Part IV: Non Depository Institutions

1
Part IV Non Depository Institutions

• Topic 12 Investment Companies (a.k.a. Mutual
  Funds)

2
Household Investment Paths

• Net saving households can
• Invest directly into net borrowing firms.
• Private placements Large wealthy investors
  and/or small firms.
• Place savings in a depository institutions
  (Banks) and earn fixed interest
• Invest in Public financial markets through
  dealer/brokers (over exchanges) or investment
  bankers (IPO/SEO).
• Invest in Public financial markets through a
  financial intermediary.

3
Investment Companies

• The investment company sells shares to the public
  and invests the proceeds into a diversified
  portfolio of securities
• A Mutual Fund is one type investment company.
• Investors pool their capital and delegate the
  investment decision to a central authority
• The central authority making the investment
  decisions earns a fee for their service
• Q What exactly are the services offered by this
  central authority?

4
Benefits of Investment Company

• Diversification Divisibility
• A single investment is immediately diversified
  through the funds holdings
• Since a share in the fund is a proportion
  interest in the securities held, this could
  represent fractional interest in the underlying
  security (Example Would be very difficult to
  replicate an SP500 index fund within a personal
  portfolio)
• Liquidity
• Underlying fund securities are often illiquid
  (like Real Estate or certain non-traded debt)
• If investors can redeem or trade fund shares,
  then these underlying assets become liquid
• Investing through funds might the only avenue for
  investing in otherwise illiquid securities
  improves market completeness, and hence
  efficiency.
• Record Keeping The central agent aggregates
  holdings, computes gains and taxable income, and
  sends statements.

5
Benefits of Investment Company

• Professional Management
• Informed money managers may make better decisions
  than uninformed investors.
• But, how much more informed are these managers?
  Do they have access to private information?
• Reduced transaction costs Costs are reduced with
  economies of scale.
• Direct Costs Brokerage and exchange fees. Less
  costly to buy 500 shares of an SP500 index fund
  than one share of each of the underlying firms.
• Indirect Costs Search costs and decision making
• Taxes These costs might be higher or lower
  depending on certain factors

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Are Investment Companies Necessary?

• What reasons are there for not investing through
  an investment company?
• Internet has revolutionized investing within the
  last decade.
• Record keeping made simple with online portfolio
  trackers
• Online brokerages are increasingly less costly
  (5, 8 trades)
• Information on securities is widely available,
  analyst reports, news articles, SEC filings
• Double taxation investment companies are pass
  through entities, which refers to tax
  liabilities.
• Pay taxes when you sell your fund shares.
• Pay taxes when others sell their fund shares.
• Pay taxes when funds churn investments.
• Indexing investments requires no Active
  management.
• SP500 funds only require rebalancing when firms
  enter or exit the index.
• Do you really need to hire an agent to rebalance
  your portfolio?

7
Types of Investment Companies

• Open end fund a.k.a. mutual fund.
• Most common investment company
• These funds are open to new investment. New
  investor proceeds are exchanged for new shares in
  the fund, and are invested in the portfolio.
• Investors buy-in at the Net Asset Value (NAV)
• NAV Market value of the portfolio -
  Liabilities
• Shares outstanding
• The market value is easy to calculate at any
  point in time if the underlying securities are
  traded in liquid markets (particularly true for
  an equity fund),
• However, investment companies do not real-time
  mark to market
• For most funds and investors, there is a 100PM
  commitment to purchase shares, but at the 430PM
  NAV (market close)
• Fund size is determined by
• The change in value of investments
• Net flow of funds -- buy-ins () and redemptions
  (-).
• If a fund is performing well, then its growth
  through Net New Flow of Funds will likely be
  bigger than the growth through changes in
  investment value (Dont confuse fund growth with
  return!!!).

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Types of Investment Companies

• Closed end fund This fund is closed to new
  investment.
• Number of shares stays constant An underwriter
  issues the shares and they remain constant for
  the duration of the fund (capitalized only once),
  or a fund that starts as open-ended closes to new
  investment.
• Liquidity provided for in secondary market
  Entering a closed-end fund requires buying shares
  from existing shareholders. Exiting the fund may
  also require selling the shares to new investors.
• Deviations in valuation Since shares are traded
  instead of redeemed, it is possible for their to
  exist a deviation between the NAV and traded
  price
• The supply and demand for the fund shares may
  influence their price (this could not be true in
  a perfect capital market violates perfect
  competition.
• Trading at a discount ? Share price below NAV
  (most common)
• Trading at a premium? Share price above NAV
• What is an efficient capital market (ECM)
  explanation for these deviations?
• Tax liabilities are priced into the shares, but
  not the NAV.
• Transaction costs required to arbitrage the
  difference is too high. Cant liquidate the fund
  unless you buy-out all investors. This is costly.

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Types of Investment Companies

• Unit Trust
• A unit trust is similar to a closed-ended fund in
  that the number of units is fixed
• It is different in that the investments do not
  change over the duration of the fund life. The
  trust might consist of a portfolio of bonds that
  are held until maturity.
• Exchange Traded Fund A cross between all three
  of the prior investment companies
• Similar to a closed-end fund, there is continuous
  trading of shares
• Similar to an open-end fund, investors can redeem
  shares (they receive the underlying securities)
• Investments are generally passive (do not
  change), tracking an index.

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Growth in Mutual Funds

• At year-end 2004
• Mutual funds accounted for 24 of the U.S.
  retirement market, or 3.1 trillion. This amount
  represented about 38 of all mutual fund assets.
• Mutual funds own 22 percent of all U.S. corporate
  equity.

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Mutual Fund Size by Type of Funds(millions)
12
Top 10 Mutual Fund Companies1
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Difference between Banks and Mutual funds
14
Difference between Banks and Mutual funds
15
Organizational Structure
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Organizational Structure

• Investment Advisor Manages the fund in
  accordance with the prospectus outlined by the
  board. If the investment advisor is not also the
  fund sponsor (example Vanguard, Janus,
  Fidelity), then it is referred to as a sub
  advisor.
• Distributor Principal underwriter of the fund
  who sells shares to the public, either directly,
  or through brokerages. The distributor may also
  be the Investment advisor and fund sponsor, but
  not necessarily.
• Custodian Holds the funds assets, maintaining
  them separate from the distributor and investment
  advisor to protect shareholder interests. They
  are the repository (vault) for title to invested
  securities.
• Transfer Agent Processes the buy and sell orders
• Independent Public Accountant Certifies
  financial statements in the same manner firms
  have their financial statements certified.

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Ownership Structure

• The board of directors (fund trustees) is
  assembled to represent the interests of
  shareholders. However, there are inherent
  problems in this structure, including
• Shareholders are generally dispersed and may not
  take an active interest in monitoring (through
  elections) the directors
• Most directors are former fund advisors, who
  choose their cronies to manage the fund
• There are thousands of Funds requiring oversight,
  but only a limited pool of qualified monitors
  (board candidates). As a result, directors often
  sit on multiple boards, as many as 100, so the
  efficiency of their monitoring in suspect.
• The organization form of the fund is established
  prior to investment by shareholders, so all of
  the afore mentioned problems may never be
  addressed if investors cannot organize.

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Recent Problems in the Mutual Fund Industry(post
dot.com buble burst)

• Soft money transactions Funds pay kickbacks to
  distributors in exchange for pushing their
  products. This is not necessarily illegal, but
  the effect is that it hides fees.
• After hours trading Some funds allowed hedge
  funds or other large investors to trade in their
  funds after hours, but at the 430 close price.
  This is Illegal!! Equivalent to insider trading
  since privileged trades can trade on information
  that no one else has (the after hours
  information).
• New rule by the SEC serve to limit these problems
  by requiring that 40 of the board is
  independent. However, not enough time has passed
  measure effectiveness.

19
Compensation and Fee Structure

• Mutual Funds charge fees that are independent of
  performance.
• Mangers cannot tie their pay to performance
  unless they apply the compensation equally to
  gains as well as losses.
• The magnitude of the downside is too large to
  make feasible, so instead, their compensation is
  tied to fund size. This is done in the following
  way
• Loads Front/back-end fees are charged to
  investors entering/exiting a fund.
• Historically these fees were around 2-3 (Charged
  as a percent of amount invested), and can be as
  high as 8.5 per government restrictions
• Industry competition has largely eroded these
  fees. Most funds can now be bought as no-load.
• 12b-1 fees Advertising fees, must be less than
  1, and are charges as a percent of assets under
  management (fund size)
• Management fees Charged annually as a percent of
  assets by the investment advisor, and may be as
  low as 18 basis points or as high as 2. This is
  independent of fund performance.

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Compensation and Fee Structure

• Soft dollars
• These are fees that are not explicitly broken out
  by the Fund.
• For example, in exchange for distributing shares
  in one of its funds, a sponsor may pay one of its
  brokers by directing its trades through them. The
  broker earns fees off these trades, and to
  maintain this business, they push the sponsors
  financial products.
• The sponsor might even pay higher than required
  brokerage fees if other services, like analyst
  research, is given in return.
• Soft dollars are not necessarily inefficient, but
  they are not transparent.
• Expense Ratio Sum of 2 and 3.
• Comment ? how you charge the fee is irrelevant
  (12b-1 or management or load). Its all a fee.
• Funds generally offer multiple share classes
  that allow investors to choose the fee structure
  most desirable, in the same way that insurance
  policy holders choose deductibles. For example,
  Class A shares may be for customers choosing
  front-end load, B shares for Back-end, C shares
  for level load, and D shares for no load.

21
Compensation and Fee Structure
What would you rather have, a 1 load or 1
management fee? Loads are 1 time, management fees
are annual, the 1 load is better.
22
Chasing Returns

• Investors and advisors are frequently accused of
  chasing returns, moving money in to high
  performing funds, but after the funds have
  performed well.
• What does this say about investor beliefs in
  market efficiency?
• Managers understand that investors will move
  money to high performing funds more quickly than
  investors pull out of low performing funds, and
  since managers are compensated based on their
  size and not performance, managers have incentive
  to increase their risk at year end.
• Academics Chevallier Ellison found a non-linear
  relationship between the net flow of new funds
  (money coming into the fund) and the funds
  return.
• More money comes in for past good performance
  than leaves for past bad performance.
• Managers will take extra risk to get into the set
  of good funds if the downside is limited see
  next graph

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Chasing Returns
Positive Payoff If the increase in risk results
in another 5 excess return, then the manager
receives a 40 gain in net new flows A This is
the gain in net new assets if the manager wins
from increasing risk to increase expected returns
by a few percent. Negative Payoff If the
increase in risk results in a 5 loss in excess
returns, then the manager only suffers a 10 loss
in net new funds. B This is the loss in net new
assets if the manager loses from increasing
risk to increase expected returns by a few
percent.
Hypothetical situation A fund has outperformed
the benchmark by 18, but is not yet in the set
of good funds that will be recognized by investors
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Chasing returns

• Depending on where the investment advisor is on
  this curve, the advisor can either increase risk
  in an attempt to move performance, or lock in
  gains to preserve the following years net new
  flow of funds. In fact, if an investment advisor
  is sufficiently ahead of the benchmark 6 months
  into the year, the investment advisor may simply
  lock in the gains by rebalancing the funds
  portfolio to reflect its benchmark index.
• These incentive structures have created an
  environment where funds and their investments
  turnover at an increasing rate. In todays
  environment, neither investors nor investment
  managers tend to pursue buy and hold strategies.
• The following chart is turnover of investor money
  in funds. This includes moving between funds
  (exchanges) and cashing out (redemption)

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Investor Turnover
Reprinted from financialservicesfacts.org What
happened in 1987 to help facilitate that turnover
regime?
26
Turnover within funds
The following is a chart of turnover of
investments within funds. 100 indicates that the
average investment in the fund is bought and sold
within one year.
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Management Styles

• Passively managed funds The investment advisor
  tracks an index and rebalances holdings only when
  an index changes composition
• NASDAQ 100
• SP500
• Wilshire 2000
• Dow Jones Industrial
• Expenses are generally lower since there is
  reduced overhead. There is no investment decision
  making, no information collecting, and no attempt
  to beat the market.
• Are index funds really passively managed? No! An
  index fund manager delegates the decision making
  to the institutional organization that has
  created and manages the composition of the
  benchmark index
• Dow Jones, Standard and Poors, NASDAQ, Willshire

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Management Styles

• Actively managed funds An investment advisor
  actively trades securities in an attempt to beat
  the market.
• There are two management styles that describe all
  actively managed funds!
• Market timing
• The manager choose the level of risk (Beta) by
  moving into and out of stocks at the right time
• This is not the same as stock picking. Rather,
  the investment advisor might move between a
  diversified portfolio of stocks, bonds or even
  cash.
• Stock picking
• Managers choose idiosyncratic (firm-specific)
  risk by selecting stocks that will beat the
  market
• Managers try to find stocks that are under-valued
  (buy these) or over-valued (sell/short these).
  They take advantage of mispricing
• What is the value of having and active fund
  manager? Less than 10 of actively managed funds
  beat their index on an average year.

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CAPM Mutual Funds

• Market Timing (choose risk level)
• Investment advisor moves between value and growth
  stocks
• Investment advisor moves between cash and stocks.
• Any time the investor advisor changes risk level,
  this is market timing
• Stock picking (choose firm-specific risk)
• Investment advisor looks for undervalued stocks
• Investment advisor chooses specific sector.
• Any time the investor advisor looks for
  mis-pricing, this is stock picking.

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Management Styles

• Why cant actively managed funds beat the
  market more than 10 of the time?
• Transactions costs
• Overhead
• Information collecting
• and the fact that it is damn hard to beat the
  market.
• Are the 10 of the funds that beat that market,
  actually well managed, or are they lucky?
• E.g., you can win in Vegas, but does this make
  you good or lucky?
• Independent of luck or skill of the fund manager,
  if you happen to pick a successful fund, was
  this luck or skill on your part?

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Fund Objectives

• Fund Objectives Fund charters will list in the
  prospectus the strategy of the investment
  advisor. No matter what Active strategy is
  chosen, it will be a function of
• Market Timing and/or
• Stock Picking.
• Consider the following
• Size Factors
• Small Cap small firms
• Mid Cap
• Large Cap large firms (IBM, Microsoft, Intel)
• Growth Factors (high or low beta - can be
  aggressive or non aggressive)
• Value (low growth/ low beta)
• Blend
• Growth (high beta stocks)

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Fund Objectives

• International (regional or type of market)
• Europe
• Asia
• South America
• Latin America
• Emerging markets
• Developing markets
• Sector Funds Investors take on the idiosyncratic
  risk of the industry (stock picking)
• Semiconductor
• Pharmaceuticals
• Energy
• Financial Services
• Heath care
• Agriculture
• Retail
• Note the size of the fund may limit the
  investment options available to the investment
  advisor. Fidelity Magellan has

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Double Taxation - revisited

• 1940 Investment Act Investment companies are tax
  exempt if at lest 90 of dividends and interest
  are paid out to shareholders
• Pass-thru entity
• Does not consider capital gains in payout
• Double Taxation Investors get taxed twice
• Exiting a Fund Investors pay capital gains when
  they exit the fund.
• Buy in at a 15 NAV and sell your shares at 75,
  you have a capital gains tax liability of 60 per
  share.
• High Turnover and Fund Trading Investors pay
  capital gains from Mutual Fund trading as its
  realized
• Buy in at 15 NAV and you dont sell your shares
• Earn dividends and interest, but no capital
  gains.
• Receive 1099 at year end which includes
  Dividends, Interests and realized capital gains
  of the fund.
• This is tax inefficient from an investors
  perspective. If a fund has high turnover (ie.
  100) then all of the capital gains become a tax
  liability to investors in the Fund.

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Double Taxation - revisited

• Selling Winners Investment advisors may choose
  to lock in gains per their incentive contract,
  but doing so requires that they cash out of
  winning stocks.
• Selling losers Similarly, funds might sell their
  underperforming shares to take an offsetting
  loss, and then buy back the shares at a later
  date. The risk is that the shares will increase
  during that time
• Negative net flow of funds Investors pay capital
  gains when other investors redeem shares. This
  might be one of the worst reasons to have to pay
  taxeshere is how it works.
• A fund experiences a NEGATIVE net flow of funds ?
  a significant number of investors leave an open
  ended fund, more so than the investment advisor
  can accommodate redemptions from cash on hand and
  new investors.
• A liquidity problem results, just like at a Bank
  facing a large number of withdrawing depositors.
  The Fund must begin to sell assets to meet
  redemptions.
• If the assets have realized capital gains, then
  the resulting tax liabilities are passed on to
  NON redeeming fund holders, and for the only
  reason that other shareholders are withdrawing.
• This occurred after the bubble burst in 2000.
  Investors began to withdraw funds such that the
  new flow of funds were negative, and this
  required funds to sell assets and experience
  capital gains.

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Double Taxation - revisited

• New Investor Tax
• New investors entering a fund are responsible for
  the realized tax liabilities within the year
  purchased
• If you buy into a fund in December, then your
  1099 will include tax liabilities for the entire
  year.
• Solutions to the Double Taxation Problem
• Choose funds that do no have high turnover
  (passively managed funds only trade to meet
  investor redemptions and to rebalance according
  to the index being benchmarked)
• Dont buy into a fund in December
• Buy and exchange traded fund (ETF)
• Mutual funds set restrictions on short-term
  trading that may affect redemptions and tax
  liabilities.

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Exchange Traded Funds

• ETF characteristics that are similar to other
  types of investment companies
• Closed-end fund Priced at every point in time,
  trade in secondary market.
• Open-end fund Investors can purchase new shares,
  and share can be redeemed, in addition to trading
  on a secondary market.
• Unit Trust The investments are passive ? ETFs
  generally track and index.
• What are the important features of an ETF that
  contribute to it explosive growth?
• Shares are liquid and can be traded at any point
  in time. This circumvents mutual fund
  restrictions of buying in by 1PM at the 430PM
  price
• If the Stock price deviates from the NAV, then
  arbitragers can redeem large blocks of stock and
  take advantage of the mis-pricing. The result is
  that ETF shares reflect fairly closely the value
  of the underlying stock.
• Costs are low. Management fees on order of
  passively managed index funds (18bp) are common.
• Tax liabs are REDUCED! ETF investors own a
  fractional share of the underlying stock (these
  are basket shares). In other words, an investors
  ownership is directly mapped to shares in the
  repository, hence, when other investors redeem
  shares, their tax liabilities are not passed on
  to you. NO DOUBLE TAXATION.

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Mutual Fund v. ETF

• With all of these advantages, why arent Mutual
  Funds gone?
• ETFs trade on an exchange, and investors are
  charge brokerage fees (ie. 19.95 per trade). If
  you are a dollar cost average investors (invest a
  little bit each month), then these fees become
  significant. Mutual funds will generally let you
  add investment to your funds without additional
  transaction feels.
• Popular ETFs
• QQQ Qubes Nasdaq 100
• DIA Diamonds Dow Jones Industrial Average
• WEBS ishares World Equity Benchmark (MSCI
  Morgan Stanley Capital International index)
• SPR SPDRS SP500 index