1. FINA 2802: Investments and Portfolio Analysis Institutional Investing Dragon Yongjun Tang January 28 & February 2, 2010

2. 2 Lecture 6 & 7: Mutual Funds and other Investment Companies Reading: Chapter 4 Reading: Chapter 4 Practice Problem Sets: 1,2,3,4,6,7,8,9,10,12,13,14,18,20,21 Practice Problem Sets: 1,2,3,4,6,7,8,9,10,12,13,14,18,20,21

3. 3 Managing Your Money Your portfolio Do it yourself Delegate to a professional

4. 4 Invest with Warrant Buffet?

5. 5 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

6. 6 Functions: 1.Pooling of Assets 2.Diversification 3.Professional management 4.Lower transaction costs (economies of scale) 5.Record keeping Investment Companies

7. 7 Net Asset Value (NAV) Used as a basis for valuation of investment company shares Used as a basis for valuation of investment company shares –Selling new shares –Redeeming existing shares Calculation Market Value of Assets - Liabilities Market Value of Assets - Liabilities Shares Outstanding Shares Outstanding NAV=

8. 8 Investment Companies Unmanaged Unmanaged Managed - Securities continually bought and sold 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

9. 9 Types of Investment Organizations Unit Trusts Unit Trusts Managed Investment Companies Managed Investment Companies –Open-End –Closed-End Other investment organizations Other investment organizations –Commingled funds –REITs –Hedge Funds

10. 10 Unit Investment Trusts Fixed portfolio Usually fixed-income Not actively managed

11. 11 Commingled Funds Investment pools Offered by a bank or insurance company Used for trust or retirement account

12. 12 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

13. 13 Hedge Funds Not registered, not subject to SEC regulation (like individual investors) Not registered, not subject to SEC regulation (like individual investors) Open only to wealthy or institutional investors Open only to wealthy or institutional investors Highly levered, very sophisticated, “market neutral” strategies, risky! Highly levered, very sophisticated, “market neutral” strategies, risky! - Long-Term Capital Management (LTCM) - Citadel - Citadel

14. 14 Open-End and Closed-End Funds: Key Differences Shares Outstanding Shares Outstanding Closed-end: no change unless new stock is offered Closed-end: no change unless new stock is offered Open-end: changes when new shares are sold or old shares are redeemed Open-end: changes when new shares are sold or old shares are redeemed Pricing Pricing Open-end: Net Asset Value(NAV) Open-end: Net Asset Value(NAV) Closed-end: Premium or discount to NAV Closed-end: Premium or discount to NAV

15. 15 Figure 4.1 Closed-End Mutual Funds

16. 16 Figure 4.2 Listing of Mutual Fund Quotations

17. 17 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

18. 18 Table 4.1 Classification of U.S. Mutual Funds

19. 19 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

20. 20 How Funds Are Sold Directly marketed Directly marketed Sales force distributed Sales force distributed Revenue sharing on sales force distributed Revenue sharing on sales force distributed –Potential conflicts of interest Financial supermarkets Financial supermarkets

21. 21 Potential Conflicts of Interest - Revenue Sharing Brokers put investors in funds that may that may not be the most appropriate Brokers put investors in funds that may that may not be the most appropriate Mutual funds could direct trading to higher cost brokers Mutual funds could direct trading to higher cost brokers Revenue sharing is not illegal but it must be disclosed to the investor Revenue sharing is not illegal but it must be disclosed to the investor

22. 22 Investment Companies in HK and China HK: 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: 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

23. 23 HK Funds (in US$ million) As at end 截至 Bond 債券基 金 Equity 股票基 金 Diversified 多元化基金 Money Market 貨幣市場基金 Fund of Funds 基金的基金 Warrant 權證基金 Index* 指數基金 * Guaranteed ** 保證基金 ** Hedge 對沖基 金 Other Specialised*** 其他特別基金 *** Total 總值 12/199712,718100,5039,5867,078591277n.a. 1,629132,383 12/199828,891124,84014,26612,6761,036306n.a. 1,078183,092 12/199931,383226,86126,29611,1931,227419n.a. 1,501298,879 12/200044,544219,93426,86915,7882,52922n.a. 1,765311,449 12/200148,499181,54726,12312,2222,2831.35,2105,780n.a.3,545285,210 12/200277,703143,29028,84269,7392,375n.a.7,87011,734160421342,134 12/2003112,048270,58241,09581,4723,863n.a.8,13915,999405685534,288 12/2004112,486272,96238,43394,5404,813n.a.7,36218,4031,1741,046551,219 12/2005147,379356,73137,65092,5745,528n.a.8,97016,4551,0381,260667,585 12/2006184,431510,37155,033126,7906,794n.a.11,63211,8381,6621,703910,254

24. 24 Mutual Funds Expenses Front-End Load (0%-6.25%) Front-End Load (0%-6.25%) Back-End Load (5%-6%, decreasing with time) Back-End Load (5%-6%, decreasing with time) Operating Expenses (0.2%-2%) Operating Expenses (0.2%-2%) 12b-1 Charges (1%) 12b-1 Charges (1%) Soft Dollars Soft Dollars “Fee is the most robust predictor of performance”

25. 25 Table 4.2 Impacts of Costs on Investment Performance

26. 26 Trading Scandal with Mutual Funds Late trading – allowing some investors to purchase or sell later than other investors 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 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 Net effect is to transfer wealth from existing owners to the new purchasers or sellers

27. 27 Potential Reforms Strict 4:00 PM cutoff with late orders executed the following trading day 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 Fair value pricing with net asset values being adjusted for trading in open markets Imposition of redemption fees Imposition of redemption fees

28. Mutual Fund Returns All NAV’s are net of loads and other expenses

29. 29 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? 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?

30. 30 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?

31. 31 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?

32. 32 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?

33. 33 Taxes on Mutual Funds Investor directed portfolios can be structured to take advantage of taxes while mutual funds cannot Investor directed portfolios can be structured to take advantage of taxes while mutual funds cannot Pass-through of capital gains and dividend income Pass-through of capital gains and dividend income High turnover (=Amount of Sales/Fund Value) leads to tax inefficiency High turnover (=Amount of Sales/Fund Value) leads to tax inefficiency More disclosure on taxes was required in 2000 More disclosure on taxes was required in 2000

34. 34 Exchange Traded Funds (ETF) ETF allow investors to trade index portfolios like shares of stock ETF allow investors to trade index portfolios like shares of stock Examples – Spiders, Diamonds, Cubes, Viper, and Webs Examples – Spiders, Diamonds, Cubes, Viper, and Webs Potential advantages Potential advantages –Trade continuously –Lower taxes –Lower costs Potential disadvantages Potential disadvantages

35. 35 Mutual Fund Performance How can we measure Mutual Fund Performance? Benchmark Performance Benchmark Performance Wilshire 5000 Wilshire 5000 S&P 500 S&P 500 What is the proper benchmark? What is the proper benchmark? How can we disentangle skill from luck? How can we disentangle skill from luck?

36. 36 First Look at Mutual Fund Performance Evidence shows that average mutual fund performance is generally less than broad market 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 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.”

37. 37 Figure 4.3 Percentage of Funds Below Wilshire 5000

38. 38 Table 4.4 Consistency of Investment Results

39. 39 Sources of Information on Mutual Funds Prospectus, Annual Reports Prospectus, Annual Reports Morningstar (www.morningstar.com) Morningstar (www.morningstar.com) Yahoo (biz.yahoo.com/funds) Yahoo (biz.yahoo.com/funds) Wiesenberger ’ s Investment Companies Wiesenberger ’ s Investment Companies Investment Company Institute Investment Company Institute Popular press Popular press Investment services Investment services

40. 40 Summary Type of investment companies Type of investment companies Mutual fund expenses Mutual fund expenses Mutual fund performance Mutual fund performance Next Class: Risk and Return Next Class: Risk and Return