PartFive

PortfolioManagement
PartFourIncludes
Chapter13

MutualFunds:ProfessionallyManagedPortfolios

Chapter14

ManagingYourOwnPortfolio

239Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter13
MutualFunds:ProfessionallyManagedPortfolios
.1

Outline

Learning Goals
I.

TheMutualFundPhenomenon
A) AnOverviewofMutualFunds
1. PooledDiversification
2. AttractionsandDrawbacksofMutualFundOwnership
3. HowMutualFundsAreOrganizedandRun
4. MutualFundRegulations
B) OpenorClosedEndFunds
1. OpenEndInvestmentCompanies
2. ClosedEndInvestmentCompanies
C) ExchangeTradedFunds
D) SomeImportantConsiderations
1. LoadandNoLoadFunds
2. OtherFeesandCosts
3. KeepingTrackofFundFeesandLoads
E) OtherTypesofInvestmentCompanies
1. UnitInvestmentTrusts
2. HedgeFunds
ConceptsinReview

II.

TypesofFundsandServices
A) TypesofMutualFunds
1. GrowthFunds

2.
3.
4.
5.
6.
7.
8.
9.

AggressiveGrowthFunds
ValueFunds
EquityIncomeFunds
BalancedFunds
GrowthandIncomeFunds
BondFunds
MoneyMarketFunds
IndexFunds

241Gitman/JoehnkFundamentalsofInvesting,NinthEdition

10.
11.
12.
13.

SectorFunds
SociallyResponsibleFunds
AssetAllocationFunds
InternationalFunds

B) InvestorServices
1. AutomaticInvestmentPlans
2. AutomaticReinvestmentPlans
3. RegularIncome
4. ConversionPrivilegesandPhoneSwitching
5. RetirementPrograms
ConceptsinReview
III. InvestinginMutualFunds
A) InvestorUsesofMutualFunds
1. AccumulationofWealth
2. StorehouseofValue
3. SpeculationandShortTermTrading
B) TheSelectionProcess
1. ObjectivesandMotivesForUsingFunds
2. WhattheFundsOffer
3. WhittlingDowntheAlternatives
4. StickwithNoLoadsorLowLoads
C) InvestinginClosedEndFunds
1. SomeKeyDifferencesBetweenClosedEndandOpenEndFunds
2. WhattoLookforinaClosedEndFund

Chapter13MutualFunds:ProfessionallyManagedPortfolios242

D) MeasuringPerformance
1. SourcesofReturn
2. WhatAboutFuturePerformance?
3. MeasuresofReturn
a. HPRwithReinvestedDividendsandCapitalGains
b. MeasuringLongTermReturns
c. ReturnonClosedEndFunds
4. TheMatterofRisk
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
13.1. ReverendRobinPondersMutualFunds
13.2. TomYeeSeekstheGoodLife
ExcelwithSpreadsheets

243Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

1.

Thebasiccharacteristicsofmutualfunds,andhowdiversificationandprofessionalmanagementare
thecornerstonesoftheindustry.

2.

Theadvantagesanddisadvantagesofowningmutualfunds.

3.

Thekindsoffundsavailableandthevarietyofinvestmentobjectivesthesefundsseektofulfill.
Recentadditionstotheassortmentcoveredincludehedgefundsandexchangetradedfunds.

4.

Thearrayofspecialservicesofferedbymutualfundsandhowtheseservicescanfitintoan
investmentprogram.

5.

Investorusesofmutualfunds,andwaysofassessingandselectingfundsthatarecompatiblewiththe
investmentneedsoftheindividual.

6.

Aspectsofinvestinginclosedendmutualfunds.

7.

Sourcesofreturninmutualfundsandwaystocalculaterateofreturn.

.3

Overview

Thischapterfocusesonmutualfunds.
1.

Thechapterbeginswithanoverviewofthemajorfeaturesandcharacteristicsofmutualfunds.Atthe
outset,thedifferencebetweenbuyingintoamutualfundandinvestingdirectlyinsecuritiesshouldbe
clarifiedbytheinstructor;itsalsohelpfultoemphasizeearlyonthatpooleddiversificationisoneof
themajorbenefitsofinvestinginamutualfund.Theinstructormightalsomentionthattheadditional
benefitsofprofessionalmanagementandmodeststartupcapitalrequirementsmakeinvestingin
mutualfundsattractive,evenforsmallinvestors.Drawbacksofmutualfundsarepointedout.The
openingsectionendswithadiscussionabouthowmutualfundsaremanagedandregulated.

2.

Closedendandopenendmutualfundsareintroduced.Othertypesofpooledinvestments,suchas
investment(unit)trusts,andloadversusnoloadfundsarealsodescribed,alongwiththevarious
typesofmutualfundfeesandcharges.Theinstructorshouldindicatethetypesofinvestmentsthese
fundsrepresent.Theclassmaybeshownhowtoreadmutualfundquotationsfromthefinancial
pages.

3.

Inthenextsection,mutualfundsareclassifiedaccordingtoinvestmentobjectives.Growthfunds,
aggressivegrowthvaluefunds,equityincome,balancedfunds,growthandincome,bondfunds,
moneymarketfunds,indexfunds,sectorfunds,sociallyresponsiblefunds,assetallocationfunds,and
internationalfundsaredefined.Theinstructorshouldexplainhowsuchfundschoosetheinvestments
thatenablethemtomeettheirprescribedobjectives.Howandwhyinvestorsmightchooseonetype
offundratherthananothershouldbeexplored,andthevariousinvestorservicesofferedbythese
fundsneedstobebrieflydiscussedinclass.

4.

Giventheirpopularityandhybridnature,exchangetradedfundsshouldbecovered.Discussionof
advantagesanddisadvantagesofexchangetradedfundsputssomeofthecomparativeadvantagesand
disadvantagesofopenendmutualfundsintoperspective.

Chapter13MutualFunds:ProfessionallyManagedPortfolios244

5.
6.

7.

.4

Next,adiscussionofhowinvestinginclosedendfundsfollows.Somekeydifferencesbetween
investinginclosedendversusopenendfundsaremade.
Amutualfundsperformancemaybemeasuredbyrateofreturn.Itmightbehelpfulatthispointto
discussthesourcesofreturnandhowinvestorscangetahandleonthefutureperformanceofa
mutualfund;withthatbackgroundoutoftheway,theinstructorcanworkoutexamplesinclass
showingholdingperiodreturn(HPR)andyieldcalculationssimilartothoseinthetext.Consideration
ofriskshouldalsobeemphasizedwhencomparingthereturnoftwofunds.
Thereisanabundanceofinformationonmutualfunds,includingtheWallStreetJournalsmonthly
MutualFundsreport,whichistypicallypublishedonthefirstdayofthemonth.Instructorsshould
provideinformationonrecentmutualfundreturnswheneverpossible.

Answers to Concepts in Review

1.

Amutualfundinvestsinadiversifiedportfolioofsecuritiesandissuessharesintheportfolioto
individualinvestors;mutualfundsrepresentownershipinamanagedportfolioofsecurities.The
mutualfundconcept,therefore,revolvesarounddiversification.Diversification,whichreducesthe
overallriskbornebytheinvestor,isavailablethroughamutualfund.This,coupledwiththefactthat
mutualfundshaveprofessionalmanagementwhichfreestheindividualinvestorfrommanaginghis
ownportfolio,makesmutualfundsattractivetoindividuals.

2.

Themajoradvantageofmutualfundsisthattheyprovidediversificationandfulltimeprofessional
management.Investorswithmodestamountsofcapitalcaninvestinmutualfundsandreceivethe
advantagesoftheseservices.Also,mutualfundsmayofferseveralattractiveservices(likemonthly
withdrawalplans).Theyalsohandleallthepaperworkandrecordkeeping,dealinfractionalshares,
andautomaticallyreinvestdividends,iftheinvestorsodesires.
Thereareseveraldisadvantages,however.Foronething,thefundscanbequiteexpensivetoacquire
iftheyareloadfunds,orhaveothertypesofchargesandfees(like12(b)1fees).Intermsof
performanceoverthelongrun,mutualfunds,onaverage,havenotdoneallthatwell;indeed,onlya
handfulhavebeenabletooutperformthemarketwithsomedegreeofregularity.Theirperformance,
ingeneral,hascorrespondedtotheperformanceofthemarketasawhole.Ofcourse,indexbased
mutualfundsshouldprovidethereturnofthatmarketcoveredlessmutualfundrelatedcosts.

3.

Mutualfundsarefrequentlyopenendedinvestmentcompanies;investorsinmutualfundsare
essentiallybuyingasmallpieceofalarge,welldiversifiedportfolioofsecurities.Amutualfundisa
financialservicesorganizationthatreceivesmoneyfromitsshareholdersandinveststhosefundsina
portfolioofsecurities.Theinvestorsinagivenmutualfundareallpartownersofthatportfolio.
Individualmutualfundsarecreatedbymanagementcompanies,likeFidelity,Dreyfus,andVanguard.
Theyalsorunthefundsdailyoperationsandusuallyserveastheinvestmentadvisor.Theinvestment
advisorbuysandsellssecuritiesandotherwiseoverseesthefundsportfolio.Thisisnormallycarried
outby:themoneymanager,whoactuallyrunstheportfolio;securityanalysts,wholookforviable
investmentcandidates;andtraders,whoattempttotradelargeblocksofsecuritiesatthebestpossible
price.Inaddition,therearefunddistributors,whoactuallybuyandsellthefundshares;custodians,
whotakephysicalpossessionofthefundssecuritiesandotherassets;andthetransferagent,who
keepstrackoffundshareholders.(Note:Alltheseparticipantsarepartofopenendmutualfunds;
however,closedendinvestmentcompaniesdonotrequireadistributor.Sharesinthesefundstradein
theopenmarkets.)

245Gitman/JoehnkFundamentalsofInvesting,NinthEdition

4.

(a) Anopenendinvestmentcompanyisamutualfundinwhichinvestorsactuallybuytheirshares
fromandsellthembacktothemutualfunditself.Thereisnolimitonthenumberofsharesan
openendfundcanissue,andthisisbyfarthemostcommontypeofmutualfund.
(b) Aclosedendinvestmentcompanyisafundthatoperateswithafixednumberofoutstanding
sharesanddoesnotregularlyissuenewsharesofstock.Thesefunds,whicharefewinnumber
relativetoopenendfunds,operatewithafixedcapitalstructureandtradeinthestockmarket
mostarelistedontheNYSE
(c) Exchangetradedfunds(ETF)isatypeofopenendmutualfundthattradesasalistedsecurityon
oneofthestockexchanges.
(d) Aunitinvestmenttrustrepresentsaninterestinanunmanagedpoolofinvestments,which
generallyhaveagiventermorlife.OnceaportfolioofsecuritiesisputtogetherforaUIT,itis
simplyheldinsafekeepingforinvestorsunderconditionssetoutinthetrustagreement.
Traditionally,theseportfoliosweremadeupofvarioustypesoffixedincomesecurities,with
longtermmunicipalbondsbeingthemostpopularbyfar.Thereisnotradingintheportfolios,so
thereturns,oryields,arefixedandfairlypredictable.Thereisnotradingintheportfolio,so
managementfeesarelow.Varioussponsoringbrokeragehousesputthesediversifiedpoolsof
investmentstogetherandthensellunitstoinvestors.
(e) Likemutualfunds,hedgefundssellshares(orparticipation)unitsinaprofessionallymanaged
portfolioofsecurities.However,hedgefundsareprivatepartnershipsthattendtolimittheir
clienteletotherichindividuals.Themangerisageneralpartner,whiletheinvestorsarelimited
partners.Hedgefundshaveverylimitedreportingrequirementsandaregenerallyunregulated.
Somehedgefundsattempttolimitthedownsideriskthroughemploymentofoptionsandfutures,
whileothersinvestinanyopportunitythathasthepotentialofapositivereturn.

5.

Aloadfundisamutualfundthatchargesacommissiontopurchasesharesinthefund.Anoload
funddoesnotrequireanycommissionsonthepartoftheinvestors.Thenoloadfundoffersan
advantagetoinvestorsbecause,byavoidingthecommission(oftenashighas8.5percent),theycan
buymoresharesinthefundwithagivenamountofcapital,andtherefore,otherthingsbeingequal,
earnahigherrateofreturn.
A12(b)1fundmayappeartobeanoloadfund,butinfact,itchargesanannualfeewhichreplaces
anupfrontloadcharge.Manysocallednoloadfundslevy12(b)1charges;theycontinuetoreferto
themselvesasnoloadseventhough12(b)1chargescanaddupovertime.

6.

Inadditionto12(b)1fees,thereareanumberofothertypesofloadfeesandcharges.Abackend
loadfundchargesa(redemption)fee/commissionwhentheinvestorsellsthefund.(Redemptionfees
oftendeclineovertimeanddisappearalltogetherafterthefirst35yearsofownership).Alowload
fundisatypeoffrontendloadfundbutitkeepstheloadchargeverylow,usuallylessthan2or3%,
whileahiddenloadisatermusedtodescribea12(b)1fee.
Theeasywaytodistinguishbetweenaloadandanoloadfundistolookforadifferencebetweenthe
netassetvalue(NAV)andofferpricesofafund.Iftheresadifference,itsaloadfundandthe
amountofthedifferencerepresentsthesizeofthefrontendloadcharge(thecommissiontobuy
thefund).Inaddition,theWSJandothermajorpapersuselettersintheirmutualfundquotesto
identifyvarioustypesoffees;forexample,rmeansthefundhasaredemptioncharge.Finally,
everyfundprospectusmustcontainafeetablethatfullydisclosesthetypesandamountsoffeesand
charges.

Chapter13MutualFunds:ProfessionallyManagedPortfolios246

7.

Thereisawidevarietyofmutualfunds.
(a) Aggressivegrowthfundsarehighlyspeculativefundsthatconcentrateonobtaininglargecapital
gains.Thesefundstendtobesmallandtheirportfoliosconsistofspeculativecommonstocks.
Returnsonthesefundsgenerallymovewiththemarket,butinlargerincrements:whenthe
marketsup,thesefundsdogreat,butwhenthemarketfalls,theydoreallypoorly.
(b) Equityincomefundsemphasizecurrentincomebyinvestingprimarilyinhighyieldingcommon
stocks.Inadditiontohighgradecommonstocks,thesefundsalsoinvestinconvertiblesecurities,
preferredstocksandevenbonds.Theylikesecuritiesthatprovidehighcurrentyields,butalso
considerpotentialpriceappreciationoverthelongerhaul.Thesefundsaregenerallyviewedasa
fairlylowriskwayofinvestinginstocks.
(c) Growthandincomefundsseekabalancedreturnmadeupofbothcurrentincomeandlongterm
capitalgains,withthegreatestemphasisplacedongrowthofcapital.Unlikebalancedfunds,
growthandincomefundshave8090%oftheircapitalincommonstocks).Theytendtoinvestin
growthorientedbluechips(fortheircapitalgains)andhighyieldcommonstocks(fortheir
currentincomeduetohighdividends).
(d) Bondfundscomeinallshapesandcolors(fromthegovernmentbondfundstohighyield[junk]
corporatebondfunds)andtheyallhaveonethingincommon:theyinvestprincipally(or
exclusively)insometype(s)offixedincomesecurity.Whilecurrentincomeistheprimary
objectiveofthesefunds,capitalgainsisnotignoredalltogether.Today,theresafullrangeof
bondfunds,rangingfromtheveryconservativetotheveryrisky.
(e) Sectorfundsaremutualfundsthatconcentratetheirholdingsinoneormoreindustriesthatmake
upatargetsector.Forinstance,ahealthcaresectorfundmayholddrugcompanies,medical
suppliers,biotechcompanies,andhospitalmanagementcompanies.Theyarenotwidely
diversifiedandthereforeareriskierthandiversifiedfunds.
(f) Sociallyresponsiblefundsaremutualfundsthatactivelyanddirectlyincorporateethicsand
moralityintotheinvestmentdecision.Thesefundswillconsideronlysociallyresponsible
companiesforinclusionintheirportfolios.Forexample,thesefundsgenerallywillnotinvestin
companiesthatderiverevenuesfromtobacco,alcohol,orgambling;companiesthatareweapons
contractors;orthatoperatenuclearpowerplants.

8.

Assetallocationfundsspreadinvestorsmoneyacrossdifferenttypesofmarkets.Mostothermutual
fundsfocusononeparticulartypeofinvestmentsuchasportfolioofstocks,aportfolioofbonds,or
moneymarketsecuritiesassetallocationfundsallocatemoneytoallofthesemarkets.
Inanassetallocationfund,themanagerestablishesadesiredallocationmixandpurchasessecurities
forthefundintheseproportions.Thus,asthemarketchangesovertime,sodothesefundsthisis
whatseparatesallocationsfundsfromothermutualfunds.

9.

Eventhoughgrowth,income,andcapitalpreservationareprimarymutualfundobjectives,eachfund
concentratesononeormoreparticulargoal(s).Thus,forpeoplewhorelyheavilyoncurrentincome,
aninvestmentinanincomefundwouldbetherightchoice.Investorswhodonotrequirethecurrent
incomeandarecontentwithwaitingforcapitalappreciationcanbenefitfromgrowthfunds.These
classificationsofmutualfundsarehelpfulindeterminingwhetherornotthegoalofthemutualfund
iscompatiblewithonesowninvestmentobjective.TheSECrequiresthatthespecificobjectiveofa
fundbestatedinitsprospectus,alongwithhowitintendstomeetitsobjective.

247Gitman/JoehnkFundamentalsofInvesting,NinthEdition

10. Fundfamiliesaresimplyinvestmentmanagementcompaniesthatofferanumberofdifferentkindsof
mutualfundstotheinvestingpublic.ThetwolargestfundfamiliesFidelityandVanguardeach
haveoveratrilliondollarsinassets.Fidelityhasover300differentfundsinitsfamily.Thebigfund
familiesofferafullmenuofdifferenttypesoffundseverythingfromgrowth,equityincome,and
sectorfundstoavarietyofbondfundsandmoneymarketfunds.Andthat,ofcourse,isthebig
advantageofinvestinginafundfamily:i.e.,theinvestorcanfullymanagehisportfoliooffundsby
easilyandinexpensivelymovingfromonefundtoanotherasthemarketdictates.Onthedownside,
allthetradinghastobeconfinedtothesamefamilyoffunds;ifthefundsarentinsometypeoftax
shelteredvehicle(likeanIRAorKeoghaccount),theneverytimeatradeismade,ataxliabilityis
created.(Fortaxpurposes,movingmoneyfromonefundtoanotherisregardedasasalefollowedby
asubsequentpurchaseofanewsecuritythefactthatitwasdoneinthesamefamilyoffundsis
totallyirrelevant).
11. Mutualfundsofferavarietyofservicestoinvestors.Theseinclude:Savingsandautomatic
reinvestmentplan:Investorsareprovidedawaytoaccumulatecapitalandhavereturnssystematically
andautomaticallyreinvestedforthelonghaul(atlittleornocost);Withdrawalplans:Investors
receiveregularpaymentsfromthemutualfunds;andconversionprivilegesandphoneswitching:
Whentheinvestmentclimatechangesand/oraninvestorsgoalschange,heorshecanquicklyand
easilyswitchfromonekindoffundtoanotherwithinthesamefamily,usingtheconversionprivilege.
Somemutualfunds(mostlymoneyfunds)areextremelyliquidbecausetheyoffercheckwriting
privileges.Mostmutualfundsalsowilldesignandprovideforindividualretirementplans.
Automaticinvestmentplansallowshareholderstoautomaticallysendamountsofmoneyfromtheir
paycheckorbankaccountsintothefund.Automaticreinvestmentplansenablemutualfundinvestors
tokeeptheircapitalfullyemployed;thisisimportantbecausethatsthewayinvestorsearnfully
compoundedratesofreturn.Normally,dividendsandcapitalgainsdistributionsarepaidintheform
ofcash;inanautomaticreinvestmentplan,however,thosedividendsandcapitalgainsdistributions
areusedtobuyadditionalsharesinthefund.Thus,thenumberofsharesownedbytheinvestorwill
growovertime.Phoneswitchingisatypeofconversionprivilegewhichenablesfundownersto
simplypickupthephonetomovetheirmoneyfromonefundtoanother(suchamove,ofcourse,
mustbeconfinedtothesamefamilyoffunds).Investorswouldusesuchaserviceasawaytomeet
theirchanginginvestmentgoals:i.e.,whentheinvestmentenvironmental/outlookchanges,investors
canmovebetweenfundsasthesituationdictates.
12. Sinceamutualfundisreallyalargeportfolioofsecurities,itbehavesverymuchlikethemarketasa
whole,oragivensegmentofthemarket(asbondfundswouldrelatetobondmarkets).When
economicconditionsaregoodandthestockmarketmovesup,mutualfundsdowell.Whenthe
markettakesaplunge,mutualfundsdopoorly.Somefunds,suchassectorfunds,maynotmovewith
theoverallmarketatall.Thatisonereasonthesefundsareattractivetosomeinvestors.
Pastperformanceisimportanttothemutualfundselectionprocessitsanindicationofhowwell
thefundanditsfundmanagershavedoneovertime.Andinthisregard,itsimportanttolookatpast
performanceoveranextended(510year)periodoftime,coveringbothgoodmarketsandbad.Ifa
fundanditsmanagershavedonewellinbothupmarketsanddownmarkets,thatsaprettygood
indicationofwhattheyrecapableofdoinginthefuture.Whethertheyactuallywillperformupto
expectationsisanothermatterandisdependenttoalargeextentonwhatthefuturebehaviorofthe
marketholds.Thatswhyitssoimportanttotrytogetahandleonthefuturedirectionofthemarket:
ifyouthinkitsheadedup,thatshouldbodewellformutualfunds.Combiningthesetwovariables
(thepastperformanceofthefundwiththefutureexpectationsofthemarket)isanimportantmethod
forselectingamongfunds.

Chapter13MutualFunds:ProfessionallyManagedPortfolios248

13. Themajortypesofclosedendfundsincludethosethatspecializeinmunicipalbonds,taxablebonds,
varioustypesofequitysecurities,internationalsecurities,andregionalandsinglecountryfunds.
Regionalfundsfocusonagroupofcountrieswithinabroadgeographicarea,suchasEuropeorLatin
America.Incontrast,singlecountryfundswilltargeteitheremergingmarketsordevelopedmarkets.
Keydifferencesbetweenclosedend(CEFs)andopenend(OEFs)mutualfundsinclude:
(1) CEFstradelikestockswhileOEFsaretradeddirectlywiththefundoperators.
(2) LargetradersofCEFsaffectthebuyorsellprice,whiletradinglargeamountsofOEFstypically
donotaffecttheprice,i.e.,CEFsaremuchlessliquidthanOEFs.
(3) CEFsdonotprovidethefullrangeofservicesprovidedbyOEFs.
(4) CEFstypicallyhavearelativelyconstantcapitalization.UnlikeOEFs,CEFinvestorsdonot
continuallybuynewshares.
(5) Mostimportantly,althoughOEFsaretraded(boughtandsold)atnetassetvalue,CEFshavetwo
values,amarketvalueandanetassetvalue,andthesearerarelythesame.
14. Thethreesourcesofreturnforamutualfundare(1)dividendincome,(2)capitalgainsdistributions,
and(3)changesinthenetassetvalueofthefund.Eachofthesecomponentshasaneffectonthetotal
returnofamutualfund.Thegreaterthereturnfromanyofthesecomponents,thegreaterthetotal
returntotheinvestor.Forclosedendinvestmentcompanies,changesinpricepremiumsordiscount
areanothersourceofreturn.Thepremiumordiscountactuallyaffectsthemarketprice(ornetasset
value)ofthefundandhenceinvestmentreturni.e.,asdiscountorpremiumchanges,itaffectsthe
changesinNAVand,therefore,totalreturn.
15. Majorriskformutualfundsismarketrisk(systematicrisk)becauseamutualfundisalarge,
diversifiedportfolio.Therefore,itsfortunesaregenerallytiedtothebehaviorofthemarket.Asecond
kindofriskarisesfrommanagementpractices.Ifamutualfundismanagedaggressively,the
probabilityofalossincapitalmaybehigh.Thisisnottoimplythataconservativestrategyisthe
onlyfeasiblestrategyforamutualfund.Obviously,allfundsarenotsubjecttothesameamountof
risk.Themoreaggressiveisthefundmanagement,thegreaterthepotentialreturnandthegreaterthe
amountofrisk.Moreover,sincefundsdealindifferentmarkets,theirmarketriskmaynotbethe
sameeither.

.5

Suggested Answers to Investing in Action Questions

Adding ETFs to Your Investment Portfolio (p. 552)

(a) Whatarefourwaysofstructuringexchangetradedfunds?
(b) WhatinvestmentadvantagesdoETFsoffer?
Answers:
(a) ETFscanbestructuredintermsofinvestmentstyle(e.g.,valueorgrowth),marketcapitalization(e.g.,
small,mid,orlargecapcompanies),sector(e.g.,biotechnologysectororpharmaceuticalindustry),
andregion(e.g.,PacificRimorEurope).
(b) ETFscanbetradedthroughouttheday,haveminimalexpenseratios,attractivereturns,andnotax
liabilityuntiltheETFissold.

249Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.6

Suggested Answers to Ethics in Investing Questions

When Mutual Funds Behave Badly (p. 546)

Willtheimpositionof2.0%redemptionfeesforsaleswithin90daysofpurchaseeliminatetrading
abuses?
Answer:
A2%redemptionfeefortradersmaydiminishthenumberofprofitabletradesformarkettimersbutisnot
likelytoeliminatetradingabusesaslongasmutualfundsbenefitfromthesepractices.Redemptionfees
maybringinadditionalrevenuestofundsbutcreateahassleforsmallinvestorswhoneedtoselltheir
sharesforwhateverreason.Abetterpolicywillbetorequirefundstocalculatetheirnetassetvaluesbased
onfair(continuous)marketpricingratherthanusingdelayed(stale)pricesofforeignorthinlytraded
domesticsecurities.Also,mutualfundsneedtostrictlyenforcetheirownpoliciesagainstmarkettiming
setforthintheirprospectuses.Manyfundspromisetobarthosewhomakemorethan24roundtrip
tradesayearfrominvestinginafund,yetnotallofthemenforcethatrulewhenitcomestolarge
institutionalinvestors.Aproperdeterrentwouldbetoprosecutethoseguiltyofviolatingprospectus
policiesforsecuritiesfraudandmakingfalsestatements.Itis,afterall,alegaldocumentsetforthand
approvedbytheSEC.Latetrading,ontheotherhand,isalreadyillegalandstricterenforcementof
existinglawsisneededratherthancreatingnewregulations.

.7
1.

Suggested Answers to Discussion Questions

ArgumentsforMutualFundOwnership
Greaterlevelofdiversification
Professionalmanagement
Establishaninvestmentprogramwithalimitedamountofcapital
ArgumentsforDirectInvestmentinStocksandBonds
Greatercontroloverthetypesofinvestmentsmade
Closerfittoriskpreferencesoftheindividualinvestor
Greaterliquiditywhenbuyingandselling

2.

(a)
(b)
(c)
(d)
(e)
(f)
(g)

Clipper
SalePrice
84.50
12(b)1fees
No
Redemptionfee
No
Both12(b)1and
No
redemptionfees
Noload
Not
Available
Frontendload
Not
Available
YTDreturn
11.6%

HiYldBd
9.38
Yes
No
No

Canad
25.28
No
Yes
No

EqIncC
13.73
Yes
Yes
Yes

Not
Available
Not
Available
23.1%

No

No

Not
Available
39.5%

Not
Available
28.8%

FMI
Focusfd
31.60
No
No
No
Not
Available
Not
Available
37.6%

FidelityCanadahasthehighestyeartodatereturn,ClipperFundthelowest.

Chapter13MutualFunds:ProfessionallyManagedPortfolios250

3.

(a) Growthversusgrowthandincomefunds:Growthfundshavemoreriskduetogreater
investmentforcapitalgainandthereforenewergrowingcompanies.
(b) Equityincomeversushighgradecorporatebondfunds:Bondsarelessriskysincetheyare
ratedinvestmentqualityascomparedtoordinarycommonstockdividendsthataredeclaredafter
interestincometobondholdersispaid.
(c) Balancedversussectorfunds:Sectorfundslackdiversificationandthereforemaycontain
highernonsystematicriskthanabalancedmorediversifiedfund.
(d) Globalversusaggressivegrowthfunds:Thisdependsonwhattypeofglobalfundisused.
Globalfundsmayalsohaveaggressivegrowthtargetsbuthavepoliticalrisknotassociatedwith
domesticaggressivegrowthfunds.
(e) Intermediatetermbondsversushighyieldmunicipalbondfunds: Highyieldmunicipalbonds
havelessrisksincetheyareusuallyassociatedwithcitiesandmunicipalities.Buttheseunits
mayalsohavehighriskdependingontheircreditratings.

4.

Exchangetradedfundsaresimilartoindexmutualfundsbuttradelikestocks.Eachsharerepresents
abasketofsecuritiesthatcloselytracksonespecificindex.ETFshaveextremelylowcostsduetothe
facttheyhavenoresearchormanagementfeesandminimalbackofficeexpenses.Becausetheyare
tradedonexchanges,theyaresimilartoclosedendfunds.Also,becausetheyarenotactively
managed,theyhavenotaxableincome.
SPDRSareaspecifictypeofEFTbasedontheS&P500index.TheVanguardfamilyoffunds
containsafund,knownastheVanguard500IndexFund,thatissimilar;thatis,theybothtrackthe
S&P500index.
However,youcanonlyinvestintheVanguard500Indexattheendoftheday,whiletradingin
SPDRSoccursduringnormalmarkethours.TheSPDRStendtohavelowcost,lowturnover,andlow
taxliability.MoneyearnedonyourbehalfcanbeautomaticallyreinvestedbyVanguarddaily.
Excludingthisonedisadvantage,theSPDRSwouldbepreferable.

5.

Youcanbuyopenendedfundsattheirnetassetvaluebecauseyouaredealingdirectlywiththefund.
Closedendfunds(CEFs)havebothamarketvalue(stockprice)andanetassetvalue,whichtendto
differ.CEFssellatapremiumtonetassetvalueintheunlikelycasethattheCEFsstockprice
exceedsthenetassetvalue.Itisuncommonforinvestorstopaymoreforasetofsharesthantheir
costwouldbeifboughtdirectly.
DiscountsexistifmoreindividualswereattemptingtosellCEFsharesthanbuythem.Discountsalso
existiftherewaspoorpastfundperformance,alowannualpayoutandyield,poormanagername
recognition,whenverylittlecashisheldbytheCEFmakingitdifficulttotakeadvantagesofnew
opportunities,andifseveralsharesintheportfoliohaveappreciatedsignificantly.Althoughthevalue
ofthesesharesexceedsthepurchasepriceby$X,investorswouldonlyrealize$X(1taxrate)after
taxes.
AdvantagesofbuyingCEFsincludetheenhanceddividendyieldarisingfrominvestinglessthanfull
price.Beyondthis,oneopenendandclosedendmutualfundsshouldbeevaluatedontheexpected
priceperformanceoftheunderlyingassetsandthedistributionofproceedsfromcurrentincomeand
capitalgains.InvestorsshouldtypicallyavoidCEFssellingatapremiumandnewCEFs.

6.

Answerswillvarywitheachstudent.

251Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.8
1.

Solutions to Problems
(a) Returnfortheyear(allchangesonapersharebasis):
Changeinprice($9.10$8.50) $0.60
Dividendsreceived
0.90
Capitalgainsdistributions
0.75
Totalreturn
$2.25
Holdingperiodreturn

$2.2526.47%
$8.50
(b) Whenalldividendsandcapitalgainsdistributionsarereinvestedintoadditionalsharesofthe
fund($8.75/share):
Dividendsandcapitalgainspershare: $0.90$0.75$1.65
Totalreceivedfrom200shares:
$1.65200 $330.00
Additionalsharesacquired:
$330/$8.75 37.7shares
Valueof237.7sharesheldatendofyear: 237.7shares$9.10$2,163
Pricepaidfor200shares
200shares$8.50 $1,700
atbeginningofyear
Thus,theholdingperiodreturnwouldbe:
H.P.R

$2,163 $1, 700

$463

27.24%
$1, 700
$1, 700

2.
Purchase(offer)pricebeginningofyear
Currentprice(NAV)endofyear
Decrease
Returnfortheyear:
Dividendandgainsdistribution
Lossinvalue
Totalreturn

$23.35
23.04
($0.31)
$1.05
(0.31)
$0.74

Note:Thisisagoodproblemtodemonstratetheimpactofloadchargesoninvestorreturn.The
instructormightwanttopointoutthateventhoughtheNAVofthefundincreasedby$1.54ashare
($23.04$21.50),theinvestorstillisfacedwitha$.31lossinvalueovertheyear,sinceyoubuyat
theofferpriceandsellattheNAV.Inthiscase,eventhoughtheNAVwentup,theinvestorhadto
absorba$1.85loadcharge;thenetresultisa$.31loss.Asapointofinterest,ifthishadbeenano
loadfund,theHPRwouldhavebeen:
($1.54$1.05)$21.5012.05%

Chapter13MutualFunds:ProfessionallyManagedPortfolios252

3.

5yearCompoundedRateofReturn
2003
(a)Beginning
NAV
(b)Dividends
(c)Capital
Gains
(d)Closing
NAV
NetCashFlow

0.95
1.05

2002

2001

2000

1999

0.85
1.00

0.85

0.75
1.00

0.60

0.85

1.75

0.60

15.73
17.73

1.85

UsingaFinancialcalculator,the5yearcompoundedrateofreturnis:21%
3yearCompoundedRateofReturn
(a)Beginning
NAV
(b)Dividends
(c)Capital
Gains
(d)Closing
NAV
NetCashFlow

1998
10

2003

2002

2001

0.95
1.05

0.85
1.00

0.85

1.85

0.85

2000
10.64

15.73
17.73

10.64

10

253Gitman/JoehnkFundamentalsofInvesting,NinthEdition

UsingaFinancialcalculator,the3yearcompoundedrateofreturnis:26%
5yearHoldingPeriodReturn
TotaldividendsTotaldistributedcapital
gainsCapitalgainonshareprice
($0.95$0.85$0.85$0.75$0.60)
($1.05$1.00$1.00)($15.73$10.00)
$4.00$3.055.73
$12.78pershare
Shewouldhavemorethandoubledhermoney.
Totalprofitpershare
overthe5yearperiod

4.
EndingNAV
Purchase(offer)price
Netincrease/(decrease)
Returnfortheyear:
Dividendsreceived
Capitalgainsdistribution
Netincreaseinprice
Totalreturn
Holdingperiodreturn
Totalreturn/Purchaseprice

2002
$43.20

55
.00
($11.80)

2003
$60.47

46
.20
$14.27

2004
$57.75

64
.68
($6.93)

Total

$2.10
1.83
(11.80)
($7.87)

$2.84
6.26
14
.27
$23.37

$2.61
4.32
(6.93)
$0

$7.55
12.41

14.3%

50.58%

0%

Chapter13MutualFunds:ProfessionallyManagedPortfolios254

Theaverageannualcompoundrateofreturnoverthe3yearperiod:
3yearCompoundedRateofReturn
(a)Beginning
NAV
(b)Dividends
(c)Capital
Gains
(d)Closing
NAV
NetCashFlow

2001
55

2002

2003

2004

2.10
1.83

2.84
6.26

2.61
4.32
57.75

55

3.93

9.10

64.68

UsingaFinancialcalculator,the3yearcompoundedrateofreturnis:13.2%
Giventhatalldividendsandcapitalgainsdistributionsarereinvestedinadditionalsharesofthefund
atanaveragepriceof$52.50pershare:
Dividendsandcapitalgainspershare:$2.84$6.26$9.10
Totalincomefrom500shares:
$9.10500 $4,550
Additionalsharesrequired:
$4,550/$52.50 86.7shares
(Numberofshares (Numberofshares
Endingprice)
Beginningprice
Holdingperiodreturn
(Numberofshares Initialprice)
(586.7 $60.47) (500 $46.20)

500 $46.20
$35, 477.75 $23,100.00

$23,100.00
$12, 377.75

53.6%
$23,100.00
5.

Holdingperiodreturnsfor2004and2001:
EndingNAV
BeginningNAV
Netincrease/(decrease)
Returnfortheyear:
Dividendsreceived
Capitalgainsdistribution
NetincreaseinNAV
Totalreturn
Holdingperiodreturn
(Totalreturn/BeginningNAV)

2004
$64.84
58.60
$6.24
$0.83
2.42
6
.24
$9.49
16.2%

2001
$44.10
59
.85
($15.75)
$0.72
9.02
(15.75)
($6.01)
10.0%

255Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Holdingperiodreturnsfor2004and2001witha3%load:
Withafrontendloadof3%onNAV,thepurchasepriceBeginningNAV1.03.
Totalreturnbeforeanyload
Less:Loadat3%
Totalreturnwithload
Purchaseprice
HPR

2004
$9.49
(1
.76)
$7.73
$60.36
12.81%

2001
($6.01)
(1
.80)
($7.81)
$61.65
12.7%

Sincethefrontendloaddecreasesthetotalreturnandincreasesthepurchaseprice,thecumulative
effectwillbeadecreaseintheHPR.
Averageannualrateofreturnoverthetwoperiods:
20002004
Capital
Dividends
Gains
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

$0.46
0.72
0.90
1.24
0.83

$6.84
9.02

3.82
2.42

19952004
Capital
Dividends
Gains
$0.58
$9.92
0.33
1.23
0.26
1.88
0.37
3.69
0.65
1.78
0.46
6.84
0.72
9.02
0.90

1.24
3.82
0.83
2.42

CompoundedReturnforthe5yearperiodwithLoading
(a)Beginning
NAV
(b)Dividends
(c)Capital
Gains
(d)Closing
NAV
NetCashFlow

2004

2003

2002

2001

2000

0.83
2.42

1.24
3.82

0.90

0.72
9.02

0.46
6.84

5.06

0.90

9.74

7.30

1999
55.34

64.84
68.09

UsingaFinancialcalculator,the5yearcompoundedrateofreturnis:12.71%

55.34

Chapter13MutualFunds:ProfessionallyManagedPortfolios256

CompoundedReturnforthe10yearperiodwithLoading
(a)Beginning
NAV
(b)Dividends
(c)Capital
Gains
(d)Closing
NAV
NetCashFlow

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

0.83
2.42

1.24
3.82

0.90

0.72
9.02

0.46
6.84

0.65
1.78

0.37
3.69

1.88

0.33
1.23

0.58
9.92

5.06

0.90

9.74

7.30

2.43

4.06

2.14

1.56

10.50

1994
29.82

64.84
68.09

UsingaFinancialcalculator,the10yearcompoundedrateofreturnis:21%
Ifthefundchargesa3%loadonNAV,thebeginningpricewouldbedifferentandthatwouldchange
theyield:
Beginningprice,1995 $29.821.03$30.71
Beginningprice,1999 $55.341.03$57.00
CompoundedReturnforthe5yearperiodwithLoading
2004

2003

2002

2001

2000

(b)Dividends 0.83
(c)Capital
2.42
Gains
(d)Closing
64.84
NAV
NetCashFlow 68.09

1.24
3.82

0.90

0.72
9.02

0.46
6.84

5.06

0.90

9.74

7.30

(a)Beginning
NAV

1999
57

57

UsingaFinancialcalculator,the5yearcompoundedrateofreturnis:11.9%
CompoundedReturnforthe10yearperiodwithLoading
2004
(a)Beginning
NAV
(b)Dividends 0.83
(c)Capital
2.42
Gains
(d)Closing
64.84
NAV
NetCashFlow 68.09

2003

2002 2001

2000

1999 1998

1997

1996

1995

1994
30.71

1.24
3.82

0.90

0.72
9.02

0.46
6.84

0.65
1.78

0.37
3.69

0.26
1.88

0.33
1.23

0.58
9.92

5.06

0.90

9.74

7.30

2.43

4.06

2.14

1.56

10.50 30.71

29.82

257Gitman/JoehnkFundamentalsofInvesting,NinthEdition

UsingaFinancialcalculator,the10yearcompoundedrateofreturnis:20.4%

6.

7.

Inbothcasestheyieldwentdown,butonlymarginally,comparedtotheoneyearHPR,which
decreasedsignificantly.Thisoccursbecausetheimpactofthefrontendload,payableonlyatthetime
oftheinitialpurchaseisminimizedoverlongerholdingperiods.
Thereisnosetsolutiontothisproblem,sincetheanswerswillvarywiththefundsselectedbythe
student.Therearemanyfundsthatthestudentcanchoosefromtoanswerthisquestion.The
instructormightwanttoreferthestudenttooneofseveralfundservicesthatareavailable,especially
MorningstarsMutualFundValues,DonoghuesMutualFundsAlmanac,orWeisenberger
InvestmentCompanies.Websitesincludemorningstar.com,indexfunds.com,andquicken.com.It
mightbeusefultobringexamplestoclasstoshowthetypesofinformationavailable.
(a) NAVbasedHPRfortheyear:
$0.40 $0.95 ($11.69 $10.40)
$10.40
25.38%

(b) MarketbasedHPRfortheyear:
(i) Beginningperiodmarketprice
(marketprice NAV)
NAV
(marketprice $10.40)
0.18
$10.40
$8.53 marketprice

premium(ordiscount)

(ii) Endingperiodmarketprice
(marketprice $11.69)
$11.69
$12.16 marketprice
0.04

(iii)

HPR HPR
HPR 58.38%

($0.40 $0.95) ($12.16 $8.53)

$8.53

Themarketdiscountappliedtothepurchasepriceandthemarketpremiumappliedtothesale,
therefore,theinvestorsreturnbenefited.
(c) MarketbasedHPRfortheyear:
(i) Beginningperiodmarketprice
(marketprice $10.40)
$10.4
$12.27 marketprice
0.18

(ii) Endingperiodmarketprice
(marketprice $11.69)
$11.69
$11.22 marketprice
0.04

Chapter13MutualFunds:ProfessionallyManagedPortfolios258

(iii)

($0.40 $0.95) ($11.22 $12.27)

$12.27
HPR 2.44%
HPR

Becausethepremiumappliedtothepurchasepriceandthediscountappliedtotheendingperiod
price,theHPRissignificantlylower.Obviously,boththepremiumanddiscountvaluesaffectthe
investorsHPR.
8.

(a) NAVbasedHPRfortheyear:
$1.20 $0.90 ($9.25 $7.50)
$7.50
51.33%

(b)

(marketprice NAV)
NAV
($7.75 $7.50)

$7.50
3.33%

Beginningperiodpremium=

($9.00 $9.25)
$9.25
2.7%

Endoftheperiodpremium

(c) MarketbasedHPRfortheperiod:
($1.20 $0.90) ($9.00 $7.75)
$7.75
43.2%

HPR

Themarketpremiumincreasedthepurchasepriceandthemarketdiscountreducedthesaleprice,
therefore,ithurttheinvestorsholdingperiodreturn.
9.

ThisisasinglecashflowIRRproblem.Initialinvestmentis$20,000.Threeyearslater,thevalueis
$25,201(1,100$22.91).
$20,000FVIFX%,3periods$25,201
8%factor1.26.$20,0001.26$25,200.
CalculatorSolution
3N,20,000PV,25,201FV;CPTI/Y8.01%

10. Herethereisanadditional3%addedtothecostoftheinitialpurchase.Theinitialinvestment
becomes($20,0001.03)$20,600.
$20,600FVIFX%,3periods$25,201
7%factor1.225.$20,0001.225$25,235.
FinancialCalculator:3N,20,600PV;25,201FV;CPTI/Y6.95%

259Gitman/JoehnkFundamentalsofInvesting,NinthEdition

11. TheproblemassumesthatOhYesMutualFundanoloadfund.

Chapter13MutualFunds:ProfessionallyManagedPortfolios260

HPR [DivDist+GainsDist+(NAVEnding NAVBeginning )]/NAVBeginning

HPR [1.50+2.00+(26.00 25.00)}/25.00
4.50/25.00=0.18or18%.
12. TheproblemassumesthatOhYesMutualFundiscarriesa2%load.IftheinitialNAVwas$25.00,
theinitialcostwas$25.50($251.02).RecomputingtheHPRgives:
HPR [DivDist+GainsDist+(NAVEnding InitialCost)]/InitialCost
HPR [1.50+2.00+(26.00 25.50)}/25.50
4.00/25.50=0.157or15.7%.
13.

HPR [DivDist+GainsDist+(NAVEnding InitialCost)]/InitialCost

HPR [1.30+0+(14.50 12.66)}/12.66
[1.30+1.84]/12.66=0.2480or24.80%.

14. Cashflowsare:
Period
0
1
2
3
Cashflow $12.66 $1.30 $1.30 $16.68
12.661.3(PVIFx%,1)1.30(PVIFx%,2periods)16.98(PVIFx%,3)
Using17%:1.3(0.885)1.3(0.731)16.98(0.624)
1.15050.950310.595512.6963
Sincethisvalueiscloseto12.66,thediscountratemustbenear17%.
Calculator:3N,12.66PV,1.30PMT,15.68FV;CPTI/Y17.01%
15. ThefundistradingatadiscountbecausethemarketpriceisbelowtheNAV.(Shareprice
NAV)/NAV($20.00$22.5)/$22.50$2.50/$22.500.1111or11.11%.
16. Taxeswillbe15%onhalfofthedistribution(dividends)and25%ontheotherhalf(interestincome).
Totaldistributionis1,000$2.00$2,000.
Tax($1,0000.15)($1,0000.25)$150$250$400.

.9

Solutions to Case Problems

Case 13.1 Reverend Robin Ponders Mutual Funds

Thiscaseenablesthestudenttodealwiththeissuesincludedinputtingtogetheralongtermmutualfund
programthatwillmeetsomeprettyspecificinvestmentobjectives.
(a) ReverendRobinneedstoaccumulatecapitalandneedsavehiclethatwillserveasastorehouseof
value.Givenhislackofinvestmentexpertiseandthesmallsumhehastoinvest,mutualfundswould
beanidealvehicle.Hewillgainprofessionalinvestmentmanagementandfargreaterdiversification
thanhecouldifheinvestedhissmallamountoffundsdirectly.Moreover,hecansetupsavingsand
reinvestmentplanstohelphimtowardhisgoaloflongtermcapitalaccumulation.

261Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Asindicatedearlierinthetext,certainprerequisitesmustbesatisfiedpriortoenteringaninvestment
program.ReverendRobincancoverthenecessities,butheshouldbesurethathealsohasadequate
insuranceandsufficientliquidity.Allorpartofthe$15,000canbeinvestedinamoneymarketmutual
fundwithoutlosinganyliquidity,butwithagainininterest.ReverendRobincoulduseamoney
marketfundtoaccumulatefundsthatcanlaterbemovedtoanotherfundinthesamefamilyof
funds.
(c) ReverendRobinsspecificinvestmentneedsareretirementandcollegeeducationforhischild.Both
objectivesfavoraconservativegrowthfundoragrowthandincomefund.Agoodstrategywouldbe
tostarttheReverendRobinusingamoneymarketfundwithconversionprivilegeswhenadequate
liquidityisestablished.Usingautomaticsavingsandreinvestmentservices,ReverendRobinshouldbe
abletoaccumulatecapitaltomeetbothobjectiveswithoutunduerisk.Inmeetinghisretirementneeds,
heshouldalsoinvestigateanIRAaccount.HecanprobablycontributetohisIRAaccount,andtaxes
onthisamount(alongwithearningsonthefund)aredeferreduntilhedrawsthefundsatretirement.

Case 13.2 Tom Yee Seeks the Good Life

Incontrasttothepreviouscase,inwhichtheinvestorwasinterestedinlongtermwealthaccumulation,
thiscaseillustratesasituationinwhichcurrentincomeistheprimaryobjective.
(a) GivenTomsexistingfinancialcondition,hecantakeonacertainamountofrisk.Also,Tomwantsto
consumeimmediately.Inthatsense,anincomefundseemsattractive.Hecouldobviouslyusethe
currentincomesuchafundcanprovide.Althoughheseemsfinanciallycapableofassumingincreased
risktogenerateahigherreturn,hehasalsostatedthatheintendstobearoundforalongtime.
Therefore,preservationofcapitalwouldseemtobeanotherofTomsobjectives.Asaresult,hemight
alsoconsideramoneymarketfund,orperhapsanintermediatetermbondfund.Thechoicewillboil
downtoTomsgreatestneed;orperhapshecaninvestinboth.
(b) Thefactorsthatmustbetakenintoconsiderationare(1)Tomsexistingwealthlevel,(2)hisabilityto
takeonrisk,(3)hisdemandforcurrentincome,and(4)hisdesireforcapitalpreservation.These
considerationswillclearlydictatethekindofmutualfundTomshouldselect.Hisdemandforcurrent
incomeandhisdesireforpreservationofcapitalshouldbeparamountintheselectionprocess.Heis
financiallywelloff;hehasnochildrenandisawidower,sohecanaffordtotakesomerisk.Butheis
alsoinhisretirementyears,andheknowstheimportanceofcapitalpreservation.Taxesarenotan
issue,soheshouldavoidmunicipalbondfundsandsimilartaxshelteredfunds.
Someviableinvestmentcandidatescouldincludeoneormoreofthefollowing:highyieldmoney
fundsforyieldandcapitalpreservation;corporatebondfundsthatinvestheavilyinAandBaarated
issuesforhighyield(notethatextensiveportfoliodiversificationwouldbeessentialtokeeprisktoa
minimum);governmentbondfundswithintermediate(threetotenyear)maturitiesforsafety,yield,
andpreservationofcapital;orpossiblyevenequityincomefunds,whichcouldprovidenotonly
currentincomebutalsosomecapitalappreciationforthelonghaul.However,Tomshouldunderstand
thatthisoptioncouldinvolvesomeperiodic/shorttermsacrificeofhiscapitalpreservationgoal.
(c) Tomisclearlynotinneedofanysavingsplan.Healreadyhasaconsiderableamountofsavingsandis
abletomanagethingswellonhisown.WhatheneedsisawithdrawalplanbecauseTomwouldlike
toreceivetheincomeperiodicallyandatregularintervals.Thereareseveralpopularvariationsof
withdrawalplans,andheshouldpicktheonethatbestsuitshisneeds.SinceTomwouldliketo
receive$1,000$1,500monthly,heshouldinitiateafixeddollaramountwithdrawalplan.A
conversionprivilegewouldalsobeaplus.

Chapter13MutualFunds:ProfessionallyManagedPortfolios262

(d) Fundearns12percent:Startingbalanceis$100,000.Attheendofthefirstyear,thiswouldbeworth
$100,0001.10$110,000.Letusassume(foreaseofcalculation)thatTomwithdraws$15,000per
yearattheendofeachyearandcomputethevalueafterhemakeshisfifthwithdrawal:
Year
1
2
3
4
5

Initial
Sum
$100,0001.10
95,0001.10
91,4001.10
83,4501.10
76,7951.10

Ending
Sum
110,000
104,500
98,450
91,795
84,474

LessAnnual
Withdrawal
$15,000
$15,000
$15,000
$15,000
$15,000

Balance
EndofYear
95,000
89,500
83,450
76,795
69,474

Thus,ata10%earningrate,thevalueofhis$100,000investmentwillsteadilydeclineto$69,474by
theendofthe5thyear.Thereasonforthisissimple:hestakingoutmorethanhesearning.Thiswill
eventuallyresultintotalcapitalconsumption,somethingTomwouldliketoavoid.Obviously,the
earningrateisimportanttothepreservationofcapitalinfact,theonlywaytoavoiddepletionof
capitalinthiscaseistoinvestinafundearningatleast15percent.Sucharatewillyield$15,000a
yearfroma$100,000investment.Shortofthis(i.e.,findingafundthatyields15%),Tomhasthree
choices:
(1) acceptthefactthathiscapitalwilldeclineovertime.
(2) reducethesizeofhiswithdrawalstosomethingclosertotheearningrateonthefund(e.g.,to
$10,000peryearfromafundthatearns10%);or
(3) increasethesizeoftheinitialinvestmentsotheannualpayoffisclosertohisneedse.g.,he
wouldhavetoinvest$150,000toreceive$15,000peryearfromafundthatearns10%.

.10 Outside Project

Chapter 13The Other Kind of Investment Company
Themostpopularformofinvestmentcompanyistheopenendmutualfund.Buttheclosedendcompany
alsoholdsaplaceinthemarketforprofessionallymanagedinvestmentcompanies.Thisprojectwillhelp
youunderstandthedifferencebetweenopenendmutualfundsandclosedendinvestmentcompanies.
Fromthelistofclosedendcompaniesgiveninthetest,selectadiversifiedstockfundandabondfund;in
addition,findtwoopenendmutualfundsthathaveroughlythesameinvestmentobjectives.Youcanfind
informationonfundobjectives,etc.inWeisenbergerInvestmentCompaniesoranyothersimilar
investmentcompanyservices.Now,comparethefourfundsbylookingatthefollowingfeatures:
a. managementfeecharged
b. howlongthefundhasexisted
c. sizeofthefundoramountofdollarsundermanagement
d. financingofthefunddoesitissuedebttoemployleverage?
e. dividendandcapitalgainsdistributionsforthelastthreetofiveyears
f. theapproximateyieldforthelastthreeyears
g. loadcharges
Commentonyourfindings.Doyouthinkopenandclosedendcompaniesreallybehaveallthat
differently?Inthefinalanalysis,whatsthemostimportantthingindeterminingtheamountofinvestment
success(orfailure)achievedbyopenandclosedendfunds?