Question

QUESTION 5 a) What is a mutual fund? In what sense is it a financial institution? b) What benefits do mutual funds have for individual investors? c) What is the difference between an open-end mutual fund and a closed-end fund? What is the difference between an open-end fund and an Exchange Traded Fund (ETF) closed-end fund? d) What is a hedge fund and how is it different from a mutual fund? e) An investor purchases a mutual fund share for $100. The fund pays dividends of $3, distributes a capital gain of $4, and charges a fee of $2 when the fund is sold one year later for $105. What is the net rate of return from this investment?

Answer 1

A). A mutual fund is a kind of Investment vehicle in which money is collected from a large number of small investors and invested in stocks, bond, debenture according to the fund mandate. The fund manager manages the mutual fund for that he is paid a certain percenatge of fee from the fun itself. Mutual fund is an asset management financial institution. A financial institution is a place where financial activities are performed. Mutual funds do fall in the category of asset management institution.

B) For Individual investor, mutual funds are the most popular investment category. They are poupular because of a number of reasons:

• Individual can Invest in mutual funds with very small amounts, no large amount is required.
• They do get access to professionaly managed funds.
• The expense ratio of mutual funds are low comparative to other products.
• The risk is also limited in mutual funds. The fund is managed according to the fund mandate.

C) Close end funds and open ended funds majorly operate in the same way, except for few differences in their share distribution and the way share are created.

Open-end mutual funds Mutual fund is one type of open end funds. These are sold directly to the Investors. There is no limit on the number of shares these funds can offer to the general public. Prices for these funds are fixed once a day with reference to NAV (Net asset value). Closed end Funds Closed end funds offer fixed number of shares through an Investment company. When they raise money through an IPO, the number of shares offered are fixed, so if someone wants to buy their share after the IPO, they have to buy them in the secondary market.

The way exchange traded funds differ from the open end funds is the ETFs are a type of closed end funds. ETFs acts as investment vehicle which tries to replicate the performance of an Index. For example SPY is an exchange traded fund which replicates the performance of the INDEX S&P 500. Open end funds generally do not do that. Mutual funds simply tries to manage the fund according to the fund mandate and generate returns for theInvestors whereas ETF tries to generate a return which is in line with the Index performance being replicated.

D) Hedge fund is a kind of Investment vehicle which pools large amount of money from small group of high net worth Individuals and manage the funds. The hedge funds are type of actively managed funds which uses complex investment methods to determine Investment and generate excess return over the market. They are high risk and high reward kind of Investment.

Hedge funds differ from mutual funds in significant number of ways. Mutual funds are heavily regulated whereas hedge funds are not that much regulated.Most retail Investor prefer to Invest in mutual funds but high net worth investor choose to go with hedge funds. Most mutual funds are passive managed funds but almost all hedge funds are actively managed funds. Hedge funds use complex investment methods where as it is very rare for mutual funds to get into derivatives, short selling, arbitarge e.t.c