Mutual funds (see Ch. 16 Hirschey and Nofsinger)

Investment Companies An investment company invests a pool of funds belonging to many individuals in a portfolio of individual investments such as stocks and bonds Benefits: Diversification Professional management Low capital requirement Reduced transaction costs Access to illiquid markets Access to non-traditional trading strategies

Mutual Funds An investment company that issues its portfolio shares to investors. Money from shareholders are pooled and invested in a wide range of stocks, bonds, or money market securities. Managed by professional managers Each investor shares proportionately in the income and investment gains and losses, as well as the brokerage expenses and management fees. Open end fund: # of shares issued solely depends on investor demand Bought and sold directly through the investment company (not an exchange)

Net Asset Value Used as a basis for valuation of mutual funds. Selling new shares Redeeming existing shares Calculation: Market Value of Assets – Fund Expenses - Liabilities Shares Outstanding A mutual fund has $100 mil in assets and $3 mil in short term liabilities. 10.765 mil shares outstanding. What is the NAV? Solution ($100 mil - $3 mil) / 10.765 mil = $9.0107 per share

Sources of Information Lipper Inc.: leading provider of data and analysis on the investment company business ( www.lipperweb.com ) Morningstar.com: provide unbiased data and analysis and candid editorial commentary (www.morningstar.com) Vanguard Group: providing competitive investment performance and lowest operating expenses ( www.vanguard.com )

Mutual Funds: Investment Policies Money Market Fixed Income Equity Balance & Income Asset Allocation Indexed Specialized Sector

Mutual Fund Organization Mutual fund shareholders: own mutual funds, elect the board of directors Majority of the directors must be independent directors Investment advisor: manages the day-to-day operations Principal underwriter, administrator, transfer agent, custodian, and independent public accountant

Types of Investment Organizations Mutual funds Open-End Closed-End (Stock trades on secondary market; Net asset value (NAV) is determined daily, but market price determined by supply and demand) - ETFs (Exchange Traded Funds) Hedge Funds Private equity/venture capital funds

Costs of Investing in Mutual Funds Fee Structure Front-end load Back-end load Operating expenses 12 b-1 charges distribution costs paid by the fund Alternative to a load Fees and performance

Mutual funds: Performance It’s not conclusive Most of the studies suggest that the average MF underperforms its benchmark There is some evidence of short-term performance persistence The evidence show that it’s not easy to find funds that outperform for a long period of time Nonetheless, “hot” funds receive a disproportionately amount of new money

Closed-End Funds Issues a fixed number of shares at a given point in time Collect money from investors through and IPO and use this money to invest in securities. # of securities are fixed at the time of IPO. When the market price exceeds its NAV, selling at a premium, otherwise, selling at a discount (closed-end funds typically sell at a discount) Suited to specialized investing in small or illiquid markets

Exchange Traded Funds Are similar to closed-end funds: traded securities; entails commission costs Each ETF is a claim on a trust that holds a specified pool of assets (e.g. S&P500 index components) Examples:SPDRS,ishares,HOLDERS Advantages: Liquidity Taxes Can be purchased on margin or sell short ETF are appropriate for short-term investors and the ones who buy in large lots

Alpha Alpha = mutual fund return – benchmark return Higher the Alpha better the fund performance

Morningstar rating Created in 1984 to provide comprehensive assessment of mutual funds The star system was not meant to predict future performance 5* - the top 20% of the funds 1* the bottom 20%

Hedge Funds Considerable confusion exists concerning hedge funds – what they are (and are not) and how they work Hedge funds are privately organized, pooled investment vehicle with no restrictions in terms of investment strategies, asset classes and use of leverage Many of them registered off-shore for tax and regulatory reasons Can’t have more than 100 “accredited” investors or 500 “super-accredited” investors Accredited investor: net worth > 1 million or income of $200,000 in each of the past two years Super-Accredited investor: net worth > 5 million

Hedge Funds Do they all hedge? Are not allowed to advertise broadly and engage in “ general solicitation” to the investing public Charge 1-2% of assets under management and 20-25% of profits First hedge fund on record, Jones Hedge Fund, was established in 1949 He hedged the US equity market risk and focused on stock selection By 2001, more than 5,000 funds in existence world-wide Common features: - shorting - leverage - concentration Do they all hedge?

Hedge Fund Strategies Long-short equity Equity market neutral Fixed-income arbitrage Convertible arbitrage Merger arbitrage Global macro Special situations

Learning objectives Discuss the advantages and disadvantages of mutual funds Know how to calculate NAV Define and Discuss the differences between open end, closed end and ETFs Briefly discuss the costs, loads and fees of investing in mutual funds Morningstar and Style boxes Discuss the governance structure, Mutual Funds as Tournaments, and Performance (p. 513-516) Discuss what the hedge funds are, and how do they differ from traditional professionally managed investment products End of chapter questions 16.2, 16.3, 16.4,16.6, 16.7, 16.11