Chapter 23
Mutual Fund Operations
Outline
Background on Mutual Funds
Pricing Shares of a Mutual Fund
Mutual Fund Distributions to Shareholders
Stock and Bond Mutual Funds
Money Market Funds
Hedge Funds
Hedge Funds’ Use of Financial Leverage
Hedge Fund Fees
Other Types of Funds
Valuation and Performance of Mutual Funds
Valuation of Stock Mutual Funds
Valuation of Bond Mutual Funds
Chapter 23: Mutual Fund Operations ❖ 2
Key Concepts
2. Describe the various types of money market funds and elaborate where necessary.
3. Discuss the participation of mutual funds in financial markets.
POINT/COUNTER-POINT:
Should Mutual Funds be Subject to More Regulation?
POINT: No. Mutual funds can be monitored by their shareholders (just like many firms), and the
shareholders can enforce governance.
WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue
and then formulate your own opinion.
ANSWER: Recent scandals have found that some mutual funds were allowing their shares to be traded
Questions
1. Mutual Fund Services. Explain why mutual funds are attractive to small investors. How can mutual
funds generate returns to their shareholders?
ANSWER: Mutual funds enable small investors to benefit from a portfolio manager’s expertise, and
2. Open- versus Closed-End Funds. How do open-end mutual funds differ from closed-end funds?
ANSWER: Shares of open-end mutual funds can be sold back to the sponsoring investment company,
3. Load versus No-Load Mutual Funds. Explain the difference between load and no-load mutual
funds.
ANSWER: Load mutual funds require a fee to help pay for marketing commissions. No-load mutual
4. Use of Funds. Like mutual funds, commercial banks and stock-owned savings institutions sell shares;
yet, proceeds received by mutual funds are used in a different way. Explain.
ANSWER: Shares issued by commercial banks and savings institutions are used to obtain capital,
5. Risk of Treasury Bond Funds. Support or refute the following statement: Investors can avoid all
types of risk by purchasing a mutual fund that contains only Treasury bonds.
6. Fund Selection. Describe the ideal mutual fund for investors who wish to generate tax-free income
but also maintain a low degree of interest rate risk.
7. Exposure to Exchange Rate Movements. Explain how changes in foreign currency values can
affect the performance of international mutual funds.
ANSWER: As foreign currencies depreciate (appreciate) against the dollar, the prices of foreign stocks
8. Reform of Hedge Funds. Explain how the Financial Reform Act of 2010 applies to hedge funds.
ANSWER: The Financial Reform Act mandates that hedge funds managing more than $100 million
9. Tax Effects on Mutual Funds. Explain how the income generated by a mutual fund is taxed when it
distributes at least 90 percent of its taxable income to shareholders.
10. Performance. According to research, have mutual funds outperformed the market? Explain. Would mutual
funds be attractive to some investors even if they are not expected to outperform the market? Explain.
ANSWER: Mutual funds have not outperformed the market, based on a risk-return comparison with
the market.
Chapter 23: Mutual Fund Operations ❖ 4
11. Money Market Funds. How do money market funds differ from other types of mutual funds in
terms of how they use the money invested by shareholders? Which securities do money market funds
invest in most often? How can a money market fund accommodate shareholders who wish to sell
their shares when the amount of proceeds received from selling new shares is less than the amount
needed to cover the withdrawals?
ANSWER: Money market funds are composed of money market securities, such as Treasury bills,
12. Risk of Money Market Funds. Explain the relative risk of the various types of securities in which a
money market fund may invest.
13. Interest Rate Risk of Funds. Is the value of a money market fund or a bond fund more susceptible to
increasing interest rates? Explain.
ANSWER: A bond fund is more susceptible to increasing interest rates because the securities
14. Diversification among Mutual Funds. Explain why diversification across different types of mutual
funds is highly recommended.
ANSWER: The performance of each type of mutual fund is influenced by a particular economic
15. Impact of Credit Crisis on Hedge Funds Explain why some hedge funds failed as a result of the
credit crisis of 2008-s009.
ANSWER: Some hedge funds failed because they invested heavily in mortgages during the credit
16. REITs. Explain the difference between equity REITs and mortgage REITs. Which type would likely
be a better hedge against high inflation? Why?
ANSWER: Equity REITs invest directly in properties, while mortgage REITs invest in mortgage and
Chapter 23: Mutual Fund Operations ❖ 5
Advanced Questions
17. Comparing Management of Open- Versus Closed-End Funds. Compare the portfolio managers of
closed-end funds with an open-end fund. Given the differences in the fund characteristics, explain
why the portfolio manager’s management of liquidity is different in the open-end fund as compared
with the closed-end fund. Assume that the size of each fund is the same and that the goal is to invest
in stocks and to earn a very high return. Which manager do you think will achieve higher increase in
the fund’s net asset value? Explain.
ANSWER: The closed-end fund manager does not need to worry about redemptions since the fund is
18. Selecting a Type of Mutual Fund. Consider the prevailing conditions that could affect the demand
for stocks, including inflation, the economy, the budget deficit, and the Fed’s monetary policy,
political conditions, and the general mood of investors. Based on the current conditions, recommend a
specific type of stock mutual fund that you think would perform well. Offer some logic to support
your recommendation.
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
19. Comparing Hedge Funds to Mutual Funds. Explain why hedge funds may be able to achieve
higher returns for their investors than mutual funds do. Explain why the risk of hedge funds may
differ from mutual funds. When the market is overvalued, why might hedge funds be better able to
capitalize on the excessive market optimism than mutual funds can?
ANSWER: The hedge funds are subject to fewer restrictions on what they can invest in than mutual
20. How Private Equity Funds Can Improve Business Conditions. Money that had previously been
invested by individual and institutional investors in stocks is now being invested in private equity
funds. Explain why this should result in improved business conditions.
ANSWER: Private equity funds pool money provided by individual and institutional investors and
Chapter 23: Mutual Fund Operations ❖ 6
When investors invested in stocks, the focus was only on picking the stocks that would perform
21. Source of Mutual Fund versus Private Equity Fund Returns. Explain the difference between how
equity mutual funds generate returns for their investors, versus how private equity funds generate
returns for their investors. Which fund do you think would be more capable of capitalizing on a weak
publicly traded firm that has ignored all forms of shareholder activism?
ANSWER: Equity mutual funds generate returns by purchasing stocks that they believe are
undervalued and selling those stocks after their value increases. Private equity funds generate returns
22. Impact of Private Equity Funds on Market Efficiency. In recent years, private equity funds have
grown substantially. Will the creation of private equity funds increase the semi-strong form of market
efficiency in the stock market? Explain.
ANSWER: Private equity funds commonly acquire private companies so they will not necessarily
23. Hedge Fund Reliance on Expert Networks Explain the motivation of hedge funds to rely on expert
networks in recent years.
ANSWER: Some hedge funds rely on experts who have experience within a particular industry for
Chapter 23: Mutual Fund Operations ❖ 7
CRITICAL THINKING QUESTION
Hedge Fund Strategy A critic recently claimed that hedge funds cause market volatility to increase when
they publicize (and document) that a public corporation exaggerated its earnings. The critic argued that
hedge funds should not be allowed to make such public statements and should not be allowed to take
short positions that bet against the firm that is being criticized. Write a short essay that supports or refutes
this opinion.
ANSWER
Some hedge funds generate profits by taking a short position on firms that they believe have
misrepresented their financial statements. To the extent that the hedge fund has documented evidence that
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Just because a mutual fund earns 20 percent return in one year, that does not mean that investors
should rush into it. The fund’s performance must be market-adjusted.”
b. “An international mutual fund’s performance is subject to conditions beyond the fund manager’s
control.”
An international mutual fund’s performance is partially influenced by the economic conditions of
c. “Small mutual funds will need to merge to compete with the major players in terms of
efficiency.”
Small mutual funds are not normally as efficient as larger mutual funds, because larger mutual
Chapter 23: Mutual Fund Operations ❖ 8
Managing in Financial Markets
As an individual investor, you are attempting to invest in a well-diversified portfolio of mutual funds, so
that you will be somewhat insulated from any type of economic shock that may occur.
a. An investment adviser recommends that you buy four different U.S. growth stock funds. Because
these funds contain more than 400 different U.S. stocks, the adviser says that you will be well
insulated from any economic shocks. Do you agree? Explain.
This entire portfolio is subject to adverse U.S. stock market effects, and therefore is not a well-
b. A second investment adviser recommends that you invest in four different mutual funds that are
focused on different countries in Europe. The adviser says that you will be completely insulated
from U.S. economic conditions, and that your portfolio will therefore have low risk. Do you
agree? Explain.
This portfolio may not be exposed to U.S. economic conditions, but it is highly exposed to
c. A third investment adviser recommends that you avoid exposure to the stock markets by investing
your money in four different U.S. bond funds. The adviser says that because bonds make fixed
payments, these bond funds have very low risk. Do you agree? Explain.
If U.S. interest rates increase, all of these bond funds will perform poorly. Even though the bond
Flow of Funds Exercise
How Mutual Funds Facilitate the Flow of Funds
Carson Company is considering a private placement of bonds with Venus Mutual Fund.
a. Explain the interaction between Carson and Venus. How would Venus Mutual Fund serve
Carson’s needs, and how would Carson serve Venus’s needs?
Venus receives funds from its shareholders and can use some funds to provide Carson with
b. Why does Carson interact with Venus Mutual Fund instead of trying to obtain the funds directly
from individuals who invested in Venus Mutual Fund?
Chapter 23: Mutual Fund Operations ❖ 9
Individuals do not have sufficient funds to provide large loans or to buy large amounts of bonds.
c. Would Venus Mutual Fund serve as a better monitor of Carson Company than the individuals
who provided money to the mutual fund? Explain.
Yes. One large investor has more at stake than many small investors. Venus recognizes that its
performance could be affected if Carson or any other issuer of bonds fails to make its timely