Financial Services Industry Training: Investment Funds

Financial Services Industry Training

Introduction to
Investment Companies,
Mutual Funds and Exchange
Traded Funds

Saunders Learning Group, LLC
Saunders Learning Group, LLC, Andover, KS

Training from Saunders Learning Group
Saunders Learning Group provides a variety
of training programs, workshops and
seminars targeted to the financial services
industry.

Programs are available in a wide range of
topics, and we are specialists in developing
custom programs that are targeted to your
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Contact the founder, Floyd Saunders at
316-680-6482 or at
floyd@floydsaunders.com for more
information.

1

Topics

1. Investment Companies
2. Open-End Mutual Funds
3. Closed-End Funds
4. Benefits of Investment Companies
5. Regulation of Investment Companies
6. Fees
7. Fund Objectives
8. Selecting a Mutual by Investment Objectives
9. Management Styles

Saunders Learning Group, LLC, Andover, KS Slide 2

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?


Difference between Banks and Mutual Funds
Banks Mutual Funds
Leverage Banks have leverage – can borrow funds at Have no debt in their capital structures – cannot
a fixed rate of interest borrow funds

Incentive Investment quality is signaled through the Managers collect fees and do not own equity; There
market value of equity. Banks risk (invest) is no incentive alignment with investors based on
their own capital (borrowed from performance of the investments. Profits and losses
depositors at a fixed rate) which gives them are simply passed through.
strong incentives to invest wisely

Transparency Investments (loan portfolios) are opaque Investments are relatively transparent, with
investment advisors required to list their portfolios
at certain intervals

Types of Banks cannot invest in equity securities – Mutual funds do not negotiate loans. They may
investments conflicts of interest may develop purchase loans if securitized

Ownership Managers of the firm can also be owners Mutual Fund managers cannot invest in their own
(stock and/or options) which promotes fund, and since they do not risk their own capital,
incentive alignment are not incentive aligned.

Saunders Learning Group, LLC, Andover, KS Slide 4

Open-End Investment Companies or Mutual Funds

 An open-end investment company is commonly called a mutual fund and is the 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. A mutual fund has no limit on the size of the fund or the number
of shares outstanding.
 The value of a mutual fund share is called its net asset value.
 Mutual fund shares are not sold in the traditional sense. Instead, they are redeemed by the fund
management.
 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), Stats:
 However, investment companies do not real-time mark to market • 8,200 firms
• < 7,100 stock
 For most funds and investors, there is a 1:00PM commitment to and bonds
purchase shares, but at the 4:30PM NAV (market close) funds.
 Fund size is determined by: • Total assets of
 The change in value of investments $5.12 trillion.
• $6.97 trillion if
 Net flow of funds -- buy-ins (+) and redemptions (-).
money market
 If a fund is performing well, then its growth through Net New Flow mutual funds
of Funds will likely be bigger than the growth through changes in included
Investment value (Don’t confuse fund growth with return!!!). As of XXXX


Top 10 Mutual Fund Companies1

Total net
Rank Company asssets
1 Fidelity Investments $949,043,326
2 Vanguard Group 864,809,332
3 Capital Research & Management 721,894,829
4 Franklin Templeton Investments 258,649,755
5 Morgan Stanley 212,703,042
6 J.P. Morgan Chase & Co. 197,084,517
7 Columbia Management Group 193,563,642
8 PIMCO Funds 178,399,578
9 TIAA-CREF 173,865,479
10 OppenheimerFunds/MassMutual 168,695,094

(1) As of March 31, 2005. Includes members of Investment Company Institute only.
Source: Investment Company Institute.
Reprinted from financialservicesfacts.org


Mutual Fund Size by Type of Funds
($millions)
Taxable Tax-exempt
Money Money
Year Equity Hybrid Bond Market Market Total
2004 4384.10 519.30 1290.30 1602.80 310.40 8106.90
2003 3684.20 430.50 1247.80 1763.60 288.40 7414.40
2002 2662.50 325.50 1130.50 1997.20 274.80 6390.40
2001 3418.20 346.30 925.10 2013.00 272.40 6975.00
2000 3961.90 346.30 811.20 1607.30 238.00 6964.70
1999 4041.90 378.80 812.50 1408.70 204.40 6846.30
1998 2977.90 365.00 830.60 1163.20 188.50 5525.20
1995 1249.10 210.30 598.90 630.00 123.00 2811.30
1990 239.50 36.10 291.30 414.70 83.60 1065.20
1985 111.30 17.60 122.70 207.50 36.30 495.40
Source: Investment Company Institute.
Reprinted from financialservicesfacts.org


Closed-End Investment Companies
 A closed-end investment company has a fixed number of shares and is closed to new
investment.
 Investors buy and sell these shares on an exchange just like shares of stock.
 The pricing of closed-end fund shares is a financial puzzle - they usually sell at a discount
to their net asset value.
 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


Unit Trusts and Exchange Traded Funds
 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.


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.


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


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.


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


Regulation of Investment Companies

 One of the most closely regulated among non-depository FIs.
 Primary regulator: SEC
 Emphasis on full disclosure and anti-fraud measures to protect small investors.
 NASD supervises mutual fund share distributions.
 Securities Act 1933, 1934
 Investment Advisers Act, 1940.
 Insider Trading and Securities Fraud Enforcement Act of 1988.
 Market Reform Act of 1990
 Allows SEC to halt trading and introduce circuit breakers.
 National Securities Markets Improvement Act of 1996.
• Exempts mutual fund sellers from state securities regulatory oversight.


The Investment Company Industry: Regulation

 Almost all mutual funds choose to
organize as a regulated investment company, so that
any tax liability on capital gains and income can be
passed on to the accountholders.

 The Investment Company Act of 1940 provides
the potential investor with some degree of
protection from misleading advertising or
incomplete investment information.



 The Investment Company Amendments Act of 1970 serves primarily to
clarify legal points. It mandates that the fund manager and the board of
directors be held to fiduciary standards in their actions.
 Many states have their own version of the Securities and Exchange
Commission. Today, these blue sky laws function largely to inform
investors of the suitability of certain proposed investments.



 The National Securities Markets Improvement Act of 1996 sought to
largely eliminate Federal and state regulatory overlap. The principal
effects include lower registration fees, lower broker-dealer margin
fees, and ensuring that a fund’s name is consistent with its objective.


Mutual Fund Costs
 Two types of fees:
 Sales loads
 Generally, negative effect on performance outweighs benefits
 Fund operating expenses
 Management fee
 12b-1 fees


The Investment Company Industry: Fees
Most mutual funds separate their charges into a number of
categories, making it difficult to determine the actual cost of
investing. Some fees are avoidable, others can be managed.

 Load vs. No-Load Fees
 Load funds have a salesforce and the shareholders have to pay a
sales charge.
 If paid at the time of purchase, the fee is a front-end load.
 If levied when shares are sold, the fee is a back-end load, or
contingent deferred sales charge.
 A no-load fund charges no sales commission.
 In addition, all funds have management and administrative fees
 Some funds have fees for marketing costs (known as 12-1B
charges)


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.


Management Fees
 Certain expenses such as the management fee are associated with
operating a mutual fund. These fees are measured by the fund’s expense
ratio, which is the fund’s total expenses expressed as a percentage of the
fund’s assets.
 Note that within the same fund, there may be several classes of shares
with different fee combinations. Their relative merits depend on how long
the investor anticipates keeping the investment.


Additional Fees

 The annual 12b-1 fees permit the fund manager to pass certain
advertising costs on to the accountholders.
 A trailing commission is an annual fee paid to a broker, sometimes
independent of the level of activity in the account or its size.
 Other fees include fund transfer charges, custodian fees, low-balance
fees, account opening or closing fees etc.
 Studies indicate that the lower the expense ratio, the better the fund
performance.


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.

The Investment Company Industry : Fees

Prevalence of Load Charges by Type

Level Load
No Load 15%
35%

Front End
Load
Back End 29%
Load
21%

Source: Wiesenberger Mutual Funds Update


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)


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.


Selecting A Mutual Fund
 With a mutual fund, return comes from the change in the net
asset value, capital gains distributions, and income
distributions.

change in
net asset capital gains income
+ distributions + distributions
value
before-load
(gross) return =
beginning net asset value

change in
net asset capital gains income load
+
distributions + -
distributions fee
value
after-load
(net) return =
beginning net asset value

27

Selecting A Mutual Fund : Types of Funds

 Money market funds invest in short-term government
securities and sometimes in short-term corporate securities.
They are used primarily as a temporary cash haven.
 Bond funds invest in fixed income securities. They vary widely,
and have no common maturity date to simultaneously return
the components to their par value.
 Stock funds vary widely in their risk and price behavior. They
are classified as growth or value, and as large-cap or small-cap.



 A balanced fund is a mixture of stocks and fixed income
securities. It forces discipline on the fund manager.
 An international fund is limited to buying securities
registered outside the country where it is sold, while a global
fund can invest anywhere in the world.
 Fund of funds invest only in other mutual funds. Their
diversification is good, but their expense ratios tend to be
higher than that of the typical mutual fund.



 Sector : Such funds invest in specific market sectors, such as
physical commodities or stocks closely tied to natural
resources e.g. oil, forest products, and gold.
 An index fund may be a stock or bond fund that tries to
behave exactly like the market. A stock index fund, for
instance, may seek to mirror the performance of the
Standard & Poor’s 500 stock index.
 Investors should determine their investment objective first,
and then choose an appropriate fund or group of funds.


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.


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”.
 Are 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…


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.


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.


Resources
 For details of regulation of securities firms and investment banks, visit:
SEC: www.sec.gov
NASD: www.nasd.com
 For investor information, visit:
Morningstar www.morningstar.com
 Several periodicals like Forbes, Fortune and Business Week provide
≈
excellent coverage of the investment company industry.
 Some organizations like the Investment Company Institute publish some
educational material for the public.
 Most public libraries carry some
reference material, such as the Morningstar Mutual Funds and the
Weisenberger Investment Company Survey.


Questions


Post Workshop Action Plan

 Complete the Post Workshop Action Plan

37

Module Summary
 Monday morning you will have XX new financial
management techniques that you can use immediately on
your project
 Don’t wait for a new project, verify financials controls on
your current project

38

Thank You !

Saunders Learning Group, LLC

About the Author/Presenter
 Floyd Saunders has worked on Wall Street
with both Bank of America and JPMorgan,
where is was a vice president in global
financial systems. He has worked across the
industry in retail, commercial, and
investment banking.
 He has taught courses in Money and Banking
and extensively for the American Institute of
Banking and various colleges.
 As a consultant, he developed and taught a
wide range of banking and investing courses.
 He authored three programs for the
American Bankers Association: Banking on
Mutual Funds and Annuities, Introduction to
Securities Markets and Investing in Securities.
 He is the author of “Figuring Out Wall Street”
and his next book is “Family Financial
Freedom” a book on personal money
management.


Reference Material

Figuring Out Wall Street Consumer’s Guide To
Financial Markets
By Floyd Saunders
Publisher: Saunders Learning Group

ISBN: 978-0-9824019-0-3

Available from Amazon:
http://www.amazon.com/Figuring-Out-Wall-Street-
Consumers/dp/0982401906
and many other online book stores.
Book summary: Figuring Out Wall Street, is the
concise guide to help everyone understand how what to do
now to restore our financial systems. Written in an easy to
understand manner, even the most complex financial
concepts are easy to digest. This book provides help to
monitor investments with a review of investment products,
financial regulators and economic indicators. Learn how the
stock market exchanges work and the world of investment
banking, hedge funds, venture capital and private equity.
Every chapter includes action plans for investing.


Financial Services Industry Training: Investment Funds

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