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Class Business

Class Business. Homework #2 Example. How Funds are Sold. Fund “underwriter” has exclusive rights to distribute shares of the fund. Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter. Example: Charles Schwab Offers many funds to investors

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Class Business

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  1. Class Business • Homework #2 • Example

  2. How Funds are Sold • Fund “underwriter” has exclusive rights to distribute shares of the fund. • Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter. • Example: Charles Schwab • Offers many funds to investors • When investors buy a “Vanguard” fund through Charles Schwab, Charles Schwab earns a commission.

  3. Mutual Fund Fees • Front-end loads • Used to pay brokers who sell funds • May not exceed 8.5%, rarely higher than 6% in practice • Reduce amount of money invested • Back-end loads • Used to pay brokers who sell funds • 0 to 6% • Operating expenses • Used to pay for admin. expenses and advisory fees • 0.2% to 2% per year

  4. Mutual Fund Fees • 12b-1 charges (0 to 1%) • Used to pay for advertising, promotional literature, and brokers • 0 to 1% per year • Fees for Different Classes of Funds • A: high front end loads • B: 12b-1 and back-end loads • C: just 12b-1 fees • D: front end loads and 12b-1 fees

  5. Mutual Fund Returns • Incorporates 12b-1 fees and operating expenses since these reduce NAV • Ignores front-end loads and back-end loads

  6. Mutual Fund Returns • Start of year (just after annual expenses have been deducted) • Assets (stock portfolio): 400 million • Liabilities: 0 • Shares: 20 million • During Year • Value of portfolio of stocks increases by 3% • End of Year • Portfolio of stocks pays dividend of $30 million • Fund charges 12b-1 fees of 2%

  7. Mutual Fund Returns • NAV at start of year: • 400m/20m= $20 per share • NAV at end of year: • 400(1.03)(.98)/20m =20.19 • Dividends per share: 30m/20m = $1.50 • Return to investor: • (20.19-20 + 1.50)/20 = 8.45%

  8. Mutual Fund Returns • Suppose fund has front-end load of 6% • What do you pay for one share of the fund? • Front-end loads reduce the amount of money that goes towards the purchase of shares. 20 = Price(0.94) implies Price = $21.28 • What is the return on the fund after one year? • Return to investor: • (20.19 – 21.28 + 1.50)/21.28 = 1.9%

  9. Taxation of Mutual Funds • Mutual fund have “pass-through status.” • Taxes on capital gains, dividends, and interest income are paid only by the investor and not by the fund itself. • Funds must distribute 90% of all income to shareholders. • Funds must satisfy some diversification requirement. • Investors cannot determine when to sell, nor the frequency of turnover. • Funds with higher turnover impose higher tax costs on fund holders. • These costs are irrelevant if fund is held in an IRA or 401(k) account

  10. Current Mutual Fund Issues • Late Trading - illegal • Market Timing – current debate • Conflicts of Interest • Directed Brokerage • Mutual Funds steer trades to brokerage • In return, brokerage house promotes fund • SEC voted to ban the practice August 2004

  11. The Largest Mutual Funds (February 28, 2003)

  12. Mutual Fund Performance • Most actively-managed funds do not beat market indices. Source: Malkiel (2003)

  13. Mutual Fund Performance • There is not much persistence in mutual fund performance. • How well did the top 20 Equity Fund in the 1980s perform in the 1990s?

  14. Spiders, Vipers, Diamonds, … • Exchange-Traded Funds (ETFs) are unit investment trusts that will primarily hold securities that are in a market index. • Investors have the right to exchange their shares for the underlying securities of the fund. • Examples: • SPDRs (S&P 500 Depository Receipts) • Cubes (Nasdaq 100) • Diamonds (Dow Jones Industrial Average) • I-shares (Barclays) • VIPERs (Vanguard) • Others, see Amex.com

  15. Advantages of ETFs Relative to Mutual Funds • Advantages: • ETFs can be bought and sold anytime like regular stocks at real-time prices. • ETFs can be sold short. • ETFs have relatively low fees. • ETFs are relatively tax-efficient. • Disadvantages • Prices can move away slightly from NAV • Open-End Mutual funds are always purchased at NAV • Pay the bid-ask spread when trading an ETF

  16. Hedge Funds • A private investment pool, open to wealthy or institutional investors. • Minimum investment at least $1million (by law) • Not registered as mutual funds and not subject to SEC regulation. • Pursues more speculative policies. • Name comes from the fact that hedge funds want to create market-neutral strategies by going long in some assets and going short in related assets.

  17. Hedge Funds vs. Mutual Funds

  18. Other Investment Companies Real estate investment trusts (REITS) • closed-end fund that holds real estate assets • some hold properties directly - usually have 70% debt • some hold mortgages on properties • exempt from taxes as long as 95% of taxable income is distributed

  19. Chapter 17: Investors and the Investment Process • Specify objectives • Identify constraints • Formulate an investment policy • Monitor performance • Reevaluate and modify portfolio as determined from monitoring

  20. Specifying Objectives: Individual Investors • Balance risk and return • Life Cycle is critical to the process of determining the risk/return trade-off • Investment Horizon and risk

  21. Specifying ObjectivesInstitution Perspective • Personal Trusts • Determined by the individual for whom the funds are being managed • Mutual Funds • Varies with type of fund • Detailed in the prospectus • Pension Funds • Defined contribution - shifted to the individual • Defined benefit - depends on average time to retirement of individuals • Endowment Funds • Gifts to nonprofits are invested • Funds from the endowment used by the nonprofit

  22. Specifying ObjectivesInstitution Perspective contd. • Life Insurance Companies • Investments are hedged against potential claims of policy holders • Banks • Sources of funds: deposits and borrowed funds • Investment of funds: predominately in loans and fixed income securities • Active in the securitized loan and asset markets • Not active in equity except in the Trust Function

  23. Investor Constraints • Liquidity - speed and ease with which an asset can be converted into cash • Investment Horizon - the planned liquidation date • Regulations - specific regulations that may apply to the investor • Prudent Investor Rule • Mutual Fund Diversification • Charitable contribution limits • Tax Considerations - special considerations related to tax position of the investor • Other Unique Needs- special considerations related to the underlying investors • Diversification requirements related to employment

  24. Investment Policy: Asset Allocation Decision Individual - depends on life cycle Younger Higher equity 75% Lower safe assets 25% Older Lower equity 40% Higher safe assets 60% Institutional - depends on objectives Example - an all stock mutual fund would want nearly 100% in stock Sector or Region allocations

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