RPA2 Module 4

Question 1

What is an investment company?

Answer 1

An investment company is a company that is engaged primarily in the business of investing in and managing a portfolio of securities. By pooling the funds of thousands of investors, a selected portfolio of financial assets can be purchased with a specific purpose, and the investment company can offer its owners a variety of services in addition to diversification, including professional management and liquidity.

Question 2

What is the major role of the Securities and Exchange Commission (SEC) with
regard to investment companies?

Answer 2

The major role of SEC is to ensure full disclosure of fund information to investors,
both prospective investors and current shareholders. However, investment
companies are not insured or guaranteed by any government agency, including SEC

Question 3

How is a regulated investment company taxed for federal income tax purposes?

Answer 3

Most regulated investment companies pass on their earnings each year in the form of dividends, interest and realized capital gains to their shareholders. The investment company acts as a conduit, with distributions flowing through to shareholders who pay the taxes.

Note that a fund’s shareholders are responsible each year for paying taxes on the distributions they receive from an investment company whether they receive the distributions in cash or have them reinvested in additional shares

Question 4

What is a closed-end investment company?

Answer 4

The oldest form of the three major types of investment companies, a closed-end investment company offers investors an actively managed portfolio of securities and usually sells no additional shares of its own stock after the initial public offering.

Its shares trade in the secondary market exactly like any other stock, with investors using their brokers, paying (or receiving) the current price and paying brokerage commissions.

Question 5

What is an exchange-traded fund (ETF)?

Answer 5

The newest form of the three major types of investment companies, an ETF is a basket of stocks that tracks a particular sector, investment style, geographical area or the market as a whole.

Until recently, ETFs were passive (unmanaged) portfolios that simply held a basket of stocks; actively managed ETFs are now available. Like closed-end funds, ETFs trade on exchanges like individual stocks. That means they can be bought on margin and sold short anytime the exchanges are open. Like open-end funds, ETF shares are created and extinguished in response to the demand for them.

Because ETF portfolios are typically unmanaged portfolios, they have much lower annual expense ratios compared to actively managed funds. A particularly appealing feature of ETFs to investors is their tax efficiency. Many ETFs report little or no capital gains over the years. Shareholders in mutual funds, in contrast, have no control over the amount of distributions their funds may make in a given year.

Question 6

What is a mutual fund?

Answer 6

A mutual fund is an open-end investment company, the most familiar type of
investment company. Unlike closed-end funds and ETFs, mutual funds do not trade
on stock exchanges. Investors buy mutual fund shares from investment companies
and sell their shares back to the companies.
Traditionally, mutual funds have served as the core investment asset for millions of
Americans and, despite new products and technologies, will likely continue to do so
for the foreseeable future.

Question 7

What makes a mutual fund an “open-end” investment company?

Answer 7

A mutual fund is open-end because it constantly issues new shares to investors and
stands ready to buy back shares from shareholders.

Question 8

Name the four basic types of mutual funds.

Answer 8

The four basic types of mutual funds are:

(1) Money market mutual funds
(2) Equity (stock) funds
(3) Bond funds
(4) Hybrid or balanced (stock and bond) funds.

Question 9

Describe characteristics of money market funds.

Answer 9

Money market funds involve neither redemption fees nor sales charges, but they do assess a management fee.

The funds are not insured, and the interest they pay is credited on a daily basis.

Their shares can be redeemed at any time by phone or wire. The shares of money market funds are targeted to be held constant at $1.00; therefore, there are no capital gains or losses on money market shares under normal
circumstances.

Money market funds can be divided into (1) taxable funds—holding assets such as Treasury bills, negotiable certificates of deposits (CDs) and prime commercial paper—and (2) tax-exempt funds—consisting of national funds that invest in shortterm municipal securities and state tax-exempt money market funds that invest in the issues of a single state.

Approximately 90% of money market assets are in taxable funds.

Question 10

Is there a maximum average maturity limit on what constitutes a money market
fund?

Answer 10

SEC regulations limit the maximum average maturity of money market funds to 90
days

Question 11

Equity funds include the following types of funds:

Answer 11

Capital appreciation funds seek capital appreciation; dividends are not a
primary consideration.

Total return funds seek a combination of current income and capital
appreciation.

World equity funds invest primarily in stocks of foreign companies.

Question 12

(b) Taxable bond funds include the following types of funds:

Answer 12

• Investment grade funds seek current income by investing primarily (65%) in
investment grade debt securities.
• High-yield funds seek current income by investing two-thirds or more of
their portfolios in lower rated corporate bonds.
• Government bond funds pursue an objective of high current income by
investing in taxable bonds issued, or backed, by the U.S. government.
• Multisector bond funds seek to provide high current income by investing
predominantly in a combination of domestic securities, including mortgagebacked securities and high-yield bonds, and may invest up to 25% in bonds
issued by foreign entities.
• World bond funds seek current income by investing in the debt securities of
foreign companies and governments.

Question 13

(c) Tax-exempt bond funds include the following types of funds:

Answer 13

National municipal bond funds invest in a national mix of municipal bonds
with the objective of providing high after-tax yields.
• State municipal bond funds invest primarily in municipal bonds issued by a
single state. The bonds are exempt from federal income tax as well as state
taxes for residents of that state.

Question 14

Explain the nine categories of investment styles that Morningstar, Inc., a wellknown Chicago mutual fund research firm, uses for U.S. stock funds.

Answer 14

Morningstar characterizes a fund’s investment styles using a nine-square grid to
depict three investment styles (value, growth and blend) for each of the three
capitalization (cap) sizes (large, mid and small). For example, a mutual fund
designated as a large value fund (the term value fund is defined in the next question)
would be investing primarily in stocks that are considered undervalued with a
median market cap of $5 billion or more.

Question 15

As noted in the previous question, most equity funds can be divided into two
categories: value and growth. What is the difference between value funds and
growth funds?

Answer 15

A value fund generally seeks to find stocks that are inexpensive on the basis of standard, fundamental analysis yardsticks, such as earnings, book value and dividend yield. Growth funds invest in companies that are expected to show strong future growth even if current earnings are poor or nonexistent. (A blend fund is a blend of both growth and value funds.)

Question 16

What are index funds, and how have they performed relative to actively managed funds?

Answer 16

Index funds are unmanaged funds seeking to match a chosen market index.

Vanguard describes the investment objective of its Standard & Poor’s (S&P) 500 Index fund as: Designed to track the performance on the Standard & Poor’s 500 Index, a widely recognized benchmark of U.S. stock performance that is dominated by the stocks of large U.S. companies. The fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.

As for the performance of index funds: Of the actively managed funds in operation since the mid-1970s when the first index fund was created, only one in four has managed to outperform Vanguard’s S&P 500 fund. (Vanguard changed the basis for its 500 Index Fund and no longer tracks to the Standard & Poor’s 500 Index.)

Question 17

What is the net asset value (NAV) of a mutual fund, and why is this number important to shareholders?

Answer 17

The NAV is the market value of the securities in the mutual fund’s portfolio less any
liabilities, divided by the number of shares currently outstanding. This number is
important because the fund is legally obligated to pay a shareholder this value if
shares are redeemed. It changes daily as the value of the securities held changes and
as income from the securities is received and paid out.

Question 18

Explain how an investor in a closed-end fund can have a gain or a loss even if
the value of the portfolio of securities does not change.

Answer 18

The market prices of closed-end funds can vary from their NAVs. A discount refers to the situation in which the closed-end fund is selling for less than the NAV.

By purchasing a fund at a discount, an investor is actually buying shares in a portfolio of securities at a price below their market value. Therefore, even if the value of the portfolio of securities does not change, an investor in a closed-end fund can have a gain or loss if the discount narrows or widens.

Question 19

What is a 12b-1 fee?

Answer 19

A 12b-1 fee is a “distribution fee” that covers a mutual fund’s cost of distribution, marketing and advertising. The fee ranges as high as 1%.

Question 20

What is the difference between a load fund and a no-load fund?

Answer 20

A load fund charges a sales fee (load), currently up to about 5.75%, that goes to the
marketing organization that sells the shares. No-load funds are purchased directly
from the fund itself and involve no sales charge.

Question 21

How is an investment company compensated if it has no sales charge?

Answer 21

All mutual funds charge shareholders an expense fee to cover operating expenses. The fee is paid out of the fund’s income, derived from dividends, interest and capital gains. The annual expense fee consists of management fees, overhead and 12b-1 fees, if any, and are typically stated as a percentage of average net assets, which gives us the expense ratio

Question 22

What are the tax efficiencies of ETFs over index mutual funds?

Answer 22

When investors sell their mutual fund shares back to the company, the fund may have to sell securities to purchase the shares. If enough redemptions occur, the mutual fund could generate a capital gains liability for the remaining shareholders.

In contrast, ETF redemptions do not involve the ETF fund at all but, rather, one
investor selling to another. The ETF manager does not have to sell shares to pay for redemptions; therefore, ETFs avoid redemptions and the capital gains that could result from this activity.

Question 23

Describe the measure of performance known as the average annual total return that is used in the mutual fund industry.

Answer 23

The average annual total return is a hypothetical rate of return that, if achieved annually, would have produced the same cumulative total return if performance had been constant over the entire period.

It is a geometric mean and reflects the compound rate of growth at which money grew over time. This measure of performance allows investors to make direct comparisons among funds.

Question 24

What is considered one of the best known references by investors for assessing mutual fund performance?

Answer 24

The rating system developed by Morningstar.

Question 25

Do mutual funds with good investment performance tend to continue good
performance? Explain.

Answer 25

A number of academic studies have studied the consistency of mutual fund
performance, and the results are mixed. Earlier studies tended to find a lack of
consistency in fund performance, whereas some recent studies find some persistence
in fund performance. Overall, the evidence on consistent fund performance across
time is not encouraging. Typically, over a period such as five years, about 75% of
mutual fund managers fail to outperform the market.

Question 26

What is meant by the term survivorship bias as it applies to fund performance?

Answer 26

The term refers to the bias resulting from the fact that analyzing a sample of funds at a point in time reflects only those companies that survived, ignoring those that did not. Such a bias can overstate the performance of actively managed fund portfolios.

Question 27

How do international funds differ from global funds?

Answer 27

International funds tend to concentrate primarily on non-U.S. stocks, but global
funds tend to keep a minimum of 25% of their assets in the United States.

Question 28

What are hedge funds?

Answer 28

Hedge funds are unregulated investment companies that seek to exploit various market opportunities to earn larger-than-ordinary returns for their investors.

They require a substantial initial investment and may have restrictions on timing of withdrawals.

They may use leverage or derivative securities, or they may invest in illiquid assets, strategies not generally available to the typical mutual fund.

They traditionally do not disclose information to their investors about their investing activities. Also, the funds charge substantial fees and typically take at least 20% of the profits earned.

Question 29

What are the arguments against international diversification?

Answer 29

1) Benefits of international diversification are overstated because the markets tend to be more synchronized than suggested previously.
2) Skeptics point to the fact that, in recent periods, their domestic markets have generated greater returns than most other markets, and hence that there is no need for international investments in the future.
3) There are numerous potential barriers to international investing.

Question 30

Describe some potential barriers to foreign investments.

Answer 30

(1) Unfamiliarity with foreign markets
(2) Political risk
(3) Market inefficiencies
(4) Regulations
(5) Transaction costs
(6) Taxes
(7) Currency risk

Question 31

Unfamiliarity with foreign markets (Barriers to Foreign Inv.)

Answer 31

Cultural differences are a major
impediment to foreign investments. Investors are often unfamiliar with foreign
cultures and markets.

Question 32

Political risk (Barriers to Foreign Inv.)

Answer 32

Many emerging markets have periodically suffered from political,
economic or monetary crises that badly affected the value of local investments.

Question 33

Market inefficiencies (Barriers to Foreign Inv.)

Answer 33

A key problem is that of illiquidity. Some markets are
very small; others have many issues traded in large volume. Also, another
liquidity risk is the imposition of capital controls on foreign portfolio
investments. Such capital control prevents the sale of a portfolio of foreign assets
and the repatriation of proceeds. In addition, in some countries, especially
emerging countries, corporations do not provide timely and reliable information
on their activity and prospects. Finally, another market efficiency issue is that
some countries have historically been quite lax in terms of price manipulation,
insider trading and corporate governance.

Question 34

Regulations (Barriers to Foreign Inv.)

Answer 34

In some countries, regulations constrain the amount of foreign
investment that can be undertaken by local investors. For example, institutional
investors are sometimes constrained on the proportion of foreign assets they can
hold in their portfolios. Also, some countries limit the amount of foreign
ownership in their national corporations.

Question 35

Transaction costs (Barriers to Foreign Inv.)

Answer 35

The transaction costs of international investments can be
higher than those of domestic investments, especially when trying to determine
a so-called average commission for bonds. Also, management fees charged by
international money managers tend to be higher than those charged by domestic
money managers.

Question 36

Taxes (Barriers to Foreign Inv.)

Answer 36

Withheld taxes exist on most stock markets. The country where a
corporation is headquartered generally withholds an income tax on the
dividends paid by the corporation. This tax can usually be reclaimed after several months; this time lag creates an opportunity cost.

Question 37

Currency risk (Barriers to Foreign Inv.)

Answer 37

This type of risk can be a major cause of the higher volatility of
foreign assets but is often overstated.

Question 38

How have doubts about the value of international investing been addressed?

Answer 38

While there is still some evidence that the international correlation of equity markets increases in periods of market distress, the evidence is not as strong as suggested by some practitioners.

The pitfall in estimating correlations during volatile periods is that correlations conditioned on part of a sample are biased. The apparent
observation that correlation increases in periods of market turbulence can simply be an observation that market turbulence has increased, but the true correlation has remained constant.

Also, it is true that economies and markets are becoming increasingly integrated, and business cycles are increasingly synchronized as corporations pursue global strategies. Yet there still exist vast regional and national differences.

To take the late 1990s as an example, most of Asia was in a prolonged recession while the United States was booming. Even within the European Union, the economic performance differs widely among countries. The three leading economies, France, Germany and
the United Kingdom, demonstrated big differences in the timing and intensity of their economic growth.

Finally, the traditional approach to international diversification has been based on the premise that country factors are the dominant factors affecting all stocks of a country. With increased globalization, industry factors are growing in importance, while country factors see their influence reduced. As the industry factors dominate, global investing refers to investing in the best companies, wherever they are located in the world, and to recognizing that these companies will also be investing worldwide.