1. Personal Investing 2 Market Efficiency Indexes and Index Funds Mutual Funds Fixed Income Securities

2. Personal Investing 22 Efficient Market Hypothesis  Definition  Prices of securities fully reflect all available information about these securities  Question  Is it worth going after a $100 bill you find while walking down a busy street?

3. Personal Investing 23 Random Walk Hypothesis  Tracing the evolution of several economic variables  predict stock prices?  Kendall (1953)  no predictable patterns  Random Walk  Stock prices are random  More precisely  Expected return is positive over time  Positive trend and random around the trend

4. Personal Investing 24 Random Walk Hypothesis  Positive Trend with random fluctuation Time SecurityPrices

5. Personal Investing 25 Efficient Markets and Random Walk  Stock prices fully and immediately reflect all available information  Once information becomes available, market participants analyze it  Competition assures that prices reflect all available information

6. Personal Investing 26 Implications of EMH  Passive Investing beats Active Investing  Index Funds and Buy-and-Hold strategy are best!  Role of Investment Advisors and Portfolio Management:  Diversification  Idiosyncratic risk should be diversified away at a minimal cost  Appropriate risk level  Provide the systematic risk level that investors can tolerate  Tax considerations  Growth vs Income stocks, munis vs Treasuries  Other considerations

7. Personal Investing 27 Indexes: Equity and Bond  What are they?  An indicator of average security prices  Why do we need them?  Tracking market returns  Benchmarking fund manager performance  Bases for derivatives, e.g., index options  Factors affecting an index  Representative?  Weighting of components?

8. Personal Investing 28 Equity Indexes  DJIA  S&P 500, S&P Mid Cap.  NASDAQ 100  Nikkei 225 (Tokyo Stock Exchange)  FTSE 100 (London)  Wilshire 5000  MSCI-EAFE Index  Morgan Stanley Capital International Europe, Australia, Far East Index (including 21 developed countries outside North America)

9. Personal Investing 29 Equity Indexes: DJIA  Some facts  30 industrial stock price-weighted average.  Oldest and best-known in the U.S.  Used to representing about a quarter of the market value of the NYSE stocks.  Quantitatively  Divisor changes when stock splits or stock is replaced by another

10. Personal Investing 210 Equity Indexes: DJIA  Construction  Suppose DJIA has two stocks Divisor

11. Personal Investing 211 Equity Indexes: DJIA  What happens when a stock splits?  At market close today, B has a 2-for-1 split  Where does the new divisor come from? Divisor

12. Personal Investing 212 Equity Indexes: S&P 500  Including 500 NYSE, Amex, NASDAQ stocks  Considered to be a much broader index of the U.S. market than the DJIA  Numerous financial products derived from the index  Mutual funds indexed to the S&P 500 Index  S&P Depository Receipts (SPDR)  S&P 500 Index Options and Futures  Market value-weighted index – larger companies have more weight in S&P 500

13. Personal Investing 213 Equity Indexes: S&P 500  Market value-weighted index - Calculation

14. Personal Investing 214 Equity Indexes: S&P 500  When does the divisor change?  NOT for stock split  YES for stock replacement in the index  E.g., C replaces B in the index Divisor

15. Personal Investing 215 Example: Amazon.com joining S&P 500 AMZN joins S&P 500 on Nov 18, 2005 Announcement is made after market closing on Nov 14, 2005

16. Personal Investing 216 Equally Weighted Indexes  Equally Weighted Stock Indexes Equally weighted stock indexes place equal weight on each stock return, and call for a portfolio strategy that places equal dollar values in each stock.  E.g. Stock A has a return of 2% and stock B has a return of 1%. An equally weighted index of A and B has a return of 0.5*2% + 0.5*1% = 1.5%  Real life example:  Guggenheim S&P 500 ® Equal Weight ETF (see LINKS) Guggenheim S&P 500 ® Equal Weight ETF  Constant portfolio rebalancing is required to track such an index!

17. Personal Investing 217 Bond Indexes  An indicator for bond market returns * Now Barclays Capital Aggregate Bond Index

18. Personal Investing 218 Mutual Funds - Basics  What is a Mutual Fund?  Financial intermediaries that invest on behalf of individual investors  Why Mutual Fund?  Diversification and divisibility  Fractional shares yet many different securities  Professional management  Portfolio managers and security analysts  Lower transaction costs  Large block trade, reduced commissions and fees  Record keeping and administration  Status report about distribution, dividends, etc.

19. Personal Investing 219 Mutual Funds - Basics  Net Asset Value (NAV)  A basis for valuation of shares in investment companies  Same as an open fund’s market value Individual investors Investment company Assets Liabilities Shares

20. Personal Investing 220 Basics  An Example  A mutual fund manages a portfolio of securities worth $120 million. It owes $4 million to its investment advisors and another $1 million to various suppliers of office products. The fund has 5 million shares. What is the Net Asset Value?  Answer

21. Personal Investing 221 Types: Open-End Funds  Managed investment company  Investors can invest/divest in the fund by cashing in/out at NAV (at the day’s closing prices)  Market price = NAV: sold at par  Dominant type of investment: over 90%  Assets under management: nearly $12 trillion by 2011 Individual investors Redeemable shares Fund’s board of directors Management company Assets Liabilities

22. Personal Investing 222 Types: Investment Policies  Money market funds  Specializing in money market securities  Equity Funds  Fixed Income Funds  Treasury, corporate, high yield bonds Current income Capital appreciation Maximum Capital Gains Growth Growth and Income Income Income and Security Risk

23. Personal Investing 223 Types: Investment Policies  Balanced and Income Funds  Fixed % equities and fixed-income securities  Asset Allocation Funds  Variable % equities and fixed-income securities  Market timers  Specialized Sector Funds  Internet, biotech, pharmaceuticals, etc.  Index Funds  Tracking S&P500, DJIA, etc.  Global Funds  Invest in securities of other countries

24. Personal Investing 224 Open-End Funds – Strategies  Can not use leverage  Can not use short sales  Can not use fast turnover  Must receive less than 30% of the gross income from the sale of securities held less than 3 months  What can they do?

25. Personal Investing 225 Costs: Sales Load  Front-end load (“entrance fee”)  A commission or sales charge  Not to exceed 8.5%  Low load funds: 1-3%  Back-end load (“exit fee”)  A redemption fee  Contingent deferred sales charges  5-6% with 1% sliding down per year

26. Personal Investing 226 Costs: Operating Expenses  Administrative expenses  Investment advisory fees  Range from 0.2% to 2% of asset value  12b-1 charges  Commissions to brokers, distribution costs  Up to 1%  Payment of expenses  No explicit bill for operating expenses  Automatic deduction from fund assets

27. Personal Investing 227 Costs: Example  $10,000 each invested in fund A, B, C. Each fund has 12% before-tax return out of which 5% is dividend yield. How much money you have in each fund after a year?  Results  A: $10,000×[1+(.12–.005)] = $11,150  B: $10,000×[1+(.12–.01–.005)]= $11,050  C:(10,000–800)×[1+(.12–.005–.08×.05)]=$10,221  Dividend reinvestment subject to front-end load

28. Personal Investing 228 Taxation  “Pass-through” Status  Investors responsible for paying taxes  Investors lose tax-timing options  Turnover rate  Ratio of total trading volume to asset value  Higher turnover ratio, higher tax liability  E.g. e-Tech fund has asset value of $100 million, over the last year. It sold $60 million of old stocks and bought the same amount of new stocks. What is the turnover ratio?  Turnover ratio = 60/100 = 60%

29. Personal Investing 229 Taxation  Example  An investor’s asset is $1M. In the year, he sells 1K shares of Microsoft at $80, and 2K shares of Ford at $40. He then buys 1.6K shares of IBM at $100  What’s the portfolio’s turnover rate?  If the purchase price for Microsoft and Ford are $70 and $35, and the investor has 28% tax rate, what’s his tax liability?  Answer:  Trading volume = 1,000×80+2,000×40=$160,000  Turnover rate = Trading vol./Asset = 160,000/1MM=16%  Profit = 1,000×(80-70)+2,000×(40-35)=$20,000  Tax = 20,000×28% = $5,600

30. Personal Investing 230 Closed-End Funds (CEFs)  Managed investment company  Investors invest/divest in the fund by buying/selling the company shares Individual investors Non-redeemable shares Fund’s board of directors Management company Assets Liabilities Exchange listed

31. Personal Investing 231 CEFs - NAV vs. Price  Market price of shares on an exchange is determined by  relative supply and demand of shares on the market  general market and economic conditions  other factors beyond our control  Market price of CEF shares could be at, above, or below their NAV?  Closed-End Fund Puzzle  IPO price > NAV: sold at premium  Secondary market price < NAV: sold at discount

32. Personal Investing 232 CEFs – Snapshot Fund NAVMkt PricePrem/Disc %52 Wk Return % Adams Express Company (ADX) 12.8911.11−13.8126.13 Advent/Clay Enhcd G&I (LCM) 12.1611.58−4.7723.52 BlackRock Equity Div (BDV) 10.6510.03−5.8227.39 BlackRock Str Eq Div Achv (BDT) 11.810.68−9.4926.17 Cohen & Steers CE Oppty (FOF) 14.6413.46−8.0625.17 Cohen & Steers Dvd Mjrs (DVM) 14.7013.82−5.9949.28 Eaton Vance Tax Div Inc (EVT) 18.7517.19−8.3229.89 Gabelli Div & Inc Tr (GDV) 18.6416.58−11.0543.52 Gabelli Equity Trust (GAB) 6.086.100.3348.48 General Amer Investors (GAM) 32.7128.26−13.6030.93 Guggenheim Enh Eq Inc (GPM) 9.589.650.7338.93

33. Personal Investing 233 CEFs – Issuers and Resources  CEFs are issued or sponsored by many financial companies, e.g.  BlackRock  Eaton Vance  ING  Nuveen  PIMCO  Vanguard  http://www.cefconnect.com/ – comprehensive CEF resource site sponsored by Nuveen Investments http://www.cefconnect.com/

34. Personal Investing 234 Example: Nuveen New York Performance Plus Municipal Fund  Nuveen New York Performance Plus Municipal Fund is a closed-end, diversified management investment company. The Fund seeks current income exempt from regular Federal as well as New York State and New York City income tax.  The Fund may engage in financial futures and options in order to hedge its portfolio.  The Fund may leverage up to 35% of its capital through the issuance of preferred stock. This fund uses leverage to seek to enhance the income produced for common shareholders through the issuance of short-term preferred shares. The proceeds from the sale of the preferred shares can be used to purchase additional long-term bonds.  This fund is composed of quality municipal bonds - those rated investment grade (BBB/Baa or better at the time of purchase) by either Moody's Investor Service or Standard & Poor's Corporation, or those found by fund's investment adviser to be of equivalent credit quality.  This fund is designed to pay monthly dividends free from regular federal and state income taxes.  Dividends can be reinvested automatically. There may be a nominal charge associated with reinvestment.  Shareholders who choose not to reinvest will receive monthly dividend checks, and will also receive a check for any capital gains distributions.  This fund is actively managed with no fixed term.

35. Personal Investing 235 Example: Nuveen New York Performance Plus Municipal Fund  Portfolio Manager:Scott Romans  NYSE Symbol:NNP  NASDAQ Symbol:XNNPX  Cusip Number:67062R104  Inception Date:11/16/1989  Inception NAV:$14.05  Inception Share Price:$15.00  Total Net Assets as of 12/6/2013 :$310.293M  Share Price as of 12/6/2013 :$13.03  NAV as of 12/6/2013 :$14.70  Premium/Discount as of 12/6/2013 : -11.36%

36. Personal Investing 236 Open-End vs. Closed-End Funds Key Differences  Shares Outstanding  Closed-end: No change unless new stock offered  Open-end: Changes when new shares are sold or old shares are redeemed  Pricing  Open-end: Fund share price = NAV  Closed-end: Fund share price may trade at premium or discount to NAV

37. Personal Investing 237 Mutual Fund Resources  Prospectus  Investment objectives and policies  Fee structure  Morningstar (web or Fund Sourcebook) Morningstar  Yahoo Finance (market data => mutual fund) Yahoo Finance  Performance  Expense ratio  Minimal initial investment  Turnover rate  Manager  Top holdings

38. Personal Investing 238 Performance  How well mutual funds fare?  Evidence  On average, equity fund outperforms money market as compensation for investment risk.  Benchmark: Wilshire 5000, S&P500, etc  You can buy and hold index at very low cost (~18bp)  Vanguard S&P 500 or Total stock market fund  Risk adjustment: beta risk, factor risk, etc  Higher return does not mean a fund is better, risk has to be factored in to evaluate a fund performance.

39. Personal Investing 239 Performance  Historical comparison (1980 - 2005)*  S&P 500 – 12.3% average yearly return  Average Mutual Fund - 10% average yearly return  Historical comparison (1971 - 2010)**  Wilshire 5000 – 10.3% average yearly return  Average Mutual Fund return was 0.8% lower than Wilshire 5000  Consensus: passive equity fund (indexed) outperforms active managed funds * The Economist, Feb 28, 2008 ** BKM, 9 th ed.

40. Investments 640 Performance

41. Personal Investing 241 Performance – Hot Hands  Hot Hands  Generally mixed evidence  What do we learn from the exceptions?  Warren Buffet  Peter Lynch  George Soros

42. Investments 642 Performance – Past and Future

43. Personal Investing 243 Performance – Past and Future

44. Personal Investing 244 Persistence of Mutual Fund Performance Carhart (1997, JF) - not much of a long term persistence!

45. Personal Investing 245 Other Investment Organizations  Hedge Funds  Private speculative investment pool, exempt from SEC regulation  Unit Investment Trusts  Money pooled from many investors is invested in portfolio fixed for life of fund  Commingled Funds  Partnership of investors pooling funds; designed for trusts/larger retirement accounts to get professional management for fee  Real Estate Investment Trusts (REITs)  Similar to closed-end funds, invests in real estate/real estate loans

46. Personal Investing 246 Hedge Funds  Strategies  No restrictions  Objectives  Arbitrage  To achieve absolute returns  Usually market- neutral (market- hedged) positions  Check this out:  www.hedgeindex.com www.hedgeindex.com

47. Personal Investing 247 Unit Investment Trusts  Pools of money invested in a portfolio that is fixed for the life of the fund  Who are they?  Fixed-income portfolios (90% of UITs)  Tax-exempt debt portfolios (90% of fixed-income portfolio)  Unmanaged funds (e.g. SPDR or “Spider”) Individual investors Sponsor Brokerage Company Assets Liabilities Redeemable trust certificates Trust

48. Personal Investing 248 Unit Investment Trusts  What’s in for the sponsors  Sell trust shares at a premium over NAV  An Example  A trust purchases $5 million of assets. It then sells 5,000 shares to the public at a price of $1,030 per share. What is the premium?  Answer

49. Personal Investing 249 Recent Developments - ETFs  Exchange-Traded Funds (ETFs)  Funds that allow investors to trade index portfolios  Examples:  “Spiders,” “Diamonds,” and “Cubes” “Spiders,” “Diamonds,” and “Cubes”  Spiders - the first index ETF started in 1993 Spiders  iShares by BlackRock iShares  Market Vectors by Van Eck Global Market Vectors

50. Personal Investing 250 ETFs – Sponsors and Products

51. Personal Investing 251 ETFs – Pros and Cons  Potential Advantages  Trade continuously throughout day like stocks  Can be sold short or purchased on margin  Lower costs (no marketing, lower fund expenses)  Potentially lower tax rates  Potential Disadvantages  Small deviations from NAV possible  Brokerage commission to buy ETF

52. Personal Investing 252 Growth of U.S. ETFs over Time

53. Personal Investing 253 Growth of U.S. ETFs over Time

54. Personal Investing 254 Where are We Now?  Investment Company Assets Under Management, 2011 ($ Billion)

55. Personal Investing 255 Fixed-Income Securities  Publicly Issued  Treasury Notes and Bonds  Agency Issues (Federal Government)  Municipal Bonds  Federal tax exemption  Local and state tax exemption for state residents  Privately Issued  Corporate Bonds  Mortgage-Backed Securities

56. Personal Investing 256 Fixed-Income Securities  What are they?  A security promising full payment of coupon and principal according to a fixed time schedule  E.g., A 10 year $10,000 T-note with 6¼% coupon  Three Prominent Characteristics  Principal  Face value of a bond  Interest  Coupon of a bond  Maturity  Life span of a bond

57. Personal Investing 257 Source of Risks  Interest Rate Risk (Market Risk)  The major factor affecting bond prices  The price of bond changes in the opposite direction of interest change  All bonds are exposed  Inflation Risk  Inflation reduces purchasing power  Yield changes to reflect the expected inflation  Reinvestment Risk  No guarantees that coupon payments could be reinvested at the same rate

58. Personal Investing 258 Source of Risks  Credit Risk  Inability of issuer to pay coupon and/or principal  Corporate, Emerging market and high-yield bonds  Credit linked debt securities, credit derivatives  Liquidity Risk  Inability to unload position without substantial loss  Municipal, Corporate, and Emerging market bond  FX Risk  The risk of exchange rate fluctuation in reducing the return on a foreign bond

59. Personal Investing 259 Source of Risks – Foreign Bonds

60. Personal Investing 260 Rearview Mirror

61. Personal Investing 261 Rearview Mirror

62. Personal Investing 262 Bond Prices and Yields Price Yield

63. Investments 1563 Price Sensitivity to Interest Rates  Although 1-yr and 30-yr interest rates are closely correlated…

64. Investments 1564 Price Sensitivity to Interest Rates 1-yr and 30-yr bond prices display drastically different interest rate sensitivity!

65. Personal Investing 265 Debt Classes: Definition  Bond (Fixed Income Security)  A security obligating issuer to pay interest and principal to the holder on specified dates.  Coupon Interest rate, e.g. 4%, 5 3/4%, etc.  Face/par value or Principal amount, e.g. $100 MM, $3B.  Maturity, e.g. 3 month, 1 year, 30 years, etc.  Bond can be classified according to its attributes  Payment type, e.g. semi-annual coupon, amortizing, etc.  Issuer, e.g. government, agency, corporate, etc.  Maturity, e.g. short, medium, long, etc.  Security, e.g. secured, unsecured debenture, etc.

66. Personal Investing 266 Debt Classes: Payment Type  Pure Discount or Zero-Coupon Bond  No coupon payments prior to maturity.  Bond’s face value paid at maturity.  Coupon Bond  A stated coupon paid periodically prior to maturity.  Bond’s face value paid at maturity.  Perpetual (Consol) Bond  A stated coupon paid at periodic intervals.  Self-Amortizing Bond  Certain amount paid at each payment period.  No balloon payment at maturity.

67. Personal Investing 267 Debt Classes: U.S.Treasuries  Treasury Bills  maturity  1 year when issued  typically 3 months and 6 months  pure discount bond, no coupon  Treasury Notes  Maturity: 1 year  maturity  10 years when issued  Typically, 2, 3, 5, and 10 year  Coupon: semi-annual  Treasury Bonds  Maturity: >10 years when issued  Typically, 20, 30 (last issued Feb 15, 2001)  Coupon: semi-annual

68. Personal Investing 268 Debt Classes: U.S.Treasuries  Treasury STRIPS are zero-coupon securities that are made by “stripping” coupons or principals from Government Notes and Bonds.  Treasury Strips are issued under the U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) program.  Prices of Notes, Bonds, and STRIPS are quoted as prices per $100 of face value. Prices of Bills are quoted in terms of rate of discount.

69. Personal Investing 269 Debt Classes: Municipal Bonds  Municipal Bonds  Maturity varies from one month to 40 years  Exempt from federal taxes and state taxes (for residents of issuing state)  Generally two types:  Revenue bonds  backed by the revenue of a particular project  e.g. water bond  General Obligation bonds  backed by the tax revenue of local government  e.g. school bond  Riskier than U.S. Government bonds

70. Personal Investing 270 Debt Classes: Corporate Bonds  Secured Debt (backed by collateral assets)  Secured by real property  Property reverts to bondholder upon default  Subordinate Debenture  General creditors subordinate to secured debt  Higher priority over stockholders  Other Features of corporate bonds (optional)  Convertible bonds: convertible to equity  Callable bonds: issuer’s right to buys back bond  Putable bonds: holder’s right to sell bond to issuer  Sinking funds: reduced face amount over time

71. Personal Investing 271 Corporate Bonds – Default Risk  One of the biggest differences between Corporate Bonds and U.S. Treasury Bonds is the default risk on corporate bonds  Corporate bonds are rated on the basis of their default risk by a few rating companies

72. Personal Investing 272 Factors Used by Rating Companies  Coverage ratios  Leverage ratios  Liquidity ratios  Profitability ratios  Cash flow to debt  Effects of bond covenants

73. Personal Investing 273 Corporate Bonds – Default Ratings Rating Companies  Moody’s Investor Service  Standard & Poor’s  Fitch Rating Categories  Investment grade  Aaa, Aa, A, Baa by Moody’s ratings  AAA, AA, A, BBB by S&P ratings  Speculative grade or “Junk” bonds  Rated below Baa by Moody’s and BBB by S&P

74. Personal Investing 274 Debt Classes: Corporate Bonds  Credit Rating

75. Personal Investing 275 Average One-Year Credit Loss Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

76. Personal Investing 276 Ratings and Average Time to Default Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006 Original Rating Average # of Years from Original Rating to Default AAA8.0 AA9.5 A8.5 BBB6.5 BB4.8 B3.6 CCC3.3

77. Personal Investing 277 Mean and Median Recovery Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

78. Personal Investing 278 Protection Against Default  Sinking funds  Subordination of future debt  Dividend restrictions  Collateral

79. Personal Investing 279 Bond Provisions  Call Provision allows the issuer to repurchase the bond at a specified call price before the maturity date  Put Provision allows a bondholder to reclaim a principal, or to extend bond’s life  Convertible Provision allows a bondholder to exchange a bond for common stock  Typically are callable as well  Secured Bonds have specific collaterals for bonds  Sinking Funds guarantee gradual repurchase of corporate bonds by the issuer  Floating Rate Bonds have interest payments tied to some measure of current market rates

80. Personal Investing 280 Bond Resources  WSJ - Bonds WSJ - Bonds  Yahoo – Bonds Yahoo – Bonds  Bloomberg - Bonds Bloomberg - Bonds  Lehman Brothers Bond Indices (what’s left of them…) Lehman Brothers Bond Indices  www.investinginbonds.com www.investinginbonds.com  PIMCO - Everything You Need to Know About Bonds PIMCO - Everything You Need to Know About Bonds