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 stock was expected to go public in the next three to four years. Until then, a company stock price is set each year by the board of directors. 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. Because 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 Bledsoe S&P 500 Index Fund charges expenses of .15 percent of assets per year. 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 Bond Fund This fund invests in long-term corporate bonds issued by U.S.-domiciled companies. The fund is restricted to investments in bonds with an investment-grade credit rating. This fund charges 1.40 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. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of a negative return. The fund charges 60 percent in expenses. 1. 2. 3. 4. 5. What advantages do the mutual funds offer compared to the company stock? Assume that you invest 5 percent of your salary and receive the full 5 percent match from East Coast Yachts. What EAR do you earn from the match? What conclusions do you draw about matching plans? 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 Bledsoe Large-Company Stock Fund compared to the Bledsoe S&P 500 Index Fund? The returns on the Bledsoe 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? page 315 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. Assume that the expected return and standard deviation of the company stock will be 15 percent and 65 percent, respectively. Calculate the Sharpe ratio for the company stock. How appropriate is the Sharpe ratio for these assets? When would you use the Sharpe ratio? Assume the risk-free rate was 2.76 percent. 10-Year Annual Return Bledsoe S&P 500 Index Fund 11.85% Standard Deviation 23.85% Bledsoe Small-Cap Fund 15.32 Bledsoe Large-Company Stock Fund Bledsoe Bond Fund 10.73 29.62 26.73 8.04 10.34 6. What portfolio allocation would you choose? Why? Explain your thinking carefully. *The first article was Roger Ibbotson and Rex Sinquefield, "Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926-1974)," Journal of Business 49, no. 1 (1976), pp. 11-47- 2 Jeremy J. Siegel has estimated the U.S. equity risk premium with data from 1802. As can be seen in the following table, from 1802 to 2008, the historical equity risk premium was 5.2 percent. Average Returns 1802-2008 (%) Common stock Treasury bills Equity risk premium 9.5 4.3 5.2