Investments BSC Winter Semester 2010 Chap 3 Indirect

Investments BSC Winter Semester 2010

Chap 3 Indirect Investing

Chapter 3 Indirect Investing Learning Objectives n What is Indirect Investing? n Direct Investing n Indirect Investing n What is an Investment Company? n What are Types of Investment Companies? n What are Types of Mutual Funds? n What are the mechanics of Investing Indirectly? n What is Investment Company Performance? n What are Exchange Traded Funds?

What are major types of Financial Assets? DIRECT INVESTING Non-Marketable securities Money Markets Capital Markets Derivatives Markets INDIRECT INVESTING Investment Companies Mutual Funds Stock, Bond Funds Exchange Traded Funds

What are major types of Financial Assets? In-direct Investing n Buying & Selling of shares of investment companies, which then hold portfolios of securities. n Funds are given to professional money managers to make decisions on an investors behalf (for better or worst) n Fees are charged for this service

What are major types of Financial Assets? In-direct Investing n Investment Company?

What are major types of Financial Assets? In-direct Investing n Investment Company? A financial company which sells shares in itself to the public & uses these funds to invest in a portfolio of securities n Investment Company Regulations n Investment Company Taxation

Types of Investment Companies Exchange Traded Funds (ETF) Unit Investment Trusts (UIT) Closed-End Investment Companies Open-end Investment Companies (Mutual Funds)

Exchange Traded Funds

Exchange Traded Funds An exchange traded fund is a basket of stocks that tracks a particular index, sector, investment style, geographical area or the market as a whole. ETFs unlike mutual funds can be bought on margin & sold short. Tax Efficient Very small premiums & discounts from NAV Unlike mutual Funds, can be traded anytime during the day. Lower Expenses

Unit Investment Trusts

Unit Investment Trusts Unit Investment Trust is an unmanaged portfolio of tax exempt securities put together by a sponsor & 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 commission.

Closed-End Investment Companies

Closed-End Investment Companies Closed Investment Company offers investors an actively managed portfolio of securities. Its capitalization is fixed unless a new public offering is made. Shares of closed-end Funds trade on Stock exchanges & hence their prices are determined by forces of supply & demand.

Closed-End Investment Companies. Mechanics of Investing Indirectly Net Asset Value- NAV is per share value of portfolio of securities held by the investment company on a given day. If NAV > Market price Discount If NAV < Market price Premium NAV = (Market Value of Fund’s Securities – Liabilities) Total Number of shares outstanding

Open-End Investment Companies (Mutual Funds)

Open-End Investment Companies (Mutual Funds) Mutual Funds are either corporations or Business trusts 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 number of shares outstanding of an open end investment company is continually changing.

Mutual Funds - Types There are four basic types of Mutual Funds: 1. Money Market Mutual Funds 2. Equity Funds 3. Bond Funds 4. Hybrid Funds

Mutual Funds - Types Money Market Mutual Funds No Load Funds Taxable Vs Tax Exempt Funds 2. Equity Funds Capital Appreciation Fund Total Return fund World Equity Fund 3. Bond Funds 4. Hybrid Funds 1.

Mutual Funds Value Funds Vs Growth Funds Index Funds

Mutual Funds- Trading Mechanics Mutual Fund Share prices Owners of shares can sell them back to the company anytime they choose; the mutual fund is legally obligated to redeem them.

Mutual Funds- Trading Mechanics Fees Vs Expenses Front-End Load Back-end Load Management Fee Distribution Fee (12 b-1) Load & No load Funds

Mutual Funds- Trading Mechanics Mutual Fund Share Classes Class A Shares Class B Shares Class C shares

Hedge Funds

Hedge Funds are unregulated companies that seek to exploit various market opportunities & thereby earn larger returns than are ordinarily available. As hedge funds are unregulated, they may invest in assets not typically available to mutual Funds. A high water mark provision

Hedge Funds - Classifications Long/Short Funds: These funds take long & short common stock positions, use leverage & are invested in markets world wide. Market-neutral Funds: These funds take long & short positions, but the positions will offset each other so that the effect is a net zero exposure to the market. Global Macro Funds: These funds are typically highly leveraged & rely heavily upon derivatives.

Fund of Funds investing involves creating a fund open to both individual & institutional investors, which in turn invests in hedge funds. Benefits for investors with limited capital? Benefits for investors with more capital? Drawbacks?

Hedge fund performance measurement There are numerous hedge fund indices designed to measure historical performance. Some general conclusions regarding hedge funds can be derived: Hedge Funds have demonstrated a lower risk profile than traditional equity investments as measured by a standard deviation. In recent years, the Sharpe Ratio has been consistently higher for hedge funds than for most equity investments. There is a low correlation between the performance of hedge funds & conventional investments.

Hedge fund performance measurement Biases Self selection Bias Backfilling Bias Survivorship Bias Smoothed pricing of infrequently traded assets

Alternative Investments Closely held companies Distressed Securities Venture Capital Investing

Alternative Investments – Closely held companies The equity shares of closely held companies are not publicly traded & are not subject to the same SEC regulations as public companies regarding reporting & disclosure. The Cost approach The comparables approach The income approach

Alternative Investments – Distressed Securities When companies are on the brink of bankruptcy or have already filed for bankruptcy protection, their securities are considered Distressed.

Alternative Investments – Venture Capital Investing Venture Capital Investments are private, non exchange traded equity investments in business venture. Investments may be made at any point of the business cycle of the company, from the initial planning stage of a new venture to an established firm ready to go public. Long term investment horizon Difficulty in valuation Requirement for extensive operation analysis

Valuing a Venture Capital Investment Example A venture capital fund manager is considering investing 2. 5 million in a new project that he believes will pay $12 million at the end of five years. The cost of equity for the investor is 15% & the estimated probability of failure is presented in the figure below. Year Failure Probability 1 0. 20 2 0. 20 3 0. 17 4 0. 15 5 0. 15

Valuing a Venture Capital Investment Example The probability that Venture Capital survives for five years is calculated as: (1 -0. 20)*(1 -0. 17)*(1 -0. 15) = 0. 3838 NPV if the project survives: [-2. 5 m + {12 m/(1. 155)}] = $3. 466121 Million NPV if the project fails: = - $2. 5 million (Initial Investment) Expected NPV of the project (Probability weighted average): = (0. 3838*3, 466, 121) + (0. 6162* (-2, 500, 000)) = - $210, 203

Assignment # 3 Q 1: A venture capital fund manager is considering investing 3. 5 million in a new project that he believes will pay $30 million at the end of five years. The cost of equity for the investor is 13% & the estimated probability of failure is presented in the figure below. Year Failure Probability 1 0. 10 2 0. 20 3 0. 07 4 0. 25 5 0. 05

Assignment # 3 Q 2: A venture capital fund manager is considering investing 1. 75 million in a new project that he believes will pay $25 million at the end of six years. The cost of equity for the investor is 12% & the estimated probability of survival is presented in the figure below. Year survival Probability 1 0. 75 2 0. 80 3 0. 80 4 0. 85 5 0. 90 6 0. 95

Chapter 3 Indirect Investing Summary n What is Indirect Investing? n Direct Investing n Indirect Investing n What is an Investment Company? n What are Types of Investment Companies? n What are Types of Mutual Funds? n What are the mechanics of Investing Indirectly? n What is Investment Company Performance? n What are Exchange Traded Funds?

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