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Class Notes for CH 17: Investment Companies (Mutual Funds and Hedge Funds)Outline-“Mutual Fund Returns and Costs”-NAV Example-Mutual Fund Costs / Fee Structure-Hedge Funds Motivation- retirement plans, mutual fundsLearning GoalsLG 17-4 Calculate the net asset value of and the return on a mutual fund investmentLG 17-7 Know what a hedge fund is“Mutual Fund Returns and Costs”LG 17-4 Calculate the net asset value of and the return on a mutual fund investmentopen-end mutual fund: a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of sharesBrief History of Mutual Funds:1924: First mutual fund was established in Boston1970s: Money market mutual funds became popular as an alternative to commercial bank deposits (due to interest rate ceilings imposed by regulators on banks)1990s: Equity mutual funds became popular due to investors’ desire to earn returns during the bull stock marketTable 17-11990: 3,079 funds in existence, 1 billion in net assets2000: 8,155 funds in existence, 7 billion in net assets2013: 7,707 funds in existence, 15 billion in net assetsFigure 17-1In terms of industry assets, mutual fund industry is smaller than commercial banking, but larger than insurance.Example: Calculation of NAV on an Open-End Mutual FundNAV: the net asset value of a mutual fund; equal to the market value of the assets in the mutual fund portfolio divided by the number of shares outstandingNAV = market value of assets – liabilities/shares of funds outstandingOpen ended funds buy and sell at NAVFund holdings:1,000 shares of Sherwin-Williams2,000 shares of eBay1,500 shares of AutoZoneThere are no liabilities and the fund has 15,000 shares outstanding held by investorsClosing stock prices are:Day 1Day 2Sherwin-Williams$38.75$45.00eBay$43.20$48.00AutoZone$46.67$50.001. Calculate NAV at Day 1(38,750 + 86,400 + 70,0050)/15,000 = $13.012. Calculate NAV at Day 2 (assuming number of shares outstanding stays the same)(45,000 + 96,000 + 75,000)/15,000 = $14.403. Assume that 1,000 shares are sold at the NAV of Day 1. How much does this give the manager to invest? $13,0104. Assume that the fund manager invests all this cash into Sherwin-Williams at the Day 1 price. What is the new portfolio holding of the fund (number of shares per stock)?(13,010/38.75) = 335.74 + 1000 = 1,3355. What is the NAV at Day 2?(60,075 + 96,000 + 75,000)/16,000 = $14.446. What happens to NAV and why?NAV is slightly increased because they invested in stock whose price rose.NAV Example #2A mutual fund owns 500 shares of Coca Cola and 2,000 shares of Home Depot. The fund has 10,000 shares outstanding. Stock prices for Day 1 and Day 2 are given below. At the end of Day 1, the fund issues 2,000 new shares to investors at the NAV. The fund manager invests the additional capital into only Coca Cola Stock. Given the stock prices below, will the fund’s NAV at Day 2 be greater than, less than, or the same as the NAV at Day 1?PricesDay 1Day 2Coca Cola$100$105Home Depot$25$20NAV Day 1: (50,000 + 50,000)/10,000 = 1010,000/100 = 200 sharesNAV Day 2: (10,500 + 40,000)/12,000 = $9.46Fund manager made good choice but NAV still goes downMutual Fund Costs / Fee StructureLoad fund: a mutual fund with an up-front sales or commission charge that the investor must payOperating expenses. typically given as an expense ratio, a percentage of assets under management. Includes management fees, trading costs, etc. assessed annually. Every fund has this.Front-end load. sales charge paid when you purchase the shares. Example: pay 3% of your investment up front (invest $1000, $970 goes into fund- $30 fee to seller)Back-end load. sales charge paid when you sell the shares. Example: pay 2% fee when you liquidate your investment**Trend is away from charging loads12b-1 fees. fund assets used to pay for distribution costs (advertising, promotional literature, commissions paid to brokers who sell the fund to investors). Assessed annually. Not every fund has these fees. Expressed as a % of assets. Ex = .10%Practice Problem, Mutual Fund Fees:You have $12,500 to invest and you are considering investing in Fund X. The fund charges a front-end load of 3% and an annual expense fee of 2.25% of the average asset value over the year. You believe the fund's gross rate of return will be 8% per year. If you make the investment, what should your investment be worth in one year? In two years??Active vs. Passive ManagementPassive management: holding a well-diversified portfolio without attempting to search out security mispricing. Active management: attempt to achieve higher returns than suggested by the risk level by forecasting broad markets and/or by identifying mispriced securities. Active managers might follow one of the following strategies:1. Stock selection. Includes individual stocks or industries2. Market timing. Switching between risky assets and cash based on forecasts of market Example: Hold market portfolio (no timing): 9.20%; off 8% of the time, correct 92% of the time return would then only be 9.02% lose to buy & hold strategy!3. Volatility timing. Attempting to predict future volatility and limiting exposure to itCarhart (1997)Best performing funds cannot keep it up over a long period of time. Also, worst performing funds do not under perform for a long period of time.Takeaway: It is not worth large fees to pay fund managers to pick stocksHedge Funds LG 17-7 Know what a hedge fund isMutual fund (open-end)Hedge fundBasic IdeaInvestment poolingInvestment poolingNet Asset ValueRepresents the value of the investor’s stake in the portfolioRepresents the value of the investor’s stake in the portfolioTransparencySubject to regulation that requires periodic public (quarterly) disclosureProvide minimal information, and only to investors and potential investorsInvestorsOpen to all investorsRestricted to about 100 “sophisticated” investors (requires minimum net worth)Typically requires $250k to $1M min. investmentInvestment strategyClosely follow a disclosed strategyEx- large cap, growth, mid cap value, sector specific. Use of short sales, derivatives, and leverage is limited.Can invest in anything. The fund’s focus can change over time. Very opportunistic. Can use leverage, short sales, derivatives.Liquidity Very liquidNet asset value is calculated daily.Much less liquidOften have lock-up periods that can be several years. Redemption notices of several months are pensation structureSalary plus bonus (3 year performance).Fixed percentage of assets (from .5% to 1.5%)Very low ownership of the manager.Management fee plus incentive fee. 2 and 20.High powered incentives. High ownership of managers.Warren Buffett’s ChallengeHedge fund:Initial investment$1,000,000Raw Return7%Before Fees$1,070,0002% fee(1,070,000 + 1,000,000)/2 * .02 = $20,700Performance fee 20 % of profit(1,070,000 – 1,000,000) * .20 = $4,000Net1,070,000 – 20,700 – 14,000 = 1,035,000Warren Buffett invests $1,000,000 into an S&P 500 Index fund that has an expense ratio of 0.16% (calculated based on the average value of the fund). The fund earns a raw return of 7% over one year. What is the value of his investment after one year? Instead, suppose the fund earns a raw return of 4% per year. What is the value of Mr. Buffett’s investment? A hedge fund charges a 2% asset management fee (calculated based on the average value of the fund) and a performance fee of 20% of profits. The fund has a raw return of 7% over one year. What is the value of $1,000,000 invested in this fund after one year?Hedge Funds:Merger Arbitrage ExampleA hedge fund has a strategy which buys stock in M&A targets immediately after the announcement of an acquisition. These shares are then transformed into cash or stock of the acquirer when the deal is complete. Below are the returns to 10 such deals as well as information about the deal outcome and market returns around the transaction. Evaluate this strategy. Notes: -Approximately 97% of deals are completed. The number of failed deals is oversampled in this table.-Using the S&P 500 as a benchmark, this strategy outperforms by over 3% per year.DealDeal OutcomeHedge Fund ReturnMarket Return1Completed0.50%6.00%2Completed0.60%7.00%3Completed0.20%7.00%4Failed-18.00%-3.00%5Completed0.20%6.00%6Completed0.40%4.00%7Failed-15.00%-2.00%8Completed0.50%2.00%9Completed0.40%5.00%10Failed-12.00%-2.00%1. Create a scatter plot of the Hedge Fund (y-axis) versus the Market Return (x-axis).2. Fit a line (or two lines) to this strategy. What payoff structure does this represent? Hint: options.3. Is the S&P 500 a proper benchmark for this strategy?4. Intuitively, what type of risk transfer is the hedge fund manager providing for the shareholders of target firm stock? ................
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