Financial Markets

1
Financial Markets Instruments

• Andrei Simonov (HHS)
• Finance I HHS MBA

2
Course Outline

• Financial markets and products
• Risk and return
• measure of profitability
• comparison across time
• realized vs expected risk and return
• Idiosyncratic and systematic risk
• diversification
• efficient portfolios

3
Course Outline (cont)

• Valuation
• CAPM and other asset pricing models
• anomalies and behavioral finance
• Fixed Income
• duration
• term structure
• Derivatives
• options
• futures

4
Administration

• Grading
• class participation
• group assignments
• Exam
• Textbook
• Investments Bodie, Kane and Markus (McGraw-Hill)
  latest edition
• My assumptions about you
• You know and understand basic regression and
  statistical analysis (what is R2, statistical
  significance, etc.)
• You are willing to learn...

5
(No Transcript)
6
Introduction

• The field of Finance and Investments
• Individual agents making decisions to supply
  capital to the markets
• Firms getting capital from the financial markets
  (when, where, how?)
• Capital Markets acting as market clearing device.
• Goal of the course
• To familiarize you with real world of
  investments.
• To give broad overview of modern investment
  issues. By December one should know what does
  that mean to be investment professional.

7
Financial Assets

• Claims to cash generated by real assets
• Real assets
• those which contribute to economic production
  (land natural resources, buildings, machines )
• Financial assets
• contribute indirectly to the productive capacity
  of the economy
• allocate profits and risks to various market
  participants and investors

8
Functions of the Financial System

• To allocate funds efficiently by transferring
  resources
• across time (saving for retirement)
• across distance (investing across countries)
• To provide means of sharing risk
• between households and firms (stocks)
• among firms (futures)
• among households (insurance contracts)
• To provide means of controlling risk
• diversification (mutual funds)
• options, credit derivatives
• To provide and aggregate information about
  expectations
• on macro variables (exchange rates, inflation
  etc.)
• on companies
• To efficiently separate ownership and management
• To provide ways to settle payments for goods and
  services

9
Investment process

• Typical investors faces two steps of decisions
• Asset allocation
• Choice among broad asset classes
• (Ex) stocks, bonds, real estate, commodities,
  etc.
• This requires economic analysis (boom or bust)
  or industry analysis
• Security selection
• Choice of particular securities within each asset
  class
• (Ex) GM, IBM, etc.
• This requires the valuation process of particular
  securities, so called, security analysis
• Therefore, investors face the following problems
• Forecasting future returns (or cash flows)
• Identifying sources of risk and measuring risk
• Evaluating whether the expected return
  compensates for the risk
• Investment decisions

10
Principles of the markets

• No-free-lunch rule (or no arbitrage rule)
• Financial markets are competitive enough to rule
  out any profit opportunity from investing in
  obviously underpriced securities
• Risk-return trade-off
• Assets with higher expected returns have greater
  risk
• Higher-risk assets should be priced lower to
  offer higher expected return than lower-risk
  assets
• How to measure risk?
• Market efficiency hypothesis
• All relevant information is quickly and
  efficiently reflected in prices
• In reality, however, we observe near-efficient
  markets where there may exist profit
  opportunities for diligent and creative
  investors. This provides an incentive for
  actively managing ones investment portfolios

11
Financial Markets

• Role of the markets aggregation of information
• Primary market for new issues of securities
• Company sells shares and bonds directly to
  investors
• Private placements offers to a restricted group
  of investors
• Public offerings offer to the general investment
  public
• Secondary market for existing securities
• Existing owner sells to another party
• Company does not receive proceeds and is not
  directly
• involved

12
Primary Market Public Offerings

• Investment bank underwrites the issue performing
  four tasks
• Origination information gathering and advice on
  timing and pricing of the issue, forming
  syndicate
• Distribution selling of the issue
• Risk bearing buys the security from the firm and
  then resell them to clients (in some cases)
• Certification certify the quality of the issue

13
Investment Banking (IB)

• IBs are specialized in advising and marketing
  public offerings of stocks or bonds, and are
  called underwriters
• An underwriting syndicate is formed to share the
  responsibility of large offerings
• IBs provide services such as valuation, marketing
  plan, roadshow, bookbuilding, pricing,
  allocation, and price support in aftermarkets
• IBs tend to offer a bargain price to induce
  potential investors to submit their interest in
  the bookbuilding process
• This tendency commonly causes underpricing of
  IPOs, which is reflected in price jumps occurring
  on the first date of trading (New Issue Puzzle)
• Besides underwriting fees of about 7, such
  underpricing is an implicit cost to the issuing
  firm
• Highly expensive for small firms, and internet
  IPOs introduced

14
Public Offerings

• Underwriting types Firm commitment vs. Best
  Efforts
• Firm commitment IBs buy the issue and assume
  risk of selling
• Best Efforts no firm commitment, and act as an
  intermediary
• Negotiated vs. Competitive Bid
• Negotiated issuing firm negotiates terms with
  investment banker
• Competitive issuer structures the offering and
  takes bids from IBs
• SEC registration required for new issues to the
  public
• Registration of new securities must be approved
  by SEC (Preliminary prospectus, or Red herring)
• Once approved, Prospectus is distributed to the
  public together with Tombstone advertisements
• Shelf registration (SEC Rule 415, since 1982)

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Private Placements

• Sale to a small number of institutions and
  sophisticated investors
• Does not require registration at the SEC (Rule
  144A), and thus, cheaper than public offerings
• Very active market for debt securities, but not
  active for stock offerings

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How to place an order?

• Instruct your broker the following order
  specification
• Online vs. offline
• Name and type of the security to trade
• Indicate a purchase or sale
• Order size round lots vs. odd lots
• Order type market vs. limit orders, etc.
• Length of time of the order

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Types of Orders

• Market order
• Buy or sell orders are to be executed immediately
  at the best price currently available
• Limit order
• Specify prices at which buy or sell orders are
  executed
• Stop-loss order
• Sell stocks when price falls below a stipulated
  level
• This is to stop further losses from a long
  position
• Stop-buy order
• Buy stocks when price rises above a stipulated
  level
• This is to limit potential losses from a short
  position
• Good-till-canceled order
• Fill or Kill order (FOK)
• immediately execute a trade completely, or else,
  cancel it
• Market-on-close order

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Evolution of limit order book

• Suppose the following limit order book for stock
  XYZ observed at time 0 on a day.
• Sell Price Buy (At time 0) Sell Price Buy (At
  time 4)
• .... .... .... ....
• 1000 32 ??? 32
• 2000 31 ??? 31
• 30 ? 30
• 29 29
• 28 3000 28 ???
• 27 2000 27 ???
• .... .... .... ....
• What will be the trade prices for the following
  orders?
• At time 1, a market buy order of 1000 shares
  arrived.
• At time 2, a market buy order of 1500 shares
  arrived.
• At time 3, a market sell order of 2000 shares
  arrived.
• At time 4, a limit sell order of 1000 shares at
  31 arrived.
• How would the limit order book look like just
  after time 4?
• What would be the implicit cost of market buying
  and selling a share simultaneously just after
  time 4?

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Costs of Trading

• Brokerage commission
• Fees paid to broker
• Full-service vs. discount broker
• Explicit cost of trading
• Bid-ask spread implicit cost of trading
• Bid price that a dealer is willing to buy from
  you
• Ask price that a dealer is willing to sell to
  you
• Typically, Ask gt Bid
• and the difference ask bid is called as
  bid-ask spread, which is dealers gain for the
  market-making service

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Margin Trading

• Only a portion of the investment proceed comes
  from your own money
• Remaining portion is borrowed from a broker
• Bet on a rise in the price of the security
• Higher leverage, magnifying upside and downside
  risks
• Stocks purchased on margin must be maintained
  with the broker as collateral for the loan
• Initial margin
• Currently 50, set by the Fed
• You can borrow up to 50 of the stock value
• Maintenance margin
• Minimum amount of equity maintained in the
  account
• Margin call call from a broker to put up more
  equity funds
• Margin arrangements differ for stocks and futures

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Margin Trading Initial Margin

• X Corp. 70 current price
• 1,000 Shares Purchased
• 50 Initial Margin
• 40 Maintenance Margin
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity 35,000

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Margin Trading Maintenance Margin

• If stock price falls to 60 per share,
• New Position
• Stock 60,000 Borrowed 35,000
• Equity 25,000
• Margin () Equity in account / Value of stock
• 25,000 / 60,000 41.67
• Rate of return (25,000 35,000)/35,000
  -28.57
• Rate of return if own money of 35,000 is used to
  buy 500 shares
• (30,000 35,000) / 35,000 14.28

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Margin Trading Margin Call

• How far can the stock price fall before getting a
  margin call?
• Margin () Equity in account / Value of stock
• (1,000P - 35,000) / 1,000P 40
• ? P 58.33
• If stock price falls below 58.33, one gets a
  margin call

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Short Sales

• Opposite case of the margin purchase, i.e., only
  a portion of the securities are supplied by the
  seller
• Remaining portion of the securities are borrowed
  from a broker
• Bet on a decline in the price of the security
• Higher leverage, magnifying upside and downside
  risks
• The proceeds from the short sale must be
  maintained with the broker as collateral
• Mechanics
• Borrow stocks from a broker
• Sell it, and deposit the proceeds and margin
  money in an account
• Close out the position by buying the stock and
  returning it to the lender
• Short-seller must pay any dividends paid during
  the short sale to the lender of the stock

25
Short Sale Initial Conditions

• Z Corp 100 current price
• 100 Shares sold short
• 50 Initial Margin
• 30 Maintenance Margin
• Initial Position
• Sale proceeds 10,000 Stock owed 10,000
• Margin(cash,etc) 5,000 Equity
  5,000

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Short Sale Maintenance Margin

• If stock price rises to 110,
• New Position
• Sale proceeds 10,000 Stock owed 11,000
• Initial margin 5,000 Equity
  4,000
• Margin () Equity in account / Value of stock
• 4,000 / 11,000 36.36
• Rate of return (4,000 5,000) / 5,000 20
• Rate of return if own 50 shares are sold at 100
• (5,000 55,000) / 5,000 10

27
Short Sale Margin Call

• How much can the stock price rise before getting
  a margin call?
• Margin () Equity in account / Value of stock
• (15,000 100P) / (100P) 30
• ? P 115.38
• If stock price rises above 115.38, one gets a
  margin call

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Secondary Markets

• Organized exchanges
• OTC market
• Third market
• Fourth market

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Organized Exchanges

• Auction markets with centralized order flow
• NYSE, AMEX, and regional exchanges
• Listing requirements
• Dealership function by Specialists at NYSE
• Have exclusive right to make the market in a
  specified stock on the NYSE
• Must maintain a fair and orderly market
• Can be competitive or assigned by the exchange
• Traded securities
• stock, bonds, futures, options contracts

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OTC Market

• An informal exchange of brokers and dealers
  negotiating trades, without centralized order
  flow
• NASDAQ largest OTC market since 1971
• Computer-linked system providing information on
  dealers quotation of bid and ask prices
• Nasdaq National Market System
• Nasdaq SmallCap Market
• Lower volume securities
• OTC Bulletin Board
• Pink Sheets from NASD
• Traded securities
• Stocks, bonds and some derivatives
• Most secondary bonds transactions

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Third Market

• Trading of exchange-listed securities away from
  the exchange
• Institutional market, facilitating trades of
  larger blocks of securities
• Involves services of dealers and brokers

32
Fourth Market

• Investors trading directly with other investors
• Originally developed for institutional trading
• Technological developments lead to individual
  investors trading directly, without the need of
  market makers
• Advent of ECN
• Computer networks allowing direct trading
• Captures about 30 of the trading volume for
  NASDAQ-listed stocks in 2001
• (Ex) INSTINET, POSIT
• Competing with Nasdaq and NYSE for volume
• Implication of future structure of stock exchanges

33
Market Mechanics Alternative Ways of Trade
Execution
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Regulation and Market Trends

• ECNs present new challenges in regulation
• Global markets with alliances are developing
• Current Issues with Insider trading violations
• Agency problems associated with investment
  banking and research
• Most of top managers have long been engaged in
  earnings management with analysts and auditors,
  and they have been overly compensated by stock
  options or performance shares due to stock price
  increases
• We are currently seeing Sarbanes-Oxley acts, SEC
  and FBI investigations, and criminal/civil
  actions against corporations, corporate
  executives, auditors, investment banks, and
  analysts

35
Regulation and Market Trends 2

• Agency problems associated with investment
  banking and research (Continued)
• Market for corp. control (takeovers) cannot solve
  the problem Recent evidence shows value
  destruction in a large scale
• Equity-based compensation is like throwing
  gasoline on a fire
• Real solution is to not allow the market price to
  get substantially out of line with the true value
  of the firm, and to reset the value

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Financial Markets
T-Bills CD CP BA Repos/Reverses Federal
funds LIBOR market
(Short-term) Money Market
Traditional Financial Markets
T-Notes/Bonds Municipal bonds Corporate
Bonds ABS/MBS
(Long-term) Capital Market
Bonds
Financial Markets
Stocks
Forward Futures Option Swap
Derivatives
Foreign Exchange Market
Whole sales market Retail market
37
Financial Markets Instruments

• Money Market - short-term (maturity lt 1yr)
  fixed-income instruments
• Certificates of deposits (CDs)
• Commercial paper
• Treasury bills
• Fixed-Income longer term
• Municipal Bonds
• Government Bonds
• Corporate Bonds
• Asset and Mortgage Backed Securities

38
Financial Markets Instruments

• Equity
• Common stocks
• Preferred stock
• ADRs
• Derivatives
• Options
• Futures
• Forwards

39
Money Market

• Certificate of Deposit (CD)
• time deposit with a bank funds cannot be
  withdrawn
• interest and principal at the end of a fixed term
• can be traded (thin market for 3 months or more
  maturities)
• Commercial Paper (CP)
• short term unsecured debt usually backed up by a
  line of credit
• up to 270 days maturity usually 30 to 60 days
• Eurodollars
• dollar denominated deposits at non-US banks or
  branches
• Bankers Acceptances
• bank endorsed postdated checks (maturities 6
  months)
• Treasury Bills (T-Bills)

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T-Bills issuer and structure

• Debt securities issued by the US Treasury
• Extremely liquid
• Safe (no default risk)
• Pure discount security (no interest payments)
• Investors pay P dollars (e.g. 990) now
• Investors get F dollars (e.g. 1,000) in the
  future at maturity
• F gt P trading at discount
• Maturity 3, 6, 12 months

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Example 1 (Cashflow of T-Bills)
1,000 Face Value (par amount)
Today
Maturity (e.g. 3m)
Pay less than 1,000 (e.g. 990)

• Initial investment 990
• Payment at maturity 1,000
• Profit 10 (the interest you earned on the
  loan to the government)
• Return over 3m (1,000-990) / 990 1.01

42
Fixed Income

• Municipal Bonds
• issued by state and local governments
• tax exempt in the US
• Government bonds
• Treasuries
• Corporate Bonds
• credit risk
• Asset Backed securities
• example of securitization

43
T-Bonds issuer and structure

• issued by the US treasury
• T-Notes 1-10 years, T-Bonds 10-30 years
• semiannual coupons and principal at maturity
• adjusted for inflation for TIPS
  (inflation-indexed bonds)
• held by households, firms and financial
  institutions
• TIPS are mostly held by pension funds,
  endowments, individuals saving for retirement

44
T-Bills and Bonds trading and riskiness

• Initial sale through auction
• a weeks advance notice
• competitive bids price and quantity
• non-competitive bids only quantity
• bidding through one of about 50 dealers
• no bid for more than 35 of the total offer
• Subsequent trading through primary dealers on OTC
  market
• Riskiness negligible default risk (backed by
  government ability to tax), interest-rate risk

45
Corporate Bonds

• Issued by large corporations via investment banks
  through underwriting process
• Maturities and coupon payments similar to T-Bonds
• Traded in a dealer market connected by computers
• Held by mutual and pension funds and insurance
  companies mainly

46
Credit Risk

• Unlike treasuries, corporate bonds carry
  significant default risk, hence we distinguish
• Secured bonds specific collateral backing in the
  event of default
• Debentures unsecured bonds (no collateral)
• Subordinated debentures lower priority claims
  than debentures
• Bond covenants regulate the rights of the lender
  and the restriction on the borrower

47
Bond Covenants

• Asset covenants
• govern firm acquisition, disposition and use of
  assets
• Dividend covenants
• restriction of dividend payments
• Financing covenants
• prevents firm from issuing new debt
• Bonding covenants
• mechanism to enforce covenants, e.g. trustee to
  oversee that covenants are not violated
• Sinking fund covenants
• certain parts of the bond must be retired by
  certain dates

48
Cash Flow Patterns

• Straight coupon bond (bullet bond)
• fixed rate semiannual coupon, principal paid only
  at terminal date (balloon payment)
• Medium term notes (MTN) belong typically to this
  class
• Zero coupon or pure discount bond
• no periodic payments, single payment at maturity
• Deferred coupon bond
• interest is deferred for a period, so that
  cash-constrained firms can fund other projects
• Consol (perpetuity) bond
• bonds that pay only interest forever
• Annuity bond
• pay a mix of principal and interest until maturity

49
Bond Options

• Callability
• allows the issuing firm to retire the bond before
  maturity at a pre-specified price
• Convertibility
• allows bondholders the option to convert the bond
  into another security, typically common stock
• Exchangeability
• allows issuing firm to exchange the bond for a
  different type of bond
• Putability
• allows bondholders to sell the bond back to the
  firm

50
Corporate Bond Ratings
51
Transition Probability Matrix
52
Asset Backed Securities

• Asset securitization
• collect many sufficiently homogeneous assets in
  the same pool
• issue securities that are claims on the pool cash
  flow
• converts illiquid loans into liquid securities
  that can be bought by a much wider group of
  investors
• Many assets are securitized nowadays
• mortgages
• airplane leasing
• credit card loans

53
Mortgage Backed Securities

• In the US 80 of mortgages are securitized
• Explosion of the market in the US
• Not yet in Europe

54
Equities

• Issued by corporations
• Each share represents ownership in the company
• right to share of dividend
• right to vote at shareholders meetings
• Residual claimant
• get payouts only if all other claims are met
• debt claims are senior to equity claims
• Limited liability
• liability limited to the shareholders initial
  capital deposited

55
Equity Types and Issuance

• Common stock
• Shareholders are residual claimants (lowest
  priority)
• Represents real ownership in the firm (voting
  rights)
• Limited liability
• Preferred stocks hybrid of bond and stock
• Bond-like features
• no voting rights
• promise to pay fixed dividends, often convertible
• Stock like features
• cant force bankruptcy
• no specified maturity
• low priority

56
Equity Types and Issuance (cont)

• ADRs American Depositary Receipts
• receipts for the shares of a foreign base
  corporation held in the vault of a US bank and
  entitling the shareholder to all dividends and
  capital gains
• Two ways to raise capital through public equity
  issues
• IPO, Initial public offering first sale of stock
  by a formerly private company
• SEO, Seasoned equity offering subsequent sales
  of stock by an already public company

57
Options

• Call Option
• gives the holder the right to purchase an asset
  for a specified price, called the exercise or
  strike price on or before a specified expiration
  date
• Put Option
• gives the holder the right to sell an asset for a
  specified price, called the exercise or strike
  price on or before a specified expiration date
• Derivative assets since their value depends on
  the value of the underlying asset

58
Example - European Call Option

• Today
• You buy a 6-month call option on GE, i.e. the
  right to purchase GE stock at price X in six
  months
• notice that the right cannot be exercised before
  6 months
• In 6 months
• GE stock is worth ST
• If STltX, no point in exercising the call Payoff
  0
• If STgtX, you exercise the option, pay X for the
  stock, can resell it at ST Payoff ST X

59
Futures

• Delivery of an asset at a specified delivery or
  maturity date for an agreed-upon price, the
  futures price, to be paid at contract maturity
• long position obligation to buy the asset
• short position obligation to deliver the asset
• Options on futures grant the right (not the
  obligation) to buy or sell the asset at the
  exercise price
• Underlying assets can be
• currencies (US, EURO )
• goods (oil, wheat )
• financial assets (e.g. stocks) and indexes (e.g.
  SP500)

60
Where to get data?

• Easiest web search engine, financial sites
  (Yahoo, Infoseek, msn, etrade, etrade-SE, CNNfn,
  etc.)
• Bulk suppliers
• Bloomberg, DataStream, CRSP, Reuters, Trust,
  Commodity Systems, Inc., Securities Data Corp.,
  etc...
• Look at departamental web site
  http//www.hhs.se/secfi/Databases/Databases.htm
• Dividends
• Volume
• Splits

61
Indexes

• Uses
• Track average returns
• Comparing performance of managers
• Base of derivatives
• Factors in constructing or using an Index
• Representative?
• Broad or narrow?
• How is it constructed?
• Subjectivity Factor (Bethleham Steel)

62
Examples Stock and Bond Indices

• Dow Jones price weighted arithmetic
• Standard Poors value weighted arithmetic
• Specialized indexes Wilshire, Russell etc.
• European indexes Eurostoxx 50
• Bond indexes Lehman Brothers, Merrill Lynch,
  Salomon Brothers all value weighted

63
Indexes - Methodology

• Price Weighted Indexes
• average price of 1 share of the companies in the
  index
• measures the performance of a portfolio with 1
  share of each stock in the index
• Value Weighted Indexes
• average market value of the companies in the
  index
• measures the performance of a portfolio in which
  each stock counts as its market capitalization

64
Wilshire 5000 Index
65
Top 20 companies in SP500 Index
66
Asset Classes Returns US History
67
Asset Classes Returns Swedish History
68
GoetzmannJorion International Evidence
69
GoetzmannJorion International Evidence
Median Market RR 0.75 GDP-weighted RR 4
70
Services of Investment Companies

• Administration record keeping
• Periodic reports on capital gains, dividends,
  investments, and redemption
• Diversification divisibility
• Each investor has a claim to the portfolio in
  proportion to his investment
• Professional management
• Full-time staffs of security analysts and
  portfolio managers
• Reduced transaction costs

71
Net Asset Value

• Value of each share of a mutual fund
• Used as a basis for valuation of mutual funds,
  e.g., when selling new shares or redeeming
  existing shares
• Market Value of Assets - Liabilities
• Shares Outstanding
• (Example) A mutual fund with 5 mil shares
• Portfolio of securities 120 mil
• Investment advisory fees payable 4 mil
• Other Liab.(rent, wages due, expenses) 1
  mil
• NAV (120 5) / 5 23 per share

72
Types of Investment Companies

• Investment Company Act of 1940
• Unit Investment Trusts
• Investment portfolios are fixed and unmanaged
  (lower operating expenses than actively managed
  funds)
• Managed Investment Companies
• Closed-End vs. Open-End Funds
• Discount puzzle of closed-end funds
• Various commissions (sales, management,
  performance fees, etc.)
• Unrealized capital gains and taxes
• Individual investors sentiment

Closed-end Open-end
Redemption of shares Cannot redeem its shares, but traded on stock exchanges Can redeem or issue its shares at NAV, but not listed on exchanges
Shares outstanding No change unless new share is offered Changes daily as new shares are sold or old shares are redeemed
Pricing Premium or discount to NAV NAV
73
Other investment Organizations

• Similar functions, but not formally regulated as
  investment companies
• Commingled funds
• Similar to open-end funds, and units are offered
• Money market fund, bond fund, etc, by a bank or
  insurance company
• REITs
• Similar to closed-end funds
• Investing in real estate (Equity trusts) or
  mortgage loans (Mortgage trusts)
• Hedge Funds
• Private investment pool, not subject to SEC
  regulation
• Heavy use of derivatives, short sales, and
  leverage, speculating on convergence of valuation
  differences across two sections

74
Investment Policies

• Investment policies of mutual funds are described
  in prospectus
• Get a free prospectus for many mutual funds at
• http//usatodayonl.fundinfo.wilink.com/asp/F116_s
  earch_ENG.asp
• Various kinds of investment policies (styles)
• Money Market Funds
• Fixed Income Funds
• Balanced Income Funds
• Equity Funds
• Index Funds passive strategy, tracking a broad
  market index
• Asset Allocation Funds actively engaged in
  market timing and forecasting
• Specialized Sector Funds industry-specific or
  international stocks

75
Costs of Investing in Mutual Funds

• Front-end vs. Back-end load vs. no-load
• Front-end load sales commission paid at time of
  purchase (about 6)
• Back-end load redemption fee at time of
  redemption (about 6, and gradually lowers every
  year)
• Operating expenses
• Administrative expenses and advisory fees paid to
  the investment manager (0.2 to 2 of total
  assets)
• Periodically deducted from the fund assets
• 12 b-1 charges
• Annual fees charged by a fund manager to pay for
  marketing and distribution costs of annual
  reports and prospectuses, and sales broker
  commissions (limited to 1 of a funds average
  net assets per year)
• Annually deducted from the fund assets
• Different classes of shares have different fee
  structures
• Allow investors to choose the best combination of
  fees, depending on their investment horizons.

76
MF Returns, Fees, and Taxes

• Rate of return before fund expenses
• (NAV1 NAV0 Dividend and capital gain
  distributions) / NAV0
• Fund expenses affect the returns
• Front-end or back-end loads, operating expenses,
  and 12b-1 charges are periodically deducted from
  fund assets, having substantial negative effects
  on the rate of return
• Costs incurred in soft dollars are difficult to
  measure
• High trading commissions will eventually reduce
  fund returns
• The pass-through status of fund income
• If at least 90 of all income is distributed to
  shareholders, and
• less than 30 of its income comes from the sale
  of securities held for less than three months
• Then, investors (but not the fund) pay income
  taxes at their own tax rate
• It may be a disadvantage since it is difficult to
  control when to realize capital gains and how to
  manage tax liabilities
• Such a tax management issue is irrelevant if a
  mutual fund is held in a tax-deferred retirement
  account such as an IRA or 401(k) account

77
Exchange Traded Funds

• A variant of mutual funds that allow investors to
  trade index portfolios like shares of stock
• Examples SPDRs and Diamonds
• Potential advantages
• Trade continuously, and can be sold short or
  bought on margin
• Tax advantage over mutual funds
• Redeemable for shares of stocks in the portfolio
  without selling them, thus not triggering capital
  gains taxes
• Investor can buy ETFs through brokers (save sales
  charges)
• Lower management fees, 0.090.18
• Potential disadvantages
• Sometimes depart from the NAV, giving arbitrage
  opportunities
• Trading incurs brokerage fee and bid-ask spreads

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Mutual Fund Performance

• Choice of an appropriate benchmark is difficult
• Must have similar risk characteristics
• A simple comparison with Wilshire 5000 index (Fig
  4.3)
• The index has outperformed the median managers in
  more years during 1972-2001, and the average
  difference of annualized compound returns is
  1.09 (12.20 vs. 11.11)
• This margin could have reduced to 0.79 for
  passively managed low-cost index fund, and thus,
  passive index fund would have outperformed
  actively managed funds
• Repeated winners?
• Tab 4.4 shows that 62 of initial winners repeats
  in the following period, which is consistent with
  at least some part of a funds performance is a
  function of skill as opposed to luck
• Bad performance is more likely to persist than
  good performance due to high turnover ratios and
  expense ratios

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Sources of Information on Mutual Funds

• Prospectus
• Is required to contain investment objectives,
  policies, risks, fee table, portfolio managers,
  etc.
• Two other sources
• Statement of Additional Information (Part B of
  Prospectus), and Annual Report show portfolio
  composition, financial statements, etc.
• Which funds to choose?
• Morningstars Mutual Fund Sourcebook
• Wiesenbergers Investment Companies
• Investment Company Institutes Directory of
  Mutual Funds

80
Recent Fraud in Mutual Fund Industry

• Late trading or market timing is discouraged
  or prohibited
• Mutual fund companies state in their prospectuses
  that they discourage or prohibit "late trading"
  and "market timing" by large investors. However,
  mutual fund managers were found to permit certain
  companies to conduct such trades in exchange for
  payments and other inducements.
• http//www.usatoday.com/money/perfi/funds/2003-10-
  02-mym_x.htm
• http//www.usatoday.com/money/perfi/funds/2003-10-
  02-prospectus_x.htm
• http//www.lieffcabraser.com/mf_main.htm (fraud
  investigation documents)
• Late trading involves purchasing mutual fund
  shares at the 4 pm price after the market closes,
  a practice which is illegal, and like allowing
  betting on a horse race after the horses have
  crossed the finish line.
• Market timing is a short-term, "in and out"
  trading of mutual fund shares. It is designed to
  exploit market inefficiencies by buying mutual
  fund shares at the stale NAV, and realizing a
  profit later when selling them.
• Typically, funds limit the number of round trips
  an investor can make during a 12-month period,
  and allow exchanges from one fund to another
  within the same fund family several times a year
  for a low or no fee.

81
The Future

• Globalization continues and offers more
  opportunities
• Securitization continues to develop
• Derivatives and exotics continue to develop
• Strong fundamental foundation is critical
• Integration of investments corporate finance