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FINA 2802: Investments and Portfolio Analysis
Institutional Investing
Dragon Yongjun Tang
January 28 & February 2, 2010
Lecture 6 & 7: Mutual Funds and
other Investment Companies
Reading: Chapter 4
Practice Problem Sets:
1,2,3,4,6,7,8,9,10,12,13,14,18,20,21
2
Managing Your Money
Your portfolio
Do it yourself Delegate to a professional
3
Invest with Warrant Buffet?
4
Learning Objectives
Advantages and disadvantages of investing with
an investment company
Compare open-end mutual funds with closed-end
funds and unit investment trusts
Define net asset value and measure the rate of
return of a mutual fund
Classify mutual funds according to investment
style
Demonstrate the impact of expenses and turnover
on mutual fund investment performance
5
Investment Companies
Functions:
1. Pooling of Assets
2. Diversification
3. Professional management
4. Lower transaction costs (economies of scale)
5. Record keeping
6
Net Asset Value (NAV)
Used as a basis for valuation of investment
company shares
– Selling new shares
– Redeeming existing shares
Calculation
Market Value of Assets - Liabilities
NAV=
Shares Outstanding
7
Investment Companies
Unmanaged
Managed - Securities continually bought and sold
– Open-End
–Redeem Shares at NAV
–Shares Outstanding Varies
– Closed-End
–Fixed number of Shares Outstanding
–Trade on Exchanges like stocks
–Values are different from NAV
8
Types of Investment
Organizations
Unit Trusts
Managed Investment Companies
– Open-End
– Closed-End
Other investment organizations
– Commingled funds
– REITs
– Hedge Funds
9
Unit Investment Trusts
•Fixed portfolio
•Usually fixed-income
•Not actively managed
10
Commingled Funds
• Investment pools
• Offered by a bank or insurance
company
• Used for trust or retirement
account
11
Real Estate Investment Trusts
(REITs)
• Similar to a closed-end mutual fund
• Equity trusts invest in real estate
directly
• Mortgage trusts invest in mortgage or
construction loans
• Highly leveraged
12
Hedge Funds
Not registered, not subject to SEC regulation
(like individual investors)
Open only to wealthy or institutional investors
Highly levered, very sophisticated, “market
neutral” strategies, risky!
- Long-Term Capital Management (LTCM)
- Citadel
13
Open-End and Closed-End Funds:
Key Differences
Shares Outstanding
Closed-end: no change unless new stock is
offered
Open-end: changes when new shares are
sold or old shares are redeemed
Pricing
Open-end: Net Asset Value(NAV)
Closed-end: Premium or discount to NAV
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Figure 4.1 Closed-End Mutual Funds
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Figure 4.2 Listing of Mutual
Fund Quotations
16
Types of Mutual Funds
Investment policies, styles, management
• Money Market funds
• Bond funds - Taxable
- Tax-free
- High-income (junk bonds)
• Stock funds - Aggressive Growth
- Growth
- Growth and income
- Income
• Balanced and income funds
• Specialized sector funds
• Index funds
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Table 4.1 Classification
of U.S. Mutual Funds
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Trading in Mutual Funds
NAV (for open ended) and
Share price (for closed ended) are Quoted Daily
No margin or short positions
(not for Exchange Traded Funds or ETF!)
May have tax disadvantages
19
How Funds Are Sold
Directly marketed
Sales force distributed
Revenue sharing on sales force distributed
– Potential conflicts of interest
Financial supermarkets
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Potential Conflicts of
Interest - Revenue Sharing
Brokers put investors in funds that may that
may not be the most appropriate
Mutual funds could direct trading to higher
cost brokers
Revenue sharing is not illegal but it must be
disclosed to the investor
21
Investment Companies in HK and China
HK:
– the number of retail funds offered to the public has grown from 783
at the end of 1989 to 1,980 in 2007. In value terms, the size of retail
funds has grown 22 times, from HKD283 B to HKD6,154 B
– including exchange-traded funds, index funds, guaranteed funds and
hedge funds
– Can invest in China through QFII
China:
– Industry size RMB3.2T (including HF and PE)
– In June 2007, the CSRC announced that QDII fund management
companies and securities firms are allowed to invest in overseas
– Allow foreign investors since joining WTO
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HK Funds (in US$ million)
Bond Equity Money Guaranteed Hedge Other
As at end 債券基 股票基 Diversified Market Fund of Funds Warrant Index* ** 對沖基 Specialised*** Total
截至 金 金 多元化基金 貨幣市場基金 基金的基金 權證基金 指數基金* 保證基金** 金 其他特別基金*** 總值
12/1997 12,718 100,503 9,586 7,078 591 277 n.a. n.a. n.a. 1,629 132,383
12/1998 28,891 124,840 14,266 12,676 1,036 306 n.a. n.a. n.a. 1,078 183,092
12/1999 31,383 226,861 26,296 11,193 1,227 419 n.a. n.a. n.a. 1,501 298,879
12/2000 44,544 219,934 26,869 15,788 2,529 22 n.a. n.a. n.a. 1,765 311,449
12/2001 48,499 181,547 26,123 12,222 2,283 1.3 5,210 5,780 n.a. 3,545 285,210
12/2002 77,703 143,290 28,842 69,739 2,375 n.a. 7,870 11,734 160 421 342,134
12/2003 112,048 270,582 41,095 81,472 3,863 n.a. 8,139 15,999 405 685 534,288
12/2004 112,486 272,962 38,433 94,540 4,813 n.a. 7,362 18,403 1,174 1,046 551,219
12/2005 147,379 356,731 37,650 92,574 5,528 n.a. 8,970 16,455 1,038 1,260 667,585
12/2006 184,431 510,371 55,033 126,790 6,794 n.a. 11,632 11,838 1,662 1,703 910,254
23
Mutual Funds Expenses
Front-End Load (0%-6.25%)
Back-End Load (5%-6%, decreasing with time)
Operating Expenses (0.2%-2%)
12b-1 Charges (1%)
Soft Dollars
“Fee is the most robust predictor of performance”
24
Table 4.2 Impacts of Costs on
Investment Performance
25
Trading Scandal with
Mutual Funds
Late trading – allowing some investors to
purchase or sell later than other investors
Market timing – allowing investors to buy
or sell on stale net asset values
– International
Net effect is to transfer wealth from existing
owners to the new purchasers or sellers
26
Potential Reforms
Strict 4:00 PM cutoff with late orders
executed the following trading day
Fair value pricing with net asset values being
adjusted for trading in open markets
Imposition of redemption fees
27
Mutual Fund Returns
NAVt 1 - NAVt Income and Cap. Gain Dist.
Rate of Return
NAVt
All NAV’s are net of loads
and other expenses
Mutual Fund Returns
Example: Consider a fund with $100 million in assets at
the start of the year and 10 million shares outstanding.
The fund invests in a portfolio of stocks that provides no
income but that increases in value by 10%. The expense
ratio, including 12b-1 fees, is 1%. What is the rate of
return for an investor in the fund?
29
Problem 11, Chapter 4(p.110)
A closed-end fund starts the year with a net asset value of
$12.00. By year-end, NAV equals $12.10. At the beginning of
the year, the fund is selling at a 7% discount to NAV. The fund
paid year-end distributions of income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the
year?
b. What would have been the rate of return to an investor who
held the same securities as the fund manager during the year?
30
Problem 13, Chapter 4(p.110)
Consider a mutual fund with $200 million in assets at the
start of the year and with 10 million shares outstanding. The
fund invests in a portfolio of stocks that provides dividend
income at the end of the year of $2 million. The stock
included in the fund’s portfolio increase in price by 8%, but
no securities are sold, and there are no capital gains
distributions. The fund charges 12b-1 fees of 1%, which are
deducted from portfolio assets at year-end. What is net asset
value at the start and end of the year? What is the rate of
return for an investor in the fund?
31
Problem 16, Chapter 4(p.110)
You purchased 1,000 shares of the New Fund at a price of
$20 per share at the beginning of the year. You paid a front-
end load of 4%. The securities in which the fund invests
increase in value by 12% during the year. The fund’s
expense ratio is 1.2%. What is your rate of return on the
fund if you sell your shares at the end of the year?
32
Taxes on Mutual Funds
Investor directed portfolios can be structured to
take advantage of taxes while mutual funds cannot
Pass-through of capital gains and dividend income
High turnover (=Amount of Sales/Fund Value)
leads to tax inefficiency
More disclosure on taxes was required in 2000
33
Exchange Traded Funds (ETF)
ETF allow investors to trade index portfolios
like shares of stock
Examples – Spiders, Diamonds, Cubes, Viper,
and Webs
Potential advantages
– Trade continuously
– Lower taxes
– Lower costs
Potential disadvantages
34
Mutual Fund Performance
How can we measure Mutual Fund Performance?
Benchmark Performance
Wilshire 5000
S&P 500
What is the proper benchmark?
How can we disentangle skill from luck?
35
First Look at Mutual Fund
Performance
Evidence shows that average mutual fund
performance is generally less than broad
market performance
Evidence suggests that over certain horizons
some persistence in positive performance
– Evidence is not conclusive
– Some inconsistencies
“Past performance is not necessarily indicative of future results.”
36
Figure 4.3 Percentage of Funds
Below Wilshire 5000
37
Table 4.4 Consistency of
Investment Results
38
Sources of Information
on Mutual Funds
Prospectus, Annual Reports
Morningstar (www.morningstar.com)
Yahoo (biz.yahoo.com/funds)
Wiesenberger’s Investment Companies
Investment Company Institute
Popular press
Investment services
39
Summary
Type of investment companies
Mutual fund expenses
Mutual fund performance
Next Class: Risk and Return
40
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