CHAPTER 6
INVESTMENT COMPANIES: MUTUAL FUNDS
Teaching Guides for Questions and Problems in the Text
QUESTIONS
6-1. Investment companies, which include mutual funds, receive special tax treatment
provided they distribute the income they receive and capital gains they realize. Mutual
6-2. 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
6-3. 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.
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
6-4. 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
6-5. 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
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
6-6. Money market mutual funds invest in highly liquid short-term assets, especially
commercial paper, treasury bills, negotiable certificates of deposit, and repurchase
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.,
6-7. 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
6-8. 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
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
12b-1 fees. The individual should read the prospectus to ascertain the fund’s fees.)
6-9. 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
6-10. 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
6-11. This question asks the student to review the important concept that absolute returns
6-12. This question continues the preceding question by asking how absolute returns may
The other techniques construct indices of performance. The Treynor index subtracts the
PROBLEM
6-1. Assets $10,000,000
6-2. Load fee: $25 – $23.40 = $1.60
6-3. The investor earned $13.20 on an investment of $31.40 for a percentage gain of 42.0
$12.75, and the percentage return 40.6 percent. Notice that the 1 percent exit fee applies to
6-4. 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 =
6-5. 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.
d. The future value is $3,000(57.275) = $171,825.
6-6. a. Without adjusting for risk, the performance ranking is B, E, A, C, and D. The
Treynor index for each fund is
Fund Risk-adjusted return (Treynor Index)
A 12.4/1.14 = 10.88
On a risk-adjusted basis the ranking is E, D, C, A, and B. Fund B had the largest absolute
return, but on a risk-adjusted basis, it was the worst performer.
b. The preceding risk adjustment used beta coefficients. If the standard deviations of return
had been used, the risk adjusted ranking would be
Fund Risk adjustment (Sharpe Index)
A 12.4/4.5 = 2.76
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
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
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
1. This first question illustrates the large amount to which
a modest amount will grow over an extended time period.
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
3. In this question Bozena withdraws the funds from the accounts. In the case of the
401(k), the annual withdrawal is
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
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.
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.
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
8. Since Bozena is young, she should invest in the funds offering the highest return, so she