Question

A Job at S&S Air V ou recently graduated from college, and your job search led you to S&S Air. Because you felt the company's business was headed I skyward, you accepted the job offer. As you are finishing your employment paperwork, Chris Guthrie, who works in the finance department, stops by to inform you about the company's new 401(k) plan. A 401(k) is a type of retirement plan offered by many companies. A 401(k) is tax deferred, which means that any deposits you make into the plan are deducted from your current income, so no current taxes are paid on the money. For example, assume your salary will be $30,000 per year. If you contribute $1,500 to the 401(k) plan, you will pay taxes only on $28,500 in income. No taxes will be due on any capital gains or plan income while you are invested in the plan, but you will pay taxes when you withdraw the money at retirement. You can contribute up to 15 percent of your salary to the plan. As is common, S&S Air also has a 5 percent match program. This means that the company will match your contribution dollar-for-dollar up to 5 percent of your salary, but you must contribute to get the match. The 401(k) plan has several options for investments, most of which are mutual funds. As you know, 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, similar to purchasing shares of stock in a company. 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, who makes all of the investment decisions for the fund. S&S Air uses Arias Financial Services as its 401(k) plan administrator. Chris Guthrie then explains that the retirement investment options offered for employees are as follows: 1. Company stock. One option is stock in S&S Air. The company is currently privately held. The price you would pay for the stock is based on an annual appraisal, less a 20 percent discount. When you interviewed with the owners, Mark Sexton and Todd Story, they informed you that the company stock was expected to be publicly sold in three to five years. If you needed to sell the stock before it became publicly traded, the company would buy it back at the then- current appraised value. 2. Arias SAP Soo Index Fund. This mutual fand tracks the S&P 500. Stocks in the fund are weighted exactly the same as they are in the S&P 500. This means that the fund's return is approximately the return of the S&P 500, minus expenses. With an index fund, the manager is not required to research stocks and male investment decisions, so fund expenses are usually low. The Arias S&P 500 Index Fund charges expenses of 20 percent of assets per year. 3. Arias Small-Cap Pund. This fund primarily invests in small capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside the United States. This fund charges 1.70 percent of assets in expenses per year. 4. Arias Large-Company Stock Pund. This fund invests primarily in large capitalization stocks of companies based in the United States. The fand is managed by Melissa Aries and has outperformed the market in six of the last eight years. The fund charges 1.50 percent in expenses. 5. Arias Bond Pund. This fund invests in long-term corporate bonds issued by U.S. domiciled companies. The fund is restricted to investments in boods with an investment grade credit rating. This fund charges 1.40 percent in expenses 6. Arias Money Market Fund. This fund invests in short-term, high credit quality debt instruments, which include Treasury bills. As such, the return on money market funds is only slightly higher than the return on Treasury bills. Because of the credit quality and short-term Dature of the investments, there is only a very slight risk of the return. The fund charges 60 percent in expenses QUESTIONS Page 348 1. What advantages/disadvantages do the mutual funds offer compared to company stock for your retirement investing? 2. Notice that, for every dollar you invest, S&S Air also invests a dollar. What return on your investment does this represent? What does your answer suggest about matching programs? 3. Assume you decide you should invest at least part of your money in large capitalization stocks of companies based in the United States. What are the advantages and disadvantages of choosing the Arias Large Company Stock Fund compared to the Arias S&P 500 Index Fund? 4. The returns of the Arias Small Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund? 5. A measure of risk-adjusted performance that is often used in practice is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviations and returns for the funds over the past 10 years are listed here. Assuming a risk-free rate of 4 percent, calculate the Sharpe ratio for each of these. In broad terms, what do you suppose the Sharpe ratio is intended to measure? Arias S&P 500 Index Fund Arias Small Cap Fund Arias Large Company Stock Fund Arias Bond Fund 10-Year Annual Return 9.154 14.05 Standard Deviation 19.35% 26.82 23.82 11.45 8.73

Answer 1

1. Mutual funds help to invest in companies and thereby have ownership, but mutual funds would be a portfolio of products. The advantage includes getting exposure to various funds that would by investing a small amount. Also through diversification, the risk is minimised. The liquidity of mutual funds is high. Other benefits include less operating/ fund management cost, unlike hedge funds.

Few disadvantages include that the return is defined and cannot match as per the positive side of equity.

2. SAS will contribute 5% of the salary if the employee invests min 5% or more part of his salary. This would ultimately add on the net return and thereby includes the income at the retirement. If not much, at least this would also offset the tax portion.

3. Though the expense ratio for Arias Large Company Stock fund is greater, the past performance of the fund has outperformed the market making it a good bet. Moreover, the fund is actively managed fund, as compared to index funds which are passively managed. The fund is also ideal for the person who has a long investment horizon and is willing to take some risk.

4. The difference between the expense ratio of actively managed funds like Large funds, small funds, bond funds etc is not much. Hence this won't be factor of not considering small funds. However, since the portfolio allows a part of exposure in International market, giving a hedge to the portfolio for sudden volatile in other regimes, as the market now is globally connected. And also the return would be maximum in this type of funds. Therefore, the suggestion of including a part would obviously by advisable.