Power Point Slides for Financial Institutions Markets and

Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University and Lanny R. Martindale, Texas A&M University Copyright© 2006 John Wiley & Sons, Inc. 1

CHAPTER 20 Investment Companies Copyright© 2005 John Wiley & Sons, Inc

History of Investment Companies Investment companies were first started in Belgium in 1822. Early U. S. investment companies Began at end of 1800 s Closed-end companies First mutual fund in 1924 Declines in Great Depression Regulations enhanced confidence Growth very rapid in 1945 to 1965 period as the stock market performed well. Inflation, high interest rates, and poor market performance hurt growth in 1970 s. Copyright© 2006 John Wiley & Sons, Inc. 3

History of Investment Companies (continued) New types of funds post 1970 s Municipal bonds funds - tax-free income Government security funds - safety Money market funds - safety and high rates with inverse yield curve. Exchange traded Funds (ETFs) – represents indices. Copyright© 2006 John Wiley & Sons, Inc. 4

Investment Funds Purchase direct, long term, capital market securities and issue indirect, liquid, small denomination securities, called shares. (IF) offer the financial investor the following: Provide risk intermediation by investing in a diversified portfolio of assets. Provide denomination intermediation by issuing shares in smaller denominations than the direct securities purchased. Provide marketability for IF shares. Offer economies of scale in investment management and transaction costs. Copyright© 2006 John Wiley & Sons, Inc. 5

Net Asset Value (NAV) Value of shares is called Net Asset Value (NAV) Copyright© 2006 John Wiley & Sons, Inc. 6

Closed-end Investment Companies Have a fixed number of shares outstanding like any publicly traded corporation. Shares are traded and priced in the market. Market value of close- end fund shares sells at a 10%-20% discount off the NAV. Copyright© 2006 John Wiley & Sons, Inc. 7

Closed-end Investment Companies Size of discount varies by type of closedend fund – equity versus bond funds, domestic vs. global equity funds. [See Exhibit 20. 1]. Discounts could be due to a variety of reasons including poor management, tax considerations, and market demand. The majority of closed-end funds are either bond funds or global equity funds. [See Exhibit 20. 2] Copyright© 2006 John Wiley & Sons, Inc. 8

Closed End Funds Copyright© 2006 John Wiley & Sons, Inc. 9

Open-end Investment Companies Most common and dominates asset holdings. Mutual funds stand ready to buy(redeem) or sell their shares at the current market price of assets - net asset value. No limit to the number of shares issued. Copyright© 2006 John Wiley & Sons, Inc. 10

Exchange-Traded Funds (ETF) First introduced in 1989 at Toronto Stock Exchange Shares traded on organized exchanges like closed-end funds Created with deposit of portfolio of stock. Tremendous growth since 2000. Copyright© 2006 John Wiley & Sons, Inc. 11

Exchange-Traded Funds (ETF) Redemptions in form of stock portfolio Most track stock index – SPDRs, DIAMONDS, etc. ETF shares traded for portfolio of stock—no large premiums or discounts on ETF shares because of arbitrage activities. Tax advantage, low expense ratios, ease of buying/selling and ease of tracking prices. Copyright© 2006 John Wiley & Sons, Inc. 12

Assets of ETFs Copyright© 2006 John Wiley & Sons, Inc. 13

No. of ETFs – Exhibit 20. 3 (continued) Copyright© 2006 John Wiley & Sons, Inc. 14

Selected ETFs on the AMEX Copyright© 2006 John Wiley & Sons, Inc. 15

Investment Trust or Unit Trust. Assets are not actively managed. Provide small denomination share claims against a diversified, fixed portfolio of securities. Trust sponsors usually will repurchase shares at net asset value, less a commission. Copyright© 2006 John Wiley & Sons, Inc. 16

Importance of Investment Companies Investments in mutual funds exploded in the 1990 s because Many new funds were developed. Individual Retirement Accounts (IRAs) were developed. The shift of many pension plans from defined benefit to defined contribution plans(401 k). Increased investment by baby boomers. The high rates of return available on common stocks. Primary vehicle for retirement savings. By year-end 2003, 8126 mutual funds exist in the U. S. holding a total of over $7. 0 trillion in assets. [See Exhibit 20. 5] Copyright© 2006 John Wiley & Sons, Inc. 17

Growth of Mutual Funds Copyright© 2006 John Wiley & Sons, Inc. 18

Investment composition of investment funds Composition varies with economy Cash Holdings - Short-term liquid assets Hold more cash items when interest rates rising and high Reduce short-term securities, buy long term when rates are at peak and falling Delayed redemption and paid-in-kind redemption policies, along with bank lines of credit have reduced the proportion of cash held. Shift to equity funds in the late 1990 s – 49% of all assets held by mutual funds. Composition varied over time. [See Exhibit 20. 6] Copyright© 2006 John Wiley & Sons, Inc. 19

Types of Investment Funds Growth and income funds Growth funds Aggressive growth funds Balanced funds Income funds Specialty funds. Global Tax-exempt Sector Copyright© 2006 John Wiley & Sons, Inc. 20

Types of Investment Funds Growth & Income Funds They seek a balance between capital gains and current income. Mostly invest in highly rated companies’ stock. Ideal for investors who are looking for some income, but would also want to invest in growth stocks. Growth Funds The objective of growth funds is to invest in industries and companies that are not mature and are still experiencing sizable growth. Investors looking for a higher return and a moderate risk are attracted to such funds. Focus is on capital appreciation rather than steady income so investors’ outlook needs to be long-term. Copyright© 2006 John Wiley & Sons, Inc. 21

Types of Investment Funds Aggressive Growth Funds These are similar to growth funds in their outlook, but are more risky because they focus on emerging industries and unproven firms. Investors trade off a very high return potential for high risk. Copyright© 2006 John Wiley & Sons, Inc. 22

Types of Investment Funds Balanced Funds Such funds are a hybrid portfolio of growth stocks and fixed-income securities. The proportion of each determines the level of return for each fund. Generates higher proportion of income than growth and income funds and are less volatile. Investors who have a few more years to retirement and are typically in their early 50 s are attracted to such funds. Copyright© 2006 John Wiley & Sons, Inc. 23

Types of Investment Funds Income funds consist of bonds that provide steady coupon cash flows and are quite varied in their risk level. Income funds could be made up of a portfolio of entirely corporate bonds (risky) or a portfolio of entirely Treasury issues (no default risk) or of mortgage-backed securities. Income funds are exposed to not only default risk, but also to interest rate risk. Such income funds are attractive to investors close to retirement age as the income stream of fund’s instruments provides them with necessary income. Copyright© 2006 John Wiley & Sons, Inc. 24

Mutual Fund Families Mutual fund managing companies market a variety of types of mutual funds to investors, called families of funds. The intent is to provide an opportunity to change risk, asset, term and other investment profiles without changing mutual fund companies or retirement account manager. Funds may be switched from fund to fund at nominal charges. Copyright© 2006 John Wiley & Sons, Inc. 25

Mutual Fund Families (concluded) Other services may include: discount brokerage service - purchase/sale of individual direct securities, such as stocks and bonds. Transaction Accounts - check writing and/or debit card relationship to mutual fund. Pension fund management for businesses Copyright© 2006 John Wiley & Sons, Inc. 26

Regulation of Mutual Funds-SEC and States Regulation relates to adequate required disclosure, adequate diversification, sales practices, and management practices. [See People & Events Exhibit] Federal laws Securities Act of 1933 SEC Act of 1934 Investment Company Act of 1940 and 1970 Mutual funds income and capital gains are not taxed-owners of shares are. Copyright© 2006 John Wiley & Sons, Inc. 27

Mutual Fund Fee Structures Load funds - investor pays a sales commission when shares are purchased from brokers. No-load funds - no initial sales fees, but other charges (Bank-end load, contingent deferred sales charge, or redemption fees) may be levied for services provided. 12 b-1 fees - an annual fee levied against fund assets by some funds. Management or advisory fees Exchange fees and account maintenance fees. Copyright© 2006 John Wiley & Sons, Inc. 28

Hedge Funds Hedge funds comprise investment pools that use a combination of market philosophies and analytical techniques. Hedge funds seek to develop financial models to identify, evaluate, and execute trading decisions. Hedge funds typically are organized as limited partnerships. The goal of a hedge fund is providing consistent, above-market returns while reducing the risk of loss. Copyright© 2006 John Wiley & Sons, Inc. 29

Hedge Funds Differ from Mutual Funds Hedge funds are private, unregistered investment pools open to a limited number of accredited investors. Hedge fund managers receive a fee that is based on their performance. Mutual funds are heavily regulated investment pools registered with the SEC that are open to all investors. Mutual fund managers receive a fee that is percentage of the assets under management. Copyright© 2006 John Wiley & Sons, Inc. 30

Hedge Fund Investment Strategies Traditional hedge fund strategies include: domestic hedge strategies. global macro strategies. market neutral strategies. sector strategies. short strategies. Copyright© 2006 John Wiley & Sons, Inc. 31

Arbitrage Hedge Fund Investment Strategies Arbitrage hedge fund strategies include: Fixed income arbitrage. Index arbitrage. Closed-end fund arbitrage. Convertible arbitrage. Copyright© 2006 John Wiley & Sons, Inc. 32

Event-driven Investment Strategies Event-driven hedge fund strategies include: Risk arbitrage. Distressed securities. Special situation. Copyright© 2006 John Wiley & Sons, Inc. 33

Money Market Mutual Funds (MMMF) Short-term money market investments. Provide excellent liquidity for investors. High quality and high yield when yield curve is inverse. Compete with bank deposits. Copyright© 2006 John Wiley & Sons, Inc. 34

Growth of MMMFs & Reg. Q When market rates were above Regulation Q maximum deposit rates, MMMFs grew rapidly. Banks were able to compete after the 1982 Depository Institutions Act when they were permitted to offer insured, Money Market Deposit Accounts (MMDA). MMMF offer higher yields than bank MMDA’s? Copyright© 2006 John Wiley & Sons, Inc. 35

MMMFs’ Role in the Economy At year end 2001, MMMFs had peaked at over $2 trillion worth of shares outstanding and by 2003 declined to $1. 763 billion. MMMFs offer transactional conveniences that make them very competitive with bank deposits. Check writing privileges, debit cards, wire transfers, sweep features. MMMFs that invest in tax-exempt securities can pass through interest payments that are exempt from federal (and possibly state) income taxes. Interest earned on bank deposits is fully taxable. Copyright© 2006 John Wiley & Sons, Inc. 36

Growth of MMMFs Copyright© 2006 John Wiley & Sons, Inc. 37

Real Estate Investment Trust (REIT) An investment fund selling shares and investing in real estate related assets Own income property. Acquire mortgages. Finance real estate development and construction. Acquire and lease property. Copyright© 2006 John Wiley & Sons, Inc. 38

Real Estate Investment Trust (REIT) Regulated under federal Real Estate Investment Act of 1960 and state regulation REITs are exempt from federal income tax is they accrue a minimum of 75% of income from real estate investments and pay 90% of their net income to shareholders. Grew rapidly in the inflationary boom period of the late 1960 s and early 1970 s, then the bubble burst Financed short (commercial paper) and invested long in rising rate environment Copyright© 2006 John Wiley & Sons, Inc. 39