Fin 525 Week 9

1. Fin 525 Week 9 Defined Contribution Plans and Mutual Funds (including ETFs)

2. For Your Write-Up I Look at Three Things and Count Them Roughly Equally • Explanation of the stock price prediction • Explanation of the hedge portfolio • How you “tell your story” that includes (in order of importance) • Coherence • Clarity • Originality/flair Professor Ross Miller • Fall 2007

3. A Suggestion for Budgeting Your 1,000 Words • Overview: 75 to 200 words • Stock Price Prediction: 150 to 500 words • Hedge Portfolio: 150 to 500 words • Conclusion: 25 to 100 words • Some obvious points • If you use a lot of words in one place, you will have to use less somewhere else • It is difficult to get by with less than 500 words Professor Ross Miller • Fall 2007

4. Two Approaches to Price Prediction • CAPM approach • Demonstrate that you understand what you are doing (show lots of details) • Explain the limitations • Show that the company is more than just numbers • Alternative methods • The more unorthodox your approach, the more that you have to explain • If you take this route, expect to spend most of your words here Professor Ross Miller • Fall 2007

5. Hedge Portfolio • Unless you are sufficiently creative, this is all numbers • Explain exactly what you did, do not just give me the answer that you got from your spreadsheet Professor Ross Miller • Fall 2007

6. Telling Your Story • Convince me that you are knowledgeable about GMCR • If you tried but discarded alternative approaches, tell me about them concisely • Make it as interesting as possible, I have to read a lot of these Professor Ross Miller • Fall 2007

7. Going From Individual Securities to Portfolios • 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 • Portfolios themselves can themselves be included in larger portfolios • Many individuals investors find themselves owning a portfolio of both individual securities and portfolios • Portfolios are good because they diversify risk Professor Ross Miller • Fall 2007

8. Defined Contribution Plans • Come in various types, often named after the regulation that created them • 401(k) plans are savings plans predominantly from profit-making companies • 403(b) are the nonprofit equivalent of 401(k) plans • IRAs, profit-sharing and employee stock ownership plans (ESOPs) are other arrangements • The distinguishing feature is that the amount of benefits is not determined by the sponsor, unlike a defined benefit (or pension) plan Professor Ross Miller • Fall 2007

9. Defined Contribution Plans are Beginning to Dominate the Retirement Arena • Companies do not like the obligations and accounting headaches associated with defined benefit plans • IBM and other companies no longer offer the plans to new employees • New companies are much less likely to have them than older, established companies • 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 Professor Ross Miller • Fall 2007

10. 401(k) Plans • Supplemental retirement plans offered by many employers (and virtually all large employers) • Provide tax advantages through the deferral of taxes • Matching of contributions by the employer is standard • Contributions are limited by a formula that changes from time to time • Investment options are chosen by the employer (often with employee input) • Employers consider many factors when they determine what type of plan to offer and with what options • 401(k) plans are regulated by ERISA, the same federal agency that regulates pension plans Professor Ross Miller • Fall 2007

11. The Enron 401(k) Disaster • Many Enron employees lost their life saving when Enron stock collapsed • Poor diversification, especially when one considers that their jobs were at Enron • A lock-up period occurred while Enron stock was dropping • Was it rational? • Enron stock provided at a discount • Safety in the herd? • Rosy reports from management • Enron’s employees skewed toward the young Professor Ross Miller • Fall 2007

12. The Three Types of Investment Companies • Mutual funds (also known as open-end funds) • Closed-end funds • Unit investment trusts (UITs), including most exchange-traded funds (ETFs) Professor Ross Miller • Fall 2007

13. Mutual Funds • A mutual fund is a pooled investment that is run by an investment manger for the mutual benefit of the fundholders • Mutual funds invest in relatively liquid assets • Real estate investment trusts (REITs) are like mutual funds, but hold real estate and real estate-related assets, such as commercial mortgages • Most bond funds use pricing services to determine the prices for infrequently traded corporate and municipal bonds Professor Ross Miller • Fall 2007

14. Practical Details about Mutual Funds • Order deadlines for funds are 4pm or earlier • 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) • 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) • Purchases/sales settle the next business day (T+1), unlike stocks which are T+3 Professor Ross Miller • Fall 2007

15. Practical Details about Mutual Funds (continued) • Funds are “open” because the total number of shares is constantly changing • Daily price determined by the net asset value (NAV), the value of the assets net of fees and commissions Professor Ross Miller • Fall 2007

16. Mutual Funds Can Have Many Classes • Retails classes (A, B, C, LW, etc.) can have different combinations of loads and expenses • Institutional classes (I, IA, IB, etc.) have lower fees and often waive all loads (like the LW class) • 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 Professor Ross Miller • Fall 2007

17. Closed-End Funds • Shares are usually fixed and closed-end funds trade continuously like stocks • Tend not to be marketed as aggressively as open-end funds Professor Ross Miller • Fall 2007

18. Unit Investment Trusts • 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 • Generally, have a maturity date—there are well-suited to fixed income and real estate • Shares in ETFs can be created from “pieces” or redeemed (but only by large investors) Professor Ross Miller • Fall 2007

19. Many 401(k) Plans (But Not GE’s) Contain Trusts Rather Than Mutual Funds • The two biggest vendors of trusts found in defined contribution plans are Barclays Global Investors (BGI) and State Street Global Advisors (SSgA) • Trusts generally have lower expenses than mutual funds, including the Class I and Z shares • Trusts are less transparent than mutual funds (no reporting requirements and no publicly available NAVs in the newspaper or on the web) Professor Ross Miller • Fall 2007

20. Other Things That Do Not Appear in GE’s 401(k) Plan, But Often Appear in Other Plans • Company stock fund • 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” • The liquidity cushion dilutes the returns from the stock and generates fees for the fund manager • “Stable value” funds • Invest primarily in Guaranteed Investment Contracts (GICs, an insurance company product) and synthetic GICs (a bank product) • Designed to protect capital and generate a “fixed” rate of return that is minimally influenced by changes in market interest rates Professor Ross Miller • Fall 2007

21. “Passive” Portfolio Management • Tries to match an index or benchmark • Tracking ability is measured by R2—the ability to “track” the index as well as alpha (the constant term in the regression of fund returns against index returns) • Higher (or less negative) alpha tends to come from lower management fees Professor Ross Miller • Fall 2007

22. Active Portfolio Management • Tries to benchmarks and funds with similar “styles” • Performance is measured several ways • Alpha, Sharpe ratio, and other quantitative measures • Performance ratings from Lipper, Value Line, and others • Stars from Morningstar (the most popular way) • Morningstar’s star system is closely related to the Sharpe ratio, the standard reward-to-risk measure Professor Ross Miller • Fall 2007

23. Fund Styles According to Morningstar Standard 3-by-3 “Style Box” • Investment orientation: value vs. growth (combination of Price/Book and Price/Earnings ratios) • Company size (measured by market cap) Professor Ross Miller • Fall 2007

24. Mutual Fund Performance • A high rating does not ensure above-average future performance • A low rating makes future low performance more likely • Expenses always detract from performance, but can be necessary for specialized asset classes • Active management will generally cost more than passive management • Beware of shadow indexers Professor Ross Miller • Fall 2007

25. Style Matters • Until about ten years ago, it was standard practice to compare all stock funds with the S&P 500 Index • Then, style analysis was born • It was based on the idea that investment managers should only be rewarded for picking stock, not picking a style Professor Ross Miller • Fall 2007

26. Mutual Fund Resources (Cheap or Free) • Yahoo! Finance provides a good overview of funds, including some Morningstar information and historical data • Morningstar itself fills in a few holes in Yahoo!’s coverage (best-fit benchmark is one of them) • Mutual fund screening programs can be found all over the Internet (some of them require registration or being a broker’s client) • Barron’s has good weekly coverage • Many business magazine have special issues and Morningstar has an annual book Professor Ross Miller • Fall 2007

27. It Can Be Easy to Download Mutual Fund (and Other) Prices Directly into Excel • Create a sample query in Yahoo! Finance(here is one for VIIIX) • 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) • Run Excel, type “/FO” (File Open) and paste the URL into the dialog box • Change ticker symbol and/or dates to download data for other funds (or stocks) Professor Ross Miller • Fall 2007

28. General Electric Common Stock (GE) • The stock usually tracks the S&P 500 Index most closely • Beta around 1.0 (until recently) • R-squared among the highest for individual stocks • GE workers will already be exposed to considerable GE-specific risk Professor Ross Miller • Fall 2007

29. Vanguard Institutional Index Plus (VIIIX) • Relative of the largest mutual fund in the U.S. with over $75B in assets under management • Designed to track the S&P 500 Index closely • Extremely low management fees—normally 2.5 b.p. and only available through large institutional investors • Tends to slightly outperform the S&P 500 by using return-enhancement strategies • Three stars from Morningstar Professor Ross Miller • Fall 2007

30. A Note about Vanguard Institutional Index Fund (VINIX) • The other institutional version of Vanguard’s S&P 500 Index Fund • The only real difference relative to VIIIX is that it charges 5 b.p. in expenses vs. 2.5 b.p. for VIIIX • The Vanguard3funds.xls example taken from 2004-2005 uses it instead of VIIIX • There is no real difference; however, you should grab data on VIIIX in working out your 401(k) choices Professor Ross Miller • Fall 2007

31. GE S&S Program Mutual Fund (GESSX) • A typical stock fund dominated by large-cap U.S. stocks • As a typical stock fund, it tends to underperform the S&P 500 • Includes some bonds and tends to be less risky than the S&P 500 (recent beta = 0.92) • Three stars from Morningstar Professor Ross Miller • Fall 2007

32. GE S&S Income Fund (GESLX) • GE’s bond fund • Tends to hold maturities that average between five and ten years • Four stars from Morningstar Professor Ross Miller • Fall 2007

33. GE Institutional Strategic Investment (GSIVX) • Allocates assets between stocks and investment-grade bonds • Relatively new GE fund • Four stars from Morningstar Professor Ross Miller • Fall 2007

34. GE Institutional International Equity (GIEIX) • Holds mainly large-cap foreign stocks • Guarantees only minimal geographic diversification • Four stars from Morningstar Professor Ross Miller • Fall 2007

35. GE Institutional Small-Cap Equity (GSVIX) • Holdings drawn mainly from the Russell 2000 (a major small-cap index) • Used to be a small-cap value fund • Three stars from Morningstar Professor Ross Miller • Fall 2007

36. GE Money Market (GEMXX) • Run-of-the-mill money market fund • Price fixed at $1 (so it will not be tracked) • Yahoo! gives 7-day yield • Unless you expect a forthcoming disaster, you can eliminate this choice Professor Ross Miller • Fall 2007

37. For Week 10 • Dig up more information on the 401(k) eight choices (including historical pricing data) • You should look at the example for three Vanguard mutual funds Professor Ross Miller • Fall 2007