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3-1. Indirect investing involves the purchase and sale of investment company
shares. Since investment companies hold portfolios of securities, an investor owning
investment    company shares indirectly owns a pro-rata share of a portfolio of

3-2. An investment company is a financial corporation organized for the purpose
of investing in securities, based on specific objectives.

      • Open-end investment companies (mutual funds) continually sell and redeem
their       shares, based on investor demands. Shareowners deal directly with the

        • Closed-end investment companies have a fixed capitalization, and their
shares trade on                    exchanges or over-the-counter.

3-3. A closed-end fund selling at a discount is technically worth more dead than
alive in the    sense that if investors could take over the fund, they could liquidate the
portfolio and enjoy a gain. Think of a closed-end selling at a 20 percent discount. If
assets could be         bought for $0.80 on the dollar and liquidated at face value, in
principle a nice gain could be realized. Of course, attempts to take over a fund
would likely drive the price up and reduce some, or all, of the potential gain.

3-4. A regulated investment company can elect to pay no federal taxes by “flowing
through” distributions of dividends, interest, and realized capital gains to
shareholders who pay their own marginal tax rates on these distributions.

3-5. A money market fund is an investment company formed to invest in a
portfolio of short-term, highly liquid, low risk money market instruments. Interest
is earned daily,     and shares can be sold at anytime. There are no sales
commissions or redemption fees.

        Most money market mutual funds hold a substantial part of their assets in the
form of Treasury bills because of their safety and liquidity. In effect, these funds
are doing for investors what they could do for themselves if they had enough funds
to purchase Treasury bills and earn the going risk-free rate of return directly.

         Money market funds have appealed to investors seeking to earn the often-
attractive rates       being paid on money market instruments but who could not
afford the large minimum      initial investments required. Liquidity is excellent, and
safety has been no problem although an investor’s funds are uninsured. Fund
expenses are very low. In addition, most money market funds offer check writing
privileges (often with some minimum           amount constraint).

        The creation of the money market deposit accounts at financial institutions has
lessened the appeal of money market funds. MMDAs are insured, and locally
3-6.      Benefits of money market funds include:

          (a) current money market rates can be earned
          (b) securities with high minimum denominations, which
              most investors could not purchase, are held by these
              funds on behalf of shareholders
          (c) diversification
          (d) check-writing privileges--investors continue to earn
              interest until the check actually clears
          (e) shares are quickly redeemable by wire
          (f) no sales charge or redemption charge
          (g) interest is earned and credited daily

          A possible disadvantage is that these funds are not insured.

        The money market deposit accounts (MMDAs) offered by banks and other
financial institutions are a close substitute for a money market fund.

3-7. The board of directors of an investment company must specify the objective
that the company will pursue in its investment policy. The company will try to
follow a consistent investment policy, given its objective.

        (a) common stock funds: aggressive growth, growth, growth and income,
international,             and precious metals

          (b) balanced funds: hold both bonds and stocks

       (c) bond and income funds: income funds, bond funds, municipal bond
funds and            option/income funds

          (d) specialized funds: index funds, dual-purpose funds, and unit investment

3-8. A unit investment trust is an unmanaged portfolio handled by an
independent trustee, while investment companies are actively managed. The
sponsor maintains a secondary            market for the trust for those wishing to sell,
while investment company shares are             traded, or redeemed, more actively. The
assets in the portfolio of a trust are seldom changed, a situation completely different
from an investment company which pursues a              more active management

3-9. The net asset value (NAV) for any investment company share is computed
daily by calculating the total market value of the securities in the portfolio,
subtracting any trade payables, and dividing by the number of investment company
fund shares currently outstanding.

3-10. The term open-end refers to the capitalization of the investment company. It
is    constantly changing for an open-end company as investors buy shares from,
and sells shares back to, the investment company. Therefore, the number of
outstanding shares of an open-end company is constantly changing.

3-11. Investors might prefer a closed-end fund because it could be bought on an
exchange, through a broker, like any other stock. Thus, it would be added to the
portfolio like any    other security, and when it came time to sell all that would be
required would be a call to the broker. Also, an investor might feel there is an
advantage to buying a closed-end      fund at a discount, because a narrowing of the
discount would lead to a gain for the investor. Finally, a particular closed-end fund
might appeal to an investor better than the open-end funds that are available
because of the closed-end fund’s particular focus, managers, expenses, past record,
and so forth.

3-12. So-called international funds tend to concentrate primarily on international
stocks. In one recent year Fidelity Overseas Fund was roughly one-third invested in
Europe and one-third in the Pacific Basin, whereas Kemper International had
roughly one-sixth of its      assets in each of three areas, the United Kingdom,
Germany, and Japan.

        On the other hand, global funds tend to keep a minimum of 25 percent of their
assets in the United States. For example, in one recent year Templeton World Fund
had over 60 percent of its assets in the United States, and small positions in
Australia and Canada.

3-13. A cumulative total return measures the actual performance over a stated
period of time,         such as the past 3, 5 or 10 years. Standard practice in the
mutual fund industry is to     calculate and present the average annual return, a
hypothetical rate of return that, if   achieved annually, would have produced the
same cumulative total return if performance had been constant over the entire period.
The average annual return is a geometric mean          (discussed in Chapter 6)
reflecting the compound rate of growth at which money grew.

3-14. A value fund generally seeks to find stocks that are cheap on the basis of
standard fundamental analysis yardsticks, such as earnings, book value, and
dividend yield.

       Growth funds, on the other hand, seek to find companies that are expected to
show rapid    future growth in earnings, even if current earnings are poor or,
possibly, nonexistent.

3-15. The Morningstar ratings provide investors with a convenient, quickly
understood rating    system for mutual funds based on their performance. One
knows immediately that a 5- star fund is a top-rated fund and a 1-star fund is a
bottom-rated fund. Looking at a set of,      say, 20 funds, one can easily pick out the
good performers.

        The weakness of this system is that the ratings are based on past performance,
and there is a strong likelihood that performance will not continue as is. Therefore,
many top-rated         funds will subsequently stumble, and some poorly rated funds
will subsequently perform     better.
3-16. Mutual fund shares are typically purchased directly from the investment
company that operates the fund. The investor contacts the company, obtains a
prospectus and      application, and buys and sells shares by mail and phone.

        Alternatively, mutual funds can be purchased indirectly from a sales agent,
including securities firms, banks, life insurance companies, and financial planners.
Mutual funds may be affiliated with an “underwriter,” which usually has an
exclusive right to distribute shares to investors. Most underwriters distribute shares
through broker/dealer firms.

3-17. When the investor is ready to sell the shares of Equity-Income Fund, he or she
would contact Fidelity by phone or mail and instruct Fidelity to sell the shares. The
company is obligated to do so under normal circumstances at the NAV prevailing
at the time of sale.

3-18. An index fund is a passive portfolio, holding the securities of some index. No
active management decisions are made involving what securities to buy and sell, and
when to buy and sell.

      Passive investing refers to making few if any decisions regarding the
management of a      portfolio. The investor holds some set or index of securities.

3-19. Mutual funds are corporations typically formed by an investment advisory
firm that selects the board of trustees’ directors for the company. The trustees, in
turn, hire a  separate management company, normally the investment advisory
firm, to manage the firm.

        The shareholders of a fund “own” the mutual fund in terms of the portfolio of

3-20. Survivorship bias refers to the fact that when investors observe a set of mutual
fund returns over time, they are seeing results for those mutual funds that survived
over that period of time. Some poorly performing funds may be done away with,
typically by merging them with another mutual fund in the same company.
Alternatively, some are     started by mutual fund companies but are never sold to
the public because of poor performance. Thus, investors see only the “survivors.”

        Investors are not able to judge mutual fund performance fully because of the
survivorship bias. The actual performance record for a set of mutual funds over
time is overstated     because only the record of the survivors is seen.

3-21. The “load” refers to the sales charge. A no-load fund has no sales charge,
while a load fund has a sales charge, which may often be as much as 5-6 percent. A
low-load fund has a lower sales charge, such as 2 percent.

3-22. Passively managed country funds are geared to match a major stock index of a
particular country. Each of these offerings will typically be almost fully invested,
have little turnover, and offer significantly reduced expenses to shareholders.
3-23. Once an investor buys a particular fund within an investment company, such
as Vanguard or Fidelity, he or she can easily sell the shares of that fund and
purchase shares of another fund within the same organization. This can be done by
phone or mail.

3-24. Hedge funds are investment pools for wealthy investors, subject (traditionally)
to little    regulation. They are known for taking large risks in pursuit of large
returns. They traditionally have invested in ways that most mutual funds cannot or
do not, such as          selling short or investing in less liquid investments.
Furthermore, they often do not           disclose as much information about their
activities as do mutual funds.

       Mutual funds, in contrast, are subject to significant regulation under the
Investment    Company Act of 1940. They cannot engage in the same activities as
hedge funds. Their portfolios must be disclosed quarterly.

3-25. A fund supermarket is a mechanism by which investors can buy, own and sell
the funds of various mutual fund families through one source, such as a brokerage
firm. “Supermarket” refers to the fact that an investor has hundreds of choices
available through one source.

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