Investment Analysis & Portfolio Management
Lecture 10
INDIRECT INVESTING
Investing Indirectly:
Indirect investing in this discussion usually refers to the buying and selling of the shares of
investment companies' that, in turn, hold portfolios of securities. Most of our attention is focused
on investment-companies, arid mutual funds in particular, because of their importance to
investors. However, we will conclude the chapter with a discussion of Exchange-Traded Funds
(ETFs), which represent a bridge between direct and indirect in vesting. Investors buy ETFs like
any other stock, but many ETFs can be compared to index mutual funds.
The decision of whether to invest directly or indirectly is an important one that all investors
should think about carefully. Because-each alternative has possible advantages arid
disadvantages, it is not necessarily easy to choose one over the other. Investors can be, active
investors, investing directly, or passive investors, investing indirectly. Of course, they can do
both at the same time, and many individuals do exactly that!
An investment company such as a mutual fund is a clear alternative for an investor seeking to
own- stocks and bonds. Rather .than purchase securities and manage a portfolio, investors' can,
in effect, indirectly invest by turning their money over to an investment company which will do
all the work and make all the decisions (for a fee,-of course). Investors who purchase shares of a
particular portfolio managed by an investment company
The primary difference is that the investment company stands between the investors and the
portfolio of securities, Although technical qualifications exist, the point about indirect investing
is that investors gain and lose through the investment company's activities in the same manner
that they would gain and lose from holding a portfolio directly.
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The differences are the, costs (any sales charges plus the management fee) and the benefits
which consist of additional services gained from the investment company, such as recordkeeping
and check-writing privileges.
The line between direct and indirect investing is becoming blurred. For example, investors can
invest indirectly by investing directly— 'that is, they can buy various mutual funds through their
brokerage accounts. This is explained at the end of the chapter when we discuss fund
"supermarkets." And, as noted above, ETFs have characteristics of both direct and indirect
investing.
What Is An Investment Company?
An investment company is a financial service organization that sells shares in it to the public and
uses the funds it raises to invest in a portfolio of securities such as money market instruments or
stocks and bonds. By pooling the funds of thousands of investors, a widely diversified portfolio
of financial assets can be purchased and the investment company can offer its owners
(shareholders) a variety of services.
.
A regulated investment company can elect to pay no federal taxes on any distribution of
dividends, interest, and realized capital gains to its shareholders. The investment company acts as
a conduit, "flowing through" these distributions to stockholders who pay their own marginal tax,
rates on them. In effect, fund shareholders are treated as if they held the securities in the fund's
portfolio. Shareholders pay the same taxes they would pay if they owned the shares directly.
Fund taxation is unique with income taxed only once when it is received by its shareholders. A
funds short-term gains and other earnings are taxed to shareholders as ordinary income, whereas
its long-term capital gains are taxed to shareholders as" long-term, capital gains. Tax-exempt
income received by a fund is generally tax exempt to the shareholder.
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Investment companies are required by the Investment Company Act of 1940 to register with the
Securities and Exchange Commission (SEC). This detailed regulatory statute contains numerous
provisions designed to protect shareholders. Both federal and state laws require appropriate
disclosures to investors.
It is important to note that investment companies are not insured or guaranteed by any
government agency or by any financial institution from which an investor may obtain shares.
These are risky investments, losses to, investors can and do occur (just think 2000 to 2002), and
investment companies' promotional materials state this clearly.
Types of Investment Companies:
All investment companies begin by selling shares in themselves to the public. The proceeds are
then used to buy a portfolio of securities. Most investment companies are managed companies,
offering professional management of the portfolio as one of the benefits. One less well-known
type of Investment Company is unmanaged. We begin here with the unmanaged type and then
discuss the two types of managed investment companies. After we consider each of the three
types, we focus on mutual funds, the most popular type of investment company by far for the
typical' individual investor.
Unit Investment Trusts:
An alternative form of. Investment Company that deviates from the normal managed type is the
unit -investment trust, (OIT), which typically is an unmanaged, fixed-income security portfolio
put together by a sponsor and handled by an independent trustee. Redeemable trust certificates
representing claims against the assets, of the trust are sold to investors at net asset value plus a
small commission. All interest (or dividends) and principal repayments are distributed to the
holders of the certificates. Most unit investment trusts hold either equities or tax-exempt
securities. The assets are almost always kept unchanged, and the trust ceases to exist when the
bonds mature, although it is possible to redeem units of the trust.
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In general, unit investment trusts are designed to be bought and held, with capital preservation as
a major objective. They enable 'investors to gain diversification, provide professional,
management that takes care of all the details, permit the purchase of securities by (he trust at a
cheaper; price than, if purchased individually, and ensure minimum operating costs.. If
conditions change, however, investors lose the ability to make rapid, inexpensive, or costless
changes in their positions.
Closed-End Investment Companies:
One of the two types of managed investment companies, the closed-end investment company,
usually sells no additional shares of its own stock after the initial public offering. Therefore, their
capitalizations are fixed, unless a new public offering is made.
The shares of a closed- end fund trade in the secondary markets (e.g., on the-exchanges) exactly
like any other stock.10 To buy and sell, investors use their brokers, paying (receiving) the current
price at which the shares are selling plus (less) broker age commissions.
Open-End Investment Companies (Mutual Funds):
Open-end investment companies, the most familiar type of managed company are popularly
referred to as mutual funds and continue to sell shares to investors after the initial sale of shares
that starts the fund. The capitalization of an .open-end investment company is continually
changing—that is, it is open-ended—as new investors buy additional shares and some existing
shareholders cash in .by selling their shares back to the company.
Mutual funds typically are purchased either:
1. Directly from a fund company, using mail or telephone, or at the company's office
locations.
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2. Indirectly from a sales agent, including securities firms, banks, life insurance companies,
and financial planners.
Mutual funds may be affiliated with an underwriter, -which usually has an exclusive right to
distribute shares to investors: Most underwriters distribute shares through broker/dealer firms.
Mutual funds are either corporations or business trusts typically formed by an investment
advisory firm that selects the/board of trustees (directors) for the company. The trustees, in turn,
hire a separate management company, normally the investment advisory firm, to manage the
fund. The management company is contracted by the investment company to perform necessary
research and to manage the portfolio, as well as to handle the administrative chores, for which it
receives a fee.
Major Types of Mutual Funds:
The general range of mutual funds arrayed along a return-risk spectrum. As we can see', money
market funds are on the lower end; and bond funds and balanced funds (which hold both bonds
and stocks) are in the middle. Stock funds are on the upper-end of the risk-return spectrum.
There are two major types of mutual funds:
1. Money market mutual funds
2. Stock (also called equity) funds and bond & income funds
These types of funds parallel of money markets and capital markets. Money market funds
concentrate on short-term investing by holding portfolios of money market assets, whereas stock
funds and bond & income funds concentrate on longer term investing by holding mostly capital
market assets. We will discuss each of these two types of mutual funds in turn.
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Money Market Funds:
A major innovation in the investment company industry has been the creation, and subse-quent
phenomenal growth, of money market funds (MMFs), which are open-end investment companies
whose portfolios consist of m6ney market instruments. Created in 1974, when interest rates were
at record-high levels, MMFs grew rapidly as investors sought to earn these high short-term rates.
However,-with- the deregulation of the thrift institutions, competition has increased dramatically
for investors' short-term savings. Money market deposit accounts (MMDAs) pay competitive
money market rates and are insured, and therefore have attracted large amounts of funds.
Nevertheless in August 2002, money market mutual fund assets approximated $2.3 trillion.
Money market funds can be divided into taxable funds and tax-exempt funds. Approximately 85
percent of these assets are in taxable funds. Investors in higher tax brackets should carefully
compare the taxable equivalent yield on tax-exempt money market funds with that available on
taxable funds because the tax-exempt funds often provide an edge.
Taxable MMFs hold assets such as Treasury bills, negotiable certificates of deposit (CDs), and
prime commercial paper. Some funds hold only bills, whereas others hold various mixtures.
Commercial paper typically accounts for 40 to 50 percent of the total assets held by these funds,
with Treasury bills, governmental agency securities, domestic and foreign bank obligations, and
repurchase agreements rounding out" the portfolios. The average maturity of money market
portfolios ranges from approximately one to twp months. SEC regulations limit the maximum
average maturity of money funds to 90 days.
Stock Funds and Bond A Income Funds:
The board of directors (trustees) of an investment company must specify the objective that the
company will pursue in its investment policy! The companies try to follow a consistent
investment policy according to their specified objective. Investors purchase mutual funds on the
basis of their objectives.
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The Investment Company Institute, a well-known organization that represents the investment
company industry, uses multiple major categories of investment objectives, most of which are
for equity and bond, & income funds (the remainder are-for money market funds as previously
explained).
Mutual Funds:
Some mutual funds use a sales force to reach investors, with shares being available from brokers,
insurances agents, and financial planners. In an alternative form of distribution called direct
marketing, the company uses advertising and direct mailing to appeal to investors. About 60
percent of all stock, bond; and income fund sales are made by funds using a sales force.
Mutual funds can be subdivided into:
1. Load funds (those that charge a sales fee)
2.
No-load funds (those that do not charge a sales fee)
INVESTMENT COMPANY PERFORMANCE:
Measures of Fund Performance:
Throughout this text we will use total return to measure the return from any financial asset,
including a mutual fund. Total return for a mutual fund includes reinvested dividends and capital
gains, and therefore includes all of the ways investors make money from financial assets. It
instated as a percentage or a decimal, and can cover any time periods-one month, one year, or
multiple years.
A cumulative total return measures the actual cumulative performance over a stated period of
time, such as the past 3, 5 and 10 years. This allows die investor to assess total performance over
some stated period of time.
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Investing Internationally Through Investment Companies:
The mutual fund Industry has become a global industry. Open-end funds around the world have
grown rapidly, including emerging market economies. Worldwide assets as of mid-2002 were
approximately $11.6 trillion. About 42 percent of worldwide mutual future assets were invested
in equity funds and another 26 percent in money market funds.
Aggregate mutual fund assets in Europe amount to about one-third of the world total. .In Latin
America, roughly one of every 200 people owns a mutual fund (compare to one in three in the
United States). In Japan, mutual fund assets approximate one-half trillion dollars. In early 1999,
there were more than 41,000 funds worldwide.
U.S. investors can invest internationally by buying and selling both mutual funds and closed-end
funds whose shares are traded on exchanges. Funds that specialize in international securities
have become both numerous and well known in recent years.
1. So-called international funds tend to-concentrate primarily on international stocks. In one
recent year, Fidelity Overseas Fund was roughly one-third invested in Europe and onethird in the Pacific Basin, whereas Kemper International had roughly one-sixth of its
assets in each of three areas, the United Kingdom, Germany, and Japan.
2. Global funds tend to keep a minimum of 25 percent of their-assets in the United States.
For example, in one recent year, Templeton World Fund had over 60 percent of its assets
in the United States and small positions in Australia and Canada.
Most mutual funds that offer "international" investing invest primarily in non U.S. stocks,
thereby exposing investors to foreign markets, which may behave differently from U.S. markets.
However; investors may also be exposed to currency risks. An alternative approach to
international investing is to seek international exposure by investing in U.S. companies with
strong earnings abroad, which is a natural extension of the globalization concept.
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Exchange-Traded Funds (ETFs):
A new investing trend of increasing importance is the exchange-traded funds (ETFs). These new
financial assets have some characteristics of index mutual funds, closed-end funds, and even
individual stocks.
An ETF is a basket of stocks that tracks a particular sector, investment style, geographical area,
or the market as a whole. As of August 2002, there were approximately 125 ETFs, with perhaps
$100 billion in assets. Although this, is tiny compared to the assets in mutual funds, the growth
rate in assets for ETFs has been impressive, as more and more investors discover them.
Like an index mutual fund, ETFs to date are passive portfolios (although actively managed ETFs
are under consideration) that simply hold a basket of stocks. Unlike a mutual fund, however, and
like a stock or a closed-end fund, an ETF trades on an exchange throughout the day, and can be
bought on margin and sold short. And like a closed-end fund, ETFs can trade at discounts and
premiums, but to date, the differences between NAV and price have been tiny, and this will
almost certainly continue to be the case because of the unique mechanisms that were developed
to create and liquidate ETF shares.
Let's consider some ETFs. Probably the best-known ETF is the "Spider" (Standard & Poor's
Depositary Receipts, SPDRs), which was introduced in 1993 to reflect the S&P 500 Index.
SPDRs are traded on the Amex, and priced continuously during the day Other ETFs include
"Diamonds" (the DJIA), "Cubes" (Nasdaq-100 Index Tracking Stock), and "Shares" (S&P 500 as
well as other S&P indexes for small cap, mid-cap, and growth and value indexes, various Russell
Indexes, various Dow Jones Sector funds, and various country funds), there are 77 different
Share ETFs. Vanguard, the investment company, created VIPERs to track the entire stock
market.
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The Required Rate of Return:
The required rate of return was the discount rate for valuing common stocks. The required rate of
return for a common stock, or any security, is defined as the minimum expected rate of return
needed to induce an investor to purchase it, is, given its risk, a security must offer some
minimum expected return before par investor can be persuaded to buy it.
The CAPM provides investors with a method of actually calculating a required (expected) rate of
return for a stock, an industry, or the market as a Our interest, here is to think of the required rate
of return on an overall basis as it after the strategies that investors employ and the management
of their portfolios.
|
What do Investors require (expect) when they invest? First of all, investors can earn a riskless
rate of return by investing in riskless assets such as Treasury bills. This nominal risk-free rate of
return is designated RF throughout this text. It consists of a real risk-free rate of interest and an
expected inflation premium. In summary, as an approximation:
Risk-free rate of .return =Real risk = free value f Expected Inflation
In addition to the risk-free rate of return available from riskless assets, rational risk-averse
investors purchasing a risky asset expect to be compensated for this additional risk.
Therefore, risky assets must offer risk premiums above and beyond the riskless rate of return and
the greater, the risk of the asset, the greater the promised risk premium must be.
The risk premium should reflect all the uncertainty involved in the asset. Thinking risk in terms
of its traditional sources, such components as the business risk and the financial risk of a
corporation would certainly contribute to the risk premium demanded by investor for purchasing
the common stock of the corporation. After all, the risk to the investor is the expected income
(return) will not be realized because of unforeseen events.
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The particular business that a company is in will significantly affect the risk to the investor. One
has only to look at the textile and steel industries in the last few years to appreciate business risk
which leads to an understanding of why industry analysis is important. And the financial
decisions that a firm makes (or fails to make) also affect the riskiness of the stock.
Understanding the Required Rate of Return:
The required rate of return any investment opportunity can be expressed as Equation. This is, in
effect, CAPM model.
Required rate of return = Risk- free rate + Risk premium
It is important to note that there are many financial assets and therefore many different required
rates of return. The average required rate of return on bonds is different from average required
rate of return on preferred stocks, and both are different from the typical required rates of return
for common stocks, warrants, or puts and calls. Furthermore within a particular asset category
such as common stocks, there are many required rates of return. Common stocks cover a
relatively wide range of risk from conservative utility stocks to small, risky high-technology
stocks.
SML
E(R)
A
kM
B
C
kRF
0
0.5
1.0
1.5
2.0
BetaM
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The trade-off between the required rate of return and risk is linear arid upward sloping that is, the
required rate of return increases as the risk, measured by beta, increases; the stock market taken
as a whole has a beta of 1.0, indicated by point M. The required rate of return for, all stocks is
therefore kM. A stock with a beta lower than 1.0 has a required rate of return below k M, because
its risk (beta) is less than that of the market. On the other hand, a stock with a beta greater than
1.0 has a required rate of return greater than that of the market.
It is also important to be aware that the level of required rates of return changes over time. For
example, required rates t of return change as inflationary expectations change, because the
inflation premium is a component of the risk-free rate of return, which in turn is a component of
the requited rate of return. The level also changes as the risk premiums change. Investor
pessimism will increase the risk premium and the required rate investor optimism lowers both.
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