1. Copyright© 2008 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 10th Edition Authors: Kidwell, Blackwell & Whidbee Prepared by: Vladimir Kotomin, University of Wisconsin – Eau Claire and Lanny R. Martindale, Texas A&M University

2. CHAPTER 20 Investment Companies

3. Copyright© 2008 John Wiley & Sons, Inc.3 History of Investment Companies Investment companies were first started in Belgium in 1822. Early U.S. investment companies Began at end of 1800s Closed-end companies First mutual fund in 1924 Declines in Great Depression Regulations enhanced confidence Growth very rapid in 1945 to 1965 period as the stock market performed well. Inflation, high interest rates, and poor market performance hurt growth in 1970s.

4. Copyright© 2008 John Wiley & Sons, Inc.4 History of Investment Companies (continued) New types of funds after 1970s Municipal bonds funds - tax-free income Government security funds - safety Money market funds - safety and liquidity Exchange-Traded Funds (ETFs) – represent indices.

5. Copyright© 2008 John Wiley & Sons, Inc.5 Investment Funds Purchase direct, long-term, capital market securities and issue indirect, liquid, small denomination shares. Investment funds provide to the financial investor: Risk intermediation by investing in a diversified portfolio of assets. Denomination intermediation by requiring small minimum investments. Liquidity for IF shares. Economies of scale in investment management and transaction costs.

6. Copyright© 2008 John Wiley & Sons, Inc.6 Net Asset Value (NAV) Value of shares is called Net Asset Value (NAV)

7. Copyright© 2008 John Wiley & Sons, Inc.7 Closed-end Investment Companies Have a fixed number of shares outstanding like any publicly traded corporation. Shares are traded and priced in the market. Closed-end fund shares may sells at a premium or (more often) a discount to NAV Sometimes as much as 10%-20% below NAV.

8. Copyright© 2008 John Wiley & Sons, Inc.8 Closed-end Investment Companies Size of discount varies by type of closed- end fund – equity versus bond funds, domestic vs. global equity funds. [See Exhibit 20.1]. Discounts could be due to a variety of reasons including poor management, tax considerations, and market demand. The majority of closed-end funds are either bond funds or global equity funds. [See Exhibit 20.2]

9. Copyright© 2008 John Wiley & Sons, Inc.9 Closed-end Funds

10. Copyright© 2008 John Wiley & Sons, Inc.10 Open-end Investment Companies Are most common; dominate asset holdings. Mutual funds stand ready to buy (redeem) or sell their shares at NAV. No limit to the number of shares issued.

11. Copyright© 2008 John Wiley & Sons, Inc.11 Exchange-Traded Funds (ETF) First introduced in 1989 at Toronto Stock Exchange Shares traded on organized exchanges like closed-end funds Created with deposit of portfolio of stock. Tremendous growth since 2000.

12. Copyright© 2008 John Wiley & Sons, Inc.12 Exchange-Traded Funds (ETF) Redemptions in form of stock portfolio Most track stock index – SPDRs, DIAMONDS, etc. ETF shares traded for portfolio of stock - no large premiums or discounts on ETFs because of arbitrage activities. Tax advantage, low expense ratios, ease of buying/selling, and ease of tracking prices.

13. Copyright© 2008 John Wiley & Sons, Inc.13 Investment Trust or Unit Trust. Assets are not actively managed. Provide small denomination share claims against a diversified, fixed portfolio of securities. Trust sponsors usually will repurchase shares at net asset value, less a commission.

14. Copyright© 2008 John Wiley & Sons, Inc.14 Importance of Investment Companies Investments in mutual funds exploded in the 1990s because Many new funds were developed. Individual Retirement Accounts (IRAs) were developed. The shift of many pension plans from defined benefit to defined contribution plans (401k). Increased investment by baby boomers. The high rates of return on common stocks. By year-end 2006, 8120 mutual funds existed in the U.S. holding a total of over $10 trillion in assets. [See Exhibit 20.6]

15. Copyright© 2008 John Wiley & Sons, Inc.15 Growth of Mutual Funds

16. Copyright© 2008 John Wiley & Sons, Inc.16 Investment composition of investment funds Composition varies with economy Cash Holdings - Short-term liquid assets Hold more cash items when interest rates rising and high Reduce short-term securities, buy long term when rates are at peak and falling Delayed redemption and paid-in-kind redemption policies, along with bank lines of credit have reduced the proportion of cash held. Composition varied over time.

17. Copyright© 2008 John Wiley & Sons, Inc.17 Types of Investment Funds Growth and income funds Growth funds Aggressive growth funds Balanced funds Income funds Specialty funds. Global Tax-exempt Sector

18. Copyright© 2008 John Wiley & Sons, Inc.18 Types of Investment Funds Growth & Income Funds Seek balance between capital gains and current income. Invest in highly rated companies’ stock. Ideal for investors who are looking for some income, but would also want to invest in growth stocks. Growth Funds The objective is to invest in industries and companies that are experiencing sizable growth. Investors looking for a higher return and a moderate risk are attracted to such funds. Focus is on capital appreciation rather than steady income.

19. Copyright© 2008 John Wiley & Sons, Inc.19 Types of Investment Funds Aggressive Growth Funds Focus on emerging industries and unproven firms. Investors trade off a very high return potential for high risk.

20. Copyright© 2008 John Wiley & Sons, Inc.20 Types of Investment Funds Balanced Funds Are hybrid portfolios of growth stocks and fixed- income securities. The proportion of each determines the level of return for each fund. Generate higher proportion of income than growth and income funds and are less volatile. Investors who have a few more years to retirement are attracted to such funds.

21. Copyright© 2008 John Wiley & Sons, Inc.21 Types of Investment Funds Income Funds Consist of bonds that provide steady coupon cash flows; quite varied in their risk level. Can be made up of corporate bonds (risky), Treasury issues (no default risk), or mortgage- backed securities. Exposed to not only default risk and interest rate risk. Attractive to investors close to retirees as the cash stream of fund’s instruments provides them with necessary income.

22. Copyright© 2008 John Wiley & Sons, Inc.22 Mutual Fund Families Mutual fund managing companies that market a variety of mutual funds to investors. Money may be moved from fund to fund at nominal charges. Investors can change risk profile, asset class, term, and other investment characteristics without much hassle.

23. Copyright© 2008 John Wiley & Sons, Inc.23 Mutual Fund Families (concluded) Other services may include: Discount brokerage service - purchase/sale of individual direct securities, such as stocks and bonds. Liquidity services – checks and/or debit cards tied to mutual fund balances. Pension fund management for businesses.

24. Copyright© 2008 John Wiley & Sons, Inc.24 Regulation of Mutual Funds - SEC and States Regulation relates to adequate required disclosure, adequate diversification, sales practices, and management practices. Federal laws Securities Act of 1933 SEC Act of 1934 Investment Company Act of 1940 National Securities Markets Improvement Act of 1996 Mutual funds are not taxed on income and capital gains - owners of shares are.

25. Copyright© 2008 John Wiley & Sons, Inc.25 Mutual Fund Fee Structures Load funds - investor pays a sales commission when shares are purchased from brokers. No-load funds - no initial sales fees, but other charges (back-end load, contingent deferred sales charge, or redemption fees) may be levied. 12b-1 fees - an annual fee levied against fund assets by some funds. Management or advisory fees. Exchange fees and account maintenance fees.

26. Copyright© 2008 John Wiley & Sons, Inc.26 Hedge Funds Investment pools that use a combination of market philosophies and analytical techniques. Seek to develop financial models to identify, evaluate, and execute trading decisions. Typically are limited partnerships. The goal is providing consistent, above-market returns while reducing the risk of loss.

27. Copyright© 2008 John Wiley & Sons, Inc.27 Hedge Funds Differ from Mutual Funds Hedge funds Are private, unregistered investment pools open to a limited number of accredited investors. Pay managers based on their performance. Mutual funds Are heavily regulated investment pools registered with the SEC and open to all investors. Pay managers a fee that is percentage of the assets under management.

28. Copyright© 2008 John Wiley & Sons, Inc.28 Hedge Fund Investment Strategies Traditional hedge fund strategies include: domestic hedge strategies. global hedge strategies. global macro strategies. market neutral strategies. sector strategies. short strategies.

29. Copyright© 2008 John Wiley & Sons, Inc.29 Arbitrage Hedge Fund Investment Strategies Arbitrage hedge fund strategies include: Fixed income arbitrage. Index arbitrage. Closed-end fund arbitrage. Convertible arbitrage.

30. Copyright© 2008 John Wiley & Sons, Inc.30 Event-driven Investment Strategies Event-driven hedge fund strategies include: Risk arbitrage. Distressed securities. Special situation.

31. Copyright© 2008 John Wiley & Sons, Inc.31 Money Market Mutual Funds (MMMF) Short-term money market investments. Provide excellent liquidity for investors. High quality and high yield when yield curve is inverse. Compete with bank deposits.

32. Copyright© 2008 John Wiley & Sons, Inc.32 Growth of MMMFs & Reg. Q When market rates were above Regulation Q maximum for bank deposit rates, MMMFs grew rapidly (1970s and early 80s). Banks were able to compete after the 1982 Depository Institutions Act when they were permitted to offer insured, Money Market Deposit Accounts (MMDA). MMMF offer higher yields than bank MMDA’s MMMF are not insured by FDIC

33. Copyright© 2008 John Wiley & Sons, Inc.33 MMMFs’ Role in the Economy Around $2 trln. under management in early 2000s. Transactional convenience Check writing privileges, debit cards, wire transfers, sweep features Helps compete with bank deposits MMMFs that invest in tax-exempt securities pass through interest payments that are exempt from federal (and possibly state) income taxes. Interest earned on bank deposits is fully taxable.

34. Copyright© 2008 John Wiley & Sons, Inc.34 Growth of MMMFs

35. Copyright© 2008 John Wiley & Sons, Inc.35 Real Estate Investment Trust (REIT) An investment fund selling shares and investing in real estate related assets Own income property. Acquire mortgages. Finance real estate development and construction. Acquire and lease property.

36. Copyright© 2008 John Wiley & Sons, Inc.36 Real Estate Investment Trust (REIT) Regulated under federal Real Estate Investment Act of 1960 and state regulation REITs are exempt from federal income tax if accrue a minimum of 75% of income from real estate investments and pay 90% of their net income to shareholders. Grew rapidly in the inflationary boom period of the late 1960s and early 1970s, then the bubble burst Financed short (commercial paper) and invested long in rising rate environment