Chapter 20 - Mutual Funds

Question 1

Mutual funds

Answer 1

financial intermediaries that pool the investors’ resources by selling them shares and using the proceeds to buy securities.

Question 2

what do mutual funds do? (2)

Answer 2

1. the pooling of resources reduces the transaction cost and brings better diversification to small investors
2. the majority of mutual funds continuously sells new shares to investors and allows redemption of outstanding shares at market price

Question 3

Benefits of mutual funds (5)

Answer 3

1. liquidity intermediation: investors can quickly convert investment to cash
2. denomination intermediation: investors can participate in equity and debt offerings that require more capital than they possess
3. diversification: even for small investments
4. cost advantages: the mutual fund can negotiate lower transaction fees that would be available to the individual investor
5. managerial expertise: many investors prefer to rely on professional money managers to select their investments

Question 4

Mutual funds structure (2)

Answer 4

1. Closed-End Fund: a fixed number of nonredeemable shares. Shares sold through an IPO then traded in the OTC. After IPO no $ can be added or withdrawn. More common for funds that invest in less liquid securities
2. Open-End Fund: investors may buy or redeem shares at any point. Funds can grow to infinity, but need to keep liquidity. Price is determined by net asset value of the fund.

Question 5

Net Asset Value (NAV)

Answer 5

NAV is the total market value of the mutual fund’s stocks, bonds, cash and other assets minus any liabilities, divided by the number of shares outstanding.

Question 6

Investment objective classes (4)

Answer 6

1. Stock funds
2. bond funds
3. hybrid funds
4. money market funds

Question 7

Money market mutual funds

Answer 7

open-end funds that invest only in money market securities.

Question 8

Fee Structure of mutual funds (3)

Answer 8

1. Load funds charge an upfront fee (% of total sale) for buying the shares
2. Deferred load funds charge a fee (% of original sale) when the shares are redeemed.
3. no-load funds charge no front or back end fees (55-65% of bonds and equity funds)

Question 9

Index funds

Answer 9

a special class of mutual funds that is not actively managed. the fund contains the stock of the index it is mimicking. offers benefits of traditional mutual funds with lower fees

Question 10

Exchange Traded Funds (ETFs)

Answer 10

ETFs are open-end investment companies that replicate an index. they are different from index funds because they trade continuously during the trading day (like an individual stock).

Question 11

Creation/redemption mechanism

Answer 11

the mechanism by which the shares of the ETF are adjusted in response to D&S.
Creation = increase in the no of outstanding shares
redemption = decrease in the no of outstanding shares