Investments An Introduction, 11thE, Mayo, Ch 6, Questions

Should an investor expect a mutual fund to outperform the market? If not why should the investor buy the shares?

-The investor may want the management of a mutual fund to outperform the market but should not expect it. Securities markets are efficient, and few mutual funds outperform the market consistently. In a given year some do outperform (and under perform) the market, but those funds rarely achieve success on a consistent basis (i.e., over an extended period of time).

Why may the annual growth in a fund's net asset value not be comparable to the return earned by an individual investor?

The growth in a fund's net asset value is one measure of the fund's performance, but the individual investor may not experience the same performance. Loading, exit, and 12b-1 fees reduce the investor's return. Taxes also reduce the return, since the investor must pay taxes on the fund's distributions. Taxes reduce the impact of compounding (i.e., the reinvestment of distributions). Funds, however, report compounded returns using the assumption that the entire distribution is reinvested.

What is a loading charge? Do all investment companies charge this fee?

The loading charge is the sales fee charged by a mutual fund. It is levied when the investor purchases the shares. While load fees vary among the funds and with the amount invested, the fees can be as high as 6.5 percent. Some mutual funds do not have a sales charge, and these are referred to as no‑load funds. (Some funds also have reverse‑load or exit fees.)

What is a specialized mutual fund? What differentiates large and small cap funds? Value funds and growth funds?

-A specialized mutual fund stresses one type of investment (e.g., money market mutual funds), a particular industry (e.g., airlines or utilities), or a special situation fund invests in companies, which may offer considerable potential in the immediate future. -A large cap fund invests in large corporations with large capitalization (i.e., price of the stock times the number of shares outstanding). Such large cap stocks are usually worth in excess of $10 billion. Small cap funds invest in smaller companies ("small cap"). While the definition of what constitutes small cap stock varies, it tends to be between $1 and $5 billion. Obviously these corporations are not that small, and the phrase "small cap" does not denote small, cheap stocks. -Value funds versus growth funds refers to the analysis used to select the funds. Value funds select securities that are considered to be undervalued by whatever analysis used by the portfolio managers (e.g., low P/E ratios or high return on equity). The portfolio managers of growth funds select stocks with large potential for growth in sales, earnings, market share. Often these stocks have high P/E ratios and may not be generating current earnings but offer the possibility of large and rapidly growing earnings in the future. Few stocks would appeal to the portfolio managers of both value and growth funds.

What assets do money market mutual funds acquire? Could an individual investor with $12,345 to invest in a safe, short-term security acquire these assets?

-Money market mutual funds invest in highly liquid short‑term assets, especially commercial paper, treasury bills, negotiable certificates of deposit, and repurchase agreements (REPOs). There is no legal reason why individuals cannot also acquire these assets, but the large denominations preclude most investors. -If a saver has $12,345, that individual is limited by the amount available to invest. Since many short‑term money market instruments are issued in larger denominations, (e.g., commercial paper and negotiable certificates of deposit are issued in minimum amounts of $100,000), this saver cannot buy these money market securities. The individual is limited to certificates of deposit (CDs), savings accounts, and shares in money market mutual funds. (Treasury bills issued in units of $10,000 are also possible.)

What differentiates a traditional savings account at a commercial bank from a money market mutual fund? Are investments in money market funds as safe as savings accounts and certificates of deposit with a commercial bank?

-Savings accounts are issued by depository institutions such as commercial banks. Savings accounts are issued in small amounts and are payable on demand. (Certificates of deposit are time deposits that are issued in specified units (e.g., $1,000) for a specified time period (e.g., two years). Time deposits may be redeemed from the issuing bank, which can charge a penalty for the premature withdrawal.) -Shares of money market mutual funds offer individuals safe, highly liquid investments. The shares are bought from the funds. The individual may withdraw the funds (sell the shares back to the fund) with little risk of loss. One reason for the safety is the frequent turnover of the fund's portfolio as its securities rapidly mature. There is little, if any, interest rate risk. Since only extremely credit worth firms are able to issue the short-term securities purchased by the money market mutual funds, there is little default risk. (There have been virtually no losses generated by money market mutual funds and during 2008, the shares received coverage by FDIC insurance.)

If a portfolio manager earned 15 percent when the market rose by 12 percent, does this prove that the manger outperformed the market?

-This question continues the preceding question by asking how absolute returns may be adjusted for risk. Three methods are considered in the text. One technique, the Jensen measure of performance, subtracts the realized return from the return expected for the amount of risk. If the difference is positive, the return is superior (i.e., outperformed the market). -The other techniques construct indices of performance. The Treynor index subtracts the risk‑free rate from the realized return and divides the difference by the portfolio's beta. The Sharpe index divides the difference by the standard deviation of the portfolio's return. The Treynor and Sharpe indices are similar: the only difference is the denominator. The Treynor index assumes the portfolio is sufficiently diversified that beta is the appropriate measure of risk. The Sharpe index does not make this assumption. Both techniques, however, permit the ranking of performance on a risk‑adjusted basis.

What advantage do "families" of funds offer?

A "family" of funds is a group funds operated by one investment firm (e.g., Vanguard). The various funds offer the individual investor choice such as a money market fund, a growth fund, and a large-cap fund. The fund operator also offers a variety of types of accounts such as IRAs or accounts designed to meet a specified need. The investor may readily move funds between the accounts with minimal (or no) load and exit charges.

What are the differences among loading fees, exit fees, and 12b-1 fees?

A loading fee is a one‑time sales charge levied when the shares of a mutual fund are purchased. The exit fee is a one‑time fee levied when the shares are sold. In some cases exit fees are levied only if the investor sells the shares within a specified time period such as six months or a year. Such fees discourage an investor from liquidating the position soon after acquiring it. -A 12b‑1 fee is an annual charge levied by a mutual fund to cover its marketing (e.g., advertising) expenses. Since a no‑load mutual fund lacks a sales force, it may use other means to attract investors. The expenses associated with such advertising are paid by existing stockholders through 12b‑1 expenses. The fees may also be used to compensate financial planners who direct clients to these no-load funds. (Some load funds also have 12b‑1 fees. The individual should read the prospectus to ascertain the fund's fees.)

How may beta coefficients can be used to standardize returns for risks to permit comparisons of mutual funds performance?

Beta coefficients are used and index of risk and facilitate comparisons of mutual funds' risk-adjusted returns. Funds with beta coefficients greater than 1.0 experience more volatile returns than funds with betas of less than 1.0. Higher beta coefficients are indicative of more systematic, non-diversifiable risk. Beta coefficients are used in the Treynor index to adjust mutual funds' returns for risk, and these risk-adjusted returns are used to compare funds' performance.

Are mutual funds subject to federal income taxation? Are distributions form mutual funds taxable?

Investment companies, which include mutual funds, receive special tax treatment provided they distribute the income they receive and capital gains they realize. Mutual funds collect dividends and interest on their investments and then distribute the income to stockholders. Any applicable taxes are paid by the fund's stockholders as part of the tax on their incomes.