Economics 71a: Spring 2007 Mayo 17, Malkiel 8 Lecture 4.8 Investment Companies Economics 71a: Spring 2007 Mayo 17, Malkiel 8 Lecture 4.8

Goals History Closed and open funds Performance and fees Types of funds Index funds ETF’s Hedge funds How well do funds perform?

History First funds, March 1924 Boston is key location Growth State Street Research Massachusetts Investment Trust Massachusetts Financial Services now owned by Sun Life of Canada Boston is key location Growth Recently phenomenal Increase in total capital between 25-50 times since 1980 Number of funds has also exploded 1980 = 468 funds in U.S 1997 = 5,765 Today around 10,000

Closed versus Open Funds Closed end fund Traded like regular stock (price) Fixed number of shares Basically a corporation whose only assets are its portfolio Open end fund New shares issued for each buyer Valued at current market value of the fund portfolio Net asset value (NAV)

Net Asset Value (NAV) Total net worth of fund NAV/share Assets - Liabilities Assets: Stocks, bonds Liabilities: Borrowing NAV/share

More on Closed versus Open Most funds are Open-End Closed-end funds occasional trade differently from their asset values (NAV) P<NAV, or P>NAV

Performance (open end) (Reported numbers often exclude fees.) NAV = Net asset value I, CG = Income + Capital gain distributions

Performance (closed end) P = Market price I, CG = Income + Capital gain distributions

Costs and Fees Loading fees (paid at start, 3-6 percent) 12b-1 fees (sales expenses) Continue over years Management fees Paid to investment advisor Between 0.25 and 1.5% Fund expenses (legal, admin) Trading costs

Benefits Diversification Stock selection skills Bookkeeping

Types of Funds Stocks Bonds Money Market

Stock Funds Index (see next slide) Growth Value Sector Market neutral Green and socially responsible funds International Country Emerging markets

Index Mutual Funds Designed to match (but not beat) the market Examples Track S&P 500 Country funds Why? Market efficiency Cost

Other Index Instruments Exchange Traded Funds (ETF) Traded on regular exchanges Can be short sold Types Standard and Poors Depository Receipts (SPDRS) World Equity Benchmarks (WEBS) Diamonds (Dow) Qubes (NASDAQ) (QQQ)

More ETF Info (See Economist) Growing fast Expanding into new areas Gold Nanotechnology “Ultrashort QQQ” Goes down 2% when NASDAQ up 1% Advantages Easy to trade long or short indices Disadvantages May encourage short run trading Liquidity for some may be low

Hedge Funds Small numbers of large investors (> $1.5 million) Not SEC regulated (registered) More flexible in strategies May hold derivatives Short sales Leveraged (borrowing) Performance based fees 2% of total assets and then 20% of profits (2 and 20) Limit withdrawals

Other Managed Funds Funds of hedge funds Pension funds Insurance companies Endowments/foundations

Mutual Fund Performance Malkiel Chapter 8 Good data experiment Do mutual funds out perform the rest of the market?

Mutual Funds vs. Market 10 years ending December 31, 2001 S&P 500: +12.94 % per year Stock mutual funds: +10.98 % Rankings: 70’s -> 90’s Twentieth century growth 1 -> 176 Templeton growth 2 -> 126

More on rankings Average return in 70’s Average return in the 80’s Top 20 funds in 70’s +19% All funds +10.4% Average return in the 80’s Top 20 funds in the 70’s 11.1% 11.7%

More on rankings Average return in 80’s Average return in the 90’s Top 20 funds in 80’s +18% S&P +14% Average return in the 90’s Top 20 funds in the 80’s 13.7% 14.9%

The Problem of Size and Success for Mutual Funds As funds get bigger size gets in the way Difficult to buy stocks 50 stock fund 1 billion in assets Control <5% in each stock Universe = 1850 20 billion in assets <5% in each stock Universe = 182 Transaction costs and “price impact”

Gurus: Luck Versus Chance Appear to be some people who do well consistently Peter Lynch: Michael Jordan of mutual funds (retired ahead) Generates consistent performance Is he smart or lucky? Statistically, we should see some people do well for long periods of time do to chance “Survivorship Bias”

Summary Mutual funds are convenient way to diversify portfolios Index funds are a powerful tool Performance of the industry in general is not great