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Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
Chapter 4
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  • 1. Chapter 4: Mutual Funds and the Institutional Environment
    • Objective: To give an overview of institutional investors and institutional investing
      • Management by institutions: objectives & constraints
      • Investment companies
      • Mutual funds
      • Costs of investing in mutual funds
      • Performance appraisal
  • 2. 1. Management by institutions
      • A process for making investment decision
      • Expected portfolio return
      • risk tolerance
    • subject to
    • liquidity  investment
    • horizon policies
    • regulations
    • taxes
    • unique needs
  • 3. Variable Mutual funds Variable Banks Conservative Insurance companies Generally conservative Endowment funds Depends on proximity of payouts Pension funds Life cycle Individual and personal trusts Risk Tolerance Type of Investor
  • 4. Constraints in portfolio management
    • Liquidity
    • Investment horizon
    • Regulatory constraints (institutional investors)
      • The prudent person law
      • Limits on foreign holdings
      • Limits on individual firm holdings
    • Taxes
    • Unique needs
  • 5.
    • Investment companies pool funds from individual investors and invest the funds on their behalf.
    • Functions and benefits
      • Administration & record keeping
      • Diversification & divisibility
      • Professional management
      • Reduced transaction costs
      • Increased investment opportunities
    2. Investment companies
  • 6.
    • Value of a share of investment company
      • Selling new shares
      • Redeeming existing shares
    Net Asset Value
  • 7. Types of investment companies
    • Open-end and closed-end funds
    • Trading
    • Open-end: buy and sell shares through the fund at NAV.
    • Closed-end: trade in the stock market at current price.
    • Fund flows and the N. of shares outstanding
    • Open-end: changes when new shares are sold or old shares are redeemed
    • Closed-end: no change unless new stock is offered
  • 8.
    • Closed-end fund discount puzzle
      • closed-end funds are share are traded at a typical discount over 10%
      • initial public offering (IPO) price at a premium of about 10% (Weiss (1989))
      • discounts are persistent and their fluctuation appears to be mean-reverting (Thompson (1978))
      • discounts disappear on the open-ending of the fund (Bauer (1984)).
  • 9.
    • Load funds and no-load funds
    • Other investment organizations
      • Commingled funds
        • Partnership of investors typically of trust and retirement accounts.
        • Similar to open-end funds
      • Real estate funds
        • Real estate limited partnerships (Real estate investment trust (REIT) in U.S.)
        • Mortgage funds
      • Segregated funds
        • Mutual funds typically sold by insurance companies with a guaranteed payout (75%-100%) at maturity or upon death of the investor.
  • 10.
    • Hedge funds
      • Hedge funds pool investors’ fund. They are not registered as mutual funds, and under less stringent regulations than mutual funds.
      • Typically open to wealthy or institutional investors.
      • Heavy use of derivatives, short sales and leverage.
      • Typically attempt to exploit temporary mispring. E.g., abnormally high mortgage-backed securities (MBS) relative to T-bonds. Then buy MBS and short-sell T-bonds.  The fund hedges interest rate risk, but bets on relative pricing of the two assets.
      • High leverage results in high volatile returns.
  • 11.
    • The most popular form of investment vehicle for individuals.
    • Industry grew immensely during 1990s.
      • As of Jan. 2004, 1,887 funds managed $451B.
      • Money market funds accounted for 1/8.
      • index funds become quite attractive.
    • Management companies offer a collection of funds under one umbrella – family or complex of mutual funds.
    • Investment Policies
      • Money Market
      • Fixed Income
    3. Mutual funds
  • 12.
      • Balanced and Income
        • They hold both equities and bonds in relatively stable proportions.
      • Asset allocation funds engage in market timing.
      • Equity funds
      • Index funds
        • try to match the performance of a broad market index.
        • Passive investment is a low cost alternative to actively managed investment.
      • Specialized Sector
  • 13.
    • Mutual funds are sold directly or by brokers and agents,
      • Brokers and agents receive commissions and trailer fees.
    • Timing of sales of securities is out of your control.
      • Investing in mutual fund reduces ability to engage in tax management.
  • 14.
    • Globe&Mail
      • Monthly business survey of mutual funds: Globefund.
    • PALTrak (Morningstar)
    • Wiesenberger’s Investment Companies (US)
    • Morningstar (US)
    • Investment Funds Institute of Canada
    • Investment Company Institute (US)
    • Investment services (SEI, Comstat, etc.)
    Information on mutual funds
  • 15.
    • Fee Structure
      • Front-end and back-end load
      • Many no-load funds appear to have comparable performance.
    • Operating expenses
      • Costs in operating the fund, e.g., administrative expenses and investment advisory fees
    • Other charges
      • Distribution costs paid by the fund (known as “12b-1 charges” in U.S.)
      • Include commissions paid to brokers
    • Management Expense Ratio (MER)
      • Include operating expenses and other charges
    4. Costs of investing in mutual funds
  • 16.
    • Fees and performance
      • Return = (NAV 1 – NAV 0 + income and capital gain distribution)/ NAV 0
      • Example: consider a fund with $100m and 10m shares. One year later, the fund portfolio grows to $110m. The expense ratio is 1%.
        • Initial NAV=$10.
        • NAV 1 =$109m/10m=$10.9
        • 9% return, or 10% gross return less MER
        • Fees have non-trivial effect on performance.
  • 17.
      • Soft dollar
        • Brokerage firms pay for mutual funds’ expenses such as stock research, software, etc, in return for the funds’ directing their trades.
        • Ultimately, investors pay for needless high brokerage commission, and mutual funds receive the soft-dollar rebate.
  • 18. 5. Mutual fund investment performance
    • The majority of funds underperform relative to index funds. Figure 4.5.
    • Persistence in Fund Performance: Do some mutual funds consistently outperform?
    • Mixed evidence on persistence
    • Evidence shows consistent poor performance, and it is far harder to keep superior performance.
  • 19. Exchange Traded Funds (ETF)
    • ETFs allow investors to trade index portfolios like shares of stock
    • iUnits (on TSX). QQQ (“cubes”), SPDRs (spiders) are most heavily traded securities.
    • EFTs cover a variety of composite indices, industries, and foreign index shares.
    • Potential advantages
      • Trade continuously
      • Lower taxes
      • Lower costs (management fee of 0.2-0.5%; 0.3-1% for index fund; 1.5%-3% for actively managed funds)
    • Potential disadvantages
      • Pay brokerage commissions.

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