Investments An

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Chapter 7 Closed-end Investment Companies, Real Estate
Investment Trusts (REITs), and Exchange-Traded Funds (ETFs)

TRUE/FALSE

T 1. A closed-end investment company is not a "mutual fund."

T 2. The per share net asset value of the shares in a

closed-end investment company depends on the difference
between the fund's assets and liabilities and the number of
shares outstanding.
T 3. If a closed-end investment company were liquidated, the
investor should receive the net asset value minus the cost of
the liquidation.

F 4. A closed-end investment company’s shares cannot sell

for a discount from net asset value.

T 5. The shares of a closed-end investment company often

sell for a discount from their net asset value.

F 6. The discount paid for the shares of a closed-end

investment company is fixed by the firm.

F 7. The only costs of investing in a closed-end investment

company are the commissions to buy and sell the shares.

T 8. Distributions from an investment company may include

earnings and capital gains.

T 9. Distributions from a closed-end investment are subject

to federal income taxation.

T 10. A unit trust is a passive investment that holds a fixed

portfolio of securities such as federal government bonds.

T 11. Many unit trusts are self-liquidating.

T 12. A loading fee charged by a mutual fund does not apply

to a closed-end investment company.

F 13. If a closed-end investment company specializes in the

securities of one sector of the economy, systematic risk is
reduced.

T 14. Real estate investment trusts (REITs) are illustrative

of a closed-end investment company.

F 15. The cash flow generated by REITs is taxed as income by

the federal government.
T 16. A mortgage trust is a REIT that specializes in mortgage
loans.

F 17. An equity REIT does not use financial leverage (i.e.,

its financing is entirely equity).

T 18. The first exchange-traded funds (ETFs) were a type of

index fund.

F 19. Since ETFs mimic an index, they do not buy individual

shares of stock.

T 20. As a result of arbitrage, ETFs tend to sell for their

net asset value.

F 21. An investor may not sell short the shares of an ETF.

T 22. Compared to selecting individual stocks, ETFs ease the

process of constructing a well diversified portfolio.

F 23. If an investor believes that financial markets are

inefficient, that argues for the individual to pursue a more
active portfolio strategy and purchase exchange-traded funds
instead of individual stocks.

F 24. A hedge fund is a conservative type of mutual fund.

F 25. The shares of hedge funds are registered with the SEC.

F 26. The shares of hedge funds are often included in an

individual investor’s IRAs.

T 27. Hedge fund strategies may include buying one stock

while shorting another.

T 28. Hedge funds are sold primarily to high net worth

investors and financial institutions such as pension plans.

T 29. American investors may acquire shares in mutual funds

that specialize in foreign investments.

F 30. A global fund invests solely in foreign securities.

T 31. The shares of closed-end investment companies that

invest in foreign securities may sell for a premium over
their net asset values.
F 32. If foreign securities markets are as efficient as U. S.
securities markets, then foreign investments may offer the U.
S. investor no advantages over investing in domestic
securities.
MULTIPLE CHOICE

a 1. Closed-end investment companies

1. have a fixed capital structure
2. issue new stock whenever an individual buys shares
3. may sell for a premium over net asset value
4. must sell for their net asset value
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4

a 2. The net asset value of a closed-end investment company

fund increases with
a. higher stock prices
b. lower stock prices
c. larger number of shares
d. increased liabilities

b 3. Since closed-end investment companies acquire

securities
in efficient financial markets, they
a. cannot outperform the market consistently
b. should not outperform the market consistently
c. will underperform the market when security
prices decline
d. primarily bear unsystematic risk

d 4. Closed-end investment companies with beta coefficients

less than 1.0
a. have outperformed the market
b. have underperformed the market
c. have more systematic risk than the market
d. have less systematic risk than the market

b 5. If a closed-end investment company sells for a

discount,
a. its price exceeds the net asset value
b. its price is less than the net asset value
c. dividend income exceeds capital gains
d. capital gains exceed dividend income.

c 6. A real estate investment trust

a. pays federal income taxes
b. retains all of its earnings
c. invests in mortgages or rental properties
d. cannot use debt financing
d 7. Which of the following is not a consideration for
investing in real estate investment trusts (REITs)?
a. fluctuations in dividend payments
b. excessive use of debt financing by some REITs
c. fluctuating interest rates affecting securities
valuations
d. the federal tax rate paid by the trust
c 8. Exchange traded funds
a. redeem their shares
b. only buy exchangeable securities
c. are bought and sold in secondary markets
d. cannot be sold short

b 9. Exchange-traded funds
a. consistently outperform other funds
b. mimic an index of securities
c. require investors to select individual stocks
d. are illustrations of load funds

c 10. Many exchange-traded funds limit their portfolios to

a. high quality securities
b. stocks that respond to changes in consumer
prices (the Consumer Price Index or CPI)
c. stocks included in an aggregate measure of
stock prices
d. stocks and bonds of companies in a particular
industry

c 11. A hedge fund

a. is a public financial institution
b. has its shares registered with the Federal Reserve
c. is open to a select number of individual investors
d. has actively traded shares

b 12. Hedge funds follow investment strategies such as

a. acquiring shares in mutual funds
b. shorting “overvalued” stocks while buying
“undervalued” stocks
c. limiting their portfolios to money market
instruments
d. underwriting new issues (IPOs)

b 13. The portfolios of international funds

a. stress European securities
b. exclude U. S. securities
c. are a diversified mix of securities from all
countries with security markets
d. specialize in the securities of one country

d 14. An American investor may take a position in foreign

equities by acquiring
1. iShares specializing in foreign country indexes
2. international mutual funds
3. country closed-end investment companies
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above
PROBLEMS

1. If an investor purchases shares in a no load mutual fund

for $36, receives cash distributions of $1 and redeems the
shares after one year for $42, what is the percentage return
on the investment?

2. The net asset value of shares in a closed-end investment

company is $36. An investor buys the shares for $34 in the
secondary market. The company distributes $1 and after one
year, the net asset rises to $42. The investor sells the
shares for $44 in the secondary market.
a. What is the discount?

b. What is the percentage return on the investment?

c. In both problems 1 and 2, the investment company’s net

asset value rose from $36 to $42 and the company distributed
$1. Why are the percentage returns different?

3. If an investor buys shares in a closed-end investment

company for $46 and the net asset value is $53, what is
the discount? If the company distributes $1, the net asset
value rises to $58, and the investor sells the shares for a
premium of 5 percent over the net asset value, what is the
percentage earned on the investment?

4. Mutual fund A earned 10 percent while B earned 8 percent.

The standard deviations of the returns were 10 percent and 7
percent, respectively. According to the Sharpe ratio, which
fund performed better?

5. A mutual fund’s net asset value is $50, but the fund

charges an exit fee of 1 percent of net asset value and a
load fee of 4 percent of net asset value. An individual
purchases the shares. During the year the fund distributes
$2.34. The net asset value rises to $58.38 and the investor
redeems the shares.

a. What is the percentage return the fund can report that

was achieved by its portfolio managers.

b. What is the percentage return the individual earned on

the investment?
c. Why are the two percentages different?
6. You buy a REIT for $50 a share. The REIT distributes $3.00
consisting of return of capital. You are in the 30% income tax
bracket (which also applies to short-term capital gains) and
the 15 percent long-term capital gains bracket. What is the tax
implication of this distribution?

7. An investor bought 100 shares of a REIT for $54 a share and

two years later sold the shares for $62. The REIT annually
distributed $4.00 per share ($400) consisting of $2.00 return
of capital $200), $1.20 ($120) in income and $0.80 ($80) in
long-term capital gains. The investor’s income tax bracket is
30%. The long-term capital gains tax rate is 15 percent. What
is your second year’s tax obligation?
SOLUTIONS TO THE PROBLEMS

1. The percentage return: ($42 – 36 + 1)/$36 = 16.67%

2. a. The discount is $36 - $34 = $2 (5.9% of NAV).

b. The percentage return: ($44 – 34 + 1)/$34 = 32.3%

c. The percentage returns differ because initially the

closed-end investment company sold for a discount of $2 from
net asset value. The closed-end investment company sold for a
premium of $2 above net asset value when the shares were
sold. This increase of $4 increased the percentage return on
the investment.

3. The discount is $53 - 46 = $7 (The shares initially sell

for a discount of $7/53 = 13.2 percent from net asset value.)

The percentage return is ($1 + 1.05(58) - 46)/$46 = 34.6%.

4. The Sharpe ratios are .10/.10 = 1 and .08/.07 = 1.14

which indicates that fund B did better on a risk-adjusted
basis.

5. The percentage return reported by the fund:

(57.80 - 50 + 2.34)/$50 = 20.28%.

b. The shares cost $50 + .04($50) = $52. When the shares are
redeemed, the investor nets $58.38(0.99) = $57.80.

The percentage return is ($57.80 – 52 + 2.34)/$52 = 15.65%.

c. The load fee charged when the shares are purchased and
the exit fee charged when the shares are redeemed decrease
the return the investor realizes.

6. No taxes are owed since the distribution is totally a

return of capital. The cost basis of the shares is reduced by
$3 to $47 ($50 - $3), which will be used to determine any
capital gain or loss when the shares are sold.
7. The annual distribution was $400 and consisted of
$200 return of capital
$120 income
$80 long-term capital gain.

The tax on the income distribution:

$120 x .3 = $36

The tax on the long-term capital gain: $80 x .15 = $12

The tax on the sale (long-term):

Cost basis: $5400 - $400 = $4800 after reducing the
initial cost basis for the $200 return of capital for each of
the two years (a total of $400)
Capital gain: $6200 - $4800 = $1400
Tax on the capital gain: $1400 x .15 = $210.

Total tax: $36 + $12 + $210 = $256.