Lesson 3: Financial Services: Mutual and Hedge Funds Pt1 Flashcards
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.
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 maximise shareholder wealth, not to be diversified.
How is the net asset value (NAV) of a mutual fund
determined? What is meant by the term marked-to-market daily?
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 distributionsof the companies held; or
c. changes in ownership of the fund.
This process of daily recalculation of the NAV is called
marking-to-market
Suppose today a mutual fund contains 2,000 shares of J.P. Morgan Chase, currently trading at $64.75, 1,000 shares of Wal-mart, 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
Suppose today a mutual fund contains 2,000 shares of J.P. Morgan Chase, currently trading at $64.75, 1,000 shares of Wal-mart, 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.
b. Calculate the change in the NAV of the fund if tomorrow J.P. Morgan’s shares increase to $66, Wal-mart’s shares increase to $68, and Pfizer’s shares increase to $34.
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.
Suppose today a mutual fund contains 2,000 shares of J.P. Morgan Chase, currently trading at $64.75, 1,000 shares of Wal-mart, 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.
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 Wal-mart. Calculate tomorrow’s NAV given the same rise in share values as assumed in part b.
(Part b Share Value Rise: Calculate the change in the NAV of the fund if tomorrow J.P. Morgan’s shares increase to $66, Wal-mart’s shares increase to $68, and Pfizer’s shares increase to $34.)
At today’s market price, the manager could buy 430 additional shares ($27,135/$63.10) of Wal-mart. Thus, its new portfolio of shares has 2,000 in J.P. Morgan 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).
