20-Mutual Funds

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20-Mutual Funds

  1. 1. Mutual Funds and Investment Companies
  2. 2. How Much do Investment Companies Own? OWNERSHIP as a PERCENT of TOTAL MARKET-CAP
  3. 3. Advantages <ul><li>record keeping and administration </li></ul><ul><li>diversification </li></ul><ul><li>professional management </li></ul><ul><li>lower transaction costs </li></ul>
  4. 4. Investment Companies <ul><li>Investors buy “shares” of the investment company. </li></ul><ul><li>Share is a claim to the stream of cashflows generated by company assets. </li></ul><ul><li>Net Asset Value: </li></ul>Net asset value (NAV) = Market value of assets - Liabilities Shares outstanding
  5. 5. Mutual Funds <ul><li>Open-end funds </li></ul><ul><ul><li>You buy or sell shares directly through the mutual fund </li></ul></ul><ul><ul><li>Shares are purchased at NAV per share </li></ul></ul><ul><ul><li>NAV is calculated every day at 4:00pm </li></ul></ul><ul><ul><li>All orders placed before 4:00pm buy at this NAV </li></ul></ul><ul><ul><li>Fund companies adjust the number of shares according to the demand by investors </li></ul></ul>
  6. 6. Open-End Fund Example 1 <ul><li>Fund ABC 4:00pm Monday: </li></ul><ul><ul><li>Total Assets = 36 billion </li></ul></ul><ul><ul><li>Total Liabilities = 0 </li></ul></ul><ul><ul><li>Shares Outstanding = 900 million </li></ul></ul><ul><ul><li>NAV = 36B/900M = $40 </li></ul></ul><ul><li>Throughout day on Tuesday </li></ul><ul><ul><li>Asset Value increases by 1% </li></ul></ul><ul><ul><li>New flows of $500,000 </li></ul></ul>
  7. 7. Open-End Fund Example 1 <ul><li>4:00pm on Tuesday </li></ul><ul><ul><li>Asset value is now 36B(1.01)=36.36B </li></ul></ul><ul><ul><li>NAV = 36.36B/900M=40.4 </li></ul></ul><ul><ul><li>% change: 40.4/40-1= 1% </li></ul></ul><ul><li>New Flows of $500,000 </li></ul><ul><ul><li>500,000/40.4 = 12,376 shares </li></ul></ul><ul><ul><ul><li>New investors buy these shares at 40.4 per share </li></ul></ul></ul><ul><ul><li>Total shares outstanding = 900M + 12,376 </li></ul></ul><ul><ul><li>Total Assets = 36.36B + 500,000 </li></ul></ul>
  8. 8. Open-End Fund Example 2 Adding a Little Leverage <ul><li>Fund ABC 4:00pm Monday: </li></ul><ul><ul><li>Total Assets = 36 billion </li></ul></ul><ul><ul><li>Total Liabilities = 1 billion </li></ul></ul><ul><ul><li>Shares Outstanding = 900 million </li></ul></ul><ul><ul><li>NAV = 35B/900M = $38.89 </li></ul></ul><ul><li>Throughout day on Tuesday </li></ul><ul><ul><li>Asset Value increases by 1% </li></ul></ul><ul><ul><li>New flows of $500,000 </li></ul></ul>
  9. 9. Open-End Fund Example 2 Adding a Little Leverage <ul><li>4:00pm on Tuesday </li></ul><ul><ul><li>Asset value is now 36B(1.01)=36.36B </li></ul></ul><ul><ul><li>NAV = 35.36B/900M=39.29 </li></ul></ul><ul><ul><li>% Change = 39.29/38.89-1=1.029% </li></ul></ul><ul><li>New Flows of $500,000 </li></ul><ul><ul><li>500,000/39.29 = 12,726 shares </li></ul></ul><ul><ul><ul><li>New investors buy these shares at 39.29 per share </li></ul></ul></ul><ul><ul><li>Total shares outstanding = 900M + 12,726 </li></ul></ul><ul><ul><li>Total Assets = 36.36B + 500,000 </li></ul></ul>
  10. 10. How Funds are Sold <ul><li>Fund “underwriter” has exclusive rights to distribute shares of the fund. </li></ul><ul><li>Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter. </li></ul><ul><li>Financial Supermarkets </li></ul><ul><ul><li>Example: Charles Schwab </li></ul></ul>
  11. 11. Front-End Loads <ul><li>What they are for </li></ul><ul><ul><li>Used to pay brokers who sell funds </li></ul></ul><ul><li>How they affect price paid </li></ul><ul><ul><li>NAV of fund: $13 </li></ul></ul><ul><ul><li>Front End Load: 4% </li></ul></ul><ul><ul><li>What price do you pay per share? </li></ul></ul><ul><ul><ul><li>NAV=96% of price </li></ul></ul></ul><ul><ul><ul><li>13=0.96*P </li></ul></ul></ul><ul><ul><ul><li>P = 13/.96 = 13.54 </li></ul></ul></ul><ul><ul><li>Fund NAV must increase to 13.54 (4.2%) just to break even, assuming no other fees. </li></ul></ul>
  12. 12. Front End Loads <ul><li>Another way of looking at front end loads: </li></ul><ul><li>Assume front-end = 4% </li></ul><ul><ul><li>If you invest $1000, only $960 is actually used to buy shares of the fund </li></ul></ul><ul><ul><li>The other $40 is gone in fees </li></ul></ul><ul><ul><li>Your investment must increase to 1000 (4.2%) just to break even, assuming no other fees </li></ul></ul>
  13. 13. Front End Loads <ul><li>How they affect returns </li></ul><ul><li>Fund: </li></ul><ul><ul><li>NAV=$10 </li></ul></ul><ul><ul><li>Front End load of 5% </li></ul></ul><ul><ul><li>NAV grows by 14% per share each year </li></ul></ul><ul><li>Assume you invest $X and hold investment for two years. </li></ul>
  14. 14. Back End Loads <ul><li>What they are for </li></ul><ul><ul><li>Used to pay brokers who sell funds </li></ul></ul><ul><ul><li>0 to 6% </li></ul></ul><ul><ul><li>Usually reduced 1% point for each year you hold the fund </li></ul></ul><ul><li>How they affect price paid </li></ul><ul><ul><li>They don’t </li></ul></ul><ul><ul><li>Assuming no other fees, price is NAV </li></ul></ul>
  15. 15. Back End Loads <ul><li>How they affect price received when sold </li></ul><ul><ul><li>NAV of fund: $13 </li></ul></ul><ul><ul><li>Back End Load: 5% </li></ul></ul><ul><ul><li>What price do you get when you sell the fund? </li></ul></ul><ul><ul><li>13*.95 = $12.35 </li></ul></ul>
  16. 16. Back End Loads <ul><li>How they affect returns </li></ul><ul><li>Fund: </li></ul><ul><ul><li>NAV=$10 </li></ul></ul><ul><ul><li>Back End load of 5% </li></ul></ul><ul><ul><li>Fund earns 14% per share each year </li></ul></ul><ul><li>Assume you invest $X and hold investment for two years. </li></ul>
  17. 17. Annual Expenses <ul><li>Operating expenses </li></ul><ul><ul><li>What They are for </li></ul></ul><ul><ul><ul><li>Used to pay for administrative expenses and advisory fees </li></ul></ul></ul><ul><li>12b-1 charges </li></ul><ul><ul><li>What they are for </li></ul></ul><ul><ul><ul><li>Used to pay for advertising, promotional literature, and brokers </li></ul></ul></ul>
  18. 18. Annual Expenses <ul><li>How they affect returns </li></ul><ul><li>Fund: </li></ul><ul><ul><li>NAV=$10 </li></ul></ul><ul><ul><li>Annual expenses (expense ratio) of 5% </li></ul></ul><ul><ul><li>Fund earns 14% per share each year </li></ul></ul><ul><li>Assume you invest $X and hold investment for two years </li></ul><ul><li>Each year gross return net of fees is 1.14 - 0.05 = 1.09 </li></ul>
  19. 19. Summary <ul><li>Assume: </li></ul><ul><ul><li>A fund portfolio grows by r each year. </li></ul></ul><ul><ul><li>The fund has front-end load of f . </li></ul></ul><ul><ul><li>The fund has back-end load of b . </li></ul></ul><ul><ul><li>The fund has annual expense ratio of a . </li></ul></ul><ul><ul><li>No capital gains or distributions </li></ul></ul><ul><li>The gross return for an investor in the fund over n periods is </li></ul>
  20. 20. Example: Fund or CD’s? <ul><li>Investment Choices: </li></ul><ul><li>mutual fund, </li></ul><ul><ul><li>3% front-end load </li></ul></ul><ul><ul><li>annual expense ratio of 0.6%. </li></ul></ul><ul><li>CD: 5% per year </li></ul><ul><li>What return must the fund portfolio earn for you to be better off in the fund than in the CD if you plan to hold the investment for 4 years? </li></ul>
  21. 21. Example: Fund or CD’s? <ul><li>In 4 years: </li></ul><ul><ul><li>CD: gross return = (1.05) 4 = 121.55% </li></ul></ul><ul><ul><li>Fund: gross return = .97 (1+r-0.006) 4 </li></ul></ul><ul><ul><li>.97 (1+r-0.006) 4 = 1.2155 </li></ul></ul><ul><ul><li>(1+r-0.006) 4 = 1.2155/.97=1.253 </li></ul></ul><ul><ul><li>1+r =0.006+1.253 1/4 </li></ul></ul><ul><ul><li>r = 6.4% </li></ul></ul>
  22. 22. Mutual Funds <ul><li>Closed-end funds </li></ul><ul><ul><li>Fund companies issue a fixed number of shares </li></ul></ul><ul><ul><li>You buy or sell shares on an exchange </li></ul></ul><ul><ul><li>The funds usually trade at a discount of about 10% relative to NAV per share. </li></ul></ul><ul><ul><ul><li>Puzzle </li></ul></ul></ul>
  23. 23. Alphas of Actively Managed Funds
  24. 24. Mutual Fund Performance <ul><li>If momentum and value have given positive alpha over the last 30 years, why haven’t active fund managers been able to capture it? </li></ul>
  25. 25. Average Active Mutual Fund Performance 1975-1994 Russ Wermers, 2000 Journal of Finance
  26. 26. ETF <ul><li>Exchange-Traded Funds (ETFs) are unit investment trusts that will primarily hold securities that are in a market index. </li></ul><ul><li>Investors have the right to exchange their shares for the underlying securities of the fund. </li></ul><ul><li>Exchange traded notes are ETFs that buy all securities within a bond index. </li></ul>
  27. 27. Examples of ETFs <ul><li>SPDRs (S&P 500 Depository Receipts) </li></ul><ul><li>Cubes (Nasdaq 100) </li></ul><ul><li>Diamonds (Dow Jones Industrial Average) </li></ul><ul><li>I-shares (Barclays) </li></ul><ul><li>HOLDRs (Merrill Lynch) </li></ul><ul><li>VIPERs (Vanguard) </li></ul><ul><li>See http://www.nyse.com/screener/index.php for a complete list </li></ul>
  28. 28. Advantages of ETFs Relative to Mutual Funds <ul><li>ETFs can be bought and sold anytime like regular stocks at real-time prices. </li></ul><ul><li>ETFs can be sold short. </li></ul><ul><li>ETFs have relatively low fees. </li></ul><ul><li>ETFs are relatively tax-efficient. </li></ul>
  29. 29. Some Disadvantages of ETF’s <ul><li>Prices can move away slightly from NAV </li></ul><ul><ul><li>Open-End Mutual funds are always purchased at NAV </li></ul></ul><ul><li>Pay the bid-ask spread when trading an ETF </li></ul>
  30. 30. Hedge Funds <ul><li>A private investment pool, open to wealthy or institutional investors. </li></ul><ul><li>Not registered as mutual funds and not subject to SEC regulation. </li></ul><ul><li>Pursues more speculative policies in liquid assets such as stocks, bonds, currencies, options, and other derivatives. </li></ul><ul><li>Name comes from the fact that hedge funds want to create market-neutral strategies by going long in some assets and going short in related assets. </li></ul>
  31. 31. Hedge Funds vs. Mutual Funds Mutual Funds Hedge Funds Investment methods Buy publicly traded securities. Little use of leverage or short-sales. Buy also non-public securities, currencies and commodities. Wide use of leverage and short-sales. Diversification Hold broad mix of assets. Holdings are often concentrated. Fees Relatively low fees that do not depend on performance Relatively high fees that depend on performance. Withdrawls Investors can sell back shares at any time Investor money is “locked up” for long periods Regulation Heavy Regulation Light Regulation Initial investments Relatively low Very high investments necessary.

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