Mutual Funds Mutual Funds and Hedge and Hedge Funds Funds Chapter 5 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin
Mutual Funds and Mutual Funds and Hedge FundsHedge Funds
Chapter 5
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
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Overview
In this segment: Mutual Funds and Hedge Funds: Activities of mutual Size, structure and composition Balance sheets and recent trends Regulation of mutual funds Activities of hedge funds Global issues Size, structure and composition Balance sheets and recent trends Regulation of hedge funds
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Mutual Funds
Diversification opportunities enhanced for small investors Economies of scale Predominantly open-ended funds
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Mutual Funds
Rapid growth in funds during the 1990s Slower rate of growth in the industry in early
2000s than in 1990s Trading abuses contributed to slowdown
2007: Almost 7,100 stock and bond mutual
companies. Total assets of $8.21 trillion. 8,125 firms and $10.57 trillion if money market
mutual funds included
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Size, structure and composition
First mutual fund: Boston, 1924. Slow growth, initially. Advent of money market mutual funds, 1972.
Regulation Q. Total assets in stock and bond mutual funds:
1940: $0.5 billion. 1990: $1,065.2 billion 2000: $6,964.6 billion 2006: $10,413.7
Institutional funds 80 percent of retirement plan investments
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Size, Structure and Composition
By asset size, mutual fund industry second most important FI group.
Recent inroads by commercial banks and insurance companies
Mellon purchase of Dreyfus State Farm (9,000 agents) As of 2006, insurance companies managed
approximately 10% of mutual fund assets
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Types of Mutual Funds
Long-term funds 74.3% of assets, 1999 2002, long-term funds dropped to 62.1% of
assets, losing ground to MMMFs 75.4% in 2006
Types of Long-term Funds: Bond and income funds. Equity funds. Hybrid.
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Types of Mutual Funds
Short-term funds 25.7% of assets, 1999. 37.9% of assets, 2002. 24.6% in 2006 Taxable and tax-exempt MMMFs Generally higher returns than bank deposits but
uninsured. Impact of low interest rates during early to
mid 2000s Decline in MMMFs Lowering of MMMF fees
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Number of Mutual Funds
Year
Equity
Hybrid
Bond
Taxable
MM
Tax-exempt
MM 1980 288 N/A 170 96 10
1990 1,099 193 1,046 506 235
2007 4,784 501 1,993 574 273
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Overview of Mutual Funds
Objectives (and adherence to stated objectives), rates of return and risk characteristics vary.
Examples: Capital appreciation funds World equity Corporate bond High-yield bond World bond Government bond
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Returns to Mutual Funds
Income and dividends of underlying portfolio. Capital gains on trades by mutual fund
management. Capital appreciation in values of assets held in
the portfolio. Marked-to-market. Net-asset value (NAV).
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Web Resources
For information on the performance of mutual funds, visit:
Morningstar www.morningstar.com
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Types of Funds
Open-ended funds: comparable to most corporate securities traded on stock exchanges.
Closed-end investment companies: Fixed number of shares
Example: REITs. May trade at premium or discount. Exchange traded funds (ETFs)
Load versus no-load funds.
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Mutual Fund Costs
Two types of fees: Sales loads
Generally, negative effect on performance outweighs benefits
Short term versus long term investment alters impact of loads on cost
Fund operating expenses Management fee 12b-1 fees Front end and back end fees
• Class A, Class B and Class C differences• SEC creation of new rules• Sweeping decreases in fees, 2005 and 2006
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Balance Sheet and Trends
Money Market Funds Key assets are short-term securities (consistent
with deposit-like nature) 2006: $1,514.9 billion (65.5% of total assets)
Most have share values fixed at $1 and adjust number of shares owned by the investor.
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Balance Sheet and Trends
Long-term Funds Stocks comprised over 70.7 % of asset
portfolios in 2006. Credit market instruments 27.2% of asset
portfolios Shift to other securities such as credit market
instruments, U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.
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Regulation
One of the most closely regulated among non-depository FIs.
Primary regulator: SEC Emphasis on full disclosure and anti-fraud measures
to protect small investors. NASD supervises mutual fund share distributions.
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Regulatory Changes
Prosecutions in light of trading abuses in early 2000s. Market timing Late trading Directed brokerage Improper fee assessments
Changes include: SEC requirements for independent board members; reporting and disclosure requirements
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Legislation
Securities Act 1933, 1934 Investment Advisers Act, 1940. Insider Trading and Securities Fraud Enforcement
Act of 1988. Market Reform Act of 1990
Allows SEC to halt trading and introduce circuit breakers.
National Securities Markets Improvement Act of 1996.
Exempts mutual fund sellers from state securities regulatory oversight.
Sarbanes-Oxley Act of 2002
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Global Issues
Worldwide growth in mutual fund investment not as great as in the U.S. $2.575 trillion in 1996 to $10.490 trillion in 2006
Over 307% growth Larger returns in U.S.stock markets Greatest development in countries with most
advanced markets Opportunities from declining Japanese markets Efforts to reduce barriers for U.S. mutual fund
sponsors China and other Asian countries
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Hedge Funds
Not technically mutual funds Not subject to SEC regulation Organized as limited partnership
Small number of sophisticated investors Common feature is use of leverage
High returns in 1990s
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Hedge Funds
Near collapse of Long-Term Capital Management $3.6 billion bailout Precipitated SEC scrutiny of hedge funds
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Types of Hedge Funds
More risky Market directional
Moderate risk Market neutral or value orientation
Risk avoidance Moderate, consistent returns with low risk as
objectives Fees
Generally management fees and performance fees
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Offshore Hedge Funds
Major centers include Cayman Islands, Bermuda, Dublin, Luxembourg.
Rules Generally not burdensome Anonymity Tax advantages
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Regulation of Hedge Funds
Generally unregulated Exemption for less than 100 investors Exemption if accredited
Scandals such as Canary Capital Partners Illegal trading with mutual funds
Amaranth Advisors, 2006 SEC scrutiny
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Pertinent Websites
American Funds www.americanfunds.com
Federal Reserve www.federalreserve.gov
Fidelity Investments www.fidelity.com
Investment Company Institute www.ici.org
Morningstar, Inc. www.morningstar.com
NASD: www.nasd.com
SEC: www.sec.gov
Vanguard www.vanguard.com
Wall Street Journal www.wsj.com