Chapter 23 Mutual Fund Operations Outline Background on Mutual Funds Pricing Shares of Mutual Funds Mutual Fund Distributions to Shareholders Regulation of Mutual Funds Management of Mutual Funds Expenses Incurred by Mutual Fund Shareholders Governance of Mutual Funds Governance of Corporations by Mutual Funds Mutual Fund Categories Stock Mutual Fund Categories Bond Mutual Fund Categories Asset Allocation Funds Performance of Mutual Funds Performance of Stock Mutual Funds Performance of Bond Mutual Funds Performance from Diversifying among Funds Ratings on Mutual Funds Research on Mutual Fund Performance Money Market Funds Asset Composition of Money Market Funds Risk of Money Market Funds Management of Money Market Funds Other Types of Funds Closed-end Funds Exchange-Traded Funds Venture Capital Funds Private Equity Funds Hedge Funds Real Estate Investment Trusts Key Concepts 1. Describe the various types of mutual funds, and elaborate where necessary. 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. COUNTER-POINT: Yes. Mutual funds need to be governed by regulators, because they are accountable for such a large amount of money. Without regulation, there could be massive withdrawals from mutual funds when unethical behavior by managers of mutual funds is publicized. 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 after the market closed but at the price that existed at the market close. More regulation can prevent future scandals. However, there is a fine line between enough regulation to prevent such abuses and too much regulation. 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 from diversification capabilities due to a large portfolio. Mutual funds can provide dividends or capital gain distributions to investors. In addition, investors also benefit from share price appreciation; they may be able to sell the shares at a higher price then they paid. 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, whereas shares of closed-end mutual funds cannot. 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 funds do not require such a fee. 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, which may be used to finance their fixed assets such as land and buildings. Shares issued by mutual funds are used to obtain funds, which are invested in the mutual fund portfolio. 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. ANSWER: A mutual fund containing Treasury bonds is susceptible to interest rate risk. If interest rates rise, the market value of the Treasury bonds contained in the mutual fund will decline. 6. Fund Selection. Describe the ideal mutual fund for investors who wish to generate tax-free income and also maintain a low degree of interest rate risk. ANSWER: A short-term municipal bond fund can avoid taxes and has a low degree of interest rate risk. 7. Exposure to Exchange Rate Movements. Explain how changing 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 as measured in dollars decline (rise). Thus, depreciation (appreciation) of foreign currencies tends to decrease (increase) the net asset value of international mutual funds that are held by U.S. investors. 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 are required to register with the Securities and Exchange Commission as investment advisors. These hedge funds must also disclose financial data that can be used by the Financial Stability Oversight Council (created by the Financial Reform Act) in order to assess systemic risk in the financial system. The act also restricts commercial banks from investing no more than 3% of their capital to invest in hedge fund institutions, private equity funds, or real estate funds. 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. ANSWER: The mutual fund is not taxed if it distributes at least 90 percent of 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. Mutual funds provide diversification benefits that investors could not afford to achieve on their own. Mutual funds also allow investors to rely on someone else’s investment decisions rather than on their own judgment. 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 security 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? ANSWER: Money market funds are composed of money market securities, such as Treasury bills, commercial paper, Eurodollar deposits, banker’s acceptances, repurchase agreements, or CDs. Conversely, mutual funds are composed of stocks and bonds. Money market funds invest more money in commercial paper than in any other type of security. Money market funds could sell some of their security holdings in order to generate sufficient funds to cover the redemptions. 12. Risk of Money Market Funds. Explain the relative risk of the various types of securities in which a money market fund may invest. ANSWER: Most money market securities exhibit some default risk, since the issuers of securities could go bankrupt. Eurodollar deposits, CDs and commercial paper are exposed to default risk. U.S. Treasury bills are free from default risk. 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 contained in a bond fund have longer maturities than securities contained in a money market fund. 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 factor. Thus, diversifying within one specific type of mutual fund creates significant exposure to that factor. The stock market movements influence stock fund performance, interest rate movements influence bond fund performance, and exchange rates and foreign market movements influence international funds. Diversification across stock funds, bond funds, and international funds limits the exposure to any single economic factor. 15. Impact of Credit Crisis on Hedge Funds Explain why some hedge funds failed as a result of the credit crisis. ANSWER: Some hedge funds failed because they invested heavily in mortgages during the credit crisis, and their investments were highly levered (supported with borrowed funds). 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 construction loans. Equity REITs would likely be a better hedge against inflation because rents and property (the sources of income for equity REITs) tend to rise with inflation. 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 closed, whereas the open-fund manager must worry about accommodating redemptions and therefore must always maintain some liquidity for this purpose. Therefore, the closed-end fund manager has more flexibility to invest. It can invest in illiquid stocks without having to worry about selling those stocks to accommodate redemptions. 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 prevailing conditions, recommend a specific type of stock mutual fund that you think would perform well. Offer some logic to support your recommendation. ANSWER: Considering prevailing conditions and factors that affect the demand for stocks, a specific type of stock mutual fund that may perform well is a "growth stock mutual fund." Here's the rationale behind this recommendation: 1. Economic Growth Outlook: If prevailing economic conditions indicate robust economic growth and positive corporate earnings prospects, growth stocks tend to outperform value stocks. Growth companies typically have strong earnings growth potential and reinvest profits into expanding operations, making them attractive in a growing economy. 2. Monetary Policy: If the Federal Reserve maintains accommodative monetary policy with low interest rates and liquidity support, growth-oriented sectors such as technology, healthcare, and consumer discretionary may benefit. Low interest rates reduce borrowing costs for growth companies and stimulate consumer spending, supporting their earnings growth potential. 3. Innovation and Technology Trends: In an environment characterized by technological advancements and innovation, growth stocks in sectors such as technology, biotechnology, and renewable energy may outperform. Companies at the forefront of innovation tend to have higher growth rates and can capture market share from traditional industries. 4. Investor Sentiment and Risk Appetite: Positive investor sentiment and a willingness to take on risk often favor growth stocks, which have the potential for higher returns but also come with higher volatility. In a bullish market environment, investors may gravitate towards growth-oriented mutual funds in search of capital appreciation. 5. Political and Regulatory Environment: Political stability and favorable regulatory policies can provide a conducive environment for growth-oriented sectors to thrive. Policies that support innovation, research and development, and infrastructure investment may benefit growth companies and sectors. Based on these considerations, a growth stock mutual fund may be well-positioned to capitalize on prevailing conditions characterized by economic growth, accommodative monetary policy, technological innovation, and positive investor sentiment. However, it's essential to conduct thorough research and due diligence to select a mutual fund with a strong track record, experienced management team, and appropriate risk profile that aligns with investors' objectives and risk tolerance. 19. Comparing Hedge Funds to Mutual Funds. Explain why hedge funds may be able to achieve higher returns for their investors than mutual funds. 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? ANSWER: The hedge funds are subject to fewer restrictions on what they can invest in than mutual funds. For example, they are not limited to just investing in stocks. They can engage in short selling and therefore take advantage of expectations that the stock prices will decline, while many mutual funds are not allowed to take such positions. Hedge funds typically have a high degree of risk because they are not subject to restrictions on their investment strategy. When hedge funds engage in short selling, there is downward pressure on the stock’s price. To the extent that the stock was overvalued, short selling can correct the price. Mutual funds are normally subject to restrictions on short selling. 20. How Private Equity Funds Can Improve Business Conditions. Describe private equity funds. How can they 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 buy majority (or entire) stakes in businesses. They commonly purchase businesses that are struggling, and have much potential to improve. This allows them to purchase the businesses cheap, revise their operations to them, and sell them at a much higher price than they paid for them. There is very limited information about private businesses, so that the private equity fund managers may see opportunities to buy a business cheap and improve it. When investors invested in stocks, the focus was only on picking the stocks that would perform better, without any focus on improving businesses. Now more money is channeled through private equity funds and they do not simply buy stocks. They buy businesses with the goal of improving them so that they can sell them for more money than what they invested. 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 by purchasing businesses that they believe are undervalued and selling the business after the value increases. Private equity funds are commonly involved in the restructuring of operations of the business they purchase, while mutual funds are simply shareholders and do not have control of the firm. The private equity fund may be more capable of capitalizing on a weak publicly-traded firm that ignores shareholder activism because it could attempt to acquire the firm and restructure it. Mutual funds are not in the business of acquiring firms. 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 affect stock market efficiency. However, they could acquire some public companies that they believe are undervalued, which means that they could remove some stock market inefficiencies. 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.” The fund’s performance may be more properly measured by comparing the fund’s return to the return on the market. In fact, the fund’s performance may even be compared to the performance of other funds with the same objective. 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 the country (or region) of concern. 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 funds can achieve economies of scale. When mutual funds merge, they can combine their servicing centers and service a much larger customer base at lower cost per customer. They can also consolidate their portfolio management to reduce expenses per dollar of investment in the funds they manage. 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. Since these funds contain over 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-diversified portfolio. 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 European economic conditions. Even though the portfolio contains stocks of different European countries, all four mutual funds are subject to general economic conditions throughout Europe. 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 payments are fixed, the values of the bonds (and therefore the values of the bond mutual funds) will decline if U.S. interest rates rise. Therefore, this portfolio of mutual funds has a high degree of risk. 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 serve Carson’s needs, and how would Carson serve the needs of Venus? Venus receives funds from its shareholders and can use some funds to provide Carson with funding so that Carson can expand its business. In return, Carson agrees to make timely interest payments on its debt to Venus, and Venus will distribute the interest payments to its shareholders. Venus essentially serves as the agent for its shareholders who want to receive periodic income from their investment. 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? Individuals do not have sufficient funds to provide large loans or to buy large amounts of bonds. They also are not skilled at assessing creditworthiness. They are incapable of diversifying on their own. Venus Mutual Fund can pool funds, assess creditworthiness, and diversify. 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 payments on the bonds held by Venus. The fund managers who decide how to invest money for the mutual fund could be fired if they invest in many bonds that default. A mutual fund has some power in ensuring that bond issuers make their payments. If the issuer is not complying with the terms of the bond, the mutual fund has the resources to take action, or could sell a large amount of these bonds in the secondary market, which may cause a decline in the bond price. Individuals who invest money in a mutual fund would not be effective monitors of Carson Company. They invest small amounts and are not capable of monitoring companies, nor do they want to use their time in that manner. They rely on the mutual fund to make the investment decisions and to monitor companies that issued the securities issued by the companies. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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