InvestmentsInvestments
BSCBSCWinter Winter
Semester Semester 20102010
Chap 3Chap 3Indirect Indirect InvestingInvesting
What is Indirect Investing? Direct Investing
Indirect Investing
What is an Investment Company?
What are Types of Investment Companies?
What are Types of Mutual Funds?
What are the mechanics of Investing Indirectly?
What is Investment Company Performance?
What are Exchange Traded Funds?
What are major types of Financial Assets?
DIRECT INVESTING
Non-Marketable securities
Money MarketsCapital MarketsDerivatives Markets
INDIRECT INVESTING
Investment CompaniesMutual FundsStock, Bond FundsExchange Traded
Funds
Buying & Selling of shares of investment companies, which then hold portfolios of securities.
Funds are given to professional money managers to make decisions on an investors behalf (for better or worst)
Fees are charged for this service
Investment Company?
Investment Company?
A financial company which sells shares in itself to the public & uses these funds to invest in a portfolio of securities
Investment Company Regulations
Investment Company Taxation
Types of Investment Companies
Exchange Traded Funds (ETF)Unit Investment Trusts (UIT)Closed-End Investment CompaniesOpen-end Investment Companies (Mutual
Funds)
Exchange Traded Funds
Exchange Traded FundsAn 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 EfficientVery small premiums & discounts from NAVUnlike mutual Funds, can be traded anytime during
the day.Lower Expenses
Unit Investment Trusts
Unit Investment TrustsUnit 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 CompaniesClosed 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 IndirectlyNet Asset Value- NAV is per share value of portfolio
of securities held by the investment company on a given day.
If NAV > Market price DiscountIf NAV < Market price PremiumNAV = (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 - TypesThere are four basic types of Mutual Funds:1. Money Market Mutual Funds2. Equity Funds3. Bond Funds4. Hybrid Funds
Mutual Funds - Types1. 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 Funds4. Hybrid Funds
Mutual Funds Value Funds Vs Growth FundsIndex Funds
Mutual Funds- Trading MechanicsMutual Fund Share pricesOwners of shares can sell them back to the
company anytime they choose; the mutual fund is legally obligated to redeem them.
Mutual Funds- Trading MechanicsFees Vs ExpensesFront-End LoadBack-end LoadManagement FeeDistribution Fee (12b-1)Load & No load Funds
Mutual Funds- Trading MechanicsMutual Fund Share ClassesClass A SharesClass B SharesClass C shares
Hedge Funds
Hedge FundsHedge 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 - ClassificationsLong/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 FundsFund 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 - BiasesSelf selection BiasBackfilling BiasSurvivorship BiasSmoothed pricing of infrequently traded assets
Alternative InvestmentsClosely held companiesDistressed SecuritiesVenture Capital Investing
Alternative Investments – Closely held companiesThe 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 approachThe comparables approachThe income approach
Alternative Investments – Distressed SecuritiesWhen companies are on the brink of bankruptcy or
have already filed for bankruptcy protection, their securities are considered Distressed.
Alternative Investments – Venture Capital InvestingVenture 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 horizonDifficulty in valuationRequirement 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 - ExampleThe probability that Venture Capital survives for five
years is calculated as:(1-0.20)*(1-0.20)*(1-0.17)*(1-0.15)*(1-0.15) = 0.3838
NPV if the project survives:[-2.5 m + {12m/(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 # 3Q1: 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 # 3Q2: 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
What is Indirect Investing? Direct Investing
Indirect Investing
What is an Investment Company?
What are Types of Investment Companies?
What are Types of Mutual Funds?
What are the mechanics of Investing Indirectly?
What is Investment Company Performance?
What are Exchange Traded Funds?
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