deal in different markets, their market risk may not be the same either.   Suggested Answers to Investing in Action Questions Adding ETFs to Your Investment Portfolio (p. 552) (a) What are four ways of structuring exchange-traded funds? (b) What investment advantages do ETFs offer? Answers: (a) ETFs can be structured in terms of investment style (e.g., value or growth), market capitalization (e.g., small-, mid-, or large-cap companies), sector (e.g., biotechnology sector or pharmaceutical industry), and region (e.g., Pacific Rim or Europe). (b) ETFs can be traded throughout the day, have minimal expense ratios, attractive returns, and no tax liability until the ETF is sold.
  11. 11. 248  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition   Suggested Answers to Ethics in Investing Questions When Mutual Funds Behave Badly (p. 546) Will the imposition of 2.0% redemption fees for sales within 90 days of purchase eliminate trading abuses? Answer: A 2% redemption fee for traders may diminish the number of profitable trades for market timers but is not likely to eliminate trading abuses as long as mutual funds benefit from these practices. Redemption fees may bring in additional revenues to funds but create a hassle for small investors who need to sell their shares for whatever reason. A better policy will be to require funds to calculate their net asset values based on fair (continuous) market pricing rather than using delayed (stale) prices of foreign or thinly traded domestic securities. Also, mutual funds need to strictly enforce their own policies against market timing set forth in their prospectuses. Many funds promise to bar those who make more than 2-4 round-trip trades a year from investing in a fund, yet not all of them enforce that rule when it comes to large institutional investors. A proper deterrent would be to prosecute those guilty of violating prospectus policies for securities fraud and making false statements. It is, after all, a legal document set forth and approved by the SEC. Late trading, on the other hand, is already illegal and stricter enforcement of existing laws is needed rather than creating new regulations.   Suggested Answers to Discussion Questions 1. Arguments for Mutual Fund Ownership • Greater level of diversification • Professional management • Establish an investment program with a limited amount of capital Arguments for Direct Investment in Stocks and Bonds • Greater control over the types of investments made • Closer fit to risk preferences of the individual investor • Greater liquidity when buying and selling 2. FMI Clipper HiYldBd Canad EqIncC Focusfd (a) Sale Price 84.50 9.38 25.28 13.73 31.60 (b) 12(b)-1 fees No Yes No Yes No (c) Redemption fee No No Yes Yes No (d) Both 12(b)-1 and No No No Yes No redemption fees (e) No load Not Not No No Not Available Available Available (f) Front-end load Not Not Not Not Not Available Available Available Available Available (g) YTD return 11.6% 23.1% 39.5% 28.8% 37.6% Fidelity Canada has the highest year-to-date return, Clipper Fund the lowest.
  12. 12. Chapter 13 Mutual Funds: Professionally Managed Portfolios  249 3. (a) Growth versus growth and income funds: Growth funds have more risk due to greater investment for capital gain and therefore newer growing companies. (b) Equity-income versus high-grade corporate bond funds: Bonds are less risky since they are rated investment quality as compared to ordinary common stock dividends that are declared after interest income to bondholders is paid. (c) Balanced versus sector funds: Sector funds lack diversification and therefore may contain higher nonsystematic risk than a balanced more diversified fund. (d) Global versus aggressive growth funds: This depends on what type of global fund is used. Global funds may also have aggressive growth targets but have political risk not associated with domestic aggressive growth funds. (e) Intermediate-term bonds versus high-yield municipal bond funds: High yield municipal bonds have less risk since they are usually associated with cities and municipalities. But these units may also have high risk depending on their credit ratings. 4. Exchange-traded funds are similar to index mutual funds but trade like stocks. Each share represents a basket of securities that closely tracks one specific index. ETFs have extremely low costs due to the fact they have no research or management fees and minimal back office expenses. Because they are traded on exchanges, they are similar to closed-end funds. Also, because they are not actively managed, they have no taxable income. SPDRS are a specific type of EFT based on the S&P 500 index. The Vanguard family of funds contains a fund, known as the Vanguard 500 Index Fund, that is similar; that is, they both track the S&P 500 index. However, you can only invest in the Vanguard 500 Index at the end of the day, while trading in SPDRS occurs during normal market hours. The SPDRS tend to have low cost, low turnover, and low tax liability. Money earned on your behalf can be automatically reinvested by Vanguard daily. Excluding this one disadvantage, the SPDRS would be preferable. 5. You can buy open-ended funds at their net asset value because you are dealing directly with the fund. Closed-end funds (CEFs) have both a market value (stock price) and a net asset value, which tend to differ. CEFs sell at a premium to net asset value in the unlikely case that the CEF’s stock price exceeds the net asset value. It is uncommon for investors to pay more for a set of shares than their cost would be if bought directly. Discounts exist if more individuals were attempting to sell CEF shares than buy them. Discounts also exist if there was poor past fund performance, a low annual payout and yield, poor manager name recognition, when very little cash is held by the CEF making it difficult to take advantages of new opportunities, and if several shares in the portfolio have appreciated significantly. Although the value of these shares exceeds the purchase price by $X, investors would only realize $X(1-tax rate) after taxes. Advantages of buying CEFs include the enhanced dividend yield arising from investing less than full price. Beyond this, one open-end and closed-end mutual funds should be evaluated on the expected price performance of the underlying assets and the distribution of proceeds from current income and capital gains. Investors should typically avoid CEFs selling at a premium and new CEFs. 6. Answers will vary with each student.
  13. 13. 250  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition   Solutions to Problems 1. (a) Return for the year (all changes on a per share basis): Change in price ($9.10 – $8.50) $0.60 Dividends received 0.90 Capital gains distributions 0.75 Total return $2.25 Holding period return = $2.25 = 26.47% $8.50 (b) When all dividends and capital gains distributions are reinvested into additional shares of the fund ($8.75/share): Dividends and capital gains per share: $0.90 + $0.75 = $1.65 Total received from 200 shares: $1.65 × 200 = $330.00 Additional shares acquired: $330/$8.75 = 37.7 shares Value of 237.7 shares held at end of year: 237.7 shares × $9.10 = $2,163 Price paid for 200 shares 200 shares × $8.50 = $1,700 at beginning of year Thus, the holding period return would be: $2,163 − $1, 700 $463 H.P.R = = = 27.24% $1, 700 $1, 700 2. Purchase (offer) price—beginning of year $23.35 Current price (NAV) end of year 23.04 Decrease ($0.31) Return for the year: Dividend and gains distribution $1.05 Loss in value (0.31) Total return $0.74 Note: This is a good problem to demonstrate the impact of load charges on investor return. The instructor might want to point out that even though the NAV of the fund increased by $1.54 a share ($23.04 – $21.50), the investor still is faced with a $.31 loss in value over the year, since you buy at the offer price and sell at the NAV. In this case, even though the NAV went up, the investor had to absorb a $1.85 load charge; the net result is a $.31 loss. As a point of interest, if this had been a no- load fund, the HPR would have been: ($1.54 + $1.05)/$21.50 = 12.05%
  14. 14. Chapter 13 Mutual Funds: Professionally Managed Portfolios  251 3. 5-year Compounded Rate of Return 2003 2002 2001 2000 1999 1998 (a) Beginning –10    NAV (b) Dividends 0.95 0.85 0.85 0.75 0.60 (c) Capital 1.05 1.00 1.00    Gains (d) Closing 15.73    NAV Net Cash Flow 17.73 1.85 0.85 1.75 0.60 −10 Using a Financial calculator, the 5-year compounded rate of return is: 21% 3-year Compounded Rate of Return 2003 2002 2001 2000 (a) Beginning –10.64   NAV (b) Dividends 0.95 0.85 0.85 (c) Capital 1.05 1.00   Gains (d) Closing 15.73   NAV Net Cash Flow 17.73 1.85 0.85 −10.64 Using a Financial calculator, the 3-year compounded rate of return is: 26% 5-year Holding Period Return Total profit per share = Total dividends + Total distributed capital over the 5-year period gains + Capital gain on share price = ($0.95 + $0.85 + $0.85 + $0.75 + $0.60) + ($1.05 + $1.00 + $1.00) + ($15.73 – $10.00) = $4.00 + $3.05 + 5.73 = $12.78 per share She would have more than doubled her money. 4. 2002 2003 2004 Total Ending NAV $43.20 $60.47 $57.75 — Purchase (offer) price 55.00 46.20 64.68 — Net increase/(decrease) ($11.80) $14.27 ($6.93) — Return for the year:  Dividends received $2.10 $2.84 $2.61 $7.55  Capital gains distribution 1.83 6.26 4.32 12.41  Net increase in price (11.80) 14.27 (6.93) —  Total return ($7.87) $23.37 $0  Holding period return –14.3% 50.58% 0%  Total return/Purchase price
  15. 15. 252  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition The average annual compound rate of return over the 3-year period: 3-year Compounded Rate of Return 2001 2002 2003 2004 (a) Beginning –55   NAV (b) Dividends 2.10 2.84 2.61 (c) Capital 1.83 6.26 4.32   Gains (d) Closing 57.75   NAV Net Cash Flow −55 3.93 9.10 64.68 Using a Financial calculator, the 3-year compounded rate of return is: 13.2% Given that all dividends and capital gains distributions are reinvested in additional shares of the fund at an average price of $52.50 per share: Dividends and capital gains per share: $2.84 + $6.26 = $9.10 Total income from 500 shares: $9.10 × 500 = $4,550 Additional shares required: $4,550/$52.50 = 86.7 shares (Number of shares − (Number of shares × Ending price) Beginning price Holding period return = (Number of shares × Initial price) (586.7 × $60.47) − (500 × $46.20) = 500 × $46.20 $35, 477.75 − $23,100.00 = $23,100.00 $12, 377.75 = = 53.6% $23,100.00 5. Holding period returns for 2004 and 2001: 2004 2001 Ending NAV $64.84 $44.10 Beginning NAV 58.60 59.85  Net increase/(decrease) $6.24 ($15.75) Return for the year:  Dividends received $0.83 $0.72  Capital gains distribution 2.42 9.02  Net increase in NAV 6.24 (15.75)   Total return $9.49 ($6.01) Holding period return 16.2% –10.0%  (Total return/Beginning NAV)
  16. 16. Chapter 13 Mutual Funds: Professionally Managed Portfolios  253 Holding period returns for 2004 and 2001 with a 3% load: With a front-end load of 3% on NAV, the purchase price = Beginning NAV × 1.03. 2004 2001 Total return before any load $9.49 ($6.01) Less: Load at 3% (1.76) (1.80) Total return with load $7.73 ($7.81) Purchase price $60.36 $61.65 HPR 12.81% –12.7% Since the front-end load decreases the total return and increases the purchase price, the cumulative effect will be a decrease in the HPR. Average annual rate of return over the two periods: 2000–2004 1995–2004 Capital Capital Dividends Gains Dividends Gains 1995 $0.58 $9.92 1996 0.33 1.23 1997 0.26 1.88 1998 0.37 3.69 1999 0.65 1.78 2000 $0.46 $6.84 0.46 6.84 2001 0.72 9.02 0.72 9.02 2002 0.90 — 0.90 — 2003 1.24 3.82 1.24 3.82 2004 0.83 2.42 0.83 2.42 Compounded Return for the 5-year period with Loading 2004 2003 2002 2001 2000 1999 (a) Beginning –55.34   NAV (b) Dividends 0.83 1.24 0.90 0.72 0.46 (c) Capital 2.42 3.82 9.02 6.84   Gains (d) Closing 64.84   NAV Net Cash Flow 68.09 5.06 0.90 9.74 7.30 −55.34 Using a Financial calculator, the 5-year compounded rate of return is: 12.71%
  17. 17. 254  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Compounded Return for the 10-year period with Loading
  18. 18. Chapter 13 Mutual Funds: Professionally Managed Portfolios  255 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 (a) Beginning –29.82   NAV (b) Dividends 0.83 1.24 0.90 0.72 0.46 0.65 0.37 0.33 0.58 (c) Capital 2.42 3.82 9.02 6.84 1.78 3.69 1.88 1.23 9.92   Gains (d) Closing 64.84   NAV
  19. 19. 256  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Net Cash Flow 68.09 5.06 0.90 9.74 7.30 2.43 4.06 2.14 1.56 10.50 −29.82
  20. 20. Chapter 13 Mutual Funds: Professionally Managed Portfolios  257 Using a Financial calculator, the 10-year compounded rate of return is: 21% If the fund charges a 3% load on NAV, the beginning price would be different and that would change the yield: Beginning price, 1995 $29.82 × 1.03 = $30.71 Beginning price, 1999 $55.34 × 1.03 = $57.00 Compounded Return for the 5-year period with Loading
  21. 21. 258  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 2004 2003 2002 2001 2000 1999 (a) Beginning –57   NAV (b) Dividends 0.83 1.24 0.90 0.72 0.46 (c) Capital 2.42 3.82 9.02 6.84   Gains (d) Closing 64.84   NAV
  22. 22. Chapter 13 Mutual Funds: Professionally Managed Portfolios  259 Net Cash Flow 68.09 5.06 0.90 9.74 7.30 −57
  23. 23. 260  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Using a Financial calculator, the 5-year compounded rate of return is: 11.9% Compounded Return for the 10-year period with Loading
  24. 24. Chapter 13 Mutual Funds: Professionally Managed Portfolios  261 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 (a) Beginning –30.71   NAV (b) Dividends 0.83 1.24 0.90 0.72 0.46 0.65 0.37 0.26 0.33 0.58 (c) Capital 2.42 3.82 9.02 6.84 1.78 3.69 1.88 1.23 9.92   Gains (d) Closing 64.84   NAV
  25. 25. 262  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Net Cash Flow 68.09 5.06 0.90 9.74 7.30 2.43 4.06 2.14 1.56 10.50 −30.71 Using a Financial calculator, the 10-year compounded rate of return is: 20.4% In both cases the yield went down, but only marginally, compared to the one-year HPR, which decreased significantly. This occurs because the impact of the front-end load, payable only at the time of the initial purchase is minimized over longer holding periods. 6. There is no set solution to this problem, since the answers will vary with the funds selected by the student. There are many funds that the student can choose from to answer this question. The instructor might want to refer the student to one of several fund services that are available, especially Morningstar’s Mutual Fund Values, Donoghue’s Mutual Funds Almanac, or Weisenberger Investment Companies. Web sites include,, and It might be useful to bring examples to class to show the types of information available. 7. (a) NAV-based HPR for the year: $0.40 + $0.95 + ($11.69 − $10.40) = $10.40 = 25.38% (b) Market-based HPR for the year: (i) Beginning period market price (market price − NAV) premium (or discount) = NAV (market price − $10.40) −0.18 = $10.40 $8.53 = market price (ii) Ending period market price (market price − $11.69) +0.04 = $11.69 $12.16 = market price ($0.40 + $0.95) + ($12.16 − $8.53) (iii) HPR = HPR = $8.53 HPR = 58.38% The market discount applied to the purchase price and the market premium applied to the sale, therefore, the investor’s return benefited. (c) Market-based HPR for the year: (i) Beginning period market price (market price − $10.40) +0.18 = $10.4 $12.27 = market price (ii) Ending period market price (market price − $11.69) +0.04 = $11.69 $11.22 = market price
  26. 26. Chapter 13 Mutual Funds: Professionally Managed Portfolios  263 ($0.40 + $0.95) + ($11.22 − $12.27) (iii) HPR = $12.27 HPR = 2.44% Because the premium applied to the purchase price and the discount applied to the ending period price, the HPR is significantly lower. Obviously, both the premium and discount values affect the investor’s HPR. 8. (a) NAV-based HPR for the year: $1.20 + $0.90 + ($9.25 − $7.50) = $7.50 = 51.33% (market price − NAV) (b) Beginning period premium = NAV ($7.75 − $7.50) = $7.50 = 3.33% ($9.00 − $9.25) End of the period premium = $9.25 = −2.7% (c) Market-based HPR for the period: ($1.20 + $0.90) + ($9.00 − $7.75) HPR = $7.75 = 43.2% The market premium increased the purchase price and the market discount reduced the sale price, therefore, it hurt the investors holding period return. 9. This is a single cash flow IRR problem. Initial investment is $20,000. Three years later, the value is $25,201 (1,100 × $22.91). $20,000 × FVIFX%, 3 periods = $25,201 8% factor = 1.26. $20,000 × 1.26 = $25,200. Calculator Solution 3N, –20,000PV, 25,201 FV; CPT I/Y = 8.01% 10. Here there is an additional 3% added to the cost of the initial purchase. The initial investment becomes ($20,000 × 1.03) = $20,600. $20,600 × FVIFX%, 3 periods = $25,201 7% factor = 1.225. $20,000 × 1.225 = $25,235. Financial Calculator: 3N, – 20,600PV; 25,201FV; CPT I/Y = 6.95%
  27. 27. 264  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 11. The problem assumes that Oh Yes Mutual Fund a no-load fund. HPR = [DivDist + Gains Dist + (NAVEnding − NAVBeginning )]/NAVBeginning HPR = [1.50 + 2.00 + (26.00 − 25.00)}/25.00 = 4.50/25.00 = 0.18 or 18%. 12. The problem assumes that OhYes Mutual Fund is carries a 2% load. If the initial NAV was $25.00, the initial cost was $25.50 ($25 × 1.02). Recomputing the HPR gives: HPR = [DivDist + Gains Dist + (NAVEnding − Initial Cost)]/Initial Cost HPR = [1.50 + 2.00 + (26.00 − 25.50)}/25.50 = 4.00/25.50 = 0.157 or 15.7%. 13. HPR = [DivDist + Gains Dist + (NAVEnding − Initial Cost)]/Initial Cost HPR = [1.30 + 0 + (14.50 − 12.66)}/12.66 = [1.30 + 1.84]/12.66 = 0.2480 or 24.80%. 14. Cash flows are: Period 0 1 2 3 Cash flow −$12.66 $1.30 $1.30 $16.68 12.66 =1.3 (PVIFx%, 1) + 1.30 (PVIFx%, 2 periods) + 16.98 (PVIFx%, 3) Using 17%: 1.3(0.885) + 1.3 (0.731) + 16.98 (0.624) = 1.1505 + 0.9503 + 10.5955 = 12.6963 Since this value is close to 12.66, the discount rate must be near 17%. Calculator: 3N, –12.66PV, 1.30PMT, 15.68FV; CPT I/Y = 17.01% 15. The fund is trading at a discount because the market price is below the NAV. (Share price – NAV)/NAV = ($20.00 – $22.5)/$22.50 = –$2.50/$22.50 = –0.1111 or –11.11%. 16. Taxes will be 15% on half of the distribution (dividends) and 25% on the other half (interest income). Total distribution is 1,000 × $2.00 = $2,000. Tax = ($1,000 × 0.15) + ($1,000 × 0.25) = $150 + $250 = $400.   Solutions to Case Problems Case 13.1 Reverend Robin Ponders Mutual Funds This case enables the student to deal with the issues included in putting together a long-term mutual fund program that will meet some pretty specific investment objectives. (a) Reverend Robin needs to accumulate capital and needs a vehicle that will serve as a storehouse of value. Given his lack of investment expertise and the small sum he has to invest, mutual funds would be an ideal vehicle. He will gain professional investment management and far greater diversification than he could if he invested his small amount of funds directly. Moreover, he can set up savings and reinvestment plans to help him toward his goal of long-term capital accumulation.
  28. 28. Chapter 13 Mutual Funds: Professionally Managed Portfolios  265 (b) As indicated earlier in the text, certain prerequisites must be satisfied prior to entering an investment program. Reverend Robin can cover the necessities, but he should be sure that he also has adequate insurance and sufficient liquidity. All or part of the $15,000 can be invested in a money market mutual fund without losing any liquidity, but with a gain in interest. Reverend Robin could use a money market fund to accumulate funds that can later be moved to another fund in the same “family” of funds. (c) Reverend Robin’s specific investment needs are retirement and college education for his child. Both objectives favor a conservative growth fund or a growth-and-income fund. A good strategy would be to start the Reverend Robin using a money market fund with conversion privileges when adequate liquidity is established. Using automatic savings and reinvestment services, Reverend Robin should be able to accumulate capital to meet both objectives without undue risk. In meeting his retirement needs, he should also investigate an IRA account. He can probably contribute to his IRA account, and taxes on this amount (along with earnings on the fund) are deferred until he draws the funds at retirement. Case 13.2 Tom Yee Seeks the Good Life In contrast to the previous case, in which the investor was interested in long-term wealth accumulation, this case illustrates a situation in which current income is the primary objective. (a) Given Tom’s existing financial condition, he can take on a certain amount of risk. Also, Tom wants to consume immediately. In that sense, an income fund seems attractive. He could obviously use the current income such a fund can provide. Although he seems financially capable of assuming increased risk to generate a higher return, he has also stated that he “intends to be around for a long time.” Therefore, preservation of capital would seem to be another of Tom’s objectives. As a result, he might also consider a money market fund, or perhaps an intermediate-term bond fund. The choice will boil down to Tom’s greatest need; or perhaps he can invest in both. (b) The factors that must be taken into consideration are (1) Tom’s existing wealth level, (2) his ability to take on risk, (3) his demand for current income, and (4) his desire for capital preservation. These considerations will clearly dictate the kind of mutual fund Tom should select. His demand for current income and his desire for preservation of capital should be paramount in the selection process. He is financially well off; he has no children and is a widower, so he can afford to take some risk. But he is also in his retirement years, and he knows the importance of capital preservation. Taxes are not an issue, so he should avoid municipal bond funds and similar tax-sheltered funds. Some viable investment candidates could include one or more of the following: high-yield money funds for yield and capital preservation; corporate bond funds that invest heavily in A– and Baa–rated issues for high yield (note that extensive portfolio diversification would be essential to keep risk to a minimum); government bond funds with intermediate (three- to ten-year) maturities for safety, yield, and preservation of capital; or possibly even equity-income funds, which could provide not only current income but also some capital appreciation for the long-haul. However, Tom should understand that this option could involve some periodic/short-term sacrifice of his capital preservation goal. (c) Tom is clearly not in need of any savings plan. He already has a considerable amount of savings and is able to manage things well on his own. What he needs is a withdrawal plan because Tom would like to receive the income periodically and at regular intervals. There are several popular variations of withdrawal plans, and he should pick the one that best suits his needs. Since Tom would like to receive $1,000–$1,500 monthly, he should initiate a fixed dollar amount withdrawal plan. A conversion privilege would also be a plus.
  29. 29. 266  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition (d) Fund earns 12 percent: Starting balance is $100,000. At the end of the first year, this would be worth $100,000 × 1.10 = $110,000. Let us assume (for ease of calculation) that Tom withdraws $15,000 per year at the end of each year and compute the value after he makes his fifth withdrawal: Initial Ending Less Annual Balance Year Sum Sum Withdrawal End of Year 1 $100,000 × 1.10 = 110,000 – $15,000 = 95,000 2 95,000 × 1.10 = 104,500 – $15,000 = 89,500 3 91,400 × 1.10 = 98,450 – $15,000 = 83,450 4 83,450 × 1.10 = 91,795 – $15,000 = 76,795 5 76,795 × 1.10 = 84,474 – $15,000 = 69,474 Thus, at a 10% earning rate, the value of his $100,000 investment will steadily decline to $69,474 by the end of the 5th year. The reason for this is simple: he’s taking out more than he’s earning. This will eventually result in total capital consumption, something Tom would like to avoid. Obviously, the earning rate is important to the preservation of capital—in fact, the only way to avoid depletion of capital in this case is to invest in a fund earning at least 15 percent. Such a rate will yield $15,000 a year from a $100,000 investment. Short of this (i.e., finding a fund that yields 15%), Tom has three choices: (1) accept the fact that his capital will decline over time. (2) reduce the size of his withdrawals to something closer to the earning rate on the fund (e.g., to $10,000 per year from a fund that earns 10%); or (3) increase the size of the initial investment so the annual pay-off is closer to his needs—e.g., he would have to invest $150,000 to receive $15,000 per year from a fund that earns 10%.   Outside Project Chapter 13   The Other Kind of Investment Company The most popular form of investment company is the open-end mutual fund. But the closed-end company also holds a place in the market for professionally managed investment companies. This project will help you understand the difference between open-end mutual funds and closed-end investment companies. From the list of closed-end companies given in the test, select a diversified stock fund and a bond fund; in addition, find two open-end mutual funds that have roughly the same investment objectives. You can find information on fund objectives, etc. in Weisenberger Investment Companies or any other similar investment company services. Now, compare the four funds by looking at the following features: a. management fee charged b. how long the fund has existed c. size of the fund or amount of dollars under management d. financing of the fund—does it issue debt to employ leverage? e. dividend and capital gains distributions for the last three to five years f. the approximate yield for the last three years g. load charges Comment on your findings. Do you think open and closed end companies really behave all that differently? In the final analysis, what’s the most important thing in determining the amount of investment success (or failure) achieved by open and closed end funds?