Mini-Case Study A Job At East Coast Yachts

Your 401 (k) Account At East Coast Yachts

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Your 401 (k) Account At East Coast Yachts

You have been at your job for East Coat Yachts for a week now and have decided you need to sign up for the company's 401(k) plan. Even after your decision with Sarah Brown, the Bledsoe Financial Services Representative, you are still unsure as to which investment option you should choose. Recall that the options available to you are stock in East Coast Yachts, the Bledsoe S&P 500 index fund, the Bledsoe Small-cap fund, the Bledsoe Large-Company Stock Fund, the Bledsoe Bond Fund, and the Bledsoe Money Market Fund. You have decided that you should invest in a diversified portfolio, with 70 percent of your investment in equity, 25 percent in bonds, and 5 percent in the money market. You have decided to focus your equity investment on large-cap stocks, but you are debating whether to select the S&P 500 Index fund or the Large-Company Stock Fund.

In thinking it over, you understand the basic difference in the two funds. One is a purely passive fund that replicates a widely followed large-cap index, the S&P 500, and has low fees. The other is actively managed with the intention that the skill of the portfolio manager will result in improved performance relative to an index. Fees are higher in the latter fund. You're just not certain on which way to go, so you ask Dan Ervin, who works in the company's finance area, for advice.

After discussing your concerns, Dan gives you some information comparing the performance of equity mutual funds and the Vanguard 500 index fund. The Vanguard 500 in the world's largest equity index mutual fund. It replicates the S&P 500, and it's return is only negligibly different from the S&P 500. Fees are very low. As a result, the Vanguard 500 is essentially identical to the Bledsoe S&P 500 index fund offered in the 401k plan, but it has been in existence for much longer, so you can study its track record for over two decades. The graph on the following page summarizes Dan's comments by showing the percentages of equity mutual funds that outperformed the Vanguard 500 fund over the previous ten years. So for example, from January 1977 to December 1986, about 70 percent of equity mutual funds outperformed the Vanguard 500. Dan suggests that you study the graph and answer the following questions:

1. What implications do you draw from the graph for mutual fund investors?

2. Is the graph consistent or inconsistent with market efficiency? Explain carefully.

3. What investment decision would you make for the equity portion of your 401k account? Why?

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Answer 1: It seems like that in recent decade less than 30% of the mutual funds have beaten the Vanguard 500. In reality, there has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds (this is proved by the graph provided); one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average ...

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Unformatted text preview: Case Study 1: A JOB AT EAST COAST YACHTS You recently graduated from university and your job search led you to East Coast Yachts. Because 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 to get the match. The 401(k) plan has several options for investments, most of which are mutual funds. A mutual fund is a portfolio of assets. 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 is currently privately held. However, when you interviewed with the owner, Larissa Warren, she informed you the company was expected to go public in the next three to four years. Bledsoe S&P 500 Index Fund: This mutual fund tracks the S&P 500. Stocks in the fund are weighted exactly the same as the S&P 500. This means the fund return is approximately the return on the S&P 500, minus expenses. Bledsoe Small—Cap Fund: 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 in expenses. Bledsoe Large—Company Stock Fund: This fund invests primarily in large—capitalization stocks of companies based in the United States. The fund is managed by Evan Bledsoe and has outperformed the market in‘six of the last eight years. The fund charges 1.50 percent in expenses. Bledsoe Money Market Fund: This fund invests in short—term, high—credit quality debt instruments, which include Treasury bills. As such, the return on the money market fund is only slightly higher than the return on Treasury bills. Required: 3) Critically analyse the 5 different ways of aforementioned investment (Company Stock , Bledsoe S&P 500 Index Fund, Bledsoe Small—Cap Fund, Bledsoe Large—Company Stock Fund , Bledsoe Money Market Fund ). (20 Marks) 1)) Explain the presence of each type of systematic and unsystematic risks in the mutual funds with reference to portfolio management. (15 Marks) c) Elaborate how would each risk factor identified be managed? (15 Marks) (Total: 50 Marks) ...
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