20-Mutual Funds
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Transcript of 20-Mutual Funds
Mutual Funds and Investment Companies
How Much do Investment Companies Own?
OWNERSHIP as a PERCENT of TOTAL MARKET-CAP
Advantages
record keeping and administration
diversification
professional management
lower transaction costs
Investment Companies Investors buy “shares” of the
investment company.
Share is a claim to the stream of cashflows generated by company assets.
Net Asset Value:Net asset value (NAV) =
Market value of assets - Liabilities
Shares outstanding
Mutual Funds
Open-end funds You buy or sell shares directly through the
mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at this
NAV Fund companies adjust the number of
shares according to the demand by investors
Open-End Fund Example 1
Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 0 Shares Outstanding = 900 million NAV = 36B/900M = $40
Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000
Open-End Fund Example 1
4:00pm on Tuesday Asset value is now 36B(1.01)=36.36B NAV = 36.36B/900M=40.4 % change: 40.4/40-1= 1%
New Flows of $500,000 500,000/40.4 = 12,376 shares
New investors buy these shares at 40.4 per share Total shares outstanding = 900M + 12,376 Total Assets = 36.36B + 500,000
Open-End Fund Example 2Adding a Little Leverage
Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 1 billion Shares Outstanding = 900 million NAV = 35B/900M = $38.89
Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000
Open-End Fund Example 2Adding a Little Leverage
4:00pm on Tuesday Asset value is now 36B(1.01)=36.36B NAV = 35.36B/900M=39.29 % Change = 39.29/38.89-1=1.029%
New Flows of $500,000 500,000/39.29 = 12,726 shares
New investors buy these shares at 39.29 per share Total shares outstanding = 900M + 12,726 Total Assets = 36.36B + 500,000
How Funds are Sold
Fund “underwriter” has exclusive rights to distribute shares of the fund.
Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter.
Financial Supermarkets Example: Charles Schwab
Front-End Loads What they are for
Used to pay brokers who sell funds
How they affect price paid NAV of fund: $13 Front End Load: 4% What price do you pay per share?
NAV=96% of price 13=0.96*P P = 13/.96 = 13.54
Fund NAV must increase to 13.54 (4.2%) just to break even, assuming no other fees.
Front End Loads
Another way of looking at front end loads: Assume front-end = 4%
If you invest $1000, only $960 is actually used to buy shares of the fund
The other $40 is gone in fees Your investment must increase to 1000 (4.2%)
just to break even, assuming no other fees
Front End Loads
How they affect returns Fund:
NAV=$10 Front End load of 5% NAV grows by 14% per share each year
Assume you invest $X and hold investment for two years.
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Back End Loads
What they are for Used to pay brokers who sell funds 0 to 6% Usually reduced 1% point for each year you hold
the fund
How they affect price paid They don’t Assuming no other fees, price is NAV
Back End Loads
How they affect price received when sold NAV of fund: $13 Back End Load: 5% What price do you get when you sell the
fund? 13*.95 = $12.35
Back End Loads
How they affect returns Fund:
NAV=$10 Back End load of 5% Fund earns 14% per share each year
Assume you invest $X and hold investment for two years.
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Annual Expenses
Operating expenses What They are for
Used to pay for administrative expenses and advisory fees
12b-1 charges What they are for
Used to pay for advertising, promotional literature, and brokers
Annual Expenses How they affect returns Fund:
NAV=$10 Annual expenses (expense ratio) of 5% Fund earns 14% per share each year
Assume you invest $X and hold investment for two years
Each year gross return net of fees is 1.14 - 0.05 = 1.09
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Summary
Assume: A fund portfolio grows by r each year. The fund has front-end load of f. The fund has back-end load of b. The fund has annual expense ratio of a. No capital gains or distributions
The gross return for an investor in the fund over n periods is
)1(11 ReturnGross br-a)-f)(( n
Example: Fund or CD’s?
Investment Choices: mutual fund,
3% front-end load annual expense ratio of 0.6%.
CD: 5% per year
What return must the fund portfolio earn for you to be better off in the fund than in the CD if you plan to hold the investment for 4 years?
Example: Fund or CD’s?
In 4 years: CD: gross return = (1.05)4
= 121.55% Fund: gross return = .97 (1+r-0.006)4
.97 (1+r-0.006)4 = 1.2155 (1+r-0.006)4 = 1.2155/.97=1.253 1+r =0.006+1.2531/4
r = 6.4%
Mutual Funds
Closed-end funds Fund companies issue a fixed number of
shares You buy or sell shares on an exchange The funds usually trade at a discount of
about 10% relative to NAV per share. Puzzle
Alphas of Actively Managed Funds
Mutual Fund Performance
If momentum and value have given positive alpha over the last 30 years, why haven’t active fund managers been able to capture it?
Average Active Mutual Fund Performance 1975-1994
Russ Wermers, 2000Journal of Finance
ETF
Exchange-Traded Funds (ETFs) are unit investment trusts that will primarily hold securities that are in a market index.
Investors have the right to exchange their shares for the underlying securities of the fund.
Exchange traded notes are ETFs that buy all securities within a bond index.
Examples of ETFs
SPDRs (S&P 500 Depository Receipts) Cubes (Nasdaq 100) Diamonds (Dow Jones Industrial Average) I-shares (Barclays) HOLDRs (Merrill Lynch) VIPERs (Vanguard) See
http://www.nyse.com/screener/index.php for a complete list
Advantages of ETFs Relative to Mutual Funds
ETFs can be bought and sold anytime like regular stocks at real-time prices.
ETFs can be sold short.
ETFs have relatively low fees.
ETFs are relatively tax-efficient.
Some Disadvantages of ETF’s
Prices can move away slightly from NAV Open-End Mutual funds are always
purchased at NAV
Pay the bid-ask spread when trading an ETF
Hedge Funds
A private investment pool, open to wealthy or institutional investors.
Not registered as mutual funds and not subject to SEC regulation.
Pursues more speculative policies in liquid assets such as stocks, bonds, currencies, options, and other derivatives.
Name comes from the fact that hedge funds want to create market-neutral strategies by going long in some assets and going short in related assets.
Hedge Funds vs. Mutual Funds
Mutual Funds Hedge Funds
Investment methods
Buy publicly traded securities. Little use of leverage or short-sales.
Buy also non-public securities, currencies and commodities. Wide use of leverage and short-sales.
Diversification Hold broad mix of assets. Holdings are often concentrated.
Fees Relatively low fees that do not depend on performance
Relatively high fees that depend on performance.
Withdrawls Investors can sell back shares at any time
Investor money is “locked up” for long periods
Regulation Heavy Regulation Light Regulation
Initial investments
Relatively low Very high investments necessary.