A popular trend concerning indirect investing is the mutual fund“supermarket”—indeed, a number of observers feel that fund supermarkets are the future of mutual funds sold directly to investors.Fund supermarketsare a mechanism by which investors can buy, own, and sell the funds of various mutual fund families through one source, such as a brokerage firm.
“Supermarket”refers to the fact that an investor has hundreds of choices available through one source, and does not have to go to each mutual fund company separately to buy one of their funds.
The discount brokerages of Schwab and Fidelity have been pioneers in making funds available to investors through brokerage accounts offered by them. Schwab and Fidelity are two of the largest supermarkets, but many other discount brokeragefirms and fundfirms have smaller programs.
Fund supermarkets have two tracks, or“aisles”: a no-fee aisle, where investors can buy various mutual funds without paying a sales charge or transaction fee, and a transaction-fee aisle, where they do pay a fee. The mutual funds participating in the fund supermarket which want to offer their shares with no fees to investors pay the supermarkets an annual charge of 0.35 percent of the assets that the fund has acquired at the supermarket. As a result, the typical new fund being sold without fees will establish expense charges that are enough to cover the supermarket fees.
Hedge Funds
We close our discussion of investment companies by considering an offshoot, an unregulated investment company. The Investment Company Act of 1940 gave primacy to the open- end investment company (or mutual fund) as the way to protect investors from the excesses of the unregulated companies of the 1920s. The key was that such companies would be heavily regulated as to investor protections. However, the Act also left open the possibility of a money manager handling funds for a small group of sophisticated investors in an unregulated format. In 1949 a fund was started to“hedge”market risk by both buying and selling short, thus initiating the hedge fund industry. Today there are many hedge funds and a lot of notoriety about them, for better or worse.
Hedge fundsare unregulated companies that seek to exploit various market opportu- nities and thereby earn larger returns than are ordinarily available. For example, they may use leverage or derivative securities, or invest in illiquid assets, strategies not generally available to the typical mutual fund. They require a substantial initial investment from investors, and may have restrictions on how quickly investors can withdraw their funds. Unlike mutual funds, they traditionally do not disclose information to their investors about their investing activities.
Hedge funds charge substantial fees, and take a percentage of the profits earned, typically at least 20 percent.
Over time, the performance of hedge funds has been thought to be good, with larger returns and less risk than the typical mutual fund. Part of this is a result of some funds that
Example 3-16
Fidelity Investments has a fund supermarket known as FundsNetwork. Over 70 companies participate, offering over 1,200 funds.Fund
Supermarkets Offered by brokeragefirms, these allow thefirm’s customers to choose from a large set of mutual funds through their brokerage accounts
Hedge Funds Unregulated companies that seek to exploit various market opportunities and thereby earn larger returns than are ordinarily available to investment companies
perform strongly for a period receiving a lot of publicity. In Chapter 12 we examine some evidence suggesting average performance has not been very good. Furthermore, there have been some well-known failures, such as Bayou in 2005, whereby the principals are alleged to have drained investor monies for their own purposes. The most spectacular failure was Long Term Capital in 1998, which got in trouble as a result of Russia’s defaulting on its debt. In this case the Federal Reserve had to step in to calm the waters.
Today there are thousands of hedge funds with large sums under management. A legitimate issue to consider is whether there are enough talented managers to run thousands of funds, all looking for opportunities to exploit. Many hedge funds, like other investors, cannot overcome a financial crisis year such as 2008 when the financial markets underwent tre- mendous turmoil. A number of hedge funds went out of business.
Hedge funds do close when conditions change. For example, in late 2011 Goldman Sachs closed the Global Alpha Fund LP which had about $1 billion in assets, down from $12 billion in 2007. This fund was down about 40 percent in 2007, and as of late Fall 2011 it was down about 12 percent for the year.
A revolutionary move has now started whereby a hedge fund, in addition to its portfolios designed for institutional clients, is offering its skills to individual investors in the form of mutual funds. AQR, a highly successful hedge fund, has made available several mutual funds using techniques developed for its hedge fund clients. These funds will rely heavily on momentum investing.
Summary
⁄ As an alternative to purchasing financial assets them- selves, all investors can invest indirectly, which involves the purchase of shares of some type of investment company.
⁄ Investment companies are financial intermediaries that hold a portfolio of securities on behalf of their shareholders.
⁄ Investment companies are classified as either open- end or closed-end, depending on whether their own capitalization (number of shares outstanding) is con- stantly changing or fixed.
⁄ ETFs bundle together a basket of stocks based on some index or grouping of stocks and trade as one security on an exchange. They resemble closed-end funds but generally sell close to NAV and have certain tax advantages.
⁄ Open-end investment companies, commonly called mutual funds, can be divided into four categories, money market funds and stock, bond, and hybrid funds.
⁄ Money market mutual funds concentrate on portfolios of money market securities, providing investors with a way to own these high face value securities indirectly.
⁄ Stock, bond, and hybrid funds own portfolios of stocks and/or bonds, allowing investors to participate in these markets without having to purchase these securities directly.
⁄ Investors transacting indirectly in closed-end funds encounter discounts and premiums, meaning that the price of these funds is unequal to their net asset values.
⁄ Mutual funds can be load funds or no-load funds, where the load is a sales charge calculated as a per- centage of the amount invested in the fund.
⁄ All investment companies typically charge a fee (called the annual expense ratio or simply“expense ratio”) to shareholders to pay for the operating costs and the management fee.
⁄ Total return for a mutual fund includes reinvested dividends and capital gains. A cumulative total return measures the actual performance over a stated period of time, such as the past three,five, or 10 years. The average annual return is a hypothetical rate of return that, if achieved annually, would have produced the same cumulative total return if performance had been constant over the entire period.
⁄ International funds tend to concentrate primarily on international stocks while global funds tend to keep a minimum of 25 percent of their assets in the United States.
⁄ Single-country funds, which traditionally have been closed-end funds, concentrate on the securities of a single country.
⁄ Fund supermarkets are a mechanism by which investors can buy, own, and sell the funds of various mutual fund families through one source, such as a brokerage firm.
⁄ Hedge funds are unregulated companies that seek to exploit various market opportunities and thereby earn larger returns than are ordinarily available.
Questions
3-1 What is meant by“indirect”investing?
3-2 What is an investment company? Distinguish between an open-end and a closed-end company.
3-3 What does the term“open-end”mean with regard to an investment company’s capitalization? What about the term“closed-end?”
3-4 List some reasons an investor might prefer an ETF to an open-end fund.
3-5 It has been said that many closed-end funds are
“worth more dead than alive.”What is meant by this expression?
3-6 How similar is an ETF to a closed-end fund?
3-7 What does it mean for an investment company to be regulated?
3-8 What is meant by an investment company’s
“objective”? What are some of the objectives pursued by equity, bond, and income funds?
3-9 How is the net asset value for a mutual fund calculated?
3-10 What is a money market fund? Why would it appeal to investors?
3-11 List the benefits of a money market fund for investors? List the disadvantages. What alternative investment is a close substitute?
3-12 Distinguish between a value fund and a growth fund.
3-13 Distinguish between a global fund and an inter- national fund.
3-14 What is the difference between the average annual return for a fund and the geometric mean return for that fund?
3-15 What is the value to investors of Morningstar ratings? What is the weakness of these ratings?
3-16 Distinguish between the direct and indirect methods by which mutual fund shares are typi- cally purchased.
3-17 How would the owner of some shares of Fidelity’s Equity-Income Fund “cash out” when she was ready to sell the shares?
3-18 What does it mean to say an index fund is related to passive investing?
3-19 What percentage of equity mutual fund assets are accounted for by index equity mutual funds?
Should a typical investor pay 75 or 100 basis points in annual expenses for an index equity mutual fund?
3-20 What is survivorship bias? How does it affect investors in judging mutual fund performance?
3-21 What is the difference between a load fund and a no-load fund?
3-22 What are passively managed country funds? Give an example.
3-23 What is meant by the exchange privilege within a
“family of funds”?
3-24 How does a hedge fund differ from a mutual fund?
3-25 What is a fund supermarket?
3-26 John Bogle started the first equity index fund in 1976. It struggled atfirst, and the fund met with overt hostility from most of the industry, which wanted to see it fail. Why do you think this happened?
Computational Problems
3-1 A mutual fund has the following returns for three consecutive years: 8%, 5%, and 12%.
a. What is the cumulative wealth per $1 invested?
b. What is the geometric mean return for this three-year period.
3-2 For a recent 10-year period, T. Rowe Price, a mutual fund company, reported performance (average annual total return) for two of its funds as follows:
Equity-Income Fund 12.48%
Personal Strategy Growth Fund 12.26%
Assume you invested $5,000 in each fund at the beginning of this 10-year period. How much difference would there be in the ending wealth between the two funds?
3-3 For the same two funds discussed in 3-2, the ending wealth after five years was $1.2438 per dollar invested at the beginning for the Equity- Income Fund, and $1.0492 per dollar invested at
the beginning for the Personal Strategy fund.
What were the annual average total returns for each fund for thisfive-year period?
3-4 The net asset value per share for the T. Rowe Price Global Stock Fund at the beginning of one recent year was $15.07. During the year the fund earned
$.04 in net investment income and $1.82 in“net gains or losses on securities.”It distributed $.03 in dividends and $.02 in capital gains. What was the net asset value for this fund at the end of the year?
3-5 As of December 31, 2012, the 10-year annualized rate of return (geometric mean) for the Wall Street Emerging Growth Fund was 8.45 per- cent. Assume an investor invested $10,000 in this fund on January 1, 2003. How much would this investment be worth on December 31, 2012, a 10-year period?
3-6 For the period ending July 2012, Vanguard’s Prime Money Market Fund Investor Shares earned .03 percent. What was the ending wealth given a $1,000 investment.
Spreadsheet Exercises
3-1 The years 19951999 were thefive greatest consecutive years in the stock market in terms of performance. They were followed by three years of significant declines, and a recovery in 2003.
The data below show the percentage annual returns for two Fidelity funds, Fidelity Growth (symbol5 FDGRX) and Fidelity Aggressive Growth (symbol5FDEGX). Note that the per- formance of both funds mirrored that of the market, showing strong positive returns thefirstfive years, followed by three years of negative returns, and then positive performance in 2003.
FDGRX FDEGX
1995 39.6 35.9
1996 16.8 15.8
1997 18.9 19.5
1998 27.2 43.3
1999 79.5 103
2000 26.3 227.1
2001 225.3 247.3
2002 233.5 241.2
2003 41.4 33.4
a. Calculate the average performance for each fund for the nine-year period. Use the spreadsheet function {5Average(B2:B9)} where B2:B9 represents the cells with the first fund’s annual returns.
b. Now calculate how much $10,000 invested in each fund at the beginning of 1995 would have grown to by the end of 1999, when the market was booming. To do this, construct two new columns, one for each fund, showing the decimal equivalent of the fund’s return added to 1.0 (call this thereturn relative—tofind it, divide each return by 100 and add 1.0). For example, for FDGRX, thefirst entry would be 1.396. Then for each fund multiply $10,000 by each of thefirstfive return relatives in turn. How much money would an investor in each fund have at the end of 1999? Which fund performed better up to that point?
c. Using the answer determined in (b), calculate the amount of money an investor would have in each fund at the end of 2003. Do this in a manner similar to (b), compounding the result you found at the end of 1999 by each of the four remaining return relatives.
d. What is the difference in ending wealth between the two funds, having started with
$10,000 in each fund?
e. Now calculate the average annual total return (geometric mean) for each fund using the spreadsheet function {5 geomean (D2:D9) } assuming for example that the return rela- tives for one fund are in the cells D2:D9.
f. How does the difference in the average annual total returns for each fund compare to the arithmetic averages for each over the nine-year period?
3-2 Fill in the missing data in the spreadsheet below to calculate the net asset value of this mutual fund for each of the years shown.
Years ended December 31, 2012 2011 2010 2009 2008
Selected Per Share Data
Net asset value, beginning of period $ 45.26 $ 65.21 $ 56.34
Income from Investment Operations
Net investment income (loss)B .12 .23 .41
Net realized and unrealized gain (loss) (27.22) 12.34 6.92 8.95
Total from investment operations 13.22 12.82 9.22
Distributions from net investment income (.21) (.46) (.39) (.23)
Distributions from net realized gain (.09)
Total distributions (.20) (.86) (4.92) (6.88) (1.20)
Net asset value, end of period $ 58.28 $ 45.26 $ 64.71
Checking Your Understanding
3-1 Mutual funds are by far the most popular type of investment company because they have existed for many years, as have closed-end funds, but the latter fell out of favor with investors a long time ago. ETFs are relatively new and while growing rapidly, have a long way to go to catch up with mutual funds. Very heavy promotion and publicity also accounts for the popularity of mutual funds.
3-2 ETFs have largely eliminated the issue of discounts and premiums which plague closed-end funds. They typically offer targeted diversification while closed-ends often resemble mutual funds.
3-3 Money market funds by definition hold money market assets, the safest financial assets because of their high credit quality and very short maturity. Therefore, they are simply a reflection of the type of assets they hold.
3-4 A hybrid fund holds both bonds and stocks, thereby offering a combination to investors in one fund. Typically, such funds should have higher returns, on average, than bond funds while offering lower risk than stock funds.
3-5 Investor tend to favor value stocks for certain periods of time, and growth stocks at other times based on perceived economic conditions. Therefore, growth funds and value funds will reflect these varying expectations.
3-6 Investors may choose to buy load funds and pay sales charges because of ignorance about the alternatives available, or carelessness in seeking out the lower-cost alternative of no-load funds. Of course, if investors believe that a particular fund/manager offers better opportunities than the alternatives, and such a fund charges a sales charge, they will be willing to pay the load fees.
3-7 Some investors simply wish to avoid paying an up-front sales charge, which can be avoided by buying B or C class shares. Of course, what really matters is what an investor pays in total in fees during the period the shares are owned; therefore, investors in mutual funds with share classes should do some calculations to try to determine which class of shares will be least expensive during the time period the shares are owned.
3-8 A closed-end fund typically trades at a premium when investors are convinced that the future performance of the fund will be so strong that paying a premium for the shares is warranted.
For example, a closed-end fund might concentrate on a single country expected to perform very strongly over the future, and other readily available alternatives for participating in this particular country are not available.
chapter 4 Matter to All Securities Markets Investors
A
syou prepare to invest your inheritance, you realize that like most people you have certainly heard of the New York Stock Exchange as well as NASDAQ because their activities are reported daily, but you really don’t know how they work. Why should you care where the stocks you buy and sell trade? Having heard of the bubble in the NASDAQ market that burst in 2000, causing investors spectacular losses, you also wonder if you should even consider NASDAQ stocks. And someone has mentioned that Electronic Communications Networks (ECNs) may be the future of investing, but you do not know what these are. Even more basic, despite listening to the national news each night and hearing how the Dow Jones Index and NASDAQ Index closed for the day, you clearly realize that this doesn’t tell you much. Does a 75-point gain in the Dow in one day constitute a great day, or could it be less significant in today’s world than in the past? Even more confusing, in 2011 the stock market was up 5.5 percent for the year, although it was also unchanged—how is this possible? Finally, what about bonds—where do they trade, and how will you handle their purchase and sale?Chapter 4 outlines the structure of the markets where investors buy and sell securities. Although primary markets, including the role of investment bankers, are considered, the emphasis is on secondary markets where most investors are active. We focus in particular on equity markets because most investors are primarily interested in stocks;
bond markets and derivative markets are outlined. Market indexes are analyzed in some detail because of their uni- versal everyday use by investors.
The structure and operating mechanisms of the securities markets in the United States have changed drastically in the last 10 years. Given thefinancial crisis starting in 2008, more changes can be expected.
AFTER READING THIS CHAPTER YOU WILL BE ABLE TO:
⁄ Distinguish between primary and secondary markets.
⁄ Outline where the three major types of securities discussed in Chapter 2—bonds, equities, and deri- vatives—are traded.
⁄ Understand how the equity markets, where stocks are traded, are organized, how they operate, and how they differ from each other.
⁄ Recognize and understand the various stock market indexes typically encountered by investors.