Answers to Chapter 17
Questions:
1. A mutual fund represents a pool of financial resources obtained from individuals and invested in the money and
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
3. 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
4. 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 when the spread earned
on MMMFs investments relative to deposits was mostly positive. Figure 17–2 illustrates the net cash flows invested
in taxable money market mutual funds and the interest rate spread between MMMFs and the average rate on
5. In 2013, 80.1 percent of all mutual fund assets were in long term funds; the remaining funds, or 19.9 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, and 25.8 percent in 1999. The decline in the growth rate of short term funds and increase
6. The principal type of risk for short-term funds is interest rate risk, because of the predominance of fixed-income
securities. Because of the shortness of maturity of the assets, which often is less than 60 days, this risk is mitigated
to a large extent. Short-term funds generally have virtually no liquidity or default risk because of the types of assets
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
8. Table 17-4 lists some characteristics of household mutual fund owners. As of 2013, 53.8 million (44.4 percent of)
U.S. households owned mutual funds. This was down from 56.3 million (52.0 percent) in 2001. Most are long-term
owners, with 37 percent making their first purchases before 1990. While mutual fund investors come from all age
9. Mutual funds are open end in that the number of shares outstanding fluctuates daily with the amount of share
redemptions and new purchases. Shares are redeemable (meaning that investors buy and sell shares from and to the
mutual fund company at their approximate net asset value (NAV, see below) that is set once a day, after markets
close). Thus, the demand for shares determines the number of shares outstanding. Open-end mutual funds can be
10. Exchange traded funds (ETFs) are long-term mutual funds that are also designed to replicate a particular stock
market index. (In February 2008 the SEC gave approval for the first actively managed ETF and a growing number
of them are now actively managed.) However, unlike index Funds where the price per share (or Net Asset Value,
NAV, see below) is determined only once a day after markets have closed, ETFs trade intraday on a stock exchange
at prices that are determined by the market. While legally classified as open-end mutual funds, ETFs are similar to
11. In March 2009, the SEC adopted amendments to the form used by mutual funds to register under the Investment
Company Act of 1940 and to offer their securities under the Securities Act of 1933 in order to enhance the
12. The investor receives the income and dividends paid by the companies, capital gains from the sale of securities
13. 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
14. It is quite likely that for people in the early years of investing, 20 and 30 year old, they would prefer a fairly
15. A load fund charges an up-front fee that often is called a sales charge and is used as a commission payment for
sales representatives. These fees can be as high as 5.75 percent. A no-load fund does not charge a sales fee, although
16. 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
17. The primary reason for the increased proportion of funds in equities during the 1990s was the strength of the
equity market that was driven by the underlying strength of the economy during this period. Contrarily, the
18. 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
19. 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. Late
trading allegations involved cases in which some investors were able to buy or sell mutual fund shares long after the
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. 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
To ensure that the required rule changes took 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
New SEC rules also called 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,
Finally, in a February 2013 letter sent to the Financial Stability Oversight Council (FSOC) (set up as a
result of the Wall Street Reform and Consumer Protection Act to oversee the financial system), the leaders of all 12
regional Federal Reserve banks called for a significant overhaul of the money market industry. The letter stated that,
even four years after the financial crisis, without reform money market mutual fund activities could spread the risk
of significant credit problems from the funds to banks to the broader financial system. New York Fed President,
20. Mutual funds have been the fastest-growing sector in the U.S. financial institutions industry throughout the
1990s and into the 2000s. Only the worldwide financial crisis and the worst worldwide recession since the Great
Depression curtailed the growth in this industry. Worldwide investment in mutual funds is shown in Table 17–9.
Combined assets invested in non–U.S. mutual funds are approximately equal to that invested in U.S. mutual funds
alone. However, recent growth in non–U.S. funds has exceeded that in U.S. funds. Worldwide (other than in the
21. Hedge funds are investment pools that invest funds for (wealthy) individuals and other investors (e.g.,
commercial banks). They are similar to mutual funds in that they are pooled investment vehicles that accept
investors’ money and generally invest it on a collective basis. Hedge funds, however, are not subject to the numerous
Historically, hedge funds avoided regulations by limiting the number of investors to less than 100
individuals (below that required for SEC registration), who must be deemed “accredited investors.” To be
Because hedge funds have been exempt from many of the rules and regulations governing mutual funds,
they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program
22. Most hedge funds are highly specialized, relying on the specific expertise of the fund manager(s) to produce a
profit. Hedge fund managers follow a variety of investment strategies, some of which use leverage and derivatives,
others use more conservative strategies and involve little or no leverage. Generally, hedge funds are set up with
specific parameters so investors can forecast a risk-return profile.
“More risk” funds are the most aggressive and may produce profits in many types of market environments. Funds in
this group are classified by objectives such as: aggressive growth, emerging markets, macro, market timing, and
short selling. Aggressive growth funds invest in equities expected to experience acceleration in growth of earnings
per share. Generally, high price-to-earnings ratios, low or no dividend companies are included. These funds hedge
“Moderate risk” funds are more traditional funds, similar to mutual funds, with only a portion of the portfolio being
hedged. Funds in this group are classified by objectives such as: distressed securities, fund of funds, opportunistic,
multi strategy, and special situations. Distressed securities funds buy equity, debt or trade claims at deep discounts of
companies in or facing bankruptcy or reorganization. Profits opportunities come from the market’s lack of
“Risk avoidance” funds are also more traditional funds, similar to mutual funds, with only a portion of the portfolio
being hedged. Funds in this group are classified by objectives such as: income, market neutral – arbitrage, market
23. Hedge fund managers generally charge two type of fees: management fees and performance fees. As with mutual
funds, the management fee is computed as a percentage of the total assets under management and typically run
between 1.5 to 2.0 percent. Performance fees are unique to hedge funds. Performance fees give the fund manager a
24. Hedge funds that are organized in the U.S. are designated as domestic hedge funds. These funds require
investors to pay income taxes on all earnings from the hedge fund. Funds located outside of the U.S. and structured
under foreign laws are designated as offshore hedge funds. Many offshore financial centers encourage hedge funds
to locate in their countries. The major centers include the Cayman Islands, Bermuda, Dublin, and Luxembourg. /the
Problems:
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.
3. a. NAV = (300 x $22 + 400 x $28)/1,000 = $17,800/1,000 = $17.80.
4. a. NAV = (2,000 x $46.75 + 1,000 x $70.10 + 2,500 x $27.50)/10,000 = $232,350/10,000 = $23.235
6. The individual invests $20,000 in a load mutual fund with a load fee of 2.5 percent of the amount invested which
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:
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:
7. Initial investment in the fund = $10,000
