Department of Banking and Finance
SPRING 2007-08
Mutual Funds and Other Investment
Companies
by
Asst. Prof. Sami Fethi
Ch 4 : Mutual fund
Mutual Funds

Mutual fuds are firms that manage pools of
individual investor money.
 The objectives of mutual funds is to invest
such shares that the income generated by the
funds.
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Investment Management
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Ch 4 : Mutual fund
Investment Companies
 These
companies are financial
intermediaries that collect funds from
indivudual investors and invest those
funds in a potetially wide range of
securities or other assets.
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Ch 4 : Mutual fund
Investment Companies

Pooling of assets is the key idea behind
investment companies.
 Each investor has a claim to the Porfolio
established by the investment company in
proportion to the amount invested.
 These companies thus provide a mechanism
for small investors to team up to obtain the
benefits of large-scale investing.
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Ch 4 : Mutual fund
Services of Investment Companies
Investment companies perform several
important function for their investors:
 Administration & record keeping
 Diversification & divisibility
 Professional management
 Reduced transaction costs
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Investment Management
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Ch 4 : Mutual fund
Administration & record keeping

Investment companies issue periodic status
reports, keeping track of capital gains
distributions, dividends, investments, and
redemptions, and they may reinvest
dividend and interest income for
shareholders.
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Investment Management
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Ch 4 : Mutual fund
Diversification & divisibility

By pooling their money, investment
companies enable investors to hold
fractional shares of many different
securities. They can act as large investors
even if any individual shareholder cannot.
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Ch 4 : Mutual fund
Professional management

Most, but not all, investment companies
have full-time staffs of security analysts and
portfolio managers who attempt to achieve
superior investment results for their
investors.
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Ch 4 : Mutual fund
Reduced transaction costs

Investment
companies
can
achieve
substantial saving on brokerage fees and
commissions due to the large blocks of
securities.
 Investment companies also need to divide
claims to these assets among those investors
as they pool the assets of individual
investors.
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Investment Management
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Ch 4 : Mutual fund
Net Asset Value

Investor buy shares in investment
companies, and ownership is proportional
to the number of shares purchased. The
value of each share is called the net asset
value or NAV.
 NAV equals assets minus liabilities
expressed on a per-share basis:
 NAV= Market value of assets- Liabilities/
Share outstanding
Investment Management
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© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
NAV
NAV  MarketValue Assets Liabilities
Shareoutstanding
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Investment Management
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Ch 4 : Mutual fund
Example 1

Consider a mutual fund that manages a
portfolio of securities worth $ 120 mn.
Assume that the fund owes $ 4 mn to its
investment advisers and owes another +$ 1
mn for rent, wages due and miscellanous
expenses. The fund has $ 5 mn
shareholders. What is the net asset value of
the portfolio?
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Ch 4 : Mutual fund
Answers 1
 NAV=
(120-5)/5= $ 23 per share
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Example 2
Stock Share
Price

A
200000 $ 35
B
300000 40
C
400000 20
D
600000 25
The composition of X
fund portfolio is as
follows:
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Ch 4 : Mutual fund
Example 2 cont…

The fund has not borrowed any funds, but
its management fee with the porfolio
manager currently total $ 30000. There are
also $ 4 mn shares outstanding.
 What was the NAV?
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Ch 4 : Mutual fund
Answers 2

MVA= Share x Price
 MVA=(A=7mn)+(B=12mn)+(C=8mn)+(D=
15mn)
 MVA Total=42mn
 NAV=$ 42mn-$ 30000/$ 4mn
 NAV=$ 10.49
 30000=0.03
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Ch 4 : Mutual fund
Types of Investment Organizations

Unit Trusts
 Managed Investment Companies
– Open-End
– Closed-End
 Other investment organizations
– Commingled funds
– REITs
– Hedge Funds
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Ch 4 : Mutual fund
Unit Investment Trust

Investment companies can be classifed as
either unit investment trusts or managed
investment companies.
 Unit investment trusts: They are essentially
fixed and thus are called unmanaged.
 More specifically, a unit trust is a pool of
funds invested in a portfolio that is fixed for
the life of the fund.
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Ch 4 : Mutual fund
Unit Investment Trust

Sells to the public shares or unit in trust.
These are called redeemable trust
certificates.
 Due to the portfolio composition is fixed,
these trusts are referred to as unmanaged.
 The trust life is dependent on the maturity
of securities.
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Ch 4 : Mutual fund
Management Investment Companies
 There are two types of managed companies:
 closed-end and open-end.
 In both cases, the fund’s board of directors
which is elected by shareholders hires a
management company to sort the portfolio
out for an annual fee that typically ranges
from 0.2% to 1.5% of assets.
 This type of company in many cases is the
firm that organized the fund.
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Ch 4 : Mutual fund
Open-end and closed-end funds

A fund that issues or redeems shares at their
net asset value (NAV). When investors in
open-end fund wish to cash out their shares,
they sell back to fund at NAV.
 A fund that do not issue or redeem shares.
Investors in closed-end fund who wish to cash
out must sell their shares to other investors.
Shares in this type of fund are traded at prices
that differ from NAV. This can be purchased
through brokers just like other common stock.
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Ch 4 : Mutual fund
Open-end and closed-end funds cont…
 Since the shares in closed-end funds are
required in second market, prices for such
shares are commonly at premiums or
discounted from the underlying NAV.
 When discussing premiums or discounts on
closed-end funds, it is worth to emphasize the
fact that the NAVs are generally reported on
weekly basis. For such investment companies
the premiums and discounts from the reported
NAV are accurate for closing prices on the
reporting day.
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Ch 4 : Mutual fund
Open-End and Closed-End Funds: Key
Differences
Shares Outstanding
 Closed-end: no change unless new stock is
offered
 Open-end: changes when new shares are
sold or old shares are redeemed
Pricing
 Open-end: Net Asset Value (NAV)
 Closed-end: Premium or discount to NAV
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Investment Management
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Ch 4 : Mutual fund
Offering Price and load

In contrast to closed-end funds, the price of
opened-end funds cannot fall below NAV.
Because these funds stand ready to redeem
shares at NAV. However, the offering price
can exceed NAV, if the fund carries a load.
 A Load- a sales commission charged on a
mutual fund.
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Ch 4 : Mutual fund
Example 3

An open-end fund has a net value asset of $
10.70 per share. It is sold wıth a load of 6%.
What is the offering price?
 Offering price=NAV/(1-load)
 10.70/(1-0.06)
 11.38
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Investment Management
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Ch 4 : Mutual fund
Example 4

Would you expect a typical open-end fixed-income
mutual fund to have higher or lower operating
expenses than a fixed income unit investment trust?
 The
unit investment trust should have lower
operating expenses. Because the investment trust
portfolio is fixed once the trust is established, it
does not have to pay portfolio managers to
constantly monitor and rebalance the portfolio as
perceived needs or opportunities change.
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Ch 4 : Mutual fund
Other Investment Organization
 Commingled funds
 REITs
- Real Estate Investment Trust
 Hedge Funds
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Ch 4 : Mutual fund
Commingled Funds

This type of funds are partnerships for investors
that pool their funds. The management firm that
organizes the partnership, for example, a bank or
insurance company manages the funds for a fee.
 They
are similar in firm to open-end mutual
funds and are commonly used in trust accounts for
which investors do not have large enough pools of
funds to warrant individual management.
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Ch 4 : Mutual fund
Real Estate Investment Trusts
• They are investment vehicles that are similar to
closed-end funds in that they invest in real estate
or in bonds secured by real estate. REITs provide
financial leverage (with debt ratio of 70%) and
offer an investor the possibily to invest in real
estate with professional management.
• -Equity-invest real estate
• -mortgage trust-invest in mortgage construction
load.
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Ch 4 : Mutual fund
Hedge Funds

Like mutual funds, hedge funds are vehicles that
allow private investors to pool assets to be invested
by a fund manager, however they are not registered
as mutual funds. They are open only to wealthy or
institutional investors.
As hedge funds are only lightly regulated, their
managers can pursue investment strategies that are
not open to mutual fund managers (i.e. Heavy use
of derivatives, short sales and leverage). They have
more speculative polies than mutual funds.

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Ch 4 : Mutual fund
Mutual Funds

This type of fund is the common name for an
open-end investment company and they have a
specified investment policy.

i.e. Money market mutual funds hold the short-term, lowrisk instruments of the money market whereas bonds funds
hold fixed-income securities. These types of funds can be
classified by investment policy.
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Ch 4 : Mutual fund
Investment Policies

Money Market
 Fixed Income
 Equity
 Balance & Income
 Asset Allocation
 Indexed
 Specialized Sector
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Ch 4 : Mutual fund
Money Market

This kind of fund invest in money market
securities. They usually provide check
writing features and NAV is fixed at $ 1
per share, hence there are no tax
implications such as capital gains or loses
association with redemption of share.
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Ch 4 : Mutual fund
Fixed income or Bond

As the name itself suggests, these funds
specialize in the fixed-income sector. In this
sector, however, there is considerable room
for specialization. i.e. Various funds
concentrate on corporate bonds, Treasury
bond, morgage-backed securities or
municipal bonds due to free-tax.
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Investment Management
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Ch 4 : Mutual fund
Equity

Equity funds invest primarily in stock,
although they may, at the porfolio
manager’s discretion, also hold fixedincome or other types of securities. This
type of funds will hold about 5% of total
assets in money market securities to
provide the liquidity necessary to meet
potential redemption of shares.
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Investment Management
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Ch 4 : Mutual fund
Equity

Income Funds: tend to hold share shares of
firms with high dividend yields that provide
high current income.
 Growth Funds: are willing to forgo current
income focusing instead on prospects for
capital gains.
 Growth funds are riskier and respond far
more dramatically to change in economic
conditions then income funds.
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Investment Management
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Ch 4 : Mutual fund
Balanced and Income funds
They are based on individual’s entire
investment, holding both equities and fixedincome securities in relatively stable
proportions.
 Balanced funds minimize investment risks
whereas income funds maintain current
income and long-term growth.

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Investment Management
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Ch 4 : Mutual fund
Asset allocation

They are similar to balanced funds in that
hold both stocks and bonds.
 Assets allocation funds may vary the
proportions allocated to each market in
accord with the portfolio manager’s forecast
of the relative performance of each sector,
however, they are not desingned to be lowrisk investment vehicles.
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Index Funds

They have intention to match the
performance of a broad market index.
 These funds buy shares in securities
included in a particular index in proportion
to the security’s representation in that index.
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Investment Management
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Ch 4 : Mutual fund
Specialized Sector Funds

This kind of fund concentrates on a
particular industry.
 i.e. Biotechnology or telecomunications.
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Investment Management
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Ch 4 : Mutual fund
Costs of Investing in Mutual Funds

Fee Structure
– Front-end load
– Back-end load

Operating expenses
 12 b-1 charges
– distribution costs paid by the fund
– Alternative to a load

Fees and performance
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Fee Structure
 Fee
Structure
- An individual investor choosing a
mutual fund should consider not only
the fund’s stated investment policy and
past performance, but also its
management fees and other expenses.
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Front-end load and Back-end load
– Front-end load
– A Front-end load is a commission or sales
charge paid by when you purchase the
share.
Funds with a front-end load initially
reduce the investment amount.
– Back-end load
– A Back-end load is a redemption fee
incurred when you sell your share.
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Investment Management
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Ch 4 : Mutual fund
Operating expenses

Operating expenses: are the costs incurred
by the mutual fund in operating the
portfolio, including administrative expenses
and advisory fees paid to the investment
manager. These expenses usually expressed
as a percentage of total assets under
management, may range from 0.2% to 2%.
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
12 b-1 charges

12 b-1 charges
 Annual fees charged by a mutual fund to
pay for marketing and distribution costs.
– distribution costs paid by the fund
– Alternative to a load
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Fees and Mutual Fund Returns

The rate of return on an investment in a
mutual fund is measured as the increase or
decrease in NAV plus income distribution
such as dividends or distributions of capital
gains expressed as a fraction of NAV at the
beginning of the investment period. We can
denote the NAV at the start and final period
as NAVo and NAV1 respectively.
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Rate of Return
 ROR=(NAV1-NAVo+I+CGD)/(NAVo)
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Example-ROR

If a fund has an initial NAV of £20 at the
start of the month, makes income
distributions of $ 0.15 and capital gain
distributions of $ 0.05, and ends the month
with NAV of $ 20.10. What is the rate of
return?
ROR=(20.10-20.00+0.15+0.05)/20.00
ROR=0.015 or 1.5%
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Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Example-12b-1 Fee

The Equity fund sells class A shares with a
front-end load of 4% and class B shares with
12b-1 fees of 0.5 % annually as well as backend load fees that start at 5% and fall by 1%
for each full year the investor holds the
portfolio until the fifth year. Assume ROR on
the fund portfolio net of operating expenses is
10% annually. What will be the value of a $
10,000 investment in class A and B shares if
the shares are sold (a) 1 year, (b) 4 years, (c)
10 years and which fee structure provide
higher proceeds?
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Investment Management
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Ch 4 : Mutual fund
Solution-12b-1 Fee

Inv in Class A is (10,000x4)/100=400
 Class A after 4% commission 10,000-400= 9600
 Investment grow with 10% earn, 9600x (1.10)n
 1 year: $ 10,560 4 year: 14,055.36
 10 year : 24,899.93
 After 12b-1, net return is 9.5%
 Investment grow with the following
 10,000 (1.095)n (1-percentage exit fee)
 Year 1 (1-0.04): $ 10,512 year 4 (1-0.01): 14,232.89
 Year 10: 24,782.28
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Investment Management
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Ch 4 : Mutual fund
Comment

In one year time, the class A shares are
better choice. The front-end and back-end
loads are equal, however the class A shares
do not have to pay the 12b-1 fees.
 For four years, the class B shares dominate
because the front-end of the class A shares is
more costly than the 12b-1 fees.
 For 10 years, class A dominates
 In this case, one time front-end load is less
expensive than the continuing 12b-1 fees.
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Investment Management
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Ch 4 : Mutual fund
Taxation of Mutual Fund Income

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. This means that taxes are paid
by investors, not by the fund itself.
 Tax inefficient: a fund with a high portfolio turnover
rate can be particularly tax inefficient.
 Turnover: the ratio of the trading activity of a
portfolio to the assets of the portfolio.
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Investment Management
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Ch 4 : Mutual fund
Example
An investor’s portfolio currently is worth $ 1 million.
The investor sells 1000 shares of Microsoft at a price
of $ 80 per share and 2000 shares of ford at a price of
$ 40 per share. The aim is to buy 1600 shares of
IBM at $ 100 per share.
 A) What was the portfolio turn over rate?
 B) If the shares in Microsoft and Ford were
purchased $ 70 and $ 35 respectively and tax rate on
capital income is 20%, how much extra will investor
owe taxes as a result of these transactions?

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Investment Management
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Ch 4 : Mutual fund
Solution

a) Turnover is $ 160,000 per $ 1 mn =16%
 b) Realized Capital gain = $ 10x1000=
10000 on Microsoft and $ 5x2000=$ 10000
on ford.
 Tax owed on the capital gains is therefore
0.20x $ 20000=$ 4000.
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Ch 4 : Mutual fund
Exchange Traded Funds

ETF allow investors to trade index portfolios like
shares of stock
 Examples - SPDRs (S&P 500) and Webs
 Potential advantages
– Trade continuously
– Lower taxes
– Lower costs
 Potential disadvantages
– Higher costs (price deviation from NAV)
– Brokers’ fee
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Ch 4 : Mutual fund
SPDRs and Webs

The first ETF was the spider, a nickname for
SPDR or standard & Poor’s Depository Receipt,
which is a unit trust holding a portfolio matching
the S&P 500 index.
 Spiders give a rise to many similar products such
as Diamonds (Dow Jones Industrial Average)DIA, Cubes (Nasdaq 100 index)-QQQ and WEB
(World Equity Benchmark Shares which are
shares in portfolios of foreign stock market
indexes).
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Ch 4 : Mutual fund
Exchange Traded Funds
Exchange Traded Funds have become
popular
and
offer
investors
alternatives to traditional mutual
funds.
 ETFs
allow investors to trade
portfolios
of
indexes
as
individual shares of stock.
A
wide variety of indexes, both
international and domestic can be
traded.
 Some advantages include lower taxes and costs as
well as the ability to trade the index portfolios
intra-day. Potential disadvantages include price
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deviation from NAV and payment of brokerage

Investment Management
© 2005 Sami Fethi, EMU, All Right Reserved.
Ch 4 : Mutual fund
Problem1-ch 4

Consider a mutual fund with $200 mn in assets at
the start of the year and with 10mn shares
outstanding. The fund invests in a portfolio of
stocks that provides dividend income at the end of
the year of $ 2mn. The stocks included in the fund’s
portfolio increase in price 8%, but no securities are
sold and there are no capital gains distributions.
The fund charges 12b-1 fees of 1%, which
deducted from portfolio assets at year-end.
 a)
what is NAV at the start and end of the year?
 b)
What is the ROR for an investor in the fund?
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Ch 4 : Mutual fund
Answer 1-ch





a) Start of year NAV = $20
Dividends per share = $0.20
End of year NAV is based on the 8% price gain,
less the 1% 12b-1 fee:
End of year NAV = $20  (1.08)  (1 – 0.01) =
$21.384
b) Rate of return = ($21.384-$20+$0.20)/$20=
0.0792 = 7.92%
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Ch 4 : Mutual fund
Problem 2- ch 4
 You purchased 500 shares of the new fund at a
price of $45 per share at the beginning of the
year. You paid a front-end load of 6%. The
securities in which the fund invests increase in
value by 14% during the year. The Fund’s
expense ratio is 1.4%.
 a) What is your ROR on the fund if you sell your
shares at the end of the year?
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Ch 4 : Mutual fund
Answer 2- ch 4
As an initial approximation, your return equals the
return on the shares minus the total of the expense
ratio and purchase costs: (14%  1.4%  6%) =
6.6%
 But the precise return is less than this because the
6% load is paid up front, not at the end of the year.
To purchase the shares, you would have had to
invest: [$22,500/(1  .06)] = $23,936. The shares
increase in value from $22,500 to: [$22,500  (1.14
 0.014)] = $25,335.
The rate of return is: [(25,335  23,936)/23,936] =
5.84%

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Ch 4 : Mutual fund
Sources of Information on Mutual Funds
Wiesenberger’s Investment Companies
 Morningstar
 Investment Company Institute
 Popular press
 Investment services

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Ch 4 : Mutual fund
The End
Thanks
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