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A fund™s short-term capital gains, long-term capital gains, and dividends are passed through
to investors as though the investor earned the income directly. The investor will pay taxes at
the appropriate rate depending upon the type of income as well as the investor™s own tax
The pass through of investment income has one important disadvantage for individual in-
vestors. If you manage your own portfolio, you decide when to realize capital gains and losses
on any security; therefore, you can time those realizations to efficiently manage your tax lia-
bilities. When you invest through a mutual fund, however, the timing of the sale of securities
from the portfolio is out of your control, which reduces your ability to engage in tax manage-
ment. Of course, if the mutual fund is held in a tax-deferred retirement account such as an IRA
or 401(k) account, these tax management issues are irrelevant.
A fund with a high portfolio turnover rate can be particularly “tax inefficient.” Turnover is turnover
the ratio of the trading activity of a portfolio to the assets of the portfolio. It measures the frac- The ratio of the
tion of the portfolio that is “replaced” each year. For example, a $100 million portfolio with trading activity of a
$50 million in sales of some securities with purchases of other securities would have a portfolio to the assets
of the portfolio.
turnover rate of 50%. High turnover means that capital gains or losses are being realized con-
stantly, and therefore that the investor cannot time the realizations to manage his or her over-
all tax obligation.

An interesting problem that an investor needs to be aware of derives from the fact that capital gains and dividends
on mutual funds are typically paid out to shareholders once or twice a year. This means that an investor who has just
purchased shares in a mutual fund can receive a capital gain distribution (and be taxed on that distribution) on trans-
actions that occurred long before he or she purchased shares in the fund. This is particularly a concern late in the year
when such distributions typically are made.
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

112 Part ONE Elements of Investments

In 2000, the SEC instituted new rules that require funds to disclose the tax impact of port-
folio turnover. Funds must include in their prospectus after-tax returns for the past 1-, 5-, and
10-year periods. Marketing literature that includes performance data also must include after-
tax results. The after-tax returns are computed accounting for the impact of the taxable distri-
butions of income and capital gains passed through to the investor, assuming the investor is in
the maximum tax bracket.

3. An investor™s portfolio currently is worth $1 million. During the year, the investor
sells 1,000 shares of Microsoft at a price of $80 per share and 2,000 shares of
CHECK Ford at a price of $40 per share. The proceeds are used to buy 1,600 shares
of IBM at $100 per share.
a. What was the portfolio turnover rate?
b. If the shares in Microsoft originally were purchased for $70 each and those in
Ford were purchased for $35, and if the investor™s tax rate on capital gains
income is 20%, how much extra will the investor owe on this year™s taxes as a
result of these transactions?

Exchange-traded funds (ETFs) are offshoots of mutual funds that allow investors to trade in-
dex portfolios just as they do shares of stock. The first ETF was the “Spider,” a nickname for
SPDR or Standard & Poor™s Depository Receipt, which is a unit investment trust holding a
Offshoots of mutual
portfolio matching the S&P 500 index. Unlike mutual funds, which can be bought or sold only
funds that allow
at the end of the day when NAV is calculated, investors could trade Spiders throughout the
investors to trade
index portfolios. day, just like any other share of stock. Spiders gave rise to many similar products such as
“Diamonds” (based on the Dow Jones Industrial Average, ticker DIA), Cubes (based on the
Nasdaq 100 Index, ticker QQQ), and WEBS (World Equity Benchmark Shares, which are
shares in portfolios of foreign stock market indexes). By 2000, there were dozens of ETFs in
three general classes: broad U.S. market indexes, narrow industry or “sector” portfolios, and
international indexes, marketed as WEBS. Table 4.3, Panel A, presents some of the sponsors
of ETFs; Panel B is a sample of ETFs.
ETFs offer several advantages over conventional mutual funds. First, as we just noted, a
mutual fund™s net asset value is quoted”and therefore, investors can buy or sell their shares
in the fund”only once a day. In contrast, ETFs trade continuously. Moreover, like other
shares, but unlike mutual funds, ETFs can be sold short or purchased on margin.
ETFs also offer a potential tax advantage over mutual funds. When large numbers of mu-
tual fund investors redeem their shares, the fund must sell securities to meet the redemptions.
This can trigger capital gains taxes, which are passed through to and must be paid by the re-
maining shareholders. In contrast, when small investors wish to redeem their position in an
ETF they simply sell their shares to other traders, with no need for the fund to sell any of the
underlying portfolio. Moreover, when large traders wish to redeem their position in the ETF,
redemptions are satisfied with shares of stock in the underlying portfolio. Again, a redemption
does not trigger a stock sale by the fund sponsor.
The ability of large investors to redeem ETFs for a portfolio of stocks comprising the in-
dex, or to exchange a portfolio of stocks for shares in the corresponding ETF, ensures that the
price of an ETF cannot depart significantly from the NAV of that portfolio. Any meaningful
discrepancy would offer arbitrage trading opportunities for these large traders, which would
quickly eliminate the disparity.
ETFs are also cheaper than mutual funds. Investors who buy ETFs do so through brokers,
rather than buying directly from the fund. Therefore, the fund saves the cost of marketing
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

4 Mutual Funds and Other Investment Companies

A. ETF Sponsors
TA B L E 4.3
Sponsor Product Name
ETF sponsors
and products
Barclays Global Investors i-Shares
Merrill Lynch HOLDRS (Holding Company Depository Receipts: “Holders”)
StateStreet/Merrill Lynch Select Sector SPDRs (S&P Depository Receipts: “Spiders”)
Vanguard VIPER (Vanguard Index Participation Equity Receipts: “VIPERS”)

B. Sample of ETF Products

Name Ticker Index Tracked

Broad U.S. Indexes
Spiders SPY S&P 500
Diamonds DIA Dow Jones Industrials
Cubes QQQ Nasdaq 100
iShares Russell 2000 IWM Russell 2000
VIPER VTI Wilshire 5000
Industry Indexes
Energy Select Spider XLE S&P 500 energy companies
iShares Energy Sector IYE Dow Jones energy companies
Financial Sector Spider XLF S&P 500 financial companies
iShares Financial Sector IYF Dow Jones financial companies
International Indexes
WEBS United Kingdom EWU MCSI U.K. Index
WEBS France EWQ MCSI France Index
WEBS Japan EWJ MCSI Japan Index

itself directly to small investors. This reduction in expenses translates into lower management
fees. For example, Barclays charges annual expenses of just over 9 basis points (i.e., .09%) of
NAV per year on its S&P 500 ETF, whereas Vanguard charges 18 basis points on its S&P 500
index mutual fund.
There are some disadvantages to ETFs, however. Because they trade as securities, there is
the possibility that their prices can depart by small amounts from NAV. As noted, this dis-
crepancy cannot be too large without giving rise to arbitrage opportunities for large traders,
but even small discrepancies can easily swamp the cost advantage of ETFs over mutual funds.
Second, while mutual funds can be bought for NAV with no expense from no-load funds,
ETFs must be purchased from brokers for a fee. Investors also incur a bid“ask spread when
purchasing an ETF.
ETFs have to date been a huge success. Most trade on the Amex and currently account for
about half of Amex trading volume. So far, ETFs have been limited to index portfolios.
A variant on large exchange-traded funds in a “built-to-order” fund, marketed by sponsors
to retail investors as folios, e-baskets, or personal funds. The sponsor establishes several
model portfolios that investors can purchase as a basket. These baskets may be sector or
broader-based portfolios. Alternatively, investors can custom-design their own portfolios. In
either case, investors can trade these portfolios with the sponsor just as though it were a per-
sonalized mutual fund. The advantage of this arrangement is that, as is true of ETFs, the indi-
vidual investor is fully in charge of the timing of purchases and sales of securities. In contrast
to mutual funds, the investor™s tax liability is unaffected by the redemption activity of other
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

114 Part ONE Elements of Investments

investors. (Remember that in the case of mutual funds, redemptions can trigger the realization
of capital gains that are passed through to all shareholders.) Of course, investors would simi-
larly control their tax position using a typical brokerage account, but these basket accounts al-
low one to trade ready-made diversified portfolios. Investors typically pay an annual fee to
participate in these plans.

Exchange Traded Funds
Go to William J. Bernstein™s website, http://www.efficientfrontier.com/ef/901/shootout.
htm, for a discussion of potential advantages and disadvantages of ETFs versus index
mutual funds.
After reading the discussion, address the following questions:
1. What did Mr. Bernstein conclude about tracking error on ETFs compared to
index funds?
2. What four reasons did he give for possibly favoring ETFs over index funds?
3. What did the author mean by the statement that the ETF is only as good as its
underlying index?

We noted earlier that one of the benefits of mutual funds for the individual investor is the abil-
ity to delegate management of the portfolio to investment professionals. The investor retains
control over the broad features of the overall portfolio through the asset allocation decision:
Each individual chooses the percentages of the portfolio to invest in bond funds versus equity
funds versus money market funds, and so forth, but can leave the specific security selection
decisions within each investment class to the managers of each fund. Shareholders hope that
these portfolio managers can achieve better investment performance than they could obtain on
their own.
What is the investment record of the mutual fund industry? This seemingly straightforward
question is deceptively difficult to answer because we need a standard against which to eval-
uate performance. For example, we clearly would not want to compare the investment per-
formance of an equity fund to the rate of return available in the money market. The vast
differences in the risk of these two markets dictate that year-by-year as well as average per-
formance will differ considerably. We would expect to find that equity funds outperform
money market funds (on average) as compensation to investors for the extra risk incurred in
equity markets. How can we determine whether mutual fund portfolio managers are perform-
ing up to par given the level of risk they incur? In other words, what is the proper benchmark
against which investment performance ought to be evaluated?
Measuring portfolio risk properly and using such measures to choose an appropriate bench-
mark is an extremely difficult task. We devote all of Parts II and III of the text to issues sur-
rounding the proper measurement of portfolio risk and the trade-off between risk and return.
In this chapter, therefore, we will satisfy ourselves with a first look at the question of fund
performance by using only very simple performance benchmarks and ignoring the more sub-
tle issues of risk differences across funds. However, we will return to this topic in Chapter 11,
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition

4 Mutual Funds and Other Investment Companies

where we take a closer look at mutual fund performance after adjusting for differences in the
exposure of portfolios to various sources of risk.
Here, we will use as a benchmark for the performance of equity fund managers the rate of
return on the Wilshire 5000 Index. Recall from Chapter 2 that this is a value-weighted index
of about 7,000 stocks that trade on the NYSE, Nasdaq, and Amex stock markets. It is the most
inclusive index of the performance of U.S. equities. The performance of the Wilshire 5000 is
a useful benchmark with which to evaluate professional managers because it corresponds to a
simple passive investment strategy: Buy all the shares in the index in proportion to their out-
standing market value. Moreover, this is a feasible strategy for even small investors, because
the Vanguard Group offers an index fund (its Total Stock Market Portfolio) designed to repli-
cate the performance of the Wilshire 5000 Index. The expense ratio of the fund is extremely
small by the standards of other equity funds, only .20% per year. Using the Wilshire 5000 In-
dex as a benchmark, we may pose the problem of evaluating the performance of mutual fund
portfolio managers this way: How does the typical performance of actively managed equity
mutual funds compare to the performance of a passively managed portfolio that simply repli-
cates the composition of a broad index of the stock market?
By using the Wilshire 5000 as a benchmark, we use a well-diversified equity index to eval-
uate the performance of managers of diversified equity funds. Nevertheless, as noted earlier,
this is only an imperfect comparison, as the risk of the Wilshire 5000 portfolio may not be
comparable to that of any particular fund.
Casual comparisons of the performance of the Wilshire 5000 Index versus that of profes-
sionally managed mutual fund portfolios show disappointing results for most fund managers.
Figure 4.3 shows the percent of mutual fund managers whose performance was inferior in
each year to the Wilshire 5000. In more years than not, the Index has outperformed the median
manager. Figure 4.4 shows the cumulative return since 1970 of the Wilshire 5000 compared
to the Lipper General Equity Fund Average. The annualized compound return of the Wilshire
5000 was 12.20% versus 11.11% for the average fund. The 1.09% margin is substantial.
To some extent, however, this comparison is unfair. Real funds incur expenses that reduce
the rate of return of the portfolio, as well as trading costs such as commissions and bid“ask

F I G U R E 4.3
Percent of equity
mutual funds
outperformed by
Wilshire 5000 Index,


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