Chapter 13 Review Questions and Answers 1 What is a mutual fund Discuss the mutual fund concept including the importance of diversification and professional management A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors Mutual funds represent ownership in a managed portfolio of securities The mutual fund concept revolves around diversification Diversification reduces the overall risk borne by the investor without reducing the average return This together with the fact that mutual funds provide professional management which free individual investors from managing their own portfolios makes mutual funds attractive to individuals 2 What are the advantages and disadvantages of mutual fund ownership The major advantage of a mutual fund is the provision of diversification and full time professional management Investors with modest amounts of capital can invest in mutual funds and receive these advantages In addition mutual funds also handle all paperwork and record keeping deal in fractional shares and automatically reinvest dividends if the investor so desires There are several disadvantages however Funds can be quite expensive to acquire if they are load funds or have other types of charges and fees such as 12 b 1 fees While it s expected that index based passively managed mutual funds will have a slightly lower return than that of the market covered actively managed mutual funds haven t performed that well either Only a few have been able to outperform the market with any degree of regularity and their performance generally has corresponded only to the performance of the market as a whole This is because of the high expenses which reduce investor returns 3 Briefly describe how mutual funds operate Mutual funds are open ended investment companies Investors in mutual funds are essentially buying a small piece of a large well diversified portfolio of securities Mutual funds receive money from shareholders and invest it in a securities portfolio Investors in a given mutual fund are all part owners of that portfolio 4 Define each of the following a Open end investment company An open end investment company is a mutual fund in which investors buy their shares from and sell them back to the mutual fund itself direct investing There is no limit on the number of shares an open end fund can issue They are by far the most common type of mutual fund b Closed end investment company A closed end investment company is a fund that issues a fixed number of outstanding shares and does not regularly issue new stock shares These funds which are relatively few when compared to the number of open end funds operate with a fixed capital structure relationship of debt to equity that a company has and trade in the stock market Most of them are listed on the NYSE 1 c Exchange traded funds An exchange traded fund ETF is a type of open end investment company its assets are primarily a portfolio of securities that trades as a listed security on one of the stock exchanges It s a hybrid product that combines some of the best features of mutual funds with closed end funds d Hedge funds Like mutual funds hedge funds sell shares or participation units in a professionally managed portfolio of securities However hedge funds are private partnerships that limit their clientele to accredited investors The manager is a general partner while the investors are limited partners There also tends to limit the number of limited partners to fewer than 100 Hedge funds have very limited reporting requirements to the SEC and are generally unregulated 5 What is the difference between load and no load funds What are the advantages of each type A load fund is a mutual fund that charges a commission to purchase fund shares A no load fund does not charge investors a commission No load funds offer an advantage because by avoiding commissions can be as high as 8 5 they can buy more fund shares with a given amount of capital Other things being equal this results in a higher rate of return 6 What is a 12 b 1 fund Can such a fund operate as a no load fund A mutual fund can legally refer to itself as a no load fund if it charges no more that of a percent 25 in annual 12 b 1 fees A true no load fund doesn t charge any 12 b 1 fees Load funds can charge a maximum of 1 annual 12 b 1 fees 12 b 1 funds are annual charges and can significantly reduce returns over time 7 Describe a back end load and a hidden load How can you tell what kind of fees and charges a fund has A back end load is a redemption fee commission that an investor pays when he sells fund shares Redemption fees typically decline over time and disappear altogether after the first three to five years of ownership They are intended to provide an incentive for investors to retain the fund at least long enough to avoid any redemption fee The easiest way to know if a front end load back end load or 12 b 1 fee is charged is to look at the fee table found in the mutual fund s prospectus Fee tables must by SEC rules fully disclose types and amounts of fees and charges at the time of purchase Be aware however that these fees can be changed by the fund The first time mutual fund shares are bought a prospectus must be sent to the new investor by SEC rules Periodically thereafter investors should request an updated prospectus from the mutual fund 7 What is an automatic reinvestment plan Automatic reinvestment plans enable mutual fund investors to keep their capital fully invested This is important because it lets investors earn fully compounded rates of return Normally dividends and capital gains distributions are paid in the form of cash Through automatic reinvestment plans however those dividends and capital gains distributions are used to buy additional fund shares resulting in the number of shares owned by an investor increasing over time 2 8 How important is the general behavior of the market in affecting the price performance of mutual funds Explain Does the future behavior of the market matter in the selection process Explain Since a mutual fund is really a large portfolio of securities it behaves very much like the market as a whole or a given market segment depending on what securities the portfolio holds When economic conditions are good and the stock market moves up mutual funds do well When the market takes a plunge mutual funds do poorly Some funds such as sector funds may not move with the overall market This is
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