Chapter 04 - Investment Companies: Mutual Funds, Exchange-Traded Funds, Closed-End Funds, and Unit

Investment Trusts

SOLUTIONS MANUAL
CHAPTER 4
INVESTMENT COMPANIES: MUTUAL FUNDS, EXCHANGE-
TRADED FUNDS, CLOSE-END FUNDS, AND UNIT INVESTMENT
TRUSTS

Answers to Text Discussion Questions

1. Do mutual funds, on average, outperform the market?

4-1. Mutual funds, on average, do no better than the Standard & Poor's 500 Stock
Index, the Dow Jones Industrial Average, etc.
Some instructors, however, may choose to add that a few funds in the
international area have had exceptional returns, partly because of the falling dollar
exchange rate.

2. Do mutual funds generally provide efficient diversification?

4-2. Yes. This is perhaps the best attribute a mutual fund has.

3. Explain why the vast array of mutual funds available to the investor may be a partial
drawback and not always an advantage.

4-3. The investor has so many mutual funds to choose from it may be as hard to select
a mutual fund as it is a stock.

4. What is the basic difference between a closed-end fund and an open-end fund?

4-4. In a closed-end fund, there is a fixed number of shares and purchasers and sellers
of shares must deal through each other, rather than with the fund. With an open-
end arrangement, the fund stands ready at all times to sell new shares or buy back
old shares. The number of shares is open-ended.

5. Define net asset value. Do closed-end funds normally trade at their net asset value?
What about open-end funds?

4-5. The net asset value is equal to the current value of the securities owned by the
fund minus any liabilities divided by the number of shares outstanding. Closed-
end funds usually trade at a discount or a premium in relation to their net asset
value (the discount is the more likely case). Open-end funds trade at their net
asset value subject to any commissions.

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Chapter 04 - Investment Companies: Mutual Funds, Exchange-Traded Funds, Closed-End Funds, and Unit
Investment Trusts

6. Is it mandatory that you pay a load fee when purchasing an open-end

mutual fund? What is a low-load fund?

4-6. No, many open-end funds have no load or commission. A low-load fund is one
that charges 2 to 3 percent in comparison to the normal fee of 7.25 percent and
more.

7. Should you get better performance from a load fund in comparison to a no-load fund?

4-7. No, research evidence indicates one is not necessarily superior to the other in
terms of performance.

8. If there is a difference between the net asset value (NAV) and the offer price for a
mutual fund, what does that tell us about the fund?

4-8. That it is a load mutual fund.

9. How can you distinguish between regular growth funds and aggressive growth funds?

4-9. Aggressive growth funds concentrate on speculative issues, emerging small

companies and "hot" sectors of the economy, and frequently use financial
leverage to magnify their returns. Regular growth funds generally invest in
common stocks of more stable firms.

10. What type of fund is likely to invest in convertible securities?

4-10. A balanced fund is likely to invest in convertible securities.

11. Why might there be some potential danger in investing in sector funds?

4-11. An initial offering of sector funds usually occurs after the sector has been the
subject of intense interest based on recent spectacular performance. As a result,
stocks in that sector are probably fully priced or overpriced. These funds also
provide less diversification.

12. What does Rule 12b-1 enable mutual funds to do? Is this normally beneficial to
current mutual fund shareholders?

4-12. Rule 12b-1 allows mutual funds to use fund assets for marketing purposes. Since
marketing expenses have nothing to do with advancing shareholder's interests and
everything to do with increasing the manager's fees, investors should be alert to
this in the prospectus.

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Chapter 04 - Investment Companies: Mutual Funds, Exchange-Traded Funds, Closed-End Funds, and Unit
Investment Trusts

13. Are earnings of mutual funds normally taxed at the fund level or the
shareholder level?

4-13. Mutual fund earnings are normally taxed at the shareholder level. A fund that distributes at least
90 percent of its net investment income and capital gains is not subject, as an entity, to federal
income taxes. It simply acts as a "conduit" in channeling taxable sources of income from securities
held in the portfolio to the fund's shareholders.

14. What is the advantage of investing in a mutual fund that offers an exchange privilege?

4-14. Within certain limits, shareholders are free to move their money between the
different funds in the family of funds on a net asset value basis. Only a minimal
charge is common to cover paperwork.

15. What is dollar-cost averaging? If you were a particularly astute investor at timing
moves in the market, would you want to use dollar-cost averaging?

4-15. With dollar-cost averaging, the investor buys a fixed dollar's worth of a given
security at regular intervals regardless of the security's price or the current market
outlook. If you are a successful market timer, you would not want to use dollar-
cost averaging.

16. From the viewpoint of an individual investor, what is the potential tax disadvantage
of investing in a mutual fund?

4-16. You cannot control the timing of when to take a loss or gain on a mutual fund like
you can when you own an individual stock. Furthermore, in a bull market you
may buy into a fund that has previously accumulated gains for which you will be
taxed even though you were not a fund holder at the time of the gain.

17. What is the difference between a mutual fund and a unit trust?

4-17. A unit trust has a portfolio of securities that don’t change during the life of the
trust. These are usually municipal bonds. The unit owner owns a proportionate share of
the assets and receives interest payments from the trust. The trust usually has a maturity
date and so when the bonds mature, the trust is closed. Mutual funds are actively
managed and the securities in a mutual fund portfolio change over time.

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