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