Question

PART III Risk A JOB AT EAST COAST YACHTS You recently graduated from college and your job search led you to East Coast Yachts. Became you felt the company's business was seaworthy, you accepted a job offer. The first day on the job, while you are finishing your employment paperwork, Dan Ervin, who works in Finance stops by to inform you about the company's 401(k) plan. A 401(k) plan is a retirement plan offered by many companies. Such plans are tax-deferred savings vehicles, meaning that any deposits you make into the plan are deducted from your current pretax income, so no current taxes are paid on the money. For example, assume your salary will be $50,000 per year. If you contribute $3,000 to the 401(k) plan, you will pay taxes on only $ 47,000 in income. There are also no taxes paid on any capital gains or income while you are invested in the plan, but you do pay taxes when you withdraw money at retirement, As is fairly common, the company also has a 5 percent match. This means that the company will match your contribution up to 5 percent of your salary, but you must contribute the amount that you want matched, up to the maximum. The 401(k) plan has several options for investments, most of which are mutual funds. A mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fund's assets. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee, paid to the fund manager. The management fee is compensation for the manager, who makes all of the investment decisions for the fund. East Coast Yachts uses Bledsoe Financial Services as its 401(k) plan administrator. Here are the investment options offered for employees: Company Stock One option in the 401(k) plan is stock in East Coast Yachts. The company

Answer 1

1. Mutual Funds offer following advantages compared to company stock:

• Liquidity: The company is currently unlisted and thus the shares are not marketable. Thus, the owner of shares can't sell and wealth will remain tied up till the company's shares are traded in secondary market.
• Diversification: Mutual funds involve less risk because of the diversified investment portfolio which mitigates the overall market risk. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields adequate level of risk reduction.
• Less need of involvement: Mutual funds are typically managed by experienced and qualified professionals who manage the portfolio allocation across stocks as well as appropriate buying and selling levels. Thus, the investor does not need to be actively involved in buying and selling decisions which is required in case of stocks.

2. This subpart is vague.

3. Both Bledsoe Large Company stock fund and Bledsoe S&P 500 index funds are invest in large corporations.

Advantages of choosing Bledsoe Large Company stock fund are:

• Bledsoe Large Company stock fund is actively managed by a fund manager while the Bledsoe S&P 500 index fund is a passive fund i.e. it simply tracks the S&P500 index
• Due to active management by a professional, Bledsoe Large Company is likely to generate better returns which is also apparent from the fact that it has beaten the index in 6 out of last 8 years.

Disadvantages of choosing Bledsoe Large Company stock fund are:

• Higher management fee : This fund charges a fee of 1.5% which reduces the overall returns while the other one charges a nominal fee of 0.15% only.
• Any change in the fund manager may change the whole dynamics of the fund (improving or deteriorating the fund performance) while this will not be an issue with a passive fund

4. Small Cap funds are, by design, high risk - high reward investments. While the returns are more volatile (which is measured as standard deviation of annual returns), over a longer period small cap funds usually give better overall returns than large cap funds. This is also visible in the 10year return of Bledsoe small cap fund of 16.14% as compared to 11.04% for index fund and 12.15% for large cap fund. The difference in management fee is only 20 basis points as compared to large cap fund (1.7% vs 1.5%). This is a minor difference as compared to the difference in returns and thus should not be a major deciding factor of whether or not to invest in this fund.