Chapter 14 Investment Companies And Mutual Funds Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline Questions to be answered: • What are the different ways that professional asset management firms can be organized? • How has the structure of the asset management industry changed over time? • How are managers at investment advisory firms compensated? Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline • Who manages the investment company portfolio and how are its managers compensated? • How do you compute the net asset value (NAV) for an investment company? • What is the difference between closed-end and openend investment companies? • What is the difference between the NAV and market price for a closed-end fund? Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline • What are load fees, 12b-1 fees, and management fees and how do they influence investment company performance? • What are the two major means of fund distribution and what has been the trend for each approach? • Given the breakdown of all funds by investment objectives, which groups have experienced relative growth or decline? Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 14 Outline • Given a desire to have a personal portfolio manager perform certain functions for you, how do investment companies help fulfill this need? • What are the ethical dilemmas involved in the professional asset management industry? • What has been the risk-adjusted performance of mutual funds relative to alternative market indexes? Copyright © 2000 by Harcourt, Inc. All rights reserved. The Asset Management Industry: Structure and Evolution 1. Contract directly with a management and advisory firm relationship with client assets under management (AUM) separate accounts customized 2. Commingling of investment capital of several clients in an investment company Copyright © 2000 by Harcourt, Inc. All rights reserved. What is an Investment Company? • An investment company invests a pool of funds belonging to many individuals in a portfolio of individual investments such as stocks and bonds • The total market value of all investments divided by the number of fund shares outstanding is the net asset value (NAV) • Portfolio management is handled by an investment management company Copyright © 2000 by Harcourt, Inc. All rights reserved. Types Of Funds • Open-End Funds – Mutual funds (MFs) • Closed -End Funds – Investment trusts Copyright © 2000 by Harcourt, Inc. All rights reserved. Closed-End Funds • Developed in Europe 1820s • No Additional Shares Issued • Easier to Manage – No liquidity requirement • Shares Trade on Secondary Market Copyright © 2000 by Harcourt, Inc. All rights reserved. Pricing Of Closed-End Funds • NAV • CMP • Premium or Discount CMP – NAV = + Premium or - Discount NAV Copyright © 2000 by Harcourt, Inc. All rights reserved. Reasons For Premium Or Discount • Unrealized Capital Appreciation • Management Fees and Transfer Costs • Performance of the Fund • Turnover Copyright © 2000 by Harcourt, Inc. All rights reserved. Open-End Funds • Load and No-Load Funds • Prospectus – Required by law to be provided to investors • Family of Funds • Growth of Mutual Funds – See next slide Copyright © 2000 by Harcourt, Inc. All rights reserved. Growth Of Mutual Funds (MFs) 4000 3500 3000 2500 Growth in $millions Total Assets 2000 1500 1000 500 0 1940 1950 1960 1970 1980 1990 1996 Copyright © 2000 by Harcourt, Inc. All rights reserved. Growth Of MFs 7000 6000 5000 4000 Growth in Number of Funds 3000 2000 1000 0 1940 1950 1960 1970 1980 1990 1996 Copyright © 2000 by Harcourt, Inc. All rights reserved. Closed-End Versus Open-End Investment Companies • Closed-end investment company – Stock trades on secondary market – Net asset value (NAV) is determined twice daily, but market price determined by supply and demand – Discounts from NAV can be opportunities • Closed-end fund index • Open-end investment companies – Mutual funds – Sell and repurchase shares at NAV Copyright © 2000 by Harcourt, Inc. All rights reserved. Benefits Of Investing In MFs • Diversification • Professional • Checking Accounts • Switching Fund Management • Reduced Trading Costs • Systematic Accumulation and Withdrawal Plans Services • Security Custody and Bookkeeping • Increasing an Economy’s Capital Supply Copyright © 2000 by Harcourt, Inc. All rights reserved. Costs Of Investing In MFs • Load • Management Fees • Suboptimal • 12b-1 Fees • Transaction Costs • Higher Income Tax Investment • Accounting, Distribution, and Other Costs Rate • Disadvantage of Being too Big Copyright © 2000 by Harcourt, Inc. All rights reserved. Mutual Fund Costs • Load versus no-load open-end funds – Load funds charge sales commission up to 8.5% of NAV, but usually not a redemption fee – No-load imposes no initial sales charge, so it sells shares at NAV, but may charge a small redemption fee of 1/2% – Low-load imposes a front-end sales charge in the 3% range Copyright © 2000 by Harcourt, Inc. All rights reserved. Types of Investment Companies Based on Portfolio Objectives • Common stock funds – General Equity – Specialized Equity – World Equity • Balanced funds •… Copyright © 2000 by Harcourt, Inc. All rights reserved. Types of Investment Companies Based on Portfolio Objectives • Taxable bond funds – Convertible Securities – Dual Purpose – Loan Participations – Bond – World Income • Municipal bond funds – National Municipal – Single State Municipal • Money market funds Copyright © 2000 by Harcourt, Inc. All rights reserved. Global Investment Companies • Foreign funds – International funds – Global funds • Fund categories, regions, countries Copyright © 2000 by Harcourt, Inc. All rights reserved. • • • • • • • • • • • • Sources of Information About Mutual Funds The Wall Street Journal Barron’s - weekly and quarterly Investment Companies Mutual Funds Update Mutual Funds Report Closed-end Weekly Review FundEdge Management Results Forbes Business Week - “Mutual Fund Scoreboard” Morningstar Mutual Funds Value Line Copyright © 2000 by Harcourt, Inc. All rights reserved. Ethics and Regulation in the Professional Asset Management Industry • Agency - looking out for the interest of another • Asset management industry is based on handling • • • • • someone else’s money Investment Company Act of 1940 Securities Act of 1933 Securities Exchange Act of 1934 Investment Advisors Act of 1940 ERISA (1974) - Prudent man rule Copyright © 2000 by Harcourt, Inc. All rights reserved. Ethics and Regulation in the Professional Asset Management Industry • Association for Investment Management and Research (AIMR) has a Code of Ethics and Standards of Professional Conduct • Chartered Financial Analyst (CFA) • Compensation dilemma - incentives and risk • Soft dollars Copyright © 2000 by Harcourt, Inc. All rights reserved. Performance of Investment Companies • Below average returns for actively managed equity and bond funds • Do a fund’s objectives matter? – Positive relationship between stated objectives and risk measures • Do managers generally outperform the market? – Results are more consistent in shorter time periods Copyright © 2000 by Harcourt, Inc. All rights reserved. Your Portfolio Manager 1. Determine your risk-return preferences and develop a portfolio that is consistent with them 2. Diversify your portfolio to eliminate unsystematic risk 3. Maintain your portfolio diversification and your desired risk class while allowing flexibility so you could shift between alternative investment instruments as desired 4. Attempt to achieve a risk-adjusted performance that is superior to aggregate market performance 5. Administer the account, keep records of costs, provide timely information for tax purposes, and reinvest dividends if desired Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio: The Objective Semantics are important in any statement of investment objectives. The four main portfolio objectives are stability of principal, income, growth of income, and capital appreciation. In a world with taxes, one dollar in capital gains is worth more than one dollar in income. The overriding investment objective is utility maximization. Copyright © 2000 by Harcourt, Inc. All rights reserved. Relative Riskiness of Portfolio Objectives 20 18 capital appreciation small company stocks expected return 16 14 large company stocks 12 growth of income 10 intermediateterm 8 government bonds 6 long-term corporate bonds 4 T-bills inflation 2 stability 0 of principal 0 6 12 long-term government bonds income 18 24 standard deviation (%) Copyright © 2000 by Harcourt, Inc. All rights reserved. 30 36 Structuring a Stock Portfolio : Asset Allocation An asset class refers to a broad category of investments. U.S. equities, foreign equities, bonds, and cash are four widely used asset classes. The relative distribution of funds across asset classes is called asset allocation. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio : Asset Allocation Portfolio attitude toward risk need for return individual choice stocks bonds real estate ASSET CLASSES cash foreign equities asset class mix Copyright © 2000 by Harcourt, Inc. All rights reserved. realized return and risk with the passage of time investment results Structuring a Stock Portfolio: Categories of Stock A blue chip stock usually has a long history of uninterrupted dividends. Income stocks are those that historically have a higher-than-average payout ratio (the proportion of net income after taxes paid as a dividend). A cyclical stock is one whose fortune is directly tied to the state of the overall national economy. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio: Categories of Stock A defensive stock is largely immune to changes in the economy. Growth stocks reinvest most of their earnings rather than paying them out as dividends and may be good candidates for above-average returns. A speculative stock has a high probability of a loss and a small probability of a large profit. Penny stocks refer to unusually risky, especially inexpensive shares. Copyright © 2000 by Harcourt, Inc. All rights reserved. Structuring a Stock Portfolio : Active vs. Passive Management A strategy of passive management is one in which, once established, the portfolio is largely left alone. An active management policy, in contrast, is one in which the composition of the portfolio is dynamic. Copyright © 2000 by Harcourt, Inc. All rights reserved. Index Funds • Replicate a Given Index – S&P 500 index • Holds No Cash • Sell Stock – When investors redeem shares • No Telephone Sales • Redemption Fee – Time factor Copyright © 2000 by Harcourt, Inc. All rights reserved. Ranking Global Fund Performance • Forbes Global Stock Fund Composite • Blended Domestic and Foreign Index Copyright © 2000 by Harcourt, Inc. All rights reserved. Portfolio Project Notes: The Portfolio Management Process The Portfolio Management Process 1. Policy statement - Focus: Investor’s short-term and longterm needs, familiarity with capital market history, and expectations 2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 1. Policy statement – specifies investment goals and acceptable risk levels – should be reviewed periodically – guides all investment decisions Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trends – determine strategies to meet goals – requires monitoring and updates Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 3. Construct the portfolio – allocate available funds to meet goals and minimize investor’s risks Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 4. Monitor and update – revise policy statement as needed – modify investment strategy accordingly – evaluate portfolio performance Copyright © 2000 by Harcourt, Inc. All rights reserved. The Need For A Policy Statement • Understand and articulate realistic investor goals – needs, objectives, and constraints – financial markets and risks of investing Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement • What are the real risks of an adverse financial outcome, especially in the short run? • What probable emotional reactions will I have to an adverse financial outcome? • How knowledgeable am I about investments and markets? Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement • What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? • What, if any, legal restrictions may affect my investment needs? • What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy? Copyright © 2000 by Harcourt, Inc. All rights reserved. Standards For Evaluating Portfolio Performance • Benchmark portfolio – risk and return • Matches risk preferences and investment needs – analysis of risk tolerance – return objective goals Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals • Capital preservation – minimize risk of real loss – strongly risk-averse or funds needed soon • Capital appreciation – capital gains to provide real growth over time for future need – aggressive strategy with accepted risk • Current income – generate spendable funds Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals • Total return – capital gains and income reinvestment – moderate risk exposure Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints • Liquidity needs – near-term goals • Time horizon – longer time horizon favors risk acceptability – short time horizon favors less risky investments because losses are harder to overcome in a short time frame Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints • Tax concerns – interest and dividends taxed at investor’s marginal tax rate – capital gains may be unrealized – basis and gain or loss realized – revisions to capital gains tax rates – tradeoff with diversification needs for employer’s stock holdings Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints • Tax concerns (continued) – interest on municipal bonds exempt from federal income tax and from state of issue – interest on federal securities exempt from state income tax – contributions to an IRA may qualify as deductible from taxable income – tax deferral considerations - compounding Copyright © 2000 by Harcourt, Inc. All rights reserved. Effect of Tax Deferral on Investor Wealth over Time Figure 2.5 Investment Value $10,063 8% Tax Deferred $5,365 5.76% After Tax Return $1,000 0 10 20 Inc. Copyright © 2000 by Harcourt, All rights reserved. Time 30 years Legal and Regulatory Factors • Limitations or penalties on withdrawals • Fiduciary responsibilities “prudent man” rule • Investment laws prohibit insider trading Copyright © 2000 by Harcourt, Inc. All rights reserved. Unique Needs and Preferences • Personal preferences - socially conscious investments • Time constraints or expertise for managing the portfolio may require professional management • Large investment in employer may require consideration of diversification needs and realistic liquidity • Institutional investors needs Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing the Policy Statement • Objectives - risk and return • Constraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences • Developing a plan depends on understanding the relationship between risk and return and the importance of diversification Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation • An investment strategy is based on four decisions – What asset classes to consider for investment – What normal or policy weights to assign to each eligible class – The allowable allocation ranges based on policy weights – What specific securities to purchase for the portfolio Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation • Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes • Higher returns compensate for risk • Policy statements must provide risk guidelines • Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes • Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns • Focusing only on return variability ignores reinvestment risk • Changes in returns from year to year Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation Summary • Policy statement determines types of assets to include in portfolio • Asset allocation determines portfolio return more than stock selection • Over long time periods sizable allocation to equity will improve results • Risk of a strategy depends on the investor’s goals and time horizon Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation and Cultural Differences • Social, political, and tax environments • U.S. institutional investors average 45% allocation in equities • In the United Kingdom, equities make up 72% of assets • In Germany, equities are 11% • In Japan, equities are 24% of assets Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary • Develop an investment policy statement – Identify investment needs, risk tolerance, and familiarity with capital markets – Identify objectives and constraints – Investment plans are enhanced by accurate formulation of a policy statement Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary • Asset allocation determines long-run returns and risk – Success depends on construction of the policy statement Copyright © 2000 by Harcourt, Inc. All rights reserved.