1. INVESTMENTS Lecture 11 Investment Companies and ETFs

2. Investment Companies  Intermediaries that collect money from investors and put that money in a wide range of securities or other assets Investor has claim to part of portfolio in proportion to the amount invested Investors benefit by mechanism that enables them to obtain benefits of large-scale investing  Functions performed Diversification Professional management Administration Lower transaction costs

3. Types of Investment Companies  Unit Investment Trusts Pools of money invested in portfolio whose composition is set for the life of the trust Units represent ownership interest in UIT  Managed Investment Companies Closed-end Open-end

4. Mutual Funds  What is a mutual fund? Group of investors pool funds Funds used to create portfolio of securities  What is each share of a mutual fund worth? NAV  Who decides what securities to put in the portfolio?  Is there a difference between a mutual fund and a closed-end fund?

5. Mutual Funds  Why are mutual funds appropriate for some investors? Diversification Liquidity Management and administration Flexibility of investments Indexing  Are there any disadvantages to using mutual funds?

6. Mutual Funds  Returns to shareholders: Dividends or interest earned by fund from shares held in the portfolio Capital gains / losses from shares/bonds held in the portfolio  Return from dividend income or capital gains can be reinvested or taken as distribution Gains / losses from the price of the fund share

7. Types of Funds  Main types depends on who is classifying – Morningstar uses Domestic stock funds International stock funds Taxable bond funds Municipal bond funds  Give investors monthly payments exempt from federal taxes  Some exempt from state if fund only invests in bonds from one state Money market funds

8. Types of Funds  Life-stage funds  Fund supermarkets

9. Expenses  Load – commission charged when investor purchases or redeems shares Front-end load Back-end load – “r” after listing in WSJ  12b-1 fee – fees charged to cover distribution costs like marketing and advertising – annual  Management fee  Determine overall expense ratio – turnover important

10. Net Asset Value  Per share value of fund  (mkt value assets - liabilities)/shares outstanding Shares outstanding is number of fund shares  NAV changes as prices of underlying asset change  Capital gain and dividend distributions reflected in NAV  NAVs determined daily  Price at which fund shares are bought/sold

11. Open End Funds  Services offered Automatic reinvestment of distributions Automatic investment plans Check writing Exchange privileges Periodic statements

12. Mutual Fund Performance  Hard for funds to outperform benchmark because of fees Funds with lower expense ratios outperform funds with higher expense ratios Funds with low turnover outperform funds with higher turnover (need about 2-3% more return to match)  Performance of funds vs. market  Styles  Loads  taxes

13. Open End Funds  To index or not to index, that is the question Pros of indexing:  Low operating expenses  Better tax efficiency  Historical performance  Able to track variety of types Cons of indexing:  Will never make as much as actual index  Often not a balanced portfolio  Rebalancing  Performance in bear markets

14. Suggested Strategies 1. Choose fund consistent with objectives and constraints. 2. Choose index funds for a large portion of portfolio. 3. Invest in no-load funds whenever possible. 4. Invest 10-20% in international or global funds. 5. Own funds in several different asset classes. 6. Do not attempt to time the market. 7. Avoid investing just prior to capital gains distributions. 8. Do not diversify too much across actively managed funds.

15. Closed-End Funds  Has IPO and then trades in secondary market  Market price determined by supply and demand  Often trade at a discount to NAV Maybe undistributed capital gains that will have tax effect Management  way to invest in emerging markets

16. Exchange Traded Funds  Passively managed to replicate returns to index  Shares trade in secondary market  Price stays very close to NAV but still determined by supply and demand similar to closed-end  Low expenses relative to some index funds  Capital gains distributions similar to mutual funds

17. Exchange Traded Funds (ETFs)  ETFs are mutual funds or trusts that are listed on an exchange and traded like a stock  SPDRs introduced in 1993 on AMEX Over 120 currently trading Over $80 billion invested in ETFs  Majority trade on AMEX Barclays and State Street Vanguard  Priced throughout the day just like stocks

18. Tax Benefits of ETFs  Capital gains Distributions made by mutual fund managers whether investors like it or not Distributions are infrequent with ETFs although not impossible Low turnover of securities in ETF  Only change when securities in index change Capital gains must be paid by investors when they sell shares of ETFs

19. ETFs  Can purchase ETFs based on broad market, international markets, or in specific sectors  Advantages of ETFs Low cost structure Diversification benefits as with mutual funds Variety of ways to invest in shares Trading available throughout the day Can use in variety of ways to execute specific portfolio strategy

20. ETFs  Tracking indexes Easy to see how they are performing Tracking error should be relatively low as these should track index fairly closely  Liquidity features Creations/redemptions  ETFs as alternative to other types of investments Mutual funds derivatives

21. ETFs  Buy or sell shares as easily as buying stock Go through a full-service or discount broker Shares may be purchased in odd lots  Risks Similar to risks investors face with stocks Subject to market risk Foreign securities have additional risk that domestics do not  Performance Can trade at a discount or premium to portfolio value because of supply and demand factors (similar to that associated with closed-end funds)

22. Sector ETFs  Stocks included in ETF proxy for universe of stocks in a particular index or sector Sampling technique used Should be representative of stocks in sector Sometimes dominated by largest firms in the sector  Does the ETF provide an investor with the diversification benefits that are often the reason for buying the ETF in the first place? Maybe not!

23. Investing with ETFs  As a hedge  As a core position  As a supplement to a core position  As a tax efficient investment

24. HOLDRS  HOLding company Depository Receipts  Securities representing ownership interest in either stock or ADRs of certain firms in a certain sector Single security with diversification benefits  Merrill Lynch product  Underlying stocks chosen based on active management strategy Securities in HOLDRS do not change unless corporate event occurs like merger

25. HOLDRS  Similar to ETFs but represent ownership of specific set of stocks Set not selected to track index  Attractiveness of HOLDRS as compared to individual stocks and other diversified securities  Can only buy HOLDRS in round lots  Creating HOLDRS  Canceling HOLDRS

26. TARGETS  TARgeted Growth Enhanced Terms Securities  Salomon Smith Barney product designed to combine the potential returns available from capital appreciation with a component of current income  Issued by a trust  Maturity  Price