Chapter 4: Mutual Funds and the Institutional Environment

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Chapter 4 Mutual Funds and the Institutional
Environment

• Objective To give an overview of institutional
  investors and institutional investing
• Management by institutions objectives
  constraints
• Investment companies
• Mutual funds
• Costs of investing in mutual funds
• Performance appraisal

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1. Management by institutions

• A process for making investment decision
• Expected portfolio return
• risk tolerance
• subject to
• liquidity ? investment
• horizon policies
• regulations
• taxes
• unique needs

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Constraints in portfolio management

• Liquidity
• Investment horizon
• Regulatory constraints (institutional investors)
• The prudent person law
• Limits on foreign holdings
• Limits on individual firm holdings
• Taxes
• Unique needs

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2. Investment companies

• Investment companies pool funds from individual
  investors and invest the funds on their behalf.
• Functions and benefits
• Administration record keeping
• Diversification divisibility
• Professional management
• Reduced transaction costs
• Increased investment opportunities

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Net Asset Value

• Value of a share of investment company
• Selling new shares
• Redeeming existing shares

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Types of investment companies

• Open-end and closed-end funds
• Trading
• Open-end buy and sell shares through the fund at
  NAV.
• Closed-end trade in the stock market at current
  price.
• Fund flows and the N. of shares outstanding
• Open-end changes when new shares are sold or old
  shares are redeemed
• Closed-end no change unless new stock is offered

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• Closed-end fund discount puzzle
• closed-end funds are share are traded at a
  typical discount over 10
• initial public offering (IPO) price at a premium
  of about 10 (Weiss (1989))
• discounts are persistent and their fluctuation
  appears to be mean-reverting (Thompson (1978))
• discounts disappear on the open-ending of the
  fund (Bauer (1984)).

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• Load funds and no-load funds
• Other investment organizations
• Commingled funds
• Partnership of investors typically of trust and
  retirement accounts.
• Similar to open-end funds
• Real estate funds
• Real estate limited partnerships (Real estate
  investment trust (REIT) in U.S.)
• Mortgage funds
• Segregated funds
• Mutual funds typically sold by insurance
  companies with a guaranteed payout (75-100) at
  maturity or upon death of the investor.

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• Hedge funds
• Hedge funds pool investors fund. They are not
  registered as mutual funds, and under less
  stringent regulations than mutual funds.
• Typically open to wealthy or institutional
  investors.
• Heavy use of derivatives, short sales and
  leverage.
• Typically attempt to exploit temporary mispring.
  E.g., abnormally high mortgage-backed securities
  (MBS) relative to T-bonds. Then buy MBS and
  short-sell T-bonds. ? The fund hedges interest
  rate risk, but bets on relative pricing of the
  two assets.
• High leverage results in high volatile returns.

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3. Mutual funds

• The most popular form of investment vehicle for
  individuals.
• Industry grew immensely during 1990s.
• As of Jan. 2004, 1,887 funds managed 451B.
• Money market funds accounted for 1/8.
• index funds become quite attractive.
• Management companies offer a collection of funds
  under one umbrella family or complex of mutual
  funds.
• Investment Policies
• Money Market
• Fixed Income

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• Balanced and Income
• They hold both equities and bonds in relatively
  stable proportions.
• Asset allocation funds engage in market timing.
• Equity funds
• Index funds
• try to match the performance of a broad market
  index.
• Passive investment is a low cost alternative to
  actively managed investment.
• Specialized Sector

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• Mutual funds are sold directly or by brokers and
  agents,
• Brokers and agents receive commissions and
  trailer fees.
• Timing of sales of securities is out of your
  control.
• Investing in mutual fund reduces ability to
  engage in tax management.

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Information on mutual funds

• GlobeMail
• Monthly business survey of mutual funds
  Globefund.
• PALTrak (Morningstar)
• Wiesenbergers Investment Companies (US)
• Morningstar (US)
• Investment Funds Institute of Canada
• Investment Company Institute (US)
• Investment services (SEI, Comstat, etc.)

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4. Costs of investing in mutual funds

• Fee Structure
• Front-end and back-end load
• Many no-load funds appear to have comparable
  performance.
• Operating expenses
• Costs in operating the fund, e.g., administrative
  expenses and investment advisory fees
• Other charges
• Distribution costs paid by the fund (known as
  12b-1 charges in U.S.)
• Include commissions paid to brokers
• Management Expense Ratio (MER)
• Include operating expenses and other charges

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• Fees and performance
• Return (NAV1 NAV0 income and capital gain
  distribution)/ NAV0
• Example consider a fund with 100m and 10m
  shares. One year later, the fund portfolio grows
  to 110m. The expense ratio is 1.
• Initial NAV10.
• NAV1109m/10m10.9
• 9 return, or 10 gross return less MER
• Fees have non-trivial effect on performance.

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• Soft dollar
• Brokerage firms pay for mutual funds expenses
  such as stock research, software, etc, in return
  for the funds directing their trades.
• Ultimately, investors pay for needless high
  brokerage commission, and mutual funds receive
  the soft-dollar rebate.

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5. Mutual fund investment performance

• The majority of funds underperform relative to
  index funds. Figure 4.5.
• Persistence in Fund Performance Do some mutual
  funds consistently outperform?
• Mixed evidence on persistence
• Evidence shows consistent poor performance, and
  it is far harder to keep superior performance.

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Exchange Traded Funds (ETF)

• ETFs allow investors to trade index portfolios
  like shares of stock
• iUnits (on TSX). QQQ (cubes), SPDRs (spiders)
  are most heavily traded securities.
• EFTs cover a variety of composite indices,
  industries, and foreign index shares.
• Potential advantages
• Trade continuously
• Lower taxes
• Lower costs (management fee of 0.2-0.5 0.3-1
  for index fund 1.5-3 for actively managed
  funds)
• Potential disadvantages
• Pay brokerage commissions.