Mutual Funds and Investment Companies

How Much do Investment Companies Own?

OWNERSHIP as a PERCENT of TOTAL MARKET-CAP

Advantages

record keeping and administration

diversification

professional management

lower transaction costs

Investment Companies Investors buy “shares” of the

investment company.

Share is a claim to the stream of cashflows generated by company assets.

Net Asset Value:Net asset value (NAV) =

Market value of assets - Liabilities

Shares outstanding

Mutual Funds

Open-end funds You buy or sell shares directly through the

mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at this

NAV Fund companies adjust the number of

shares according to the demand by investors

Open-End Fund Example 1

Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 0 Shares Outstanding = 900 million NAV = 36B/900M = $40

Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000

Open-End Fund Example 1

4:00pm on Tuesday Asset value is now 36B(1.01)=36.36B NAV = 36.36B/900M=40.4 % change: 40.4/40-1= 1%

New Flows of $500,000 500,000/40.4 = 12,376 shares

New investors buy these shares at 40.4 per share Total shares outstanding = 900M + 12,376 Total Assets = 36.36B + 500,000

Open-End Fund Example 2Adding a Little Leverage

Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 1 billion Shares Outstanding = 900 million NAV = 35B/900M = $38.89

Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000

Open-End Fund Example 2Adding a Little Leverage

4:00pm on Tuesday Asset value is now 36B(1.01)=36.36B NAV = 35.36B/900M=39.29 % Change = 39.29/38.89-1=1.029%

New Flows of $500,000 500,000/39.29 = 12,726 shares

New investors buy these shares at 39.29 per share Total shares outstanding = 900M + 12,726 Total Assets = 36.36B + 500,000

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.

Financial Supermarkets Example: Charles Schwab

Front-End Loads What they are for

Used to pay brokers who sell funds

How they affect price paid NAV of fund: $13 Front End Load: 4% What price do you pay per share?

NAV=96% of price 13=0.96*P P = 13/.96 = 13.54

Fund NAV must increase to 13.54 (4.2%) just to break even, assuming no other fees.

Front End Loads

Another way of looking at front end loads: Assume front-end = 4%

If you invest $1000, only $960 is actually used to buy shares of the fund

The other $40 is gone in fees Your investment must increase to 1000 (4.2%)

just to break even, assuming no other fees

Front End Loads

How they affect returns Fund:

NAV=$10 Front End load of 5% NAV grows by 14% per share each year

Assume you invest $X and hold investment for two years.

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Back End Loads

What they are for Used to pay brokers who sell funds 0 to 6% Usually reduced 1% point for each year you hold

the fund

How they affect price paid They don’t Assuming no other fees, price is NAV

Back End Loads

How they affect price received when sold NAV of fund: $13 Back End Load: 5% What price do you get when you sell the

fund? 13*.95 = $12.35

Back End Loads

How they affect returns Fund:

NAV=$10 Back End load of 5% Fund earns 14% per share each year

Assume you invest $X and hold investment for two years.

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Annual Expenses

Operating expenses What They are for

Used to pay for administrative expenses and advisory fees

12b-1 charges What they are for

Used to pay for advertising, promotional literature, and brokers

Annual Expenses How they affect returns Fund:

NAV=$10 Annual expenses (expense ratio) of 5% Fund earns 14% per share each year

Assume you invest $X and hold investment for two years

Each year gross return net of fees is 1.14 - 0.05 = 1.09

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Summary

Assume: A fund portfolio grows by r each year. The fund has front-end load of f. The fund has back-end load of b. The fund has annual expense ratio of a. No capital gains or distributions

The gross return for an investor in the fund over n periods is

)1(11 ReturnGross br-a)-f)(( n

Example: Fund or CD’s?

Investment Choices: mutual fund,

3% front-end load annual expense ratio of 0.6%.

CD: 5% per year

What return must the fund portfolio earn for you to be better off in the fund than in the CD if you plan to hold the investment for 4 years?

Example: Fund or CD’s?

In 4 years: CD: gross return = (1.05)4

= 121.55% Fund: gross return = .97 (1+r-0.006)4

.97 (1+r-0.006)4 = 1.2155 (1+r-0.006)4 = 1.2155/.97=1.253 1+r =0.006+1.2531/4

r = 6.4%

Mutual Funds

Closed-end funds Fund companies issue a fixed number of

shares You buy or sell shares on an exchange The funds usually trade at a discount of

about 10% relative to NAV per share. Puzzle

Alphas of Actively Managed Funds

Mutual Fund Performance

If momentum and value have given positive alpha over the last 30 years, why haven’t active fund managers been able to capture it?

Average Active Mutual Fund Performance 1975-1994

Russ Wermers, 2000Journal of Finance

ETF

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.

Exchange traded notes are ETFs that buy all securities within a bond index.

Examples of ETFs

SPDRs (S&P 500 Depository Receipts) Cubes (Nasdaq 100) Diamonds (Dow Jones Industrial Average) I-shares (Barclays) HOLDRs (Merrill Lynch) VIPERs (Vanguard) See

http://www.nyse.com/screener/index.php for a complete list

Advantages of ETFs Relative to Mutual Funds

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.

Some Disadvantages of ETF’s

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

Hedge Funds

A private investment pool, open to wealthy or institutional investors.

Not registered as mutual funds and not subject to SEC regulation.

Pursues more speculative policies in liquid assets such as stocks, bonds, currencies, options, and other derivatives.

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.

Hedge Funds vs. Mutual Funds

Mutual Funds Hedge Funds

Investment methods

Buy publicly traded securities. Little use of leverage or short-sales.

Buy also non-public securities, currencies and commodities. Wide use of leverage and short-sales.

Diversification Hold broad mix of assets. Holdings are often concentrated.

Fees Relatively low fees that do not depend on performance

Relatively high fees that depend on performance.

Withdrawls Investors can sell back shares at any time

Investor money is “locked up” for long periods

Regulation Heavy Regulation Light Regulation

Initial investments

Relatively low Very high investments necessary.