Solutions for End-of-Chapter Questions and Problems: Chapter Five

The solutions of the end-of-chapter questions and problems are only for the personal use for students taking this
course. They could not be reproduced, published or distributed in any form. In case of infringement, you must bear
your own legal responsibility.

1. What is a mutual fund? In what sense is it a financial institution?

A mutual fund represents a pool of financial resources obtained from individuals and
companies, which is invested in the money and capital markets. This process represents
another method for economic savers to channel funds to companies and government units
that need extra funds.

2. What are money market mutual funds? In what assets do these funds typically invest? What
factors have caused the strong growth in this type of fund since the late 1970s?

Money market mutual funds (MMMFs) invest in various mixtures of money market
securities. These securities primarily are Treasury bills, negotiable certificates of deposit,
repurchase agreements, and commercial paper. The growth in MMMFs since the late 1970s
initially occurred because of rising interest rates in the money markets, while Regulation Q
restricted interest rates on accounts in depository institutions. Many investors moved their
short-term savings from the depository institutions to the MMMFs as the spread in the
earnings rate reached double digits. A result of this activity was to introduce many investors
to the capital markets for the first time.

At the end of 2008, the share of long-term funds plunged to 59.1 percent of all funds, while
money market funds increased to 40.9 percent. Part of the move to money market funds was
the fact that during the worst of the financial crisis, the U.S. Treasury extended government
insurance to all money market mutual fund accounts on a temporary basis. As financial
markets tumbled in 2008, money market mutual funds moved investments out of corporate
and foreign bonds (12.4 percent of the total in 2007 and 6.1 percent in 2008) into safer
securities such as U.S. government securities (13.6 percent of the total investments in 2007
and 35.5 percent in 2008).

3. What are long-term mutual funds? In what assets do these funds usually invest? What factors
caused the strong growth in this type of fund from 1992 through 2007, the slowdown in
growth in 2007-2008, and the return to growth after 2008?

Long-term funds include equity funds (comprised of common and preferred stock securities),
bond funds (comprised of fixed-income securities with a maturity of longer than one year),
and hybrid funds (comprised of both bond and stock securities). Some money market assets
are included for liquidity purposes. The growth in these funds in the 1990s and 2000s
reflected the dramatic increase in equity returns, the reduction in transaction costs, and the
recognition of diversification benefits achievable through mutual funds.

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 The financial crisis and the collapse in stock and other security prices produced a sharp drop
in mutual fund activity. At the end of 2008, total assets fell to $9,620.3 billion. Investor
demand for certain types of mutual funds plummeted, driven in large part by deteriorating
financial market conditions. Equity funds suffered substantial outflows, while inflow to U.S.
government money market funds reached record highs. As the economy recovered following
the crisis, so did assets invested in mutual funds, growing to $18.7 trillion by the end of 2017
(of this, 84.81 percent were invested in long-term funds).

4. Using the data in Table 5-2, discuss the growth over the last 32 years of long-term funds
versus short-term funds.

The dollar investment in the MMMFs ($243 billion) were similar to the investment in the
long-term funds in 1985 ($251 billion). However, by 2007, long-term funds had almost a
three to one advantage on the MMMFs, $8,913 billion to $3,086 billion.

The financial crisis and the collapse in stock and other security prices produced a sharp drop
in long-term mutual fund activity. In 2008, investments in long-term funds fell to $5,787.6
billion (35 percent drop in one year), while MMMFs grew to $3,832.7 billion (24 percent
increase in one year). However, as the economy recovered, long-term funds grew back to
$15,898.7 billion by 2017, while MMMF fell to $2,847.6 billion. As of 2017, the dollar
investment in long-term funds is almost six times the investment in the MMMFs.

5. Why did the proportion of equities in long-term funds increase from 42 percent in 1990 to
more than 77 percent by 2000 and then decrease to 65 percent in 2017? How might an
investor’s preference for a mutual funds objectives change over time?

The primary reason for the increased proportion of funds in equities during the 1990s was the
strength of the equity market that was driven by the underlying strength of the economy
during this period. Contrarily, the economy experienced its worst recession since the Great
Depression in the late 2000s, causing investors to retreat from equities as preferred
investments.

As might be expected, the proportion of equities in long-term funds reflects the popularity of
different types of bond or equity funds at any point in time. For example, underscoring the
attractiveness of equity funds in 2007 was the fact that stocks comprised 71.9 percent of total
long-term mutual fund asset portfolios. Debt instruments were the next most popular assets
(18.8 percent of the long-term asset portfolio). In contrast, look at the distribution of assets in
2008, when the equity markets were plummeting. Equities made up only 63.1 percent of the
long-term mutual fund portfolios and debt instruments were 27.1 percent of long-term assets.
Note too that total long-term assets fell from $8,913.9 billion in 2007 (before the start of the
financial crisis) to just $5,788.0 billion in 2008 (at the height of the crisis), a drop of 35.1
percent. As the economy and financial markets recovered (in 2010), financial assets held by
long-term mutual funds increased to $9,029.6 billion, of which only 62.0 percent were
corporate equities. In 2017, long-term funds held financial assets totaling $15,898.9 billion,
of which 64.8 percent were corporate equities. Thus, even seven years after the start of the
financial crisis, long-term funds had not switched their holdings of corporate equities back to
pre-crisis levels.

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6. How does the risk of short-term funds differ from the risk of long-term funds?

The principal type of risk for short-term funds is interest rate risk, because of the
predominance of fixed-income securities. Because of the shortness of maturity of the assets,
which often is less than 60 days, this risk is mitigated to a large extent. Short-term funds
generally have virtually no liquidity or default risk because of the types of assets held. An
exception occurred during the financial crisis of 2008-2009. In September 2008, Primary
Reserve Fund, a large and reputedly conservative money market fund had holdings of $785
million in commercial paper issued by Lehman. As a result of Lehman’s failure, shares in
Primary Reserve Fund ‘broke the buck’ (i.e., fell below $1), meaning that its investors lost
principal. This was the first incidence of a share price dip below a dollar for any money
market mutual fund open to the general public. This fund had built a reputation for safe
investment. Hence its exposure to Lehman scared investors, leading to a broad run on money
market mutual funds. Within a few days more than $200 billion had flowed out of these
funds. The U.S. Treasury stopped the run by extending government insurance to all money
market mutual fund accounts held in participating money market funds as of the close of
business on September 19, 2008. The insurance coverage lasted for one year (through
September 18, 2009).

Long-term equity funds typically are well diversified, and the risk is more systematic or
market based. Bond funds have extensive interest rate risk because of their long-term, fixed-
rate nature. Sector, or industry-specific, funds have systematic (market) and unsystematic
risk, regardless of whether they are equity or bond funds.

7. What are the economic reasons for the existence of mutual funds; that is, what benefits do
mutual funds provide for investors? Why do individuals rather than corporations hold most
mutual funds?

One major economic reason for the existence of mutual funds is the ability to achieve
diversification through risk pooling for small investors. By pooling investments from a large
number of small investors, fund managers are able to hold well-diversified portfolios of
assets. In addition, managers can obtain lower transaction costs because of the volume of
transactions, both in dollars and numbers, and they benefit from research, information, and
monitoring activities at reduced costs.

Many small investors are able to gain benefits of the money and capital markets by using
mutual funds. Once an account is opened in a fund, a small amount of money can be invested
on a periodic basis. In many cases, the amount of the investment would be insufficient for
direct access to the money and capital markets. On the other hand, corporations are more
likely to be able to diversify by holding a large bundle of individual securities and assets, and
money and capital markets are easily accessible by direct investment. Further, an argument
can be made that the goal of corporations should be to maximize shareholder wealth, not to
be diversified.

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8. What are the principal demographics of household owners who own mutual funds? What are
the primary reasons why household owners invest in mutual funds?

As of 2018, 56.0 million (43.9 percent of) U.S. households owned mutual funds. This was
down from 56.3 million (52 percent) in 2001. Table 5–4 lists some characteristics of
household mutual fund owners as of 2018 and 1995. Most are long-term owners, with 29
percent making their first purchases before 1990. While mutual fund investors come from all
age groups, ownership is concentrated among individuals in their prime saving and investing
years. Two-thirds of households owning mutual funds in 2018 were headed by individuals
between the ages of 35 and 64. Interestingly, the number of families headed by a person with
less than a college degree investing in mutual funds is 47 percent. The bull markets of the
1990s, the low transaction costs of purchasing mutual funds shares, as well as the
diversification benefits achievable through mutual fund investments are again the likely
reasons for these trends. The typical fund-owning household had $150,000 invested in a
median number of four mutual funds. Notice, from Table 5–4, that compared to 1995, 2018
saw an increase in the median age of mutual fund holders (from 44 to 51 years) and a large
increase in median household financial assets owned (from $50,000 to $250,000) and median
mutual fund assets owned (from $18,000 to $150,000). Further, holdings of equity funds
have increased from 73 to 88 percent of all households.

9. What change in regulatory guidelines occurred in 2009 that had the primary purpose of
giving investors a better understanding of the risks and objectives of a fund?

In March 2009, the SEC adopted amendments to the form used by mutual funds to register
under the Investment Company Act of 1940 and to offer their securities under the Securities
Act of 1933 in order to enhance the disclosures that are provided to mutual fund investors.
The amendments (first proposed in November 2007) required key information to appear in
plain English in a standardized order at the front of the mutual fund statutory prospectus. The
new amendment also included a new option for satisfying prospectus delivery obligations
with respect to mutual fund securities under the Securities Act. Under the option, key
information is sent or given to investors in the form of a summary prospectus and the
statutory prospectus is provided on an Internet Web site. The improved disclosure framework
was intended to provide investors with information that is easier to use and more readily
accessible, while retaining the comprehensive quality of the information that was previously
available.

10. What are the three possible components reflected in the return an investor receives from a
mutual fund?

The investor receives the income and dividends paid by the companies, the capital gains from
the sale of securities by the mutual fund, and the capital appreciation of the underlying assets.

11. How is the net asset value (NAV) of a mutual fund determined? What is meant by the term
marked-to-market daily?

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 Net Asset Value (NAV) is the market value of each ownership share of the mutual fund. The
total market value of the fund is determined by summing the total value of each asset in the
fund. The value of each asset can be found by multiplying the number of shares of the asset
by the corresponding price of the asset. Dividing this total fund value by the number of
shares in the mutual fund will give the NAV for the fund.

The NAV is calculated at the end of each daily trading session, and thus reflects any
adjustments in value caused by (a) changes in value of the underlying assets, (b) dividend
distributions of the companies held, or (c) changes in ownership of the fund. This process of
daily recalculation of the NAV is called marking-to-market.

12. Suppose today a mutual fund contains 2,000 shares of JPMorgan Chase, currently trading at
$64.75, 1,000 shares of Walmart, currently trading at $63.10, and 2,500 shares of Pfizer,
currently trading at $31.50. The mutual fund has no liabilities and 10,000 shares outstanding
held by investors.

a. What is the NAV of the fund?

NAV = (2,000 x $64.75 + 1,000 x $63.10 + 2,500 x $31.50)/10,000 = $271,350/10,000 =

$27.135

b. Calculate the change in the NAV of the fund if tomorrow JPMorgan’s shares increase to
$66, Walmart’s shares increase to $68, and Pfizer’s shares increase to $30.

NAV = (2,000 x $66 + 1,000 x $68 + 2,500 x $34)/10,000 = $285,000/10,000 = $28.500,

or an increase of $1.365.

c. Suppose that today 1,000 additional investors buy one share each of the mutual fund at the
NAV of $27.135. This means that the fund manager has $27,135 additional funds to
invest. The fund manager decides to use these additional funds to buy additional shares in
Walmart. Calculate tomorrow’s NAV given the same rise in share values as assumed in
part b.

At today’s market price, the manager could buy 430 additional shares ($27,135/$63.10) of
Walmart. Thus, its new portfolio of shares has 2,000 in JPMorgan Chase, 1,430 in Wal-
mart, and 2,500 in Pfizer.

NAV = (2,000 x $66 + 1,430 x $68 + 2,500 x $34)/11,000 = $314,240/11,000 = $28.567,

or an increase of $1.432. Note that the fund’s value changed over the month due to both
capital appreciation and investment size. A comparison of the NAV in part b. with the one
in this part indicates that the additional shares and the profitable investments made with
the new funds from these shares resulted in a slightly higher NAV than had the number of
shares remained static ($28.500 versus $28.567).

13. A mutual fund owns 300 shares of General Electric, currently trading at $30, and 400
shares of Microsoft, Inc., currently trading at $54. The fund has 1,000 shares outstanding.

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 a. What is the net asset value (NAV) of the fund?

NAV = (300 x $30 + 400 x $54)/1,000 = $30,600/1,000 = $30.60.

b. If investors expect the price of General Electric shares to increase to $34 and the price
of Microsoft shares to decrease to $48 by the end of the year, what is the expected
NAV at the end of the year?

Expected NAV = (300 x $34 + 400 x $48)/1,000 = $29,400/1,000 = $29.4, or a decline of

3.92%

c. Assume that the expected price of the General Electric shares is realized at $34. What is
the maximum price decrease that can occur to the Microsoft shares to realize an end-of-
year NAV equal to the NAV estimated in part (a)?

[(300 x $34) + (400 x PM)]/1,000 = $30.60, implies that PM = $51.00, a decrease of

$3.00.

14. What is the difference between open-end and closed-end mutual funds? Which type of fund
tends to be more specialized in asset selection? How does a closed-end fund provide
another source of return from which an investor may either gain or lose?

Open-end funds allow shares to be purchased and redeemed according to investor demand.
The NAV of open-ended funds is determined only by changes in the value of the assets
owned. In closed-end funds, the number of shares of the fund is fixed. If investors need to
redeem their shares, they sell them to another investor. Thus, the demand for the fund
shares can provide another source of return for the investors as the market price of the fund
may exceed the NAV of the fund. Closed-end funds, such as real estate investment trusts,
tend to be more specialized.

15. Open-end fund A owns 165 shares of AT&T valued at $35 each and 30 shares of Toro
valued at $75 each. Closed-end fund B owns 75 shares of AT&T and 72 shares of Toro.
Each fund has 1,000 shares of stock outstanding.

a. What are the NAVs of both funds using these prices?

NAVopen-end = (165 x $35 + 30 x $75)/1,000 = $8.025.

NAVclosed-end = (75 x $35 + 72 x $75)/1,000 = $8.025.

b. Assume that in one month the price of AT&T stock has increased to $36.25 and the
price of Toro stock has decreased to $72.292. How do these changes impact the NAV
of both funds? If the funds were purchased at the NAV prices in part (a) and sold at
month end, what would be the realized returns on the investments?

NAVopen-end = (165 x $36.25 + 30 x $72.292)/1,000 = $8.15.

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 Percentage change in NAV = ($8.15 - $8.025)/$8.025 = 1.56%.

NAVclosed-end = (75 x $36.25 + 72 x $72.292)/1,000 = $7.92377.

Percentage change in NAV = ($7.92377 - $8.025)/$8.025 = -1.26%.

c. Assume that another 155 shares of AT&T are added to fund A. The funds needed to
buy the new shares are obtained by selling 676 more shares in fund A. What is the
effect on fund A’s NAV if the stock prices remain unchanged from the original
prices?

NAVopen-end = ((165 + 155) x $35 + 30 x $75)/(1,000 + 676) = $8.025.

Percentage change in NAV = ($8.025 - $8.025)/$8.025 = 0.00%.

16. What is the difference between a load fund and a no-load fund? Is the argument that load
funds are more closely managed and therefore have higher returns supported by the
evidence presented in Table 5-6?

A load fund charges an up-front fee that often is called a sales charge and is used as a
commission payment for sales representatives. These fees can be as high as 5.75 percent. A
no-load fund does not charge a sales fee, although a small annual fee can be charged to
cover certain administrative expenses. This small fee, which is called a 12b-1 fee, usually
ranges between 0.25 and 1.00 percent of assets. According to the data in Table 5-6, the load
funds have adjusted returns that are decreased after the fee is removed. In each case the
relative performance ranking of the fund decreases after the load is subtracted.

17. What is a 12b-1 fee? Suppose you have a choice between a load fund with no annual 12b-1
fee and a no-load fund with an annual 12b-1 fee of 25 basis points. How would the length
of your expected investment horizon, or holding period, influence your choice between
these two funds?

The 12b-1 fee is allowed by the SEC to provide assistance in covering administrative
expenses for no-load funds. Thus, in terms of fees and without consideration of time value
issues, a 4.00 percent load would be equivalent to the 12b-1 fee for 16 years. This
comparison would have to be adjusted for change in the value of the fund’s assets over
time, since the 12b-1 fee is administered on an annual basis against the fund value at that
time.

18. Suppose an individual invests $10,000 in a load mutual fund for two years. The load fee
entails an up-front commission charge of 4 percent of the amount invested and is deducted
from the original funds invested. In addition, annual fund operating expenses (or 12b-1
fees) are 0.85 percent. The annual fees are charged on the average net asset value invested
in the fund and are recorded at the end of each year. Investments in the fund return 5
percent each year paid on the last day of the year. If the investor reinvests the annual
returns paid on the investment, calculate the annual return on the mutual fund over the two-
year investment period.

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 Annual Return Calculation Based on Text Example 5-4:
Annualized load fee = 4% ÷ 2 years = 2.00%
Annual fund operating expense = 0.85%
Total annual cost = 2.85% ⇒ Annual return = 5.00% - 2.85% =
2.15%

Annual Return Calculation Based on Present Value of Investment:

Initial investment in the fund = $10,000
Front-end load of 4.00% = $400
Total investable funds = $9,600

Investment value at end of year one = $9,600 x 1.05 = $10,080.00

Operating expenses based on average NAV = $9,840 x 0.0085 = $83.64
Net investable funds for year two = $9,996.36

Investment value at end of year two = $9,996.36 x 1.05 = $10,496.18

Operating expenses based on average NAV = $10,246.27 x 0.0085 = $87.09
Net investment at end of year two = $10,409.09

Average annual compound return:

$10,409.09 = $10,000(1 + g)2 => g = 2.025%

19. Who are the primary regulators of the mutual fund industry? How do their regulatory goals
differ from those of other types of financial institutions?

The Securities and Exchange Commission (SEC) is the primary regulator of the mutual
fund industry. The SEC is not concerned with the administration of sound economic
monetary policy, which is part of the goal of the Federal Reserve System, but rather is
primarily concerned with the protection of investors from possible abuses by managers of
mutual funds.

Several pieces of legislation have been enacted to clarify and assist this regulatory process.
Under the Securities Act of 1933, mutual funds must file a registration statement with the
SEC and abide by the rules established under the act for the distribution of prospectuses to
investors. The Securities Exchange Act of 1934 establishes antifraud provisions aimed at
the accurate transmission of information to prospective investors. The 1934 act also
appointed the National Association of Securities Dealers to supervise the distribution of
mutual fund shares. The Investment Advisors Act of 1940 regulates the activities of mutual
fund advisors, and the Investment Company Act establishes rules involving fees and
charges. The Insider Trading and Securities Fraud Enforcement Act of 1988 addresses
issues of insider trading, and the Market Reform Act of 1990 provides for the establishment
of circuit breakers to halt trading in case of severe market downturns. The National
Securities Markets Improvement Act of 1996 exempts mutual funds from the regulatory
burden of state securities regulators. Finally, in March 2009, the SEC adopted amendments
to the form used by mutual funds to register under the Investment Company Act of 1940
and to offer their securities under the Securities Act of 1933 in order to enhance the

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disclosures that are provided to mutual fund investors. The amendments (first proposed in
November 2007) required key information to appear in plain English in a standardized
order at the front of the mutual fund statutory prospectus. The new amendment also
included a new option for satisfying prospectus delivery obligations with respect to mutual
fund securities under the Securities Act. Under the option, key information is sent or given
to investors in the form of a summary prospectus and the statutory prospectus is provided
on an Internet Web site. The improved disclosure framework was intended to provide
investors with information that is easier to use and more readily accessible, while retaining
the comprehensive quality of the information that was previously available.

After the financial crisis, in a February 2013 letter sent to the Financial Stability Oversight
Council (FSOC) (set up as a result of the Wall Street Reform and Consumer Protection Act
to oversee the financial system), the leaders of all 12 regional Federal Reserve banks called
for a significant overhaul of the money market industry. The letter stated that even four
years after the financial crisis, without reform money, market mutual fund activities could
spread the risk of significant credit problems from the funds to banks to the broader
financial system. New York Fed president William Dudley stated that the risk of a run on
money market funds was potentially higher in 2013 than before the crisis because banks
increasingly used these funds as a source of financing and because Congress blocked the
Fed and Treasury from using certain emergency tools that could stabilize the funds during a
market panic. As a result of the calls for reform, in 2014, the SEC adopted amendments to
the rules that govern money market mutual funds. The amendments make structural and
operational reforms to address risks of investor runs in money market funds, while
preserving the benefits of the funds. The new rules require a floating net asset value (NAV)
for institutional prime money market funds. Floating NAV allows the daily share prices of
these funds to fluctuate along with changes in the market value of fund assets. Further,
liquidity fees and redemption gates were instituted, giving money market fund boards the
ability to impose fees and gates during periods of stress. The final rules also include
enhanced diversification, disclosure and stress testing requirements, as well as updated
reporting by money market funds and private funds that operate like money market funds.

Also, in 2015 the SEC proposed rules and amendments to modernize and enhance the
reporting and disclosure of information by investment companies and investment advisers.
The new rules would enhance the quality of information available to investors and would
allow the Commission to more effectively collect and use data provided by investment
companies and investment advisers. The SEC also proposed a comprehensive package of
rule reforms designed to enhance effective liquidity risk management by open-end funds,
including mutual funds and exchange-traded funds (ETFs). Under the proposed reforms,
mutual funds and ETFs would be required to implement liquidity risk management
programs and enhance disclosure regarding fund liquidity and redemption practices. The
proposal is designed to better ensure investors can redeem their shares and receive their
assets in a timely manner. A fund’s liquidity risk management program would be required
to contain multiple elements, including: classification of the liquidity of fund portfolio
assets based on the amount of time an asset would be able to be converted to cash without a
market impact; assessment, periodic review and management of a fund’s liquidity

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 risk; establishment of a fund’s three-day liquid asset minimum; and board approval and
review.

20. What is a hedge fund and how is it different from a mutual fund?

Hedge funds are a type of investment pool that solicits funds from (wealthy) individuals
and other investors (e.g., commercial banks) and invests these funds on their behalf. Hedge
funds are similar to mutual funds in that they are pooled investment vehicles that accept
investors’ money and generally invest it on a collective basis. Hedge funds are, however,
not subject to the numerous regulations that apply to mutual funds for the protection of
individuals, such as regulations requiring a certain degree of liquidity, regulations requiring
that mutual fund shares be redeemable at any time, regulations protecting against conflicts
of interest, regulations to ensure fairness in the pricing of funds shares, disclosure
regulations, and regulations limiting the use of leverage. Further, hedge funds do not have
to disclose their full activities to third parties. Thus, they offer a high degree of privacy for
their investors. Until 2010, hedge funds were not required to register with the SEC. Thus,
they were subject to virtually no regulatory oversight (e.g., by the SEC under the Securities
Act and Investment Advisors Act) and generally took significant risk. Even after 2010,
hedge funds offered in the United States avoid regulations by limiting the asset size of the
fund.

Historically, hedge funds avoided regulations by limiting the number of investors to less
than 100 individuals (below that required for SEC registration), who must be deemed
“accredited investors.” To be accredited, an investor must have a net worth of over $1
million or have an annual income of at least $200,000 ($300,000 if married). These stiff
financial requirements allowed hedge funds to avoid regulation under the theory that
individuals with such wealth should be able to evaluate the risk and return on their
investments. According to the SEC, these types of investors should be expected to make
more informed decisions and take on higher levels of risk. However, as a result of some
heavily publicized hedge fund failures and near failures (the result of fraud by fund
managers, e.g., Bernard L. Madoff Investment Securities, and the financial crisis, e.g., Bear
Stearns High Grade Structured Credit Strategies Fund), in 2010 federal regulators increased
the oversight of hedge funds.

Because hedge funds have been exempt from many of the rules and regulations governing
mutual funds, they can use aggressive strategies that are unavailable to mutual funds,
including short selling, leveraging, program trading, arbitrage, and derivatives trading.
Further, since hedge funds that do not exceed $100 million in assets under management do
not register with the SEC, their actual data cannot be independently tracked. Therefore,
much hedge fund data are self-reported. It is estimated that in 2018 there were over 8,200
hedge funds in the world, with managed assets estimated at $3.11 trillion.

21. What are the different categories of hedge funds?

Most hedge funds are highly specialized, relying on the specific expertise of the fund
manager(s) to produce a profit. Hedge fund managers follow a variety of investment

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strategies, some of which use leverage and derivatives, others use more conservative
strategies and involve little or no leverage. Generally, hedge funds are set up with specific
parameters so investors can forecast a risk-return profile.

“More risk” funds are the most aggressive and may produce profits in many types of
market environments. Funds in this group are classified by objectives such as: aggressive
growth, emerging markets, macro, market timing, and short selling. Aggressive growth
funds invest in equities expected to experience acceleration in growth of earnings per share.
Generally, high price-to-earnings ratios, low or no dividend companies are included. These
funds hedge by shorting equities where earnings disappointment is expected or by shorting
stock indexes. Emerging market funds invest in equity or debt securities of emerging
markets which tend to have higher inflation and volatile growth. Macro funds aim to profit
from changes in global economies, typically brought about by shifts in government policy
which impact interest rates. These funds include investments in equities, bonds, currencies
and commodities. They use leverage and derivatives to accentuate the impact of market
moves. Market timing funds allocate asset among different asset classes depending on the
manager’s view of the economic or market outlook. Thus, portfolio emphasis may swing
widely between assets classes. Unpredictability of market movements and the difficulty of
timing entry and exit from markets adds significant risk to this strategy. Short selling funds
sell securities in anticipation of being able to buy them back in the future at a lower price
based on the manager’s assessment of the overvaluation of the securities or in anticipation
of earnings disappointments.

“Moderate risk” funds are more traditional funds, similar to mutual funds, with only a
portion of the portfolio being hedged. Funds in this group are classified by objectives such
as: distressed securities, fund of funds, opportunistic, multi strategy, and special situations.
Distressed securities funds buy equity, debt or trade claims at deep discounts of companies
in or facing bankruptcy or reorganization. Profits opportunities come from the market’s
lack of understanding of the true value of these deep discount securities and from the fact
that the majority of institutional investor cannot own below investment grade securities.
Fund of funds mix hedge funds and other pooled investment vehicles. This blending of
different strategies and asset classes aims to provide a more stable long term investment
return than any of the individual funds. Returns and risk can be controlled by the mix of
underlying strategies and funds. Capital preservation is generally an important
consideration for these funds. Opportunistic funds change their investment strategy as
opportunities arise to profit from events such as IPOs, sudden price changes resulting from
a disappointing earnings announcement, and hostile takeover bids. These funds may utilize
several investing styles at any point in time. and are not restricted to any particular
investment approach or asset class. Multi strategy funds take a diversified investment
approach by implementing various strategies simultaneously to realize short and long term
gains. This style of investment allows the manager to overweight or underweight different
strategies to best capitalize on current investment opportunities. Special situation funds
invest in event driven situations such as mergers, hostile takeovers, reorganizations, or
leveraged buyouts. These funds may undertake simultaneous purchases of stock in
companies being acquired, and the sale of stock in its bidder, hoping to profit from the
spread between the current market price and the final purchase price of the company.

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 “Risk avoidance” funds are also more traditional funds, emphasizing consistent but
moderate returns while avoiding risk. Funds in this group are classified by objectives such
as: income, market neutral-arbitrage, market neutral-securities hedging, and value. Income
funds invest with the primary focus on yield or current income rather than solely on capital
gains. These funds use leverage to buy bonds and some fixed income derivatives, profiting
from principal appreciation and interest income. Market neutral-arbitrage funds attempt to
hedge market risk by taking offsetting positions, often in different securities of the same
issuer, e.g., long convertible bonds and short the firm’s equity. Their focus is on obtaining
returns with low or no correlation to both the equity and bond markets. Market neutral-
securities hedging funds invest equally in long and short equity portfolios in particular
market sectors. Market risk is reduced but effective stock analysis is critical to obtaining a
profit. These funds use leverage to magnify their returns. They also sometimes use market
index futures to hedge systematic risk. Value funds invest in securities perceived to be
selling at deep discounts relative to their intrinsic values. Securities include those that may
be out of favor or underfollowed by analysts.

22. What types of fees do hedge funds charge?

Hedge fund managers generally charge two types of fees: management fees and
performance fees. As with mutual funds, the management fee is computed as a percentage
of the total assets under management and typically run between 1.5 to 2.0 percent.
Performance fees are unique to hedge funds. Performance fees give the fund manager a
share of any positive returns on a hedge fund. The average performance fee on hedge funds
is approximately 20 percent but varies widely. For example, Steven Cohen’s SAC Capital
Partners charges a performance fee of 50 percent. Performance fees are paid to the hedge
fund manager before returns are paid to the funds investors. Hedge funds often specify a
“hurdle” rate, which is a minimum annualized performance benchmark that must be
realized before a performance fee can be assessed. Further, a “high water mark” is usually
used for hedge funds in which the manager does not receive a performance fee unless the
value of the fund exceeds the highest net asset value it has previously achieved. High water
marks are used to link the fund manager’s incentives more closely to those of the fund
investors and to reduce the manager’s incentive to increase the risk of trades.

23. What is the difference between domestic hedge funds and offshore hedge funds? Describe
the advantages of offshore hedge funds over domestic hedge funds.

Hedge funds that are organized in the U.S. are designated as domestic hedge funds. These
funds require investors to pay income taxes on all earnings from the hedge fund. Funds
located outside of the U.S. and structured under foreign laws are designated as offshore
hedge funds. Many offshore financial centers encourage hedge funds to locate in their
countries. The major centers include the Cayman Islands, Bermuda, Dublin, and
Luxembourg. /the Cayman Islands is estimated to be the location of approximately 75
percent of all hedge funds. Offshore hedge funds are regulated in that they must obey the
rules of the host country. However, the rules in most of these countries are not generally
burdensome and provide anonymity to fund investors. Further, offshore hedge funds are

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not subject to U.S. income taxes on distributions of profit or to U.S. estate taxes on funds
shares.

When compared to domestic hedge funds, offshore hedge funds have been found to trade
more intensely than domestic funds, due to the zero or lower capital gains tax for offshore
funds. Further, offshore hedge funds tend to engage less often in positive feedback trading
(rushing to buy when the market is booming and rushing to sell when the market is
declining) than domestic hedge funds. Finally, offshore hedge funds have been found to
herd (mimic each other’s behavior when trading while ignoring information about the
fundamentals of valuation) less than domestic hedge funds. Many hedge fund managers
maintain both domestic and offshore hedge funds. Given the needs of their client investors,
hedge fund managers want to have both types of funds so as to attract all types of investors.

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