Two Ways of Investing

Two Ways of Investing Individuals may invest in individual assets like stocks and bonds, or Individuals may buy shares in investment companies. These companies, in turn, invest the funds in various assets, such as stocks and bonds. Reading: Chapters 6 and 7 2 Types of Investment Companies There are several types of investment companies. Open-end investment company (i.e. a mutual fund) - Chapter 6 Has a variable number of shares sold directly to investors. Investors who desire to liquidate their holdings sell them back to the company. Closed-end investment company Chapter 7 Has a specified number of shares that are bought and sold just like stocks. Other alternatives to mutual funds- Chapter 7 REITs Real restate investment trusts ETFs Exchange-traded funds Taxation Pass through vehicles Mutual fund company earnings are tax exempt. Their shareholders are taxed. Any realized gains are distributed to shareholders. However an reinvestment option is available. Chapter 6: Investment Companies: Mutual Funds 1. Investment company terminology 2. Mutual funds 3. The portfolios of mutual funds 4. Money market mutual funds 5. Selecting mutual funds 6. Taxation 7. Redeeming mutual fund shares 8. Measures of risk-adjusted performance 3 4 1. Terminology: Net Assets Value (NAV) Net assets value is the asset value of a share in an investment company. Total Assets Total Liability NAV Number of Shares E.g. If ABC Mutual Fund Company has total assets of $1 million, total liability of $0.4 million, and 10,000 shares outstanding, what is the company s Net Assets Value (NAV)? Total Assets Total Liability 1 million 0.4 million NAV $60 Number of Shares 10,000 2. Mutual Funds Load vs. No-Load Load funds - Funds that charge a up-front fee to investors who purchase shares. These fees are paid to brokers, not to the fund. These up-front fees are called Load fees or Sales Load. Load fees mean investors pay a premium over the fund's NAV. Load fees are used to compensate the sales person Load fees are expressed as a percentage of the offer price. No-load funds - Fund without a sales charge to brokers. No-load funds may have other fees. For a good discussion of load funds vs. no-load funds, see http://www.fool.com/school/mutualfunds/costs/loads.htm 5 6 1

Mutual Fund Prospectus Mutual Funds are required to provide important information in a fund prospectus. A prospectus is a legal document that institutions and businesses use to describe the securities they are offering for participants and buyers. For an example mutual fund prospectus, click HERE. Yahoo Finance has a tool that will allow you find a prospectus for any U.S. fund. Go to http://yahoo.fundinfo.wilink.com/asp/f130_search_eng.as p 3. Mutual Fund Portfolios Mutual funds may be classified by Investment type: The class of securities the fund acquires Income funds -stress dividend or interest income Growth funds -stress price appreciation Balanced funds -a mixture of securities that sample many types of assets Specialized funds -specialize in a particular area (sector funds) Index funds - duplicate an index of stock prices Investment style: The fund s investment philosophy or strategy such as capitalization (market value of a company s all stocks) Large cap - with market values of greater than 8 billion Mid cap between 1 billion to 8 billion Small cap less than 1 billion 7 8 Style Boxes Style boxes may be useful to classify mutual funds. Combining type and style one can make a style box that shows different type-style combinations. In this Morningstar style box there are 9 grids. For details see http://www.morningstar.com/ InvGlossary/morningstar_styl e_box.aspx The marked fund (black area) is a balanced large cap fund 4. Money Market Mutual Funds Specialize in short-term securities called moneymarket instruments, such as Treasury bills, negotiable certificates of deposit (CDs), or commercial paper. Shares of money market mutual funds offer individuals safe, highly liquid investments. Money market mutual fund shares are almost always priced at $1.00 NAV. 9 10 5. Selecting Mutual Funds There are 6000-20,000+ mutual funds in the U.S., depending on the definition. These are the important factors to consider: Return Fees and expenses Taxation 5.1. Mutual Fund Returns Do professional managed funds perform better than market average? The answer is no. For an interesting article on this topic, go to http://www.indexinvestor.com/free/scandal.php Do some managed mutual funds consistently outperform others? Findings are ambiguous. 11 12 2

5.2. Fees and Expenses Fees and expenses obviously affect the return earned by the investor. An example of load fee: A 6% load fee is charged on ABC mutual fund. John has $3,000 to invest. Assume the return on the mutual fund is 10% per year, after 30 years, how much money will John have in that investment account assuming annual compounding? Answer: 6% load means only $2,830 ($3000/1.06) is really invested. The difference, $170 needs to be paid as the front load. John will have 2830*(1+10%)^30=$49,382 in 30 years. Now assume John invested this $3,000 in a no-load fund. At the same annual return, how much money will John have in that account? Answer: No load means John invests all of the $3,000. After 30 years John will have 3000*(1+10%)^30=$52,348 Note the different gets compounded over time. A $170 front load becomes a difference of $2,966 in account value 30 years down the road. A load fee of 6% means the annual return is decreased. What is the annual return when the load fee is taken into consideration? Answer: 3000*(1+r)^30=49,382=> r=9.7863% In this case the load fee translates in to a 0.2147% annul return rate loss. 13 14 Other Fees and Expenses However, a no-load fund does not mean it does not charge other fees. There are plenty of other fees mutual funds can charge. Redemption fee: Charged when shareholders redeem their shares. Exchange fee: Charged when shareholders exchange to another fund within the same fund group. Account fee: Charged in connection with maintenance of shareholders accounts. E.g. a fee charged for balance less than $3000. Purchase fee: Charged when shares are purchased. Different from a sales load because this fee goes to the fund, not a broker. Management fees: Paid to the investment adviser for managing the fund s investment portfolio. 12b-1 fees: Paid to cover distribution expenses, such as marketing fees. For a detailed explanation of mutual fund fees, see SEC s website at http://www.sec.gov/answers/mffees.htm 5.2.1. Cost Disclosures for Mutual Funds Fees and expenses are required to be disclosed in its prospectus, typically under the heading fees and expenses. To practice finding that information, go back to the Vanguard Health Care Fund prospectus link and find the expense information in it. 15 16 5.2.2. How Expense Ratio Affect Investment Return Mutual funds are required to disclose total expenses in their prospectus. This information is crucial in computing the true return for investors. E.g. Assume John wants to invest $3,000. He has two options: (1) invest in Legg Mason total return trust, with a 1.94% total expense ratio, or (2) invest in Schwab International index, with a 0.95% total expense ratio. Assuming in the next 30 years, both funds returned an average of 10% per year before expenses, how much money will John have if he invests in Legg Mason (Option 1)? How much money will John have if he invests in Schwab (Option 2)? Answer: Legg Mason: The effective rate of return is 10%- 1.94%=8.06%. Total amount = 3000*(1+8.06%)^30=$31,695 Schwab: The effective rate of return is 10%-0.95%=9.05% Total amount = 3000*(1+9.05%)^30=$40,364 One can see over time the impact on return can be very substantial. 17 18 3

5.2.3. A, B, and C Shares Some funds have adopted different classes of shares. For example: Class A: front load but lower expense ratio Class B: No front load but back load, and higher expense ratio Class C: No front or back load, but have the highest expense ratio. Comparison of effective return needs to take into consideration holding period and expected annual rate of return. With that information one can compute the effective rate of return on each option. 6. Taxation Fund returns are pre-tax. Shareholders pay applicable taxes. Dividends are taxed every year as income Capital gains are taxed when shares are sold. With mutual fund investment, capital gains can be realized even if you don t sell any of your mutual funds. 19 20 Before- and After-Tax Returns: An Example Assume there are three funds: A, B, and C. The NAV of each is $20 and each earns a return of 10% for the year. The investor buys one share of each for $20. Fund A consists solely of stocks that are never sold. Stocks appreciated 10% for the year. The investor has 1 share at $22 per share for a total of $22. Fund B collects 10% on bonds. For the year $2 per share interest earning is collected. The investor reinvests the $2 of income distribution by buying 0.1 share of the same fund. At the end of the year he has 1.1 share that is worth $22 total. Fund C invests in stocks that appreciates 10%, then is sold at the end of the year by the mutual fund and the gain distributed. The fund s NAV initially increased to $22. After selling of the stocks, the investor received $2 of capital gain distribution. He reinvests this $2 in the same fund and purchases 0.1 share. At the end of the year he has 1.1 share that is worth $22 total. All three funds have the same beginning and ending value ($20 and $22, respectively). However, the tax implication for these three funds are quite different. Fund A: no realized capital gain or income distribution => no tax liability Fund B: $2 income distribution is subject to income tax, taxed at the marginal income tax rate of the investor. If the tax payer is at 28% marginal tax rate he needs to pay 56 cents tax. Fund C: $2 realized capital gain is subject to capital gain tax. Depending on how long the Mutual Fund company held these shares, this $2 may be subject to either shortterm or long-term capital gain tax. If it is long term capital gain at 15% tax rate, the tax liability is 30 cents. 21 22 After-Tax Return and Tax Efficiency Index After-tax return takes into consideration tax implications of mutual funds. In order to compute the after-tax returns, one needs to know one s marginal tax rate. Assume in this case the marginal income tax rate for this investor is 28%, and the long-term capital gain rate is 15%, then after-tax rate of return for Fund A: still 10% because there is no tax for the year. Fund B: 10%*(1-28%)=7.2% Fund B: 10%*(1-15%)=8.5% The tax efficiency index converts mutual fund returns to an after-tax basis by expressing the after-tax return as a percentage of the beforetax return. In our example, the tax efficiency index is as follows: Fund A: 100 ((10%/10%)*100) Fund B: 72 ((7.2%/10%)*100) Fund C: 85 ((8.5%/10%)*100) This index has its problems. For example, Fund A may be efficient this year, but if stocks are sold by the Fund next year, the tax efficiency index will decrease. 23 7. Redemption of Shares When selling mutual fund shares, there are tax implications for realized capital gains or losses. If shares have been purchased frequently over time and dividends reinvested, like many retirement investments, the computation of the cost basis can be complicated If all records have been kept, one can use first-in first-out method. E.g. You buy 200 shares of ABC funds on 1/10/2004 at $10/share, then again 300 shares of ABC on 12/8/2007 at $15/share. If you sell $100 shares of ABC on 4/8/2009 for $16/share, then the cost basis for your sell is the purchase you made on 1/10/2004 at $10 per share. Your capital gain is $6/share. If records have not been well kept, one can use average cost basis method. E.g. For the above scenario, the average cost basis is (200*10+300*15)/(200+300)=$13/share. The capital gain is thus $3/share. 24 4

8. Measures of Risk-Adjusted Performance Three indexes have been developed to measure riskadjusted performance The Jensen index The Treynor index The Sharpe index All three indexes use Capital Assets Pricing Model (CAPM) as a theoretical basis for comparison. Market benchmark used in the CAPM is often the S&P 500 stock index. CAPM Risk-Adjusted Returns In CAPM, r p =r f +(r m -r f )β Where r p =risk adjusted return r f =risk free return r m =market return 25 26 8.1. The Jensen Index (Also called Alpha ) 8.2. The Treynor Index The alpha measures whether the actual return exceeds the return that should have been earned based on the CAPM. Standardizes the return in excess of the risk-free return by the portfolio's beta Uses the portfolio's volatility relative to the market as the measure of risk Assumes that the portfolio is well diversified, so the beta (which measures systematic risk only) is the appropriate index of risk 27 28 8.3. The Sharpe Index Standardizes the return in excess of the risk-free return by the portfolio's standard deviation Uses the portfolio's variability as the measure of risk When the portfolio is not well diversified, Sharpe index is appropriate. Examples of Jensen, Treynor, and Sharpe Indexes You are given the following information concerning several mutual funds: Fun d Rate of Return Standard Deviation of Return Beta A 12.6% 4.6% 1.15 B 13.5% 6.2% 1.32 C 11.2% 1.4% 0.90 D 9.5% 1.2% 0.80 During the time period the Treasury bill rate (risk-free r f ) is 4%. S&P 500 return is 10% (market return r m ). 29 30 5

1. Rank the performance of each fund without adjusting for risk. Answer: B, A, C, D. Without adjusting for risk Fund D underperforms the market. 2. Rank the performance of each fund adjusting for risk using the Treynor Index. Answer: T A =(rp-rf)/β=(12.6%-4%)/1.15=0.07478=7.478% T B =(rp-rf)/β=(13.5%-4%)/1.32=0.07197=7.197% T C =(rp-rf)/β=11.2%-4%)/0.90=0.08=8.0% T D =(rp-rf)/β=9.5%-4%)/0.80=0.06875=6.875% Rank: C, A, B, D. Remember the market average (measured by S&P 500 index) outperforms the risk free rate by 6% [(10%-4%)/1]. So all four funds outperform the market when adjusted for risk using the Treynor Index. 3. Now rank the funds by the Sharpe Index. Answer: Fund A: S A =(rp-rf)/σp= =(12.6%-4%)/4.6%=1.8696 Fund B: S B =(rp-rf)/σp= =(13.5%-4%)/6.2%=1.5323 Fund C: S C =(rp-rf)/σp= =(11.2%-4%)/1.4%=5.1429 Fund D: S D =(rp-rf)/σp= =(9.5%-4%)/1.2%=4.5833 Rank: C, D, A, B. Note this ranking is different from the Treynor index ranking. That is because the Treynor index assumes sufficient diversification so the use of Beta is appropriate. Sharpe does not assume the portfolio is well diversified and uses standard deviation to adjust return. 31 32 4. Now rank the funds using the Jensen index. Answer: Fund A: α=rp-[rf+(rm-rf)β]=12.6%-[4%+(10%-4%)*1.15]=1.7% Fund B: α=rp-[rf+(rm-rf)β]=13.5%-[4%+(10%-4%)*1.32]=1.58% Fund C: α=rp-[rf+(rm-rf)β]=11.2%-[4%+(10%-4%)*0.9]=1.8% Fund D: α=rp-[rf+(rm-rf)β]=9.5%-[4%+(10%-4%)*0.8]=0.7% Rank: C, A, B, D Same as the Treynor ranking. 8.4. The Benchmark Problem The comparisons we covered so far use aggregate measures of the U.S. market. The composition of many portfolios are not comparable to the American markets. Non-comparable examples: specialized funds or global funds. For these other funds other appropriate indexes should be used. 33 34 Chapter 7. Closed-End Mutual Funds, REITs, and ETFs 1. Closed-end investment companies 2. Real estate investment trusts (REITs) 3. Exchange-traded-funds (ETFs) 4. Hedge funds and private equity firms 5. Foreign investments 1. Closed-End Investment Companies The main difference is that closed-end investment companies trade their shares in the security market while mutual funds shares do not. A closed-end investment company has a fixed number of shares, while a mutual fund s number of shares continuously changes. In that sense, closed-end investment company shares are similar to stock shares. For an example of an closed-end fund, see Adam Express Company at http://www.adamsexpress.com/ 35 36 6

1.1. Discounts and Premiums Recall that shares of mutual funds are sold at NAV. For closed-end funds, shares may sell for a premium or discount from NAV. Tendency for shares to sell at a discount from NAV 1.2. Costs of Investing in Closed- End Funds Broker commission purchase on secondary markets so must go through a broker. The investment company charges a fee to manage the portfolio. When investment company sells or buys securities, brokerage fees are passed on to investors. 37 38 1.3. Sources of Return to the Investor Collected dividends and interest income on its portfolio are distributed in the form of dividends to investors. Capital gains distributions when company sells assets and realize gains The NAV of the company may increase, leading to higher fund prices. The market price of these funds may rise relative to NAV. Investors may sell share of the funds and realize the gains. 1.4. Unit Trusts A variation on the closed-end investment company is the fixed-unit investment trust, commonly referred to as a unit trust (UIT). Passive investment assets are not traded but frozen. Self-liquidating portfolio no reinvestment. Assets are liquidated after a specified period of time. For an example of UIT, see http://www.ftportfolios.com/retail/dp/home.aspx 39 40 2. Real Estate Investment Trusts (REITs) A REIT is a type of closed-end investment company. REITs specialize in real estate investments such as Acquiring properties for rental income equity trust An equity REIT has several advantages over the direct investment in real estate properties. The trusts have professional management and can construct a diversified portfolio of properties. For the individual investor they are passive investments that involve none of the work associated with the individual's managing a property. Mortgage loans or improvement loans mortgage trust REITs and Securitization Securitization is the process of converting illiquid assets into a liquid, marketable asset. REITs are a good example of securitization Visit website for National Association of Real Estate Investment Trusts at http://www.reit.com/ 41 42 7

REIT and Taxation The taxation of REIT distributions is more complicated than cash dividends from corporation. REIT distributions may be income earnings, capital gains, and return of capital, each of which is subject to different tax rates. 3. Exchange-Traded Funds (ETFs) The creation of index mutual funds led to the creation of exchange-trade funds (ETFs). ETFs are like index funds in portfolio composition but are traded like securities on the secondary market. Unlike other closed-end investment companies, ETFs permit large institutions to exchange shares in the companies for ETF shares and vice versa. Because of this exchange feature, unlike other closedend mutual funds, ETFs cannot be sold or bought at a discount (due to arbitrage opportunities). 43 44 Over the years there has been an increase in variety of ETFs Some ETFs specialize in subsets of the markets, such as energy funds ETFs offer opportunities of secondary market trade, and short sell, while index mutual funds do not offer these opportunities. In 2008 the SEC authorized actively-managed ETFs. Leveraged ETFs An exchange-traded fund (ETF) that uses financial derivatives and debt to amplify the returns of an underlying index. A leveraged ETF follows the daily changes of an index. For example, a leveraged fund with a 2:1 ratio means that each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%. The 2:1 ratio works in the opposite direction as well. If the index drops 1%, your loss would then be 2%. 45 46 4. Hedge Funds and Private Equity Funds A hedge fund is an aggressively managed portfolio of investments that uses advanced investment strategies in both domestic and international markets with the goal of generating high returns. A private equity fund invests directly into private companies or conducts buyouts of public companies that result in a delisting of public equity Hedge funds and private equity funds offer a small number of investors with substantial cash an investment alternative. They are not subject to many of the disclosure requirement and regulations associated with public investment companies. No secondary market exists due to their private nature. 5. Foreign Investments Most investment companies offer American investors a simple, convenient means to invest in foreign securities. Currency exchange rate risk is added risk in foreign investments. 47 48 8

51. Four types of funds involving Foreign Investments Global funds: foreign and U.S. securities International funds: only foreign securities, no U.S. Regional funds: particular geographical area, such as Europe, Asia Emerging market funds: specialize in less-developed countries 5.2. ishares ishares: A family of ETFs that tracks various stock or bond markets. Example: ishares MSCI Australia Index Funds tracks an index of the Australian Stock Exchange For more information visit http://us.ishares.com/home.htm 49 50 9