Answers to GJ-Chapter 13: Mutual Funds (aka Investment Companies)
1.    What is a mutual fund?

      A mutual fund invest...
yields, are fixed and fairly predictable and management fees are low. Various sponsoring
     brokerage houses put these d...
Growth funds have two primary objectives - capital gains and long-term capital growth. These
     are viewed as long-term ...
8.   Briefly describe some of the most important services provided by mutual funds. What are
     automatic reinvestment p...
1.   The level of dividend and capital gains distributions as well as investment stability should
               be consid...
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GJ-Chapter 13: Mutual Fund Investments


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GJ-Chapter 13: Mutual Fund Investments

  1. 1. Answers to GJ-Chapter 13: Mutual Funds (aka Investment Companies) 1. What is a mutual fund? 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. What are the more important advantages and disadvantages associated with investing in mutual funds? 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. Mutual funds can be quite expensive to acquire if they are load funds, or have other types of charges and fees. In terms of performance over the long-run, mutual funds, on average, have not done all that well. Only a small number have been able to outperform the market with some degree of regularity. Their performance, overall, has corresponded to the performance of the market as a whole. 3. Distinguish among the following types of mutual funds: An open-ended mutual fund (aka investment company) is a mutual fund in which investors actually buy their shares from and sell their shares to the mutual fund itself. There is no limit on the number of shares an open-ended mutual fund can issue, and this is by far the most common type of mutual fund, accounting for approximately 90% of all mutual fund assets. The net asset value (NAV), plus (minus) any commission, is the purchase (sale) price of a share of an open-ended mutual fund. The NAV is the value calculated as being total market value of securities minus liabilities divided by the number of shares issued. Closed-end mutual fund is a mutual fund that operates with a fixed number of outstanding shares and does not regularly issue new shares of stock in the mutual fund. These funds, which are few in number relative to open-ended funds, operate with a fixed capital structure and trade in the stock market. Most closed-end funds are listed on the NYSE. The shares of stock in closed-end mutual funds may sell either above or below NAV depending on supply and demand for the shares. Most closed-end mutual funds actually sell below NAV - at a discount to NAV. A load fund is a mutual fund that charges a commission to purchase and or sell shares in the mutual fund. If the commission is charged on the purchase of shares then the fund is a front end load fund. If the commission is charged on the sale of shares then the fund is a back end load fund. Load fund commissions can be substantial (often times as high as 8.5%). A no-load fund is a mutual fund that does not charge either a front end or back end load for the purchase or sale of its shares. All other things equal, this should provide the investor in no-load funds with an advantage. 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 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. There is no trading in the portfolios, so the returns, or
  2. 2. yields, are fixed and fairly predictable and management fees are low. Various sponsoring brokerage houses put these diversified pools of investments together and then sell "units" to investors. A back end load fund charges a (redemption fee) commission when the investor sells the funds shares back to 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 that keeps the load charge low, usually less than 3% to 4%. A hidden load is a term used to describe a 12(b)-1 fee charged by the fund. You should carefully read the fund's prospectus to determine the what kinds of fees are charged, what levels of fees are charged and when those charges are applied. The fund's fee structure and expenses are required by law to be disclosed in a fee table at the front of the fund's prospectus. 4. What is a 12(b)-1 distribution fee? 12(b)-1 fees are charged by some funds to compensate investment professionals for selling and promoting mutual funds. Some funds charge 12b-1 fees to pay for distribution and marketing expenses. Funds may not charge more than 0.75% of average net assets per year for distribution and marketing. A fund may also charge a service fee of up to 0.25% of average net assets per year to compensate sales professionals for providing services or maintaining shareholder accounts. These service fees can be in the fund's 12b-1 fee; thus, 12b-1 fees can be up to 1.0% . Funds that charge 12b-1 fees above 0.25% may not call themselves no-load funds. 5. What is a mutual fund’s expense ratio? Expenses represent the costs of doing business. They include everything from the advisory fee paid to the mutual fund manager to the administrative costs such as printing and postage. The expense ratio expresses Annual Expenses as a percentage of the fund's average net assets under management. Published mutual fund returns are usually calculated net of annual expenses but investors should always be aware of what they are. Evidence suggests that low expense funds are more likely to out-perform high expense funds over the long term. Recently the average expense ratio for domestic equity funds was approximately 1.4%. For fixed income funds it was about 1.1%. International funds have higher expense ratios, averaging around 1.9%. 6. What is a mutual fund’s investment advisory fee or management fee? The amount that the fund pays to the investment adviser for managing the fund's portfolio or providing other services, such as maintaining shareholder records or furnishing shareholder statements and reports. These fees are reflected in the fund's share price and are not charged directly to the shareholder. The management fee usually ranges from 0.5% to 1% of the fund's total asset value but may be higher for specialized funds. 7. What is a fund’s administrative costs? The operating costs and expenses of the fund, including (but not limited to) costs of maintaining records and furnishing statements and reports, including postage and printing. 8. What is a fund’s turnover rate? The rate at which the fund's portfolio securities are changed each year. If a fund's assets total $100 million and the fund bought and sold $100 million worth of securities that year, its portfolio turnover rate would be 100%. Aggressively managed funds generally have higher portfolio turnover rates than do conservative funds which invest for the long term. High portfolio turnover rates generally add to the expenses of a fund. 6. Describe:
  3. 3. Growth funds have two primary objectives - capital gains and long-term capital growth. These are viewed as long-term investment vehicles for moderately aggressive investors who want to accumulate wealth. Aggressive growth funds (performance) funds are highly speculative funds that seek high returns from capital gains. They suit the more aggressive investors who are willing to accept high risk. These funds tend to be small and their portfolios consist of speculative common stocks. These funds tend to have high betas....their returns tend to be significantly more volatile than the overall market. Equity-income funds have, as their primary objective, current income from interest and/or dividends and capital preservation. They invest primarily in high-yielding stocks and tend to be more conservative and possess only a modest level of risk. Balanced funds seek income and long-term capital gains and have more fixed-income securities than do equity-income funds. Growth and income funds seek both long-term growth and current income with primary emphasis on capital gains. Bond funds are designed to generate income through investment in fixed-income securities. They may consist of government, corporate (straight and convertible), or municipal securities. They are all subject to interest rate risk. Money market mutual funds (MMMF) are relatively new - since 1972 - and offer ownership in a portfolio of short-term securities. These are very low risk funds. Index funds buy stocks (or bonds)in the same proportion as a leading index. They have a low management fee, and generally produce highly competitive returns. Sector funds tend to limit their holdings to one or more segments (industries) of the market. For example, technology firms, healthcare firms, banking firms, etc. Socially-responsible funds acquire securities from firms that meet the fund's explicit considerations of moral, ethical, or environmental issues. Asset allocation funds spread investors' funds across stocks, bonds and money market securities. These funds are designed for people who want to hire fund managers not only to select individual securities for them but also to make the strategic decision of how to allocate money among various sectors. International funds buy securities of foreign firms. A variant, the global fund, would also include US stocks. 7. If growth and income, and capital preservation are the primary objectives of mutual funds, why do we bother to categorize them by type? Are these classifications helpful to investors in the mutual fund selection process? 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.
  4. 4. 8. Briefly describe some of the most important services provided by mutual funds. What are automatic reinvestment plans, and how do they differ from automatic investment plans? Mutual funds offer a variety of services to investors. These include: savings and automatic reinvestment plans: Investors are provided a way to accumulate capital and have returns systematically an automatically reinvested for the long term (at little or no cost); Withdrawal plans: Investors receive regular payments from the investment climate changes and/or 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 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 individuals 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 fund family). 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. 9. What are the basic steps that GJ suggest that a mutual fund investor should follow in selecting among mutual fund investments? First, examine what is required of a fund: 1. investment objectives, such as required return and the amount of risk an investor can accept, may limit fund selection. 1. The intended use of the fund should reduce the set of possible funds. 1. Availability of services should also be considered in the first step. Second, what does each fund off? 1. Funds have specific investment objectives. 1. Each fund has its own manner of operation. 1. Each fund has its own range of services 1. Performance reports on mutual funds are available from the Wall Street Journal, Forbes, Business Week, Barron's, and other sources. 1. Specialized mutual fund information sources include Morningstar's Mutual Fund Values, Lipper Analytical Services, ValueLine, and Kiplinger's Individual Mutual Fund Reports. A small set of funds which have objectives, performance, and services that are consistent with the investor's requirements can be identified. The final step should be one of elimination, cost comparison and performance. 1. Returns over time and performance in good and bad markets should be considered. 1. Total expense ratio, which includes load fees, if any, fund-related fees, and any 12b-1 fee.
  5. 5. 1. The level of dividend and capital gains distributions as well as investment stability should be considered. Stability can be ascertained by looking at the turnover ratio of the fund. 10. Explain why open-end mutual funds sell at NAV while most closed-end mutual funds sell at a discount to NAV? Find the price of a share and NAV of the closed-end fund run by Warren Buffet know as Berkshire Hathaway. On what market is it listed? Find the NAV of the well known open-end fund known as Fidelity Magellan. NAV (net asset value) is the current market value of all the fund's assets, minus liabilities, divided by the total number of outstanding shares. For example, suppose that the market value, in dollars, of a fund's assets is $6m. Further, suppose the funds liabilities are $60,000 and the number of shares outstanding is 500,000. Then NAV = {($6,000,000 - $60,000)/ 500,000} = $11.88 On average, closed-end funds tend to sell at a share price that is a discount to NAV. The reason(s) for this are not known with certainty but this phenomena has been attributed to the potential for reduced liquidity on closed-fund shares. 11. Identify three potential sources of return to mutual fund investors and briefly discuss how each could affect total return to shareholders. Explain how the discount or premium to NAV of a closed-end mutual fund can also be treated as a return to investor. There are three sources of return for a mutual fund. These sources of return are (1) dividend income, (2) capital gains distributions, (3) changes in the NAV 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 the price premiums or discount are another source of return. The premium or discount actually affects the market price (or NAV) of the fund and hence investment return - i.e. as discount or premium changes, it affects the changes in NAV and, therefore, total return. 12. Discuss the various types of risk to which mutual fund shareholders are exposed. What is the major risk exposure of mutual funds? Are all funds subject to the same level of risk? Explain the risks that investment in the mutual selected in 9 (a) is exposed to. The major risk for mutual funds is market risk (systematic risk) because a mutual fund is a large, diversified portfolio of securities. 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 the fund management, the greater the potential return and the greater the amount of risk. Moreover, since funds deal in different markets, their risk may not be the same either.