©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Seventeen Mutual Funds and Hedge Funds

©2009, The McGraw-Hill Companies, All Rights Reserved 17-2 McGraw-Hill/Irwin Mutual Funds and Hedge Funds Mutual Funds (MFs) and Hedge Funds (HFs) are financial institutions (FIs) that pool the financial resources of individuals and companies and invest those resources in portfolios of assets The first MF was established in Boston in 1924 By MFs held about $50 billion in assets Money market mutual funds (MMMFs) were introduced in 1970 Tax-exempt MMMFs were introduced in 1979 By 2007 more than 8,000 MFs held over $12 trillion in assets Mutual Funds (MFs) and Hedge Funds (HFs) are financial institutions (FIs) that pool the financial resources of individuals and companies and invest those resources in portfolios of assets The first MF was established in Boston in 1924 By MFs held about $50 billion in assets Money market mutual funds (MMMFs) were introduced in 1970 Tax-exempt MMMFs were introduced in 1979 By 2007 more than 8,000 MFs held over $12 trillion in assets

©2009, The McGraw-Hill Companies, All Rights Reserved 17-3 McGraw-Hill/Irwin Mutual Funds Cash flows into MFs is highly correlated with the return on the NYSE Growth has also resulted from the rise in retirement funds under management by MFs –MFs managed ~ 25% of retirement fund assets in 2007 MFs are the second most important group of FIs as measured by asset size, second only to commercial banks Banks’ share of all MF assets has grown to 21% in 2007 Insurance companies managed 10% of MF industry assets in 2007 Cash flows into MFs is highly correlated with the return on the NYSE Growth has also resulted from the rise in retirement funds under management by MFs –MFs managed ~ 25% of retirement fund assets in 2007 MFs are the second most important group of FIs as measured by asset size, second only to commercial banks Banks’ share of all MF assets has grown to 21% in 2007 Insurance companies managed 10% of MF industry assets in 2007

©2009, The McGraw-Hill Companies, All Rights Reserved 17-4 McGraw-Hill/Irwin Mutual Funds The barriers to entry in the MF industry are low –the largest MF sponsors have not increased their market share recently the largest 25 MF companies managed 76% of industry assets in 1990 the largest 25 MF companies managed 71% of industry assets in 2007 –the composition of the top 25 firms in the industry has changed seven of the largest 25 firms in 2007 were not among the top 25 in 1990 The barriers to entry in the MF industry are low –the largest MF sponsors have not increased their market share recently the largest 25 MF companies managed 76% of industry assets in 1990 the largest 25 MF companies managed 71% of industry assets in 2007 –the composition of the top 25 firms in the industry has changed seven of the largest 25 firms in 2007 were not among the top 25 in 1990

©2009, The McGraw-Hill Companies, All Rights Reserved 17-5 McGraw-Hill/Irwin Mutual Funds The MF industry has two sectors –short-term funds invest in securities with original maturities of less than one year money market mutual funds tax-exempt money market mutual funds –long-term funds invest in portfolios of securities with original maturities of more than one year equity funds consist of common and preferred stock bond funds consist of fixed-income capital market debt securities hybrid funds consist of both stock and bond securities The MF industry has two sectors –short-term funds invest in securities with original maturities of less than one year money market mutual funds tax-exempt money market mutual funds –long-term funds invest in portfolios of securities with original maturities of more than one year equity funds consist of common and preferred stock bond funds consist of fixed-income capital market debt securities hybrid funds consist of both stock and bond securities

©2009, The McGraw-Hill Companies, All Rights Reserved 17-6 McGraw-Hill/Irwin Mutual Funds Approximately 25% of long-term funds are index funds –index funds are funds in which managers buy securities in proportions similar to those included in a specified major index –index funds involve little research or management, which results in lower management fees and higher returns than actively managed funds Exchange traded funds (ETFs) are also designed to replicate market indexes –traded on exchanges at prices determined by the market –management fees are lower than actively traded funds –unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin Approximately 25% of long-term funds are index funds –index funds are funds in which managers buy securities in proportions similar to those included in a specified major index –index funds involve little research or management, which results in lower management fees and higher returns than actively managed funds Exchange traded funds (ETFs) are also designed to replicate market indexes –traded on exchanges at prices determined by the market –management fees are lower than actively traded funds –unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin

©2009, The McGraw-Hill Companies, All Rights Reserved 17-7 McGraw-Hill/Irwin Mutual Funds Money market mutual funds (MMMFs) provide an alternative investment to interest- bearing deposits at commercial banks –bank deposits are relatively less risky, because they are FDIC insured, and generally offer lower returns than MMMFs Households own the majority of MFs –owned 69.6% of long-term funds in 2007 –owned 46.0% of short-term funds in 2007 –48.0% of all U.S. households owned MFs in 2006— which represents ~56.3 million households Money market mutual funds (MMMFs) provide an alternative investment to interest- bearing deposits at commercial banks –bank deposits are relatively less risky, because they are FDIC insured, and generally offer lower returns than MMMFs Households own the majority of MFs –owned 69.6% of long-term funds in 2007 –owned 46.0% of short-term funds in 2007 –48.0% of all U.S. households owned MFs in 2006— which represents ~56.3 million households

©2009, The McGraw-Hill Companies, All Rights Reserved 17-8 McGraw-Hill/Irwin Mutual Funds MF managers must specify their funds investment objectives in a prospectus, which is made available to potential investors –holds lists of the securities invested in by the funds –in 1998 the Securities and Exchange Commission (SEC) mandated that prospectuses must be written in “plain English” instead of overly legal language (i.e., legalese) MF managers must specify their funds investment objectives in a prospectus, which is made available to potential investors –holds lists of the securities invested in by the funds –in 1998 the Securities and Exchange Commission (SEC) mandated that prospectuses must be written in “plain English” instead of overly legal language (i.e., legalese)

©2009, The McGraw-Hill Companies, All Rights Reserved 17-9 McGraw-Hill/Irwin Mutual Funds Equity funds represent 56.7% of MF assets in 2007 (~$5.9 trillion) –capital appreciation funds (25.9%) –world equity (12.6%) –total return (18.2%) Hybrid funds represent 6.3% of MF assets (~$0.7 trillion) Bond funds represent 14.4% of MF assets (~$1.5 trillion) –corporate bonds (2.6%) –high-yield bonds (1.5%) –world bonds (0.6%) –government bonds (1.9%) –strategic income bonds (4.3%) –state municipal bonds (1.5%) –national municipal bonds (2.0%) Equity funds represent 56.7% of MF assets in 2007 (~$5.9 trillion) –capital appreciation funds (25.9%) –world equity (12.6%) –total return (18.2%) Hybrid funds represent 6.3% of MF assets (~$0.7 trillion) Bond funds represent 14.4% of MF assets (~$1.5 trillion) –corporate bonds (2.6%) –high-yield bonds (1.5%) –world bonds (0.6%) –government bonds (1.9%) –strategic income bonds (4.3%) –state municipal bonds (1.5%) –national municipal bonds (2.0%)

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds Money market funds represent 22.6% of MF assets ($2.4 trillion) –taxable funds (19.1%) –tax-exempt funds (3.5%) Four of the five largest MFs in the U.S., as of February 6, 2008, were managed by the same company –American Funds Growth;A a growth fund with $91.4 billion in assets –American Funds CWGI;A an international fund with $83.0 billion in assets –American Funds CIB;A an income fund with $81.6 billion in assets –Fidelity Invest: Contra a growth fund with $80.9 billion in assets –American Funds InvCoA a growth/income fund with $73.5 billion in assets Money market funds represent 22.6% of MF assets ($2.4 trillion) –taxable funds (19.1%) –tax-exempt funds (3.5%) Four of the five largest MFs in the U.S., as of February 6, 2008, were managed by the same company –American Funds Growth;A a growth fund with $91.4 billion in assets –American Funds CWGI;A an international fund with $83.0 billion in assets –American Funds CIB;A an income fund with $81.6 billion in assets –Fidelity Invest: Contra a growth fund with $80.9 billion in assets –American Funds InvCoA a growth/income fund with $73.5 billion in assets

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds Investor returns from MF ownership reflect three components –income and dividends on portfolio assets –capital gains on assets bought and sold at higher prices –capital appreciation on assets held in the fund MF assets are usually marked to market daily –prices are adjusted daily to reflect changes in the current market prices of the portfolio’s assets Then net asset value (NAV) of a MF share is equal to the market value of the assets in the MF portfolio divided by the number of shares outstanding Investor returns from MF ownership reflect three components –income and dividends on portfolio assets –capital gains on assets bought and sold at higher prices –capital appreciation on assets held in the fund MF assets are usually marked to market daily –prices are adjusted daily to reflect changes in the current market prices of the portfolio’s assets Then net asset value (NAV) of a MF share is equal to the market value of the assets in the MF portfolio divided by the number of shares outstanding

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds An open-end MF is a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares A closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares, but invests in the securities and assets of other firms A real estate investment trust is a closed-end investment company that specializes in investing in mortgages, property, or real estate company shares An open-end MF is a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares A closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares, but invests in the securities and assets of other firms A real estate investment trust is a closed-end investment company that specializes in investing in mortgages, property, or real estate company shares

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds MFs charge investors fees for the services they provide –sales loads –12b-1 fees are fees related to the distribution costs of MF shares cannot exceed 1% of average annual net assets for load funds cannot exceed 0.25% of average annual net assets for no-load funds –MFs may offer different share classes with different combinations of loads A load fund is an MF with an up-front sales or commission charge that the investor must pay A no-load fund is an MF that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors MFs charge investors fees for the services they provide –sales loads –12b-1 fees are fees related to the distribution costs of MF shares cannot exceed 1% of average annual net assets for load funds cannot exceed 0.25% of average annual net assets for no-load funds –MFs may offer different share classes with different combinations of loads A load fund is an MF with an up-front sales or commission charge that the investor must pay A no-load fund is an MF that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds MFs are heavily regulated because they manage and invest small investor savings –The SEC is the primary regulator –The Securities Act of 1933 –The Securities Exchange Act of 1934 –The Investment Advisers Act and Investment Company Act of 1940 –The Insider Trading and Securities Fraud Enforcement Act of 1988 –The Market Reform Act of 1990 –The National Securities Market Improvement Act (NSMIA) of 1996 MFs are heavily regulated because they manage and invest small investor savings –The SEC is the primary regulator –The Securities Act of 1933 –The Securities Exchange Act of 1934 –The Investment Advisers Act and Investment Company Act of 1940 –The Insider Trading and Securities Fraud Enforcement Act of 1988 –The Market Reform Act of 1990 –The National Securities Market Improvement Act (NSMIA) of 1996

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Mutual Funds Even with heavy regulation, investor abuses still occur –market timing is short-term trading that profits from out-of-date values on the securities in the fund’s portfolio –late trading involves buys and sells long after prices have been set at 4:00 pm E.T. –directed brokerage occurs when brokers improperly influence investors on their fund recommendations –improperly assessed fees occur when brokers trick customers into thinking they are buying no-load funds or fail to provide discounts properly Even with heavy regulation, investor abuses still occur –market timing is short-term trading that profits from out-of-date values on the securities in the fund’s portfolio –late trading involves buys and sells long after prices have been set at 4:00 pm E.T. –directed brokerage occurs when brokers improperly influence investors on their fund recommendations –improperly assessed fees occur when brokers trick customers into thinking they are buying no-load funds or fail to provide discounts properly

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedge Funds Hedge funds (HFs) are investment pools that solicit funds from wealthy individuals and other investors (e.g., commercial banks) and invest these funds on their behalf –similar to MFs, but not required to register with the SEC –subject to virtually no regulatory oversight and thus generally can (and do) take significant risk –do not have to disclose their activities to third parties and thus offer a high degree of privacy HFs avoid regulation by limiting the number of investors to less than 100 and by requiring investors to be “accredited” –accredited investors have net worth over $1 million or annual income over $200,000 if single (or $300,000 if married) Hedge funds (HFs) are investment pools that solicit funds from wealthy individuals and other investors (e.g., commercial banks) and invest these funds on their behalf –similar to MFs, but not required to register with the SEC –subject to virtually no regulatory oversight and thus generally can (and do) take significant risk –do not have to disclose their activities to third parties and thus offer a high degree of privacy HFs avoid regulation by limiting the number of investors to less than 100 and by requiring investors to be “accredited” –accredited investors have net worth over $1 million or annual income over $200,000 if single (or $300,000 if married)

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedge Funds HFs use more aggressive trading strategies than MFs such as short selling, leverage, program trading, arbitrage, and the use of derivatives Because HFs are not registered, they cannot be accurately tracked ~ 9,000 HFs in the U.S. in 2008 ~ $2.8 trillion in assets in 2008 ~ new assets flow in at a rate of about $300 billion annually ~ the 100 largest HFs control about 70% of the industry in 2008 HFs use more aggressive trading strategies than MFs such as short selling, leverage, program trading, arbitrage, and the use of derivatives Because HFs are not registered, they cannot be accurately tracked ~ 9,000 HFs in the U.S. in 2008 ~ $2.8 trillion in assets in 2008 ~ new assets flow in at a rate of about $300 billion annually ~ the 100 largest HFs control about 70% of the industry in 2008

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedge Funds There are three basic types of HFs –the most risky HFs use market directional trading strategies, seek high returns using leverage, and invest based on anticipating events –moderate risk HFs have a market neutral (or value) orientation that favors longer-term investment strategies –risk avoidance HFs take a market neutral approach and strive for consistent returns with low risk There are three basic types of HFs –the most risky HFs use market directional trading strategies, seek high returns using leverage, and invest based on anticipating events –moderate risk HFs have a market neutral (or value) orientation that favors longer-term investment strategies –risk avoidance HFs take a market neutral approach and strive for consistent returns with low risk

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedge Funds Management fees on HFs are computed as a percent of assets under management and run between 1.5% and 2% Performance fees give fund managers a share of any positive returns earned –the average is 20%, but performance fees vary substantially depending on the HF –a hurdle rate is a benchmark that must be realized before a performance fee can be assessed –a high-water mark is when a manager does not receive a performance fee unless the value of the fund exceeds the highest NAV it has previously achieved Offshore HFs are attractive to investors because they provide anonymity and are not subject to U.S. taxes Management fees on HFs are computed as a percent of assets under management and run between 1.5% and 2% Performance fees give fund managers a share of any positive returns earned –the average is 20%, but performance fees vary substantially depending on the HF –a hurdle rate is a benchmark that must be realized before a performance fee can be assessed –a high-water mark is when a manager does not receive a performance fee unless the value of the fund exceeds the highest NAV it has previously achieved Offshore HFs are attractive to investors because they provide anonymity and are not subject to U.S. taxes

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedge Funds HFs are exempt from registration requirements set forth by the Investment Company Act of 1940 –HFs have less than 100 investors each, accredited investors, and are sold only as private placements HFs are prohibited from abusive (i.e., illegal) trading practices In 2003 the SEC recommended that large HFs register with the SEC as investment advisors –approximately 25% of HFs were already registered In 2007 the U.S. Treasury, the Federal Reserve, the SEC, and the CFTC concluded that current HF regulation was sufficient HFs are exempt from registration requirements set forth by the Investment Company Act of 1940 –HFs have less than 100 investors each, accredited investors, and are sold only as private placements HFs are prohibited from abusive (i.e., illegal) trading practices In 2003 the SEC recommended that large HFs register with the SEC as investment advisors –approximately 25% of HFs were already registered In 2007 the U.S. Treasury, the Federal Reserve, the SEC, and the CFTC concluded that current HF regulation was sufficient