Mutual Funds and Other Investment Companies

Investment Companies • Pool funds of individual investors and invest in a wide range of securities or other assets. “pooling of assets” • Provide several functions to investors: –Administration & record keeping Status reports, keep track of dividend, gains etc.. –Diversification & divisibility can Act as large investors even if any individual can not –Professional management can hire professional analysts, fund managers. –Reduced transaction costs substantial brokerage and commissions.

NAV : Net asset value

• Investment companies need to divide claims to the pooled assets among investors

• Investor buy shares in investment companies, the value of each share are expressed as net asset value.

Example : Assets $3352.8 Liabilities $270.3 #Shares 110.2 The net asset value (NAV) of the portfolio : = (3352.8 - 270.3) / 110.2 = $27.97 per share

NAV : Net asset value

Types of Investment Companies • Unit Investment Trusts (Unit Trust)

– Fixed portfolio : brokerage buys a portfolio of securities and sell to investors. – Unmanaged : fixed portfolio composition – Sponsors profits generated from buy low sell high – Lost market share to mutual fund : Total assets have declined from $105 billion in 1990 to $29 billion in 2009

Types of Investment Companies • Managed Investment Companies Open-End (commonly known as mutual funds) • Number of shares changes daily : Fund stand ready to issues new shares when investors buy in and redeems shares when investors cash out • Priced at Net Asset Value (NAV) • investors buy and liquidate via investment company : mutual fund do not traded on organized exchanges

Types of Investment Companies • Managed Investment Companies – Closed-End • no change in numbers of shares outstanding; old investors cash out by selling to new investors • Priced at premium or discount to NAV • Traded on organized exchange, just like other common stock

Types of Investment Companies • Other investment organizations – Commingled funds (pooled fund) economies of scale – REITs Invest in real estate or loan backed by real estate Equity trust : invest directly in real estate Mortgage trust : invest in mortgage loan – Hedge Funds Lightly regulated : not subject to SEC regulations usually have “lock ups” – initial investment can not withdrawn for the first years thus, allow hedge fund to invest in illiquid assets

Mutual Funds: Open-End Investment Companies Many fund types • Money Market • Equity • Sector • Bond • Balanced (bond & equity) • Asset Allocation and Flexible (high risk) • Index • International

How Funds Are Sold • Direct-marketed funds - Mail, Newspaper or Internet • Sales force distributed – Revenue sharing on sales force distributed – Potential conflicts of interest : brokerage tend to recommend funds that pay them

Costs of Investing in Mutual Funds Apart from past performance and fund policy, investors should take a look at costs.

• Fee Structure: Four types 1. Operating expenses % of assets usually 1-2% 2. Front-end load sales charge for broker 3. Back-end load “exit fee” 4. 12b-1 charges deductable from net assets if <= 1% • Fees must be disclosed in the prospectus • Share classes with different fee combinations

Mutual Fund Returns are measures as the changes on NAV plus income distributions, expressed as a fraction of NAV at the beginning of investment period Example : Mutual fund returns

Mutual Fund Returns

The equity fund sell share in Class A : front-end load 4% Class B : 12b-1 0.5% annually & back-end load start at 5% and reduce by 1% each year (until fifth year) Assume 10% rate of returns net of operating expense annually. What will be the value of investment in class A and Class B shares after 1) 4 years 2) 10 years ? Which asset class provide higher net proceeds at the end of each horizon?

Mutual Fund Returns : Example

Sol. 4 year : Class A : front end load 4%, Class B: x% 12b-1 fee + 1% back end load : Class A : 10% annual return , Class B : 10-0.5= 9.5% net Hence ; Net Proceed A : = (0.96*10000)*(1+0.1)4 = 14,055.36 Net Proceed B : = 10000*0.99*(1+0.095)4 = 14,232.84

4 years : Class A : front end load 4%, Class B: x% 12b-1 fee + 1% back end load : Class A : 10% annual return , Class B : 10-0.5= 9.5% net Hence ; Net Proceed A : = (0.96*10000)*(1+0.1)4 = 14,055.36 Net Proceed B : = 10000*(1-0.01)*(1+0.095)4 = 14,232.84 10 years : Class A : front end load 4%, Class B: 12b-1 fee 0% back end load : Class A : 10% annual return , Class B : 10-0.5= 9.5% net Hence ; Net Proceed A : = (0.96*10000)*(1+0.1)10 = 24,899.93 Net Proceed B : = 10000*(1+0.095)10 = 24,782.28

Mutual Fund Returns : Solutions

Exchange Traded Funds (ETF) • Textbook Examples: “spiders” S&P Depository Receipt , “diamonds” DowJoans industry ticker DIA and “cubes” NASDAQ 100 ticker QQQ • Thai Market Examples : TDEX (SET50 ETF), GLD (Gold track ETF), TH100 (SET100 ETF) • Potential advantages: – Trade continuously like stocks – Can be sold short or purchased on margin – Lower costs – Tax efficient • Potential disadvantages: – Prices can depart by small amounts from NAV – Must be purchased from a broker

Hedge Funds

Similarities : Mutual Funds and Hedge Funds Similarities

• Both are pooled investments

• Both represent investor’s stake in the portfolio as NAV

• But Many differences..

Hedge Fund Styles

Clarify each of the following strategies as directional or non-directional 1) The fund buys shares in India Investment Fund, a closed-end fund

that is selling at a discount to NAV, and sells the MSCI India index swap

2) The fund buys shares in Petrie stores and sell toy “r” us, which is a major component of Petrie’s Balance sheet

3) The fund buys shares in Generic Pharmaceuticals, betting that it will be acquired by Pfizer.

Hedge fund Strategies: Example

Clarify each of the following strategies as directional or non-directional 1) Non-directional, long in India investment, short in India index

constitute a hedged position.

2) Non-directional, both positions are driven by the performance of Toy “R” us. Hence, long petries stores and short Toy “R” us constitute a hedged position.

3) Directional. The trading strategy is an outright bet that the price of generic pharmaceuticals will receive favorable effect from the takeover bid by Pfizer.

Hedge fund Strategies: Solutions