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INVESTMENTS
Lecture 11
Investment Companies and ETFs
Investment Companies
Intermediaries that collect money from investors and put that money in a wide range of securities or other assets Investor has claim to part of portfolio in proportion to
the amount invested Investors benefit by mechanism that enables them to
obtain benefits of large-scale investing Functions performed
Diversification Professional management Administration Lower transaction costs
Types of Investment Companies
Unit Investment Trusts Pools of money invested in portfolio whose
composition is set for the life of the trust Units represent ownership interest in UIT
Managed Investment Companies Closed-end Open-end
Mutual Funds
What is a mutual fund? Group of investors pool funds Funds used to create portfolio of securities
What is each share of a mutual fund worth? NAV
Who decides what securities to put in the portfolio?
Is there a difference between a mutual fund and a closed-end fund?
Mutual Funds
Why are mutual funds appropriate for some investors? Diversification Liquidity Management and administration Flexibility of investments Indexing
Are there any disadvantages to using mutual funds?
Mutual Funds
Returns to shareholders: Dividends or interest earned by fund from
shares held in the portfolio Capital gains / losses from shares/bonds
held in the portfolio Return from dividend income or capital gains
can be reinvested or taken as distribution Gains / losses from the price of the fund
share
Types of Funds
Main types depends on who is classifying – Morningstar uses Domestic stock funds International stock funds Taxable bond funds Municipal bond funds
Give investors monthly payments exempt from federal taxes
Some exempt from state if fund only invests in bonds from one state
Money market funds
Types of Funds
Life-stage funds Fund supermarkets
Expenses
Load – commission charged when investor purchases or redeems shares Front-end load Back-end load – “r” after listing in WSJ
12b-1 fee – fees charged to cover distribution costs like marketing and advertising – annual
Management fee Determine overall expense ratio –
turnover important
Net Asset Value
Per share value of fund (mkt value assets - liabilities)/shares
outstanding Shares outstanding is number of fund
shares NAV changes as prices of underlying asset
change Capital gain and dividend distributions reflected
in NAV NAVs determined daily Price at which fund shares are bought/sold
Open End Funds
Services offered Automatic reinvestment of distributions Automatic investment plans Check writing Exchange privileges Periodic statements
Mutual Fund Performance
Hard for funds to outperform benchmark because of fees Funds with lower expense ratios outperform funds
with higher expense ratios Funds with low turnover outperform funds with
higher turnover (need about 2-3% more return to match)
Performance of funds vs. market Styles Loads taxes
Open End Funds
To index or not to index, that is the question Pros of indexing:
Low operating expenses Better tax efficiency Historical performance Able to track variety of types
Cons of indexing: Will never make as much as actual index Often not a balanced portfolio Rebalancing Performance in bear markets
Suggested Strategies
1. Choose fund consistent with objectives and constraints.
2. Choose index funds for a large portion of portfolio.
3. Invest in no-load funds whenever possible.
4. Invest 10-20% in international or global funds.
5. Own funds in several different asset classes.
6. Do not attempt to time the market.
7. Avoid investing just prior to capital gains distributions.
8. Do not diversify too much across actively managed funds.
Closed-End Funds
Has IPO and then trades in secondary market
Market price determined by supply and demand
Often trade at a discount to NAV Maybe undistributed capital gains that will
have tax effect Management
way to invest in emerging markets
Exchange Traded Funds
Passively managed to replicate returns to index Shares trade in secondary market Price stays very close to NAV but still
determined by supply and demand similar to closed-end
Low expenses relative to some index funds Capital gains distributions similar to mutual
funds
Exchange Traded Funds (ETFs) ETFs are mutual funds or trusts that are
listed on an exchange and traded like a stock
SPDRs introduced in 1993 on AMEX Over 120 currently trading Over $80 billion invested in ETFs
Majority trade on AMEX Barclays and State Street Vanguard
Priced throughout the day just like stocks
Tax Benefits of ETFs
Capital gains Distributions made by mutual fund
managers whether investors like it or not Distributions are infrequent with ETFs
although not impossible Low turnover of securities in ETF
Only change when securities in index change Capital gains must be paid by investors
when they sell shares of ETFs
ETFs
Can purchase ETFs based on broad market, international markets, or in specific sectors
Advantages of ETFs Low cost structure Diversification benefits as with mutual funds Variety of ways to invest in shares Trading available throughout the day Can use in variety of ways to execute specific
portfolio strategy
ETFs
Tracking indexes Easy to see how they are performing Tracking error should be relatively low as these
should track index fairly closely
Liquidity features Creations/redemptions
ETFs as alternative to other types of investments Mutual funds derivatives
ETFs
Buy or sell shares as easily as buying stock Go through a full-service or discount broker Shares may be purchased in odd lots
Risks Similar to risks investors face with stocks Subject to market risk Foreign securities have additional risk that
domestics do not Performance
Can trade at a discount or premium to portfolio value because of supply and demand factors (similar to that associated with closed-end funds)
Sector ETFs
Stocks included in ETF proxy for universe of stocks in a particular index or sector Sampling technique used Should be representative of stocks in sector Sometimes dominated by largest firms in the
sector Does the ETF provide an investor with the
diversification benefits that are often the reason for buying the ETF in the first place? Maybe not!
Investing with ETFs
As a hedge As a core position As a supplement to a core position As a tax efficient investment
HOLDRS
HOLding company Depository Receipts Securities representing ownership
interest in either stock or ADRs of certain firms in a certain sector Single security with diversification benefits
Merrill Lynch product Underlying stocks chosen based on
active management strategy Securities in HOLDRS do not change
unless corporate event occurs like merger
HOLDRS
Similar to ETFs but represent ownership of specific set of stocks Set not selected to track index
Attractiveness of HOLDRS as compared to individual stocks and other diversified securities
Can only buy HOLDRS in round lots Creating HOLDRS Canceling HOLDRS
TARGETS
TARgeted Growth Enhanced Terms Securities
Salomon Smith Barney product designed to combine the potential returns available from capital appreciation with a component of current income
Issued by a trust Maturity Price