CHAPTER 19
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. What type of investment company – an open-end mutual fund, a closed-end mutual fund, or an exchange-traded fund – is most likely to sell at a price that differs the most from its net asset value (NAV)? Which type is most likely to sell at a price that differs the least from its NAV? Explain why each type of fund might or might not sell at a price that diverges from its NAV.
Answer: 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%. Discounts/premiums relative to the NAV may arise due to taxes on capital gains realized by the fund, market access issues, and poor/superior management. Open-end mutual fund prices sell for their net asset value because investors can redeem or buy shares at NAV. ETFs may trade at a slight discount or premium to NAV but large deviations from NAV are not likely because so called authorized participants (large financial institutions) can exchange ETF shares for the securities in the underlying portfolio and thus arbitrage away price divergences from NAV.
2. What are the pros and cons of investments in mutual funds that try to match a general market index?
Answer: PROS:
Ø 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. If markets were truly efficient, one would find it difficult or impossible to consistently 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:
Ø 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, since 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. That is, 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?
Answer: Front-end loads are levied as sales charges when a fund is purchased. Back-end loads may take the form of contingent deferred sales charges (CDSC) assessed as percentage fees levied on the amount of money withdrawn from a fund. CDSC 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 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 salespeople. 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 within the same mutual fund family.
4. Why is it essential that potential investors thoroughly read the prospectus for any mutual fund they are considering as an investment?
Answer: 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?
Answer: Hedge funds give investors the opportunity to add securities with higher potential returns to their portfolios. They also allow investors to diversify their portfolios. It is especially true if hedge fund portfolios are not highly positively correlated with the overall market.
2. How are hedge funds different from closed-end funds and mutual funds?
Answer: Hedge funds pool investments to provide consistent above-market returns while reducing the risk of a loss. Hedge funds use a combination of market philosophies and analytical techniques to develop financial models that identify, evaluate, and execute trading decisions.
Hedge funds are different from closed-end funds and mutual funds in that they
- Are private, unregistered investment pools open only to a limited number of accredited investors;
- Have great latitude in setting and shifting investment strategies;
- Use short selling and high leverage and have investments concentrated in only a few securities;
- Usually provide performance-based incentives to their managers.
3. Why do hedge fund managers follow such specialized strategies?
Answer: 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.
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