Mutual Funds and Hedge Funds Chapter 5 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

-25-2 Overview  In this segment: Mutual Funds and Hedge Funds: Activities of mutual Size, structure and composition Balance sheets and recent trends Regulation of mutual funds Activities of hedge funds Global issues Size, structure and composition Balance sheets and recent trends Regulation of hedge funds

-35-3 Mutual Funds  Diversification opportunities enhanced for small investors Economies of scale Predominantly open-ended funds

-45-4 Mutual Funds  Rapid growth in funds during the 1990s  Slower rate of growth in the industry in early 2000s than in 1990s Trading abuses contributed to slowdown  2007: Almost 7,100 stock and bond mutual companies. Total assets of $8.21 trillion. 8,125 firms and $10.57 trillion if money market mutual funds included

-55-5 Size, structure and composition First mutual fund: Boston, Slow growth, initially. Advent of money market mutual funds,  Regulation Q. Total assets in stock and bond mutual funds:  1940: $0.5 billion.  1990: $1,065.2 billion  2000: $6,964.6 billion  2006: $10,413.7 Institutional funds  80 percent of retirement plan investments

-65-6 Size, Structure and Composition By asset size, mutual fund industry second most important FI group. Recent inroads by commercial banks and insurance companies  Mellon purchase of Dreyfus  State Farm (9,000 agents)  As of 2006, insurance companies managed approximately 10% of mutual fund assets

-75-7 Types of Mutual Funds  Long-term funds 74.3% of assets, , long-term funds dropped to 62.1% of assets, losing ground to MMMFs 75.4% in 2006  Types of Long-term Funds: Bond and income funds. Equity funds. Hybrid.

-85-8 Types of Mutual Funds  Short-term funds 25.7% of assets, % of assets, % in 2006 Taxable and tax-exempt MMMFs Generally higher returns than bank deposits but uninsured.  Impact of low interest rates during early to mid 2000s Decline in MMMFs Lowering of MMMF fees

-95-9 Number of Mutual Funds

Interest Rate Spread and Net New Cash Flow to MMMFs

Overview of Mutual Funds Objectives (and adherence to stated objectives), rates of return and risk characteristics vary.  Examples: Capital appreciation funds World equity Corporate bond High-yield bond World bond Government bond

Returns to Mutual Funds Income and dividends of underlying portfolio. Capital gains on trades by mutual fund management. Capital appreciation in values of assets held in the portfolio.  Marked-to-market.  Net-asset value (NAV).

Web Resources  For information on the performance of mutual funds, visit: Morningstar

Types of Funds Open-ended funds: comparable to most corporate securities traded on stock exchanges. Closed-end investment companies: Fixed number of shares  Example: REITs.  May trade at premium or discount.  Exchange traded funds (ETFs) Load versus no-load funds.

Mutual Fund Costs  Two types of fees: Sales loads  Generally, negative effect on performance outweighs benefits  Short term versus long term investment alters impact of loads on cost Fund operating expenses  Management fee  12b-1 fees  Front end and back end fees Class A, Class B and Class C differences SEC creation of new rules Sweeping decreases in fees, 2005 and 2006

Balance Sheet and Trends  Money Market Funds Key assets are short-term securities (consistent with deposit-like nature)  2006: $1,514.9 billion (65.5% of total assets) Most have share values fixed at $1 and adjust number of shares owned by the investor.

Balance Sheet and Trends  Long-term Funds Stocks comprised over 70.7 % of asset portfolios in Credit market instruments 27.2% of asset portfolios Shift to other securities such as credit market instruments, U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.

Regulation One of the most closely regulated among non- depository FIs. Primary regulator: SEC  Emphasis on full disclosure and anti-fraud measures to protect small investors.  NASD supervises mutual fund share distributions.

Regulatory Changes  Prosecutions in light of trading abuses in early 2000s. Market timing Late trading Directed brokerage Improper fee assessments  Changes include: SEC requirements for independent board members; reporting and disclosure requirements

Legislation Securities Act 1933, 1934 Investment Advisers Act, Insider Trading and Securities Fraud Enforcement Act of Market Reform Act of 1990  Allows SEC to halt trading and introduce circuit breakers. National Securities Markets Improvement Act of  Exempts mutual fund sellers from state securities regulatory oversight. Sarbanes-Oxley Act of 2002

Global Issues  Worldwide growth in mutual fund investment not as great as in the U.S. $2.575 trillion in 1996 to $ trillion in 2006  Over 307% growth Larger returns in U.S.stock markets Greatest development in countries with most advanced markets Opportunities from declining Japanese markets Efforts to reduce barriers for U.S. mutual fund sponsors  China and other Asian countries

Hedge Funds  Not technically mutual funds Not subject to SEC regulation Organized as limited partnership  Small number of sophisticated investors Common feature is use of leverage  High returns in 1990s

Hedge Funds  Near collapse of Long-Term Capital Management $3.6 billion bailout Precipitated SEC scrutiny of hedge funds

Types of Hedge Funds  More risky Market directional  Moderate risk Market neutral or value orientation  Risk avoidance Moderate, consistent returns with low risk as objectives  Fees Generally management fees and performance fees

Offshore Hedge Funds  Major centers include Cayman Islands, Bermuda, Dublin, Luxembourg.  Rules Generally not burdensome Anonymity Tax advantages

Regulation of Hedge Funds  Generally unregulated Exemption for less than 100 investors Exemption if accredited  Scandals such as Canary Capital Partners  Illegal trading with mutual funds Amaranth Advisors, 2006 SEC scrutiny

Pertinent Websites American Funds Federal Reserve Fidelity Investments Investment Company Institute Morningstar, Inc. NASD: SEC: Vanguard Wall Street Journal