week 2 Flashcards
Five principal benefits of mutual funds
- Liquidity intermediation: investors can quickly convert investments into cash at low cost while still allowing the fund to invest for the long term.
- Denomination intermediation: investors can participate in equity and debt offerings that, individually,
require more capital than they possess. - Diversification: investors immediately realize the benefits of diversification even for small
investments. - Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the
individual investor. - Managerial expertise: many investors prefer to rely on professional money managers to select their investments.
Sharpe ratio
(return-risk free rate)/sd(return)
Mutual Fund Complexes
Mutual Fund Complexes refer to a group of mutual funds that are managed under the same investment company but may include a variety of different types of funds.
The term “complex” emphasizes the diversity of funds that fall under the same overarching management.
Close-End Fund
In a close-end fund, a fixed number of nonredeemable shares are sold at an initial offering and are then traded in the over-the-counter market like common stock.
Once the shares have been sold, the fund cannot take in any more investment dollars. Thus, to grow the fund managers must start a whole new fund. Also, investors cannot make withdrawals.
The only way investors have of getting their money out of their investment in the fund is to sell shares.
Open-End Fund
In an open-end fund, investors can contribute at any time. The fund simply increases the number of shares outstanding.
Furthermore, the fund agrees to buy back shares from investors at any time. All shares bought and sold are traded at same net asset value of that day.
This means open-end funds have two major advantages: high liquidity and can grow unchecked.
Mutual fund’s net asset value formula
Net Asset Value (NAV) = total value of the mutual fund’s stocks, bonds, cash, and other assets minus
any liabilities such as accrued fees, divided by the number of shares outstanding.
Mutual fund structure
It includes investors who are the shareholders or the owners of the mutual fund
Board of directors who oversee the fund’s activities and sets policies and responsible for appointing the investment advisor and principal underwriter
Investment advisor: manages the portfolio of investment according to the fund’s policy
Principal underwriter: responsible for selling the fund shares
Four primary classses of mutual funds
- Stock (equity) funds
- Bond funds
- Hybrid funds
- Money market funds
Stock (equity) funds
are mutual funds that primarily invest in stocks. Here are the three major types of equity funds:
- Capital Appreciation Funds
The primary goal is to achieve rapid capital appreciation, which means increasing the share price.
- Total Return Funds
These funds seek a balance between current income (through dividends) and capital appreciation (through increases in stock prices).
- World Equity Funds
These funds primarily invest in the stocks of foreign companies, offering easy access to international diversification.
Bond funds
Strategic income funds invest primarily in US corporate bonds seeking a high level of current income. Investors are trading safety for greater returns.
Corporate bond funds invest primarily in high-grade corporate bonds
Government Bond Funds invest in US Treasury, as well as state and local government bonds, these are essentially default risk-free but have relatively low returns.
Hybrid Funds
Hybrid funds combine stocks and bonds into a single fund. The idea is to provide an investment that diversifies across different types of securities as well as across different issuers of a particular type of security.
Money Market Mutual Funds
All MMMFs are open-end investment funds that invest only in money market securities. Most funds do not charge any fee for purchasing or redeeming shares and offer check-writing privileges.
Index Funds
are a type of passively managed mutual fund or exchange-traded fund (ETF) that aims to replicate the performance of a specific market index, such as the S&P 500 rather than trying to beat the market through active management, index funds aim to match the performance of the index they track by holding a diversified portfolio of the same securities in the same proportions.
Different types of fees charged
- Load funds (class A shares) charge an upfront fee for buying the shares. No-load funds do not charge this fee.
- Deferred load (class B shares) funds charge a fee when the shares are redeemed
- If the particular fund charges no front or back end fees, a no-load fund, it is referred to as class C
shares
Other fees that might be included
- Contingent deferred sales charge: imposed at the time of redemption is an alternative way to
compensate financial professionals for their services. This fee typically applies for the first few years
of ownership and then disappears. - Redemption fee: a back-end charge for redeeming shares. It is expressed as a dollar amount or a
percentage of the redemption price. - Exchange fee: a fee (usually low) for transferring money between funds in the same family.
- Account maintenance fee: charges if the account balance is too low.
- 12b-1 fee: fee to pay marketing, advertising, and commissions.
Hedge funds
A type of investment tool that solicits funds from (wealthy) individuals and other investors (e.g., commercial banks) and invests these funds on their behalf.
How is hedge funds different from typical mutual fund
- High minimum investment, averaging around $1 million
- Long term commitment of funds is required
- High fees: typically 1% of assets plus 20% of profits
- Highly levered (leverage effect)
- Little current regulation (In 2010 federal regulators increased the oversight of hedge funds)
The LTCM debacle
Long-Term Capital Management (LTCM) was a hedge fund led by John Meriwether, with Nobel laureates Myron Scholes and Robert Merton on its board. It initially achieved over 30% annual returns but later suffered massive losses due to bad bets. With $80 billion in equity positions and $1 trillion in derivatives, its potential collapse posed a systemic risk, prompting regulators to organize a bailout.
Sources of Conflicts of Interest
It arise when there is asymmetric information and the principal’s and agent’s interests are not closely aligned, leading to abuses on the part of the fund management.
Mutual Fund Abuses
Late trading: Refers to the practice of allowing trades that are received after 4:00 p.m. to trade at the
4:00 price when they should trade at the next day’s price. This is illegal under SEC regulations.
Market timing: Taking advantage of time zone differences that allow arbitrage opportunities,
especially in foreign stocks. Mutual funds will set their 4:00 closing NAV using the most recent
available foreign prices. This is not illegal under SEC rulings.
Government Response to Abuses
- More independent directors: funds are required to have an independent board chairman and 75% of the board must be independent.
- Hardening of the 4:00 p.m. valuation rule: this addresses the late trading problem, but not market timing
- Increased and enforced redemption fees: fees to discourage market timing by additional fees for
short-term redemptions - Increased transparency: increased disclosure of operating practices to the public. Required to reveal relations between directors, fund owners and investment managers. Also, need to disclose how fees are charged and compensation arrangements with sales brokers.
