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  • 1. Part IV: Non Depository Institutions Topic 12 – Investment Companies (a.k.a. Mutual Funds)
  • 2. Household Investment Paths
    • Net saving households can :
      • Invest directly into net borrowing firms.
      • Private placements: Large wealthy investors and/or small firms.
      • Place savings in a depository institutions (Banks) and earn fixed interest
      • Invest in Public financial markets through dealer/brokers (over exchanges) or investment bankers (IPO/SEO).
      • Invest in Public financial markets through a financial intermediary.
  • 3. Investment Companies
    • The investment company sells shares to the public and invests the proceeds into a diversified portfolio of securities
      • A Mutual Fund is one type investment company.
    • Investors pool their capital and delegate the investment decision to a central authority
    • The central authority making the investment decisions earns a fee for their service
    • Q: What exactly are the services offered by this central authority?
  • 4. Benefits of Investment Company
    • Diversification & Divisibility :
      • A single investment is immediately diversified through the fund’s holdings
      • Since a share in the fund is a proportion interest in the securities held, this could represent fractional interest in the underlying security (Example: Would be very difficult to replicate an S&P500 index fund within a personal portfolio)
    • Liquidity :
      • Underlying fund securities are often illiquid (like Real Estate or certain non-traded debt)
      • If investors can redeem or trade fund shares, then these underlying assets become liquid
      • Investing through funds might the only avenue for investing in otherwise illiquid securities – improves market completeness, and hence efficiency.
    • Record Keeping : The central agent aggregates holdings, computes gains and taxable income, and sends statements.
  • 5. Benefits of Investment Company
    • Professional Management :
      • Informed money managers may make better decisions than uninformed investors.
      • But, how much more informed are these managers? Do they have access to private information?
    • Reduced transaction costs : Costs are reduced with economies of scale.
      • Direct Costs : Brokerage and exchange fees. Less costly to buy 500 shares of an S&P500 index fund than one share of each of the underlying firms.
      • Indirect Costs : Search costs and decision making
      • Taxes : These costs might be higher or lower depending on certain factors
  • 6. Are Investment Companies Necessary?
    • What reasons are there for not investing through an investment company?
    • Internet has revolutionized investing within the last decade.
      • Record keeping made simple with online portfolio trackers
      • Online brokerages are increasingly less costly ($5, $8 trades)
      • Information on securities is widely available, analyst reports, news articles, SEC filings
    • Double taxation – investment companies are pass through entities, which refers to tax liabilities.
      • Pay taxes when you sell your fund shares.
      • Pay taxes when others sell their fund shares.
      • Pay taxes when funds “churn” investments.
    • Indexing investments requires no Active management.
      • S&P500 funds only require rebalancing when firms enter or exit the index.
      • Do you really need to hire an agent to rebalance your portfolio?
  • 7. Types of Investment Companies
    • Open end fund : a.k.a. mutual fund.
      • Most common investment company
      • These funds are open to new investment. New investor proceeds are exchanged for new shares in the fund, and are invested in the portfolio.
      • Investors buy-in at the Net Asset Value (NAV)
        • NAV = Market value of the portfolio - Liabilities
        • Shares outstanding
      • The market value is easy to calculate at any point in time if the underlying securities are traded in liquid markets (particularly true for an equity fund),
        • However, investment companies do not real-time mark to market
        • For most funds and investors, there is a 1:00PM commitment to purchase shares, but at the 4:30PM NAV (market close)
      • Fund size is determined by:
        • The change in value of investments
        • Net flow of funds -- buy-ins (+) and redemptions (-).
        • If a fund is performing well, then its growth through Net New Flow of Funds will likely be bigger than the growth through changes in investment value (Don’t confuse fund growth with return!!!).
  • 8. Types of Investment Companies
    • Closed end fund : This fund is closed to new investment.
      • Number of shares stays constant : An underwriter issues the shares and they remain constant for the duration of the fund (capitalized only once), or a fund that starts as open-ended closes to new investment.
      • Liquidity provided for in secondary market : Entering a closed-end fund requires buying shares from existing shareholders. Exiting the fund may also require selling the shares to new investors.
      • Deviations in valuation: Since shares are traded instead of redeemed, it is possible for their to exist a deviation between the NAV and traded price
        • The supply and demand for the fund shares may influence their price (this could not be true in a perfect capital market – violates perfect competition.
        • “Trading at a discount”  Share price below NAV (most common)
        • “Trading at a premium”  Share price above NAV
    • What is an efficient capital market (ECM) explanation for these deviations?
      • Tax liabilities are priced into the shares, but not the NAV.
      • Transaction costs required to arbitrage the difference is too high. Can’t liquidate the fund unless you buy-out all investors. This is costly.
  • 9. Types of Investment Companies
    • Unit Trust :
      • A unit trust is similar to a closed-ended fund in that the number of units is fixed
      • It is different in that the investments do not change over the duration of the fund life. The trust might consist of a portfolio of bonds that are held until maturity.
    • Exchange Traded Fund : A cross between all three of the prior investment companies
      • Similar to a closed-end fund, there is continuous trading of shares
      • Similar to an open-end fund, investors can redeem shares (they receive the underlying securities)
      • Investments are generally passive (do not change), tracking an index.
  • 10. Growth in Mutual Funds
    • At year-end 2004:
    • Mutual funds accounted for 24% of the U.S. retirement market, or $3.1 trillion. This amount represented about 38% of all mutual fund assets.
    • Mutual funds own 22 percent of all U.S. corporate equity.
  • 11. Mutual Fund Size by Type of Funds ($millions)
  • 12. Top 10 Mutual Fund Companies 1
  • 13. Difference between Banks and Mutual funds
  • 14. Difference between Banks and Mutual funds Mutual Fund managers cannot invest in their own fund, and since they do not risk their own capital, are not incentive aligned. Managers of the firm can also be owners (stock and/or options) which promotes incentive alignment Ownership Mutual funds do not negotiate loans. They may purchase loans if securitized Banks cannot invest in equity securities – conflicts of interest may develop Types of investments Investments are relatively transparent , with investment advisors required to list their portfolios at certain intervals Investments (loan portfolios) are opaque Transparency Managers collect fees and do not own equity; There is no incentive alignment with investors based on performance of the investments. Profits and losses are simply passed through. Investment quality is signaled through the market value of equity. Banks risk (invest) their own capital (borrowed from depositors at a fixed rate) which gives them strong incentives to invest wisely Incentive Have no debt in their capital structures – cannot borrow funds Banks have leverage – can borrow funds at a fixed rate of interest Leverage Mutual Funds Banks
  • 15. Organizational Structure
  • 16. Organizational Structure
    • Investment Advisor : Manages the fund in accordance with the prospectus outlined by the board. If the investment advisor is not also the fund sponsor (example – Vanguard, Janus, Fidelity), then it is referred to as a sub advisor.
    • Distributor : Principal underwriter of the fund who sells shares to the public, either directly, or through brokerages. The distributor may also be the Investment advisor and fund sponsor, but not necessarily.
    • Custodian : Holds the fund’s assets, maintaining them separate from the distributor and investment advisor to protect shareholder interests. They are the repository (vault) for title to invested securities.
    • Transfer Agent : Processes the buy and sell orders
    • Independent Public Accountant : Certifies financial statements in the same manner firms have their financial statements certified.
  • 17. Ownership Structure
    • The board of directors (fund trustees) is assembled to represent the interests of shareholders. However, there are inherent problems in this structure, including
      • Shareholders are generally dispersed and may not take an active interest in monitoring (through elections) the directors
      • Most directors are former fund advisors, who choose their cronies to manage the fund
      • There are thousands of Funds requiring oversight, but only a limited pool of qualified monitors (board candidates). As a result, directors often sit on multiple boards, as many as 100, so the efficiency of their monitoring in suspect.
      • The organization form of the fund is established prior to investment by shareholders, so all of the afore mentioned problems may never be addressed if investors cannot organize.
  • 18. Recent Problems in the Mutual Fund Industry (post dot.com buble burst)
    • Soft money transactions : Funds pay kickbacks to distributors in exchange for pushing their products. This is not necessarily illegal, but the effect is that it hides fees.
    • After hours trading : Some funds allowed hedge funds or other large investors to trade in their funds after hours, but at the 4:30 close price. This is Illegal!! Equivalent to insider trading since privileged trades can trade on information that no one else has (the after hours information).
    • New rule by the SEC serve to limit these problems by requiring that 40% of the board is independent. However, not enough time has passed measure effectiveness.
  • 19. Compensation and Fee Structure
    • Mutual Funds charge fees that are independent of performance .
      • Mangers cannot tie their pay to performance unless they apply the compensation equally to gains as well as losses.
      • The magnitude of the downside is too large to make feasible, so instead, their compensation is tied to fund size. This is done in the following way
    • Loads : Front/back-end fees are charged to investors entering/exiting a fund.
      • Historically these fees were around 2-3% (Charged as a percent of amount invested), and can be as high as 8.5% per government restrictions
      • Industry competition has largely eroded these fees. Most funds can now be bought as “no-load”.
    • 12b-1 fees : Advertising fees, must be less than 1%, and are charges as a percent of assets under management (fund size)
    • Management fees : Charged annually as a percent of assets by the investment advisor, and may be as low as 18 basis points or as high as 2%. This is independent of fund performance.
  • 20. Compensation and Fee Structure
    • Soft dollars :
      • These are fees that are not explicitly broken out by the Fund.
      • For example, in exchange for distributing shares in one of its funds, a sponsor may pay one of its brokers by directing its trades through them. The broker earns fees off these trades, and to maintain this business, they push the sponsors financial products.
      • The sponsor might even pay higher than required brokerage fees if other services, like analyst research, is given in return.
      • Soft dollars are not necessarily inefficient, but they are not transparent.
    • Expense Ratio : Sum of 2 and 3.
      • Comment  how you charge the fee is irrelevant (12b-1 or management or load). It’s all a fee.
    • Funds generally offer multiple share classes that allow investors to choose the fee structure most desirable, in the same way that insurance policy holders choose deductibles. For example, Class A shares may be for customers choosing front-end load, B shares for Back-end, C shares for level load, and D shares for no load.
  • 21. Compensation and Fee Structure What would you rather have, a 1% load or 1% management fee? Loads are 1 time, management fees are annual, the 1% load is better.
  • 22. Chasing Returns
    • Investors and advisors are frequently accused of chasing returns, moving money in to high performing funds, but after the funds have performed well.
    • What does this say about investor beliefs in market efficiency ?
    • Managers understand that investors will move money to high performing funds more quickly than investors pull out of low performing funds, and since managers are compensated based on their size and not performance, managers have incentive to increase their risk at year end.
    • Academics Chevallier & Ellison found a non-linear relationship between the net flow of new funds (money coming into the fund) and the fund’s return.
      • More money comes in for past good performance than leaves for past bad performance.
      • Managers will take extra risk to get into the set of good funds if the downside is limited – see next graph
  • 23. Chasing Returns Positive Payoff : If the increase in risk results in another 5% excess return, then the manager receives a 40% gain in net new flows A : This is the gain in net new assets if the manager “wins” from increasing risk to increase expected returns by a few percent. Negative Payoff : If the increase in risk results in a 5% loss in excess returns, then the manager only suffers a 10% loss in net new funds. B : This is the loss in net new assets if the manager “loses” from increasing risk to increase expected returns by a few percent. Hypothetical situation: A fund has outperformed the benchmark by 18%, but is not yet in the set of good funds that will be recognized by investors
  • 24. Chasing returns
    • Depending on where the investment advisor is on this curve, the advisor can either increase risk in an attempt to move performance, or lock in gains to preserve the following year’s net new flow of funds. In fact, if an investment advisor is sufficiently ahead of the benchmark 6 months into the year, the investment advisor may simply lock in the gains by rebalancing the fund’s portfolio to reflect its benchmark index.
    • These incentive structures have created an environment where funds and their investments turnover at an increasing rate. In today’s environment, neither investors nor investment managers tend to pursue buy and hold strategies.
    • The following chart is turnover of investor money in funds. This includes moving between funds (exchanges) and cashing out (redemption)
  • 25. Investor Turnover Reprinted from financialservicesfacts.org What happened in 1987 to help facilitate that turnover regime?
  • 26. Turnover within funds The following is a chart of turnover of investments within funds. 100% indicates that the average investment in the fund is bought and sold within one year.
  • 27. Management Styles
    • Passively managed funds : The investment advisor tracks an index and rebalances holdings only when an index changes composition
      • NASDAQ 100
      • S&P500
      • Wilshire 2000
      • Dow Jones Industrial
    • Expenses are generally lower since there is reduced overhead. There is no investment decision making, no information collecting, and no attempt to “beat the market”.
    • A re index funds really passively managed? No! An index fund manager delegates the decision making to the institutional organization that has created and manages the composition of the benchmark index
      • Dow Jones, Standard and Poors, NASDAQ, Willshire…
  • 28. Management Styles
    • Actively managed funds : An investment advisor actively trades securities in an attempt to beat the market.
    • There are two management styles that describe all actively managed funds!
      • Market timing
        • The manager choose the level of risk (Beta) by moving into and out of stocks at the right time
        • This is not the same as stock picking. Rather, the investment advisor might move between a diversified portfolio of stocks, bonds or even cash.
      • Stock picking
        • Managers choose idiosyncratic (firm-specific) risk by selecting stocks that will “beat the market”
        • Managers try to find stocks that are under-valued (buy these) or over-valued (sell/short these). They take advantage of “mispricing”
    • What is the value of having and active fund manager? Less than 10% of actively managed funds beat their index on an average year.
  • 29. CAPM & Mutual Funds
    • Market Timing (choose risk level):
    • Investment advisor moves between value and growth stocks
    • Investment advisor moves between cash and stocks .
    • Any time the investor advisor changes risk level, this is market timing
    • Stock picking (choose firm-specific risk):
    • Investment advisor looks for undervalued stocks
    • Investment advisor chooses specific sector.
    • Any time the investor advisor looks for mis-pricing, this is stock picking.
  • 30. Management Styles
    • Why can’t actively managed funds “beat the market” more than 10% of the time?
      • Transactions costs
      • Overhead
      • Information collecting
      • …and the fact that it is damn hard to beat the market.
    • Are the 10% of the funds that beat that market, actually well managed, or are they lucky?
      • E.g., you can win in Vegas, but does this make you good or lucky?
      • Independent of luck or skill of the fund manager, if you happen to pick a “successful” fund, was this luck or skill on your part?
  • 31. Fund Objectives
    • Fund Objectives : Fund charters will list in the prospectus the strategy of the investment advisor. No matter what Active strategy is chosen, it will be a function of
      • Market Timing and/or
      • Stock Picking.
    • Consider the following :
      • Size Factors :
        • Small Cap – small firms
        • Mid Cap
        • Large Cap – large firms (IBM, Microsoft, Intel)
      • Growth Factors : (high or low beta - can be aggressive or non aggressive)
        • Value (low growth/ low beta)
        • Blend
        • Growth (high beta stocks)
  • 32. Fund Objectives
    • International : (regional or type of market)
      • Europe
      • Asia
      • South America
      • Latin America
      • Emerging markets
      • Developing markets
    • Sector Funds : Investors take on the idiosyncratic risk of the industry (stock picking)
      • Semiconductor
      • Pharmaceuticals
      • Energy
      • Financial Services
      • Heath care
      • Agriculture
      • Retail
    • Note: the size of the fund may limit the investment options available to the investment advisor. Fidelity Magellan has
  • 33. Double Taxation - revisited
    • 1940 Investment Act : Investment companies are tax exempt if at lest 90% of dividends and interest are paid out to shareholders
      • Pass-thru entity
      • Does not consider capital gains in payout
    • Double Taxation : Investors get taxed twice
      • Exiting a Fund : Investors pay capital gains when they exit the fund.
        • Buy in at a $15 NAV and sell your shares at $75, you have a capital gains tax liability of $60 per share.
      • High Turnover and Fund Trading : Investors pay capital gains from Mutual Fund trading as it’s realized
        • Buy in at $15 NAV and you don’t sell your shares
        • Earn dividends and interest, but no capital gains.
        • Receive 1099 at year end which includes Dividends, Interests and realized capital gains of the fund.
        • This is tax inefficient from an investor’s perspective. If a fund has high turnover (ie. 100%) then all of the capital gains become a tax liability to investors in the Fund.
  • 34. Double Taxation - revisited
        • Selling Winners : Investment advisors may choose to lock in gains per their incentive contract, but doing so requires that they cash out of “winning” stocks.
        • Selling losers : Similarly, funds might sell their underperforming shares to take an offsetting loss, and then buy back the shares at a later date. The risk is that the shares will increase during that time
      • Negative net flow of funds : Investors pay capital gains when other investors redeem shares. This might be one of the worst reasons to have to pay taxes…here is how it works.
        • A fund experiences a NEGATIVE net flow of funds  a significant number of investors leave an open ended fund, more so than the investment advisor can accommodate redemptions from cash on hand and new investors.
        • A liquidity problem results, just like at a Bank facing a large number of withdrawing depositors. The Fund must begin to sell assets to meet redemptions.
        • If the assets have realized capital gains, then the resulting tax liabilities are passed on to NON redeeming fund holders, and for the only reason that other shareholders are withdrawing.
        • This occurred after the bubble burst in 2000. Investors began to withdraw funds such that the new flow of funds were negative, and this required funds to sell assets and experience capital gains.
  • 35. Double Taxation - revisited
      • New Investor Tax :
        • New investors entering a fund are responsible for the realized tax liabilities within the year purchased
        • If you buy into a fund in December, then your 1099 will include tax liabilities for the entire year.
    • Solutions to the Double Taxation Problem
      • Choose funds that do no have high turnover (passively managed funds only trade to meet investor redemptions and to rebalance according to the index being benchmarked)
      • Don’t buy into a fund in December
      • Buy and exchange traded fund (ETF)
      • Mutual funds set restrictions on short-term trading that may affect redemptions and tax liabilities.
  • 36. Exchange Traded Funds
    • ETF characteristics that are similar to other types of investment companies
      • Closed-end fund : Priced at every point in time, trade in secondary market.
      • Open-end fund : Investors can purchase new shares, and share can be redeemed, in addition to trading on a secondary market.
      • Unit Trust : The investments are passive  ETF’s generally track and index.
    • What are the important features of an ETF that contribute to it explosive growth ?
      • Shares are liquid and can be traded at any point in time. This circumvents mutual fund restrictions of buying in by 1PM at the 4:30PM price
      • If the Stock price deviates from the NAV, then arbitragers can redeem large blocks of stock and take advantage of the mis-pricing. The result is that ETF shares reflect fairly closely the value of the underlying stock.
      • Costs are low. Management fees on order of passively managed index funds (18bp) are common.
      • Tax liabs are REDUCED! ETF investors own a fractional share of the underlying stock (these are basket shares). In other words, an investor’s ownership is directly mapped to shares in the repository, hence, when other investors redeem shares, their tax liabilities are not passed on to you. NO DOUBLE TAXATION.
  • 37. Mutual Fund v. ETF
    • With all of these advantages, why aren’t Mutual Funds gone?
    • ETF’s trade on an exchange, and investors are charge brokerage fees (ie. $19.95 per trade). If you are a dollar cost average investors (invest a little bit each month), then these fees become significant. Mutual funds will generally let you add investment to your funds without additional transaction feels.
    • Popular ETF’s
      • QQQ : Qubes – Nasdaq 100
      • DIA : Diamonds – Dow Jones Industrial Average
      • WEBS : ishares – World Equity Benchmark (MSCI – Morgan Stanley Capital International index)
      • SPR : SPDRS – SP500 index