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Indirect Investing_Ch01



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  • Looking at asset growth, it looks like a relatively smooth progression...


  • 1. Mutual Funds
    • Definition
    • Risk and Return Relationship
    • Pros and Cons of Investing in Mutual Funds
    • Structure of a Mutual Fund and a Commercial Bank
    • History of Mutual Funds
    • Challenges Facing the Industry
  • 2. Mutual Funds
    • Definition: Financial intermediary through which savers pool their monies for collective investment, primarily in publicly trades securities.
    • A fund is “mutual” in the sense that all of its returns minus its expenses, are shared by its shareholders.
    • Returns consist of dividends, realized and unrealized capital gains (losses)
    • Expenses consist of advisory fee for servicing the shareholders, annual fee for distribution (12b-1)
  • 3. Seeking Higher Returns
    • Objective is to maximize return with minimum risk
    • Efficient Market hypothesis and undervalued securities
    • Behavioral Finance
    • Mean reversion in the equity market
    • Individual securities have two main sources of risk: alpha and beta.
  • 4. Definitions for Returns
    • Return = Interest or Dividends +/- Price Change Initial Investment
    • Risk = Variation (or range) of possible returns
    • Goal => Maximize return and minimize risk
  • 5. Seeking Higher Returns (for Same Risks)
    • Random walk
      • No predictable relationship between past changes and future changes in stock prices
      • Based on extensive empirical studies
  • 6. Seeking Higher Returns (for Same Risks) (cont.)
    • Efficient market hypothesis (EMH)
      • Theory regarding information content of market prices
      • May explain random walk studies
      • Paradox of EMH and value of research
    • Behavioural finance
      • Most investors do not behave perfectly rationally, but are influenced by psychological factors
  • 7. Reducing Portfolio Risk
    • Alpha risk
      • Alpha - company specific risk usually accounts for 50%-70% of security’s price volatility;
      • can be reduced by diversification
    • Beta risk
      • Beta - market risk accounts for 30%-50% of price volatility.
      • S tock market risk; cannot be reduced by diversification
  • 8. Benefits of Investing in Mutual Funds
    • Diversification :Typically lowers  ; global fund may also lower 
    • Professional Management: Professional qualifications (CFA); access to company executives; in house research team, wall street research.
    • Lower Transaction Costs: Lower admn. cost, savings on record keeping, better execution of securities.
    • Convenience: Automatic deposits/ withdrawal, tax reporting, retirement planning, educational materials.
  • 9. Benefits of Investing in Mutual Funds
    • Higher minimum requirements for individual bonds (usually $25,000; T-bonds $1,000). Lot size is usually $100,000. One $25,000 bond lacks diversification.
    • Cost : 2% - 4% of value.
    • Bond mutual fund minimum: As low as $1,000. Can redeem fund on any business day. Do not have to hold till maturity.
    • Fund offers more diversification. Offer convenient services, such as monthly income payments, compared to quarterly or semi-annually for individual bonds
    • Similar advantages for stock funds
  • 10. Disadvantages of Investing in Mutual Funds
    • Need to pay fees/expenses even when fund performs poorly
    • Increased diversification may prevent the chance of “hitting the jackpot” from one security
    • Online trading and security research on the internet have reduced the advantage of cost and research access
    • Less control over securities portfolio and therefore timing of realized capital gains for tax purposes.
  • 11. Popular Ways to Purchase Individual Securities
    • On-line trading
    • Separate account
      • Portfolio of individual securities managed separately by a bank, broker, or financial adviser
      • Account minimums lowered for consultant or rep wraps
      • Pre-packaged model portfolios
      • “ Baskets” available through the internet
  • 12. Assets of Mutual Funds 1985 – 2000 $ Billion Source: Investment Company Institute (ICI) $ 6,967 B
  • 13. Growth of Financial Intermediaries* $ Billions * Excludes bank-administered trusts and closed-end investment companies Source: Federal Reserve Board, Federal Financial Institutions Examination Council, ICI
  • 14. Structure of a Mutual Fund
  • 15. Mutual Fund Complex Shareholders (Savers) Management Company Distribution Transfer Agency Broker Stock Funds Fixed Income Funds Money Market Funds
  • 16. Structure of a Commercial Bank
  • 17. MM Fund Versus Bank Deposit Generally cannot loan more than 15% to one borrower No more than 5% in any one issuer
    • Diversification
    CDs: funds “locked-up” for fixed period Highly liquid
    • Liquidity
    MMDA: allows limited daily withdrawals CDs: penalty for early withdrawal Redemptions daily
    • Time
    Does not track T-bill closely; longer maturity results in higher rate Tracks T-bill closely but usually higher because of credit risk
    • Rate of Return
    Bank Deposit MM Fund
  • 18. MM Fund Versus Bank Deposit (cont.) Primarily spread income from principal risk Fee income from management contract
    • Fees
    May not offer tax-exempt interest to depositors May offer tax-exempt interest to shareholders
    • Tax
    Banks must have capital meeting meeting regulatory requirements; FDIC guarantees deposits ($100K limit) Management company, not fund, has capital; no regulatory requirement or guarantee
    • Capital
    Loans subject to credit review; try to match asset maturity to liabilities; FDIC insurance ($100K) 95% must be in highest rated paper; average 90-day security maturity; no FDIC insurance
    • Risk
    Bank Deposit MM Fund
  • 19. History of Mutual Funds
    • 1940: Investment Company Act
      • established standards for fund promotion, reporting, product pricing, and portfolio investing.
    • 1950-60s: Industry experience growth.
    • 1970s: Stock market declined. Difficult to sell stock fund. Investors interested in short-term or income-oriented investments
  • 20. History of Mutual Funds (Cont’d)
    • 1970s: Money market funds were created and became the savior of the industry.
    • 1980s: High interest rate atmosphere. Banks were legally prevented from paying more than 4% - 5% interest. MM assets exceeded either stock or bond fund assets.
    • 1990s: Spectacular growth in mutual fund industry. $800b in 1987 to $5t in 1999.
  • 21. History of Mutual Funds (Cont’d)
    • Factors behind the rapid growth:
      • Bull market in U.S. stock.
      • Tax-advantaged retirement vehicles
      • attractive mutual fund products
      • enhanced services to fund shareholders.
    • Distribution channels & pricing structures:
      • Broker - Dealers are the traditional distribution channel
  • 22. History of Mutual Funds (Cont’d)
      • Front-end load declined from 81/2% in 1960 to ~4% now.
      • Currently broker-dealer may charge ‘back-end’ load. The load declines based on the length of investment.
      • Annual distribution fee 12b-1paid by the fund to the distributor. Range is from 25 bp to 75bp.
  • 23. History of Mutual Funds (Cont’d)
    • Direct marketing of funds:
      • MMF spurred direct marketin g
      • ‘ no-load’ funds. Charges are low- around 2%-3% and 12b-1 around 25bp.
    • Retirement Plan:
      • Attractive service providers to plan sponsors of 401(k) and other defined contribution plans.
  • 24. History of Mutual Funds (Cont’d)
      • Employees can choose to contribute in specific funds. Fund Co provides disclosure documents and educational materials to each employee.
      • In most cases sales loads may be waved and service fees may be negotiated .
      • Banks and Insurance Cos :
      • Glass-Steagall prohibition? Banks found ways to offer their own or other’s funds to their customers.
      • Insurance Co- joint venture with funds to offer variable annuities