Chapter 04 - Mutual Funds and Other Investment Companies

CHAPTER4:MUTUALFUNDSAND
OTHERINVESTMENTCOMPANIES
PROBLEMSETS
1.

Theunitinvestmenttrustshouldhaveloweroperatingexpenses.Becausetheinvestment
trustportfolioisfixedoncethetrustisestablished,itdoesnothavetopayportfolio
managerstoconstantlymonitorandrebalancetheportfolioasperceivedneedsor
opportunitieschange.Becausetheportfolioisfixed,theunitinvestmenttrustalsoincurs
virtuallynotradingcosts.

2.

a.

Unitinvestmenttrusts:diversificationfromlargescaleinvesting,lowertransaction
costsassociatedwithlargescaletrading,lowmanagementfees,predictable
portfoliocomposition,guaranteedlowportfolioturnoverrate.

b.

Openendmutualfunds:diversificationfromlargescaleinvesting,lower
transactioncostsassociatedwithlargescaletrading,professionalmanagementthat
maybeabletotakeadvantageofbuyorsellopportunitiesastheyarise,record
keeping.

c.

Individualstocksandbonds:Nomanagementfee,realizationofcapitalgainsor
lossescanbecoordinatedwithinvestorspersonaltaxsituations,portfoliocanbe
designedtoinvestorsspecificriskprofile.

3.

Openendfundsareobligatedtoredeeminvestor'ssharesatnetassetvalue,andthus
mustkeepcashorcashequivalentsecuritiesonhandinordertomeetpotential
redemptions.Closedendfundsdonotneedthecashreservesbecausethereareno
redemptionsforclosedendfunds.Investorsinclosedendfundsselltheirshareswhen
theywishtocashout.

4.

Balancedfundskeeprelativelystableproportionsoffundsinvestedineachassetclass.
Theyaremeantasconvenientinstrumentstoprovideparticipationinarangeofasset
classes.Lifecyclefundsarebalancedfundswhoseassetmixgenerallydependsonthe
ageoftheinvestor.Aggressivelifecyclefunds,withlargerinvestmentsinequities,are
marketedtoyoungerinvestors,whileconservativelifecyclefunds,withlarger
investmentsinfixedincomesecurities,aredesignedforolderinvestors.Assetallocation
funds,incontrast,mayvarytheproportionsinvestedineachassetclassbylarge
amountsaspredictionsofrelativeperformanceacrossclassesvary.Assetallocation
fundsthereforeengageinmoreaggressivemarkettiming.
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Chapter 04 - Mutual Funds and Other Investment Companies

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Chapter 04 - Mutual Funds and Other Investment Companies

5.

Theofferingpriceincludesa6%frontendload,orsalescommission,meaningthat
everydollarpaidresultsinonly$0.94goingtowardpurchaseofshares.Therefore:
Offeringprice=

NAV
$10.70

=$11.38
1 load 1 0.06

6.

NAV=offeringprice(1load)=$12.30.95=$11.69

7.

Stock Valueheldbyfund
A
$7,000,000
B
12,000,000
C
8,000,000
D
15,000,000
Total
$42,000,000
Netassetvalue=

8.

Valueofstockssoldandreplaced=$15,000,000
Turnoverrate=

9.

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

$15,000,000
=0.357=35.7%
$42,000,000

$200,000,000 $3,000,000
$39.40
5,000,000

a.

NAV

b.

Premium(ordiscount)=

$36 $39.40
Pr ice NAV
=
=0.086=8.6%
$39.40
NAV

Thefundsellsatan8.6%discountfromNAV.

10.

Rateofreturn=
NAV1 NAV0 distributions $12.10 $12.50 $1.50

0.088 8.8%
NAV0
$12.50

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Chapter 04 - Mutual Funds and Other Investment Companies

11.

a.

Startofyearprice:P0=$12.001.02=$12.24
Endofyearprice:P1=$12.100.93=$11.25
AlthoughNAVincreasedby$0.10,thepriceofthefunddecreasedby:$0.99
Rateofreturn=

b.

P1 P0 Distributions $11.25 $12.24 $1.50

0.042 4.2%
P0
$12.24

Aninvestorholdingthesamesecuritiesasthefundmanagerwouldhaveearneda
rateofreturnbasedontheincreaseintheNAVoftheportfolio:
Rateofreturn=
NAV1 NAV0 distributions $12.10 $12.00 $1.50

0.133 13.3%
NAV0
$12.00

12.

13.

a.

Empiricalresearchindicatesthatpastperformanceofmutualfundsisnothighly
predictiveoffutureperformance,especiallyforbetterperformingfunds.While
theremaybesometendencyforthefundtobeanaboveaverageperformernext
year,itisunlikelytoonceagainbeatop10%performer.

b.

Ontheotherhand,theevidenceismoresuggestiveofatendencyforpoor
performancetopersist.Thistendencyisprobablyrelatedtofundcostsand
turnoverrates.Thusifthefundisamongthepoorestperformers,investorswould
beconcernedthatthepoorperformancewillpersist.

NAV0=$200,000,000/10,000,000=$20
Dividendspershare=$2,000,000/10,000,000=$0.20
NAV1isbasedonthe8%pricegain,lessthe1%12b1fee:
NAV1=$201.08(10.01)=$21.384
Rateofreturn=

14.

$21.384 $20 $0.20

=0.0792=7.92%
$20

Theexcessofpurchasesoversalesmustbeduetonewinflowsintothefund.Therefore,
$400millionofstockpreviouslyheldbythefundwasreplacedbynewholdings.So
turnoveris:$400/$2,200=0.182=18.2%

15. Feespaidtoinvestmentmanagerswere:0.007$2.2billion=$15.4million
Sincethetotalexpenseratiowas1.1%andthemanagementfeewas0.7%,weconclude
that0.4%mustbeforotherexpenses.Therefore,otheradministrativeexpenseswere:
0.004$2.2billion=$8.8million

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Chapter 04 - Mutual Funds and Other Investment Companies

16.

Asaninitialapproximation,yourreturnequalsthereturnonthesharesminusthetotal
oftheexpenseratioandpurchasecosts:12%1.2%4%=6.8%
Buttheprecisereturnislessthanthisbecausethe4%loadispaidupfront,notatthe
endoftheyear.
Topurchasetheshares,youwouldhavehadtoinvest:$20,000/(10.04)=$20,833
Thesharesincreaseinvaluefrom$20,000to:$20,000(1.120.012)=$22,160
Therateofreturnis:($22,160$20,833)/$20,833=6.37%

17.

Supposeyouhave$1,000toinvest.TheinitialinvestmentinClassAsharesis$940net
ofthefrontendload.Afterfouryears,yourportfoliowillbeworth:
$940(1.10)4=$1,376.25
ClassBsharesallowyoutoinvestthefull$1,000,butyourinvestmentperformancenet
of12b1feeswillbeonly9.5%,andyouwillpaya1%backendloadfeeifyousell
afterfouryears.Yourportfoliovalueafterfouryearswillbe:
$1,000(1.095)4=$1,437.66
Afterpayingthebackendloadfee,yourportfoliovaluewillbe:
$1,437.66.99=$1,423.28
ClassBsharesarethebetterchoiceifyourhorizonisfouryears.
Withafifteenyearhorizon,theClassAshareswillbeworth:
$940(1.10)15=$3,926.61
FortheClassBshares,thereisnobackendloadinthiscasesincethehorizonisgreater
thanfiveyears.Therefore,thevalueoftheClassBshareswillbe:
$1,000(1.095)15=$3,901.32
Atthislongerhorizon,ClassBsharesarenolongerthebetterchoice.Theeffectof
ClassB's0.5%12b1feesaccumulatesovertimeandfinallyoverwhelmsthe6%load
chargedtoClassAinvestors.

18.

a.

Aftertwoyears,eachdollarinvestedinafundwitha4%loadandaportfolio
returnequaltorwillgrowto:$0.96(1+r0.005)2
EachdollarinvestedinthebankCDwillgrowto:$11.062
Ifthemutualfundistobethebetterinvestment,thentheportfolioreturn(r)must
satisfy:
0.96(1+r0.005)2>1.062
0.96(1+r0.005)2>1.1236
(1+r0.005)2>1.1704
1+r0.005>1.0819
1+r>1.0869
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Chapter 04 - Mutual Funds and Other Investment Companies

Therefore:r>0.0869=8.69%

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Chapter 04 - Mutual Funds and Other Investment Companies

b.

Ifyouinvestforsixyears,thentheportfolioreturnmustsatisfy:
0.96(1+r0.005)6>1.066=1.4185
(1+r0.005)6>1.4776
1+r0.005>1.0672
1+r>1.0722
r>7.22%
Thecutoffrateofreturnislowerforthesixyearinvestmentbecausethefixed
cost(i.e.,theonetimefrontendload)isspreadoutoveragreaternumberof
years.

c.

Witha12b1feeinsteadofafrontendload,theportfoliomustearnarateof
return(r)thatsatisfies:
1+r0.0050.0075>1.06
Inthiscase,rmustexceed7.25%regardlessoftheinvestmenthorizon.

19.

Theturnoverrateis50%.Thismeansthat,onaverage,50%oftheportfolioissoldand
replacedwithothersecuritieseachyear.Tradingcostsonthesellordersare0.4%and
thebuyorderstoreplacethosesecuritiesentailanother0.4%intradingcosts.Total
tradingcostswillreduceportfolioreturnsby:20.4%0.50=0.4%

20.

Forthebondfund,thefractionofportfolioincomegivenuptofeesis:
0.6%
=0.150=15.0%
4.0%

Fortheequityfund,thefractionofinvestmentearningsgivenuptofeesis:
0.6%
=0.050=5.0%
12.0%

Feesareamuchhigherfractionofexpectedearningsforthebondfund,andtherefore
maybeamoreimportantfactorinselectingthebondfund.
Thismayhelptoexplainwhyunmanagedunitinvestmenttrustsareconcentratedinthe
fixedincomemarket.Theadvantagesofunitinvestmenttrustsarelowturnover,low
tradingcostsandlowmanagementfees.Thisisamoreimportantconcerntobond
marketinvestors.

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Chapter 04 - Mutual Funds and Other Investment Companies

21.

Supposethatfinishinginthetophalfofallportfoliomanagersispurelyluck,andthat
theprobabilityofdoingsoinanyyearisexactly.Thentheprobabilitythatany
particularmanagerwouldfinishinthetophalfofthesamplefiveyearsinarowis()5
=1/32.Wewouldthenexpecttofindthat[350(1/32)]=11managersfinishinthetop
halfforeachofthefiveconsecutiveyears.Thisispreciselywhatwefound.Thus,we
shouldnotconcludethattheconsistentperformanceafterfiveyearsisproofofskill.We
wouldexpecttofindelevenmanagersexhibitingpreciselythislevelof"consistency"
evenifperformanceisduesolelytoluck.

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