Chapter 23 Mutual Fund Operations
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 mutual 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.
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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. Components of Mutual Funds. Considering all stock and bond mutual funds in aggregate, what type of security is dominant? ANSWER: Common stock is dominant, followed by U.S. government securities. 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.
Chapter 23/Mutual Fund Operations 245 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. Risk of Mutual 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. Tax Effects on Money Market Funds. Explain how the income generated by a money market fund is taxed if it distributes at least 90 percent of its income to shareholders. ANSWER: Money market funds are exempt from federal taxation if they distribute at least 90 percent of their income to shareholders. 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.