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

FINA 2802: Investments and Portfolio FINA 2802: Investments and Portfolio AnalysisAnalysis

Institutional InvestingInstitutional Investing

Dragon Yongjun TangDragon Yongjun Tang

January 28 & February 2, 2010January 28 & February 2, 2010

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Lecture 6 & 7: Mutual Funds and Lecture 6 & 7: Mutual Funds and other Investment Companiesother Investment Companies

Reading: Chapter 4Reading: Chapter 4 Practice Problem Sets: Practice Problem Sets:

1,2,3,4,6,7,8,9,10,12,13,14,18,20,1,2,3,4,6,7,8,9,10,12,13,14,18,20,2121

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Managing Your MoneyManaging Your Money

Your portfolio

Do it yourself Delegate to a professional

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Invest with Warrant Buffet?Invest with Warrant Buffet?

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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

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Functions:

1. Pooling of Assets2. Diversification3. Professional management 4. Lower transaction costs (economies of scale)5. Record keeping

Investment CompaniesInvestment Companies

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Net Asset Value (NAV)Net Asset Value (NAV)

Used as a basis for valuation of Used as a basis for valuation of investment company sharesinvestment company shares– Selling new sharesSelling new shares– Redeeming existing sharesRedeeming existing shares

CalculationCalculation

Market Value of Assets - Market Value of Assets - LiabilitiesLiabilities

Shares OutstandingShares Outstanding

NAV=

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Investment CompaniesInvestment Companies

UnmanagedUnmanaged ManagedManaged - Securities continually bought and sold - Securities continually bought and sold

– Open-EndOpen-End–Redeem Shares at NAVRedeem Shares at NAV–Shares Outstanding VariesShares Outstanding Varies

– Closed-EndClosed-End–Fixed number of Shares OutstandingFixed number of Shares Outstanding–Trade on Exchanges like stocksTrade on Exchanges like stocks–Values are different from NAVValues are different from NAV

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Types of Investment Types of Investment OrganizationsOrganizations

Unit TrustsUnit Trusts Managed Investment CompaniesManaged Investment Companies

– Open-EndOpen-End– Closed-EndClosed-End

Other investment organizationsOther investment organizations– Commingled fundsCommingled funds– REITsREITs– Hedge Funds Hedge Funds

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Unit Investment Unit Investment TrustsTrustsUnit Investment Unit Investment TrustsTrusts

•Fixed portfolio

•Usually fixed-income

•Not actively managed

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Commingled Commingled FundsFundsCommingled Commingled FundsFunds• Investment pools

• Offered by a bank or insurance company

• Used for trust or retirement account

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Real Estate Investment Real Estate Investment Trusts Trusts (REITs)(REITs)

Real Estate Investment Real Estate Investment Trusts Trusts (REITs)(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

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Hedge FundsHedge Funds

Not registered, not subject to SEC regulation Not registered, not subject to SEC regulation (like individual investors)(like individual investors)

Open only to wealthy or institutional investorsOpen only to wealthy or institutional investors Highly levered, very sophisticated, “market Highly levered, very sophisticated, “market

neutral” strategies, risky!neutral” strategies, risky!

- Long-Term Capital Management - Long-Term Capital Management (LTCM)(LTCM)

- Citadel- Citadel

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Open-End and Closed-End Open-End and Closed-End Funds: Funds: Key DifferencesKey Differences

Shares OutstandingShares Outstanding Closed-end: no change unless new Closed-end: no change unless new

stock is offeredstock is offered Open-end: changes when new shares Open-end: changes when new shares

are sold or old shares are redeemedare sold or old shares are redeemed PricingPricing Open-end: Net Asset Value(NAV)Open-end: Net Asset Value(NAV) Closed-end: Premium or discount to Closed-end: Premium or discount to

NAVNAV

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Figure 4.1 Closed-End Mutual Figure 4.1 Closed-End Mutual FundsFunds

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Figure 4.2 Listing of Mutual Figure 4.2 Listing of Mutual Fund QuotationsFund Quotations

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Types of Mutual Types of Mutual FundsFundsTypes of Mutual Types of Mutual FundsFundsInvestment 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 Table 4.1 Classification of U.S. Mutual Fundsof U.S. Mutual Funds

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Trading in Mutual Trading in Mutual FundsFundsTrading in Mutual Trading in Mutual FundsFunds

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

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How Funds Are SoldHow Funds Are Sold

Directly marketedDirectly marketed Sales force distributedSales force distributed Revenue sharing on sales force Revenue sharing on sales force

distributeddistributed– Potential conflicts of interestPotential conflicts of interest

Financial supermarketsFinancial supermarkets

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Potential Conflicts of Potential Conflicts of Interest - Revenue Interest - Revenue SharingSharing

Brokers put investors in funds Brokers put investors in funds that may that may not be the that may that may not be the most appropriatemost appropriate

Mutual funds could direct trading Mutual funds could direct trading to higher cost brokersto higher cost brokers

Revenue sharing is not illegal but Revenue sharing is not illegal but it must be disclosed to the it must be disclosed to the investorinvestor

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Investment Companies in HK and Investment Companies in HK and ChinaChina

HK: HK: – the number of retail funds offered to the public has grown 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 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 terms, the size of retail funds has grown 22 times, from HKD283 B to HKD6,154 BHKD283 B to HKD6,154 B

– including exchange-traded funds, index funds, guaranteed including exchange-traded funds, index funds, guaranteed funds and hedge fundsfunds and hedge funds

– Can invest in China through QFIICan invest in China through QFII

China: China: – Industry size RMB3.2T (including HF and PE)Industry size RMB3.2T (including HF and PE)– In June 2007, the CSRC announced that QDII fund In June 2007, the CSRC announced that QDII fund

management companies and securities firms are allowed to management companies and securities firms are allowed to invest in overseasinvest in overseas

– Allow foreign investors since joining WTOAllow foreign investors since joining WTO

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HK Funds HK Funds (in US$ (in US$ million)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

12/1997 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

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Mutual Funds Mutual Funds ExpensesExpenses 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 DollarsSoft Dollars

““Fee is the most robust predictor of performance”Fee is the most robust predictor of performance”

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Table 4.2 Impacts of Costs Table 4.2 Impacts of Costs on Investment Performanceon Investment Performance

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Trading Scandal with Trading Scandal with Mutual FundsMutual Funds Late trading Late trading –– allowing some allowing some

investors to purchase or sell later investors to purchase or sell later than other investorsthan other investors

Market timing Market timing –– allowing investors to allowing investors to buy or sell on stale net asset valuesbuy or sell on stale net asset values– InternationalInternational

Net effect is to transfer wealth from Net effect is to transfer wealth from existing owners to the new existing owners to the new purchasers or sellerspurchasers or sellers

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Potential Potential ReformsReforms

Strict 4:00 PM cutoff with late Strict 4:00 PM cutoff with late orders executed the following orders executed the following trading daytrading day

Fair value pricing with net asset Fair value pricing with net asset values being adjusted for trading values being adjusted for trading in open marketsin open markets

Imposition of redemption feesImposition of redemption fees

Mutual Fund ReturnsMutual Fund Returns

All NAV’s are net of loads All NAV’s are net of loads and other expensesand other expenses

NAV

Dist.Gain Cap. and Income NAV-NAVReturn of Rate

t

t1t

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Mutual Fund ReturnsMutual Fund Returns

Example:Example: Consider a fund with $100 million in assets at Consider a fund with $100 million in assets at the start of the year and 10 million shares outstanding. the start of the year and 10 million shares outstanding. The fund invests in a portfolio of stocks that provides The fund invests in a portfolio of stocks that provides no no incomeincome but that increases in value by 10%. The expense but that increases in value by 10%. The expense ratio, including 12b-1 fees, is 1%. What is the rate of ratio, including 12b-1 fees, is 1%. What is the rate of return for an investor in the fund?return for an investor in the fund?

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Problem 11, Chapter Problem 11, Chapter 4(p.110)4(p.110)

A closed-end fund starts the year with a net asset value of 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 $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 the year, the fund is selling at a 7% discount to NAV. The fund paid year-end distributions of income and capital gains of paid year-end distributions of income and capital gains of $1.50.$1.50.

a. What is the rate of return to an investor in the fund during the a. What is the rate of return to an investor in the fund during the year?year?

b. What would have been the rate of return to an investor who b. What would have been the rate of return to an investor who held the same securities as the fund manager during the year?held the same securities as the fund manager during the year?

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Problem 13, Chapter Problem 13, Chapter 4(p.110)4(p.110)

Consider a mutual fund with $200 million in assets at the Consider a mutual fund with $200 million in assets at the start of the year and with 10 million shares outstanding. The start of the year and with 10 million shares outstanding. The fund invests in a portfolio of stocks that provides dividend fund invests in a portfolio of stocks that provides dividend income at the end of the year of $2 million. The stock income at the end of the year of $2 million. The stock included in the fund’s portfolio increase in price by 8%, but included in the fund’s portfolio increase in price by 8%, but no securities are sold, and there are no capital gains no securities are sold, and there are no capital gains distributions. The fund charges 12b-1 fees of 1%, which are distributions. The fund charges 12b-1 fees of 1%, which are deducted from portfolio assets at year-end. What is net asset 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 value at the start and end of the year? What is the rate of return for an investor in the fund?return for an investor in the fund?

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Problem 16, Chapter Problem 16, Chapter 4(p.110)4(p.110)

You purchased 1,000 shares of the New Fund at a price of 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-$20 per share at the beginning of the year. You paid a front-end load of 4%. The securities in which the fund invests end load of 4%. The securities in which the fund invests increase in value by 12% during the year. The fund’s increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your rate of return on the 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?fund if you sell your shares at the end of the year?

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Taxes on Mutual Taxes on Mutual FundsFunds

Investor directed portfolios can be Investor directed portfolios can be structured to take advantage of taxes structured to take advantage of taxes while mutual funds cannotwhile mutual funds cannot

Pass-through of capital gains and Pass-through of capital gains and dividend incomedividend income

High turnover (=Amount of Sales/Fund High turnover (=Amount of Sales/Fund Value) leads to tax inefficiencyValue) leads to tax inefficiency

More disclosure on taxes was required More disclosure on taxes was required in 2000in 2000

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Exchange Traded Funds Exchange Traded Funds (ETF)(ETF)

ETF allow investors to trade index ETF allow investors to trade index portfolios like shares of stockportfolios like shares of stock

Examples Examples –– Spiders, Diamonds, Cubes, Spiders, Diamonds, Cubes, Viper, and WebsViper, and Webs

Potential advantagesPotential advantages– Trade continuously Trade continuously – Lower taxes Lower taxes – Lower costsLower costs

Potential disadvantagesPotential disadvantages

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Mutual Fund Mutual Fund PerformancePerformanceHow can we measure Mutual Fund Performance?How can we measure Mutual Fund Performance?

Benchmark PerformanceBenchmark Performance Wilshire 5000Wilshire 5000 S&P 500S&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?

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First Look at Mutual First Look at Mutual Fund PerformanceFund Performance

Evidence shows that average mutual fund Evidence shows that average mutual fund performance is generally less than broad performance is generally less than broad market performancemarket performance

Evidence suggests that over certain Evidence suggests that over certain horizons some persistence in positive horizons some persistence in positive performanceperformance– Evidence is not conclusiveEvidence is not conclusive– Some inconsistenciesSome inconsistencies

““Past performance is not necessarily indicative of future Past performance is not necessarily indicative of future results.results.””

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Figure 4.3 Percentage of Figure 4.3 Percentage of Funds Funds Below Wilshire 5000Below Wilshire 5000

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Table 4.4 Consistency of Table 4.4 Consistency of Investment ResultsInvestment Results

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Sources of Information Sources of Information on Mutual Fundson Mutual Funds

Prospectus, Annual ReportsProspectus, Annual Reports Morningstar (www.morningstar.com)Morningstar (www.morningstar.com) Yahoo (biz.yahoo.com/funds)Yahoo (biz.yahoo.com/funds) WiesenbergerWiesenberger’’s Investment Companiess Investment Companies Investment Company InstituteInvestment Company Institute Popular pressPopular press Investment servicesInvestment services

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SummarySummary

Type of investment companiesType of investment companies Mutual fund expensesMutual fund expenses Mutual fund performanceMutual fund performance Next Class: Risk and ReturnNext Class: Risk and Return