Chapter 4


Published on

  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Chapter 4

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