Chapter 20: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS

DO YOU UNDERSTAND?

1. What type of investment company is more likely to sell at a price that diverges the most or the least from its net asset value—a mutual fund with a load, a no-load fund, or a closed-end fund? Explain why each type of fund might or might not sell at a price that diverges from its net asset value.

Solution: A closed end fund may have a price that diverges the most from its net asset value. Discounts from net asset value may reach 25% or more and premia often exceed 10%. No-load fund prices diverge the least from net asset value as they sell for their net asset value, while load funds can have a price premium of as much as 8.5%.

2. What are the pros and cons on investments in mutual funds that try to match a general market index?

Solution: PROS: Index funds have low operating costs so investment returns are not reduced by high administrative charges. Index funds do, on average, about as well as the market as a whole so investors in such funds will generally do as well as the market as a whole. If markets were truly efficient, one would find it difficult or impossible to beat the market as a whole. In addition, one should expect to get an average return from taking average risk, and that is what an index fund provides. Due to high administrative costs and possibly inferior investment choices, most mutual funds with discretionary management have performed less well than index funds. CONS: Index funds, in general, will never do substantially better than the market index to which they are tied. Index funds generate average risk-return tradeoffs yet individuals may prefer to take more or less risk. If everyone invested in the same index fund, there would be no one left to evaluate the relative merits of various securities, so blind buying of securities in the index might cause their risk-adjusted prices to rise relative to securities that were not included in the index. I.e., if no one analyzed the relative merits of securities contained in the index relative to securities outside the index, the market would not be efficient and mispricings could occur. Thus, index fund buyers might later find that they had paid too much for stocks contained in the index if no one did any securities analysis.

3. What are the various types of fees and charges that may be levied by different mutual funds?

Solution: Front-end “load” charges are levied as an extra sales charge when a fund is purchased. Back end loads may take the form of contingent deferred sales charges assessed as percentage fees levied on the amount of money withdrawn from a fund. Contingent deferred sales charges often diminish in percentage terms the longer that the money has been invested in the fund prior to withdrawal. Other back end loads may take the form of “redemption fees” that are expressed as either fixed amounts or as fixed percentages of the amount withdrawn from the fund. Additional sales charges may take the form of 12b-1 fees that are levied each year as a percentage of the assets managed by the fund in order to generate income so the fund management company can pay for marketing expenses and pay salesmen. In addition, each fund will levy advisory or management fees, usually expressed as a percentage of the assets under management, each year. Finally, some funds may levy “account maintenance fees” on small balance accounts, or “exchange fees,” when a fund balance is transferred from one fund to another managed by the same fund management company.

4. Why is it essential that potential investors thoroughly read the prospectus for any mutual fund they are considering as an investment?

Solution: The prospectus will detail all the fees that a fund may charge and illustrate the impact the fees are likely to have on the fund’s net returns. In addition, the prospectus will define the securities in which the fund is permitted to invest and will explain the risks associated with investments in the fund. The prospectus may also give recent information on the actual securities held by the fund, and the fund’s returns.

DO YOU UNDERSTAND?

1. Why would an investor want to invest in a hedge fund?

Solution: Hedge funds give investors the opportunity to add securities with higher potential returns to their portfolios. Venture capital funds and hedge funds also allow investors to diversify their portfolios.

2. How are hedge funds different from closed-end funds and mutual funds?

Solution: The advantages of venture capital to an entrepreneur include access to financing for growing the company and assistance from the venture capitalists in managing the company. The disadvantages of venture capital include the high rates of return that venture capitalists expect from their investments and the fact that the venture capitalists often demand control of the company.

3. Why do hedge fund managers follow such specialized strategies?

Solution: Identifying profitable investment opportunities is difficult. Hedge fund managers must specialize in particular investment strategies in order to develop the expertise required to be successful.

DO YOU UNDERSTAND?

1. Explain the economic and regulatory climate that gave rise to MMMFs.

Solution: In the inflationary 1970's the Fed effectively used Reg Q to prevent small deposit bank customers from "market" priced rates of return. MMMF's provided small denomination, limited check-writing, relative safety, and higher market rates of return compared to banks.

2. What are the competitive advantages and disadvantages that money market mutual funds have relative to depository institutions?

Solution: Money market mutual funds have low administrative costs and are not constrained by rate ceilings so they can pay rates nearly equal to the rates they earn on their money market investments. Also, they can be part of fund management companies and brokerage firms where they can automatically sweep funds in and out and use the funds to pay for stock purchases or debit card usage. However, they generally do not have deposit insurance, and they cannot pay rates higher than they earn on short-term money market investment securities.

3. In general, why do people often invest in specialized funds like REITs? Why have REITs become more popular during the 1990s, and why do you think they operate like closed-end funds? What problem were FREITs invented to solve?

Solution: In general, people buy specialized funds because they want to own assets similar to the assets in which the fund invests. Investors in REITs want to own real estate related assets and earn returns from their real estate ownership. In the 1990’s, REITs have appealed to people because they have generated relatively high yields and have not had high failure rates. Furthermore, they provide passive real estate related income that may be advantageous to some people depending upon their tax situation. REITs operate like closed end funds because they cannot quickly liquidate their assets at good prices in order to generate cash. FREITs were established because, like closed end funds, REITs often sold for less than their net asset value and this would no longer be possible when the FREITs assets were liquidated and distributed as cash to the fund’s shareholders.

4. How have money market funds tried to cope with the fact that they do not have federal deposit insurance?

Solution: Money market mutual funds have variously restricted their asset holdings to risk free government securities, tried to obtain private deposit insurance (which was too expensive), and, in the past, were established by financial institutions that acquired non-bank banks so they could offer deposit insurance on their deposits. In addition, fund management companies have typically made up any losses incurred by the funds so they would not “break the buck” and therefore could retain investors’ confidence that they would not lose money if they invested in the fund.