Chapter 3

INDIRECT INVESTING

Multiple Choice Questions

Investing Indirectly

1. Which of the following is not a characteristic of investments companies?

a. pooled investing
b. diversification
c. managed portfolios
d. reduced expenses

(d, moderate)

2. In order to avoid paying income taxes, an investment company must:

a. be classified as a non-profit organization

b. invest only in municipal bonds.
c. pass on interest, dividends, and capital gains to the stockholders.
d. be registered as a closed-end investment company.

(c, moderate)

3. Investment companies must register with the SEC under the provisions of
the:

a. Securities Act of 1933

b. Securities Exchange Act of 1934
c. Maloney Act of 1938
d. Investment Company Act of 1940

(c, easy)

Types of Investment Companies

4. The most popular type of investment company is a:

a. unit investment trust.

b. mutual fund.
c. closed-end investment company
d. real estate investment trust.

(b, easy)

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 5. An unmanaged fixed income security portfolio handled by an independent
trustee is known as a:

a. junk bond fund

b. closed-end investment company.
c. unit investment trust.
d. hedge fund.

(c, moderate)

6. Which of the following is a major objective of unit investment trusts?

a. capital preservation
b. capital gains
c. current income
d. tax deferment

(a, moderate)

7. A major difference between a closed-end investment company and an

open-end investment company is that:

a. closed-end investment companies are generally much riskier.

b. their security portfolios are substantially different.
c. closed-end investment companies are passive investments and open-ends
are not.
d. closed-end companies have a more fixed capitalization.

(d, moderate)

8. . Which of the following generally trade on stock exchanges?

a. unit investment trusts

b. closed-end investment companies
c. open-end investment companies
d. All trade on stock exchanges.

(b, moderate)

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 9. Which of the following statements concerning the trend in investment
company growth is true?

a. The recent trend shows more growth in closed-end investment companies.

b. The recent trend shows more growth in unit investment trusts.
c. The recent trend shows more growth in open-end investment companies.
d. All investment companies have been growing at an equal rate.

(c, easy)

10. Which of the following is not one of the characteristics of exchange traded
funds (ETFs)?

a. They are passive portfolios.

b. They are managed investments.
c. They often track a particular sector of the market.
d. All of the above are characteristics of ETFs.

(b, moderate)

11. It is not important to have a secondary market for mutual funds because:

a. investors hold the securities till maturity.

b. investors trade between themselves.
c. investors sell their shares back to the company.
d. banks will cash their shares as long as they have accounts at the bank.

(c, easy)

12. Which of the following is not an ETF (exchange traded fund)?

a. Spider
b. Clubs
c. Cubes
d. Diamonds

(b, moderate)

13. Which of the following is true regarding ETFs?

a. They trade on exchanges like individual stocks.

b. They can be bought on margin or sold short.
c. They have management fees higher than other mutual funds.
d. All of the above are true regarding ETFs.

(c, moderate)

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 Types of Mutual Funds

14. A group of mutual funds with a common management are known as:

a. fund syndicates.
b. fund conglomerates.
c. fund families.
d. fund complexes.

(d, easy)

15. Which of the following is not true regarding money market funds?

a. They charge no sales charge, redemption fee or management fee.

b. Their maximum average maturity is 90 days.
c. Normally, there are no capital gains or losses on their shares.
d. All of the above are true.

(a, difficult)

16. If a mutual fund holds a substantial amount of Treasury bills, this is

probably a(an):

a. tax-exempt fund.
b. conservative bond fund.
c. income fund
d. money market mutual fund.

(d, easy)

17. Which of the following is true regarding value funds and growth funds?

a. Value funds seek stocks that are cheap by fundamental standards while
growth funds seek stocks with high current earnings.
b. Growth funds typically outperform value funds.
c. Value funds and growth funds tend to perform well at different times.
d. All of the above are true.

(c, difficult)

18. In general, index funds:

a. are higher risk than other funds.

b. are traded on the exchanges.
c. have lower expenses than other funds.
d. all of the above.

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 (b, moderate)

The Mechanics of Investing Indirectly

19. Net asset value takes into account:

a. both realized and unrealized capital gains.

b. only realized capital gains.
c. only unrealized capital gains.
d. neither realized or unrealized capital gains.

(a, difficult)

20. If NAV > market price of a fund, then the fund:

a. is selling at a discount.
b. is selling at a premium.
c. is an index fund.
d. is an ETF.

(a, moderate)

21. Mutual funds may be affiliated with an underwriter. This means:

a. the underwriter has an exclusive right to distribute shares.

b. the underwriter selects the securities in the portfolio.
c. there is no risk to the issuer of the mutual fund.
d. there is no risk to the investor of the mutual fund.

(a, difficult)

22. A loading fee is a:

a. type of income tax.

b. management fee.
c. origination fee.
d. sales charge.

(d, moderate)

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 23. A 12b-1 fee is a:

a. redemption fee.
b. sales charge
c. distribution fee.
d. loading fee.

(c, difficult)

24. No-load funds sell:

a. at net asset value.

b. below net asset value.
c. above net asset value.
d. at a discount.

(a, easy)

25. No-loads charge no sales fee because:

a. they are legally prohibited from doing so.

b. they charge a redemption fee instead.
c. they have no sales force.
d. they charge a 12b-1 fee instead.

(c, moderate)

26. Which of the following types of mutual fund shares typically does not
charge a front-end sales charge but does impose a redemption fee that
declines over time?

a. Class A shares
b. Class B shares
c. Class C shares
d. Class D shares

(b, difficult)

27. Which brokerage firm was charged in 2004 with allowing late trading of
mutual funds for some of its clients?

a. Merrill Lynch
b. E. F. Hutton
c. Charles Schwab
d. Edward D. Jones

(d, moderate)

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 28. Which of the following statements regarding fund expenses and
performance is true?

a. The higher-performing funds generally have the highest expenses.

b. The stock funds generally have higher expenses than bond funds.
c. The index funds generally have higher expenses than non-index funds.
d. The lower performing funds generally have the highest expenses.

(d, difficult)

Investment Company Performance

29. In the mutual fund industry, the most common performance measure is a
hypothetical rate of return which assumes performance is constant over the
entire period and is known as the:

a. cumulative total return.

b. average annual total return.
c. total indexed return.
d. compounded geometric return.

(b, moderate)

30. On average, which type of mutual fund is expected to have the highest
performance?

a. money market funds

b. bond funds
c. equity funds
d. municipal bond funds

(c, easy)

Investing Internationally Through Investment Companies

31. Global funds tend to keep ---------- percent of their assets in -----------.

a. 50; foreign securities.

b. 50; single-country securities.
c. 25; foreign securities.
d. 25; United States.

(d, difficult)

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 32. Single-country funds have traditionally:

a. outperformed international funds.

b. underperformed international funds.
c. been open-end.
d. been; closed-end.

(d, moderate)

The Future of Indirect Investing

33. The 2 largest fund supermarkets are:

a. Merrill Lynch and Charles Schwab

b. Edward D. Jones and Vanguard
c. Vanguard and Fidelity
d. Charles Schwab and Fidelity

(d, moderate)

34. A portfolio of directly-owned individual securities guided by an

investment manager is known as a:

a. IRA.
b. IMA.
c. SMA.
d. DCA.

(c, moderate)

35. Unregulated companies that seek to exploit various market opportunities

and require a substantial investment from investors are known as:

a. derivatives.
b. options.
c. hedge funds.
d. SMAs.

(c, moderate)

True-False Questions

Investing Indirectly

1. Each investment company investor shares in the returns of the fund's

portfolio and also shares in the cost of running the fund.

(T, easy)

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 2. Buying shares of a mutual fund is an example of indirect investing.

(T, easy)

3. To qualify as a regulated investment company, a fund must distribute at

least 50 percent of its taxable income to the shareholders.

(F, moderate)

4. Under the Securities Act of 1933, investment companies are required to

register with the SEC.

(F, moderate)

Types of Investment Companies

5. Most unit investment trusts are considered active investments.

(F, moderate)

6. ETFs are managed investment portfolios that offer investors targeted

diversification.

(F, moderate)

7. Many ETFs report little or no capital gains over the years giving them
greater tax efficiency than many mutual funds.

(T, moderate)

8. Closed-end investment companies typically sell additional shares of its

own stock every few years.

(F, moderate)

Types of Mutual Funds

9. Almost 70 percent of all U.S. households owned mutual funds as of 2005.

(F, easy)

10. Investment company managers seek to increase the size of the funds being
managed as the cost of oversee additional amounts of money rises less
than the revenue rate.

(T, moderate)

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 11. Approximately 85 percent of money market assets are in non-taxable
funds.

(F, moderate)

12. You would expect a value fund to buy stock based on a sound earnings
record while growth funds might invest in companies with no earnings
record at all.

(T, moderate)

13. Loaded funds generally outperform the no-load funds.

(F, difficult)

14. Both open-end and closed-end investment company shares may sell at a
discount from NAV.

(F, moderate)

15. A 12b-1 fee is used to cover a fund's cost of distribution.

(T, moderate)

16. Investors desiring no-load funds must generally seek them out since there
is no sales force.

(T, easy)

17. No-load funds charge a one-time expense fee to cover all operating
expenses.

(F, difficult)

Mechanics of Investing Indirectly

18. The net asset value of a mutual fund does not consider unrealized capital
gains.

(F, difficult)

19. Index funds tend to have lower expenses than other funds because they are
larger in size.

(F, difficult)

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 Investment Company Performance

20. Total return for a mutual fund includes capital gains less any reinvested
dividends.

(F, difficult)

21. Under its new system, Morningstar ranks funds against comparable funds
in approximately 50 categories.

(T, moderate)

22. It is possible under the new Morningstar ratings that one class of shares of
a mutual fund can have a different rating that another class of shares of the
same mutual fund.

(T, moderate)

23. Survivorship bias occurs when mutual funds are merged or liquidated and
only surviving funds' performance is reported.

(T, moderate)

Investing Internationally Through Investment Companies

24. Global funds tend to hold a higher percentage of their portfolio in U.S.
securities than do international funds.

(T, difficult)

Future of Indirect Investing

25. The major advantage of Separately Managed Accounts (SMA) is control

and the direct owner may be able to specify investment restrictions.

(T, difficult)

26. Hedge funds typically require a large initial investment and may have
restrictions on how quickly investors can withdraw their funds.

(T, moderate)

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 Short-Answer Questions

1. Briefly explain the fees charged by funds.

Answer: Load fees are sales charges, management fees include advisory
fees and operating expenses, and 12b-1 fees are marketing
expenses.

(moderate)

2. What are the main differences between a closed-end and an open-end

investment company?

Answer: A closed-end investment company has a fixed number of shares,

and the price depends on supply and demand. An open-end fund’s
shares increase as long as new investors contribute money, and the
price is the net asset value of the securities owned.

(moderate)

3. What is the difference between the insurance offered by the Securities

Investor Protection Corporation (SIPC) and that offered by the Federal
Deposit Insurance Corporation (FDIC)?

Answer: The FDIC insures accounts at banks from bank failures..

The SIPC provides insurance against the brokerage company going
bankrupt.

(moderate)

4. Would one expect to find higher P/E ratios in an aggressive growth fund
or in a growth and income fund?

Answer: One would expect higher P/Es in an aggressive growth fund

because investors are willing to pay a high current price for
expected future growth.

(moderate)

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 5. Would you recommend a 65-year old retiree to invest all of his/her
retirement assets in an income fund?

Answer: Probably not. The retiree will probably have a long time to live
and should consider investing part of the portfolio in growth funds
to provide protection against inflation.

(moderate)

6. You have decided to invest in an aggressive growth fund for long-run

future needs. You have a publication listing a number of such funds with
their most recent 12-month total returns. Is this a good predictor of future
performance?

Answer: Not necessarily. The best fund last year may or may not be in the
rankings next year. The literature is divided on the usefulness of
past performance in predicting fund performance in the future.
Some investors prefer longer-run performance measures such as
five-year or ten-year compounded returns, but none are sure-fire
guides to future performance.

(difficult)

7. How is the individual investor’s income tax position affected by owning

investment companies compared to owning securities directly?

Answer: The investor’s tax position should be the same whether he/she
invests indirectly through an investment company or directly in the
securities themselves. The investment companies are
intermediaries that pass on income and losses to the shareholder.

(difficult)

8. Does one mutual fund provide all the diversification that an investor
needs?

Answer: One fund typically has many (perhaps several hundred) securities,
which should provide adequate diversification for risks that are
unique to any particular company. Nonetheless, some investors
prefer to invest in several funds in order to participate in more than
one market and to gain some protection from market risk in a
particular market.

(moderate)

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 Critical Thinking/Essay Questions

1. Is an investor able to achieve significant diversification by purchasing a

single-country fund?

Answer: The fund itself might be well diversified within that country if the
fund owns a wide variety of securities. However, an investor is
seeking international diversification would not be well diversified
in terms of country risk and exchange-rate risk.

(moderate)

2. What are some of the advantages individual investors seek by buying

mutual funds or closed-end investment company shares rather than
through purchasing securities directly?

Answer: Substantial diversification even for a small amount of funds,

professional management (questioned by some), international
securities, capability to participate in the money market with a
small investment.

(moderate)

Problems

1. An environmentally-friendly balanced mutual fund began the year with a

net asset value (NAV) of $12.25 per share. During the year it received
$1.00 dividend and interest income, $0.25 in realized capital gains, and
$0.50 in unrealized capital gains. Ninety percent of the income and all of
the realized capital gain were distributed to shareholders. Calculate the
year-end NAV.

Solution: Beginning NAV

$12.25

Income from investment operations

net investment income $1.00
net realized and unrealized gain ($.25 + .50) 0.75
Total income from investment operations $1.75

Less distributions to shareholders

from net investment income (90% x $1) ($0.90)
from net realized capital gain (0.25)
Total distribution ($1.15)

Ending NAV $12.85

(moderate)

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 2. An aggressive equity mutual fund began the year with a net asset value
(NAV) of $6.50 per share. During the year it received $0.15 dividend
income, $1.25 in realized capital losses, and $0.50 in unrealized capital
gains. Ninety percent of the income was distributed to shareholders.
Calculate the year-end NAV.

Solution: Beginning NAV

$6.50

Income from investment operations

net investment income $0.15
net realized and unrealized gain (-$1.25 + .50) (0.75)
Total income from investment operations ($0.60)

Less distributions to shareholders

from net investment income (90% x $.15) ($0.135)
from net realized capital gain - _
Total distribution ($0.135)

(moderate)

3. You invested $10,000 10 years ago into Fly-By-Night Fund which has
reported performance (average annual total return) of 11.12% over this 10-
year period. What would your ending wealth position be?

Solution: on a financial calculator: 10000 PV, 11.12 interest rate, 10 N,

0 pmt, solve for FV = $28,702.67. Subtract your initial investment of
$10,000, which results in $18,702.67 cumulative total dollar return.

(moderate)

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