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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)
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.
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.
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
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.
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.
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.
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.
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.
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
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
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)
Investor Turnover Reprinted from financialservicesfacts.org What happened in 1987 to help facilitate that turnover regime?
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.
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.
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.
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.
QQQ : Qubes – Nasdaq 100
DIA : Diamonds – Dow Jones Industrial Average
WEBS : ishares – World Equity Benchmark (MSCI – Morgan Stanley Capital International index)