Institutional Investors

1
Institutional Investors

• Mutual funds
• Invests a pool of funds belonging to many
  individuals in a portfolio of individual
  investments
• Constrained by
• Legal requirements
• Fund objectives

2
Institutional Investors

• Pension funds
• Receive funds and invest them for pension
  beneficiaries
• Defined contribution
• Fixed contribution in employees name to fund
  manager. Employee directs management of fund.
  Employee bears risk.
• Defined benefit
• Employer promises a fixed benefit upon retirement
  Employer bears risk
• Pension funds generally have
• Long horizon, low liquidity needs
• Tax exempt, federally governed

3
Institutional Investors

• Endowment funds
• Arise from gifts to charitable and educational
  institutions
• Must provide income and preservation of capital
• Low liquidity needs
• Long lives
• Risk tolerance conditioned upon ability to raise
  funds
• Regulated at state level, tax exempt

4
Institutional Investors

• Insurance companies
• Collect premiums and pay out benefits
• Life insurance companies
• Portion of income subject to tax
• Regulated at state level using prudent man rule
• Established risk categories for investments made
  by industry association
• Prudent expert rule
• Property and casualty companies
• Greater uncertainty, more liquidity needs
• Taxed and state regulated
• Wider set of permissible investments

5
Institutional Investors

• Banks
• Must compete for funding
• Must manage float
• Spread between assets (loans) and deposits
  (borrowing)
• Short time horizon
• Have external liquidity and safety
• Taxed, regulated at federal and state levels

6
REITs

• Basic structure
• Closed end investment companies that sell shares
  to public. Created under REIT act of 1960.
• Allow investors to own portfolio of real estate
  assets while having limited liability
• Typically yield 1 to 2 percent above money market
  funds and about the same return as high grade
  corporate bonds
• Required to pay out 90 of income as dividends,
  keep 75 of assets in real estate investments,
  earn at least 75 of income from real estate,
  hold investments for at least four years

7
REITs

• Types of REITs
• Equity
• Invests in properties. Most common form.
• Mortgage
• Make/buy construction and mortgage loans
• Hybrid
• Advantages of REITs
• Easy method of investing in real estate
• Professional management
• Liquidity

8
Mutual funds

• Growth in mutual funds
• End of 1970 -- Managing 20 of value
• End of 1994 -- Managing 60 of value
• Over 6000 traded funds
• Over 30 of households own mutual funds
• Has overtaken amount of money in banks

9
Mutual funds

• What do we require of a fund manager?
• General requirements
• Manage style / risk-return characteristics
• Diversify as much as possible
• Minimize costs
• Return requirements
• Earn fair return for given level of risk --
  efficient markets view
• Beat the market -- non-efficient markets view

10
Closed-end mutual funds

• Characteristics
• 1. Professionally managed
• 2. Issue a fixed number of shares
• 3. Buy securities with funds raised from the
  issue
• 4. Fund shares traded in a secondary market
  through a broker

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Closed-end mutual funds

• Value/Price of a closed-end fund
• Closed-end funds have a net asset value and a
  market price
• Market price depends on supply and demand forces
• Relationship between NAV and market price
• discount - the market value of the funds shares
  traded in the market is less than the market
  value of the securities the fund holds
• premium - the market value of the funds shares
  traded in the market is greater than the market
  value of the securities that the fund holds

12
Closed-end mutual funds

• IPOs
• Generally open at a premium above net asset value
• Generally trade at a discount to net asset value
  after the initial offering
• SEOs
• Closed-end funds may issue new equity like other
  corporations
• Generally perform poorly after the issue

13
Open-end mutual funds

• Characteristics
• Professionally managed
• Issue an unlimited number of shares
• Shares bought and sold from fund directly or
  through a broker at NAV

14
Open-end mutual funds

• Characteristics
• At the end of each trading day, a fund calculates
  its NAV or the value of the funds outstanding
  shares by totaling its investments and other
  assets and deducting its liabilities
• Trades to buy or sell during day are collected
  and occur at days end after NAV is calculated

15
Open-end mutual funds

• Characteristics
• Distributions in form of interest or dividends
  made to fund are distributed to shareholders
• Load vs. no-load
• load funds charge a sales commission to investors
  who are buying or selling shares
• no-load funds charge no sales commission

16
Ways to purchase mutual funds

• Security broker
• If you buy from a broker, there will be a load
  fee
• Example
• If you invest 10,000 in fund with 6 load,
  commission is 600 and you actually invest 9,400

17
Ways to purchase mutual funds

• Fund
• Can tell whether fund is load or no-load in paper
  by seeing if NAV and offer price differ
• Investors generally buy no-load fund directly
  from fund - investors pay no commission on
  these funds but must determine for themselves
  which is best fund for their needs

18
Ways to purchase mutual funds

• Discount broker
• Discount brokers - generally offer no-load funds
  - these funds if not traded through discount
  broker may actually be load funds
• Funds pay discount brokerage firm to get shelf
  space for their funds - discount brokerage firms
  often called supermarkets
• Defined contribution plan (retirement)

19
The prospectus

• Contains information important to potential
  investors. A prospectus should be obtained
  before purchasing a mutual fund.
• However much of the information contained in the
  prospectus can now be found on the internet

20
Costs of owning a mutual fund

• Transactions Costs
• Types
• Load fees - commissions paid when shares of a
  fund are purchased - front-end load. Family of
  funds determines load
• Since load goes to broker, broker pushes high
  load funds
• Deferred sale loads - fees charged when shares
  are sold
• Load fee status and fund performance are not
  related

21
Examples

• Example 1 Assume we invest equal amounts in two
  funds with the same return characteristics, the
  following shows the difference in our ending
  value
• Load No-load
• initial investment 10,000 10,000
• load fee 6 0
• 9 return for 10 yr 22,253 23,674
• realized return 8.33 9

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Examples

• Example 2 Assume we invest in two funds, fund 1
  has a 5 load and an expected return of 12.
  Fund 2 has a no load and an expected return of
  10. Which fund would we be better off in after
  2 years if we initially invest 10,000?
• Fund 1 we invest 10,000 500 load so 9500
  investment
• After 2 years 9500 (1.12)2 11,216
• Fund 2 We invest 10,000
• After 2 years 10,000 (1.1)2 12,100

23
Costs of owning a mutual fund

• Operating Expenses
• Operating expenses are costs associated with the
  management of the fund.
• Management advisory fees - fees paid to the
  investment advisor of the fund
• Size of fee depends on assets being managed, the
  investment strategy used, and the past
  performance of the advisor
• General management fees - costs associated with
  fund accounting, reporting, etc.
• 12b-1 fees - charges used to advertise and
  promote the fund to prospective investors

24
Benefits of mutual funds

• Diversification
• Low portfolio management costs
• Access to world markets
• Ease of portfolio administration
• Continuous accurate return comparisons
• Liquidity
• Professional management
• Special fund investment programs

25
Investing in mutual funds

• Suggestions
• Choose funds on risk attributes
• Past performance and future performance are not
  highly correlated
• Pay close attention to total costs of investing
  in a fund
• When monitoring performance consider both risk
  and return
• Diversify adequately across fund types

26
Research on mutual funds

• Persistence of performance
• Research indicates that past performance does not
  correlate with future performance
• On average mutual funds do not earn abnormal
  returns
• Abnormal returns are inversely related to
  operating expenses and portfolio turnover

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Research on mutual funds

• Persistence of performance
• Given the findings on the persistence of
  performance we can say that
• Do not purchase funds with persistently poor
  performance
• Expect fund that high returns to have high
  returns for only another year
• High expenses hinder performance
• Market efficiency is supported

28
Research on mutual funds

• Impact of fund objectives
• Funds with higher stated risk objectives appear
  to have higher actual risk measures
• Appear to be able to manage risk/return
• Mixed evidence on persistence of ability to meet
  objectives
• Must continually evaluate fund to see if it is
  meeting objectives