Transcript Saunders Cornett Chapter 5

Chapter 5
Mutual Funds and
Hedge Funds
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview
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In this segment: Mutual Funds and Hedge
Funds:
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Activities of mutual
Size, structure and composition
Balance sheets and recent trends
Regulation of mutual funds
Activities of hedge funds
Global issues
Size, structure and composition
Balance sheets and recent trends
Regulation of hedge funds
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Mutual Funds
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Diversification opportunities enhanced for
small investors
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Economies of scale
Predominantly open-ended funds
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Mutual Funds
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Rapid growth in funds during the 1990s
 Slower rate of growth in the industry in early
2000s than in 1990s
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Trading abuses contributed to slowdown
2007:
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Almost 7,100 stock and bond mutual
companies.
Total assets of $8.21 trillion.
8,125 firms and $10.57 trillion if money market
mutual funds included
Size, structure and composition
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First mutual fund: Boston, 1924.
Slow growth, initially.
Advent of money market mutual funds, 1972.
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Total assets in stock and bond mutual funds:
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Regulation Q.
1940: $0.5 billion.
1990: $1,065.2 billion
2000: $6,964.6 billion
2006: $10,413.7
Institutional funds
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80 percent of retirement plan investments
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Size, Structure and Composition
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By asset size, mutual fund industry second
most important FI group.
Recent inroads by commercial banks and
insurance companies
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Mellon purchase of Dreyfus
State Farm (9,000 agents)
As of 2006, insurance companies managed
approximately 10% of mutual fund assets
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Types of Mutual Funds
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Long-term funds
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74.3% of assets, 1999
2002, long-term funds dropped to 62.1% of
assets, losing ground to MMMFs
75.4% in 2006
Types of Long-term Funds:
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Bond and income funds.
Equity funds.
Hybrid.
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Types of Mutual Funds
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Short-term funds
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25.7% of assets, 1999.
37.9% of assets, 2002.
24.6% in 2006
Taxable and tax-exempt MMMFs
Generally higher returns than bank deposits but
uninsured.
Impact of low interest rates during early to
mid 2000s
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Decline in MMMFs
Lowering of MMMF fees
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Number of Mutual Funds
TaxTaxable exempt
Year Equity Hybrid Bond
MM
MM
1980 288
N/A
170
96
10
1990 1,099
193
1,046
506
235
2007 4,784
501
1,993
574
273
Interest Rate Spread and Net New Cash
Flow to MMMFs
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Overview of Mutual Funds
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Objectives (and adherence to stated
objectives), rates of return and risk
characteristics vary.
Examples:
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Capital appreciation funds
World equity
Corporate bond
High-yield bond
World bond
Government bond
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Returns to Mutual Funds
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Income and dividends of underlying portfolio.
Capital gains on trades by mutual fund
management.
Capital appreciation in values of assets held in
the portfolio.
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Marked-to-market.
Net-asset value (NAV).
Web Resources
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For information on the performance of
mutual funds, visit:
Morningstar www.morningstar.com
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Types of Funds
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Open-ended funds: comparable to most
corporate securities traded on stock exchanges.
Closed-end investment companies:
Fixed number of shares
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Example: REITs.
May trade at premium or discount.
Exchange traded funds (ETFs)
Load versus no-load funds.
Mutual Fund Costs
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Two types of fees:
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Sales loads
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Generally, negative effect on performance outweighs
benefits
Short term versus long term investment alters impact
of loads on cost
Fund operating expenses
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Management fee
12b-1 fees
Front end and back end fees
• Class A, Class B and Class C differences
• SEC creation of new rules
• Sweeping decreases in fees, 2005 and 2006
Balance Sheet and Trends
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Money Market Funds
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Key assets are short-term securities (consistent
with deposit-like nature)
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2006: $1,514.9 billion (65.5% of total assets)
Most have share values fixed at $1 and adjust
number of shares owned by the investor.
Balance Sheet and Trends
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Long-term Funds
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Stocks comprised over 70.7 % of asset
portfolios in 2006.
Credit market instruments 27.2% of asset
portfolios
Shift to other securities such as credit market
instruments, U.S. Treasuries, municipal bonds
etc. when equity markets not performing as
well.
Regulation
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One of the most closely regulated among nondepository FIs.
Primary regulator: SEC
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Emphasis on full disclosure and anti-fraud measures
to protect small investors.
NASD supervises mutual fund share distributions.
Regulatory Changes
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Prosecutions in light of trading abuses in
early 2000s.
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Market timing
Late trading
Directed brokerage
Improper fee assessments
Changes include: SEC requirements for
independent board members; reporting and
disclosure requirements
Legislation
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Securities Act 1933, 1934
Investment Advisers Act, 1940.
Insider Trading and Securities Fraud
Enforcement Act of 1988.
Market Reform Act of 1990
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Allows SEC to halt trading and introduce circuit
breakers.
National Securities Markets Improvement Act of
1996.
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Exempts mutual fund sellers from state securities
regulatory oversight.
Sarbanes-Oxley Act of 2002
Global Issues
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Worldwide growth in mutual fund investment
not as great as in the U.S.
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$2.575 trillion in 1996 to $10.490 trillion in 2006
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Over 307% growth
Larger returns in U.S.stock markets
Greatest development in countries with most
advanced markets
Opportunities from declining Japanese markets
Efforts to reduce barriers for U.S. mutual fund
sponsors
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China and other Asian countries
Hedge Funds
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Not technically mutual funds
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Not subject to SEC regulation
Organized as limited partnership
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Small number of sophisticated investors
Common feature is use of leverage
High returns in 1990s
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Hedge Funds
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Near collapse of Long-Term Capital
Management
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$3.6 billion bailout
Precipitated SEC scrutiny of hedge funds
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Types of Hedge Funds
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More risky
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Market neutral or value orientation
Risk avoidance
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Market directional
Moderate risk
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Moderate, consistent returns with low risk as
objectives
Fees
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Generally management fees and performance
fees
Offshore Hedge Funds
Major centers include Cayman Islands,
Bermuda, Dublin, Luxembourg.
 Rules
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Generally not burdensome
Anonymity
Tax advantages
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Regulation of Hedge Funds
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Generally unregulated
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Exemption for less than 100 investors
Exemption if accredited
Scandals such as Canary Capital Partners
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Illegal trading with mutual funds
Amaranth Advisors, 2006
SEC scrutiny
Pertinent Websites
American Funds www.americanfunds.com
Federal Reserve www.federalreserve.gov
Fidelity Investments www.fidelity.com
Investment Company Institute www.ici.org
Morningstar, Inc. www.morningstar.com
NASD: www.nasd.com
SEC: www.sec.gov
Vanguard www.vanguard.com
Wall Street Journal www.wsj.com
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