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• Unit investment trusts, closed-end management companies, and open-end management
companies are all classified and regulated as investment companies. Unit investment trusts
are essentially unmanaged in the sense that the portfolio, once established, is fixed.
Managed investment companies, in contrast, may change the composition of the portfolio
as deemed fit by the portfolio manager. Closed-end funds are traded like other securities;
they do not redeem shares for their investors. Open-end funds will redeem shares for net
asset value at the request of the investor.
• Net asset value equals the market value of assets held by a fund minus the liabilities of
the fund divided by the shares outstanding.
• Mutual funds free the individual from many of the administrative burdens of owning
individual securities and offer professional management of the portfolio. They also offer
advantages that are available only to large-scale investors, such as lower trading costs.
On the other hand, funds are assessed management fees and incur other expenses, which
reduce the investor™s rate of return. Funds also eliminate some of the individual™s control
over the timing of capital gains realizations.
• Mutual funds often are categorized by investment policy. Major policy groups include
money market funds; equity funds, which are further grouped according to emphasis on
income versus growth; fixed-income funds; balanced and income funds; asset allocation
funds; index funds; and specialized sector funds.
• Costs of investing in mutual funds include front-end loads, which are sales charges; back-
end loads, which are redemption fees or, more formally, contingent-deferred sales charges;
fund operating expenses; and 12b-1 charges, which are recurring fees used to pay for the
expenses of marketing the fund to the public.
• Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as
long as the fund meets certain requirements for pass-through status, the income is treated
as being earned by the investors in the fund.
• The average rate of return of the average equity mutual fund in the last 25 years has been
below that of a passive index fund holding a portfolio to replicate a broad-based index like
the S&P 500 or Wilshire 5000. Some of the reasons for this disappointing record are the
costs incurred by actively managed funds, such as the expense of conducting the research
to guide stock-picking activities, and trading costs due to higher portfolio turnover. The
record on the consistency of fund performance is mixed. In some sample periods, the
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better-performing funds continue to perform well in the following periods; in other
sample periods they do not.

KEY
closed-end fund, 101 investment company, 100 soft dollars, 110
TERMS
exchange-traded load, 103 12b-1 fees, 108
funds, 112 net asset value (NAV), 100 turnover, 111
hedge fund, 103 open-end fund, 101 unit investment trust, 101
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




124 Part ONE Elements of Investments


1. Would you expect a typical open-end fixed-income mutual fund to have higher or lower
PROBLEM
operating expenses than a fixed-income unit investment trust? Why?
SETS
2. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end
load of 6%. What is the offering price?
3. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a
front-end load of 5%, what is its net asset value?
4. The composition of the Fingroup Fund portfolio is as follows:

Stock Shares Price
A 200,000 $35
B 300,000 40
C 400,000 20
D 600,000 25


The fund has not borrowed any funds, but its accrued management fee with the portfolio
manager currently totals $30,000. There are 4 million shares outstanding. What is the net
asset value of the fund?
5. Reconsider the Fingroup Fund in the previous problem. If during the year the portfolio
manager sells all of the holdings of stock D and replaces it with 200,000 shares of stock
E at $50 per share and 200,000 shares of stock F at $25 per share, what is the portfolio
turnover rate?
6. The Closed Fund is a closed-end investment company with a portfolio currently worth
$200 million. It has liabilities of $3 million and 5 million shares outstanding.
a. What is the NAV of the fund?
b. If the fund sells for $36 per share, what is its premium or discount as a percent
of NAV?
7. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV
equaled $12.10. The fund paid year-end distributions of income and capital gains of
$1.50. What was the rate of return to an investor in the fund?
8. A closed-end fund starts the year with a net asset value of $12.00. By year-end, NAV
equals $12.10. At the beginning of the year, the fund is selling at a 2% premium to
NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund
paid year-end distributions of income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the year?
b. What would have been the rate of return to an investor who held the same securities
as the fund manager during the year?
9. What are some comparative advantages of investing your assets in the following:
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a. Unit investment trusts.
b. Open-end mutual funds.
c. Individual stocks and bonds that you choose for yourself.
10. Open-end equity mutual funds find it necessary to keep a significant percentage of total
investments, typically around 5% of the portfolio, in very liquid money market assets.
Closed-end funds do not have to maintain such a position in “cash-equivalent”
securities. What difference between open-end and closed-end funds might account for
their differing policies?
11. Balanced funds and asset allocation funds invest in both the stock and bond markets.
What is the difference between these types of funds?
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Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




125
4 Mutual Funds and Other Investment Companies


12. a. Impressive Fund had excellent investment performance last year, with portfolio
returns that placed it in the top 10% of all funds with the same investment policy.
Do you expect it to be a top performer next year? Why or why not?
b. Suppose instead that the fund was among the poorest performers in its comparison
group. Would you be more or less likely to believe its relative performance will
persist into the following year? Why?
13. Consider a mutual fund with $200 million in assets at the start of the year and with
10 million shares outstanding. The fund invests in a portfolio of stocks that provides
dividend income at the end of the year of $2 million. The stocks included in the fund™s
portfolio increase in price by 8%, but no securities are sold, and there are no capital
gains distributions. The fund charges 12b-1 fees of 1%, which are deducted from
portfolio assets at year-end. What is net asset value at the start and end of the year?
What is the rate of return for an investor in the fund?
14. The New Fund had average daily assets of $2.2 billion in the past year. The fund sold
$400 million and purchased $500 million worth of stock during the year. What was
its turnover ratio?
15. If New Fund™s expense ratio was 1.1% and the management fee was .7%, what were the
total fees paid to the fund™s investment managers during the year? What were the other
administrative expenses?
16. You purchased 1,000 shares of the New Fund at a price of $20 per share at the
beginning of the year. You paid a front-end load of 4%. The securities in which the fund
invests increase in value by 12% during the year. The fund™s expense ratio is 1.2%.
What is your rate of return on the fund if you sell your shares at the end of the year?
17. The Investments Fund sells Class A shares with a front-end load of 6% and Class B
shares with 12b-1 fees of .5% annually as well as back-end load fees that start at 5%
and fall by 1% for each full year the investor holds the portfolio (until the fifth year).
Assume the portfolio rate of return net of operating expenses is 10% annually. If you
plan to sell the fund after four years, are Class A or Class B shares the better choice for
you? What if you plan to sell after 15 years?
18. Suppose you observe the investment performance of 350 portfolio managers for five
years, and rank them by investment returns during each year. After five years, you find
that 11 of the funds have investment returns that place the fund in the top half of the
sample in each and every year of your sample. Such consistency of performance
indicates to you that these must be the funds whose managers are in fact skilled, and
you invest your money in these funds. Is your conclusion warranted?
19. You are considering an investment in a mutual fund with a 4% load and an expense ratio
of .5%. You can invest instead in a bank CD paying 6% interest.
a. If you plan to invest for two years, what annual rate of return must the fund portfolio
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earn for you to be better off in the fund than in the CD? Assume annual
compounding of returns.
b. How does your answer change if you plan to invest for six years? Why does your
answer change?
c. Now suppose that instead of a front-end load the fund assesses a 12b-1 fee of .75%
per year. What annual rate of return must the fund portfolio earn for you to be better
off in the fund than in the CD? Does your answer in this case depend on your time
horizon?
20. Suppose that every time a fund manager trades stock, transaction costs such as
commissions and bid“ask spreads amount to .4% of the value of the trade. If the
portfolio turnover rate is 50%, by how much is the total return of the portfolio reduced
by trading costs?
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




126 Part ONE Elements of Investments


21. You expect a tax-free municipal bond portfolio to provide a rate of return of 4%.
Management fees of the fund are .6%. What fraction of portfolio income is given up to
fees? If the management fees for an equity fund also are .6%, but you expect a portfolio
return of 12%, what fraction of portfolio income is given up to fees? Why might
management fees be a bigger factor in your investment decision for bond funds than for
stock funds? Can your conclusion help explain why unmanaged unit investment trusts
tend to focus on the fixed-income market?




WEBMA STER
Mutual Fund Report
Go to http://morningstar.com. From the home page select the Funds tab. From this
location you can request information on an individual fund. In the dialog box enter the
ticker JANSX, for the Janus Fund, and enter Go. This contains the report information
on the fund. On the left-hand side of the screen are tabs that allow you to view the
various components of the report.
Using the components specified, answer the following questions on the Janus Fund:
1. Morningstar analysis: What is the Morningstar rating? What has been the fund™s
year-to-date return?
2. Total returns: What are the 5- and 10-year returns and how do they compare
with the return of the S&P?
3. Ratings and risk: What is the beta of the fund? What are the mean and standard
deviation of returns? What is the 10-year rating on the fund?
4. Portfolio: What two sectors™ weightings are the largest? What percent of the
portfolio assets are in cash?
5. Nuts and bolts: What is the fund™s total expense ratio? Who is the current
manager of the fund and what was his/her start date? How long has the fund
been in operation?




SOLUTIONS TO 1. NAV ($14,754 $1,934)/419.4 $30.57

>
2. The net investment in the Class A shares after the 4% commission is $9,600. If the fund earns
Concept a 10% return, the investment will grow after n years to $9,600 (1.10)n. The Class B shares
CHECK have no front-end load. However, the net return to the investor after 12b-1 fees will be only 9.5%.
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In addition, there is a back-end load that reduces the sales proceeds by a percentage equal to
(5 years until sale) until the fifth year, when the back-end load expires.

Class A Shares Class B Shares

(1.10)n (1.095)n
Horizon $9,600 $10,000 (1 percentage exit fee)
1 year $10,560.00 $10,000 (1.095) (1 .04) $10,512.00
(1.095)4 (1
4 years 14,055.36 $10,000 .01) $14,232.89
(1.095)10
10 years $24,899.93 $10,000 $24,782.28
Bodie’Kane’Marcus: I. Elements of Investments 4. Mutual Funds and Other © The McGraw’Hill
Essentials of Investments, Investment Companies Companies, 2003
Fifth Edition




127
4 Mutual Funds and Other Investment Companies


For a very short horizon such as one year, the Class A shares are the better choice. The front-end
and back-end loads are equal, but the Class A shares don™t have to pay the 12b-1 fees. For moderate
horizons such as four years, the Class B shares dominate because the front-end load of the Class A
shares is more costly than the 12b-1 fees and the now smaller exit fee. For long horizons of 10
years or more, Class A again dominates. In this case, the one-time front-end load is less expensive
than the continuing 12b-1 fees.
3. a. Turnover $160,000 in trades per $1 million of portfolio value 16%.
b. Realized capital gains are $10 1,000 $10,000 on Microsoft and $5 2,000 $10,000 on
Ford. The tax owed on the capital gains is therefore .20 $20,000 $4,000.
4. Twenty percent of the managers are skilled, which accounts for .2 400 80 of those managers
who appear in the top half. There are 120 slots left in the top half, and 320 other managers, so the
probability of an unskilled manager “lucking into” the top half in any year is 120/320, or .375.
Therefore, of the 120 lucky managers in the first year, we would expect .375 120 45 to repeat
as top-half performers next year. Thus, we should expect a total of 80 45 125, or 62.5%, of
the better initial performers to repeat their top-half performance.




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