Answers to Chapter 17 Questions 1.

A mutual fund represents a pool of financial resources obtained from individuals and invested in the money and capital markets. It represents another way for those with extra funds to channel those funds to those in need of extra funds. 2. Investing in mutual funds allows an investor to achieve a greater level of diversification than could likely be achieved by investing in individual stock on one's own account. A single share of a mutual fund could represent ownership in over a thousand different companies. Whereas the investment in the mutual fund might cost one hundred dollars, buying over a thousand individual shares of stock could cost over one hundred thousand dollars. Further, since mutual funds can buy and sell securities in large blocks, its trading cost are much lower than those of the individual investor buying a few shares at a time. 3. Money market mutual funds (MMMFs) invest in assets that have maturities of less than one year. These assets primarily are Treasury bills, negotiable certificates of deposit, repurchase agreements, and commercial paper. The growth in MMMFs during the late 1970s and early 1980s occurred because of rising interest rates in the money markets while rates in depository institutions were restricted by Regulation Q. Many investors moved their short-term savings from the depository institutions to the MMMFs as the spread in the earnings rate reached double digits. 4. Long-term mutual funds primarily invest in assets that have maturities of more than one year. The most common assets include long-term fixed-income bonds, common stock, and preferred stocks. Some money market assets are included for liquidity purposes. The growth in these funds in the 1990s and early 2000s reflected the dramatic increase in equity returns. The reduction in transaction costs, and the recognition of diversification benefits achievable through mutual funds. 5. In 2004, 74.3 percent of all mutual fund assets were in long term funds; the remaining funds, or 25.7 percent, were in money market mutual funds. From Table 17-3, the percentage invested in long term versus short term funds can, and has, varied considerably over time. For example, the share of money market funds was 55.2 percent in 1980, 44.8 percent in 1990, 25.8 percent in 1999, 29.0 percent in 2000, and 35.1 percent in 2001. The decline in the growth rate of short term funds and increase in the growth rate of long term funds reflects the increase in equity returns during the period 1980-1999 and the generally low level of short term interest rates over the period. In the early 2000s, as interest rates rose and equity returns fell, growth in money market funds outpaced the growth in long-term funds. Further, despite low interest rates in 2001, the continued drop in equity values resulted in money market fund growth that well outpaced that of long-term funds. In 2003 and 2004, as the U.S. economy recovered and stock values increased, the share of long term funds grew, while money market funds decreased. Money market mutual funds provide an alternative investment opportunity to interest-bearing deposits at commercial banks, which may explain the increase in MMMFs in the 1980s and early 2000s. The net cash flows invested in taxable money market mutual funds and the interest rate spread between MMMFs and the average rate on savings deposits from 1985 through 2001. Both investments are relatively safe and earn short-term returns. The major difference between the two is that interest-bearing deposits (below $100,000) are fully insured by the FDIC but, because of bank regulatory costs (such as reserve requirements, capital adequacy requirements, and FDIC deposit insurance premiums), generally offer lower returns than noninsured MMMFs. Thus, the net gain in switching to MMMFs is a higher return in exchange for the loss of FDIC deposit insurance coverage. Many investors appear willing to give up FDIC insurance coverage to obtain additional returns in the 1980s, early 1990s, and early 2000s.


6. Since the short term funds are more likely to be fixed income securities, the principal type of risk is interest rate risk. This type of risk will be mitigated somewhat by the short term nature of the securities. Long term funds tend to be more equity based. Since these funds are typically fairly well diversified, then the risk could be classified as systematic. In the case of a bond fund, of course there is interest rate risk. A sector or industry fund will be exposed to some unsystematic risk as well. 7. One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, portfolio managers are able to hold well-diversified stocks. In addition, they also can obtain cheaper transactions costs and engage in information, research, and monitoring activities at lower costs. 8. Table 17-5 lists some characteristics of household mutual fund owners. As of 2004, 53.9 million (48.1 percent of) U.S. households owned mutual funds. This was down from 56.3 million (52.0 percent) in 2001. Table 7-5 lists some characteristics of household mutual fund owners as of 2004. Most are long-term owners, with 49 percent making their first purchases before 1990. Forty-nine percent of all mutual fund holders are members of the Baby Boom Generation (born between 1946 and 1964), 23 percent are from the Silent Generation (born before 1946), 24 percent are Generation Xers (born between 1965 and 1976), and 4 percent are Generation Yers (born after 1976). Interestingly, the number of families headed by a person with less than a college degree investing in mutual funds is 43 percent. In 75 percent of married households owning mutual funds, the spouse also worked full- or part-time. The bull markets of the 1990s, the low transaction costs of purchasing mutual fund shares, as well ss the diversification benefits achievable through mutual fund investments are again the likely reasons for these trends. The typical fund-owning household has $48,000 invested in a median number of four mutual funds. Finally, more than a quarter of investors who conducted equity fund transactions used the Internet for some or all of these transactions. This compares to 6 percent in 1998. Notice from Table 7-5, that compared to 1995, 2004 has seen a slight increase in the median age of mutual fund holders (from 44 to 48 years) and a large increase in median household financial assets owned (from $50,000 to $125,000) and median mutual funds assets owned (from $18,000 to $48,000). Further, holdings of equity funds have increased from 73 to 80 percent of all households. 9. In 1998, the SEC adopted a new procedure in which key sections of all fund prospectuses must be written in Aplain@ English instead of legal boiler plate. The idea was to increase the ability of investors to understand the risks related to the investment objectives or profile of a fund. 10. The investor receives the income and dividends paid by the companies, capital gains from the sale of securities by the mutual fund, and capital appreciation of the underlying assets. 11. Net Asset Value (NAV) is the average market value of the mutual fund. The total market value of the fund is determined by summing the total value of each asset in the fund. The value of each asset can be found by multiplying the number of shares of the asset by the corresponding price of the asset. Dividing this total fund value by the number of shares in the mutual fund will give the NAV for the fund. The NAV is calculated at the end of each daily trading session, and thus reflects any adjustments in value cased by (a) changes in value of the underlying assets, (b) dividend distributions of the companies held, or (c) changes in ownership of the fund. This process of daily recalculation of the NAV is called marking-to-market.


12. The dollar return is $1.50 + $2.00 + $2.50 - $2.00 = $4.00. The rate of return is $4/$50 = 8%. 13. Open-ended mutual funds allow shares to be purchased and redeemed according to investor demand. In closed-end funds, the numbers of shares are fixed. If investors need to redeem their shares they sell them to another investor. Closed-end funds tend to be more specialized, such as real estate investment trusts (REITs). 14. a. NAV of Fund A = ($100 x 100 + $50 x 50)/100 = $12,500/100 = $125.00 NAV of Fund B = ($100 x 75 + $50 x 100)/100 = $12,500/100 = $125.00 b. NAV of Fund A = ($100 x 200 + $50 x 50)/100 = $22,500/100 = $225.00 c. NAV of Fund A = ($105 x 100 + $45 x 50)/100 = $12,750/100 = $127.50 Percentage increase in NAV = ($127.50 - $125.00)/ $125.00 = 2% NAV of Fund B = ($105 x 75 + $45 x 100)/100 = $12,375/100 = $123.75 Percentage decrease in NAV = ($123.75 - $125.00)/$125.00 = -1% Thus, the changes in prices lead to different effects. Fund A saw its NAV increase while Fund B saw it decline. The reason is Fund B had more shares that had a price decline than a price increase. 15. a. NAV = ($14 x 200 + $140 x 200)/100 = $30,800/100 = $308 b. NAV = ($18 x 200 + $110 x 200)/100 = $25,600/100 = $256, a decline of 16.88% c. ($18 x 200 + (P) x 200)/100 = $308 Solving for P, we get $136. The maximum decline is $4. 16. It's quite likely that for people in the early years of investing, 20 and 30 year old, they would prefer a fairly aggressive high growth type of fund. As these people mature into their forties and fifties and retirement becomes a bit more imminent, they may switch to a fund with more of a balance between income and growth. In their later years, investors may try to protect their saving by switching to higher yield stock and bond funds. 17. The dollar return is 3 + 4 + 5 - 2 = 10, so the rate of return is 10/100 or 10%. 18. No-load funds generally require a small percentage (or fee) of investable funds to meet fund level marketing and distribution costs. Such annual fees are known as 12b-1 fees after the SEC rule covering such charges. Because these fees, charged to cover fund operating expenses, are paid out of the fund=s assets, investors indirectly bear these expenses. Generally, the longer your holding period, the more you would prefer the load fund since a longer holding period would allow you to spread the cost of the load across more years. Eventually, the annualized cost of the load would be less than the annual 12b-1 fee. 19. The individual invests $20,000 in a load mutual fund with a load fee of 2.5 percent of the amount invested which is deducted from the original funds invested. Thus, the individual=s actual investment, after the load fee is deducted, is: $20,000 (1 - .025) = $19,500. Investments in the fund return 7 percent each year paid on the last day of the year. Thus, after one year his operating fees deducted and the value of his investment are:


Annual operating expenses = average net asset value Ηannual operating expenses= ($19,500 + $19,500(1.07))/2 Η .0055 = $111.00375 Value of investment at end of year 1 = $19,500(1.07) - $111.00375 = $20,753.99625 The investor=s return on the mutual fund investment after 1 year is: ($20,753.99625 - $20,000)/$20,000 = 3.77% In year 2, the investor earns another 7 percent on the beginning value and the investor=s fees deducted and investment value at the end of the year are: Annual operating expenses = ($20,753.99625 + $20,753.99625(1.07))/2 Η .0055 = $118.142124 Value of investment at end of year 2 = $20,753.99625(1.05) - $118.142124 = $22,088.633814 After 2 years the investor has paid a total of $500 in load fees and $229.145874 in operating expenses, and he has made $2,088.633864 above his original $20,000 investment. Thus the investor=s annual return on the mutual fund is 5.09 percent (or, $20,000 = $22,088.633814(PVIFi, 2 ) => i = 5.09%). 20. The primary reason for the increased proportion of funds in equities is the strength of the equity market which was driven by the underlying strength of the economy during this period. As equity market values fell in 2001 long-term mutual funds decreased their holdings of corporate equities. The pattern of investor objectives will change over the life of an investor. Aggressive high growth funds may be preferred during the early career years of the 20s, 30s, and into the 40s. As investors mature and retirement becomes a closer reality, investors may switch to a balance of growth and income funds. Finally, at retirement investors may try to protect their investment savings by switching to high yield stock and bond funds. 21. The Securities and Exchange Commission (SEC) is the primary regulator of the mutual fund industry. The SEC is not concerned with the administration of sound economic monetary policy, but rather is primarily concerned with the protection of investors from possible abuses by managers of mutual funds. Several pieces of legislation have been enacted to clarify and assist this regulatory process. Under the Securities Act of 1933, mutual funds must file a registration statement with the SEC and abide by the rules established under the act for the distribution of prospectuses to investors. The Securities Exchange Act of 1934 establishes antifraud provisions aimed at the accurate transmission of information to prospective investors. The 1934 act also appointed the National Association of Securities Dealers to supervise the distribution of mutual fund shares. The Investment Advisors Act of 1940 regulates the activities of mutual fund advisors, and the Investment Company Act establishes rules involving fees and charges. The Insider Trading and Securities Fraud Enforcement Act of 1988 addresses issues of insider trading, and the Market Reform Act of 1990 provides for the establishment of circuit breakers to halt trading in case of severe market downturns. Finally, the National Securities Market Improvement Act of 1996 exempts mutual funds from the regulatory burden of state securities regulators.


22. The abusive activities fell into four general categories: market timing, late trading, directed brokerage, and improper assessment of fees to investors. Market timing involves short term trading of mutual funds that seeks to take advantage of short term discrepancies between the price of a mutual fund’s shares and out-of-date values on the securities in the fund’s portfolio. It is especially common in international funds as traders can exploit differences in time zones. Typically market timers hold a fund for only a few days. For example, when Asian markets close with losses, but are expected to rebound the following day, market timers can buy a U.S. mutual fund, investing in Asian securities after the loss on that day and then sell the shares for a profit the next day. This single day investment dilutes the profits of the fund’s long term investors, while market timers profit without much risk. The Ethical Debates box highlights one particularly flagrant case of in which a mutual fund allowed selected traders to engage in market timing. Late trading allegations involved cases in which some investors were able to buy or sell mutual fund shares long after the price had been set at 4:00pm Eastern time each day (i.e., after the close of the NYSE and NASDAQ). Under existing rules, investors had to place an order with their broker or another FI by 4:00pm. But the mutual fund company may not have received order until much later, sometimes as late as 9:00pm. However, because of this time delay, some large investors had been able to call their broker back after the market closed and alter or cancel their order. Diluted brokerage involves arrangements between mutual fund companies and brokerage houses and whether those agreements improperly influenced which funds brokers recommended to investors. The investigation examined whether some mutual fund companies agreed to direct orders for stock and bond purchases and sales to brokerage houses that agreed to promote sales of the mutual fund company’s products. Finally, regulators claimed that the disclosure of 12b-1 fees allowed some brokers to trick investors into believing they were buying no-load funds. Before 12b-1 fees all funds sold through brokers carried front-end load fees. As discussed above, with 12b-1 fees, fund companies introduced share classes, some of which carried back-end loads that declined over time and others that charged annual fees of up to 1 percent of asset values. Funds classes that charged annual 12b1 fees would see performance decrease by that amount and thus not perform as well as an identical fund that carried a lower 12b-1 fee. The shareholder, however, only saw the fund’s raw return (before annual fees) and not the dollar amount of the fee paid. Further regulators discovered in late 2002 that brokers often overcharged customers by failing to provide discounts to fund investors who qualified to receive them. Since discount policies differ from fund to fund, brokers did not always realize which customers qualified for them. Table 17-11 lists some of the mutual fund companies at the center of these abuses, the abuses they were accused of, and outcomes of some of the investigations.


The result of these illegal and abusive activities were new rules and regulations imposed (in 2004) on mutual fund companies. The rules were intended to give investors more information about conflicts of interest, improve fund governance, and close legal loopholes that some fund managers had abused. Many of these new rules involve changes to the way mutual funds operate including requirements that funds have an independent board headed by an independent chairman. Specifically, the SEC required an increase in the percentage of independent board members to 75 percent from the previous level of 50 percent. The SEC saw independent directors as those who better serve as watchdogs guarding investors’ interests. Further, the Sarbanes-Oxley Act of 2002, requires public companies, including mutual fund companies, to make sure their boards' audit committees have at least one individual who is familiar with generally accepted accounting principles and has experience with internal auditing controls, preparing or auditing financial statements of "generally comparable issuers," and applying GAAP principles for estimates, accruals, and reserves. The SEC also took steps to close a loophole that allowed improper trading to go unnoticed at some mutual funds. Prior to the new rules, the SEC required that funds report trading by senior employees in individual stocks but not in shares of mutual funds they manage. The SEC now requires portfolio managers to report trading in funds they manage. Investment advisors also have to protect information about stock selections and client holdings and transactions. The SEC and other regulators had found that advisory personnel revealed confidential information about fund portfolio holdings so that others could exploit the funds. To address the problem of market timing, the SEC now requires funds to provide expanded disclosure of the risks of frequent trading in fund shares and of their policies and procedures regarding such activities. Mutual funds also now have to be more open about their use of fair value pricing (a practice of estimating the value of rarely traded securities or updating the values of non-U.S. securities that last traded many hours before U.S. funds calculate their share prices each day) to guard against stale share prices that could produce profits for market timers. The market timing provisions also require mutual funds to explain when they use fair value pricing. Fair value pricing is one of the most effective way of combating the market timing that was most common in some mutual funds holding non-U.S. stocks. Many mutual funds had rarely used fair value pricing. Further, new SEC rules require brokers to tell investors about any payments, compensation, or other incentives they receive from fund companies including whether they were paid more to sell a certain fund. Conflicts would have to be disclosed before the sale is completed. To ensure that the required rule changes take place, starting October 5, 2004, the SEC required that mutual funds hire chief compliance officers to monitor whether the mutual fund company follows the rules. The chief compliance officer will report directly to mutual fund directors, and not to executives of the fund management company. To further insulate the chief compliance officer from being bullied into keeping quiet about improper behavior, only the fund board can fire the compliance officer. Duties of the compliance officer include policing personal trading by fund managers, ensuring accuracy of information provided to regulators and investors, reviewing fund business practices such as allocating trading commissions, and reporting any wrongdoing directly to fund directors.


Finally, the new SEC rules call for shareholder reports to include the fees shareholders paid during any period covered, as well as management’s discussion of the fund’s performance over that period. As of September 1, 2004, mutual fund companies must provide clear information to investors on brokerage commissions and discounts, including improved disclosure on upfront sales charges for broker-sold mutual funds. Investors now get a document showing the amount they paid for a fund, the amount their broker was paid, and how the fund compares with industry averages based on fees, sales loads, and brokerage commissions. As of December 2004, mutual funds must provide to investors summary information in a fund prospectus on eligibility for breakpoint discounts and explain what records investors may need to show brokers to demonstrate they qualify for discounts. While not approved as of mid-2004, the SEC has also proposed that mutual funds or their agents receive all trading orders by 4:00pm Eastern time, when the fund’s daily price is calculated. This “hard closing,” which would require fund orders to be in the hands of the mutual fund companies by 4:00pm, is intended to halt late trading abuses. This proposal had not yet been passed because some argued that the change would cause significant problems for investors who buy funds through brokers. The move requires deadlines several hours earlier at intermediaries such as brokerage firms, forcing them to place orders as early as 10:00am so their requests are processed on the same day. Thus, mutual fund investors using brokers for their trades would have less flexibility than direct mutual fund investors.


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