Mutual Funds

1. Mutual Funds

2. Introduction • More than 92 million people in the U.S. invest in mutual funds. i.e., in the US alone, trillions of dollars are invested in mutual funds. • Basically, a mutual fund is a collection of stocks and/or bonds. • It is a company that brings together a group of people and invests their money in stocks, bonds, and other securities • Investors are everyday, average individuals. • Regulated by the SEC • Each investor owns shares, which represent a portion of the holdings of the fund. Shares come with voting rights in proportion to the investor’s ownership of the fund. • Every mutual fund issues a prospectus describing investment style of the fund

3. Overview • Advantages • Diversification • Economies of Scale • Liquidity • Simplicity for average individual • Disadvantages • Little or no control • Dilution • Fees • Not knowing how to evaluate fund manager

4. How Mutual Funds Work • Theory: pooling money together with that of a lot of other investors provides a lot more power to invest. • Most funds require only moderate minimum investments -- from a few hundred to a few thousand $ -- enabling investors to create a diversified portfolio much more cheaply than they could on their own • The typical fund investor is a middle-income, middle-aged individual • The money is then invested by professionals who research stocks, bonds, or other assets and then place the money as wisely as they can. • The managers charge an annual fee - generally 0.5% to 2.5% of assets - plus other expenses – which puts a drag on total return. But in exchange, investors get professional management and instant diversification

5. How Investors Obtain Returns • Dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. • Capital gain on securities that the fund sells that have increased in price. Most funds also pass on these gains to investors in a distribution. • Price increase in shares if fund holdings increase in price but are not sold by the fund manager. Investors can then sell their mutual fund shares for a profit.

6. Types of Mutual Funds • Load funds: impose a sales charge -- a cut of any new money that comes into the fund, or a cut of withdrawals • No-load funds: no sales charge • Open-end funds: sell shares to anyone who cares to buy; essentially, they are willing to invest any new money that the public wishes to pump into the fund • share price is determined by the value of the underlying investments, and is calculated anew each evening after the close of the U.S. markets • Closed-end funds: issue a limited number of shares that then trade on the stock exchange like stocks • price can fluctuate above or below the actual value of the underlying shares held within the portfolio

7. Mutual funds by investment strategy – Equity/Stock Funds • Index funds – long-term performance, based on the S&P 500; lower fees, but lower returns • Growth funds – higher risk, investments made in the stock of companies whose profits grow rapidly. These typically rise more quickly than overall market - and fall faster if they don't live up to investors' expectations • Value funds – investments into companies that appear to be cheap, relative to their earnings. e.g. mature companies that send some of their earnings back to s/h in the form of dividends • equity-income / growth-and-income funds • Sector funds –focused in a particular industry sector, e.g. technology or financials • There is a lot of overlap among these funds in the companies they invest in.

8. Other types - Aggressive funds • Aggressive growth funds • Capital appreciation funds • Small-cap funds • Mid-cap funds • Emerging growth funds • Tend to be more volatile than large-cap funds • Common characteristics • smaller companies, where earnings aren't as reliable as at bigger firms but where the potential for gains (and losses) is higher. • pricey, high-growth stocks. • stocks that are in "hot" industries, such as technology or biotech. • just a handful of companies.

9. International and Fixed-Income/Bond Funds • International Funds • Typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. • Global funds are similar, but they can also invest heavily in US. • Emerging market funds invest in riskier regions, like Latin America, Eastern Europe, and Asia • Fixed income/Bond Funds - tend to be segmented across the risk spectrum, with those that specialize in Treasury securities being the safest (and the lowest-yielding) and those that specialize in junk bonds being the riskiest but offering the highest yield. • divide according to whether the bonds they hold are taxable or tax-free. • Types • government bond funds • high-yield bond funds, aka junk bond funds • municipal bond funds.

10. Regulatory framework • U.S. mutual funds are among the most strictly regulated financial product • However, they are not guaranteed or insured by the FDIC or any other government agency • Mutual fund companies must register with the SEC • Four federal laws govern mutual funds: • Securities Act of 1933 • Imposed prospectus requirement • Securities Exchange Act of 1934 • Investment Company Act of 1940 • cornerstone of mutual fund regulation • regulates the structure and operation and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records • Investment Advisers Act

11. Investment Company Act of 1940: Basic Approach - Registration • Requires registration of all funds sold to public (absent exemption); those sold to the general public (no private placement exemption) must also register under ‘33 Act • Disclosure of investment policies, fees and portfolio • Rules to control pyramiding, conflicts of interest, and embezzlement

12. 40 Act Goals - protect against: • (1) insufficient disclosure to investors regarding the character of their investment company shares and the policies and financial responsibility of investment companies and their management; • (2) conflicts of interest in the management of investment companies and the selection of securities; • (3) inequitable control and irresponsible management of investment companies; • (4) unsound or misleading accounting without independent review; • (5) transfer of control or management and change in corporate structure or purpose without shareholder consent; • (6) excessive leverage; and • (7) inadequate capitalization.

13. Additional requirements imposed • The Internal Revenue Code sets additional requirements regarding a fund's portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers (NASD) oversees most mutual fund ads and other sales materials. • Federal law imposes a fiduciary duty on a mutual fund's investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules.

14. Protection for investors • The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. • The SEC requires that funds engaging in certain investment techniques (including the use of options, futures, forward contracts and short selling) "cover" their positions. • In early 2001, the SEC tightened their regulations so that mutual fund companies are required to invest at least 80% (an increase from the previous 65%) of their portfolio in the strategy advertised by their name.

15. Governance issues - requirement of independent directors • Mutual funds must have directors who are responsible for extensive oversight of the fund's policies and procedures. • For virtually all funds, at least 75% of their directors and the chairman of the fund board must be independent of the fund's management. • Congress conceived of independent directors as "independent watchdogs," in the words of the Supreme Court, who would "supply an independent check on management and . . . provide a means for the representation of shareholder interests in investment company affairs.” • But independent directors have been the "last to know" about fund conflicts and wrongdoing

16. Fraud in mutual fund industry • In September 2003, NY Attorney General, Eliot Spitzer filed a complaint against Canary Capital Partners (a hedge fund), documenting their late trading and market timing abuses. • Alleged corruption of mutual fund managers, broker-dealers, and bankers and illegal mutual fund trades. • one of their schemes involved “late-trading”, buying fund shares after market close, but at prices that hadn't yet factored in underlying stock moves from the day's activity • trades in fund shares after 4 PM on Day 1 should be at Day 2 4 PM closing price. Must be forward looking. • “Late trading” tactics guided the fund to market-beating returns from mid-1998 to the end of 2002.

17. Trading Violations • Late trading—after 4 p.m. (illegal); and market timing—in and out, day-to-day (requires disclosure) • Timing dilutes gains of other shareholders: • 4 p.m. NAV is based on closing prices of stocks in the portfolio • Prices of foreign securities are stale, e.g. LSE has been closed for 5 hours when NAV is calculated • Suppose London stock X announces big deal after close of trading in London, then NAV is too low • So I buy in at low NAV on day 1 and sell my position on day 2 at the NAV that now reflects the big deal

18. Late Trading Scandal • NAV on Day 1: $10.00 per share • Good News after 4 PM • FMV at 5 PM - $12.00 per share • Late trader buys at $10.00 at 5 PM • Cannot sell until Day 2 at 4 PM but reduces risk

19. Implications of Canary case • Mutual-fund firms named in Spitzer's complaint are among some of the most respected: the Bank of America's Nations Funds, Strong Capital Management, Bank One and Janus Group • Spitzer thinks if greater transparency is always helpful, that alone is unlikely to stop the sorts of illegal practices • Spitzer's complaint against Canary Capital hints that the mutual-fund industry may not be as safe and ethical as its been touted to be.

20. Post-Canary cases • Following Canary, federal and state regulators raised a number of civil and criminal actions against: Alliance Capital Management, BofA, FleetBoston, Franklin Templeton, Invesco, Millenium Partners, Mutuals.com, Prudential, Putnam • Others were under regulatory scrutiny: BankOne, Charles Schwab, Janus • Where was the SEC in enforcement of regulations?

21. Post-Canary Regulatory Response • SEC • Office of Risk Assessment and Strategic Planning established • Examination Program into funds and advisers – more in-depth and frequent • New compliance rules • Code of Ethics • Investment company governance • Proposed “Hard 4:00 p.m. rule” to curb late trading • Amendment to Rule 22c-1 of 1940 Act • All orders must be received by the fund no later than the time at which the fund prices its securities.

22. Trading Violations • SEC proposed in December 2003 “hard” trade close which would prevent any trades being processed after 4 p.m. • Currently many trades, e.g. pension funds, are entered before 4 but processed after 4 (processing takes time) • Late traders abused late processing (entered trade before 4 but cancel after 4 if market moves against them) • Did not adopt because of liquidity concerns • SEC proposed 2% redemption fee for funds redeemed within 5 business days of investment: did not adopt because of liquidity concerns—instead gave funds the option of imposing such fees (March 2005)

23. Late trading scandal • SEC adopts enhanced disclosure requirements on April 13, 2004 • Alternative solutions • fair value pricing (update price after market close) • T+1 pricing (purchase on Day 1 but get closing price on Day 2) • Hurts investor liquidity and increases uncertainty • Exchange-traded funds (ETFs), currently passive index, might be actively-traded in future • Unclear whether same problems with foreign funds (Templeton Fund in Canada)

25. Mutual Funds Cross Border Issues

26. Globalization barrier? • US “virtually excludes foreign mutual funds from selling their shares publicly in the United States by requiring them to be structured like U.S. mutual funds, and U.S. mutual funds face similar impediments abroad.” Va. J. Intl. Law (1996)

27. Why Require Foreign Investment Companies to Register under ‘40 Act? • Foreign Law inadequate - must subject to U.S. Law (or meet the requirements of Section 7(d)) • Enforcement is the key concern • Exemption theoretically possible: • “Special circumstances/arrangements” • “legally and practically feasible” to enforce the 40 Act • 1975 Guidelines: SEC says “practical equivalence” ok

28. Getting out of the 40 Act? • (1) the foreign applicant's charter and by-laws must contain the substantive provisions of the 1940 Act (investor protection); • (2) all parties involved with the management and investment of the funds must file an agreement stating that each will comply with the 1940 Act (enforcement); • (3) at least a majority of the directors and officers of the applicant foreign fund must be U.S. citizens, and of these, a majority must reside in the United States (enforcement); • (4) all of the foreign fund's assets must be maintained in a U.S. bank (anti-embezzlement); and • (5) the applicant's principal underwriter and auditor must be U.S. entities (enforcement re liability of agents).

29. US v. ROW - realities • ICA prohibits affiliated transactions and self-dealing, such transactions are commonplace in many foreign jurisdictions. • Foreign laws often do not require disinterested directors on investment company boards; some do not require directors or shareholder voting at all • Business practices abroad may make it impossible for affiliated parties to accept personal liability by submitting to the jurisdiction of U.S. courts. • some foreign funds are not organized as separate corporate entities and are defined differently than in the United States. • whereas the ICA mandates forward pricing of fund shares, some foreign jurisdictions allow investors to buy a fund's shares at the previous day's market price. • The accounting, disclosure and tax regimes of foreign jurisdictions may make it difficult or impossible for foreign investment companies to comply with U.S. standards in those areas.

30. Section 7(d): Union - Investment (UI) • Under German Law, • Mutual funds are not separately incorporated: Unifonds was a “separate estate” run by UI, a management company owned by 40 banks • Managers of fund could not be U.S. citizens or residents • All assets must be in custody of German bank

31. Unifonds • Only attempt to secure a 7(d) exemption post 1975 • Started process in 1977 • Six years later, ICI (US industry group) requested a hearing at SEC • UF withdrew; SEC indicated later it would have denied exemption

32. UI and Separate Incorporation • Why does incorporation make a difference? • In U.S., management companies, and not shareholders or Boards of a fund, actually run funds • Management company selects Board, but usually 40% of the Board must be independent • In 2006, under SEC rule, in litigation, 75% of Board must be independent and there must be an independent chairman • Not true of management companies in Germany

33. UI and U.S. Citizens or Residents as Managers • Under German law, managers of fund could not be U.S. citizens or residents. • Why is this a problem?

34. UI and U.S. Citizens or Residents as Managers • Enforcement problem against Europeans • Letter of credit (5% holdings of U.S. investors) alternative? • Boards of foreign issuers of securities need not be U.S.–why Boards of mutual funds?

35. Pattern of SEC Action on 7(d) • 1960 - 1973: Permitted foreign funds from Canada, Australia, Bermuda, United Kingdom and South Africa to register • 1973 - No further registrations (or applications) • What explains this pattern?

36. Why Foreigners Do Not Invest in U.S. Funds • U.S. funds must distribute current realized income (taxable to shareholders) to be exempt from current tax at fund level: most foreign funds (tax havens) do not have to do so, so foreigners invest only in them • Dividends to foreign shareholders subject to 30% withholding taxes (reduced to 15% by tax treaties)

37. Taxation of Offshore Funds: Why U.S. Investors Will Not Invest in Foreign Funds • U.S. anti-deferral rules, PFIC (passive foreign investment company), requires taxation on earnings even if not distributed • Applies to foreign (as well as U.S.) investment company whose gross income is 75% or more passive • Foreign funds usually do not distribute because foreign jurisdictions permit deferral, e.g. Luxembourg • If PFIC provides shareholder with report of earnings, shareholder can elect to be taxed on undistributed share of earnings (QEF-qualifying electing fund), thus mimicking U.S. tax treatment of domestic funds • Many funds do not provide because of expense/disclosure reasons

38. Tax constraints • Mark-to-Market alternative: taxpayers can pay tax on current net asset value of shares - adjusted basis, e.g. cost, but then taxed on Fund’s unrealized gains, and need mark-to-market information. • Default Rule (not a QEF or MtM): When taxpayer sells Fund’s shares, pays O.I. rate plus interest representing value of tax deferral when >125% avg. of prior 3 years distributions • often excessive compared to actual economic value of deferral

39. Alternatives to U.S. Registration: Mirror Funds Registered Mirror Fund Unregistered in U.S. • Mirror fund is a separate U.S. organized company that invests in the same portfolio (often foreign securities) as the Foreign Fund. • For U.S. investors, is investing in the U.S. Mirror Fund, the equivalent of investing in the Foreign Fund? Foreign Investors (cannot sell to U.S. Investors) U.S. Fund Foreign Fund U.S. Investors Portfolio X Portfolio X

40. Mirror Funds and Rebalancing Problem: U.S. investors sell U.S. Fund, while foreign investors increase investment in Foreign Fund T1 Opening Positions U.S. Fund Portfolio Foreign Fund Portfolio • ($1) 50x 50x $1 • ($1) 50y 50y $1 • ($1) 50z 50z $1 • <$150> $150 T2 Changes in Positions • U.S. Fund Portfolio: Foreign Fund Portfolio: • 50% redemptions Purchases increase by 50% • What does it liquidate? What does it buy?

41. Master Feeder Alternative to U.S. Registration Master Fund Single Portfolio U.S. registration of Master-Feeder required EU: UCITS prohibits Master/Feeder structure Feeder Fund A Feeder Fund B U.S. Investors Foreign Investors

42. Hedge Funds

43. Introduction • Originated in 1949 to describe the investment strategy of Alfred Winslow Jones • By 1990, there were 530 hedge funds with $50 billion in assets • The 2001 bankruptcy of Enron, once the world's largest energy trading firm, prompted some traders to set up hedge funds • By 2005, investors had sunk roughly $1 trillion into more than 8,000 hedge funds • Hedge funds are notorious for volatility – a high stakes game. • In 2005, 850 hedge funds disappeared.

44. Overview • Hedge funds are like mutual funds in two ways: • they are pooled investment vehicles (i.e. several investors entrust their money to a manager) and • they invest in publicly traded securities. • But there are distinct differences between them, most significantly in the hedge fund's charter: investors give hedge funds the freedom to pursue absolute return strategies. • Use of unconventional investment strategies • While mutual funds seek relative returns (“beat the bogey”), hedge funds actively seek absolute returns

45. Hedge Funds • Offshore hedge funds may have more relaxed requirements, e.g. Hong Kong, Singapore and Germany • Avoids PFIC by structuring as partnership (since not registered under ‘40 Act not forced to operate as corporation) • $870 billion in assets (fees of $44.8B) compared with mutual funds of $3.8 trillion (fees of $42B) (August 2004 assets from SEC; fees from UBS)—hedge funds growing at faster rate ($1 trillion in 2005)

46. What is a Hedge Fund? • Unregistered “private” fund, partnership or corporation • Limited to 100 U.S. beneficial owners, 3(c)(1), or U.S. qualified purchasers (those with over $5 million in investments), 3(c)(7)—both groups must have $1.5 million net worth if the fund is advised by a registered adviser • Different hedge funds have different investment strategies, i.e. they are not all foreign exchange speculators

47. How Hedge Funds Work • Most hedge funds are entrepreneurial organizations that employ proprietary or well-guarded strategies • Limited partnerships with minimum investment usuallly at $1M • Not registered with SEC • Limit on the number of investors and requirement of “accredited” investors • Investors have to do more of their own due diligence before investing in a hedge fund • Prohibited from soliciting or advertising to a general audience • More expensive than mutuals because risk and return are higher • Portion of management fees are performance-based

48. Mutual funds v. Hedge funds • Mutual funds are “long-only” (they make only buy or sell decisions) • Tend to be more popular in bull markets • Hedge funds engage in more aggressive strategies and positions, e.g. short selling, trading in derivatives (options) and using leverage (borrowing) to enhance the risk/reward profile of their bets • Popular in bear markets

49. Hedge Fund categories - based on investment strategy • Arbitrage strategies / Relative value • Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. • Enabling trends: use of derivatives, trading software, and various trading exchanges • Arbitrage is perishable and self-defeating: if a strategy is too successful, everyone copies it and its edge over others gradually disappears • “Relative value” strategy – not risk-free • Example: convertible arbitrage is buying a corporate convertible bond, which can be converted into common shares, while simultaneously selling “short” the common stock of the same company that issued the bond. • The idea is to make money from the bond's yield if the stock goes up but also make money from the short sale if the stock goes down.

50. Hedge Fund categories - based on investment strategy (cont’d) • Event-driven strategies • take advantage of transaction announcements and other one-time events • Distressed securities – invests in vulnerable companies • Activist funds – predatory strategy • e.g. merger arbitrage, used in acquisition announcement - buy the stock of the target company and hedge the purchase by selling short the stock of the acquiring company. • Directional or Tactical Strategies • Used by most hedge funds • macro fund – global; makes "top-down" bets on currencies, interest rates, commodities or foreign economies • George Soros’ Quantum Fund in the 90’s • Long/short strategies • Market neutral - goal is to negate the impact and risk of general market movements, trying to isolate the pure returns of individual stocks • Dedicated short - short sale of over-valued securities