ANSWERS TO END-OF-CHAPTER QUESTIONS (Chapter 3) 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 securities. 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 company. • 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 available. 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 trusts. 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 strategy. 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 securities. 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.