Mutual Funds, ETFs, and Hedge Funds

Chapter 4

Services of Investment Companies

1. Administration and record keeping

2. Diversification and divisibility

3. Professional management

4. Lower Transaction Costs

Characteristics of Investment Companies

• Typically small minimum investments

• Assets are pooled together, so one client is affected by other client actions

• No special tax strategies possible

• Clients do not own the actual shares of stocks they are invested in

• Instead, they own shares of the fund that owns the underlying stocks

Market Value Calculation:Net Asset Value

gOutstandin Shares Fund Total

Expenses FundPortfolio of ValueMarket Total NAV

Example

Market Value = $100 mil

Number of Shares = 10 mil

NAV = $100 / 10 = $10 / share

Suppose Market Value goes up to $112.5 mil, and the fund expenses during that period were $0.1 mil. What is the ending NAV?

NAV = (112.5 – 0.1) / 10 = $11.24 / share

Types of Investment Organizations

• Managed Investment companies

– Open-end funds (mutual funds)

– Closed-end funds

• Other investment organizations

– ETFs (Exchange Traded Funds)

– Hedge Funds

Open-end (Mutual Fund)

• Number of shares outstanding can vary from day to day.

• Buy back (redeem) shares or sell additional shares at the NAV. Need to hold cash reserve for redemptions.

• There may be a sales charge (load) when the fund sells the shares to customers.

• May charge a redemption fee when the customers sell their shares back by the fund.

• Fund can “cap” out and not accept new investors. Otherwise, the fund can continue to grow by issuing new shares.

Mutual Fund Styles

• Money market

• Fixed Income

• Equity

• Balance & Income

• Asset allocation

• Specialized sector (gold, financial)

• Style (Growth versus Value)

• Indexed

• Income Funds: High Dividend yield stocks.

• Growth Funds: Forego dividend yield for capital gains. Invest in well-established firms.

• Aggressive Growth: Seek maximum capital growth.

Equity Mutual Funds Classes

Mutual Fund Fees• Sales and Marketing Fees

– Front End Load: Paid when shares are purchased.• Load: from 3% to approximately 8% of NAV• Low-Load: Up to 3%• No-Load: No sales charge

– Be careful! Back-End Loads• 5-6% fee on sale. Typically drops by say 1% every year.

– 12b-1 Fees• An alternative to a load to cover advertising & marketing

expenses. No-Load and Low-Load funds use these.• Can deduct as much as 0.75% of assets annually to cover

fund advertising & marketing.

Sales & Marketing Fee Choice

• Some funds give you a choice as to how you want to pay your share of the expenses by offering alternatives called choices “A”, “B” or “C”.A: Front-end load. No 12b-1 fees. No back-end load.B: No Front-end load. Small 12b-1 fees. back-end load

that decreases the longer you hold shares.C: No Front-end load. Larger 12b-1 fees. Shorter back-

end load penalty period.

Management and Record Fees

• Management Fees

– Range is typically 0.20% to 1.00%.

• Records Fees

– Can be as much as 0.25% of assets annually.

Expense Ratio

Total Annual Expenses include:12b-1 fees, Management fees, records fees

Expense Ratio = Total Annual Expenses/$ Amt of Fund Assets

Studies find that funds with lower expense ratios earn higher returns than those with higher expense ratios.

Typical Feesfor US. Domestic Equity Funds

as of 2005

Closed-End Funds

• Shares of the fund trades on the secondary market

• Fund does not usually offer additional shares or repurchase shares

• No need for cash reserve for liquidity needs.

• Market price is often different from (usually at a discount to) the NAV.

Closed-End Fund Fees

• Management and Record fees can be charged within the fund

• Sales charges do not exist• Commissions are charged to each

purchase and sale, exactly like a stock transaction

ETFs (Exchange Traded Funds)• A Hybrid of open-end fund and the closed-end fund.

– Traded throughout the day, similar to the closed-end fund.– Institutional investors can redeem shares for the underlying

securities, or exchange the portfolio of stocks for the shares, similar to the open end mutual fund.

• Implication on premium/discount.

• Examples– SPDR, “DIAMOND”, “Qubes”– iShares track international indices– Sector ETFs (energy, utilities, technology, industrials,

transportation, etc.)

ETFs (Exchange Traded Funds)

• Example– Spiders

• One share 1/10 of price S&P 500 index.• Can create or delete by exchanging shares plus

cash at the end of the day in units of 50,000 shares and cost of $3,000. (fixed, not affected by number of units).

Concerns: Turnover & Taxes

• Turnover: Fraction of portfolio replaced each year.

• Mutual funds, CEFs, and ETFs have pass-through-status which means that taxes are paid only by the investor, not the mutual fund.

• To accomplish this, the fund must pass on all capital gains and dividends to the client.

• Not an issue if in a tax-deferred retirement account

Hedge Funds

• Often off shore• Typically only offered to “qualified” investors• More risk allowed, and typically taken• More flexible in their investments: short

positions, leverage, private placements• Higher fees charged• More frequent change in their composition• Pure ones are market neutral

Hedge Funds

• Dynamic investment– Rarely buy-and-hold– Fees reflect active management– Information-driven trading– Static risk analytics not appropriate

Hedge Funds

• Long/Short Market Neutral Strategy– CAPM:

• Beta of the portfolio=0.

– Fama-French 3-factor:• Small cap manager: 50% long, 50% short in

growth stocks so neutral regarding style risk.• Growth style manager: 50% long, 50% short in

small cap stocks so neutral regarding size risk.

Index Fund and Passive Equity Management

• Logic: Market is fairly efficient. Too difficult to overcome 1 - 2% costs of running an active equity portfolio.

• Goal: Don’t try to beat the market, just equal it!• Passive Features

– Portfolio is built without using technical or fundamental analysis.

– Buy & Hold: The securities are purchased and then held with only occasional re-balancing (reinvest dividends, a change in the index etc…)

Index Funds

• Passive portfolios that track an index and sell shares to investors are called Index Funds: (Eg: Vanguard 500 Index which tracks the S&P 500.)

• Manager Performance: Judged by how well he/she tracks the index or sector and by the costs generated to do so.

Size of Indexing--- as of June 2003

Index Assets

Benchmarked($ billions)

Ratio of assetsbenchmarked to market

value of index

S&P 500 includinggrowth/value 1,127 11.3%

Russell 1000 includingGrowth/Value 430 3.8%

Russell 2000 includingGrowth/Value 264 26.4%

Russell Mid-Cap incl.Growth/Value 81 2.7%

S&P Mid-Cap 400 44 5.0%

Wilshire 5000 13 0.1%

Nasdaq Composite 3 0.1%

Dow Jones 2 0.1%

S&P Small-Cap 600 2 0.5%

Total US Markets 12,500

Index Fund Types

1. Full Replication: Buy all stocks in the index in proportion to their weights in the index.

2. Sampling: Buy the stocks with larger index weights & hold a representative sample of the others.– Benefit Relative to Full Replication: Lower

commissions (fewer stocks to purchase and to reinvest dividends).

– Drawback Relative to Full Replication: Tracking Error.

Evaluating Index Fund Manager Performance

• R-Square: Measures how closely the fund is moving with the benchmark index– This measures tracking, but not costs

• Tracking error: Measures tracking and costs: absolute value of (Rit – Rmt), t = 1 to T, or

(Rit – Rmt)2, t = 1 to T

Addition and Deletion Effects for Indexes

• Additions: – What to expect? Why?

• Deletions:– What to expect? Why?

• Empirical Evidence– Chen, Noronha, and Singal (2004, Journal of

Finance)

Figure 1. Price Responses to Changes to the S&P 500 Index198910-200212

-16

-12

-8

-4

0

4

8

12

AnnDate -1 AnnDate EffDate EffDate + 20 EffDate + 60

Additions

Deletions

Implication for Index Fund Investors

• NY Times (July 4, 2004)• Barron’s (April 3, 2006)• Chen, Noronha and Singal (2006, FAJ)

– Compare losses to two popular indexes• Investors in funds indexed to S&P 500 lose up to 0.10% per

year• Investors in funds indexed to the Russell 2000 lose up to

1.84% per year• Total loss = Up to $5 billion• Note: Losses in the mutual fund scandal were estimated

between $0.5 and $3 billion.

Assignment

• Chapter 4 Problems:– 2, 3, 4, 6, 10, 11, 18