An investor is considering the purchase of CHECK Fund for his portfolio. Like many U.S.-based mutual funds today, CHECK has more than one class of shares. Although all classes hold the same portfolio of securities, each class has a different expense structure. This particular mutual fund
has three classes of shares: A, B, and C. The expenses of these classes are summarized in the following table:
The time horizon associated with the investor's objective in purchasing CHECK is five years. He expects equity investments with risk characteristics similar to CHECK to earn 8% per year, and he decides to make his selection of fund share class based on an assumed 8% return each year, gross of any of the expenses given in the table above.
a. Based on only the above information, determine the class of shares that is most appropriate for this investor. Assume that expense percentages given will be constant at the given values. Assume that the deferred sales charges are computed on the basis of NAV.
b. Suppose that, as a result of an unforeseen liquidity need, the investor needs to liquidate his investment at the end of the first year. Assume an 8% rate of return has been earned. Determine the relative performance of the three fund classes, and interpret the results.

Question

An investor is considering the purchase of CHECK Fund for his portfolio. Like many U.S.-based mutual funds today, CHECK has more than one class of shares. Although all classes hold the same portfolio of securities, each class has a different expense structure. This particular mutual fund
has three classes of shares: A, B, and C. The expenses of these classes are summarized in the following table:
  The time horizon associated with the investor's objective in purchasing CHECK is five years. He expects equity investments with risk characteristics similar to CHECK to earn 8% per year, and he decides to make his selection of fund share class based on an assumed 8% return each year, gross of any of the expenses given in the table above.
a. Based on only the above information, determine the class of shares that is most appropriate for this investor. Assume that expense percentages given will be constant at the given values. Assume that the deferred sales charges are computed on the basis of NAV.
b. Suppose that, as a result of an unforeseen liquidity need, the investor needs to liquidate his investment at the end of the first year. Assume an 8% rate of return has been earned. Determine the relative performance of the three fund classes, and interpret the results.

Quizplus · Accepted Answer

The Answer is a. To address this question, we compute the terminal value of $1 invested at the end of year five
(or rather a day after the fifth year). The share class with the highest terminal value net of all expenses would be the most appropriate for this investor, as all classes are based on the same portfolio and thus have the same portfolio risk characteristics.
Class A. $1 *(1 - 0.03) = $0.97 is the amount available for investment at t = 0, after paying the front-end sales charge. Because this amount grows at 8% for five years, reduced by annual expenses of 0.0125, the terminal value per $1 invested after five years is $0.97 * 1.08⁵ *(1 - 0.0125)⁵ =$1.3384.
Class B. Ignoring any deferred sales charge, after five years, $1 invested grows to $1 * 1.08⁵ *
(1- 0.015)⁵ = $1.3624. According to the table, the deferred sales charge would be 1% at any
time during year five; therefore, the terminal value is $1.3624 * 0.99 =$1.3488.
Class C. After 5 years, $1 invested grows to $1 *1.08⁵ * (1-0.0175)⁵ = $1.3452. There is no deferred sales charge in the fifth year, so $1.3452 is the terminal value.
In summary, the ranking by terminal value after five years is Class B ($1.3488), Class C ($1.3452), and Class A ($1.3384). Class B appears to be the most appropriate for this investor with a long-time horizon.
b. For Class A shares, the terminal value per $1 invested is $0.97 *1.08 * (1 -0.0125) = $1.0345. For Class B shares, it is as $1 * 1.08 * (1 -0.015) * (1 - 0.05) =$1.0106, reflecting a 5% redemption charge. For Class C shares, it is $1* 1.08 * (1 -0.0175) * (1 - 0.01) = $1.0505, reflecting a 1% redemption charge.
Thus, the ranking is Class C ($1.0505), Class A ($1.0345), and Class B ($1.0106). Although Class B is appropriate given a five-year investment horizon, it is a costly choice if the fund shares need to be liquidated soon after investment. That eventuality would need to be assessed by the investor we are discussing. Class B, like Class A, is more attractive, the longer the holding period, in general. Class A is more attractive than Class B if the shares are held for a very long time because annual expenses are lower. Because Class C has the higher annual expenses, however, it becomes less attractive the longer the holding period, in general.

An Investor Is Considering the Purchase of CHECK Fund for His