4. Mutual Funds, Investment Dealers, and Other FIs Two types of mutual funds: Closed-End Funds Open-End Funds 4.1 Closed-End funds Sold at an exchange or Over-the-counter Price can sell at a premium or discount to the mark-to-market value of the underlying securities. Closed-End fund puzzle is that the shares usually sell at a discount. Agency costs, tax liabilities, and illiquidity of assets do not explain 1

4.2 Open End Funds Number of shares vary depending on purchases and redemptions Shareholders redeem at the current Net Asset Value (NAV) Two types of funds: Retail and institutional Large selection of funds: Balanced, Money Market, Growth, Industrial, Index. Research shows open-end funds underperform other similar investment vehicles. Much of this is explained by the fees charged. Enormous growth. By 1996, 21.2% of market is owned by stock mutual funds compared to 7% in 1987. 1

4.3 Open End Funds--Pricing Invest $2500 into a Growth Mutual Fund Current Price is $10/unit You purchase 250 units Annual Return is 10%, what is the price per unit? How much would you receive in cash? What would happen to NAV if there was a 3% management fee? 1

4.4 Fees Charged by Open End Funds Load fees (Front and back-end loads) and Share classes Management fees Administrative 12b1 fees (Trailer fees) Fee Waivers Soft-dollars Capital gains taxes and the affect on investment What are the net returns reported on your mutual fund statement? What are the expense ratios reported in a prospectus? What is the 10% free rule? 1

Financing B shares Limited partnership LP Mutual Fund Broker Investors Initial and Trailing Commission Fixed Price LP Mutual Fund Broker Loads and fixed %NAV Loads & 12b1 Investors Tax Arbitrage?

Financing B shares Securitization SPV Mutual Fund Broker Investors Initial and Trailing Commission Fixed Price SPV Mutual Fund Broker Loads and fixed %NAV Fixed Income Security Loads & 12b1 Investors Investors Tax Arbitrage?

4.5 Money Market Funds Restricted to holding assets with maturities less than 270 days Very liquid Grew enormously during the 1970s and 1980s by attracting depositors away from banks Accounting rules allow money market funds to report book values rather than market values because the durations are short. These are the only funds allowed to do this. Net Asset Value is always $1 per share but the dividends can change What does it mean to break-the-buck? 1

4.6 Manager’s Incentives How could a company like Steadman charge expenses of 20%? 1

4.7 Manager’s Incentives Performance and Asset Growth in Money Market Funds 1

4.7 Manager’s Incentives Performance and Fee Waiving in Money Market Funds 1

4.8 Issues raised on mutual funds Does the transfer from institutional investors to individual investors through mutual funds create market instability? Are management fees too high? Are mutual funds getting too big to invest in the market? Why are investors slow to leave poor performing funds? Should management fees be visible on statements? What conflicts of interest could arise between the fund manager and the unit holder? 1

4.9 Investment Dealers Several tasks performed by Investment Dealers. Two broad areas 1. Customer Services 2. Market Transactions and Services 1. CUSTOMER SERVICES INCLUDE: Retail Brokerage (Discount and Full-Service) Wholesale Brokerage 1

4.9 Investment Dealers 2. MARKET SERVICES INCLUDE: Investment Banks Private Placements Underwriting a Public Offering (IPO) Primary Market of debt, equity, and derivatives Best Efforts versus full underwriting Merger and Acquisition advisors Merchant Banks and Mezzanine Financing Market Makers and Designated Jobber (Secondary Market) Investing for investors or for themselves Trading -- position, pure arbitrage, risk arbitrage, program Back-office 1

4.10 Investment Dealers: Regulation and Trends Liquid Balance sheet Liabilities include short-term REPOs and short positions of assets Self-regulatory organisations: IDA, stock exchanges, OSC by its size has evolved as the federal regulator: licenses, monitors, reviews prospectuses and investigates violations CIPF Canadian Investor Protection Fund 1

4.11 Questions on Investment Dealers What is the difference between a merchant bank and an investment bank? What is the risk to an investment broker that builds up its inventory of long-term bonds but funds it in the short-term market (REPOs)? Why is risk arbitrage not riskless? Is high stock volatility good or bad for investment dealers? How does the reorganization of the exchanges get around problems facing Canadian Investment Dealers? What differences in culture between banks and investment dealers would make integrating these two cultures difficult? 1

4.12 Financing Institutions Leasing Company Government Companies Canada Mortgage and Housing Corporation Export Development Corporation Farm Credit Corporation Business Development Bank of Canada How do these institutions differ from a bank? From an investment dealer? Do you think leasing companies supported the proposed bank mergers? 1

4.13 Summary Mutual funds bear little to no risk (except for expense costs). Instead the investor bears the risk of market fluctuations. The only mutual fund which is exposed to some risk from asset price fluctuations are money market funds. Investment Dealers are the main financial institution in the primary market Mutual funds compete with banks for demand deposits Financing Companies compete with banks for loans 1

4.14 Websites www.osc.gov.on.ca www.sec.gov www.sedar.com www.tse.com www.nasdaq.com www.amex.com www.nyse.com 1