Mutual funds are currently one of the most popular investment vehicles for the majority of investors but before investing in one, it's crucial to understand the advantages they offer as well as the disadvantages. Show
Key Takeaways
Mutual Funds: An OverviewThere are a variety of funds covering different industries and different asset classes available. Some of the advantages of this kind of investment include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution. Here's a more detailed look at both the advantages and disadvantages of this investment strategy. Advantages of Mutual FundsThere are many reasons why investors choose to invest in mutual funds with such frequency. Let's break down the details of a few. Advanced Portfolio ManagementWhen you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio. Dividend ReinvestmentAs dividends and other interest income sources are declared for the fund, they can be used to purchase additional shares in the mutual fund, therefore helping your investment grow. Risk Reduction (Safety)Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities—depending on the focus. Numerous stock index mutual funds own 1,000 or more individual stock positions. Convenience and Fair PricingMutual funds are easy to buy and easy to understand. They typically have low minimum investments and they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice. As with any type of investment, the specifics of your budget, timeline and profit goals will dictate what the best mutual fund options are for you. Disadvantages of Mutual FundsHowever, there are also disadvantages to being an investor in mutual funds. Here's a more detailed look at some of those concerns. High Expense Ratios and Sales ChargesIf you're not paying attention to mutual fund expense ratios and sales charges, they can get out of hand. Be very cautious when investing in funds with expense ratios higher than 1.50%, as they are considered to be on the higher cost end. Be wary of 12b-1 advertising fees and sales charges in general. There are several good fund companies out there that have no sales charges. Fees reduce overall investment returns. Management AbusesChurning, turnover, and window dressing may happen if your manager is abusing their authority. This includes unnecessary trading, excessive replacement, and selling the losers prior to quarter-end to fix the books. Tax InefficiencyLike it or not, investors do not have a choice when it comes to capital gains payouts in mutual funds. Due to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors typically receive distributions from the fund that are an uncontrollable tax event. Poor Trade ExecutionIf you place your mutual fund trade anytime before the cut-off time for same-day NAV, you'll receive the same closing price NAV for your buy or sell on the mutual fund. For investors looking for faster execution times, maybe because of short investment horizons, day trading, or timing the market, mutual funds provide a weak execution strategy. Chapter 19: The Capital MarketJust click on the button next to each answer and you'll get immediate feedback.Note: Your browser must support JavaScript in order to use this quiz. 1.Letter stock isa handwritten certificate representing a corporate IOU. a mass mailing offering a security for sale. securities issued by the United States Postal Service. privately placed common stock that cannot be immediately resold to the general public. 2.A preliminary prospectus is known as agolden parachute. red herring. blue sky. green shoe. 3.If an investment banker has agreed to sell a new issue of securities on a best-efforts basis, the issuemost likely involves an unusually large stock offering. most likely involves bonds instead of common stock. results in no assumption of underwriting risk by the investment banker. most likely involves a well-established, large company. 4.The actual market value of a right will differ from its theoretical value for all of the following reasons EXCEPT for:the size of the firm's marginal tax rate. the amount of transactions costs incurred. investor speculation. the irregular exercise and sale of rights over the subscription period. 5.In a common stock rights offering the subscription price is generally:set equal to the current market price of the stock. set below the current market price of the stock. set above the current market price of the stock. set after the stock goes "ex-rights." 6. When the investment banker bears the risk of not being able to sell a new security at the established price, this is known as:a best efforts offering. underwriting. shelf registration. making a market. 7.To say that there is "asymmetric information" in the issuing of common stock or debt means thatinvestors have nearly perfect information. the markets have nearly perfect information. investors have more accurate information than management has. management has more accurate information than investors have. 8.In calculating the value of one right when the stock is selling "rights-on," the analyst needs to know the number of rights needed to buy one share of stock and:the subscription price per share. the transactions costs involved. the price-earnings ratio of the firm's stock. the length of the rights offering period. 9.A best efforts offering is sometimes used in connection with a of new, long-term securities.private placement privileged subscription public issue all of the above 10. permits what is known as a shelf registration.SEC Rule 144 SEC Rule 144a SEC Rule 415 SEC Form 13D 11.A company can ensure the complete success of a rights offering by making use of astandby arrangement. oversubscription privilege. green shoe provision. shelf registration. 12.The market price of K-T-Lew Corporation's common stock is $60 per share, and each share gives its owner one subscription right. Four rights are required to purchase an additional share of common stock at the subscription price of $54 per share. If the common stock is currently selling "rights-on," the theoretical value of a right is closest to$0.96 $1.20 $1.50 $6.00 13.(See Question 12 above.) The theoretical value of one share of K-T-Lew common stock when it goes "ex-rights" is closest to$54.00 $58.50 $58.80 $59.04 14.Financial intermediaries .do not invest in new long-term securities include insurance companies and pension funds include the national and regional stock exchanges are usually underwriting syndicates 15.The Sarbanes-Oxley Act of 2002 (SOX) was largely a response to:a series of corporate and accounting frauds involving Enron, Arthur Andersen, WorldCom, and numerous others. a dramatic rise in the US trade deficit. charges of excessive compensation to top corporate executives. rising complaints by investors and security analysts over the financial accounting for stock options. The following item is NEW to the 13th edition. 16.Because of US "Securities Offering Reform" can take advantage of a special streamlined "shelf registration" process that provides for automatic effectiveness of a registration statement upon filing with the SEC (i.e., no SEC review). only unseasoned issuersonly seasoned issuers only well-known seasoned issuers (WKSIs) only seasoned issuers and well-known seasoned issuers (WKSIs)  Multiple-Choice Quiz questions are Copyright © by Pearson Education Limited. Used by permission. All rights reserved.
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All of the following are advantages of using the services of an investment company except:
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