978-0078034800 Chapter 5

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Chapter 05 – Financial Services: Mutual Funds and Hedge Funds

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Education.

Solutions for End-of-Chapter Questions and Problems: Chapter Five

1. What is a mutual fund? In what sense is it a financial institution?

2. What are money market mutual funds? In what assets do these funds typically invest?

What factors have caused the strong growth in this type of fund since the late 1970s?

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

3. What are long-term mutual funds? In what assets do these funds usually invest? What

factors caused the strong growth in this type of fund from 1992 through 2007, the

slowdown in growth in 2007-2008, and the return to growth after 2008?

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4. Using the data in Table 5-2, discuss the growth and ownership holdings over the last 32

years of long-term funds versus short-term funds.

The dollar investment in the money market mutual funds (MMMF) exceeded the investment in

the long-term funds in 1980. However, by 2007, long-term funds had more than a two to one

5. Why did the proportion of equities in long-term funds increase from 38.3 percent in 1990

to more than 70 percent by 2000, and then decrease to 54 percent in 2012? How might an

investor’s preference for a mutual funds objectives change over time?

The primary reason for the increased proportion of funds in equities during the 1990s was the

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6. How does the risk of short-term funds differ from the risk of long-term funds?

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

7. What are the economic reasons for the existence of mutual funds; that is, what benefits do

mutual funds provide for investors? Why do individuals rather than corporations hold most

mutual funds?

One major economic reason for the existence of mutual funds is the ability to achieve

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8. What are the principal demographics of household owners who own mutual funds? What

are the primary reasons why household owners invest in mutual funds?

9. What change in regulatory guidelines occurred in 2009 that had the primary purpose of

1933 in order to enhance the disclosures that are provided to mutual fund investors. The

amendments (first proposed in November 2007) required key information to appear in plain

English in a standardized order at the front of the mutual fund statutory prospectus. The new

10. What are the three possible components reflected in the return an investor receives from a

11. How is the net asset value (NAV) of a mutual fund determined? What is meant by the term

marked-to-market daily?

Net Asset Value (NAV) is the market value of each ownership share of the mutual fund. The

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12. Suppose today a mutual fund contains 2,000 shares of J.P. Morgan Chase, currently trading

at $46.75, 1,000 shares of Wal-mart, currently trading at $70.10, and 2,500 shares of Pfizer,

currently trading at $27.50. The mutual fund has no liabilities and 10,000 shares

outstanding held by investors.

a. What is the NAV of the fund?

b. Calculate the change in the NAV of the fund if tomorrow J.P. Morgan’s shares increase

to $50, Wal-mart’s shares increase to $73, and Pfizer’s shares increase to $30.

c. Suppose that today 1,000 additional investors buy one share each of the mutual fund at

the NAV of $23.235. This means that the fund manager has $23,235 additional funds to

invest. The fund manager decides to use these additional funds to buy additional shares

in J.P. Morgan Chase. Calculate tomorrow’s NAV given the same rise in share values

as assumed in part b.

13. A mutual fund owns 300 shares of General Electric, currently trading at $22, and 400

shares of Microsoft, Inc., currently trading at $28. The fund has 1,000 shares outstanding.

a. What is the net asset value (NAV) of the fund?

b. If investors expect the price of General Electric shares to increase to $26 and the price

of Microsoft shares to decrease to $20 by the end of the year, what is the expected

NAV at the end of the year?

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c. Assume that the expected price of the General Electric shares is realized at $26. What is

the maximum price decrease that can occur to the Microsoft shares to realize an end-of–

year NAV equal to the NAV estimated in part (a)?

14. What is the difference between open-end and closed-end mutual funds? Which type of fund

tends to be more specialized in asset selection? How does a closed-end fund provide

another source of return from which an investor may either gain or lose?

15. Open-end fund A owns 165 shares of AT&T valued at $35 each and 50 shares of Toro

valued at $45 each. Closed-end fund B owns 75 shares of AT&T and 120 shares of Toro.

Each fund has 1,000 shares of stock outstanding.

a. What are the NAVs of both funds using these prices?

b. Assume that in one month the price of AT&T stock has increased to $36.25 and the

price of Toro stock has decreased to $43.375. How do these changes impact the NAV

of both funds? If the funds were purchased at the NAV prices in part (a) and sold at

month end, what would be the realized returns on the investments?

c. Assume that another 155 shares of AT&T are added to fund A. The funds needed to

buy the new shares are obtained by selling 676 more shares in fund A. What is the

effect on fund A’s NAV if the stock prices remain unchanged from the original prices?

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16. What is the difference between a load fund and a no-load fund? Is the argument that load

funds are more closely managed and therefore have higher returns supported by the

and 1.00 percent of assets. According to the data in Table 5-6, the load funds have adjusted

17. What is a 12b-1 fee? Suppose you have a choice between a load fund with no annual 12b-1

The 12b-1 fee is allowed by the SEC to provide assistance in covering administrative expenses

for no-load funds. Thus, in terms of fees and without consideration of time value issues, a 4.00

18. Suppose an individual invests $10,000 in a load mutual fund for two years. The load fee

entails an up-front commission charge of 4 percent of the amount invested and is deducted

from the original funds invested. In addition, annual fund operating expenses (or 12b-1

fees) are 0.85 percent. The annual fees are charged on the average net asset value invested

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19. Who are the primary regulators of the mutual fund industry? How do their regulatory goals

differ from those of other types of financial institutions?

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,

enhance the disclosures that are provided to mutual fund investors. The amendments (first

proposed in November 2007) required key information to appear in plain English in a

standardized order at the front of the mutual fund statutory prospectus. The new amendment also

included a new option for satisfying prospectus delivery obligations with respect to mutual fund

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20. What is a hedge fund and how is it different from a mutual fund?

Hedge funds are a type of investment pool that solicits funds from (wealthy) individuals and

other investors (e.g., commercial banks) and invests these funds on their behalf. Hedge funds are

similar to mutual funds in that they are pooled investment vehicles that accept investors’ money

100 individuals (below that required for SEC registration), who must be deemed “accredited

investors.” To be accredited, an investor must have a net worth of over $1 million or have an

annual income of at least $200,000 ($300,000 if married). These stiff financial requirements

allowed hedge funds to avoid regulation under the theory that individuals with such wealth

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21. What are the different categories of hedge funds?

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

market movements and the difficulty of timing entry and exit from markets adds significant risk

to this strategy. Short selling funds sell securities in anticipation of being able to buy them back

in the future at a lower price based on the manager’s assessment of the overvaluation of the

securities or in anticipation of earnings disappointments.

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“Moderate risk” funds are more traditional funds, similar to mutual funds, with only a

majority of institutional investor cannot own below investment grade securities. Fund of funds

mix hedge funds and other pooled investment vehicles. This blending of different strategies and

asset classes aims to provide a more stable long term investment return than any of the individual

funds. Returns and risk can be controlled by the mix of underlying strategies and funds. Capital

preservation is generally an important consideration for these funds. Opportunistic funds change

This style of investment allows the manager to overweight or underweight different strategies to

best capitalize on current investment opportunities. Special situation funds invest in event driven

situations such as mergers, hostile takeovers, reoganizations, or leveraged buyouts. These funds

may undertake simultaneous purchases of stock in companies being acquired, and the sale of

stock in its bidder, hoping to profit from the spread between the current market price an the final

These funds use leverage to buy bonds and some fixed income derivatives, profiting from

principal appreciation and interest income. Market neutral-arbitrage funds attempt to hedge

market risk by taking offsetting positions, often in different securities of the same issuer, e.g.,

long convertible bonds and short the firm’s equity. Their focus is on obtaining returns with low

or no correlation to both the equity and bond markets. Market neutral-securities hedging funds

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22. What types of fees do hedge funds charge?

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

23. What is the difference between domestic hedge funds and offshore hedge funds?

Describe the advantages of offshore hedge funds over domestic hedge funds.

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

funds so as to attract all types of investors.