Francis
Upcoming SlideShare
Loading in...5
×
 

Francis

on

  • 536 views

 

Statistics

Views

Total Views
536
Slideshare-icon Views on SlideShare
536
Embed Views
0

Actions

Likes
0
Downloads
0
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

    Francis Francis Presentation Transcript

    • Using Indexes Chapter 12
    • Introduction
      • Chapter focuses on using security market indexes
        • Passive investing
        • Mutual funds
        • Financial futures are introduced
    • Using An Index As Benchmark
      • Index fund
        • A mutual fund or portfolio designed to track a market index
        • Why do index funds exist?
          • Passive investors may believe that securities are priced efficiently
            • It is a waste to hire security analysts in an attempt to find over- or under-priced securities
              • Passive investors may follow a buy-and-hold policy or an indexing strategy
    • Indexing Strategy
      • Indexers invest in diversified portfolio
        • Expect future returns to mirror past returns earned by a particular class of assets
          • Example: 1926-1999 S&P500 earned 11.3% annually
        • Numerous mutual funds are indexed to different stock and bond market indexes
        • Critics claim indexing ignores new information that can be used to make profitable trades
          • However the S&P500 index has outperformed 75% of the U.S. mutual funds
    • Investment Companies
      • Business organization that markets equity shares to the public, using money generated from selling shares to purchase securities
        • Open-end investment companies (aka mutual funds) can sell additional shares
          • About 10,000 mutual funds in U.S.
        • Closed-end investment companies cannot sell or redeem original shares
          • About 500 closed-end funds in U.S.
        • Unit Investment Trusts are not allowed to actively trade securities within the portfolio and has a specified termination date
          • About 100 UITs in U.S.
    • Mutual Fund Investing
      • Are permitted to keep selling shares as long as investors are willing to buy more shares
      • No upper limit on number of shares mutual fund can sell
      • Mutual fund must publish a statement containing their investment objective
        • Objective examples
          • Aggressive growth equity funds
          • Emerging markets equity funds
          • Growth and income equity funds
          • High yield fixed income funds
          • Mortgage-backed bond funds
    • Mutual Fund Characteristics
      • Changes whenever any asset within portfolio experiences a price change
      • All U.S. mutual funds must sell and redeem shares at their NAVPS
        • Closed-end investment companies can sell at a premium or discount relative to NAVPS
    • Mutual Fund Characteristics
      • Income is received from
        • Disbursed cash flows such as cash dividends or interest
        • Disbursed capital gains —realized net capital gains (after deducting losses)
        • NAVPS change —difference in NAVPS from one time period to the next
          • Unrealized capital gains and losses
          • Realized undisbursed net capital gains
          • Undisbursed cash dividend and interest income
    • Mutual Fund Characteristics
      • The one-period rate of return for a mutual fund share is
      • Investors can re-invest disbursements by buying more shares
      • Investors must pay income taxes on each year’s disbursed income (even if disbursements are re-invested)
    • Mutual Fund Fees
      • Entry fees (load fees) —one-time sales commissions
        • Limited to 8.5% of purchase price (which is 9.3% [8.5%/(100%-8.5%)] of invested funds
        • Diminish investor’s initial NAVPS
        • Many no-load funds exist
        • Many load funds charging between 0 and 8.5% exist
        • Studies show that mutual funds charging lower entry fees tend to slightly outperform funds charging a higher fee percentage
      • Exit fees (redemption or back-end fees) discourage investors from redeeming or liquidating shares
        • Some funds charge a contingent deferred sales charge that declines toward zero the longer the fund is held
        • Most funds charge no exit fees
    • Mutual Fund Fees
      • Management fees
        • Used to pay portfolio managers’ salaries, trading commissions, office rent, utilities, etc .
        • Average 1.4% of assets per year for common stock funds
          • Range from as low as .07% to 3.5% per year
        • Studies show that poor managers charge higher fees
      • Distribution fees (12b-1 fee)
        • Mutual funds are allowed to deduct up to 1% of their assets per year to pay for sales commissions and promotional expenses
      • Transaction fees
        • Cover the costs of buying/selling securities
    • Mutual Fund Fees
      • When calculating an investor’s net rate of return, must include fees
      • Some funds omit fees when advertising rates of return
    • Example: Net Rate of Return Mutual Fund
      • You invest $1,000 in a mutual fund with an up-front load fee of 3%. After 90 days, you liquidated your investment at a NAVPS of $1,010. During the 90 days you received a $5 cash dividend disbursement and a $15 capital gain disbursement.
        • Since the fund charges a 3% load fee, only 97% of your money was invested in the fund, or $970
    • Example: Net Rate of Return Mutual Fund
      • Your return over the 90-day period ignoring all annual fees
      • Your return over the 90-day period after considering a 0.97 of 1% per year annual management fee
        • Your fees in dollars over the 90-day period
          • .97% x (90/360) x $1,000 = $2.425
        • Your 90-day return
    • Example: Net Rate of Return Mutual Fund
      • Your return after considering a redemption fee of 1.5% and the $30 load fee
        • Redemption fee in dollars
          • $1,010 x 1.5% = $15.15
        • Return
    • Mutual Fund Fees
      • Small and foreign company mutual funds typically charge higher-than-average fees
        • Costly to obtain information and trade small cap and foreign companies
        • Hard to justify large range in costs for mutual funds with similar goals
      • Most money managers offer quantity discounts
        • Investors making larger investments pay a lower fee
        • Mutual funds with load fees offer quantity discounts on load fees
        • Reflects economies of scale
    • Economies of Scale
      • Cheaper to manage one large portfolio than numerous smaller ones
        • Quantity discounts on commissions
          • A brokerage house’s processing costs for a $10,000 trade are about the same as a $100,000 trade
        • Economies of scale in portfolio management
          • After investing in high fixed costs (computers, offices, administrative staff) the cost of managing additional money is relatively small (variable costs)
    • Management Fees of Index Funds
      • Index funds do not need as large a staff of securities analysts, economists and portfolio managers
        • Decisions about what stock to buy have already be made based on index commitment
      • These savings are passed along to investors in terms of lower management fees
        • Average management fee for a managed common stock mutual fund: 1.4%
        • Management fee for Vanguard Index Trust: .18%
    • Management Fees of Index Funds
      • Let’s compare two investments’ performance over the long run
        • Assume both investments earn a 10% gross annual return
          • Vanguard Index Trust 500 Mutual Fund charges a 0.18% management fee for a net annual return of 9.82%
          • The Average Managed Mutual Fund charges a 1.4% management fee for a net annual return of 8.6%
      Initial investment: $100 After 30 years After 20 years After 10 years $1,188 $1,661 $521 $651 $228 $255 Average Managed Mutual Fund Vanguard Index Trust 500 Difference of $473 due solely to manage-ment fees!
    • Portfolio Turnover
      • Managed non-index mutual funds experience more turnover in securities than index mutual funds
        • Indexes do not tend to change securities often ; therefore, index funds experience low turnover
        • Generate smaller commission expenses which means lower management fees
    • Mutual Funds That Fail
      • Failure may be due to
        • Poor flow of funds by investors into mutual fund in the first year
        • Inept management of fund causing a reduction in total assets
          • Investors may redeem shares
          • NAVPS may drop
      • Some failed funds are liquidated while others are merged into a successful fund
        • During mid 1990s, Dreyfus family of funds merged over 12 poorly performing funds into other funds
    • Other Investment Companies
      • Closed-end investment company
        • Offers an IPO and cannot issue or redeem shares
        • Shares are traded on stock exchanges
          • Price may rise above (premium) or drop below (discount) the NAVPS
        • Have never been as popular as mutual funds
    • Other Investment Companies
      • Unit Investment Trust (UIT)
        • Closed-end portfolios with a specified termination date
        • The specified set of securities remains the same for life of UIT
        • UIT is created when a sponsor buys a narrowly defined list of securities and deposits them with a trustee (usually a commercial bank)
          • Redeemable trust certificates are sold to investors to finance the purchase of the securities
          • Certificates are sold to investors at a higher price than the cost of the securities
            • This origination fee is why sponsors create UITs
        • U.S. law prohibits active trading; therefore management fees are quite low
    • Investing in Stock Market Index Portfolios
      • Advantages
        • Management expenses are minimized
          • No need to hire highly-paid staffs
        • Higher returns
          • Professionally managed portfolios do not, on average, outperform index funds
        • No load funds
          • Many index funds do not charge a load fee
        • Fully invested
          • Many mutual funds retain 2-8% of funds as cash (to maintain liquidity for redemptions, etc .)
          • Indexed portfolios usually hold small amounts of cash
    • Investing in Stock Market Index Portfolios
        • Slow turnover
          • Underlying indexes experience slow turnover; therefore the index funds also experience slow turnover
            • Leads to lower commissions
        • Tax efficiency
          • Slow turnover leads to unrealized and untaxed capital gains
            • Taxed when investment is sold
    • Investing in Stock Market Index Portfolios
      • Disadvantages
        • Index fund may be poorly managed
          • A fund’s tracking error measures the ability of the indexed portfolio to imitate the target index
          • Tracking error = Return on targeted index – Return on indexed portfolio
            • Tracking errors can occur due to
              • Management fees
              • Fact that manager didn’t invest in all securities contained within target index
              • Weighting scheme of securities differed from that of the target index
    • Investing in Stock Market Index Portfolios
              • Manager may have a delayed reaction to changes in targeted index
              • Portfolio requires continual rebalancing to maintain weights (due to fluctuating security prices)
              • Manager may try to ‘outsmart’ the market ( enhanced indexing )
              • Manager may elect to invest in derivatives of the securities that make up an index rather than the securities themselves, therefore benefiting from lower commissions
    • Transaction Costs and Tracking Error Tradeoff
      • To reduce tracking error, portfolio may contain more of the different securities contained within the target index
        • For instance, all other things being equal, a portfolio attempting to imitate the S&P500 will have a lower tracking error if it contains 450 of the S&P500’s 500 securities than if it only contains 300 of the 500
      • However, as the number of different securities held within the portfolio increases, the commissions are likely to be higher
      • Portfolio managers may try to reduce trading costs but this can increase the chance of tracking error
    • Exchange-Traded Funds
      • Prior to 1993 could not buy a mutual fund unless investor wrote a check to the fund
      • Mutual fund must sell shares to the investor at the NAVPS on the day money was received
        • NAVPS were traditionally based on market-on-close prices
          • Prices when market stopped trading
        • Investors were frustrated when they placed an order to sell (buy) early in the day only to find the market-on-close prices dropped (rose) from the prices earlier in the day
        • In 1993 the AMEX created a new type of exchange-traded fund (ETF)
    • Exchange-Traded Funds
      • Standard & Poor’s Depository Receipt (SPDR—or ‘spider’)
        • Marketable security traded continuously on AMEX
        • Indexed to the S&P500 index using the same market-value weights used in S&P500 index
        • Unlike traditional index fund, a SPDR order is
          • Placed through your stock broker
          • Executed immediately —not at market-on-close prices
        • Management fees are below 0.18%
    • Differences between SPDRs and Traditional S&P500 Index Funds
      • SPDRs represent ownership in the SPDR Trust, which is not a mutual fund but rather a UIT
      • UIT cannot issue new shares after their IPO
        • However, AMEX has overcome this restriction by starting new (liquidating) UITs when investors are net purchasers (sellers) of spiders
      • SPDRs are listed and traded on an organized stock exchange whereas traditional index funds are not
      • There are no load fees or 12b-1 fees on SPDRs
    • Advantages of SPDRs over Traditional S&P500 Index Funds
      • Can be bought/sold throughout the day at continuously updated market prices (rather than just market-on-close prices)
      • Can sell SPDRs short, and can do so on a down-tick
      • The SPDR Trust cannot use derivatives so investors are not subject to counterparty risks
      • Since SPDR Trust cannot use derivatives, it won’t have tracking error from the misuse of derivatives
    • Advantages of SPDRs over Traditional S&P500 Index Funds
      • An investor buying 50,000 shares can elect to receive payment-in-kind when they liquidate their position
        • Can either be paid in cash or a basket of the underlying stocks
          • Advantage of the basket of stocks is that price gains occurring while the SPDRS were held are not realized for tax purposes
            • Unrealized gains are not taxable until the securities are actually sold
      • Investors can place a number of different types of orders for SPDRs that are not available to mutual fund investors
    • Cloning SPDRs
      • There are now similar instruments in the U.S. for
        • Standard & Poor’s MidCap 400 stock index (MidCap SPDRs)
        • Indexes of stock market sectors (Select Sector SPDRs)
        • Dow Jones Industrial Average (DIAMONDS)
        • Nasdaq 100 (Nasdaq 100 Shares)
      • In the international market place there are:
        • TIPs 35 that are invested in 35 liquid Canadian stocks
        • HIPs that are invested in 100 Canadian stocks
        • iUnits —indexed to the Toronto Stock Exchange
        • iFT-SE 100 —indexed to the Financial Times Stock Exchange
    • International Stock Market Index Funds
      • World Equity Benchmark Shares (WEBS) begin trading in 1996
        • Shares in a mutual fund indexed to any one of dozens of different countries, including Australia, Denmark, Switzerland, France, U.S., Germany, Netherlands
        • Created by Morgan-Stanley Capital International
        • U.S. dollar-denominated
        • Basically offers a selection of international no-load stock market index funds
        • Today there are over 50 country indexes available
    • Futures Contract on S&P500 Index
      • In 1982 Chicago Mercantile Exchange began trading futures contract on S&P500 index
      • Today 1000s of contracts trade daily
      • Price of contract is derived from the current market value of S&P500 index times $250
      • Contract buyers do not receive dividends
      • It is a cash settlement contract
        • Cash received is the different between current value of index and original price of contract
    • Futures Contract on S&P500 Index
      • Traders are required to pay some cash up front for order to be executed
        • 3% of financial future’s market value is usually sufficient ‘good faith’ money (called margin)
          • Example: You purchase 10 contracts when the S&P500 is at 1450.
            • You must put up $108,750, or 3% x 1450 x 250 x 10
        • Using margin enhances risk
        • Futures contracts are used by speculators, hedgers and arbitrageurs
    • Example: Hedging During Volatile Period
      • Example: A large mutual fund’s risk manager and portfolio manager believes interest rates may rise at any moment, leading to a decline in the stock market. In an attempt to protect the current market value of the fund, they have decided to use a S&P500 index futures contract to hedge their position. This hedge will occur tomorrow, a Tuesday.
        • They will short S&P500 futures contracts to fully hedge the entire portfolio of stocks
          • AKA a futures overlay, because short S&P500 futures (of equal aggregate market value) are placed over the stock portfolio
    • Example: Hedging During Volatile Period
      • Assume the Fed raises the federal funds rate by 0.25% (or 25 basis points) on Wednesday at which point the market drops a total of 6%. They lift (or unwind) their hedge Wednesday evening. Commission costs were 0.1% on both the buy and sell of the contracts.
    • Example: Hedging During Volatile Period Two-day hedge finished Two-day hedge in place Planning hedge Activity 2.2% 1% -6% + 5.9% = -0.1% 1.1% - 1% = 0.1% NA Returns from hedged portfolio No hedge No hedge 60/1010 = 5.9% -10/1000 = -1% No hedge Returns from short S&P500 futures position 980 959 950 1,010 1,000 Closing value of S&P500 index 2.2% 1% -6% 1.1% NA Assumed returns from fund’s long position in stocks F T W T M Trading Day Tracking error results since the S&P500 futures do not track the diversified stock portfolio perfectly.
    • Example: Hedging During Volatile Period
      • The two-day hedge increases the mutual fund’s value by 4.6%
      • Why not just liquidate all the stocks Tuesday morning and buy them back after the market volatility quieted down?
        • Broker commissions would have been much larger!
        • May impact the market price due to such a large volume of transactions
      Net gain in portfolio’s value from the two-day hedge 4.6% Commission on both buy and sell of futures contracts -0.2% Gain from S&P500 index futures short position on Wednesday +5.9% Loss on Tuesday due to hedge being established 1 day early -1.0%
    • Options on Stock Market Indexes
      • Index options are puts and calls whose values are based on an underlying stock market index
      • They are settled in cash, not by delivering the underlying security
    • Example: Using Protective Puts for Hedging
      • Given the same scenario concerning market expectations, managers could have constructed a hedge by purchasing put options on a stock market index
        • Managers should select a floor below which they cannot tolerate the stock market index to drop
        • Then select puts with an exercise price that protects them from a price decline below that floor
    • Value of Insured Portfolio Exercise Price Premium Price of optioned assets Loss Profit $ 0 Pp Value of put option on S&P500 Index alone Market Value of stocks Value of insured portfolio Exercise Price Value of Combining Long Stock Position and Protective Put Exercise Price Protective Put Price of optioned assets Loss Profit $ 0 Pp Value of uninsured diversified portfolio Value of aggregate position Value of Aggregate Position
    • Example: Using Protective Puts for Hedging
      • On Tuesday morning the managers purchase puts with an exercise price equal to minimum acceptable market index value
      • If the S&P500 index falls below the floor value, the protective puts will pay off
      • If the portfolio is fully hedged, the puts will pay gains from a falling market that exactly offset the drop in the market value of the fund due to the drop in the market
      • This is known as buying portfolio insurance, and can reshape a portfolio’s probability distribution
    • Figure 12-4: Using Protective Puts Reshapes a Mutual Fund’s Probability Distribution of Returns
    • Bond Index Funds
      • A bond index fund’s stated objective is to emulate a specified fixed income index
        • Charge low management fees in the range of .2% to 1.4%
        • Bond index funds that emulate Treasury bond indexes are able to minimize tracking error due to the highly liquid T-bond market
        • Corporate and municipal bonds are not as liquid; therefore bond index funds mimicking these indexes will have a larger tracking error
    • Bond Index Funds
      • Hundreds of bond market indexes exist
        • Popular ones include
          • Lehman Government/Corporate Bond Index
          • Solomon High Grade Long-Term Bond Index
        • Newer indexes are more diversified than the above indexes and include
          • Lehman Brothers Aggregate Bond Index
            • Based on 5,500+ bond issues including U.S. Treasury bonds, U.S. government agency bonds, high yield corporates, etc .
            • It is harder to emulate a diversified bond index
    • The Bottom Line
      • Diversified stock and bond portfolios with the stated objective of mimicking specific indexes have become very popular
      • S&P500 index funds consistently outperform the majority of actively managed mutual funds
      • Financial innovators have developed securities that emulate indexes and can be bought and sold on the exchange floor
        • SPDRs, DIAMONDS, NASDAQ-100 Shares, etc .
    • The Bottom Line
      • Tracking error results when an index fund cannot follow the targeted index closely
      • Financial futures and options on futures allow investors, speculators, hedgers and arbitrageurs the ability to utilize complex indexing strategies