Mutual Funds and Mutual Funds and Hedge FundsHedge Funds

Chapter 5

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

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Overview

In this segment: Mutual Funds and Hedge Funds: Activities of mutual Size, structure and composition Balance sheets and recent trends Regulation of mutual funds Activities of hedge funds Global issues Size, structure and composition Balance sheets and recent trends Regulation of hedge funds

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Mutual Funds

Diversification opportunities enhanced for small investors Economies of scale Predominantly open-ended funds

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Mutual Funds

Rapid growth in funds during the 1990s Slower rate of growth in the industry in early

2000s than in 1990s Trading abuses contributed to slowdown

2007: Almost 7,100 stock and bond mutual

companies. Total assets of $8.21 trillion. 8,125 firms and $10.57 trillion if money market

mutual funds included

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Size, structure and composition

First mutual fund: Boston, 1924. Slow growth, initially. Advent of money market mutual funds, 1972.

Regulation Q. Total assets in stock and bond mutual funds:

1940: $0.5 billion. 1990: $1,065.2 billion 2000: $6,964.6 billion 2006: $10,413.7

Institutional funds 80 percent of retirement plan investments

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Size, Structure and Composition

By asset size, mutual fund industry second most important FI group.

Recent inroads by commercial banks and insurance companies

Mellon purchase of Dreyfus State Farm (9,000 agents) As of 2006, insurance companies managed

approximately 10% of mutual fund assets

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Types of Mutual Funds

Long-term funds 74.3% of assets, 1999 2002, long-term funds dropped to 62.1% of

assets, losing ground to MMMFs 75.4% in 2006

Types of Long-term Funds: Bond and income funds. Equity funds. Hybrid.

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Types of Mutual Funds

Short-term funds 25.7% of assets, 1999. 37.9% of assets, 2002. 24.6% in 2006 Taxable and tax-exempt MMMFs Generally higher returns than bank deposits but

uninsured. Impact of low interest rates during early to

mid 2000s Decline in MMMFs Lowering of MMMF fees

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Number of Mutual Funds

Year

Equity

Hybrid

Bond

Taxable

MM

Tax-exempt

MM 1980 288 N/A 170 96 10

1990 1,099 193 1,046 506 235

2007 4,784 501 1,993 574 273

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Overview of Mutual Funds

Objectives (and adherence to stated objectives), rates of return and risk characteristics vary.

Examples: Capital appreciation funds World equity Corporate bond High-yield bond World bond Government bond

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Returns to Mutual Funds

Income and dividends of underlying portfolio. Capital gains on trades by mutual fund

management. Capital appreciation in values of assets held in

the portfolio. Marked-to-market. Net-asset value (NAV).

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Web Resources

For information on the performance of mutual funds, visit:

Morningstar www.morningstar.com

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Types of Funds

Open-ended funds: comparable to most corporate securities traded on stock exchanges.

Closed-end investment companies: Fixed number of shares

Example: REITs. May trade at premium or discount. Exchange traded funds (ETFs)

Load versus no-load funds.

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Mutual Fund Costs

Two types of fees: Sales loads

Generally, negative effect on performance outweighs benefits

Short term versus long term investment alters impact of loads on cost

Fund operating expenses Management fee 12b-1 fees Front end and back end fees

• Class A, Class B and Class C differences• SEC creation of new rules• Sweeping decreases in fees, 2005 and 2006

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Balance Sheet and Trends

Money Market Funds Key assets are short-term securities (consistent

with deposit-like nature) 2006: $1,514.9 billion (65.5% of total assets)

Most have share values fixed at $1 and adjust number of shares owned by the investor.

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Balance Sheet and Trends

Long-term Funds Stocks comprised over 70.7 % of asset

portfolios in 2006. Credit market instruments 27.2% of asset

portfolios Shift to other securities such as credit market

instruments, U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.

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Regulation

One of the most closely regulated among non-depository FIs.

Primary regulator: SEC Emphasis on full disclosure and anti-fraud measures

to protect small investors. NASD supervises mutual fund share distributions.

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Regulatory Changes

Prosecutions in light of trading abuses in early 2000s. Market timing Late trading Directed brokerage Improper fee assessments

Changes include: SEC requirements for independent board members; reporting and disclosure requirements

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Legislation

Securities Act 1933, 1934 Investment Advisers Act, 1940. Insider Trading and Securities Fraud Enforcement

Act of 1988. Market Reform Act of 1990

Allows SEC to halt trading and introduce circuit breakers.

National Securities Markets Improvement Act of 1996.

Exempts mutual fund sellers from state securities regulatory oversight.

Sarbanes-Oxley Act of 2002

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Global Issues

Worldwide growth in mutual fund investment not as great as in the U.S. $2.575 trillion in 1996 to $10.490 trillion in 2006

Over 307% growth Larger returns in U.S.stock markets Greatest development in countries with most

advanced markets Opportunities from declining Japanese markets Efforts to reduce barriers for U.S. mutual fund

sponsors China and other Asian countries

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Hedge Funds

Not technically mutual funds Not subject to SEC regulation Organized as limited partnership

Small number of sophisticated investors Common feature is use of leverage

High returns in 1990s

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Hedge Funds

Near collapse of Long-Term Capital Management $3.6 billion bailout Precipitated SEC scrutiny of hedge funds

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Types of Hedge Funds

More risky Market directional

Moderate risk Market neutral or value orientation

Risk avoidance Moderate, consistent returns with low risk as

objectives Fees

Generally management fees and performance fees

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Offshore Hedge Funds

Major centers include Cayman Islands, Bermuda, Dublin, Luxembourg.

Rules Generally not burdensome Anonymity Tax advantages

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Regulation of Hedge Funds

Generally unregulated Exemption for less than 100 investors Exemption if accredited

Scandals such as Canary Capital Partners Illegal trading with mutual funds

Amaranth Advisors, 2006 SEC scrutiny

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Pertinent Websites

American Funds www.americanfunds.com

Federal Reserve www.federalreserve.gov

Fidelity Investments www.fidelity.com

Investment Company Institute www.ici.org

Morningstar, Inc. www.morningstar.com

NASD: www.nasd.com

SEC: www.sec.gov

Vanguard www.vanguard.com

Wall Street Journal www.wsj.com