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

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

3. History  First funds, March 1924 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

4. 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)

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

6. More on Closed versus Open  Most funds are Open-End  Closed-end funds occasional trade differently from their asset values (NAV)  P NAV

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

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

9. 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

10. Benefits  Diversification  Stock selection skills  Bookkeeping

11. Types of Funds  Stocks  Bonds  Money Market

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

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

14. 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)

15. 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

16. 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

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

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

19. 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

20. More on rankings  Average return in 70’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% All funds  11.7%

21. More on rankings  Average return in 80’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% S&P  14.9%

22. 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  50 stock fund –20 billion in assets –<5% in each stock –Universe = 182 Transaction costs and “price impact”

23. 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”

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