Investment funds 8/8/2017
Outline for today Why funds? Types of funds Mutual funds fees and performance Active or passive management? /Michał Dzieliński, Stockholm Business School 2
Investment funds Pool capital from individual investors and invest in a wide range of financial assets. Instead of directly owning the assets, investors own shares in the investment fund indirect investment Indirect investment is the dominant form nowadays. You can obtain diversification with relatively little capital. Someone else managing your money has benefits but could also be a problem. /Michał Dzieliński, Stockholm Business School 3
The DJIA again Suppose a fund is able to attract 33,000 USD in capital. Ticker Name Shares Ticker Name Shares GS Goldman Sachs Group 15 V Visa Inc. 13 MMM 3M Company 11 AXP American Express Co 14 BA Boeing Co. 14 CAT Caterpillar Inc. 11 IBM IBM Corp. 11 DD DuPont 12 HD Home Depot 12 JPM JPMorgan Chase & Co. 13 MCD McDonald's Corp. 13 NKE Nike, Inc. 15 UNH United Health Group Inc. 11 WMT Wal-Mart Stores 11 TRV The Travelers Companies 13 MSFT Microsoft Corp. 13 AAPL Apple Inc. 13 MRK Merck & Co. 12 DIS The Walt Disney Co. 14 VZ Verizon Communications 11 JNJ Johnson & Johnson 11 KO The Coca Cola Co. 13 UTX United Technologies 12 INTC Intel Corp. 13 CVX Chevron Corp. 11 PFE Pfizer Inc. 11 PG Procter & Gamble 12 GE General Electric 13 XOM Exxon Mobil Corp. 11 CSCO Cisco Systems 12 /Michał Dzieliński, Stockholm Business School 4
Net Asset Value In total, the fund holds 371 shares of different companies. Now, it can start to issue its own shares. How many? How much is each fund share worth? NAV = Market value of assets Liabilities Shares outstanding Shares outstanding the number of shares of the fund Usually calculated at the end of each trading day. Depends on the fluctuations in prices of the assets the fund holds. /Michał Dzieliński, Stockholm Business School 5
Types of investment funds Investment companies Unmanaged Managed Unit trusts (essentially extinct) Closed-end funds Open-end (mutual) funds Exchangetraded funds (ETFs) /Michał Dzieliński, Stockholm Business School 6
Closed vs. Open-end funds Closed-End: No change in shares outstanding; old investors cash out by selling to new investors. Listed on the exchange. The price may differ from NAV: Open-End: Premium if Price > NAV Discount if Price < NAV Usually not listed Fund issues new shares when investors buy in and redeems shares when investors cash out. These trades are done at Net Asset Value Price=NAV by definition /Michał Dzieliński, Stockholm Business School 7
Closed-end fund discount (Mkt Price-NAV)/NAV /Michał Dzieliński, Stockholm Business School 8
Other types of investment funds Real Estate Investment Trusts (REIT) Funds which invest in residential and office property. Good way to gain diversified exposure to real estate. Hedge Funds: Subject to minimal regulation, only available to selected accredited investors High fees: 2% of AuM, 20% of profits Long periods during which investments cannot be cashed out (lock-ups) Typical strategies: derivatives, short sales and leverage /Michał Dzieliński, Stockholm Business School 9
Picking funds The variety of investment funds is astonishing: There are now more funds investing in stocks in the US than stocks themselves!... Can be categorized along many dimensions: Closed vs. Open-end Geography: Global, US, Europe, Asia, national Asset class: Money Market, Equity, Bond, Multi-asset Investment style: Sector, Balanced, Value, Growth, Asset allocation, Momentum and many more Actively-managed vs. Passive (index) funds /Michał Dzieliński, Stockholm Business School 10
What to look for? Two numbers to look at when evaluating a fund. 1. Assets under Management size of the fund Why is that important? 2. Total Expense Ratio (TER) determines how expensive it is to own it Most important, especially for retail investors /Michał Dzieliński, Stockholm Business School 11
Mutual funds - AuM breakdown By geographic region By asset class 12% 0.5% 13% 5% 32% 56% 14% 24% 44% Americas Europe Asia and Pacific Africa Equity Bond Money Market Balanced/Mixed Other /Michał Dzieliński, Stockholm Business School 12
Fund returns and fund fees The return of a fund before fees is given by: Return = NAV 1 NAV 0 + Income and capital gain distributions NAV 0 Suppose: NAV equals 100 million in the beginning NAV equals 110 at year end No income or capital gain distributions Return = 110 100 100 = 0.1 = 10% However, if there are fees /Michał Dzieliński, Stockholm Business School 13
Fund returns and fund fees Suppose the expense ratio is 1% Then the NAV at year end is instead (in millions): NAV 1 = 110 0.01 NAV 0 = 109 and the return is: Return = 109 100 100 = 0.09 = 9% which is the return before fees minus 1%. Fund fees directly decrease investor returns /Michał Dzieliński, Stockholm Business School 14
Fund fees in the long run Fund fees can seriously erode long term performance. /Michał Dzieliński, Stockholm Business School 15
Fund fees in the long run Expensive funds would have to consistently outperform cheaper funds to be attractive. Years Fund A (gross) Fund A (net) Fund B (net) Fund B (gross) 5 17 623 17 234 17 234 18 424 10 31 058 29 699 29 699 33 946 15 54 736 51 183 51 183 62 543 20 96 463 88 206 88 206 115 231 Ann. Return 12.0% 11.5% 11.5% 13.0% /Michał Dzieliński, Stockholm Business School 16
Passive vs. Active management Passive management (index-following): Highly diversified portfolios and no effort to outperform the market through security analysis Pros: simple, transparent, low fees Cons: standardized Active management: Attempts to outperform the market using security analysis and timing the performance of different asset classes. Pros: customized, investment skill Cons: high fees /Michał Dzieliński, Stockholm Business School 17
Passive vs. Active management Which one delivers better performance is one of the longeststanding debates in the investment community. At some level, there should not be much of a debate: The average active manager cannot beat the market. In fact, after fees s/he will underperform! You only need simple arithmetic to show that!* There could still be some active managers, who outperform. How to find them? *Source: William F. Sharpe, The arithmetic of active management, Financial Analysts Journal, Vol. 47, No. 1, January/February 1991. pp. 7-9 /Michał Dzieliński, Stockholm Business School 18
Fund α Returns of an active fund X can be decomposed as: E r X,t r f = α X + β X E r M,t r f + ε X,t This takes time to identify track record What should be the r M? benchmark What if α X < 0? What if α X = 0? What if α X > 0? /Michał Dzieliński, Stockholm Business School 19
How likely is positive α? Over the last 3 years, more than 90% of active funds in the US underperformed their benchmarks! /Michał Dzieliński, Stockholm Business School 20
Persistence of α In 2014, Wall Street Journal looked at funds, which had best ratings 10 years earlier and asked where are they now? 40% 35% 30% 25% 20% 15% 10% 5% 0% 401 funds rated 5***** in July 2004; 10 years later 3.49% 13.47% 31.42% 37.41% 14.21% 1* 2** 3*** 4**** 5***** *Source: WSJ Online /Michał Dzieliński, Stockholm Business School 21
Persistence of α Lack of persistence means funds that were at the top in the past generally do not stay there in the future. 40% 35% 30% 25% 20% 15% 10% 5% 0% *Source: WSJ Online; own analysis 401 funds rated 5***** in July 2004; 10 years later 20% 20% 20% 20% 20% 1* 2** 3*** 4**** 5***** pure chance would give you this /Michał Dzieliński, Stockholm Business School 22
Would investing in many funds help? It is possible to outperform a portfolio of index funds using actively managed funds as our analysis shows; it is just not probable. *Source: Ferri, Benke, A Case for Index Fund Portfolios /Michał Dzieliński, Stockholm Business School 23
Why is not everyone investing passively? It was not always possible What we need is a no-load, minimum-management fee mutual fund that simply buys the hundreds of stocks making up the broad stockmarket averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out, You can t buy the averages. It s time the public could. Burton Malkiel, A random walk down Wall Street, 1 st edition, 1975 Usually, whenever there is demand, there will be supply Nowadays, the easiest way is through an ETF. /Michał Dzieliński, Stockholm Business School 24
ETFs Open-end funds traded at the exchange. Usually passive index funds (not synonymous, there are both active ETFs and passive mutual funds!). They are becoming more and more popular since their creation in 1993. One big reason is low cost: For example, annual expense ratio of the SPDR (first ETF ever launched) is 0,09%! Another reason is transparency ETFs publish their holding on a daily basis (mutual funds quarterly) /Michał Dzieliński, Stockholm Business School 25
Share of US corporate equity 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 Fund trends 1: Rise of ETFs 25% 20% 15% 10% 5% 0% Finance&Insurance Closed-end funds Mutual funds (open-end) ETFs *Source: Financial Accounts of the United States, Federal Reserve; own analysis /Michał Dzieliński, Stockholm Business School 26
Fund trends 2: Falling fees Active funds are also becoming cheaper they are still a lot more expensive than index funds though! *Source: ICI Research, Trends in the Expenses and Fees of Mutual Funds 2013, May 2014 /Michał Dzieliński, Stockholm Business School 27
Fund trends 3: Closet indexing More and more active fund managers are tacitly shifting towards index-following strategies. *Source: Antti Pettajisto, Active share and mutual fund performance, Financial Analysts Journal, Vol. 69, No. 4, July/August 2013. pp. 73-93 /Michał Dzieliński, Stockholm Business School 28
Fund trends 4: From α to smart β Even a reliably identified positive α can be due to some omitted risk factors! Investors have become more and more aware of that. Smart β strategies make that fact explicit. They are: transparent and rule-based low cost relative to active management have large capacity and liquidity well-diversified and/or span the macro economy Smart β strategies usually engage in value investing: contratrading against the legions of investors who chase fads and shun recent disappointments. *Source: https://www.researchaffiliates.com/en_us/publications/articles/292_what_smart_beta_means_to_us.html /Michał Dzieliński, Stockholm Business School 29
Why is still not everyone investing passively? To save time: Buying a single asset-allocation fund is quicker than doing the asset-allocation (using different index funds) yourself. To have someone to blame: This is not a joke, studies in behavioral finance suggest outsourcing guilt might be an important factor! To be fair, all investment is to some extent active: You have to pick your index funds! /Michał Dzieliński, Stockholm Business School 30
Key takeaways Investment companies (funds) offer an alternative to directly owning assets like stocks and bonds. Buying a share of a fund is equivalent to buying a piece of its portfolio of assets. Dominant form of investment nowadays There are many ways to categorize funds: Geography, asset class, investment style Active vs. passive management Actively managed funds try to beat the index and charge high fees, while passive funds follow the index and charge low fees. Consistently beating the market is hard, so most of the active funds are not worth their fees. /Michał Dzieliński, Stockholm Business School 31