The Trading Process and Mutual Funds


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The Trading Process and Mutual Funds

  1. 1. The Trading Process and Mutual Funds B, K & M Chapters 3 & 4 End of chapter problems: (3) 2,3,7; (4) 1,2,10,17
  2. 2. Primary Markets: How Firms Issue Securities <ul><li>The primary market is used to issue new securities (IPO’s) or seasoned new issues </li></ul><ul><ul><li>There is strong evidence of underpricing of new equity issues both here and abroad </li></ul></ul><ul><li>The secondary market is used to trade outstanding securities </li></ul>
  3. 3. How Firms Issue Securities <ul><li>Investment Banking </li></ul><ul><ul><li>Shelf Registration </li></ul></ul><ul><ul><li>Private Placements </li></ul></ul><ul><ul><li>Initial Public Offerings (IPOs) </li></ul></ul>
  4. 4. Shelf Registrations <ul><li>Introduced in 1982 </li></ul><ul><li>SEC Rule 415 </li></ul><ul><ul><li>Opposed by Investment Banks </li></ul></ul><ul><li>Ready to be issued – on the shelf </li></ul>
  5. 5. <ul><li>Private placement : sale to a limited </li></ul><ul><li>number of sophisticated investors not </li></ul><ul><li>requiring the protection of registration </li></ul><ul><li>Allowed under Rule 144A </li></ul><ul><li>Dominated by institutions </li></ul><ul><li>Very active market for debt securities </li></ul><ul><li>Not active for stock offerings </li></ul>Private Placements
  6. 6. Initial Public Offerings <ul><li>Process </li></ul><ul><ul><li>Road shows </li></ul></ul><ul><ul><li>Bookbuilding </li></ul></ul><ul><li>Underpricing </li></ul><ul><ul><li>Post sale returns </li></ul></ul><ul><ul><li>Cost to the issuing firm </li></ul></ul>
  7. 7. Relationship Among a Firm Issuing Securities, the Underwriters and the Public
  8. 8. Figure 3.3 Average Initial Returns for IPOs in Various Countries
  9. 9. Long-term Relative Performance of Initial Public Offerings
  10. 10. Secondary Market Trading Mechanisms <ul><li>Dealer markets (OTC markets) </li></ul><ul><li>Electronic communication networks (ECNs) </li></ul><ul><li>Specialist markets </li></ul><ul><ul><li>Auction Markets </li></ul></ul>
  11. 11. Types of Retail Orders <ul><li>Market Orders: buy or sell orders that are executed immediately at current market prices </li></ul><ul><li>Limit Orders: specify prices at which an investor is willing to transact. Example: IBM last sold for $50. A limit may be placed at a price of $45. If the price falls to $45, this order will then be executed. </li></ul><ul><li>Stop-Loss Orders: similar to limit orders but they specify the trade is not to be executed unless the price hits a limit. (In the previous example, a stop buy order might be placed at a price of $55.) </li></ul>
  12. 12. Limit Order Book for Intel on ArcaEx Exchange
  13. 13. U.S. Security Markets <ul><li>Nasdaq Stock Market </li></ul><ul><ul><li>Nasdaq National Market System (min shareholder equity = $15mil) </li></ul></ul><ul><ul><li>Nasdaq SmallCap Market (min shareholder equity = $5mil) </li></ul></ul><ul><li>Pink Sheets ( </li></ul><ul><ul><li>Even smaller firms or those that want to avoid listing disclosure requirements </li></ul></ul><ul><li>Organized Exchanges </li></ul><ul><ul><li>New York Stock Exchange </li></ul></ul><ul><ul><li>American Stock Exchange </li></ul></ul><ul><ul><li>Regionals </li></ul></ul><ul><li>Electronic Communication Networks (ECNs) </li></ul>
  14. 14. Table 3.1 Partial Requirements for Listing on Nasdaq Markets
  15. 15. Nasdaq Market Center <ul><li>Nasdaq Market Center </li></ul><ul><ul><li>Consolidates electronic markets into an integrated system </li></ul></ul><ul><ul><li>Allows for automatic execution </li></ul></ul><ul><li>Levels of subscribers </li></ul><ul><ul><li>Level 1 – inside quotes </li></ul></ul><ul><ul><li>Level 2 – receives all quotes but they can’t enter quotes </li></ul></ul><ul><ul><li>Level 3 – dealers making markets </li></ul></ul>
  16. 16. Trading on the Nasdaq Market <ul><li>Competing dealers establish bids and asks </li></ul><ul><li>It is increasingly a computerized market with no centralized location </li></ul><ul><li>The Department of Justice settled a suit against NASD that alleged price fixing by dealers in the establishment of quotes </li></ul><ul><li>Academic studies (Christie and Schultz, 1995) detailed apparent tacit collusion, and lead to the Department of Justice and SEC’s actions </li></ul>
  17. 17. New York Stock Exchange <ul><li>The Major Players </li></ul><ul><ul><li>Commission brokers </li></ul></ul><ul><ul><ul><li>Bring a brokerage firm’s orders to the floor for execution </li></ul></ul></ul><ul><ul><li>Specialists </li></ul></ul><ul><li>Block houses </li></ul><ul><li>SuperDot </li></ul><ul><ul><li>NYSE members send orders directly to the specialist over computer lines </li></ul></ul>
  18. 18. Some Initial Listing Requirements for the NYSE
  19. 19. NYSE <ul><li>On the NYSE, each stock traded has a “specialist” who is charged with maintaining a “fair and orderly” market </li></ul>
  20. 20. Block Transactions on the New York Stock Exchange
  21. 21. Electronic Computer Networks (ECNs)
  22. 22. Market Structures in Other Countries <ul><li>London - predominately electronic trading </li></ul><ul><li>Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges </li></ul><ul><li>Tokyo Stock Exchange </li></ul>
  23. 23. Dollar Volume of Trading in Major World Markets, 2004
  24. 24. Trading Costs Explicit Costs: Commission costs which are paid to brokers are explicit (full service vs discount brokers)
  25. 25. Bid-Ask Spreads <ul><li>Bid is the highest limit order to buy </li></ul><ul><li>Ask is the lowest limit order to sell </li></ul><ul><li>Dollar Spread = Ask – Bid </li></ul><ul><li>Proportional Spread = (Ask – Bid) / (Mid-Point of Spread) </li></ul><ul><li>Proportional spreads range from well less than 1% to over 5% (over 10% for penny stocks) </li></ul><ul><li>Equally weighted average proportional spread on NYSE stocks is = .6% </li></ul><ul><li>Nasdaq spreads are higher </li></ul>
  26. 26. Determinants of the spread Spreads depend on: -the amount of competition between providers of liquidity -the need to cover the costs of being a dealer including -inventory costs -and the possibility that the dealer (specialist) will trade with a better informed trader
  27. 27. Buying on Margin <ul><li>The investor borrows part of the purchase price from the broker </li></ul><ul><li>The Fed dictates the maximum margin (currently 50%) meaning that at most 50% of the purchase price may be borrowed </li></ul><ul><li>By buying on margin, investors gain leverage and greater upside potential, but also expose themselves to greater risk </li></ul><ul><li>If the stock price falls, the investor may receive a margin call </li></ul>
  28. 28. Short Sales <ul><li>First borrow certificates for sale (from broker), then repay the loan with certificates obtained in a later purchase </li></ul><ul><li>Must be identified as a short sale (may not be made in a falling market – tick test on NYSE </li></ul><ul><li>Borrower must deposit cash equal to the initial value of the securities, and post additional margin </li></ul><ul><li>Borrower must pay the lender the equivalent of all dividends or interest received between the short sale and the subsequent repurchase </li></ul><ul><li>Potential loss of short sale is unlimited </li></ul>
  29. 29. Short Sales (cont.) <ul><li>In 2003 short sales accounted for approx. 10% of total sales (NYSE specialists and hedge funds are frequent short-sellers) </li></ul><ul><li>Short interest is the total of all shares sold short that remain uncovered (reported in the WSJ) </li></ul>
  30. 30. Mutual Funds <ul><li>Benefits to individual investors include: </li></ul><ul><ul><ul><ul><li>- Efficient record keeping </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Low-cost diversification </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Professional Management </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Lowered transaction costs </li></ul></ul></ul></ul><ul><li>Open-end funds stand ready to redeem or issue shares at their net asset value (NAV) which is the market value of all securities held divided by the number of shares outstanding. The number of shares will change daily </li></ul><ul><li>Closed-end funds are traded much like shares of common stock. They do not issue or redeem shares at NAV, and often trade at a discount or surplus NAV (have lost much market share to ETFs) </li></ul><ul><li>Often sell at a premium or discount from NAV </li></ul>
  31. 31. Mutual Funds (cont.) <ul><li>Real Estate Investment Trusts (REIT’s) : Similar to a closed-end fund invested in real estate </li></ul><ul><li>Hedge Funds : Structured as private partnerships and subject to little SEC regulation </li></ul><ul><li>Exchange Trades Funds: Typically replicate an index but trade like individual stocks </li></ul><ul><li>Unit Investment Trusts : Pools of money invested in a portfolio that is fixed for the life of the fund </li></ul><ul><ul><ul><li>---Have declined in importance </li></ul></ul></ul>
  32. 32. U.S. Mutual Funds by Investment Classification, December 2004
  33. 33. Mutual Fund Costs <ul><li>Front-end load : A commission paid when you purchase shares. Range from 0% to as much as 10% </li></ul><ul><li>Back-end load : A redemption fee paid when you sell shares. Often declines as a function of how long the shares have been held </li></ul><ul><li>Operating Expenses : The costs of operating the portfolio, including fee paid to investment advisors and administrative expenses. Low for index funds (< .5%) and sometimes approaching 5% for specialized funds </li></ul><ul><ul><ul><li>Are periodically deducted from the fund’s assets </li></ul></ul></ul><ul><ul><ul><li>Operating expenses are an important determinant of fund performance!! </li></ul></ul></ul>
  34. 34. Mutual Fund Costs (cont.) <ul><li>12b-1 Charges : These fees are named after the SEC rule that permits funds to pay for distribution costs such as advertising, promotional literature and, most importantly, commissions to brokers out of fund assets </li></ul><ul><ul><ul><li>Are deducted from the fund’s assets </li></ul></ul></ul><ul><ul><ul><li>Fees can have an important impact on fund performance </li></ul></ul></ul>
  35. 35. Mutual Fund Costs (cont) <ul><li>Many Fund Families Offer Different Classes of Shares (Dreyfus Premier Growth Fund as of 2003) </li></ul><ul><li>Class A Class B Class C Class T </li></ul><ul><li>Front-end Load 0-5.75% 0 0 0-4.5% </li></ul><ul><li>Back-end Load 0 0-4% 0-1% 0 </li></ul><ul><li>12b-1 fees .25% 1% 1% .50% </li></ul><ul><li>Expense Ratio 1.25% 1.25% 1.25% 1.25% </li></ul>
  36. 36. Very Important Advice <ul><li>Never buy a fund with a front-end load, 12b-1 fees, or an expense ratio above .5% (1% for an international fund) </li></ul><ul><li>If there is a back-end load, it should go away with time </li></ul>
  37. 37. Mutual Fund Performance Do mutual fund managers, on average, beat the market? This is an important question we will take up in detail when we discuss market efficiency.
  38. 38. ETFs (Exchange Traded Funds) <ul><li>Trade like individual stocks, but typically replicate an index </li></ul><ul><ul><li>Low expenses and tax efficient </li></ul></ul><ul><ul><li>Can be bought on margin and sold short </li></ul></ul><ul><ul><li>Purchasing (and selling involves incurring the same transactions costs associated with transacting individual stocks) </li></ul></ul>