Fin 525 Week 9


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Fin 525 Week 9

  1. 1. Fin 525 Week 9 Defined Contribution Plans and Mutual Funds (including ETFs)
  2. 2. For Your Write-Up I Look at Three Things and Count Them Roughly Equally <ul><li>Explanation of the stock price prediction </li></ul><ul><li>Explanation of the hedge portfolio </li></ul><ul><li>How you “tell your story” that includes (in order of importance) </li></ul><ul><ul><li>Coherence </li></ul></ul><ul><ul><li>Clarity </li></ul></ul><ul><ul><li>Originality/flair </li></ul></ul>
  3. 3. A Suggestion for Budgeting Your 1,000 Words <ul><li>Overview: 75 to 200 words </li></ul><ul><li>Stock Price Prediction: 150 to 500 words </li></ul><ul><li>Hedge Portfolio: 150 to 500 words </li></ul><ul><li>Conclusion: 25 to 100 words </li></ul><ul><li>Some obvious points </li></ul><ul><ul><li>If you use a lot of words in one place, you will have to use less somewhere else </li></ul></ul><ul><ul><li>It is difficult to get by with less than 500 words </li></ul></ul>
  4. 4. Two Approaches to Price Prediction <ul><li>CAPM approach </li></ul><ul><ul><li>Demonstrate that you understand what you are doing (show lots of details) </li></ul></ul><ul><ul><li>Explain the limitations </li></ul></ul><ul><ul><li>Show that the company is more than just numbers </li></ul></ul><ul><li>Alternative methods </li></ul><ul><ul><li>The more unorthodox your approach, the more that you have to explain </li></ul></ul><ul><ul><li>If you take this route, expect to spend most of your words here </li></ul></ul>
  5. 5. Hedge Portfolio <ul><li>Unless you are sufficiently creative, this is all numbers </li></ul><ul><li>Explain exactly what you did, do not just give me the answer that you got from your spreadsheet </li></ul>
  6. 6. Telling Your Story <ul><li>Convince me that you are knowledgeable about GMCR </li></ul><ul><li>If you tried but discarded alternative approaches, tell me about them concisely </li></ul><ul><li>Make it as interesting as possible, I have to read a lot of these </li></ul>
  7. 7. Going From Individual Securities to Portfolios <ul><li>This week and the next 2 weeks of the course are about how finance looks at collections of securities (most often stocks) known as portfolios </li></ul><ul><li>Portfolios themselves can themselves be included in larger portfolios </li></ul><ul><li>Many individuals investors find themselves owning a portfolio of both individual securities and portfolios </li></ul><ul><li>Portfolios are good because they diversify risk </li></ul>
  8. 8. Defined Contribution Plans <ul><li>Come in various types, often named after the regulation that created them </li></ul><ul><ul><li>401(k) plans are savings plans predominantly from profit-making companies </li></ul></ul><ul><ul><li>403(b) are the nonprofit equivalent of 401(k) plans </li></ul></ul><ul><ul><li>IRAs, profit-sharing and employee stock ownership plans (ESOPs) are other arrangements </li></ul></ul><ul><li>The distinguishing feature is that the amount of benefits is not determined by the sponsor, unlike a defined benefit (or pension) plan </li></ul>
  9. 9. Defined Contribution Plans are Beginning to Dominate the Retirement Arena <ul><li>Companies do not like the obligations and accounting headaches associated with defined benefit plans </li></ul><ul><ul><li>IBM and other companies no longer offer the plans to new employees </li></ul></ul><ul><ul><li>New companies are much less likely to have them than older, established companies </li></ul></ul><ul><li>Even employees are not thrilled with them because their were established at a time when it was common for people to spend their entire career with a single employer </li></ul>
  10. 10. 401(k) Plans <ul><li>Supplemental retirement plans offered by many employers (and virtually all large employers) </li></ul><ul><li>Provide tax advantages through the deferral of taxes </li></ul><ul><li>Matching of contributions by the employer is standard </li></ul><ul><li>Contributions are limited by a formula that changes from time to time </li></ul><ul><li>Investment options are chosen by the employer (often with employee input) </li></ul><ul><li>Employers consider many factors when they determine what type of plan to offer and with what options </li></ul><ul><li>401(k) plans are regulated by ERISA, the same federal agency that regulates pension plans </li></ul>
  11. 11. The Enron 401(k) Disaster <ul><li>Many Enron employees lost their life saving when Enron stock collapsed </li></ul><ul><ul><li>Poor diversification, especially when one considers that their jobs were at Enron </li></ul></ul><ul><ul><li>A lock-up period occurred while Enron stock was dropping </li></ul></ul><ul><li>Was it rational? </li></ul><ul><ul><li>Enron stock provided at a discount </li></ul></ul><ul><ul><li>Safety in the herd? </li></ul></ul><ul><ul><li>Rosy reports from management </li></ul></ul><ul><ul><li>Enron’s employees skewed toward the young </li></ul></ul>
  12. 12. The Three Types of Investment Companies <ul><li>Mutual funds (also known as open-end funds) </li></ul><ul><li>Closed-end funds </li></ul><ul><li>Unit investment trusts (UITs), including most exchange-traded funds (ETFs) </li></ul>
  13. 13. Mutual Funds <ul><li>A mutual fund is a pooled investment that is run by an investment manger for the mutual benefit of the fundholders </li></ul><ul><li>Mutual funds invest in relatively liquid assets </li></ul><ul><ul><li>Real estate investment trusts (REITs) are like mutual funds, but hold real estate and real estate-related assets, such as commercial mortgages </li></ul></ul><ul><ul><li>Most bond funds use pricing services to determine the prices for infrequently traded corporate and municipal bonds </li></ul></ul>
  14. 14. Practical Details about Mutual Funds <ul><li>Order deadlines for funds are 4pm or earlier </li></ul><ul><li>You are legally required to “read” the fund’s prospectus before buying (or at least they are legally required to ask if you’ve read it) </li></ul><ul><li>Watch out for loads (front and back fees) and trading restrictions (because of Eliot Spitzer many funds have taken measures to discourage frequent fund switching) </li></ul><ul><li>Purchases/sales settle the next business day (T+1), unlike stocks which are T+3 </li></ul>
  15. 15. Practical Details about Mutual Funds (continued) <ul><li>Funds are “open” because the total number of shares is constantly changing </li></ul><ul><li>Daily price determined by the net asset value (NAV), the value of the assets net of fees and commissions </li></ul>
  16. 16. Mutual Funds Can Have Many Classes <ul><li>Retails classes (A, B, C, LW, etc.) can have different combinations of loads and expenses </li></ul><ul><li>Institutional classes (I, IA, IB, etc.) have lower fees and often waive all loads (like the LW class) </li></ul><ul><li>There can be a special class (Class R, Y, Z, etc.) of some funds that may only available within defined contribution plans or to other special large investors </li></ul>
  17. 17. Closed-End Funds <ul><li>Shares are usually fixed and closed-end funds trade continuously like stocks </li></ul><ul><li>Tend not to be marketed as aggressively as open-end funds </li></ul>
  18. 18. Unit Investment Trusts <ul><li>Shares in a relatively fixed (what we will call “passively managed” in a few slides) portfolio that trades like a stock rather than like a mutual fund </li></ul><ul><li>Generally, have a maturity date—there are well-suited to fixed income and real estate </li></ul><ul><li>Shares in ETFs can be created from “pieces” or redeemed (but only by large investors) </li></ul>
  19. 19. Many 401(k) Plans (But Not GE’s) Contain Trusts Rather Than Mutual Funds <ul><li>The two biggest vendors of trusts found in defined contribution plans are Barclays Global Investors (BGI) and State Street Global Advisors (SSgA) </li></ul><ul><li>Trusts generally have lower expenses than mutual funds, including the Class I and Z shares </li></ul><ul><li>Trusts are less transparent than mutual funds (no reporting requirements and no publicly available NAVs in the newspaper or on the web) </li></ul>
  20. 20. Other Things That Do Not Appear in GE’s 401(k) Plan, But Often Appear in Other Plans <ul><li>Company stock fund </li></ul><ul><ul><li>In GE’s plan you own the stock directly, in a company stock fund you own a share in a trust that owns both the stock and a “liquidity cushion” </li></ul></ul><ul><ul><li>The liquidity cushion dilutes the returns from the stock and generates fees for the fund manager </li></ul></ul><ul><li>“ Stable value” funds </li></ul><ul><ul><li>Invest primarily in Guaranteed Investment Contracts (GICs, an insurance company product) and synthetic GICs (a bank product) </li></ul></ul><ul><ul><li>Designed to protect capital and generate a “fixed” rate of return that is minimally influenced by changes in market interest rates </li></ul></ul>
  21. 21. “Passive” Portfolio Management <ul><li>Tries to match an index or benchmark </li></ul><ul><li>Tracking ability is measured by R 2 —the ability to “track” the index as well as alpha (the constant term in the regression of fund returns against index returns) </li></ul><ul><li>Higher (or less negative) alpha tends to come from lower management fees </li></ul>
  22. 22. Active Portfolio Management <ul><li>Tries to benchmarks and funds with similar “styles” </li></ul><ul><li>Performance is measured several ways </li></ul><ul><ul><li>Alpha, Sharpe ratio, and other quantitative measures </li></ul></ul><ul><ul><li>Performance ratings from Lipper, Value Line, and others </li></ul></ul><ul><ul><li>Stars from Morningstar (the most popular way) </li></ul></ul><ul><ul><li>Morningstar’s star system is closely related to the Sharpe ratio, the standard reward-to-risk measure </li></ul></ul>
  23. 23. Fund Styles According to Morningstar <ul><li>Standard 3-by-3 “ Style Box ” </li></ul><ul><ul><li>Investment orientation: value vs. growth (combination of Price/Book and Price/Earnings ratios) </li></ul></ul><ul><ul><li>Company size (measured by market cap) </li></ul></ul>
  24. 24. Mutual Fund Performance <ul><li>A high rating does not ensure above-average future performance </li></ul><ul><li>A low rating makes future low performance more likely </li></ul><ul><li>Expenses always detract from performance, but can be necessary for specialized asset classes </li></ul><ul><li>Active management will generally cost more than passive management </li></ul><ul><li>Beware of shadow indexers </li></ul>
  25. 25. Style Matters <ul><li>Until about ten years ago, it was standard practice to compare all stock funds with the S&P 500 Index </li></ul><ul><li>Then, style analysis was born </li></ul><ul><li>It was based on the idea that investment managers should only be rewarded for picking stock, not picking a style </li></ul>
  26. 26. Mutual Fund Resources (Cheap or Free) <ul><li>Yahoo! Finance provides a good overview of funds, including some Morningstar information and historical data </li></ul><ul><li>Morningstar itself fills in a few holes in Yahoo!’s coverage (best-fit benchmark is one of them) </li></ul><ul><li>Mutual fund screening programs can be found all over the Internet (some of them require registration or being a broker’s client) </li></ul><ul><li>Barron’s has good weekly coverage </li></ul><ul><li>Many business magazine have special issues and Morningstar has an annual book </li></ul>
  27. 27. It Can Be Easy to Download Mutual Fund (and Other) Prices Directly into Excel <ul><li>Create a sample query in Yahoo! Finance ( here is one for VIIIX ) </li></ul><ul><li>Find the address (URL) associated with downloading the query by right-clicking on “Download to Spreadsheet” and choosing “Properties” from the menu and copy it to the clipboard (IE) or “Copy Link Location” (Firefox) </li></ul><ul><li>Run Excel, type “/FO” (File Open) and paste the URL into the dialog box </li></ul><ul><li>Change ticker symbol and/or dates to download data for other funds (or stocks) </li></ul>
  28. 28. General Electric Common Stock ( GE ) <ul><li>The stock usually tracks the S&P 500 Index most closely </li></ul><ul><ul><li>Beta around 1.0 (until recently) </li></ul></ul><ul><ul><li>R-squared among the highest for individual stocks </li></ul></ul><ul><li>GE workers will already be exposed to considerable GE-specific risk </li></ul>
  29. 29. Vanguard Institutional Index Plus ( VIIIX ) <ul><li>Relative of the largest mutual fund in the U.S. with over $75B in assets under management </li></ul><ul><li>Designed to track the S&P 500 Index closely </li></ul><ul><li>Extremely low management fees—normally 2.5 b.p. and only available through large institutional investors </li></ul><ul><li>Tends to slightly outperform the S&P 500 by using return-enhancement strategies </li></ul><ul><li>Three stars from Morningstar </li></ul>
  30. 30. A Note about Vanguard Institutional Index Fund ( VINIX ) <ul><li>The other institutional version of Vanguard’s S&P 500 Index Fund </li></ul><ul><li>The only real difference relative to VIIIX is that it charges 5 b.p. in expenses vs. 2.5 b.p. for VIIIX </li></ul><ul><li>The Vanguard3funds.xls example taken from 2004-2005 uses it instead of VIIIX </li></ul><ul><li>There is no real difference; however, you should grab data on VIIIX in working out your 401(k) choices </li></ul>
  31. 31. GE S&S Program Mutual Fund ( GESSX ) <ul><li>A typical stock fund dominated by large-cap U.S. stocks </li></ul><ul><li>As a typical stock fund, it tends to underperform the S&P 500 </li></ul><ul><li>Includes some bonds and tends to be less risky than the S&P 500 (recent beta = 0.92) </li></ul><ul><li>Three stars from Morningstar </li></ul>
  32. 32. GE S&S Income Fund ( GESLX ) <ul><li>GE’s bond fund </li></ul><ul><li>Tends to hold maturities that average between five and ten years </li></ul><ul><li>Four stars from Morningstar </li></ul>
  33. 33. GE Institutional Strategic Investment ( GSIVX ) <ul><li>Allocates assets between stocks and investment-grade bonds </li></ul><ul><li>Relatively new GE fund </li></ul><ul><li>Four stars from Morningstar </li></ul>
  34. 34. GE Institutional International Equity ( GIEIX ) <ul><li>Holds mainly large-cap foreign stocks </li></ul><ul><li>Guarantees only minimal geographic diversification </li></ul><ul><li>Four stars from Morningstar </li></ul>
  35. 35. GE Institutional Small-Cap Equity ( GSVIX ) <ul><li>Holdings drawn mainly from the Russell 2000 (a major small-cap index) </li></ul><ul><li>Used to be a small-cap value fund </li></ul><ul><li>Three stars from Morningstar </li></ul>
  36. 36. GE Money Market ( GEMXX ) <ul><li>Run-of-the-mill money market fund </li></ul><ul><li>Price fixed at $1 (so it will not be tracked) </li></ul><ul><li>Yahoo! gives 7-day yield </li></ul><ul><li>Unless you expect a forthcoming disaster, you can eliminate this choice </li></ul>
  37. 37. For Week 10 <ul><li>Dig up more information on the 401(k) eight choices (including historical pricing data) </li></ul><ul><li>You should look at the example for three Vanguard mutual funds </li></ul>