CHAPTER 7
CLOSED-END INVESTMENT COMPANIES, REAL ESTATE INVESTMENT TRUSTS
(REITs), AND EXCHANGED-TRADED FUNDS (ETFs)
Teaching Guides for Questions and Problems in the Text
QUESTIONS
7-1. The difference between closed-end and open-end investment companies (mutual
7-2. Investors acquire shares of mutual funds for their net asset value plus any applicable
load charges. The shares are redeemed by the fund at the shares’ net asset value minus any
7-3. A real estate investment trust (REIT) is an investment company that specializes in real
estate investments. These investments may be mortgage loans or improvement loans, or the
trust may own property and lease it to firms needing the space.
An equity REIT invests in real property and leases the space to whoever has use for it. A
mortgage REIT invests in loans to finance real estate. During periods of inflation, equity
7-4. The taxation of REIT distributions is more complicated than cash dividends from
corporation. REIT distributions may be earnings, capital gains, and return of capital, each
7-5. As the name implies, shares in exchange-traded funds (ETFs) are bought are sold in
the secondary markets while shares in mutual funds are bought and sold (redeemed) for
7-6. ETFs may be bought and sold (including selling short). If the net value were to
deviate from the fund’s net asset value, large financial institutions would arbitrage away
7-7. Researching foreign securities and keeping abreast with foreign markets and foreign
economies is difficult (if not impossible) for U. S. investors. Purchasing shares in
investment companies such as a mutual fund with foreign portfolios may be a means to
7-8. Hedge funds are private (not public) partnerships. Participants have to have sufficient
7-9. Since ETFs are a passive investment, their operating expenses should be lower than
the operating costs of mutual funds, which invest in specific foreign firms. The ETFs may
7-10. This question asks the student to compute correlation coefficients relating different
I select several combinations and assign them to various students and then compile a table
in class that shows the correlation between the investment alternatives. The coefficients are
PROBLEMS
7-1. a. The net asset value does not affect the return, which depends on the distributions
received and the change in the price. The value of 100 shares rose from $1,000 to $1,203,
b. This problem adds the commissions on the purchase and sale. The percentage return is
c. In this problem, the investor acquires shares in a mutual fund that charges a load fee,
d. The problem removes the upfront load fee but introduces the exit fee. The percentage
return is
e. In this problem, the investor acquires shares in a fund that charges neither a load nor an
f. Each of the above parts starts with the same $10 cost, the same sale price and the same
dividend, but the net return differs for each investment alternative. Fees and commissions
The next three questions consider the tax implications of the investments.
7-2. This problem permits an instructor to illustrate the taxes associated with an
investment in a REIT. The parts of the $3 distribution are classified as follows:
Long-term capital tax on the sale: (0.15)($7.20) = $1.08
Total taxes owed: $0.30 + 0.075 + 0.09 + 1.08 = $1.545.
7-3. REIT distributions are made from funds from operations so earnings may not be
meaningful when analyzing a REIT. The problem provides WRE’s actual EPS and funds
7-4. This problem is designed to illustrate the decay associated with a leveraged ETF. In
this problem, the ETF produces twice the daily percentage change in the index.
Day Value of Percentage Price of the
the Index Change in Leveraged ETF
The Index
1 100 — 100.00
2 110 10.0% 120.00
3 100 (9.1) 98.18
4 90 (10.0) 78.55
For example, during day 3 the index declines from 110 to 100 for a percentage decline of
-9.1. The price of the leveraged ETF declines from 120 to
(Prices in the column for the leveraged ETF were determined using Excel. Answers may
differ slightly as the result of rounding. For example, the price for day 3 is $98.18 in the
table and $98.16 using the above equation.)
7-5. This problem illustrates the potential gain that may result when a firm seeks to buy
another but the price of the acquired stock does not fully increase to reflect the offer price.
The differential between the offer value and the actual price may be interpreted as the
market’s perception that the merger will not occur and the price of the acquired firm will
fall when the merger is terminated.
a. Prior to the announcement ALD was selling for $2.73 and ARCC was selling for $10.69.
The value of ALD in terms of ARCC would be $10.69 x 0.325 = $3.47. Point out that this
valuation is not public information.
b. After the announcement, the prices of both stocks rise. The value of ALD in terms of
ARCC is
c. By selling ARCC short and purchasing ALD, the hedge fund manager seeks to take
d. The profit/loss on the each position at the various prices of ARCC stock are as follows:
ARCC price ALD stock ARCC sold Net profit/loss
purchased short
$8 ($1010) $1297 $287
The profit is always $287 no matter what happens to the price of ARCC stock.
e. While the investor always generates a profit in (d), that profit depends on the
acquisition being completed. If the merger does not occur and prices of each stock return to
their pre-announcement levels, the investor sustains a loss. ALD declines from $3.61 to
Teaching Guides for the Investment Advisor’s case; Investment Companies and Asset
Allocation
1. The first question serves as a review of investment companies and what differentiates
2. If Sachs sells existing holdings to acquire shares in an investment company, the sales
are taxable events, which are subject to short and long-term capital gains taxation. Point
3. Both Eva and Walther Sachs should open retirement accounts to get the benefits of tax
4. The current portfolio is too heavily weighted in large cap stocks. The implication is that
some of the $250,000 should be directed to other alternatives. While only six alternatives
are provided, the number of possible allocations is large.
One possibility is
Another alternative is
Obviously the allocation cannot exceed 100 percent so increasing one component decreases
another. Allocations expressed in ranges give the portfolio manager flexibility.
5. Diversification is achieved through combining assets whose returns are not highly,
positively correlated. Exhibit 1 indicates that historical returns on large cap stocks and
6. If selling the existing portfolio has no tax implication, then the funds may immediately
be used to construct the desired allocation. In reality, this would rarely be the case.
7. In class, I have one group give and defend their allocation and investment strategies and