2. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Investment Companies And Mutual Funds

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline Questions to be answered: What are the different ways that professional asset management firms can be organized? How has the structure of the asset management industry changed over time? How are managers at investment advisory firms compensated?

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline Who manages the investment company portfolio and how are its managers compensated? How do you compute the net asset value (NAV) for an investment company? What is the difference between closed-end and open- end investment companies? What is the difference between the NAV and market price for a closed-end fund?

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline What are load fees, 12b-1 fees, and management fees and how do they influence investment company performance? What are the two major means of fund distribution and what has been the trend for each approach? Given the breakdown of all funds by investment objectives, which groups have experienced relative growth or decline?

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline Given a desire to have a personal portfolio manager perform certain functions for you, how do investment companies help fulfill this need? What are the ethical dilemmas involved in the professional asset management industry? What has been the risk-adjusted performance of mutual funds relative to alternative market indexes?

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Asset Management Industry: Structure and Evolution 1. Contract directly with a management and advisory firm relationship with client assets under management (AUM) separate accounts customized 2. Commingling of investment capital of several clients in an investment company

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. What is an Investment Company? An investment company invests a pool of funds belonging to many individuals in a portfolio of individual investments such as stocks and bonds The total market value of all investments divided by the number of fund shares outstanding is the net asset value (NAV) Portfolio management is handled by an investment management company

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. Types Of Funds Open-End Funds –Mutual funds (MFs) Closed -End Funds –Investment trusts

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. Closed-End Funds Developed in Europe 1820s No Additional Shares Issued Easier to Manage –No liquidity requirement Shares Trade on Secondary Market

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. Pricing Of Closed-End Funds NAV CMP Premium or Discount CMP – NAV NAV = + Premium or - Discount

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. Reasons For Premium Or Discount Unrealized Capital Appreciation Management Fees and Transfer Costs Performance of the Fund Turnover

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. Open-End Funds Load and No-Load Funds Prospectus –Required by law to be provided to investors Family of Funds Growth of Mutual Funds –See next slide

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. Growth Of Mutual Funds (MFs)

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. Growth Of MFs

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. Closed-End Versus Open-End Investment Companies Closed-end investment company –Stock trades on secondary market –Net asset value (NAV) is determined twice daily, but market price determined by supply and demand –Discounts from NAV can be opportunities Closed-end fund index Open-end investment companies –Mutual funds –Sell and repurchase shares at NAV

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. Benefits Of Investing In MFs Diversification Professional Management Reduced Trading Costs Systematic Accumulation and Withdrawal Plans Checking Accounts Switching Fund Services Security Custody and Bookkeeping Increasing an Economy’s Capital Supply

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. Costs Of Investing In MFs Load Management Fees Suboptimal Investment Accounting, Distribution, and Other Costs 12b-1 Fees Transaction Costs Higher Income Tax Rate Disadvantage of Being too Big

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. Mutual Fund Costs Load versus no-load open-end funds –Load funds charge sales commission up to 8.5% of NAV, but usually not a redemption fee –No-load imposes no initial sales charge, so it sells shares at NAV, but may charge a small redemption fee of 1/2% –Low-load imposes a front-end sales charge in the 3% range

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. Types of Investment Companies Based on Portfolio Objectives Common stock funds –General Equity –Specialized Equity –World Equity Balanced funds …

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. Types of Investment Companies Based on Portfolio Objectives Taxable bond funds –Convertible Securities –Dual Purpose –Loan Participations –Bond –World Income Municipal bond funds –National Municipal –Single State Municipal Money market funds

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. Global Investment Companies Foreign funds –International funds –Global funds Fund categories, regions, countries

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. Sources of Information About Mutual Funds The Wall Street Journal Barron’s - weekly and quarterly Investment Companies Mutual Funds Update Mutual Funds Report Closed-end Weekly Review FundEdge Management Results Forbes Business Week - “Mutual Fund Scoreboard” Morningstar Mutual Funds Value Line

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. Ethics and Regulation in the Professional Asset Management Industry Agency - looking out for the interest of another Asset management industry is based on handling someone else’s money Investment Company Act of 1940 Securities Act of 1933 Securities Exchange Act of 1934 Investment Advisors Act of 1940 ERISA (1974) - Prudent man rule

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. Ethics and Regulation in the Professional Asset Management Industry Association for Investment Management and Research (AIMR) has a Code of Ethics and Standards of Professional Conduct Chartered Financial Analyst (CFA) Compensation dilemma - incentives and risk Soft dollars

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. Performance of Investment Companies Below average returns for actively managed equity and bond funds Do a fund’s objectives matter? –Positive relationship between stated objectives and risk measures Do managers generally outperform the market? –Results are more consistent in shorter time periods

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. Your Portfolio Manager 1. Determine your risk-return preferences and develop a portfolio that is consistent with them 2. Diversify your portfolio to eliminate unsystematic risk 3. Maintain your portfolio diversification and your desired risk class while allowing flexibility so you could shift between alternative investment instruments as desired 4. Attempt to achieve a risk-adjusted performance that is superior to aggregate market performance 5. Administer the account, keep records of costs, provide timely information for tax purposes, and reinvest dividends if desired

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio: The Objective  Semantics are important in any statement of investment objectives.  The four main portfolio objectives are stability of principal, income, growth of income, and capital appreciation.  In a world with taxes, one dollar in capital gains is worth more than one dollar in income.  The overriding investment objective is utility maximization.

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. Relative Riskiness of Portfolio Objectives 20 18 16 14 12 10 8 6 4 2 0 expected return standard deviation (%) capital appreciation growth of income 0 6 12 18 24 30 36 income inflation T-bills intermediate- term government bonds long-term government bonds long-term corporate bonds large company stocks small company stocks stability of principal

30. Copyright © 2000 by Harcourt, Inc. All rights reserved.  An asset class refers to a broad category of investments.  U.S. equities, foreign equities, bonds, and cash are four widely used asset classes.  The relative distribution of funds across asset classes is called asset allocation. Structuring a Stock Portfolio : Asset Allocation

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio : Asset Allocation attitude toward risk need for return individual choice stocks bonds real estate cash foreign equities Portfolio ASSET CLASSES asset class mix realized return and risk with the passage of time investment results

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio: Categories of Stock  A blue chip stock usually has a long history of uninterrupted dividends.  Income stocks are those that historically have a higher-than-average payout ratio (the proportion of net income after taxes paid as a dividend).  A cyclical stock is one whose fortune is directly tied to the state of the overall national economy.

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio: Categories of Stock  A defensive stock is largely immune to changes in the economy.  Growth stocks reinvest most of their earnings rather than paying them out as dividends and may be good candidates for above-average returns.  A speculative stock has a high probability of a loss and a small probability of a large profit.  Penny stocks refer to unusually risky, especially inexpensive shares.

34. Copyright © 2000 by Harcourt, Inc. All rights reserved.  A strategy of passive management is one in which, once established, the portfolio is largely left alone.  An active management policy, in contrast, is one in which the composition of the portfolio is dynamic. Structuring a Stock Portfolio : Active vs. Passive Management

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. Index Funds Replicate a Given Index –S&P 500 index Holds No Cash Sell Stock –When investors redeem shares No Telephone Sales Redemption Fee –Time factor

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. Ranking Global Fund Performance Forbes Global Stock Fund Composite Blended Domestic and Foreign Index

37. Portfolio Project Notes: The Portfolio Management Process

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 1. Policy statement - Focus: Investor’s short-term and long- term needs, familiarity with capital market history, and expectations 2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance

39. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 1. Policy statement –specifies investment goals and acceptable risk levels –should be reviewed periodically –guides all investment decisions

40. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trends –determine strategies to meet goals –requires monitoring and updates

41. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 3. Construct the portfolio –allocate available funds to meet goals and minimize investor’s risks

42. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 4. Monitor and update –revise policy statement as needed –modify investment strategy accordingly –evaluate portfolio performance

43. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Need For A Policy Statement Understand and articulate realistic investor goals –needs, objectives, and constraints –financial markets and risks of investing

44. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement What are the real risks of an adverse financial outcome, especially in the short run? What probable emotional reactions will I have to an adverse financial outcome? How knowledgeable am I about investments and markets?

45. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? What, if any, legal restrictions may affect my investment needs? What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?

46. Copyright © 2000 by Harcourt, Inc. All rights reserved. Standards For Evaluating Portfolio Performance Benchmark portfolio –risk and return Matches risk preferences and investment needs –analysis of risk tolerance –return objective goals

47. Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals Capital preservation –minimize risk of real loss –strongly risk-averse or funds needed soon Capital appreciation –capital gains to provide real growth over time for future need –aggressive strategy with accepted risk Current income –generate spendable funds

48. Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals Total return –capital gains and income reinvestment –moderate risk exposure

49. Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints Liquidity needs –near-term goals Time horizon –longer time horizon favors risk acceptability –short time horizon favors less risky investments because losses are harder to overcome in a short time frame

50. Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints Tax concerns –interest and dividends taxed at investor’s marginal tax rate –capital gains may be unrealized –basis and gain or loss realized –revisions to capital gains tax rates –tradeoff with diversification needs for employer’s stock holdings

51. Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints Tax concerns (continued) –interest on municipal bonds exempt from federal income tax and from state of issue –interest on federal securities exempt from state income tax –contributions to an IRA may qualify as deductible from taxable income –tax deferral considerations - compounding

52. Copyright © 2000 by Harcourt, Inc. All rights reserved. Effect of Tax Deferral on Investor Wealth over Time $1,000 Investment Value Time $10,063 $5,365 Figure 2.5

53. Copyright © 2000 by Harcourt, Inc. All rights reserved. Legal and Regulatory Factors Limitations or penalties on withdrawals Fiduciary responsibilities - “prudent man” rule Investment laws prohibit insider trading

54. Copyright © 2000 by Harcourt, Inc. All rights reserved. Unique Needs and Preferences Personal preferences - socially conscious investments Time constraints or expertise for managing the portfolio may require professional management Large investment in employer may require consideration of diversification needs and realistic liquidity Institutional investors needs

55. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing the Policy Statement Objectives - risk and return Constraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences Developing a plan depends on understanding the relationship between risk and return and the importance of diversification

56. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation An investment strategy is based on four decisions –What asset classes to consider for investment –What normal or policy weights to assign to each eligible class –The allowable allocation ranges based on policy weights –What specific securities to purchase for the portfolio

57. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments

58. Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes Higher returns compensate for risk Policy statements must provide risk guidelines Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills

59. Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns Focusing only on return variability ignores reinvestment risk Changes in returns from year to year

60. Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation Summary Policy statement determines types of assets to include in portfolio Asset allocation determines portfolio return more than stock selection Over long time periods sizable allocation to equity will improve results Risk of a strategy depends on the investor’s goals and time horizon

61. Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation and Cultural Differences Social, political, and tax environments U.S. institutional investors average 45% allocation in equities In the United Kingdom, equities make up 72% of assets In Germany, equities are 11% In Japan, equities are 24% of assets

62. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary Develop an investment policy statement –Identify investment needs, risk tolerance, and familiarity with capital markets –Identify objectives and constraints –Investment plans are enhanced by accurate formulation of a policy statement

63. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary Asset allocation determines long-run returns and risk –Success depends on construction of the policy statement