Econ 133 CH 4

1. What are the benefits to small investors of investing via mutual funds (6)? What are the costs (4)?

1. Mutual funds offer many benefits. Some of those benefits include: the ability to invest with small amounts of money, diversification, professional management, low transaction costs, tax benefits, and the ability to reduce administrative functions. The costs associated with investing in mutual funds are generally operating expenses, marketing, distribution charges, and loads. Loads are fees paid when investors purchase or sell the shares.

10. Open-end equity mutual funds find it necessary to keep a significant percentage of total investments, typically around 5% of the 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?

10. Open-end funds must honor redemptions and receive deposits from investors. This flow of money necessitates retaining cash. Close-end funds no longer take and receive money from investors. As such, they are free to be fully invested at all times.

11. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of 6%. What is the offering price? (LO 4-3)

11. The offering price includes a 6% front-end load, or sales commission, meaning that every dollar paid results in only $0.94 going toward the purchase of shares. Therefore: Offering price = NAV/(1-load)= ($10.70)/(1-0.06) = $11.38

13. The composition of the Fingroup Fund portfolio is as follows: Stock Shares Price A 200,000 $35 B 300,000 40 C 400,000 20 D 600,000 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? (LO 4-3)

13. Given that net asset value equals assets minus liabilities expressed on a per-share basis, we first add up the value of the shares to get the market value of the portfolio: Stock Value Held by Fund A $ 7,000,000 B 12,000,000 C 8,000,000 D 15,000,000 Total $42,000,000 Knowing that the accrued management fee, which adjusts the value of the portfolio, totals $30,000, and the number of the shares outstanding is 4,000,000, we can use the NAV equation: Net asset value = "Market value of assets － Market value of liabilities" /"Shares outstanding" = ($42,000,000- $30,000)/($4,000,000)= $10.49

15. 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. (LO 4-3) a. What is the NAV of the fund? b. If the fund sells for $36 per share, what is its premium or discount as a percent of NAV?

15 NAV = "Market value of assets － Market value of liabilities" /"Shares outstanding" = "$200,000,000－ $3,000,000" /"5,000,000" = $39.40 Premium (or discount) = = = -0.0863 = -8.63% The fund sells at an 8.63% discount from NAV.

16. Corporate Fund started the year with a net asset value 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 rate of return to an investor in the fund?

16. Given the NAV at the beginning and the end of the period, and the distributions during the period, we can use the equation below to solve for the rate of return of the Corporate Fund: Rate of return = "Δ(NAV) ＋ Distributions" /"Start of year NAV" = = 0.0880 = 8.80%

18. 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: (LO 4-5) a. 1 year? b. 3 years? c. 10 years?

18. Assume a hypothetical investment of $100. The end value of the investment will be equal to I × (1 - front-end load) × (1 + r - true expense ratio)T Loaded-Up: We add the 12b-1 fee to the operating expenses to obtain the true expense ratio: Expense ratio + (12b-1 fee) = 1% + 0.75% = 1.75% a. Year 1 = $100 (1 + 0.06 - 0.0175) = $104.25 b. Year 3 = $100 (1 + 0.06 - 0.0175)3 = $113.30 c. Year 10 = $100 (1 + 0.06 - 0.0175)10 = $151.62 Economy fund: a. Year 1 = $100 0.98 (1 + 0.06 - 0.0025) = $103.64 b. Year 3 = $100 0.98 (1 + 0.06 - 0.0025)3 = $115.90 c. Year 10 = $100 0.98 (1 + 0.06 - 0.0025)10 = $171.41

19. City Street Fund has a portfolio of $450 million and liabilities of $10 million. (LO 4-3) a. If there are 44 million shares outstanding, what is net asset value? b. If a large investor redeems 1 million shares, what happens to the portfolio value, to shares outstanding, and to NAV?

19 NAV = "Market value of assets － Market value of liabilities" /"Shares outstanding" = "$450,000,000 － $10,000,000" /"44,000,000" = $10 Because 1 million shares are redeemed at NAV = $10, the value of the portfolio decreases to: Portfolio value = $450million - ($10 × 1million) = $440million The number of shares outstanding will be the current shares outstanding minus the number of shares redeemed: 44million - 1million = 43million. Thus, net asset value after the redemption will be: NAV = "Market value of assets － Market value of liabilities" /"Shares outstanding" = "$440,000,000 － $10,000,000" /"43,000,000" = $10

21. 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 fund's 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 net asset value at the start and end of the year? What is the rate of return for an investor in the fund?

21 Start of year NAV = "Market value of assets － Market value of liabilities" /"Shares outstanding" = "$200,000,000 " /"10,000,000" = $20 End of year NAV is based on the 8% price gain, less the 1% 12b-1 fee: End of year NAV = $20 1.08 (1 - 0.01) = $21.384 Given the dividends per share is $0.20, we can calculate the rate of return using the following equation: Rate of return = "Δ(NAV) ＋ Distributions" /"Start of year NAV" = = 0.0792 = 7.92%

25. The Investments Fund sells Class A shares with a front-end load of 6% and Class B shares with 12b-1 fees of .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 fifth year). Assume the portfolio rate of return net of operating expenses is 10% annually. If you plan to sell the fund after four years, are Class A or Class B shares the better choice for you? What if you plan to sell after 15 years?

25. Suppose you have $1000 to invest. The initial investment in Class A shares is $940 net of the front-end load. After 4 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 4 years. Your portfolio value after 4 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. 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 5 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 cumulates over time and finally overwhelms the 6% load charged to Class A investors.

29. Why would it be challenging to properly compare the performance of an equity fund to a fixed-income mutual fund?

29. Equity funds and fixed-income funds contain different types of securities. Therefore, there are numerous differences that make comparison difficult. Equity funds invest primarily in the common stock of publically traded firms. Fixed-income funds invest in corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds. The risks associated with stocks are primarily related to economic conditions and the success of the business operations. The risks associated with fixed-income securities are primarily interest rate risk and credit risk.

3. What is a 12b-1 fee?

3. 12b-1 fees are annual fees charged by a mutual fund to pay for marketing and distribution costs.

5. What are the advantages and disadvantages of exchange-traded funds versus mutual funds?

5. Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many distributions. They have much lower transaction costs. They also do not require load charges, management fees, and minimum investment amounts. The disadvantage is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF.

7. Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating expenses than a fixed-income unit investment trust? Why?

7. An open-end fund will have higher fees since they are actively marketing and managing their investor base. The fund is always looking for new investors. A unit investment trust need not spend too much time on such matters since investors find each other.

9. What are some comparative advantages of investing your assets in the following: (LO 4-2) a. Unit investment trusts. b. Open-end mutual funds. c. Individual stocks and bonds that you choose for yourself.

9. a. A unit investment trust offers low costs and stable portfolios. Since they do not change their portfolios, investors know exactly what they own. They are better suited to sophisticated investors. b. Open-end mutual funds offer higher levels of service to investors. The investors do not have any administrative burdens and their money is actively managed. These are better suited for less knowledgeable investors. c. Individual securities offer the most sophisticated investors ultimate flexibility. Investors are able to save money since they are only charged the expenses they incur. All decisions are under the control of the investor.