FIN 355 (22) - Mutual funds, ETFs, hedge funds (module 6).pptx

FIN 355 Principles of Investments Mutual Funds, ETFs, and Hedge Funds Lecture Preview Big-Picture Motivation: One of the easiest and most cost-effective ways to invest in a diversified portfolio can be via mutual funds and/or ETFs. Some funds have significantly higher fees so it is important to u...

FIN 355 Principles of Investments Mutual Funds, ETFs, and Hedge Funds Lecture Preview Big-Picture Motivation: One of the easiest and most cost-effective ways to invest in a diversified portfolio can be via mutual funds and/or ETFs. Some funds have significantly higher fees so it is important to understand the fee structures. Many employer-sponsored retirement plans allow employees to invest their retirement in funds. Discussion Outline: • Discuss types of investment companies • Overview of mutual funds: • Formation information • Fees • Advantages and disadvantages • Discussion of other fund types (ETFs, Hedge Funds) Types of investment companies The Investment Company Act of 1940 classifies investment companies as either unit investment trusts or as managed investment companies (closed-end and open-end funds). Investment companies collect and pool funds from multiple investors and invest in underlying assets. “Investment companies are required by the Act to provide investors with information about their investment objectives, investment policies, and financial condition when stock is first sold and, henceforth, at regular intervals. Investment companies must also inform investors about investment company structure and operations…. The legislation in the Investment Company Act of 1940 is enforced and regulated by the Securities and Exchange Commission (SEC).” U.S.-registered investment companies managed $28.9 trillion in assets at year-end -- 2023 ICI factbook General information on funds Per the 2023 ICI factbook: • 71.7 million households (120.5 million US individuals) own funds in US. • 54.7% of households are invested in these funds. Of these most list retirement as their reason for investing in the funds. Median number of mutual funds owned: 3 • In the US alone there were over 8,763 mutual funds and 2,989 ETFs. • The majority of US mutual and ETF investments were in domestic equity, bonds, international equity, and money market securities. • Many investors in mutual funds own them via employer-sponsored retirement plans. • Over the last 10 years trillions of dollars of cumulative cash flows have been withdrawn from actively managed equity mutual funds and been placed in index-based equity ETFs or mutual funds. Figure 2.1 – Most investment company assets are in mutual funds “There were 16,159 investment companies offered by US financial services companies at year-end 2022 ... The overall number of investment companies is down from a decade ago as an increase in the number of exchangetraded funds (ETFs) only partially offset a decrease in the number of unit investment trusts (UITs) and closed-end funds.” - 2023 ICI factbook Figure 2.2 – The majority of investment company assets were in equity funds as of the end of 2022 “Total net assets in US-registered investment companies decreased in 2022 to a year-end level of $28.9 trillion, with the vast majority held by mutual funds and ETFs. US-registered investment company total net assets were concentrated in long-term funds, with equity funds alone holding $16.6 trillion—57 percent of all investment company total net assets at year-end 2022” - 2023 ICI factbook 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Mutual funds $6,956 6,969 6,380 7,399 8,093 8,889 10,395 11,995 9,616 11,104 11,825 11,624 13,046 15,039 15,867 15,648 16,342 18,750 17,698 21,277 23,883 26,964 ETFs $66 83 102 151 228 301 423 608 531 777 992 1,048 1,337 1,675 1,975 2,101 2,525 3,401 3,371 4,396 5,449 7,191 Closed-end funds $150 145 161 216 255 276 299 316 185 224 239 244 265 282 292 263 265 277 252 279 282 309 UITs Total $74 49 36 36 37 41 50 53 29 38 51 60 72 87 101 94 85 85 70 79 78 95 $7,245 7,246 6,680 7,801 8,614 9,507 11,167 12,973 10,360 12,144 13,107 12,976 14,720 17,082 18,234 18,106 19,216 22,513 21,391 26,031 29,692 34,559 Source: ICI Investment Company Institute 2022 factbook Figure 2.2 Numbers in billions of dollars. Hundreds of mutual funds and ETFs are opened and closed each year. “The concentration of mutual fund and ETF assets managed by the largest fund complexes has increased over time. The share of assets managed by the five largest firms rose from 35 percent at year-end 2005 to 55 percent at year-end 2022” -- 2023 ICI factbook Number of Fund Sponsors by Year The 5 largest Fund Complexes managed over 55% of the Mutual Fund and ETF Assets in 2022. -2023 ICI Factbook Managed investment companies: open-end and closed-end Open-end (“Mutual funds”) • Sold at net asset value (NAV) to sponsor • Bought and sold at the end of the day when NAV is calculated Closed-end • Sold at premium or discount to NAV to other investors • Fund companies issue a fixed number of shares • You buy or sell those shares on an exchange Managed investment companies: open-end and closed-end Open-end (“Mutual funds”) • Sold at net asset value (NAV) to sponsor • Bought and sold at the end of the day when NAV is calculated Closed-end • Sold at premium or discount to NAV to other investors • Fund companies issue a fixed number of shares • You buy or sell those shares on an exchange NAV The net asset value (NAV) is used as a basis for: • Valuation of investment shares • Selling new shares • Redeeming existing shares Calculation of NAV: NAV = (market value of assets) – (liabilities) (shares outstanding) Mutual funds • The fund’s investment style/strategy described in the prospectus • Management companies often manage a family of mutual funds. Some examples include: • Fidelity • Blackrock • Vanguard • Charles Schwab Examples of common types of mutual funds • • • • • • • • Money market Equity Specialized sector Bond Distressed firm Value or growth firms International Indexed Fees: Front - end loads affect price Front-end load fees are a commission or sales charge paid when you purchase the shares. They are used to primarily pay the brokers and are usually not more than 6%. Low load funds have fees that range up to 3%. Front-end loads affect the price you pay. Example: Assume the NAV of a fund is $13 and the front-end load is 4%. What price do you pay per share? • P = 13 + .04(P) • P = 13/.96 = 13.54 Fees: Front-end loads and returns Front-end load fees affect return calculations: Assume a fund has a NAV of $10 and a front-end load of 5%. Assume the NAV grows by 14% per share per year over 2 years. What was your gross return? If you had invested $X then your gross return over the two years would have been: Fees: Back-end loads and prices (“contingent deferred sales charges”) Back-end load fees are exit fees incurred when you sell your shares. They are typically 4-6% and may decrease with time. Back-end loads don’t affect the price you pay. Assuming no other fees, the price is the NAV. Back-end loads affect your payoff. Example: Assume the NAV of a fund is $13 and the back-end load fee is 5%. What price do you get when you sell the fund? • 13*.95 = $12.35 Fees: Back-end loads and returns Back-end load fees affect return calculations: Assume a fund has a NAV of $10 and a back-end load of 5%. The fund earns 14% per share per year over 2 years. What was your gross return? If you had invested $X then your gross return for the 2 years would have been: Annual expenses Operating expenses are used to pay for administrative expenses and advisory fees. Typically range between .2% and 2% of assets under management. 12b-1 charges are used to pay for advertising, promotional literature, and commissions to brokers. These fees can be as high as 1% but are usually less. • The SEC requires a consolidated expense table in the prospectus that lists all the fees. • Some funds offer different classes of shares that differ in their fee structures. • Mutual funds are granted “pass-through status” for taxes. Annual expenses and returns Example: • Assume a fund has a NAV of $10 and that annual expenses (expense ratio) are 5%. The fund earns 14% per share each year for 2 years. What is the gross return? • If you had invested $X the gross return net of fees would have been 1.14 - 0.05 = 1.09 Summary of fees and returns Assume: • A fund portfolio grows by r each year. • The fund has front-end load of f. • The fund has back-end load of b. • The fund has annual expense ratio of . • No capital gains or distributions The gross return for an investor in the fund over n periods is Example: Choosing between a mutual fund and a CD Investment choices: • Mutual fund, 3% front-end load, annual expense ratio of 0.6%. • CD: 5% expected return per year What return must the fund portfolio earn for you to be better off in the fund than in the CD if you plan to hold the investment for 4 years? Example cont. In 4 years: • CD: gross return = (1.05)4 = 121.55% • Fund: gross return = .97 (1 + r - 0.006)4 Set them equal and solve for r • .97 (1+r-0.006)4 = 1.2155 • (1+r-0.006)4 = 1.2155/.97=1.253 • 1+r =0.006+1.2531/4 • r = 6.4% Advantages and disadvantages of funds Advantages: • Record keeping and administration • Easy and low cost diversification and divisibility • Professional management (+/-) • Lower transaction costs (sometimes) Disadvantages: • Brokers can have monetary reasons for suggesting specific funds. • Some expenses are not transparent. • When assets are liquidated or when there are dividends there are sometimes unexpected tax implications to the investor. See the discussion in the textbook. • Turnover can be high causing capital gains events fees. ETF • Early on Exchange-Traded Funds (ETFs) were often structured as unit investment trusts that until 2008 only held securities in market indices. In more recent years many ETFs have specialized in non-index portfolios of assets. • Investors have the right to exchange their shares for the underlying securities of the fund. But most trading is between investors. Recent innovations in the ETF market include: • • • • Leveraged ETFs Inverse ETFs Actively managed ETFs Some ETFs invest in derivatives. For example, many ETFs that focus on commodities create exposure to the commodities via futures. Per the ICI 2022 factbook, the vast majority of ETFs are registered with and regulated by the SEC under the Investment Company Act of 1940. Those that aren’t are focused primarily on commodities, currencies, and futures. “At year-end 2022, net assets in large-cap domestic equity ETFs totaled $1.9 trillion, or 30 percent of ETF net assets. Bond ETFs, which have been fueled by strong investor demand over the past several years, accounted for $1.3 trillion (19 percent) of net assets.” -2023 ICI Factbook ETFs relative to mutual funds Advantages: • ETFs can be bought and sold anytime like regular stocks at real-time prices. • Some ETFs can be sold short. • (Most) ETFs have relatively low fees. • ETFs are relatively tax-efficient (fewer tax events). Disadvantages: • You pay the bid-ask spread when trading an ETF • Some ETFs have fees • If you are investing in ETFs to gain exposure to a commodity and the ETF does this through futures, then your returns will be affected by the roll yield. Hedge funds • A private investment pool, open to wealthy or institutional investors. • Not registered as mutual funds and in most cases are not subject to the same SEC regulation. If they get large enough or get more than a certain number of investors they do become subject to additional SEC regulations. • Often uses more speculative policies than mutual funds. These approaches can use leverage, short selling, options, futures, currencies, etc. • Name comes from the fact that hedge funds often want to create market-neutral strategies by going long in some assets and going short in related assets. Mutual Funds Hedge Funds Investment methods Buy publicly traded securities. Little use of leverage or short-sales. Bound by prospectus. Also can buy non-public securities, currencies and commodities. Wide use of leverage and short-sales. Investors No specific limit. Small number of sophisticated investors Diversification Hold broad mix of assets. Holdings are often concentrated. Fees Relatively low fees (compared to hedge funds, not ETFs) that do not depend on performance Withdrawals/liquidity Investors can sell back shares at any time (end of trading day) Relatively high fees that depend on performance. “2 and 20” Regulation Heavy Regulation Light Regulation Initial investments Relatively low Very high investments necessary. Investor money is “locked up” for long periods For next time.. Review the concepts and terminology introduced in today’s lecture and check the schedule for the assigned reading and assignments. Terminology You should be able to give a 1-2 sentence description of each of these terms. • Why have ETFs increased • Managed investment • Sophisticated investors in popularity over time? companies • Unit investment trusts • Which asset classes • How do loads affect return • Mutual funds make up most of the calculations? • Closed-end funds mutual fund universe? • ETFs • Hedge funds • Which asset classes make up most of the ETF universe? Thank You