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18 18 Presentation Transcript

  • Mutual Fund and Pension Fund Management Chapter 18
  • Mutual Funds
    • Are asset pools
      • Managed by professional investment advisors
      • Owned by investors who are shareholders
    • Can have assets invested in
      • Stocks
      • Bonds
      • Money market instruments
      • Real estate
      • Any combination of the above
    • Include 95% of professionally managed assets
  • Mutual Fund Types as a Percentage of Total Assets Municipal Bond Funds, 5% Hybrid Funds, 6% Stock Funds, 50% January 2004 Tax-free Money Market Funds, 4% Taxable Money Market Funds, 23% Taxable Bond Funds, 12% View slide
  • Management Structure of a Mutual Fund
    • Board of Directors
    • Investment adviser/management company
    • Distributor or principal underwriter
    • Custodian
    • Transfer agent
    • Independent public accounts
    View slide
  • Ownership Structure of Affiliates
    • Mutual fund is owned by investors
    • Board of directors is supposed to be independent and make decisions only for the best interest of the investors/shareholders
    • Independent public accounts must be separate
    • Investment management company may own all other affiliates
    • Investment management company may be publicly owned or privately held
  • Investment Management Company
    • May be
      • Publicly owned (Vanguard)
      • Privately held (Fidelity)
      • Owned by a financial institution
        • Bank or financial holding company
        • Insurance company
        • Securities firm
    • Is supposedly separate from the individual funds whose boards of directors are expected to act only in the fund shareholders best interests
  • Investment Management Company Diversification
    • Some management companies also own/offer
      • Discount brokerage
      • Personal investments and brokerage
      • Institutional retirement services
      • Wealth management services
      • Securities execution and clearance
      • Corporate systems and services
      • Office and space management services
      • Insurance and annuities
  • Industry Concentration
    • Investment Company Institute is primary source for information, data on industry ( www.ici.org )
    • Concentration
      • Largest 5 fund groups own 36% of assets
      • Largest 10 fund groups own 48%
      • Largest 25 fund groups own 72%
    • International Diversification
      • Occurred in 1990s
      • Many large groups are now global in sales
  • Types of Mutual Funds
    • Mutual fund is also called an investment company
      • Not to be confused with the investment management company which established it, sells it management services for a fee
    • Types of mutual funds
      • Open-End Mutual Funds
      • Closed-End Mutual Funds
      • Unit Investment Trusts
      • Exchange-Traded Funds (ETFs)
        • Diamonds Trust Series
        • Fixed Income Exchange Traded Securities
  • Open-end Mutual funds
    • Continuously sell shares to the public.
    • Are obligated to sell or redeem their shares at fund’s net asset value (NAV) or share price.
      • Number of shares outstanding may be capped to limit the size of the fund
      • All orders for purchase/redemption are executed at the next close-of-business NAV
    • Hold some liquid assets to redeem shares tendered
  • NAV Calculation
  • Return on Open-end Funds
    • Fund required to distribute
      • At least 90% of dividends, short-term gains and capital gains less expenses
      • Typically distributed in December
    • Total return = [  (fund value)]/(initial investment)
      • assuming all distributions are reinvested
    • Yield = (income – expenses)/(maximum offering price per share on a given date)
  • Closed-end Mutual Funds
    • Fund issues a fixed number of shares
    • Shares are never redeemed by fund
    • Once issued, shares are traded on exchanges or over the counter
      • Supply and demand determine the share price
      • Share price can be below or above NAV.
    • Often, closed-end fund shares trade at a discount, i.e, below NAV.
  • Unit Investment Companies
    • Issue unit investment trust (UITs) are interests
      • In a fixed portfolio of securities
      • Held passively
      • For an agreed period of time and then distributed among shareholders
    • Real estate investment trusts (REITs) similarly offer shares in real estate investments.
    • Unit trusts may redeem shares at NAV, but may only redeem shares in large blocks.
  • Exchange-traded Funds (ETFs)
    • Investment company with shares
      • Traded on an exchange like a stock
      • Priced by the market (supply & demand)
    • ETFs can be
      • Bought & sold during the day
      • Bought on margin
      • Sold short as well as bought long
    • ETFs are purchased/sold through a broker
  • Creation of ETFs
    • Approval of plan by SEC
    • Selection of basket of securities
    • Custodial agent ensures
      • Stock basket conforms to plan
      • Provides safekeeping & distribution of share certificates
    • Depository Trust Clearing Corporation maintains records of transactions
    • Arbitrageurs ensure ETF price is same as value of underlying securities
  • Types of ETFs
    • DIAMONDS track DJIA
    • FITRs track Treasury securities
    • HOLDRs track narrow industry groups
    • iShares index shares by Barclays
    • SPDRs track diff. S & P indexes
    • StreetTracks track DJIA + Wilshire index + others
    • VIPERs track several Vanguard funds
  • Hedge Funds
    • Are not mutual funds
    • Are limited partnerships for wealthy investors
    • Hedge funds
      • Take on significant risks
      • Use derivatives and other hedging techniques to
        • Leverage returns upward
        • Protect against loss of value in downturns
      • Are not subject to SEC reporting and monitoring
  • Mutual Fund Marketing
    • Funds can be purchased directly or indirectly
    • Marketing channels include
      • Direct channel
      • Advice channel
      • Retirement plan channel
      • Supermarket channel
      • Institutional channel
  • Mutual Fund Investment Strategies
    • Different funds focus on different investment strategies
      • Value investing
      • Growth strategies
      • Income strategies
      • Blend funds
      • Specialty fund strategies by market value size
      • Concentrated specialty funds (by industry or sector)
      • International funds
      • Index fund
  • Classifications of Funds
    • Include
      • Capital appreciation funds
        • Aggressive growth funds
        • Growth funds
      • Total return funds
        • Growth and income funds
        • Income-equity funds
      • World equity funds
  • Other Fund Types
    • Hybrid funds
      • Asset allocation funds
      • Balanced funds
    • Bond funds
      • Different durations
      • Different risk categories
      • Different tax status
    • Money market funds
      • Taxable
      • Non-taxable
  • The Cost of Mutual Fund Ownership
    • Shareholder Fees
      • Sales charge
        • No-load – no sales charge
        • Load - front-end or back-end sales charge
      • Redemption Fee
      • Exchange Fee
      • Annual Account Maintenance Fee
    • Annual Fund Operating Expenses
      • Management Fee
      • Distribution (12b-1) Fee
      • Other Expenses
  • Risk-Adjusted Performance Measures
    • Standard Deviation of Returns
      • Where
        • R i = monthly return
        • R = average monthly return
        • the larger the  , the greater the risk
    • Fund analysts use appropriate benchmark index (based on fund’s objective) to measure volatility of fund relative to average market volatility
  • Value at Risk (VAR)
    • Measures a firm’s trading risk for derivatives & other securities
    • Estimates decrease in portfolio value over a given period of time with a given probability
      • Based on historical data
      • Estimate of volatility
    • Example (95% confidence)
      • Mean monthly return = 2.00%
      • Standard deviation of monthly return = 4.00%
      • VAR = mean – 1.96 STD = 2.00 = (1.96)(4.00)= - 5.84%
      • Or, 2.5% probability of losing more than $58.40 per $1,000 invested
  • Sharpe Ratio
    • Sharpe ratio
      • Sharpe ratio = (average excess return over the risk-free rate or appropriate benchmark)/(  of fund’s excess return)
      • The higher the ratio, the greater the return for a given level of risk (volatility)
    • Example
      • Monthly mean excess return = 1.00%
      • Monthly STD of excess return = 4.00%
      • Sharpe ratio = 1.00/4.00 = 0.25
      • To annualize ratio, multiply by square root of 12
        • (0.25) X (3.46) = 0.865
  • Treynor Ratio
    • Based on the CAPM
    • Assumes any level of risk is achievable
      • Invest in highest risk fund
      • Invest part in risk-free securities (to reduce risk)
      • Borrow to leverage purchase of more of fund (to increase risk)
  • Modigliani or M-Square Measure
    • Measures fund performance relative to the market in percentage terms
    • The higher the measure, the greater the return for any level of risk
    • Example
      • S & P index’s excess return = 25%
      • Fund’s excess return = 15% (STD is 10%)
      • M-square is [(0.15/0.10)] X 0.25 = 37.5%
  • Sample Information for Risk/Return Measures for XYZ Fund 1 -1.66 .46 .16 -2.12 -.30 -1.82 2 3.37 .41 3.43 2.96 3.20 -.06 3 3.26 .43 1.87 2.83 1.44 1.39 4 4.61 .41 5.59 4.20 5.18 -.98 5 4.40 .43 3.93 3.97 3.51 .47 6 -1.45 .42 -3.79 -1.87 -4.21 2.34 7 -6.23 .44 -8.45 -6.67 -8.89 2.22 8 4.82 .44 5.94 4.38 5.50 -1.12 9 3.86 .43 3.76 3.43 3.33 .10 10 1.56 .44 -1.45 1.12 -1.89 3.01 11 4.36 .42 4.36 3.94 3.94 .00 12 3.51 .44 2.41 3.07 1.97 1.10 Month Return (%) Rate (%) Return (%) Return(%) Return (%) Benchmark (%) XYX Risk-Free Benchmark XYZ Excess Benchmark Excess XYZ Excess Return Over Arithmetic Mean Monthly 2.03 1.48 1.60 1.05 .55 Annualized 24.41 17.77 19.25 12.60 6.64 Standard Deviation Monthly 3.27 4.06 3.28 4.06 1.43 Annualized 11.34 14.06 11.36 14.08 4.97
  • Mean Monthly Return = 2.03 STD of Monthly Return =3.27% At the 95% confidence interval based on a normal distribution, the VAR is 2.03% - (1.96)(3.27) = - 4.38% There is 2.5% probability of losing no more than $43.80 a month for a $1,000 investment Value at Risk (VAR) for XYZ Fund
  • Monthly Mean Excess Return = 1.60% Monthly Standard Deviation of Excess Return = 3.28% Sharpe Ratio Annually = 0.49 × the square root of 12 = 1.69 Sharpe Ratio for XYZ Fund
  • Annualized Mean Excess Return for the Fund = 19.25% Annualized STD of Excess Return for the Fund = 11.36% STD of Excess Returns for the S&P 500 index = 15% M-Squared Measure For XYZ Fund
  • Morningstar
    • Divides mutual funds into four categories
      • Domestic stock funds
      • International stock funds
      • Taxable bond funds
      • Municipal bond funds
    • Calculates its own return & risk ratios
  • Morningstar Ratings
    • Fund Rating = Return Score – Risk Score
    • Funds are ranked by this rating within asset category
      • Top 10% 
      • Next 22.5% 
      • Middle 35% 
      • Next 22.5% 
      • Bottom 10% 
  • Mutual Fund Regulations
    • 1933
      • Investment Act of 1933 mandates specific disclosures
      • Securities Act of 1933 sets out antifraud rules
    • Investment Act of 1940
      • Requires funds to register with SEC
      • Limits financial leverage of funds
      • Established short 3’s test & diversification test
  • New Regulations Since 1990
    • National Securities Markets Improvement Act of 1996
    • In 1998, SEC streamlined disclosure of information required in a prospectus
    • Sarbanes-Oxley Act of 2002
  • Late 2003 - 2004
    • The Mutual Fund Scandals
      • Market-timing
      • Late-trading
    • Proposed New Regulations in 2004
      • SEC Commission Actions
      • State Regulators’ Mutual Fund Protections Principles
      • Current and Proposed Changes by the Mutual Fund Industry
  • Pension Plans
    • Private pension plans
      • Types of plans:
        • Defined benefits (DB)
        • Defined contribution (DC)
      • Meet income obligations through the accumulation of assets
    • Federal pension plan – Social Security is
      • the largest federal plan.
      • a “pay-as-you-go” system.
    • State and local government plans
  • Defined Benefit Plans
    • Promise a specified benefit or income stream at retirement.
    • The employer bears all the investment risk.
      • Employer makes contributions based on the age of the plan participant, the level of benefits promised, and the plan’s expected investment return.
    • ERISA of 1974 mandates that plans be fully funded.
    • A plan is fully funded if the present value of its assets equals the present value of the future pension obligations minus the present value of future contributions.
    • Fund liabilities are estimated using actuarial methods.
    • If a company fails,
      • Existing pension benefits may be reduced or eliminated
      • Future (accruing) pension benefits may be lost
    • Pension Benefit Guaranty Corporation (PBGC)
      • Established to assure payment of up to 85% of the vested benefits if a defined benefits pension fund fails
      • May fail due to bankruptcy
    Defined Benefit Plans (continued)
  • Defined Contribution (DC) Plans
    • Per-employee contributions are specified
    • Control over investment of contributions lies with the employee
    • Retirement income depends on
      • the plan’s investment returns (how wisely the employee chooses to manage this investment fund)
      • the amount of funds invested in retirement accounts
    • 401(k) plans are employer-sponsored DC plans.
    • Individual retirement accounts (IRAs)
      • Can be set up by individuals
      • Provide another investment vehicle to build retirement funds
    • Roth IRAs
      • allow anyone to make a contribution regardless of whether they actively participate in a retirement plan.
      • Contributions are limited to $2,000 and are not tax-deductible.
    • Keogh or H.R. 10 plans
      • Allow self-employed individuals and proprietors with small businesses to set up individual DC plans for themselves and their employees
    Defined Contribution (DC) Plans
  • What Is the Pension contract Between All Stakeholders?
    • Employer with DC plan
        • Takes investment risk
        • Reaps investment gains
      • Investment gains provide 80% of pension plan wealth
      • Employer contributions provide only 20%
      • Greater investment gains reduce contributions which increases corporate profits
  • Fund Performance Adjusted for Risk and Management Costs
    • Asset mix policy and implementation determined by
      • Nature of pension liabilities
      • Risk tolerance of managers
      • Funded status of pension plan
      • Prospects for long-term capital markets
    • RANVA (risk-adjusted net value added)
      • Measures performance compared to passive management
      • Sows passive management (index fund) superior in some cases
    • Decision depends on:
      • performance return of the passive policy
      • management cost to follow an active policy
      • additional risk entailed in following an active strategy.
    • Other active management considerations include:
      • fund managers investment style;
      • management fees;
      • the use of managed futures; and
      • the timing and frequency of asset rebalancing.
    Active or Passive Asset Allocation Policy?
  • Optimal Allocation for Pension Assets
    • Funds can invest in
      • Financial securities
      • Real estate
      • Oil and gas
      • Commodities, derivatives, managed futures, etc
    • Diversity is highly advantageous
    • Active management more complex
    • Asset rebalancing
    • Tactical asset allocation
    • Should pension fund smoothing be used?
      • Smoothing is used to achieve a return equal to the assumed discount rate used to project pension benefit obligations.
      • The trade-off is a reduction in a plan’s risk at the expense of higher potential returns.
      • Techniques employed include:
        • guaranteed investment contracts (GIC);
        • dedicated bond portfolios; and
        • portfolio insurance or insured asset allocation.
    Management Issues (continued)
  • Who Owns Surplus Pension Assets?
    • Employers
      • Took view they belonged to stockholders
      • Removed surplus funds from plans
    • Companies with overfunded pension plans became merger targets
    • Congress passed a bill
      • Taxes surplus withdrawn that reverts to employer
      • Provided an impetus to reduce contributions rather than build up surpluses
  • Pension Plan Underfunding and the Pension Funding Equity Act of 2004
    • Pension plan adequacy depends on
      • Actuarial assumptions
      • Discount rate used to find PV of liabilities
      • Yield on fund’s assets over time
    • Pension Funding Equity Act of 2004
      • Provided temporary relief to corporations
      • Provided some support for PBGC
  • The Pension Fund Crisis in 2004
    • Pension fund failures
      • Enron, WorldCom, Bethlehem Steel, National Steel
      • Corporate failure causes pension fund failure
    • Pension fund underfunding in early 2004
      • Single employer $350 billion
      • Multiemployer 100 billion
    • Solvency of Pension Benefit Guaranty Corporation is in jeopardy
  • Hybrid Plans Including Cash Balance Plans (CBP)
    • They are like DB plans in that:
      • the defined benefit is an agreement to a minimum rate of interest on employees’ accounts;
      • they are insured by PBGC and are subject to ERISA regulations; and
      • benefits are generally paid out in lump sums.
    • CBPs are similar to DC plans in that:
      • the employer contributes a minimum percentage of pay to the employees’ retirement accounts;
      • employees receive regular account statements of benefits; and
      • employees can take the accrued benefits with them if they leave the employer.
    • The advantages of CBPs to an employer are:
      • lower administration costs;
      • lower legal exposure; and
      • lower cost of educating employees.
    Cash Balance Plans (continued)
    • Disadvantages
      • Employer
        • employer continues to bear the investment risk
      • Employees
        • Carry the risk of inflation
        • Risk outliving the accrued benefits of their plans (like in the DC plan)
    Cash Balance Plans (CBP)