Question

You have recently graduated from college, and your job search led you to East Coat Yachts. Since you left 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 only pay taxes on $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% match. This means that the company will match your contribution up to 5% 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. 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 expense. The largest expense is typically the management fee, paid 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 Bledose Financial Services as its 401(k) plan administrator. The investment options offered for employees are discussed below.

Company Stock: One option in 401(k) plan is stock in East Coast Yachts. The company is currently privately held. However, when you have interviewed with the owner, Ms. Larissa Warren, she informed you the company stock was expected to go public in the next three to four years. Until then, a company stock price is simple set each year by the board of directors.

Bledose S&P 500 Index Fund: This mutual fund tracks the S&P 500. Stocks in the fund are weighted exactly the same was the S&P 500. This means the fund return is approximately the return on the S&P 500, minus expenses. Since an index fund purchases assets based on the composition of the index it is following, the fund manager is not required to research stocks and make investment decisions. The result is that the fund expenses are usually low. The Bledose S&P 500 Index Fund charges expenses of 0.15% of assets per year.

Bledose 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% of its assets in companies based outside the United States. This fund charges 1.70% in expenses.

Bledose 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 Bledose and has outperformed the market in six of the last eight years. The fund charges 1.50% in expenses.

Bledose Bond Fund: This fund invests in long-term corporate bonds issued by U.S. domiciled companies. The fund is restricted to investments in bond with an investment grade credit rating. This fund charges 1.40% in expenses.

Bledose 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. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges 0.60% in expenses.

Each question is worth 05 points. A total of 25 points.

1. What advantages do the mutual funds offer compared to the company stock? Explain.

2. 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 Bledose Large Company Stock Fund compared to the Bledose S&P 500 Index Fund? Explain.

3. The returns on the Bledose 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. Does this affect your decision to invest in this fund? Explain.

4. A measure of risk-adjusted performance that is often used is the Sharpe Ratio. The Sharpe Ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviation and return of the funds over the past 10 years are listed below. Calculate the Sharpe ratio for each of these funds. You may assume risk free rate as 3%.

	10 year Annual Return	Standard Deviation
Bledose S&P 500 Index Fund	10.15%	23.85%
Bledose Small Cap Fund	14.83%	29.62%
Bledose Large Company Stock Fund	11.08%	26.73%
Bledose Bond Fund	8.15%	10.34%

5. What portfolio allocation would you choose? Why? Explain your thinking carefully.

Answer 1

(1) Advantages of mutual funds compared to company stock :

• Concentration : The salary is earned from East Coast Yachts. In case of the company going bankrupt suddenly, not only will you lose the job, but also the savings invested in the company's stock. Mutual funds provide an avenue for reducing the concentration of savings in the employer's stock
• Diversification : Diversification of investments into more than one stock reduces the unsystematic risk, and the overall standard deviation / volatility of investment returns.
• Mutual funds are professionally managed by expert investment managers.

(2) Advantages :

• Bledose Large Company Stock Fund has outperformed the market in six of the last eight years
• Large cap funds have lower overall volatility / risk compared to S&P 500 funds since the latter invest a part of the portfolio in mid/small cap stocks which have higher volatility compared to large cap stocks
• Opportunity to earn alpha through active management

Disadvantages :

• Bledose Large Company Stock Fund has a much higher expense ratio compared to the S&P 500 fund
• As this fund does not invest in mid/small cap stocks, there could be an opportunity cost of missing out on the higher returns earned by mid/small cap stocks

(3) Bledose Small Cap Fund is the most volatile. However, it also has the potential for highest returns compared to any other fund. Small cap funds have higher risk, but also higher reward. As you have just graduated from college, the investment horizon is very long and hence the risk tolerance is also high. You may want to invest in this fund to generate higher returns over the long term.

Although the expense ratio is highest, it is only slightly higher than the expense ratio of the large cap fund. Investing in small cap stocks involves relatively more research and hence the higher expense ratio. This is a small trade-off when compared to the potentially higher returns over the long term. Hence the higher expense ratio will not affect my decision to invest in this fund.

(4) Sharpe Ratio = (Fund return - Risk free return) / standard deviation of Fund

Bledose S&P 500 Index Fund = (10.15 - 3) / 23.85, which is 0.2998

Bledose Small Cap Fund = (14.83 - 3) / 29.62, which is 0.3994

Bledose Large Company Stock Fund = (11.08 - 3) / 26.73, which is 0.3023

Bledose Bond Fund = (8.15 - 3) / 10.34, which is 0.4981

A rule of thumb for equity percentage allocation in a portfolio is (120 - age)

As you have recently graduated from college, a rough estimation of age is 22

So, an approximate allocation would be 98% stocks and 2% bonds.

As the investment horizon is very long, the risk tolerance is high. It may be better to invest more in funds with higher risk and higher expected return. Small cap funds have the highest risk and expected returns, and therefore the highest allocation should be to the Bledose Small Cap Fund. A good allocation is 50% of the portfolio to this fund. The remaining could be invested equally in Bledose S&P 500 Index Fund and Bledose Large Company Stock Fund.

So, I would choose the portfolio allocation as :

2% - Bledose Bond Fund

50% - Bledose Small Cap Fund

24% - Bledose S&P 500 Index Fund

24% - Bledose Large Company Stock Fund.