Indirect Investing_Ch01


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  • Looking at asset growth, it looks like a relatively smooth progression...
  • Indirect Investing_Ch01

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