The Financial Institutions

Lecture outline

Introduction: outline and learning outcomes

1. Mutual funds: their growth, structure and investment objective classes.

2. Pension funds: types, regulation and their future.

3. Investment banks: their main activities.

4. Securities brokers and dealers: what they do, and their relationship with commercial banks.

Learning outcomes

• Understand why mutual funds have become so popular, the various types of mutual funds.

• Study pension funds as financial intermediaries because they take funds from one sector and invest them in another.

• Examine the role played by investment banks (primary market), and securities dealers and brokers (secondary market).

Mutual Funds

• You want to invest for your retirement.

• You want to put some money in stocks and some money in bonds.

• Your budget will only let you to invest £30 per week.

• Mutual funds pool the resources of many small investors by selling them shares in the fund and using the proceeds to buy securities.

• Asset transformation process: Issue securities in small denominations and buy large blocks of securities.

The Growth of Mutual Funds

• At the beginning of 2004, nearly 16% of assets held by intermediaries were held by mutual funds.

• 22% of the retirement market and almost 50% of all U.S. households hold stock via mutual funds.

• Assets held by mutual funds have grown by over 17.5% per year for the last 20 years, reaching $7.4 trillion in 2004.

The Growth of Mutual Funds

• The first mutual fund similar to the funds of today was introduced in Boston in 1824.

• The stock market crash of 1929 set the mutual fund industry back because small investors avoided stocks and distrusted mutual funds.

• The Investment Company Act of 1940 reinvigorated the industry by requiring better disclosure of fees, etc.

The Growth of Mutual Funds

• There are five principal benefits of mutual funds:

1. Liquidity intermediation: investors can quickly convert investments (any amount) into cash while still allowing the fund to invest for the long term.

2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess.

The Growth of Mutual Funds

3. Diversification: investors immediately realize the benefits of diversification even for small investments.

4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor.

5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments.

The Growth of Mutual Funds

• Ownership in mutual funds has changed dramatically over the last 20 years

– In 1980, only 5.7% of households held mutual fund shares

– In the beginning of 2004, that number was 48%

– Mutual funds account for $2.7 trillion of the retirement market (estimated at $12 trillion)

• The next slide shows the time series of these trends.

Figure 21.1 Household Ownership of Mutual Funds, 1980-2003

The Growth of Mutual Funds

Mutual Fund Structure

• Mutual funds are structured in two ways:

• Closed-End Fund: a fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market. Price for the shares is determined by supply and demand forces (based on the value of the assets held by the fund).

• Investors can not make withdrawals.

• Open-End Fund: investors may buy or redeem shares at any point, where the price is determined by the net asset value of the fund.

• Because the fund agrees to buy back shares at any time the investment is very liquid.

Stocks $35,000,000Bonds $15,000,000Cash $3,000,000

Total value of assets $53,000,000Liabilities -$800,000

Net worth $52,200,000Outstanding shares 15 million

NAV = $52,200,000/15,000,000 = $3.48

Calculating a Mutual Fund’s Net Asset Value

• Net Asset Value (NAV)

• Definition: Total value of the mutual fund’s stocks, bonds, cash, and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding

Mutual Fund Structure: the Organization

• The shareholders, or owners, of the mutual fund are the investors.

• The board of directors oversees the fund’s activities, hires the investment advisor, an underwriter, etc., to manage the day to day operations of the fund.

Investment Objective Classes

• There are four primary classes of mutual funds available to investors:1. Stock (equity) funds

2. Bond funds

3. Hybrid funds

4. Money market funds

• The next slide shows the distribution of assets among these different classes.

Figure 21.4 Distribution of Assets Among Types of Mutual Fund, 2004

Investment Objective Classes

Investment Objective Classes

• Stock Funds– Other than investing in common equity, the stated objective

of any particular fund can vary dramatically.

• Bond Funds– Strategic Income Funds invest primarily in U.S. corporate

bonds, seeking a high level of current income.

– Government Bond Funds invest in U.S. Treasury, as well as state and local government bonds.

Investment Objective Classes

• Hybrid Funds

– Combine stocks and bonds into a single fund.

– The idea is to diversify across different types of securities.

– Account for about 7% of all mutual fund accounts.

• Money Market Mutual Funds

– Open-end funds that invest only in money market securities.

Investment Objective Classes

• Index Funds– A special class of mutual funds that do not fit into

any of the categories discussed so far.

– The fund contains the stock of the index it is mimicking. For example, an S&P 500 index fund would hold the equities comprising the S&P 500.

– Offers benefits of traditional mutual funds without the fees of the professional money manager.

Pensions

• Definition: A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during the nonworking years.

• Developed as Americans began relying less on children for care during their later years.

• Also became popular as life expectancy increased.

Types of Pensions - USA

• Defined-Benefit Pension Plans: a plan where the sponsor promises the employee a specific benefit when they retire.

• For example, Annual Retirement Payment =

2% average of final 3 years’ income years of service

Types of Pensions - UK

• Flat-rate pension: paid by the state to everyone above a certain age.

• Occupational pension: provided from a fund to which the employer and employee have contributed.

• Personal pension: paid from fund to which the individual has made contributions.

Types of Pensions - UK

• The flat rate pension is regarded as an unfunded pension scheme (also known as ‘pay as you go’ or PAYG schemes). This means that payments to pensioners are financed by simultaneous contributions of those currently at work. Commonly used for:– Teachers

– Civil Service

– NHS

– State earnings-related pension scheme (SERPS)

Types of Pensions - UK

• The occupational and personal pensions are regarded as funded pension schemes. This means that payments to pensioners are financed by a fund of savings built up in earlier years. Different types of schemes:– Defined benefit (DB)

– Define contribution (DC)

Investment Banks

• Investment banks perform a variety of crucial functions in financial markets

– Underwrite the initial sale of stocks and bonds

– Deal maker in mergers, acquisitions, and spin-offs

– Middleman in the purchase and sale of companies

– Private broker to the very wealthy

Investment Banks

• Investment banks were essentially created in the U.S. by the passage of the Glass-Steagall Act. Prior to this, investment banking activities were part of large, money-center commercial banks.

• The lines between investment banks and commercial banks again begins to blur as legal separation between investment banks and commercial banks is no longer required.

Investment Banks

Investment banks play many roles in both the primary and secondary markets. We will focus on their role in three areas:

• Underwriting Stocks and Bonds

• Equity Sales

• Mergers and Acquisitions

Underwriting Stocks and Bonds

• The process of underwriting a stock or a bond issue requires that the investment banker purchase the entire offering at a predetermined price and then resell the offering (securities) in the market. The services provided during this process include:

– Giving Advice

– Filing Documents

– Underwriting, Best Efforts, or Private Placement

Mergers and Acquisitions

• Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal).

• Deal may be a hostile takeover, where the target does not wish to be acquired.

• Investment bankers will assist in all areas, including deal specifics, lining up financing, legal issues, etc.

Securities Brokers and Dealers

• Securities Orders: when you call a brokerage house to buy or sell a security, you essentially have three options:

– Market Order: buy or sell security at current price

– Limit Order: you specify the most you are willing to pay (buy) or the least you are willing to accept (sell) for a security

– Short Sales: sell a security you don’t own with the intent of buying it back at a later date (hopefully at a lower price)

Securities Brokers and Dealers

• Full Service Brokers: offer clients research and investment advice, but usually charge a higher commission on trades.

• Discount Broker: provides facilities to buy/sell securities but offers no advice. Many on-line discount brokerage firms do have significant research available

Securities Brokers and Dealers

• Securities Dealers

– Hold inventories of securities on their own account

– Provide liquidity to the market by standing by ready to buy or sell securities (market maker)

– Especially important for thinly traded securities

Conclusion

• Mutual funds their growth has been dramatic.

• Mutual fund structure, including ownership, the board, and operations of the fund were reviewed.

• Pensions: the general idea and growth in pension funds was presented. Types of Pensions: the various forms, from defined-benefit to defined-contribution, were reviewed and compared.

• Investment Banks: the role of investment banks in issuing new securities and other important roles was discussed.

• Security Brokers and Dealers: the importance of dealers and brokers in making markets and offering services to investors was presented.