Indirect Investing (see Ch. 3 Jones)

1. Indirect Investing (see Ch. 3 Jones)

2. Indirect Investing • Alternative to direct investment in or ownership of securities • Refers to buying and selling the shares of intermediaries that hold securities in portfolio • Shares are ownership interest in portfolio entitled to portfolio income • Shareholders also pay expenses 3-2

3. Investment Companies An investment company invests a pool of funds belonging to many individuals in a portfolio of individual investments such as stocks and bonds Financial firm that sells shares to the public and uses the proceeds to invest in marketable securities Benefits: • Diversification • Professional management • Low capital requirement • Reduced transaction costs • Access to illiquid markets • Access to non-traditional trading strategies

4. Types of Investment Organizations • Mutual funds • Open-End • Closed-End • (Stock trades on secondary market; Net asset value (NAV) is determined daily, but market price determined by supply and demand) • - ETFs (Exchange Traded Funds) • Hedge Funds • Private equity/venture capital funds [Not covered in text]

5. Mutual Funds • An investment company that issues its portfolio shares to investors. • Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. • Managed by professional managers • Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees. • Open end fund: # of shares issued solely depends on investor demand • Bought and sold directly through the investment company (not an exchange)

6. Net Asset Value Used as a basis for valuation of mutual funds. • Selling new shares • Redeeming existing shares Calculation: Market Value of Assets – Fund Expenses - Liabilities Shares Outstanding • A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV? • Solution • ($100 mil - $3 mil) / 10.765 mil = $9.0107 per share

7. Sources of Information • Lipper Inc.: leading provider of data and analysis on the investment company business ( www.lipperweb.com ) • Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com) • Vanguard Group: providing competitive investment performance and lowest operating expenses ( www.vanguard.com)

8. Mutual Funds: Investment Policies • Money Market • Fixed Income • Equity • Balance & Income • Asset Allocation • Indexed • Specialized Sector

9. Mutual Fund Organization • Mutual fund shareholders: own mutual funds, elect the board of directors • Majority of the directors must be independent directors • Investment advisor: manages the day-to-day operations • Principal underwriter, administrator, transfer agent, custodian, and independent public accountant

10. Direct Costs of Investing in Funds • Sales charge (loads) • Front-end load • Back-end load • Redemption fee • Exchange fee

11. Indirect Costs of Investing in Funds • Account maintenance fee (Operating expenses) • 12 b-1 charges • distribution costs paid by the fund • Alternative to a load

12. Mutual funds: Performance • It’s not conclusive • Most of the studies suggest that the average MF underperforms its benchmark • There is some evidence of short-term performance persistence • The evidence show that it’s not easy to find funds that outperform for a long period of time • Nonetheless, “hot” funds receive a disproportionately amount of new money Benchmarks Survivorship bias

13. Closed-End Funds • Issues a fixed number of shares at a given point in time • Collect money from investors through and IPO and use this money to invest in securities. • # of shares are fixed at the time of IPO. • When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount (closed-end funds typically sell at a discount) • Suited to specialized investing in small or illiquid markets

14. Exchange Traded Funds • Are similar to closed-end funds: traded securities; entails commission costs • Each ETF is a claim on a trust that holds a specified pool of assets (e.g. S&P500 index components) • Examples:SPDRS,ishares,HOLDERS • Advantages: • Liquidity • Taxes • Can be purchased on margin or sell short • ETF are appropriate for short-term investors and the ones who buy in large lots

15. Morningstar rating • Created in 1984 to provide comprehensive assessment of mutual funds • The star system was not meant to predict future performance • 5* - the top 20% of the funds 1* the bottom 20%

16. Hedge Funds • Considerable confusion exists concerning hedge funds – what they are (and are not) and how they work • Hedge funds are privately organized, pooled investment vehicle with no restrictions in terms of investment strategies, asset classes and use of leverage • Many of them registered off-shore for tax and regulatory reasons • Can’t have more than 100 “accredited” investors or 500 “super-accredited” investors • Accredited investor: net worth > 1 million or income of $200,000 in each of the past two years • Super-Accredited investor: net worth > 5 million

17. Hedge Funds • Are not allowed to advertise broadly and engage in “ general solicitation” to the investing public • Charge 1-2% of assets under management and 20-25% of profits • First hedge fund on record, Jones Hedge Fund, was established in 1949 • He hedged the US equity market risk and focused on stock selection • By 2011, more than 10,000 funds in existence world-wide • Common features: - shorting - leverage - concentration Do they all hedge?

18. Learning objectives • Discuss the advantages and disadvantages of mutual funds • Know how to calculate NAV • Define and Discuss the differences between open end, closed end and ETFs • Briefly discuss the costs, loads and fees of investing in mutual funds • Morningstar and Style boxes • Benchmarks • Survivorship bias and Chasing the Hot funds (p. 73-74) • Hedge Funds • End of chapter questions 3.1 to 3.13