Deck 12: Mutual Funds and Pension Management

Question 1

Discuss the advantages of investing with a mutual fund and the general types of funds offered.

Answer 1

Advantages of mutual funds include:
$\bullet$ Professional Management: providing expertise and research and monitoring the performance of mutual funds.
$\bullet$ Diversification: not putting all your "eggs in one basket," with investments in a range of companies and industries to lower your overall portfolio risk.
$\bullet$ Affordability: Being able to invest in a portfolio of stocks for a relatively low dollar amount for an initial investment and subsequent purchases.
Liquidity: For open-end mutual funds, investors can redeem shares at any time for the current net asset value (NAV) in addition to any redemption fees.
Types of mutual funds moving from lower risk and higher liquidity to higher risk and less liquidity include:
$\bullet$ Money market funds that invest in high quality money market securities, such as U.S. government Treasury Bills, and other short-term securities with a maturity of 1 year or less that are highly marketable.
$\bullet$ Bond funds that invest in government and corporate bonds, different types and maturities, and investment quality defining their risks.
$\bullet$ Stock funds that invest in corporate stocks including many different types of stock funds including growth funds that focus on potential financial gains versus dividend; income funds that focus on paying dividends; index funds that track a particular market index, such as the Standard & Poor's 500 index, and sector funds that specialize in a particular industry segment.
$\bullet$ Hybrid or Balanced Mutual Funds that invest in both stocks and bonds, among many other types of mutual funds.

Question 2

Discuss some of the U.S. regulations for mutual funds.

Answer 2

Mutual funds are subject to strict regulations and oversight. As an example, in the U.S., mutual funds are overseen by the SEC, which requires complete disclosures to investors in a written prospectus, including the fund's goals, fees, expenses, investment strategies, and risk, along with information on purchasing and selling shares.
The Investment Act of 1933 mandates specific disclosures, and the Securities Act of 1935 sets out antifraud rules covering the purchase and sale of fund shares.
The Investment Act of 1940 requires all funds to register with the SEC and to meet certain operating standards. Section 18 of the 1970 Act also limits the financial leverage of mutual funds (with open-end funds not allowed to issue debt securities and only allowed bank loans up to 33% of a fund's total assets, as long as assets are greater than three times outstanding loans). Funds must hold securities (marked to market daily) in segregated accounts that are no less than equal to the values of the liabilities created.
The 1940 Act (subchapter M) requires mutual funds to pass-through distribution of 90 percent of income and capital gains to shareholders to allow these not to be taxed under the Internal Revenue Code.
U.S. mutual funds also must meet tests including: (1) The Short 3's Test, with no more than 30 percent of gross income can come from the sale of securities held for less than three months; and (2) Diversification Tests, whereby no more than 25 percent of assets can be held in securities of any one issuer for diversified funds, excluding government securities. Also, subject to limitations, at least 50 percent of assets must be invested in securities and cash equivalents (cash or short-term securities). With a boom in mutual funds in the 1990's, the SEC mandated clearer prospectuses for mutual funds, so average investors could understand the content, including having a statement of a fund's objectives and a brief risk/return summary at the start of each prospectus with a narrative risk summary, a bar chart showing annual return over 1, 5, and 10 years compared to benchmark indexes, and the highest and lowest return in any one quarter, a table of performance figures, and a fee table.
Other rules have been passed to encourage greater transparency, ethics, and fiduciary duty for the mutual fund industry, including in the U.S. the Mutual Fund Reform Act of 2004 amending the 40's Act to: (1) reduce from 60% to 25% the maximum number of interested directors on boards of registered investment companies; and (2) prohibiting an interested person from serving as chair of the board of directors, with the fiduciary duty of the board of directors to act in the best interests of shareholders and an investment advisor is required to supply material information needed for the independent directors to review and govern a company.
The SEC was also asked to require a registered investment company and its investment advisers and principal underwriters to adopt a code of ethics. Provisions include the certification by each senior executive officer to certify in periodic reports to shareholders that specified procedures are in place to verify compliance with transparency and specific ethical considerations, along with whistleblower protection for employees of publicly traded companies and registered investment companies. The SEC is also directed to develop standardized disclosures for: (1) expense and transaction cost ratios; (2) cost structures; (3) investment advisor compensation; (4) point of sale; and (5) additional disclosures of broker compensation (Congress.gov 2015).
Following the Subprime Loan Crisis, in 2010, the SEC enacted amendments mandating liquidity baskets in money market funds, improving underlying credit quality, shortening the maturities of holdings, and introducing stress testing (Prior 2015). In 2014, the SEC adopted money market reform rules making structural and operational reforms to address risks of investor runs requiring a floating net asset value for institutional prime money market funds versus special pricing and valuation conventions that permitted a constant share price of $1.00 to be maintained. Money market fund boards also have the right to impose fees and gates during periods of stress. The SEC also imposed enhanced diversification, disclosure and stress requirements and updated reporting by money market funds and private funds acting like money market fund.

Question 3

Discuss open-end, closed-end mutual funds, UITS, and REITS.

Answer 3

Two kinds of mutual funds are open-end and closed-end mutual funds. The majority of mutual funds are open-end funds (in the U.S. $15.9 trillion of net assets managed at year-end 2014), where open-end funds often referred to just as "mutual funds" versus other types of funds. Open-end funds continuously offer new shares to the public and redeem (buy back) shares at any time upon a shareholder's request (unless a fund becomes too large and is sometimes closed to new investors). By federal law, mutual funds in the U.S. are required to redeem (buy back) outstanding shares upon a shareholder's request at a price based at the current value of the fund's net asset value (NAV), where the calculation for NAV is:
NAV = (Market Value Securities - Liabilities) / (# of Shares Outstanding)
The NAV is given for the end of day trading, along with the change from the previous day, the percentage year to date return, and the percentage 3-year change in NAV.
Closed-end funds issue a fixed number of shares that trade over the counter or on a stock exchange. Once closed-end funds are issued, they are sold in public markets at their current market value just like stocks. Thus closed-end funds can trade below their net asset value and have brokerage commissions. They are less popular than open-end funds, since open-end funds are more liquid and redeemable at any time. However, closed-end funds can be traded more frequently. An investment company manages the fund according to the policies and objectives of the fund. Many closed-end funds are bond, convertible bond, or preferred stock funds, that allow trading of a bond portfolio dedicated to a particular type of bond, such as Muni Bond Funds, High Yield Bond Funds, U.S. Government Bond Funds, or Investment Grade Bond Funds, among others. Closed-end funds can also include portfolios of global stocks.
Closed-end funds price quotes include the NAV, along with the most recent market closing price from the exchange in which the securities are primarily traded. Closed-end funds often sell at a discount from their NAV.
Unit investment companies often issue investment trusts (UTIs) that offer interests in a fixed portfolio of securities held passively for an agreed-upon period of time, whereby assets are distributed among the shareholders. Real estate investment trusts (REITs) offer shares in real estate investments. Unit trusts may redeem shares at net asset value but only in large blocks. Hence, closed-end funds and UITs do not have the liquidity concerns of open-end funds that agree to redeem shares upon request to investors at NAV. REIT is generally operated by a company that owns and manages real estate that produces income, as established in the U.S. by an act of Congress in 1960 to allow small as well as large investors to earn rental income from commercial property. REITs must obey many regulations including the distribution of 90% of their taxable income as dividends to shareholder each year, having 75% of assets in real estate, cash, and government securities, having at least 75% of gross income from rents, mortgage interest, or other investments in real estate, and shares owned by at least 100 shareholders.
Different REITs have different specializations, with majority investing in malls, shopping centers, offices, and industrial centers, while others invest in many other types, such as movie theatres, golf courses, hotels, self-storage unit facilities, among many others. Investors benefit from higher dividend yields secured by long-term leases and gaining diversification by having real estate as part of a larger investment portfolio. Although REITs are sometimes used to diversify stock portfolios, care has to be taken in selecting REITs, since some REITs are very specialized, and can actually reduce portfolio diversification.

Question 4

What are exchange traded funds (ETFs), how are they managed, and what are some different types?

Question 5

What are alternative strategies funds and their characteristics?

Question 6

What are hedge funds and who can invest in them?

Question 7

How are mutual funds organized and structured and how are their boards of directors unique?

Question 8

What are mutual fund families and what are their advantages?

Question 9

What are different types of mutual funds with loads and what are different mutual fund fees and annual operating expenses?

Question 10

Discuss different types of mutual funds by strategies they use.

Question 11

Discuss Socially Responsible Investment Funds.

Question 12

Discuss the role and actions of pension funds for responsible investing.

Question 13

Discuss different risk-adjusted performance measures for mutual fund portfolios.

Question 14

Discuss different types of defined contribution plans.

Question 15

Discuss the history of defined benefit plans for corporations in the U.S. including ERISA, and the PBGC, and recent deficits faced by government defined benefit pension plans.

Question 16

Discuss asset allocation considerations for pension funds.

Question 17

How is RANVA used to compare active vs. passive management returns?

Question 18

An open-end mutual fund differs from a closed-end mutual fund in that:

A) Open-end funds redeem shares at net asset value
B) Open-end funds are willing to sell new shares
C) Open-end funds trade on the market just like stocks
D) a. and b.
E) a. and c. only

Question 19

Which of the following statements is true?

A) There has been a shift in many countries including the U.S. from defined benefit pension plans to defined contribution plans, giving greater investment risk to employees to have sufficient retirement wealth versus employers.
B) Defined benefit plans have become more popular in the U.S. recently since employees prefer to have guaranteed payments in retirement.
C) All government defined benefits are fully funded today with surplus funds, allowing greater benefits to be paid to retirees.
D) Government retirement funds have been reducing the minimum age of workers for retirement.

Question 20

To encourage individuals to save for their retirement, governments have initiated programs for tax-free savings vehicles, such as in the U.S. individual retirement accounts (IRAs) in either traditional IRAs whereby taxes are paid when distributions on IRAs are taken at retirement or Roth IRAs where taxes are deducted at the time of the investment, allowing distribution to be tax-free when taken at retirement.

Question 21

A survey of U.S. retail investors found that the average retail investor had excellent financial literacy.

Question 22

Which of the following are advantages of investing with mutual funds?

A) Professional management
B) Diversification
C) Affordability
D) Liquidity
E) All of the above

Question 23

Government pension benefit funds in recent years have had to grapple with pension fund deficits with greater longevity and early retirements for employees and have often increased the minimum retirement age, among other adjustments to be able to reduce future deficits.

Question 24

In the U.S. the majority of private sector workers are under defined benefit pension plans.

Question 25

Behavioral psychologists in the U.K. find that employees are more likely to save more if employers take out both employer and employee contributions from paychecks and put this in retirement accounts versus employees simply saving on their own.

Question 26

Factors that affect greater use of mutual fund in countries do not
Include which of the following:

A) The stability of a country's financial system and regulatory environment
B) The use of social media across a country
C) Market efficiency and liquidity of markets within a country
D) A strong legal system and government tax incentives for retirement vehicle
E) Economic development, income, and wealth of a country

Question 27

Studies of factors that contribute to the global growth of mutual funds include:

A) Capital market development and investor confidence in the integrity, liquidity, and efficiency of markets
B) A financial market orientation and increased globalization of markets
C) The presence of large multinational financial groups in a large number of countries
D) Transparency in markets to allow market to market valuation for assets and stronger performance for equity and bond markets, a large supply of investable securities, and effective and robust regulatory frameworks and auditing rules
E) All of the above

Question 28

Which of the following is not a U.S. mutual fund act or regulation?

A) The Investment Acts of 1933 and 1940
B) The 1940 Act (Subchapter M)
C) The Short 10 Test
D) The Short 3's Test
E) Diversification Tests

Question 29

The U.S. Mutual Fund Reform Act of 2004 focuses on corporate governance for mutual funds and greater transparency, ethics and fiduciary duty for the mutual fund industry.

Question 30

Which of the following is not correct for open-end mutual funds?

A) The majority of mutual funds in the U.S. are open-end mutual funds.
B) Open-end mutual funds do not allow new investors in.
C) Open-end mutual funds in the U.S. are required to redeem (buy back) outstanding shares at any time upon a shareholder request at a price based on the current value of the fund's net asset value (NAV).
D) All of the above are correct for open-end mutual funds.

Question 31

If a mutual fund has a $5 million market value for its securities,
And liabilities of $1 million, and 40,000 shares outstanding, what is its Net Asset Value (NAV)?

A) $80
B) $90
C) $100
D) None of the above

Question 32

Which of the following is false about UITs and REITs?

A) Unit investment trusts have a fixed portfolio of securities that are held
Passively for an agreed-upon period of time, whereby assets are
Distributed among shareholders.
B) Real estate investment trusts are short-term real estate UITs for small investors.
C) A REIT is generally operated by a company that owns and manages real estate properties that produce income.
D) REITS in the U.S. must obey many regulations including the distribution of 90% of their taxable income as dividends to shareholders each year, have 75% of assets in real estate, cash, and government securities and
Have at least 75% of grow income from real estate investments and at least 100 shareholders.
E) None of the above.

Question 33

Which of the following is false about closed-end mutual funds?

A) Closed-end funds are not publicly traded.
B) Closed-end funds issue a fixed number of shares that trade over the counter or on a stock exchange.
C) Once closed-end funds are issued, they are sold in public markets at their current market value just like stocks.
D) Closed-end funds often sell at a discount from their Net Asset Value.

Question 34

Which of the following is false about ETFs?
ETFs are a type of open-end mutual fund.

A) ETFs can be purchased just like stocks from brokers or mutual fund families.
B) ETFs are similar to mutual funds in being passively managed and mimicking an index.
C) ETFs, like closed-end funds, are like stocks and can potentially trade below their net asset values.
D) As passively managed funds, ETFs have low annual expenses.

Question 35

Which of the following is not an annual fund fee?

A) A management fee
B) A participant fee
C) A distribution fee
D) Other expenses
E) 12-b-1 fees to cover the cost of sales commissions and other marketing expenses

Question 36

Index Mutual Funds typically have lower fees than Managed Funds.

Question 37

Which of the following is not an active managed fund strategy?

A) Investing in large-cap, mid-cap, and small-cap stocks
B) Managed diversification allocations
C) Sector investing
D) Style investing
E) Free Wheel investing

Question 38

Which of the following is not a sustainability index that can be invested in?

A) The Best World Index
B) The Dow Jones Sustainability Index
C) The FTSE4Good Index Series
D) The Goldman Sachs GS SUSTAIN ESG
E) The Domini 400 Social Index

Question 39

Which of the following is not a strategy used for SRI portfolios?

A) Using positive and negative types of screens
B) Using a worst in class approach
C) Engaging with companies where a large amount of capital is being invested
D) An integrated approach using a combination of strategies

Question 40

Which of the following is not a risk-adjusted performance measure
For mutual fund portfolios?

A) Standard Deviation of Returns
B) Value at Risk
C) Un-Sharpe Ratio
D) M-Square Measure

Question 41

Morningstar is a well-known mutual fund rating organization that publishes its own star ratings that are widely used based on both excess returns for different classes of mutual funds and risk measures, including new sustainability ratings as well.

Question 42

A DB pension plan could have a funding deficit if the PV of plan assets are less than the PV of future benefits expected to be paid out.