TOPIC 2 - INVESTMENT VEHICLES Flashcards
Firms issue securities to:
raise capital necessary to finance their investments. Investment bankers market these securities to public on primary market.
Investment bankers act as:
underwriters purchasing securities from the firm and selling them to the public at a markup –> before they can sell to public must publish an SEC approved prospectus that provides info on the firm’s prospects
already issued securities are traded on
the secondary market (organised stock market - on over the counter market and sometimes direct negotiation for super large trades)
brokerage firms with access to exchanges sell
their services to individuals, charging commissions for executing trades on their behalf
Trading can occur in dealer markets, via
electronic communication networks or in specialist/designated market maker markets
What happens in a dealer market?
security dealers post bid and ask prices they’re willing to trade at. Brokers execute trades for their clients at best price available.
What happens in electronic markets?
existing book of limit orders provides the terms at which trades can be executed. Mutually agreeable offers to buy or sell securities are automatically crossed by the computer system operating the market
NASDAQ was traditionally what
dealer market - network of dealers negotiated directly over sales of securities. –> but now pretty much all electronic (Same for NYSE which was traditionally a specialist market)
Buying on margin
borrowing money from a broker to buy more securities than can be purchased with one’s money alone.
By buying shares on margin, what does an investor do?
they magnify the upside potential and downside risk. If the equity in a margin account falls below the required maintenance level, the investor will get a margin call from the broker.
Short-selling is the practice of
selling securities that the seller doesn’t own.
Short-seller borrows the securities from ….. and then
a broker, sells them and may be required to cover the short position at any time on demand.
The cash proceeds of a short sale are kept in
escrow by the broker and the broker usually requires that the short-seller deposit additional cash or securities to serve as margin (collateral).
Securities trading regulation largely pertains to
full disclosure of relevant info concerning the securities in question.
Insider trading rules prohibit
traders from attempting to profit from inside information.
investment companies comprise:
1) unit investment trusts
2) closed-end management companies
3) open-end management companies
unit investment trusts
unmanaged - once portfolio is established, it’s fixed
–> pools of $ invested in a portfolio that’s fixed for the life of the fund
managed investment companies
portfolio can change composition of portfolio as they see fit (comprised of closed-end and open-end funds)
closed-end fund
traded like other securities, they don’t redeem shares for their investors (unlike open-end funds).
open-end funds (mutual funds)
redeem shares for net asset value at the request of the investor
- priced at the NAV
if you hold $ in a unit investment trust, what sort of strategy does this reflect
buy and hold, no effort put into portfolio = lower transactions bc there’s less turnover (no constant buying and selling)
with open-end funds, if you redeem the shares noting they’re priced at the NAV, what happens?
$20/share can liquidate investment redeem it with the fund provider at the NAV, sell it back to the mutual fund at price of $20/share.
How do you get out of a closed-end fund since you can’t redeem when you wish at any time
sell into secondary markets.
The no. shares outstanding is constant and investors cash out by selling to new investors.
closed -end funds - how are shares priced?
at premium or discount to NAV
why are closed end fund’s shares priced at a premium or discount?
- Bc units can’t redeemed with fund provider at NAV, market pricing of the units can be at a premium/discount to NAV –> price can be different!
Eg, where market participants make an assessment of the liabilities of the closed end fund than that reported by the fund itself.
(Remember NAV involves subtracting liabilities – if market disagrees about value of the liabilities, then market pricing for the fund can be different to the NAV)
Net asset value =
market value of assets held by a fund - liabilities of the fund divided by the shares outstanding
Mutual funds good bc they free the individual from:
many of the administrative burdens of owning individual securities and offer professional management of the portfolio
additional reason for why mutual funds are advantageous for individual investors
gives individual investor access to advantages only available to large scale investors such as lower trading costs.
What’s a possible downside to mutual funds?
Funds are assessed management fees and incur other expenses which reduce the investor’s rate of return.
Funds also eliminate some of individual’s control over timing of capital gains realisations)
mutual funds often categorised by:
investment policy (money market funds, equity funds --> then further grouped per emphasis on income vs growth/specialisation by sector, balanced funds, bond funds, international funds, asset allocation funds, index funds)
costs of investing in mutual funds incl:
1) front-end loads (sales charges
2) back-end loads (redemption fees.contingent deferred sales charges)
3) 12b-1 charges (recurring fees to appy for expenses of marketing fund to public)
how is income taxed for mutual funds?
not taxed at the level of the fund, instead as long as the fund meets certain requirements for pass-throughs status, the income is treated as being earned by the investors in the fund
average rate of return of the average equity mutual fund in last 48 years has been:
below that of a passive index fund holding a portfolio to replicate a broad-based index like S&P 500 or Wilshrie 50000
what are some of the reasons for why the average equity mutual fund has underperformed passive index funds?
- costs incurred by actively managed funds (to conduct research to pick stocks)
- trading costs due to higher turnover
record
New trading strategies - 3 types
1) Algorithmic trading
2) dark pools
3) bond trading
1) Algorithmic trading
delegates trading to computer program - high frequency trading a form of this, computers quickly initiate orders –> increases liquidity
2) dark pools
for large traders wanting to remain anonymous through use of ‘blocks’ in private trading systems (trades not reported until after they’re crossed)
what has the impact of electronic been on markets?
pressure to make international alliances or merges to globalise markets
2 types of trading costs
a) explicit (brokerage commissions)
2) implicit costs ( dealer’s bid ask spread)
implicit costs - when we deal with investors to buy and sell stock, we’re always:
selling at a price that’s a bit lower than what we’re buying at – source of profit for dealer, but for us as an investor it’s a transaction cost
what do you use buying on margin for?
increase overall size of the funds –> take a leveraged position in the stock through –> A broker’s call loan - borrowing from the broker
If there’s a margin of 50% of stock worth $10k what does this imply?
we’re putting up $5k of our own $$$ (equity proportion as the investor) and the other $5k from a broker
maintenance margin
min equity that must be kept in a margin account
maintenance margin: if stock value falls below (say $4000), margin call is made to guard against this &
the broker will issue a margin call which requires the investor to add new cash/securities to the margin account.
If investor doesn’t respond to a margin call,
broker may sell securities from the acc to pay off enough of the loan to restore the % margin to an acceptable level
2 step mechanics of a short sale:
- investor borrows stock from broker and sells it
- investor must hen purchase a share of the same stock in order to replace the one that was borrowed (referred to as covering the short position)
ETFs
offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock
margin on short position =
equity (contributed by investor themselves)/value of shares owed
rate of return on investment for margins
= (ending value of equity - initial equity)/initial equity
Risk and Return of Illiquid Investments: A Trade‐off for Superannuation Funds Offering Transferable Accounts - READING - main finding:
across both retail and not-for-profit funds, there is a broad cross-section of investment in illiquid assets; BUT not-for-profit funds have higher illiquid asset allocation on average.
In the sample period for this study, superannuation funds realise returns from illiquid investments that reflect the non-diversifiable risk these investments contribute to the funds’ portfolios.
If the diversification benefits derived from illiquid asset classes are not at a cost of reduced investment performance, funds which include these asset classes in their portfolios will offer a better risk–return trade-off.
Investor flows and the assessed performance of open-end mutual funds (Roger)
Open-end mutual funds’ tendency toward underperformance has little to do with a lack of ability on the fund manager’s part. It results from the liquidity service that fund managers provide investors.
offering price =
NAV/1- load
load being % fee charged by the fund
rate of return =
(end E in acc - initial E in acc)/initial E in acc
portfolio turnover rate =
value of the stocks sold and replaced / total market value of the shares oustanding(firm assets)
to determine whether a fund sells at a premium or discount:
= (price - NAV)/NAV
in contrast to closed-end funds, the price of open-end funds will never fall below NAV because
these funds stand ready to redeem at NAV. However, the offering price will exceed NAV if fund carries a load (a sales charge)
