Mutual Funds and Other Investment Companies

1. Mutual Funds and Other Investment Companies P.V. Viswanath For a First Course in INvestments

2. Learning Goals • What are investment companies? • What are the different kinds of investment companies? • What are the different kinds of mutual funds? • How are they sold? • What are exchange-traded funds?

3. Functions of Investment Companies • Record keeping and administration • Diversification and divisibility • Professional management • Active portfolio management • Tax minimization • Lower transaction costs

4. Types of Investment Companies • Unit Investment Trusts • Closed-end Mutual Funds where there is no trading in the underlying assets • Managed Investment Companies • Open-end funds (mutual funds) • Closed-end funds • Commingled funds • These are similar to mutual funds, but they are not open to all investors and hence have less regulation and disclosure • REITs • Corporate entities investing in real estate that pay out 90% of their income; in return they don’t have to pay corporate taxes • Hedge funds • Mutual funds that are structured as private partnerships and have minimal SEC regulation

5. Types of Mutual Funds • Money Market Funds • Equity Funds • Sector Funds • Concentrate on a particular sector • Bond Funds • International Funds • Invest in securities of firms located outside the US • Balanced Funds • Hold stocks and bonds; meant to be an individual’s entire portfolio • Life cycle funds take the investor’s age into account • Asset Allocation Funds and Flexible Funds • Index Funds

6. How Funds are Sold • Directly by the Fund Underwriter/Distributor, who • Creates prospectus for the fund • Develops marketing campaigns (tv, internet, magazine) • Sells the shares directly to the public • Provides a wholesale market to reach a larger number of investors • Indirectly through brokers or financial advisers • Funds pay brokers for preferential treatment when making investment recommendations – revenue sharing. Note conflict of interest! • Fund Supermarkets

7. Costs of Investing in Mutual Funds • Operating Expenses • Front-End Load • Back-End • 12b-1 charges • Charges to pay for distribution costs such as advertising, promotion literature and commissions paid to brokers who sell the fund to investors. • Soft dollars • A portfolio manager earns soft dollar credits with a brokerage firm by directing the fund’s trades to that broker. On the basis of these credits, the broker will pay for some of the fund’s expenses. Purchases made with soft dollars are not included in the fund’s expenses, so funds with soft-dollar arrangements may report artificially low expense ratios. However, the fund may have paid the broker needlessly high commissions; alternatively the broker may not provide good execution. This will show up in lower returns. But this signal is much noisier.. • Late Trading • The practice of allowing some traders to buy or sell after the market has closed and the NAV has been established – these traders can then time the market. • Tax inefficient trading • Unnecessary generation of capital gains, which are passed on investors and causes them to lose out on the timing option.

8. What’s an ETF (Exchange Traded Funds)? • Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated per share by a national securities exchange at regular intervals during the trading day; • Identifies itself as an ETF in any sales literature; • Issues shares that are approved for listing and trading on a securities exchange; • Discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and • Either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund.

9. More on ETFs vs Mutual Funds • An ETF is similar to an open-ended fund in some ways – for example, there can be withdrawals from the fund and there can be additions to the fund. However, the way in which this happens is crucially different. • With an open-ended fund, investors sell back to the fund or invest additional money with the fund, which then buys additional shares. • With an ETF, investors buy from or sell shares to other investors. Addition to or reduction of the size of the fund occurs when entities called Authorized Participants (AP) exchange ETF shares for the shares of the financial assets (stocks in a stock ETF) that underlie the ETF. They buy or sell these financial assets in the open market. • The actions of these APs ensures that the ETF trading price is close to the NAV of the fund. This happens directly with an open-ended mutual fund because the fund stands ready to buy or sell at the NAV.

10. More on ETFs vs MFs • An ETF allows investors to trade during the day, while an investor in an open-ended mutual fund (MF) can only buy or sell at the end-of-day price. • ETF investors have relatively high transactions costs (brokerage fees) because their trades are likely to be small. In a MF, the fund does the trading and can do it more cheaply. • However, since an MF has to trade large amounts, market impact costs could be high; ETF trades don’t have this problem. However, an investor disinvesting from an MF doesn’t bear this cost because s/he gets the NAV. In other words, a MF investor buys illiquidity insurance, which is spread out among all the MF investors. • However this insurance is not valuable for the long-term investor who only trades infrequently. Hence, in equilibrium, MFs may have short-term investors, while ETFs may have long-term investors. • On the other hand, investors who believe they have above-average proficiency in short-term market timing would want to use ETFs. (The evidence suggests that most such investors have incorrect beliefs.)

11. ETFs and Mutual Funds • ETFs can be more tax efficient than ordinary mutual funds. Whereas with an ordinary mutual fund, whenever there is a redemption, the fund has to sell securities and recognize capital gains or losses (which must be passed on to fund holders), when an ETF holder sells an ETF, there is no corresponding tax event for other ETF holders. • Mutual funds have flow-induced costs. When mutual fund investors redeem shares, their shares are sold at the NAV of the fund at the end of the day; the redemption is achieved by subsequent trades which may have market impact costs, especially since they may be large. That is, the mere fact of selling securities is going to cause a drop in the total value of the fund (independent of the redemptions). These are called flow-induced trading costs. ETFs don’t have these costs, even when the redemptions occur on the part of an AP because the redemptions are in-kind. With respect to other investors, there is no issue at all of any cost borne by the ETF fund itself. • On the other hand, ETF investors have to bear the costs of purchasing or liquidating their shares.

12. ETFs and MFs • Mutual fund investors, however, buy insurance against future liquidity shocks -- investors pay the cost of lower average returns in exchange for better prices when they experience liquidity shocks. This is because when a fund investor wants to redeem his fund shares, the fund does not sell assets and charge him the expenses. Rather, it buys back his shares at the daily closing price of the fund. • Redemption demands are pooled and transacted at a later date. At that time, there might be a drop in the price of the assets held by the fund because of the selling pressure. But shares are redeemed at the daily closing price and do not reflect the potential price drop. This is what has been termed as insurance against liquidity shocks. • However, this cost is paid by all investors, independent of whether they use the insurance or not. Furthermore, this protection from the liquidity shock can engender excess trading. • Hence, in equilibrium, mutual funds would be used by short-term investors (who would rather have the insurance), while ETFs would be used by long-term traders. (However, to the extent that the MF investors’ liquidity needs are not correlated, this cost will not be as high, since the MF will not need to trade as much.) • If ETFs tend to have investors that are not as interested in frequent trading, then it would make sense to have ETFs track indexes that have less number of stocks, high industry concentration, high volatility, and low liquidity. Are ETFs Replacing Index Mutual Funds?, Ilan Guedj and Jennifer Huang, March 2009

13. More on ETFs vs MFs • According to an Economist article (Jan 2010), the average expense ratio for ETFs was 0.31% at the end of 2009, while it was about 0.78 for index-tracking MFs. • Synthetic ETFs • http://monevator.com/how-a-synthetic-etf-works/ • http://www.economist.com/node/21547989

14. Problems with ETFs: Synthetic • There is a slice of the ETF market, making up a little over 10% of global assets under management and concentrated in Europe, that is “synthetic”. • This means that the returns generated by the fund come from a swap with a counterparty, often an affiliate of the fund manager. • Instead of using investors' cash to buy the underlying securities, the money is put into a basket of collateral whose returns are swapped with a counterparty for the returns of the index being targeted. • This generates counterparty risk.

15. Unfunded swap ETF structure Swap Counterparty Stock Basket sold Total Return Swap Index Return Cash Basket Return Cash Authorized Participant ETF Sponsor ETFs http://www.bis.org/publ/work343.pdf

16. Motivations for Synthetic Replication • Protects the investor from tracking error. • Possible synergies may exist between the investment banking activities of the parent bank and the unit within the parent bank that acts as the ETF sponsor. These synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds that has to be funded. • When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. By transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs for these assets. • Part of this cost savings may then be passed on to the ETF investors through a lower total expense ratio for the fund holdings. • But this may lead to moral hazard problems, as well.