CHAPTER 6 INVESTMENT COMPANIES: MUTUAL FUNDS

Teaching Guides for Questions and Problems in the Text

QUESTIONS 1. 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. 2. 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.) 3. 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 capitalizations (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 70

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. 4. 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. 5. 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 funds 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.) 6. 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 71

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.) 7. 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 underperform) the market, but those funds rarely achieve success on a consistent basis (i.e., over an extended period of time). 8. 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.) 9. 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. 10. Beta coefficients are used an 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 72

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. 11. This question asks the student to review the important concept that absolute returns should not necessarily be compared since a higher return is associated with additional risk. While a higher return may be desirable, the investor must determine if the additional return is worth the additional risk. 12. 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.

PROBLEMS 1. Assets Liabilities Equity $10,000,000 790,000 $ 9,210,000

Net asset value (per share): $9,210,000/1,200,000 = $7.68

2.

Load fee:

$25 - $23.40 = $1.60

Load fee as a percent of net asset value: $1.60/$23.40 = 6.8% 73

3. The investor earned $13.20 on an investment of $31.40 for a percentage gain of 42.0 percent. The exit fee reduces the terminal value by $0.45 to $44.15, so the net gain is $12.75, and the percentage return 40.6 percent. Notice that the 1 percent exit fee applies to the total value and not the gain so that the percentage increase is reduced by more than 1 percent.

4. The investor received $0.58 and experienced appreciation of $3.41 ($23.41 - $20) for a total gain of $3.99. On an investment of $20, the return (for one year) is $3.99/$20 = 19.96%. 5. The problem shows the impact of various fees on the final value of an investment in a fund. In each part, the amount invested is $3,000; the return is 10 percent, and the number of years is 20 years. a. The future value is $3,000(57.275) = $171,825. (PV = 0; PMT = 3000; N = 20, and I = 10. FV = ? = 171,825.)

b. The future value is $2,850(57.275) = $163,234. (PV = 0; PMT = 2850; N = 20, and I = 10. FV = ? = 163,234.)

c. The future value is $3,000(51.160) = $153,480. (PV = 0; PMT = 3000; N = 20, and I = 9. FV = ? = 153,480.) Notice that the fund earns 10 percent before the fees, but you net 9 percent.)

d. The future value is $3,000(57.275) = $171,825. However, you only net 0.95 percent after the exit fee, so the final amount is $163,234. (PV = 0; PMT = 3000; N = 20, and I = 10. FV = ? = 171,825, and (1.00 -0.05) x 171,825 = 163,234.) 74

Notice that the load fee and the exit fee produce the same terminal value if their percentages are the same. Also notice that the 12b-1 fee has more impact because it is paid EVERY year while the load and exit fees are paid only once.

6. a. Without adjusting for risk, the performance ranking is B, E, A, C, and D. The Treynor index for each fund is Fund A B C D E Risk-adjusted return (Treynor Index) 12.4/1.14 = 10.88 13.2/1.22 = 10.82 11.4/0.90 = 12.67 9.8/0.76 = 12.89 12.6/0.95 = 13.25

On a risk-adjusted basis the ranking is E, D, C, A, and B. Fund B had the largest absolute return, but on a riskadjusted basis, it was the worst performer. During the time period the S&P index achieved 10.5 percent over the risk-free rate, so the Treynor index for the market would be 10.5/1 = 10.5. If a fund's score exceeds 10.5, that fund outperformed the market on a risk-adjusted basis. In this problem all five of the funds outperformed the market. Failure to make the risk adjustment would imply that Fund D achieved an inferior performance because its return was less than the market return. However, D's performance was not inferior if its lower level of risk is taken into consideration. b. The preceding risk adjustment used beta coefficients. If the standard deviations of return had been used, the risk adjusted ranking would be Fund A B C D E Risk adjustment (Sharpe Index) 12.4/4.5 = 2.76 13.2/3.1 = 4.26 11.4/1.0 = 11.4 9.8/1.4 = 7.00 12.6/3.5 = 3.60

The risk-adjusted performance ranking is C, D, B, E, and A. The small standard deviation for portfolio C results in its having the best risk-adjusted performance. To illustrate the importance of the risk adjustment, you may ask the students which they would prefer: a return of 12.4 percent which could 75

range from 16.9 percent to 7.9 percent for approximately 68 percent of the time versus 11.4 percent with a range of 12.4 percent to 10.4 percent for approximately 68 percent of the time. While the former could generate a high return, there is a real possibility that it will generate a lower absolute return. The Sharpe index for the market is 10.5/1.0 = 10.5, so any fund that has a score in excess of 10.5 outperforms the market on a risk-adjusted basis. Only fund C has a score greater than 10.5, so it is the only fund that outperformed the market using the Sharpe index. (You may want to point out that the two indices may not produce in the same ranking, especially if the portfolios are not well diversified in which case the Sharpe index is the better method because it uses total risk and not just systematic risk.)

76

Teaching Guides for Financial Advisors Case: Retirement Plans and Investment Choices This problem uses a tax deferred 401(k) pension plan as the basis for considering the choice among different types of mutual funds. Many companies with 401(k) plans offer a similar variety of investment vehicles, so that a new hire would be faced with having to make this type of decision. 1. This first question illustrates the large amount to which a modest amount will grow over an extended time period. Bozena's contribution Company's match Total contribution $1,600 $800 $2,400

PMT = -2400; N = 45; I = 10; PV = 0; FV = ? = 1725371.61. The terminal value is $1,725,371.61. The interest table for the future value of an annuity does not have 45 years. An alternative means to solve the problem is to compute the interest factor. FVAIF = (1 + i)n - 1 = (1 + .1)45 - 1 = 718.905 i .1 The next step is $2,400 X 718.905 = $1,725,372.

2. If Bozena does not participate in the 401(k) but saves $1,600 annually, she will have considerably less because (1) she does not get the matching funds and (2) her earnings are taxed. Unless she pays the tax obligation from another source of funds, she nets only 8 percent annually. The terminal value is reduced to $618,408.99. (PMT = -1600; N = 45; I = 8; PV = 0; FV = ? = 618408.99.) or FVAIF = (1 + i)n - 1 = (1 + .08)45 - 1 = 386.506 i .08

and $1,600 X 386.506 = $618,409.60.

3. In this question Bozena withdraws the funds from the accounts. In the case of the 401(k), the annual withdrawal is $1,725,372 = X(Interest factor for the present value of 77

an annuity at 10 percent for twenty years) = X(8.514) X = 202,651 (N = 20; I = 10; FV = 0; PV = 1725372; PMT = -202661.55.) After taxes of $40,530, she nets $202,651 - 40,530 = $162,121. In the case of the funds outside the 401(k) she withdraws less because she has accumulated less and she continues to earn less even after adjusting for taxes. The annual withdrawal is $618,409 = X(Interest factor for the present value of an annuity at 8 percent for twenty years) = X(9.818) X = $62,987 (N = 20; I = 8; FV = 0; PV = 618409; PMT = -62986.) She nets the entire $62,987 because the taxes have already been paid. The difference between the two withdrawals is about $100,000 annually.

4. If her salary grows, the amount in the account will also grow. The easiest way to work this problem may be to set up the following spreadsheet using a financial calculator. Years 1-5 6-10 Salary $32,000 37,000 Contribution $2,400 2,775 N = 5 5 I = 10 10 PV = 0 -14652 PMT = -2400 -2775 FV = 14652 40539 11-15 42,000 3,150 5 10 -40539 -3150 84520 16-20 21-25 47,000 52,000 3,525 3,525 5 5 10 10 -84520 -157641 -3150 -3525 157641 277692

Years 26-30 31-35 36-40 41-45 Salary $57,000 62,000 67,000 72,000 Contribution $4,272 4,650 5,025 5,400 N = 5 5 5 5 I = 10 10 10 10 PV = -277692 -473325 -790683 -1304081 PMT = -4272 -4650 -5025 -5400 FV = 473325 790683 1303081 2133203 The amount in the account now exceeds two million ($2,133,203).

78

5. The historic returns for each fund are given. If it is assumed that historic returns forecast future returns, then the global fund offers the highest return and the money fund offers the smallest return. The risk associated with each fund is also given. The standard deviation of the returns measures the dispersion around the average return. The money fund's return is virtually assured as there is almost no variability while the global fund's return has ranged from +55% to -25% for 68 percent of the time periods. The beta coefficient gives the volatility of the fund's return relative to some index of the market. (The beta is an index of systematic risk). Since the money fund is independent of the market return, its beta is zero. The Research and Technology fund has a beta of 1.1, which indicates that it is slightly more volatile than the market. The coefficient of determination (the R squared) indicates a close relationship between this fund and the market. The smaller the R squared, the more unsystematic risk (i.e., diversifiable risk) the investor is bearing.

6. Bozena bears the reinvestment risk and the risk associated with the capacity of the funds to generate income. Her employer does not guarantee the returns or the amount of her pension.

7. Bozena's father participants in a defined benefit pension plan, in which the firm guarantees a specified pension. His employer bears the risk associated with the returns earned by the assets to fund the plan. (This is an important distinction, especially since many firms are terminating defined benefit plans and substituting defined contribution plans.) The risk he bears is that the company will adequately fund the plan.

8. Since Bozena is young, she should invest in the funds offering the highest return, so she should exclude the money fund and the government bond fund. An argument could be made for virtually any combination of the remaining four funds. The high yield fund has earned a lower return than the research and technology fund and experienced more variability in its return. This argues for excluding the high yield fund. 79

However, its beta is lower, and its inclusion may help diversify the portfolio.

80