Chapter 13 Investing in Mutual Funds, Exchange-Traded Funds, and Real Estate Chapter Outline Learning Goals I. Mutual Funds and Exchange Traded Funds: Some Basics A. The Mutual Fund Concept 1. Pooled Diversification B. Why Invest in Mutual Funds or ETFs? 1. Diversification 2. Professional Management 3. Financial Returns 4. Convenience C. How Mutual Funds Are Organized and Run D. Open-End versus Closed-End Funds 1. Open-End Investment Companies 2. Closed-End Investment Companies E. ETFs F. Choosing between ETFs and Mutual Funds G. Some Important Cost Considerations 1. Load Funds 2. No-Load Funds 3. 12(b)-1 Fees 4. Management Fees 5. Keeping Track of Fund Fees and Loads H. Buying and Selling Funds *Concept Check* II. Types of Funds and Fund Services A. Types of Funds 1. Growth Funds 2. Aggressive Growth Funds 3. Value Funds 4. Equity-Income Funds 5. Balanced Funds 6. Growth-and-Income Funds 7. Bond Funds 8. Money Market Mutual Funds 9. Index Funds 10. Sector Funds 11. Socially Responsible Funds 12. International Funds 13. Asset Allocation Funds B. Services Offered by Mutual Funds 1. Automatic Investment Plans 2. Automatic Reinvestment Plans 3. Regular Income 4. Conversion Privileges 5. Retirement Plans *Concept Check* III. Making Mutual Fund and ETF Investments A. The Selection Process 1. Objectives and Motives for Using Funds 2. What Funds Have to Offer 3. Whittling Down the Alternatives 4. Stick with No-Loads or Low-Load Mutual Funds 5. Choosing between ETFs and Mutual Funds B. Getting a Handle on Mutual Fund Performance 1. Measuring Fund Performance a. Evaluating ETF Performance 2. What About Future Performance? *Concept Check* IV. Investing in Real Estate A. Some Basic Considerations 1. Cash Flow and Taxes 2. Appreciation in Value 3. Use of Leverage B. Speculating in Raw Land C. Investing in Income Property 1. Commercial Properties 2. Residential Properties D. Other Ways to Invest in Real Estate 1. Real Estate Investment Trusts 2. Real Estate Limited Partnerships or Limited Liability Companies *Concept Check* Summary Financial Planning Exercises Applying Personal Finance The Feeling's Mutual! Critical Thinking Cases 13.1 Todd’s Dilemma: Common Stocks, Mutual Funds, or ETFs? 13.2 Eileen Ponders Mutual Funds Money Online! Major Topics This chapter introduces students to mutual funds, one of the most popular investment vehicles today. Mutual funds offer attractive levels of return from professionally managed, diversified portfolios of securities. The number of funds increases each year, and the many different fund types available can make selecting the right fund for an investor's particular needs a confusing process. This chapter also helps students understand the role that real estate plays in a diversified investment portfolio, along with the basics of investing in real estate, either directly or indirectly. Therefore, this chapter guides investors to wise choices by covering the following topics: 1. The basic character of mutual funds, and how diversification and professional management are the cornerstones of the industry. 2. The advantages and disadvantages of owning mutual funds. 3. The five major types of investment companies. 4. Cost considerations when buying mutual funds. 5. The kinds of funds available and the variety of investment objectives these funds seek to fulfill. 6. The array of special services offered by mutual funds and how these services can fit into an investment program. 7. How to assess and select funds that are compatible with the investment needs of the individual. 8. How to measure mutual fund performance. 9. Understanding real estate investments. Key Concepts Mutual funds can help an investor achieve the goals of his or her personal financial plan with greater certainty. Understanding how mutual funds operate, the various types of fund offerings, and how to choose the best funds for various needs are necessary before developing a portfolio of mutual funds. Real estate investments can help an investor diversify their portfolio. Understanding real estate investments involves understanding the cash flows from investing as well as the vehicles used to invest. The following phrases represent the key concepts stressed in this chapter. 1. Mutual funds 2. Pooled diversification 3. Professional portfolio management 4. Closed-end and open-end funds 5. Exchange-traded funds 6. Unit investment trusts 7. Load and no-load funds 8. 12(b)-1 fees and other charges 9. Types of mutual funds 10. Variety of fund services available to investors 11. Fund selection 12. Measurements of fund performance 13. Investing in real estate 14. Real estate cash flows and taxes 15. Investing in income property 16. Other ways to invest in real estate 17. Open-end investment company 18. Net asset value (NAV) 19. Closed-end investment company 20. Management fee 21. General-purpose money fund 22. Tax-exempt money fund 23. Government securities money fund 24. Socially responsible fund (SRF) International fund 26. Automatic investment plan 27. Automatic reinvestment plan 28. Systematic withdrawal plan 29. Conversion (exchange) privileges 30. Real estate investment trust (REIT) Answers to Concept Check Questions 13-1. A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors; mutual funds represent ownership in a managed portfolio of securities. The mutual fund concept, therefore, revolves around diversification. Diversification, which reduces the overall risk borne by the investor, is available through a mutual fund. This, coupled with the fact that mutual funds have professional management, which frees the individual investor from managing his or her own portfolio, makes mutual funds attractive to individuals. 13-2. Individual mutual funds are created by management companies, like Fidelity, T. Rowe Price, Dreyfus, and Vanguard. They also run the fund’s daily operations and usually serve as the investment advisor. The investment advisor buys and sells securities and otherwise oversees the fund’s portfolio. This is normally carried out by the money manager, who actually runs the portfolio; security analysts, who look for viable investment candidates; and traders, who attempt to trade large blocks of securities at the best possible price. In addition, there are fund distributors, who actually buy and sell the fund shares; custodians, who take physical possession of the fund's securities and other assets; and the transfer agent, who keeps track of fund shareholders. 13-3. An open-end investment company is a mutual fund in which investors actually buy their shares from and sell them back to the mutual fund itself. There is no limit on the number of shares an open-end fund can issue, and this is by far the most common type of mutual fund. An exchange-traded fund is a type of open-end mutual fund that trades as a listed security on one of the stock exchanges. The number of shares outstanding can be increased or decreased in response to market demand like other open-end mutual funds. However, unlike open-end funds, investors can buy and sell ETFs at any time of the day by placing an order through their broker. Thus they offer all the advantages of any index fund: low costs, low portfolio turnover, and low taxes. 13-4 The most common types of ETFs available are based on market indexes, such as the S&P 500 (Spiders), DJIA (Diamonds), or NASDAQ 100 (Cubes), and are passively managed. There are also equity sector that allow investors to access specific segments of the market and provide exposure to commodities. ETFs are available composed of investments in real estate or options and derivatives. Style ETFs typically follow either certain market capitalization stocks or the value or growth stocks, tied to indexes. There are even ETFs that track bonds. Customization of ETFs can effectively create short positions for investors. However, the passive indexing of early ETFs is giving way to the creation of actively managed ETFs, like managed ETFs and leveraged ETFs, which seek to outperform rather than track the indexes. For investors, these actively managed ETFs are more risky. 13-5. A load fund is a mutual fund which must be purchased through a broker or other investment advisor. The seller is paid a commission by the mutual fund company for selling its funds. With a front-end load, the commission is assessed when purchases are made into the fund. With a back-end load, the commission is assessed when redemptions are made. Some load funds appear to be no-load funds but actually carry "hidden loads"— no front- or back-end loads, but they have higher annual expenses. Through time, funds with "hidden loads" may prove to be more expensive for the investor to hold than either front- or back-end load funds. A no-load fund does not pay commissions to brokers or investment advisors and may be purchased directly from the mutual fund company. The no-load fund offers an advantage to investors because, by avoiding the commission (which can be as high as 8.5%), they can buy more shares in the fund with a given amount of capital, and therefore, other things being equal, earn a higher rate of return. 13-6. While all funds will have some amount of annual operating expenses, those with "hidden loads" have relatively higher annual expenses and will also probably have 12(b)-1 fees. These 12(b)-1 fees are marketing fees which are often used as an indirect way of charging commissions. A fund cannot label itself as “no-load” if it charges a 12(b)-1 fee higher than 0.25%, but it can label itself as "no-load" even if its other annual expenses are high. 13-7. A back-end load fund charges a redemption fee/commission when the investor sells the fund. (Redemption fees often decline over time and may disappear altogether after 5 or 6 years of ownership). A low-load fund is a type of front-end load fund, but it keeps the load charge very low, usually less than 2 or 3%, while a hidden load is a term used to describe the 12(b)-1 fee and higher annual expenses mentioned in the previous question. There are several ways that investors can determine if a mutual fund carries a load or not. The WSJ and other major papers use letters in their mutual fund quotes to identify various types of fees; for example, "r" means the fund has a redemption charge. Internet sites, such as quicken.com and quote.yahoo.com, provide this information when you search for the various funds. Finally, every fund prospectus must contain a fee table that fully discloses the types and amounts of fees and charges. Many mutual fund companies have a Web site where you can find information about their funds as well as download a prospectus. 13-8. The objective of a growth fund is capital appreciation. Long-term growth and capital gains are the primary goals of such funds, and as a result they invest principally in common stocks that have above-average growth potential. They are usually viewed as long-term investment vehicles that are most suitable for the more aggressive investor who wants to build capital and has little interest in current income. Balanced funds are so named because they tend to hold a balanced portfolio of both stocks and bonds, and they do so for the purpose of generating a well-balanced return of current income and long-term capital gains. For the most part, they confine their investing to high-grade securities, and are therefore usually considered a relatively safe form of investing. 13-9. International funds invest most or all of their assets in foreign securities. Some limit their portfolio to a particular country or geographical region—Japan, Mexico, Europe, Asia—while others have a broader base of investments. Another type of fund that invests in foreign securities is the global fund, which includes U.S. multinational companies as well as foreign corporations. There are many categories of both international and global funds: stock, bond, money market, growth, aggressive growth, balanced, etc. In general, these funds seek higher returns by capitalizing on changing market conditions abroad and the changing value of the dollar against foreign currencies. International and global funds provide a good way for investors who lack extensive knowledge of international economics to diversify internationally. 13-10. Unlike other mutual funds that invest primarily in one asset category, asset allocation funds invest in several markets. For example, a fund may invest 50% in common stocks, 25% in fixed income securities, 15% in money market securities, and 10% in foreign securities. These funds simplify the task of dividing an investor's assets among the various classifications. Instead of buying separate funds to achieve asset allocation, an investor can find one fund that matches his or her desired allocation plan. Whereas other types of mutual funds have a prescribed distribution among asset classes, asset allocation funds adapt their mix as market conditions change. Investors should monitor these changes to be sure the fund continues to match their personal objectives. Another way to hold various asset classes in one mutual fund is through a fund of funds. Instead of picking individual securities to hold in its fund, a fund of funds holds shares of other funds. This makes for great diversity and capitalizes on the investment styles of other money managers. As an example, the Vanguard STAR fund holds shares from several of Vanguard’s other stock funds, bond funds, and money market funds in its portfolio, and the expenses of these funds are passed on to STAR fund holders on a pro rata basis. 13-11. Even though growth, income, and capital preservation are primary mutual fund objectives, each fund concentrates on one or more particular goal(s). Thus, for people who rely heavily on current income, an investment in an income fund would be the right choice. Investors who do not require the current income and are content with waiting for capital appreciation can benefit from growth funds. These classifications of mutual funds are helpful in determining whether or not the goal of the mutual fund is compatible with one's own investment objective. The SEC requires that the specific objective of a fund be stated in its prospectus, along with how it intends to meet its objective. 13-12. A fund family consists of the different funds offered by the same investment company, like Fidelity, Kemper, or Vanguard. The major advantage of these families is the right to switch among them for little or no charge as investment objectives change or as the investment environment changes. 13-13. Automatic reinvestment plans allow the shareowners to elect to have interest, dividends, and capital gains realized on their holdings automatically reinvested in additional shares. Fractional shares are issued, if necessary, and usually there is no charge on the reinvestment transaction. This keeps investors' capital fully invested, allowing it to earn compounded rates of return. Automatic investment plans, on the other hand, are programs by which investors channel a fixed amount from their bank account directly into a mutual fund at regular intervals, usually monthly or quarterly. These plans provide investors a convenient way to build up their mutual fund holdings over time. Also, many funds offer lower minimum initial investments to investors who enroll in automatic investment plans. 13-14. The most common motives for purchasing mutual fund shares are diversification, professional management, financial return, and convenience. The primary motive for investing in mutual fund shares is the ability to diversify and diminish risk by indirectly investing in a number of different types of securities and/or companies. The fact that a professional manager is paid to make investment decisions is expected to improve the owners' returns. Mutual funds also provide a way to invest in areas that an investor may not fully understand, and in reality, many people do not have the time or inclination to track their own investments. Convenience, provided by the fact that investment company shares can be purchased through a variety of sources, also adds to their appeal. In addition, mutual funds provide their investors with a variety of services, like automatic reinvestment plans, phone or online switching, and conversion privileges. Mutual funds also offer the small investor a way to invest with little start-up capital. In fact, some funds require only a very low or even no minimum initial investment if an automatic monthly draft is made from the investor’s bank account. To keep expenses low, the investor can pick a quality no-load fund and bypass the broker entirely. These funds are easy to get into, easy to get out of, and the investor doesn’t have to worry about whether to take physical possession of the securities or not. 13-15. The mutual fund selection process begins with an assessment of your investment objectives. Key factors to consider include: your reasons for investing, your risk tolerance, the use of the fund (capital accumulation, speculation, conservation of principal), what types of return you require, and services desired. Clearly, answering these questions is essential if you are to select from the universe of thousands of funds those with the investment objectives, operations, and services that meet your particular needs. Research comes next: financial publications (The Wall Street Journal, Investor's Business Daily, Barron’s, Forbes, Fortune, Kiplinger's, and Smart Money, for example) regularly publish mutual fund reports and rankings, many of which are available online. Other valuable research sources are Morningstar and Weisenberger mutual fund report services, Value Line, and similar companies. The next step is to narrow the field by choosing several types of funds that match your investment and asset allocation objectives and then apply other constraints (load versus no-load, services offered, etc.) to further define potential investment candidates. The final decision should be based on the fund's investment performance. 13-16. A load fund charges a fee, usually up front, to invest in the fund. This fee does not go to the manager to reward him or her for superior performance, but rather it goes to the sales person or broker who sold you the fund. Therefore, the only reasons you would ever want to invest in a load fund is if the sales person or broker adds value to your investment decisions or if the fund offers superior performance above that which can be found in any no-load funds. A no-load fund does not charge the investor a fee, so every dollar gets fully invested. Also, a no-load fund does not have to take as high a risk to earn the same return as a load fund because of its lower expenses. Research has shown that, indeed, load funds do not outperform no-load funds, so that there is generally no advantage to buying load funds. Beware, however, some funds do not charge a front-end load but do charge hefty annual fees, 12(b)-1 fees, and/or redemption fees, and in this case, you might truly do better with a well-managed load fund with low annual fees. Also be careful when you see performance rankings, because many times the load is not reflected in the return. In reality, if you had actually held that load fund, you would not have earned the stated return after adjusting for the load. 13-17. There are three potential sources of return to mutual fund investors: (1) current income (from the dividends and interest earned by the fund); (2) capital gains distribution (from the realized capital gains earned by the fund); and (3) change in the fund's share price. Each of these components has an effect on the total return of a mutual fund. Both dividends and realized capital gains are accumulated and then distributed to fund shareholders. Unrealized capital gains affect return because when the fund's holdings increase or decrease in price, the NAV moves as well. The greater the return from any of these components, the greater the total return to the investor. 13-18. Student preferences for dividends, realized capital gains, or unrealized capital gains will depend on several factors. Dividend and realized capital gain income can be reinvested to achieve fully compounded returns. However, there are tax consequences from each distribution: current income (interest) and short-term capital gains are taxed at the taxpayer’s marginal tax rate; long-term capital gains and dividends are taxed at lower, more favorable rates. Unrealized capital gains (increases in NAV) have no tax implications until the shares of the fund are sold, so payment of taxes on this portion can be delayed. As the taxpayer gets into the higher marginal tax brackets, the tax implications become more and more of a consideration. 13-19. Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a whole, or a given segment of the market (as bond funds would relate to bond markets). In general, when economic conditions are good and the stock market moves up, mutual funds do well. When the market takes a plunge, mutual funds do poorly, although some portfolio managers do better than others at managing downside risk. 13-20. The behavior of a well-diversified mutual fund or ETF tends to reflect the general tone of the market. So, if the feeling is that the market is going to be generally drifting up, that should bode well for the investment performance of the mutual fund and ETFs. 13-21. a. Cash flow and taxes: An investor’s cash flow, or annual after-tax earnings, depends not only on the revenues generated from a particular piece of property, but also on depreciation and taxes. Depreciation is a bookkeeping entry that is considered an expense for tax purposes even though it involves no actual outflow of cash. Therefore, it reduces your taxable income and your taxes. b. Appreciation in value: Most types of real estate – including everything from raw land to various forms of income-producing properties – have experienced significant growth in value over time. Therefore, an investment evaluation should include expected changes in property value (that is, price appreciation). Price appreciation should be treated as capital gains and included as part of the return from the investment, minus the capital gain taxes paid. c. Use of leverage: Leverage involves the use of borrowed money to magnify returns, which is a big attraction to investing in real estate. Because real estate is a tangible asset, investors are able to borrow as much as 75 to 90 percent of its cost. As a result, if the profit rate is greater than the cost of borrowing, then the return on a leveraged investment will be proportionally greater than the return generated from an unleveraged investment. 13-22. Speculating in raw land is considered a high-risk venture because the key to such speculation is to isolate areas of potential population growth and/or real estate demand (ideally before anyone else does) and purchase the property in these areas in anticipation of their eventual development. This involves a high degree of uncertainty. 13-23. The major categories of income property include commercial properties and residential properties. The advantages of investing in income properties is that they provide both attractive returns and tax advantages for investors. Disadvantages include the owner of the property being responsible for leasing the units and maintaining the property. Single-family homes can be used to generate income by the ability to deduct interest paid on a mortgage from taxes, capital gains exemption when you sell the home, renting out of a second residence, and “flipping houses”. “Flipping houses” involves buying a house, upgrading the property and then selling it for a higher price than you paid, including the cost of upgrades. 13-24. a. Stock in real estate related companies offers investors the benefits of real estate ownership – both capital appreciation and current income – without the headaches of property management. These are investment companies that invest money in various types of real estate and real estate mortgages. It is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. b. Real estate limited partnerships or limited liability companies are organized to invest in real estate. The managers assume the role of general partner, which means their liability is unlimited, and the other investors are limited partners who are legally liable only for the amount of their initial investment. Investors buy units in an LP or LLC, a unit represents an ownership position. These are riskier investment categories than the others discussed above, and appeal to more affluent investors who can afford the typical unit cost of $100,000 or more. 13-25. The basic structure of a REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. The investment consideration associated with a REIT is that income earned by the REIT is not taxed, but the income distributed to owners is designated and taxed as ordinary income while dividends on common stocks normally are taxed at preferential rates of 15 percent or less. The three basic types of REITs are: 1. Equity REITs 2. Mortgage REITs 3. Hybrid REITs Financial Planning Exercises 1. Student answers may vary but should include some of the following points: Investing directly in stocks and bonds means the investor actually owns a specific number of shares, holds a direct interest in the issuing firm (or is a lender to the firm in the case of bonds), and receives income from the issuing firm. The investor is in control of the selection and sale of securities, can select securities with the type of gains desired and can time the realization of those gains. This is particularly important to taxpayers in the higher tax brackets. With mutual funds, the investor deals with an intermediary (the investment company) that acquires the stocks, bonds, and other financial assets for the combined benefit of its stockholders. The fund manager makes the decisions concerning the selection and sale of securities, not the investor. Mutual funds are attractive to people who have limited amounts of capital but want diversification. They also appeal to investors who lack the expertise, commitment, or time to effectively manage a portfolio on their own. 2. The following chart was populated with information found on Exhibit 13.4. It is recommended that students be given a specific date to use for looking up prices and loads. [Note: Price information can be obtained from finance.yahoo.com. Find the fund's ticker and look under "Profile" for fund expense information. You can also pull up the fund family's Web site.] Fund Type of Load Front Load $ Load Purchase Price NAV or Selling Pr. A Artio Select Opportunities Fund, class A shares (GlbEqA) 12(b)-1 Redemption fee 0% $ 0 36.35 b. Artio Select Opportunities Fund (GlbEqI) None 0% 0 36.73 c. Artio International Equity Fund II (IntlEqII I) Redemption fee 0% 0 10.78 d. Artio U.S. Small Cap Fund (USSmCpA) 12(b)-1 0% 0 10.58 Highest year-to-date return: Artio International Equity Fund II, 12.9% Lowest year-to-date return: Artio Select Opportunities Fund, class A shares, 10.9% Highest 3-year return: Artio U.S. Small Cap Fund, 9.5% Lowest 3-year return: Artio International Equity Fund II, −0.6% There have been numerous changes in the mutual fund industry, and the trend has been away from charging loads. The exhibit in the text denotes some funds having loads while others have none. To illustrate how a front-end load would work, assume XYZ Fund charges a 5.25% front-end load and its quoted NAV is $25.47. 3. Student portfolios will vary considerably. However, each answer should describe the student's personal financial goals, investment objectives, and risk tolerance, and then relate these factors to the actual fund selection. For example, a student who can tolerate above average risk and is investing for capital appreciation may include aggressive growth, international, and sector funds. More conservative investors may prefer equity-and-income funds, blue chip stock funds, and balanced funds. The selection of funds within a category should be based on performance over at least a five-year time horizon, and in both up and down markets. Finally, the services offered may be a factor for some students. Students should consult various research sources during the decision process. 4. The less risky fund from each pair is as follows: a. The growth-and-income fund—because it seeks its return not only from capital gains (growth) but also interest and dividends (income) and as such, tends to invest in more conservative issues. The current income serves several functions: it boosts total return even when there is little or no capital growth, and it helps stabilize share price because if times turn sour investors may be more willing to purchase income- producing securities than those which rely on growth alone. b. The high-grade corp. bond fund—bonds, especially high (investment) grade bonds, are less risky because debt securities by nature are less risky than equity securities (the company has a legally binding obligation to repay debt whereas equity is a residual—in the event of liquidation, owners get what’s left after debt holders are paid, which is probably zip). However, this doesn’t mean that bonds are risk free. They are particularly interest rate sensitive, and the longer the maturity, the more sensitive the bond. Bond funds can also be more risky than holding individual bonds, because bond funds will be trading securities, and if interest rates rise, bond funds will realize capital losses. If you hold an individual bond until maturity and interest rates rise, you don’t realize a capital loss but have instead opportunity cost. c. The intermediate-term bond fund—maybe. The intermediate-term bond fund will consist of investment grade bonds with maturities of 7–10 years or less. The high-yield municipal bond fund will have securities rated below-investment grade, so the quality of the bonds will be lower and therefore riskier. However, municipal bonds are issued by state and local governments, most of which would not like to see their bonds default, so this is a plus even with the below-investment grade rating. Also, like other bonds, municipals can be issued for a variety of time periods, and the shorter the time to maturity, the less risk. Therefore, shorter term high-yield munis could possibly be less risky than intermediate term corporates. You would need more information on the individual funds in order to make a good choice. d. The balanced fund—anytime you go off-shore (as in an international fund), you add more risk (currency exchange rates, political risk, possibly lack of information and/or full financial disclosure); moreover, a balanced fund itself is considered to be a fairly conservative investment vehicle as it seeks both capital gains and current income from a mix of both stocks and bonds. 5. Conversion (exchange) privileges—the right to switch from one fund to another—apply to funds within one family. There may be some limitations imposed by the fund family. Some brokerages (Charles Schwab, for example) offer conversion privileges for selected funds from a variety of families. If you have an account at one of these firms, you can switch as long as the fund is on the brokerage's list. Other fund services—automatic investment and reinvestment plans, systematic withdrawal plans, and retirement plans—can be offered by any fund, whether or not it is part of a fund family. The instructor could bring in the paper to show the many fund families, such as Fidelity, Dreyfus, T. Rowe Price, Scudder, Merrill Lynch, Vanguard, etc. Emphasis can be placed on the variety of funds offered by each of these families. Student examples of fund families will vary in their offerings. 6. The instructor may wish to bring in information from a variety of investment company services or the financial media (like Forbes or Barron's). Because this is an outside project, examples have not been included here. Selection of specific funds can be done in a variety of ways, which may include: funds of a certain size; funds of a particular manager; funds with a particular level of recent or long-term performance; funds recommended by a certain publication in a recent article; funds owned by the student or someone the student knows, etc. 7. There are three sources of return from the ownership of mutual fund shares: realized capital gains, dividends, and price appreciation in the shares. Nigel earned a capital gain of $1.83, a dividend of $0.40, and price appreciation of $1.50 ($26.00 − $24.50). Using the approximate yield formula, his rate of return would be: If the price of the common stock had risen to $30.00, the appreciation in value would have been $5.50 ($30.00 − $24.50), which changes the approximate yield to: So, yes, Nigel would have made over a 20% return if the stock had risen to $30 a share. When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year, a total of $2.23 per share ($0.40 + $1.83). The keystrokes on the left show the return if the value of his stock rises to $26 at the end of the year, while those on the right show the return if the value of his stock rises to $30 at the end of the year. 8. An ETF is like an open-end fund in that the number of shares outstanding can be increased or decreased as investors send in more money or redeem shares. An ETF is also like a closed-end fund in that it trades as a listed security on one of the stock exchanges, and it can be traded at any time of day by placing an order through a broker. The Vanguard 500 Index Fund would most closely resemble a Spider, as this fund tracks the performance of the S&P 500 Index just as a Spider does. For buy-and-hold investors, the two choices would be fairly comparable, although the 500 Index Fund would not be quite as tax efficient as the Spider. For investors who trade more frequently, the Spider would probably be the better choice, as it can be bought and sold during the day. 9. Approximate Yield: When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year. Note: This is a good problem to use to demonstrate the impact of load charges on investor return; the instructor might want to point out that even though the NAV of the fund increased by $1.54 a share ($23.04 − $21.50), the investor still is faced with a 31¢ loss in value over the year, since you buy at the offer price and sell at the NAV. In this case, even though the NAV went up, the investor had to absorb a $1.85 loan charge—the net result: a 31¢ loss. The income is what makes the total return positive. As a point of interest, if this had been a no-load fund, the approximate yield would have been: When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year. 10. Using the approximate yield formula, we can find the fund's rate of return for each year as follows: When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year, a total of $5.06 per share in 2014 and $3.25 per share in 2015. The keystrokes on the left show the return for 2014, while those on the right show the return for 2015. Mile High Growth-and-Income Fund generated a rate of return of almost 20% in 2014 and over 15% in 2015. This appears to be an impressive return record—but to put it in perspective, you should compare it to its comparable market index and to other funds with the same investment objective. 11. The QQQ index-based ETF is designed to replicate the performance of the NASDAQ 100 index and compares favorably with other funds in its category. Its R-square is 97.09, which means that it matches the NASDAQ index well, since 100 would indicate a perfect match. The quartile ranking of return as compared with other funds in its category is above 50% for 7 out of the last 10 years. As Exhibit 13.10 notes, the fund’s return is high overall when compared to 16 similar funds. 12. a. Student answers will vary. Issues they should consider would be whether or not they want to be responsible for the property management with directly investing. REITs offer the benefits of investing in real estate without the burden of property management. b. Student answers will vary depending on the key characteristics that would attract them and their personal risk aversion. Key characteristics of income-producing property include: leasing or renting to tenants in order to generate an on-going stream of monthly/annual income in the form of rent receipts. These offer both attractive returns and tax advantages for investors, but the owner is responsible for leasing the units and maintaining the property. Key characteristics of speculative property include: investors seeking to generate high rates of return by investing in property they hope will undergo dramatic increases in value. These are held in anticipation of their eventual (future) development. c. One of the principle reasons for including real estate in your investment portfolio is that it provides greater diversification properties than holding just stocks or bonds. That is because real estate typically exhibits less volatility than stocks and doesn’t move in tandem with stocks. As with any investment, you must look at the future cash flows you expect to realize from the property, and compare it to the returns obtainable from alternative investment vehicles. Obviously, don’t put your money into real estate if you think you can earn more in some other type of equally risky investment. Before you decide to buy real estate for your portfolio, however, it’s essential to evaluate such issues as the outlook for the national economy, interest rate levels, supply and demand for space, and regional considerations. d. Stock in real estate related companies as they offer investors the benefits of real estate ownership – both capital appreciation and current income – without the headaches of property management. These are investment companies that invest money in various types of real estate and real estate mortgages. It is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. Mortgage backed securities (MBSs) as they represent ownership in a pool of mortgage loans, typically on residential properties. Government agencies such as GNMA and FNMA issue most of the MBSs. Most are actively traded and offer returns that are about 1 to 2 percent above similar low-risk securities. Investors receive monthly income from the principal and interest on the underlying individual mortgages. Most MBSs require a $25,000 minimum investment. Real estate limited partnerships or limited liability companies as they are organized to invest in real estate. The managers assume the role of general partner, which means their liability is unlimited, and the other investors are limited partners who are legally liable only for the amount of their initial investment. Investors buy units in an LP or LLC, a unit represents an ownership position. These are riskier investment categories than the others discussed above, and appeal to more affluent investors who can afford the typical unit cost of $100,000 or more. 13. By using leverage, she was able to increase her return on her investment. This is due to the fact that the rate of interest was less than her return on investment with no leverage. 14. Student answers will vary depending on the two publicly-traded real estate investment trusts they choose. 15. Student answers will vary depending on the three real estate related stocks they choose. Solutions to Critical Thinking Cases 13.1 Todd’s Dilemma: Common Stocks, Mutual Funds, or ETFs? 1. The key reasons for purchasing mutual fund shares are: diversification, professional management, returns, and services. Diversification is achieved because each mutual fund share represents an indirect investment in a diversified portfolio of securities. Because professional management is used to select the securities held in the fund, it is expected that the financial returns will be safer and higher than if a person managed his or her own portfolio. Todd should understand, however, that while the fund might be able to out-perform what he would be able to do, that certainly does not mean the fund will out-perform the market (indeed, over the long-haul, the chances are the fund will do no better than match the market's return). In addition to performance, mutual funds are convenient to buy and they offer a variety of attractive services (see question 2 below). 2. The features usually available from mutual funds include: automatic investment and reinvestment plans, systematic withdrawal plans, conversion privileges, and retirement programs. Three of these would probably be of interest to Todd: (1) the automatic reinvestment plans, which would enable Todd to plow back his dividends and capital gains distributions and, therefore, earn a fully-compounded rate of return; (2) conversion privileges, which would enable Todd to move (probably by phone or online) his money from one fund to another as his objectives or the investment environment changes (Todd would have to confine his moves to the same family of funds unless he has one of the special accounts mentioned in problem 5); and (3) the retirement programs that are available at most funds, which would enable Todd to enjoy the tax-sheltered benefits that accompany IRAs and other retirement programs. 3. If Todd’s goal is strictly the receipt of income, bond funds, preferred stock funds, income-oriented diversified common stock funds, money market funds, or municipal bond funds should be considered. His choice among these income-oriented funds would depend on his risk disposition and the risk-return trade-offs he perceives in each of these types of funds. If Todd is more interested in growth (capital gains), he might choose a growth fund, aggressive growth fund, growth-and-income fund, or sector fund. If he is willing to take the risks, he might also want to consider going offshore with his money by investing in an international fund. Again, the choice among these alternatives will largely depend upon Todd’s investment goals, risk disposition and the risk-return tradeoffs. Todd would probably want to also consider taxes when developing his investment goals. Because he earns a good salary and is single, he is probably in at least the 28% tax bracket. He does not need the investment income and should concentrate on either a growth-oriented fund or one providing tax-exempt income. 4. Todd’s choice between investing in common stocks, mutual funds, or ETFs can only be resolved in light of his own risk-return preferences. In general, an investment in a common stock fund would allow Todd to achieve similar types of returns as those available on common stock investments. The difference between the two is that, while the mutual fund investment will provide diversification and professional management, he will have no choice in the selection of individual securities or the timing of gains. Todd must weigh these factors in light of his own investment objectives in order to decide which alternative is preferred. He should recognize that if he chooses to directly invest in common stocks, he will probably have to devote more of his own time to managing this investment than would be the case if he were to rely on the professional management of the mutual fund. 5. ETFs are similar to mutual funds but offer a degree of flexibility not available from standard mutual funds. More specifically, ETFs offer the professional money management of traditional mutual funds and the liquidity of an exchange traded stock. 13.2 Eileen Ponders Mutual Funds 1. Eileen needs to accumulate capital and needs an investment vehicle that will achieve this goal. Given her lack of investment expertise, mutual funds would be an ideal vehicle. She would gain professional investment management and far greater diversification than if she invested her money directly. Moreover, she could set up an automatic investing plan and also reinvest gains to help her reach her goal of long-term capital accumulation. 2. As indicated earlier in the text, certain prerequisites must be satisfied prior to entering an investment program. Eileen can cover the necessities, but she should be sure that she also has adequate insurance and sufficient liquidity. All or part of the $15,000 can be invested in a money market mutual fund without losing any liquidity, but with a gain in interest. Eileen could use a money market fund to accumulate funds that can later be moved to another fund. 3. Eileen’s specific investment needs are retirement and college education for her child. These are both long-term programs: 12 years until her child goes to college and much longer until retirement. Both objectives favor a conservative growth fund or a growth-and-income fund. A good strategy would be to start Eileen with a money market fund. Once she establishes adequate liquidity, she can then move into other types of funds. Using automatic savings and reinvestment services, Eileen should be able to accumulate capital to meet both objectives without undue risk. Because Eileen is probably in the lowest tax bracket, taxes on her investments will be minimal and therefore are not a big consideration. In meeting her retirement needs, she should also investigate an IRA. So long as she earns less than the amount allowed by law (and she probably does), she can contribute up to $5,500 (as of 2013) to a traditional IRA in addition to any contributions to her employer-sponsored retirement program. Taxes on the contribution (along with earnings on the account) are deferred until she withdraws funds during retirement. She should also consider the Roth IRA (instead of the traditional) because she would pay taxes now on the amount contributed but would never have to pay taxes again on the contribution or the earnings (if left in the Roth IRA until retirement). Since she is probably in a low tax bracket, the taxes she would pay now on the $5,500 contribution would be fairly small. Also, the Roth IRA also offers more flexibility in making early withdrawals and for estate planning purposes. 4. Eileen might want to use indirect investments in real estate to diversify her portfolio. Being a single mother of a young child, she might not have time for direct investments in real estate. Flipping homes might not be a good idea for Eileen as she is not interested in taking a lot of risk and if she doesn’t have the talents needed to choose the properties and/or make good choices about which improvements a property would need, this might not be a good choice. REITs would allow her the advantages of diversifying into real estate without having to maintain the properties herself. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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