Chapter 4 End of Chapter Questions

1. Would you expect a typical open-end fixed-income mutual fund to have higher or lower operation expenses than a fixed-income unit investment trust? Why? Mutual funds offer many benefits. Some of those benefits include the ability to invest with small amounts of money, diversification, professional management, low transaction costs, tax benefits, and reduce administrative functions. 2. What are some comparative advantages of investing in the following: a. Unit investment trusts. A unit investment trusts offer low costs and stable portfolios. Since they do not change their portfolio, the investor knows exactly what they own. They are better suited to sophisticated investors. b. Open-end mutual funds. Open-end mutual funds offer higher levels of service to investors. The investors do not have any administrative burdens and their money is actively managed. This is better suited for less knowledgeable investors. c. Individual stocks and bonds that you choose for yourself. Individual securities offer the most sophisticated investors ultimate flexibility. They are able to save money since they are only charged the expenses they incur. All decisions are under the control of the investor. 3. Open-end equity mutual funds find it necessary to keep a significant percentage of total investments, typically around 5% of the portfolio, in very liquid money market assets. Closed-end funds do not have to maintain such a position in cash equivalent securities. What difference between open-end and closed-end might account for their differing policies? Open-end funds must honor redemptions and receive deposits from investors. This flow of money necessitates retaining cash. Close-end funds no longer take and receive money from investors. As such, they are free to be fully invested at all times. 4. Why can closed-end funds sell at prices that differ from net asset value while open-end funds do not? Closed-end funds trade on the open market and are thus subject to market pricing. Openend funds are sold by the mutual fund and must reflect the NAV of the investment.

5. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a front-end load of 5%, what is its net asset value? NAV = offering price (1 load) = $12.30 0.95 = $11.69 6. A close-end fund starts the year with a net asset value of $12.00. By year-end, NAV equals $12.10. At the beginning of the year, the fund was selling at a 2% premium to NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end distribution of income and capital gains of $1.50. a. What is the rate of return to an investor in the fund during the year? Start of year price = $12.00 1.02 = $12.24 End of year price = $12.10 0.93 = $11.25 Although NAV increased, the price of the fund fell by $0.99. Rate of return =
(Pr ice ) Distributions $0.99 $1.50 = = 0.0417 = 4.17% Start of year price $12.24

b. What would have been the rate of return to an investor who held the same securities as the fund manager during the year? An investor holding the same portfolio as the fund manager would have earned a rate of return based on the increase in the NAV of the portfolio: Rate of return =
( NAV ) Distributi ons $0.10 $1.50 = = 0.1333 = 13.33% Start of year NAV $12.00

7. City Street Fund has a portfolio of $450 million and liabilities of $10 million. a. If 44 million shares are outstanding, what is net asset value? 450,000,000 10,000,000) / 44,000,000 = $10 per share b. If a large investor redeems 1 million shares, what happens to the portfolio value, to shares outstanding, and to NAV? (440,000,000 10,000,000) / 43,000,000 = $10 per share 8. Suppose that every time a fund manages trades stock, transaction costs such as commissions and bid-asked spreads amount to .4% of the value of the trade. If the portfolio turnover rate is 50%, by how much is the total return of the portfolio reduced by trading costs?

The turnover rate is 50%. This means that, on average, 50% of the portfolio is sold and replaced with other securities each year. Trading costs on the sell orders are 0.4%; and the buy orders to replace those securities entail another 0.4% in trading costs. Total trading costs will reduce portfolio returns by: 2 0.4% 0.50 = 0.4% 9. Research Question: MM-$1 NAV How does that help with tax implication? Money market funds seek a stable net asset value, or NAV (which is generally $1.00 in the US); they aim never to lose money. Money market funds strive to maintain a $1.00 per share net asset value, meaning that investors earn interest income from the fund but do not experience capital gains or losses. If a fund fails to maintain that $1.00 per share because its securities have declined in value, it is said to "break the buck. This has rarely happened.