Chapter Seventeen Mutual Funds and Hedge Funds Mc

Chapter Seventeen Mutual Funds and Hedge Funds Mc. Graw-Hill/Irwin 8 -1 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds and Hedge Funds • Mutual Funds (MFs) and Hedge Funds (HFs) are financial institutions (FIs) that pool the financial resources of individuals and companies and invest those resources in portfolios of assets • The first MF was established in Boston in 1924 • By 1970 360 MFs held about $50 billion in assets • Money market mutual funds (MMMFs) were introduced in 1970 • Tax-exempt MMMFs were introduced in 1979 • By 2007 more than 8, 000 MFs held over $12 trillion in assets Mc. Graw-Hill/Irwin 17 -2 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Cash flows into MFs is highly correlated with the return on the NYSE • Growth has also resulted from the rise in retirement funds under management by MFs – MFs managed ~ 25% of retirement fund assets in 2007 • MFs are the second most important group of FIs as measured by asset size, second only to commercial banks • Banks’ share of all MF assets has grown to 21% in 2007 • Insurance companies managed 10% of MF industry assets in 2007 Mc. Graw-Hill/Irwin 17 -3 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • The barriers to entry in the MF industry are low – the largest MF sponsors have not increased their market share recently • the largest 25 MF companies managed 76% of industry assets in 1990 • the largest 25 MF companies managed 71% of industry assets in 2007 – the composition of the top 25 firms in the industry has changed • seven of the largest 25 firms in 2007 were not among the top 25 in 1990 Mc. Graw-Hill/Irwin 17 -4 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • The MF industry has two sectors – short-term funds invest in securities with original maturities of less than one year • money market mutual funds • tax-exempt money market mutual funds – long-term funds invest in portfolios of securities with original maturities of more than one year • equity funds consist of common and preferred stock • bond funds consist of fixed-income capital market debt securities • hybrid funds consist of both stock and bond securities Mc. Graw-Hill/Irwin 17 -5 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Approximately 25% of long-term funds are index funds – index funds are funds in which managers buy securities in proportions similar to those included in a specified major index – index funds involve little research or management, which results in lower management fees and higher returns than actively managed funds • Exchange traded funds (ETFs) are also designed to replicate market indexes – traded on exchanges at prices determined by the market – management fees are lower than actively traded funds – unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin Mc. Graw-Hill/Irwin 17 -6 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Money market mutual funds (MMMFs) provide an alternative investment to interestbearing deposits at commercial banks – bank deposits are relatively less risky, because they are FDIC insured, and generally offer lower returns than MMMFs • Households own the majority of MFs – owned 69. 6% of long-term funds in 2007 – owned 46. 0% of short-term funds in 2007 – 48. 0% of all U. S. households owned MFs in 2006— which represents ~56. 3 million households Mc. Graw-Hill/Irwin 17 -7 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • MF managers must specify their funds investment objectives in a prospectus, which is made available to potential investors – holds lists of the securities invested in by the funds – in 1998 the Securities and Exchange Commission (SEC) mandated that prospectuses must be written in “plain English” instead of overly legal language (i. e. , legalese) Mc. Graw-Hill/Irwin 17 -8 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Equity funds represent 56. 7% of MF assets in 2007 (~$5. 9 trillion) – capital appreciation funds (25. 9%) – world equity (12. 6%) – total return (18. 2%) • Hybrid funds represent 6. 3% of MF assets (~$0. 7 trillion) • Bond funds represent 14. 4% of MF assets (~$1. 5 trillion) – – – – corporate bonds (2. 6%) high-yield bonds (1. 5%) world bonds (0. 6%) government bonds (1. 9%) strategic income bonds (4. 3%) state municipal bonds (1. 5%) national municipal bonds (2. 0%) Mc. Graw-Hill/Irwin 17 -9 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Money market funds represent 22. 6% of MF assets ($2. 4 trillion) – taxable funds (19. 1%) – tax-exempt funds (3. 5%) • Four of the five largest MFs in the U. S. , as of February 6, 2008, were managed by the same company – American Funds Growth; A • a growth fund with $91. 4 billion in assets – American Funds CWGI; A • an international fund with $83. 0 billion in assets – American Funds CIB; A • an income fund with $81. 6 billion in assets – Fidelity Invest: Contra • a growth fund with $80. 9 billion in assets – American Funds Inv. Co. A • a growth/income fund with $73. 5 billion in assets Mc. Graw-Hill/Irwin 17 -10 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Investor returns from MF ownership reflect three components – income and dividends on portfolio assets – capital gains on assets bought and sold at higher prices – capital appreciation on assets held in the fund • MF assets are usually marked to market daily – prices are adjusted daily to reflect changes in the current market prices of the portfolio’s assets • Then net asset value (NAV) of a MF share is equal to the market value of the assets in the MF portfolio divided by the number of shares outstanding Mc. Graw-Hill/Irwin 17 -11 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • An open-end MF is a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares • A closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares, but invests in the securities and assets of other firms • A real estate investment trust is a closed-end investment company that specializes in investing in mortgages, property, or real estate company shares Mc. Graw-Hill/Irwin 17 -12 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • MFs charge investors fees for the services they provide – sales loads – 12 b-1 fees are fees related to the distribution costs of MF shares • cannot exceed 1% of average annual net assets for load funds • cannot exceed 0. 25% of average annual net assets for no-load funds – MFs may offer different share classes with different combinations of loads • A load fund is an MF with an up-front sales or commission charge that the investor must pay • A no-load fund is an MF that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors Mc. Graw-Hill/Irwin 17 -13 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • MFs are heavily regulated because they manage and invest small investor savings – – The SEC is the primary regulator The Securities Act of 1933 The Securities Exchange Act of 1934 The Investment Advisers Act and Investment Company Act of 1940 – The Insider Trading and Securities Fraud Enforcement Act of 1988 – The Market Reform Act of 1990 – The National Securities Market Improvement Act (NSMIA) of 1996 Mc. Graw-Hill/Irwin 17 -14 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Mutual Funds • Even with heavy regulation, investor abuses still occur – market timing is short-term trading that profits from out-of-date values on the securities in the fund’s portfolio – late trading involves buys and sells long after prices have been set at 4: 00 pm E. T. – directed brokerage occurs when brokers improperly influence investors on their fund recommendations – improperly assessed fees occur when brokers trick customers into thinking they are buying no-load funds or fail to provide discounts properly Mc. Graw-Hill/Irwin 17 -15 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Hedge Funds • Hedge funds (HFs) are investment pools that solicit funds from wealthy individuals and other investors (e. g. , commercial banks) and invest these funds on their behalf – similar to MFs, but not required to register with the SEC – subject to virtually no regulatory oversight and thus generally can (and do) take significant risk – do not have to disclose their activities to third parties and thus offer a high degree of privacy • HFs avoid regulation by limiting the number of investors to less than 100 and by requiring investors to be “accredited” – accredited investors have net worth over $1 million or annual income over $200, 000 if single (or $300, 000 if married) Mc. Graw-Hill/Irwin 17 -16 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Hedge Funds • HFs use more aggressive trading strategies than MFs such as short selling, leverage, program trading, arbitrage, and the use of derivatives • Because HFs are not registered, they cannot be accurately tracked ~ 9, 000 HFs in the U. S. in 2008 ~ $2. 8 trillion in assets in 2008 ~ new assets flow in at a rate of about $300 billion annually ~ the 100 largest HFs control about 70% of the industry in 2008 Mc. Graw-Hill/Irwin 17 -17 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Hedge Funds • There are three basic types of HFs – the most risky HFs use market directional trading strategies, seek high returns using leverage, and invest based on anticipating events – moderate risk HFs have a market neutral (or value) orientation that favors longer-term investment strategies – risk avoidance HFs take a market neutral approach and strive for consistent returns with low risk Mc. Graw-Hill/Irwin 17 -18 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Hedge Funds • Management fees on HFs are computed as a percent of assets under management and run between 1. 5% and 2% • Performance fees give fund managers a share of any positive returns earned – the average is 20%, but performance fees vary substantially depending on the HF – a hurdle rate is a benchmark that must be realized before a performance fee can be assessed – a high-water mark is when a manager does not receive a performance fee unless the value of the fund exceeds the highest NAV it has previously achieved • Offshore HFs are attractive to investors because they provide anonymity and are not subject to U. S. taxes Mc. Graw-Hill/Irwin 17 -19 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Hedge Funds • HFs are exempt from registration requirements set forth by the Investment Company Act of 1940 – HFs have less than 100 investors each, accredited investors, and are sold only as private placements • HFs are prohibited from abusive (i. e. , illegal) trading practices • In 2003 the SEC recommended that large HFs register with the SEC as investment advisors – approximately 25% of HFs were already registered • In 2007 the U. S. Treasury, the Federal Reserve, the SEC, and the CFTC concluded that current HF regulation was sufficient Mc. Graw-Hill/Irwin 17 -20 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved