CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

PROBLEM SETS 1. Would you expect a typical open-end fixed income mutual fund to have higher or lower expenses than a fixed-income unit investment trust? Why? The unit investment trust should have lower operating expenses. Because the investment trust portfolio is fixed once the trust is established, it does not have to pay portfolio managers to constantly monitor and rebalance the portfolio as perceived needs or opportunities change. Because the portfolio is fixed, the unit investment trust also incurs virtually no trading costs. What are some comparative advantages of investing in the following: a. Unit investment trusts: diversification from large-scale investing, lower transaction costs associated with large-scale trading, low management fees, predictable portfolio composition, guaranteed low portfolio turnover rate. b. Open-end mutual funds: diversification from large-scale investing, lower transaction costs associated with large-scale trading, professional management that may be able to take advantage of buy or sell opportunities as they arise, record keeping. Individual stocks and bonds: No management fee, realization of capital gains or losses can be coordinated with investors personal tax situations; portfolio can be designed to investors specific risk profile.

2.

c.

3.

Open-end equity mutual funds find it necessary to keep a significant percentage of total investments (5% of portfolio) in very liquid money market assets. Closed-end funds do not have to maintain such a position in cash-equivalent securities. What difference between open-end and closed-end funds might account for their differing policies? Open-end funds are obligated to redeem investor's shares at net asset value, and thus must keep cash or cash-equivalent securities on hand in order to meet potential redemptions. Closed-end funds do not need the cash reserves because there are no redemptions for closed-end funds. Investors in closed-end funds sell their shares to other investors when they wish to cash out.

4.

Balanced funds, life-cycle funds and asset allocation funds all invest in both the stock and bond markets. What are the differences among these types of funds? Balanced funds keep relatively stable proportions of funds invested in each asset class. They are meant as convenient instruments to provide participation in a range of asset classes. Life-cycle funds are balanced funds whose asset mix generally depends on the age of the investor. Aggressive life-cycle funds, with larger investments in equities, are marketed to younger investors, while conservative life-cycle funds, with larger investments in fixed-income securities, are designed for older investors. Asset allocation funds, in contrast, may vary the proportions invested in each asset class by large amounts as predictions of relative performance across classes vary. Asset allocation funds therefore engage in more aggressive market timing.
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5.

Why can closed-end funds sell at prices that differ from NAV while open-end funds do not? Unlike an open-end fund, in which underlying shares are redeemed when the fund is redeemed, a closed-end fund trades as a security in the market. Thus, their prices may differ from the NAV.

6.

What are the advantages & disadvantages of ETFs vs mutual funds? Advantages of an ETF over a mutual fund: Can be traded continuously like stocks Can be sold short or purchased on margin No Capital Gains Tax triggered when an ETF is sold (shares are just sold from one investor to another) tax efficient Investors buy from Brokers, thus eliminating the cost of direct marketing to individual small investors. This implies lower management fees lower cost Prices can depart from NAV (unlike an open-end fund) There is a Broker fee when buying and selling (unlike a no-load fund)

Disadvantages of an ETF over a mutual fund: 7.

An open-end fund has a NAV of $10.70 per share. It is sold with a font-end load of 6%. What is the offering price? The offering price includes a 6% front-end load, or sales commission, meaning that every dollar paid results in only $0.94 going toward purchase of shares. Therefore: Offering price =
NAV $10.70 = $11.38 1 load 1 0.06

8.

If the offering price of an open-end fund is $12.30 per share and the fund is sold with a frontend load of 5%, what is the NAV? NAV = offering price (1 load) = $12.30 .95 = $11.69 The composition of the Fingroup Fund portfolio is as follows: Stock A 200,000 shares at $35 each Stock B 300,000 shares at $40 Stock C 400,000 shares at $20 Stock D 600,000 shares at $25 The fund has not borrowed any funds but its accrued management fee with the portfolio manager currently totals $30,000. There are 4 million shares outstanding. What is the net asset value of the fund? Stock Value held by fund A $ 7,000,000 B 12,000,000 C 8,000,000
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D Total

15,000,000 $42,000,000
$42 ,000 ,000 $30 ,000 = $10.49 4,000 ,000

Net asset value = 10.

Reconsider the Fingroup Fund in the previous problem. If during the year, the portfolio manager sells all of the holdings of stock D and replaces it with 200,000 shares of stock E at $50 per share and 200,000 shares of stock F at $25 per share, what is the portfolio turnover rate? Value of stocks sold and replaced = $15,000,000 Turnover rate =
$15,000 ,000 = 0.357 = 35.7% $42 ,000 ,000

11.

The Closed Fund is a closed-end investment company with a portfolio currently worth $200 million. It has liabilities of $3 million and 5 million shares outstanding. What is the NAV of the fund? $200 ,000 ,000 $3,000 ,000 NAV $39 .40 a. 5,000 ,000 If the fund sells for $36 per share, what is the premium or discount as a percent of NAV? $36 $39.40 Pr ice NAV b. Premium (or discount) = = = 0.086 = -8.6% $39.40 NAV The fund sells at an 8.6% discount from NAV.

12.

Corporate Fund started the year with a NAV of $12.50. By year-end, its NAV equaled $12.10. The fund paid year-end distributions of income and capital gains of $1.50. What was the (pretax) rate of return to an investor in the fund?
NAV1 NAV0 Distributions $12.10 $12.50 $1.50 0.088 8.8% NAV0 $12.50

13.

A close-end fund starts the year with a NAV of $12.00. By year-end, NAV equals $12.10. At the beginning of the year, the fund was selling at a 2% premium to NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end distributions of income and capital gains of $1.50. What is the rate of return to an investor in the fund during the year? a. Start-of-year price: P0 = $12.00 1.02 = $12.24 End-of-year price: P1 = $12.10 0.93 = $11.25 Although NAV increased by $0.10, the price of the fund decreased by: $0.99
P $11.25 $12.24 $1.50 1 P 0 Distributions 0.042 4.2% P0 $12.24 What would have been the rate of return to an investor who held the same securities as the fund manager during the year?

Rate of return =

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CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

b.

An investor holding the same securities as the fund manager would have earned a rate of return based on the increase in the NAV of the portfolio:
NAV1 NAV0 Distributions $12.10 $12.00 $1.50 0.133 13.3% NAV0 $12.00

14.

Impressive Fund had excellent investment performance last year, with portfolio returns that placed it top 10% of all funds with the same investment policy. Do you expect it to be a top performer next year? Why or why not? a. Empirical research indicates that past performance of mutual funds is not highly predictive of future performance, especially for better-performing funds. While there may be some tendency for the fund to be an above average performer next year, it is unlikely to once again be a top 10% performer. Suppose instead that the fund was among the poorest performers in its comparison group. Would you be more or less likely to believe its relative performance will persist into the following year? Why? b. On the other hand, the evidence is more suggestive of a tendency for poor performance to persist. This tendency is probably related to fund costs and turnover rates. Thus if the fund is among the poorest performers, investors would be concerned that the poor performance will persist. Consider a mutual fund with $200 million in assets at the start of the year and with 10 million shares outstanding. The fund invests in a portfolio of stocks that provides dividend income at the end of the year of $2 million. The stocks included in the funds portfolio increase in price by 8%, but no securities are sold, and there are no capital gains distributions. The fund charges 12b-1 fees of 1%, which are deducted from portfolio assets at year-end. What is NAV at the start and end of the year? NAV0 = $200,000,000/10,000,000 = $20 Dividends per share = $2,000,000/10,000,000 = $0.20 NAV1 is based on the 8% price gain, less the 1% 12b-1 fee: NAV1 = $20 1.08 (1 0.01) = $21.384 What is the rate of return for an investor in the fund? $21.384 $20 $0.20 Rate of return = = 0.0792 = 7.92% $20

15.

16.

The New Fund has average daily assets of $2.2 billion last year. The fund sold $400 million worth of stock and purchased $600 million during the year. What was its turnover ratio? The excess of purchases over sales must be due to new inflows into the fund. Therefore, $400 million of stock previously held by the fund was replaced by new holdings. Turnover ratio: $400/$2,200 = 0.182 = 18.2% New Funds expense ratio was 1.1% and management fee was 0.7%, what were the total fees paid to the funds managers during the year? What were other administrative expenses? Fees paid to investment managers were: 0.007 $2.2 billion = $15.4 million
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CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

Since the total expense ratio was 1.1% and the management fee was 0.7%, we conclude that 0.4% must be for other expenses. Therefore, other administrative expenses were: 0.004 $2.2 billion = $8.8 million 18. You purchased 1,000 shares of the New Fund at a price of $20 per share at the beginning of the year. You paid a front-end load of 4%. The securities in which the fund invests increase in value by 12% during the year. The funds expense ratio is 1.2%. What is your rate of return on the fund if you sell your shares at the end of the year? As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs: 12% 1.2% 4% = 6.8% But the precise return is less than this because the 4% load is paid up front, not at the end of the year. To purchase the shares, you would have had to invest: $20,000/(1 0.04) = $20,833 The shares increase in value from $20,000 to: $20,000 (1.12 0.012) = $22,160 The rate of return is: ($22,160 $20,833)/$20,833 = 6.37% 19. Loaded-Up Fund charges a 12b-1 fee of 1% and maintains an expense ratio of .75%. Economy fund charges a front-end load of 2% but has no 12b-1 fee and an expense ratio of .25%. Assume the rate of return on both funds portfolios (before any fees) is 6% per year. How much will an investment in each fund grow to after: 1 year, 3 years and 10 years? Assume $1000 investment Yearly Growth 1 Year (@ 6%) 3 Years (@ 6%) 10 Years (@ 6%) Loaded-Up Fund
(1 r .01 .0075)

Economy Fund
(.98) (1 r .0025)

$1,042.50 $1,133.00 $1,516.21

$1,036.35 $1,158.96 $1,714.08

20.

City Street Fund has a portfolio of $450 million and liabilities of $10 million. If 44 million shares outstanding, what is NAV? $450, 000, 000 $10, 000000 $10 a. 44, 000, 000 If a large investor redeems 1 million shares, what happens to the portfolio value to shares outstanding, and to NAV? b. The redemption of 1 million shares will most likely trigger capital gains taxes which will lower the remaining portfolio by an amount greater than $10,000,000 (implying a remaining total value less than $440,000,000). The outstanding shares fall to 43 million and the NAV drops to below $10.

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21.

The Investment Fund sells Class A shares with a front-end load at 6% and Class B shares with 12b-1 fees at 0.5% annually as well as back-end load fees that start at 5% and fall by 1% for each full year the investor holds the portfolio (until the 5th year). Assume that the portfolio rate of return net of the operating expenses is 10% annually. If you plan to sell the fund after 4 years, are Class A or Class B shares the better choice for you? Suppose you have $1,000 to invest. The initial investment in Class A shares is $940 net of the frontend load. After four years, your portfolio will be worth: $940 (1.10)4 = $1,376.25 Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end load fee if you sell after four years. Your portfolio value after four years will be: $1,000 (1.095)4 = $1,437.66 After paying the back-end load fee, your portfolio value will be: $1,437.66 .99 = $1,423.28 Class B shares are the better choice if your horizon is 4 years. What if you plan to sell after 15 years? With a 15-year horizon, the Class A shares will be worth: $940 (1.10)15 = $3,926.61 For the Class B shares, there is no back-end load in this case since the horizon is greater than five years. Therefore, the value of the Class B shares will be: $1,000 (1.095)15 = $3,901.32 At this longer horizon, Class B shares are no longer the better choice. The effect of Class B's 0.5% 12b-1 fees accumulates over time and finally overwhelms the 6% load charged to Class A investors.

21.

You are considering an investment in a mutual fund with a 4% load and expense ratio of 0.5%. You can invest instead in a bank CD paying 6% interest. If you plan you invest for 2 years, what annual rate of return must the fund portfolio earn for you to be better off in the fund than in the CD? Assume annual compounding of returns. How does your answer change if you plan to invest for 6 years? Why does your answer change? a. After two years, each dollar invested in a fund with a 4% load and a portfolio return equal to r will grow to: $0.96 (1 + r 0.005)2 Each dollar invested in the bank CD will grow to: $1 1.062 If the mutual fund is to be the better investment, then the portfolio return (r) must satisfy: 0.96 (1 + r 0.005)2 > 1.062 0.96 (1 + r 0.005)2 > 1.1236 (1 + r 0.005)2 > 1.1704 1 + r 0.005 > 1.0819 1 + r > 1.0869 Therefore: r > 0.0869 = 8.69%
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CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

Now suppose that instead of a front-end load the fund assesses a 12b-1 fee of 0.75% per year. What annual rate of return must the fund portfolio earn for you to be better off in the fund than in the CD? b. If you invest for six years, then the portfolio return must satisfy: 0.96 (1 + r 0.005)6 > 1.066 = 1.4185 (1 + r 0.005)6 > 1.4776 1 + r 0.005 > 1.0672 r > 7.22% The cutoff rate of return is lower for the six-year investment because the fixed cost (the onetime front-end load) is spread over a greater number of years. Does your answer in this case depend on your time horizon? c. With a 12b-1 fee instead of a front-end load, the portfolio must earn a rate of return (r) that satisfies: 1 + r 0.005 0.0075 > 1.06 In this case, r must exceed 7.25% regardless of the investment horizon. 23. Suppose that every time a fund manager trades stock, transaction costs such as commissions and bid-ask spreads amount to 0.4% of the value of the trade. If the portfolio turnover rate is 50%, by how much is the total return of the portfolio reduced by trading costs? The turnover rate is 50%. This means that, on average, 50% of the portfolio is sold and replaced with other securities each year. Trading costs on the sell orders are 0.4% and the buy orders to replace those securities entail another 0.4% in trading costs. Total trading costs will reduce portfolio returns by: 2 0.4% 0.50 = 0.4% 24. You expect a tax-free municipal bond portfolio to provide a rate of return of 4%. Management fee of the fund are 0.6%. What fraction of portfolio income is given up to fees? For the bond fund, the fraction of portfolio income given up to fees is:
0.6% = 0.150 = 15.0% 4.0%

If the management fees for an equity fund also are 0.6% but you expect a portfolio return of 12%, what fraction of portfolio income is given up to fees? For the equity fund, the fraction of investment earnings given up to fees is:
0 .6 % = 0.050 = 5.0% 12.0%

Why might management fees be a bigger factor in your investment decision for bond funds than for stock fund? Fees are a much higher fraction of expected earnings for the bond fund, and therefore may be a more important factor in selecting the bond fund.
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CHAPTER 4: MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES

Can your conclusion help explain why unmanaged unit investment trusts tend to focus on the fixed-income market? This may help to explain why unmanaged unit investment trusts are concentrated in the fixed income market. The advantages of unit investment trusts are low turnover, low trading costs and low management fees. This is a more important concern to bond-market investors.

25.

Suppose you observe the investment performance of 350 portfolio managers for 5 years and rank them by investment returns during each year. After 5 years, you find that 11 of the funds have investment returns that place the funds in the top half of the sample in each and every year of your sample. Such consistency of performance indicates to you that these must be funds whose managers are in fact skilled, and you invest your money in these funds. Is your conclusion warranted? Suppose that finishing in the top half of all portfolio managers is purely luck, and that the probability of doing so in any year is exactly . Then the probability that any particular manager would finish in the top half of the sample five years in a row is ()5 = 1/32. We would then expect to find that [350 (1/32)] = 11 managers finish in the top half for each of the five consecutive years. This is precisely what we found. Thus, we should not conclude that the consistent performance after five years is proof of skill. We would expect to find eleven managers exhibiting precisely this level of "consistency" even if performance is due solely to luck.

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