Objectives:

1. Mutual Funds, ETFs, and Hedge Funds • Objectives: • Understand the different structures of mutual funds and how they are operated and regulated. • Discuss conflicts of interest that can occur between mutual fund management companies, brokers, and retail investors. • Understand the structure of exchange traded funds (ETFs) and how they differ from mutual funds. • Describe the structure of hedge funds and the types of investment strategies they pursue.

2. Mutual funds are intermediaries that pool their shareholders’ funds to invest in a portfolio of securities. • There are two main structures for mutual funds. • Open-end mutual funds invest in marketable securities and redeem current shares or issue new shares on demand. Shares can be redeemed or bought at the fund’s net asset value (NAV). • Closed-end mutual funds invest in marketable or non-marketable securities. They do not permit redemption of their current shares nor do they allow new shares to be issued. Shareholders can only liquidate their shares by trading them to another investor. Closed-end fund shares trade on exchanges such as the NYSE or AMEX at a price that, in general, does not equal the fund’s NAV.

3. Investment banks create, and underwrite the shares of, many closed-end funds. • A closed-end fund is like a typical corporation, except that it is liquidated at a pre-specified future date (20 years or more). It has a portfolio manager who selects the fund’s assets. • A closed-end structure might be preferable to an open-end one if a fund desires to hold illiquid (non-marketable) assets. Non-marketable assets makes calculating a NAV difficult. • At the end of 2003Q3, in the U.S. there were 126 closed-end equity funds holding assets of $45.1 B and 449 closed-end bond funds holding assets of $157.9 B. Most of these bond funds held (federal tax-free) municipal bonds.

4. An open-end mutual fund permits redeems shares or issues new shares at its NAV once per day, usually at 4:00 p.m. ET after major U.S. markets close. The NAV is calculated as • Example: The Vanguard Index 500 is a open-end mutual fund that invests in a portfolio of the S&P 500 stocks (the 500 largest U.S. companies). On 12/31/2003, the market value of the stocks in its portfolio (based on the stocks’ 4:00 p.m. closing prices) was $93.4 B, and the fund’s total outstanding shares were 910 M. Therefore, its NAV was

5. Note that as long as the NAV is calculated based on the current fair market value of the fund’s securities, redeeming fund shares at the NAV or adding new shares at the NAV does not change the fund’s NAV. Hence, the value of any shareholder’s investment in the fund is not directly affected by redemptions or additions of shares. • Both retail and institutional investors are mutual fund shareholders. Currently the U.S. has over 8,000 open-end funds holding total assets of over $7,000 B, making them the single largest type of financial intermediary. There are about 574 closed-end funds holding total assets of over $200 B. • Increasingly, mutual funds are part of large management companies who create and sponsor them. A family of mutual funds managed by the same company is called a fundcomplex. Examples of complexes: Fidelity, T. Rowe Price, Janus.

6. Composition of Total Open-End Fund Assets, December 2003 509 Hybrid 6% 1,265 Taxable Bond 12% 4,598 Stock 49% 778 Municipal Bond 5% 662 Taxable Money Market 24% 312 Tax-Free Money Market 4% • Total open-end fund assets: $7,413 B

7. The Securities Exchange Act of 1934 created the SEC which was given regulatory oversight of mutual funds (a.k.a. investment companies). A mutual fund was required to issue a prospectus to investors that described the fund. • The Investment Company Act of 1940 is the major legislation affecting mutual funds. It sets requirements for disclosure, organization, and management of mutual funds. 1970 amendments modified rules for management fees and sales commissions of funds. • While each investment company is organized as a corporation with investors being its shareholders, investment companies are exempt from corporate taxes. They may not borrow (issue debt), engage in short sales, buy or sell real estate or commodities, or make loans.

8. Each mutual fund has a board of directors with oversight responsibility for the fund’s management. The 1940 act stipulates that at least 40 % of the directors be independent. In practice, the company managing the mutual fund (e.g., Fidelity, Merrill Lynch, Putnam) controls the board by selecting its chairman and most of its members. • The mutual fund’s investment advisor is responsible for selecting the mutual fund’s portfolio of assets. Investment advisors are one or more individuals who are often affiliated with the mutual fund manager (e.g., Fidelity, T. Rowe Price) and, hence, often controlled by the fund manager. • However, this is not always the case. The Vanguard group uses internal investment advisors to manage its index funds and hires external investment advisors to manage its actively managed funds.

9. An investment advisor’s annual compensation usually is set to equal a fixed proportion of the mutual fund’s total assets, for example, 0.25 % of the fund’s assets. • This fixed compensation actually provides incentives for the investment advisors to produce good return performance. • Mutual funds whose return performance is better (worse) than their competitors experience inflows (outflows) of investors’ funds. Investors are said to “chase returns.” • This means that the assets of a successful (unsuccessful) mutual fund grows larger (smaller) and its investment advisor’s compensation, which is a fixed proportion of assets, grows larger (smaller).

10. Mutual Fund Distribution Channels • Mutual funds shares are sold to investors in different ways: • Funds sold through broker-dealers or financial planners who charge investors a sales load. • The most common is a front-end load that is charged at the time of purchase. It is typically 4-5%. • A back-end load is a sales charge when the investor leaves the fund or the fund complex. • Compensation from the fund manager to brokers is also paid from 12b-1 fees. In 1980, the SEC adopted ICA Rule 12b-1 allowing a mutual fund to expense from a fund’s assets fees to cover the cost of marketing and distributing fund shares. The intent was to cover costs of advertising and customer service. However, as of 2000, 63% of 12b-1 fees were paid as compensation to brokers, 32% for administrative services, 5% for advertising.

11. The various was of charging sales fees to investors to compensate brokers has led to some management companies offering different classes of shares for the same mutual fund. • Class A shares: High front-end loads, low 12b-1 fees. • Class B shares: No front-end load, high 12b-1 fees, and a back-end load that declines the longer the investor stays in the fund or the fund complex. • Class I shares: No loads or 12b-1 fees. These shares are sold to institutional investors or through fee-based financial planners. • In recent years, front-end loads have declined but broker compensation via 12b-1 fees has increased even more, perhaps because this form of compensation is not apparent to most mutual fund investors. Currently, there are proposals to make this channel of compensation more transparent.

12. Funds that are sold directly to investors by management companies. These mutual funds are usually no-load funds. Investors communicate with the fund complex by mail, toll-free telephone, or the internet. These directly marketed funds may charge advertising costs as part of 12b-1 fees. • Funds are also sold through 401k or 403b retirement plans. Mutual fund complexes are often chosen by the plan sponsor (business or non-profit) to provide retirement choices to employees. Funds are usually no-load funds or, if the fund usually charges loads, they are waived for employees. • Funds are also sold through mutual fund marketplaces, a concept originally developed by Charles Schwab but now offered by Fidelity and others. A mutual fund company (e.g., Janus) would pay the sponsor (e.g., Schwab) an annual fee (e.g, 0.25%) for a “place.” Schwab markets the fund company (along with others) and services any customer who selects it.

13. Mutual Fund Conflicts of Interest • The mutual fund industry is sometimes criticized because of the high fees and expenses charged to investors. In 2002, the average expense/asset ratio for the mutual fund industry was 1.36%. • Unfortunately, the higher expense ratio does not translate into superior return performance. In an average year, approximately two-thirds of mutual funds under-perform the return on a diversified market portfolio (e.g., the return on a low-cost, indexed mutual fund). • Because there are many retail investors who may not be sophisticated enough to understand mutual fund expenses and performance, this can give mutual fund companies power to charge excessive management and sales fees.

14. Some, such as former Vanguard Chairman John Bogle, believe expenses could be lowered by a change in organizational form. The typical mutual fund corporate structure is Own Shareholders (Investors) Mutual Fund High Expenses Services High Fees Controls Management Company Shareholders Own Management Company Excess profits

15. A mutually organized corporate structure, such as Vanguard’s, could better protect retail investors. Vanguard’s average expense ratio is 0.26 %. Own Shareholders (Investors) Mutual Fund Low Expenses Low Fees = Cost of Services Services Owns Management Company (Vanguard)

16. Market Timing and Late Trading • Certain mutual funds may be subject to “market timing” because the fund’s NAV is not calculated based on fair prices for the underlying securities. • Situations where this could occur is when the NAV is calculated using closing prices that are “stale.” A U.S. mutual fund that holds foreign stocks, such as stocks of Japanese or European firms, might use foreign market closing prices from many hours prior to 4:00 ET in the U.S. • This could lead to the following situation NAV Calculated from Stale Closing Prices Asian Markets Close News Event Likely to Affect Asian Stocks 3:00 a.m. ET 1:00 p.m. ET 4:00 p.m. ET

17. For example, suppose a mutual fund holds Asian stocks and, at the beginning of the day, has 5 m shares outstanding. Based on the 3:00 a.m. ET closing prices, the stocks are valued at $50 m, so that the fund’s calculates its NAV at $10.00/share. • But, suppose a news event occurs at 1:00 p.m. ET that is expected to raise the value of Asian stocks. At 2:00 p.m. ET, a market timer invests $10 m in the fund, obtaining 1 m shares. • Suppose, the next day, at the opening of Asian markets, Asian stocks reflect the good news by rising by 10%. The original stocks in the fund increase from $50 m to $55 m. The mutual fund then invests the $10 invested by the market timer, so that the total amount of Asian stocks held by the fund is $65 m.

18. If market timing had not occurred, note that the next day’s NAV would be • But with market timing, the next day’s NAV is • Therefore, instead of enjoying the 10% return on Asian stocks, the original shareholders of the mutual fund obtain only an 8.3% return. The market timer makes a profit of (steals) $833,333.33 at the expense of the original shareholders.

19. Some mutual fund companies eliminate market-timing by refusing orders from traders known to be market timers. • Alternatively a fund could use fair-value pricing where it uses a fair-value estimate of the value of its stocks (rather than the stale closing prices) to calculate its NAV. In our example, if the mutual fund manager realizes the news event will increase the value of the fund’s stocks by 10%, then at the end of the first day the NAV would be • In this case there would be no incentive to market time, because the market timer would pay $11, not $10 per share.

20. It is not illegal, per se, for a mutual fund to allow market timing, but most funds have written policies to, at least, discourage such trading. • Yet, some mutual fund companies allowed hedge funds to market-time some of their funds in return for the hedge fund making long-term investments in other funds. • A related, and definitely illegal, activity is when a mutual fund allows late trading. This occurs when a mutual fund accepts an order submitted after 4:00 ET. In this case, a late trader can profit from news events after 4:00. • The hedge fund, Canary Capital, allegedly paid a Bank of America broker to submit orders for trading BofA funds after 4:00 that were time-stamped before 4:00. NY attorney general Eliot Spitzer reached a $40 million settlement with Canary.

21. Soft Dollars and Directed Brokerage • Still, another conflict of interest can involve soft dollar arrangements that some mutual fund companies have with brokerage firms. • In 1975, the SEC abolished the system of fixed rates for brokerage commissions, allowing competitive rate-setting. • However, the SEC allowed investment advisors to pay higher commissions to brokers in return for receiving research services and not be subject to violating their fiduciary responsibility to obtain the lowest commissions for the fund. • Thus, instead of paying low commissions on their trades by using a discount broker, some mutual funds pay higher commissions (the extra being “soft dollars”) at full-service brokers that provide research-related services to the fund.

22. Mutual funds’ soft dollar credits are used to obtain stock-research reports (55%), news services such as Bloomberg machines (14%), and computer hardware and software. • Soft dollar costs are not included in a fund’s reported expense ratio. Ceteris paribus, a mutual fund obtaining research services via a soft-dollar arrangement will report a lower expense ratio compared to a mutual fund that uses a discount broker and directly buys its research services. • Its low reported expense ratio makes the soft dollar mutual fund appear relatively attractive, yet its performance should be no better because its assets will be depleted over time due to higher commission payments. • Proposals are being made to limit the use of soft dollars and/or have them reported as fund expenses.

23. Directed-brokeragecommissions involve agreements where a mutual fund agrees to place trades with a broker in return for the mutual fund being heavily promoted to the broker’s clients. • Morgan Stanley recently settled an SEC complaint regarding Morgan Stanley brokers’ practice of promoting “preferred partner” mutual funds over non-partner mutual funds. • Some of the partner funds agreed in advance to place their trades with Morgan Stanley and to pay higher-than-normal commissions in return for their preferred partner status. • Clearly, this arrangement would bias the advice Morgan Stanley brokers provide to their retail clients. There are current proposals to ban this practice.

24. Exchange Traded Funds • Exchange Traded Funds (ETFs) are a relatively new type of investment company. Like other mutual funds, they hold a portfolio of assets and issue only equity shares. • ETFs have some of the characteristics of closed-end funds and some of the characteristics of open-end funds. Essentially, ETFs are closed-end funds to small investors but can be open-end funds to large investors. • This is because, like closed-end funds, the shares of ETFs trade on a secondary (stock) market. They do not redeem or issue small amounts of shares on demand. • However, ETFs will redeem or issue large blocks of shares on demand. This feature differentiates an ETF from a closed-end fund.

25. The incentive for large investors to execute arbitrage trades is • whatmakes an ETF’s secondary market share price stay close to • its NAV. • Similar to a indexed mutual fund, ETF shares represent an owner- • ship stake in a trust that holds a specified portfolio of securities. • For example, the oldest ETF, the SPDR trust, was started in 1993 • and invests in the Standard & Poors 500 portfolio of stocks.

26. On 2/12/04, the S&P500 Index closed at $1152.11. Hence, the • net asset value (NAV) of one SPDR was • However, if a small investor wants to buy or sell an ETF share, • it must be done through a broker who places the order on a • stock exchange (e.g., AMEX or NYSE). The SPDR trust does • not redeem or create small amounts of shares on demand. On • 2/12/04, the AMEX closing price of a SPDR was $115.65. • One advantage of ETFs is that they can be traded throughout • the day whereas shares in open-ended mutual funds can be • bought or redeemed only at the fund’s end-of-day NAV.

27. While the ETF share price may not be exactly equal to the • trust’s NAV, ETFs are designed to facilitate arbitrage that • reduces deviations from NAV. EFTs permit large financial • institutions to deliver the underlying securities of the trust in • return for a minimum of 1 creation unit worth of new ETF • shares. Similarly, 1 creation unit worth of ETF shares can • be redeemed in return for receiving the securities in the trust. • For example, suppose the demand by small investors for • SPDR shares grows. Buy orders for SPDRs push up the • share price (e.g., $115.71) above the trust’s NAV (e.g., $115.21). • This gives a financial institution the incentive to deliver at • least 1 creation unit worth of S&P 500 stocks (at a cost of • 5,000x$1152.11= $5,760,550) in return for 50,000 SPDRs (which • can be sold for 50,000x$115.71=$5,785,500), with the arbitrage • profit equaling the difference in values ($24,950).

28. This arbitrage would increase the supply of SPDRs, reducing the share price’s deviation from NAV. Similarly, large institutions would find it profitable to buy up SPDR shares and redeem them for 1 creation unit’s worth of S&P500 stocks when the share price is sufficiently below the trust’s NAV. • Since an ETF needs to specify the particular assets composing a creation unit, ETF assets are equal to a stock or bond index. U.S. Exchange Traded Funds, December 2003

29. Like other mutual funds, ETFs pay dividends equal to the dividends paid by their underlying stocks. ETFs have return characteristics similar to indexed mutual funds. • For example, the Vanguard Total Market Index Fund, an open-end fund indexed to the Wilshire 5000 had a rate of return for the year 2003 of 31.35% and an expense ratio of 0.20 %. • The Vanguard VIPER ETF linked to the Wilshire 5000 had a rate of return for the year 2003 of 31.17 % based on its market price and of 31.43 % based on its NAV. Its expense ratio was 0.15%. • During 2003, the return on the Wilshire 5000, a value-weighted average of the 5000 largest U.S. stocks, was 31.64%.

30. Note that a closed-end mutual funds does not allow any redemptions or creations of shares. Its share price can deviate significantly from the fund’s NAV (often at 10% to 20% discounts) because arbitrage is not possible. • Below is the percentage difference between a typical closed-end mutual fund’s NAV and its secondary market share price over a 20 year period.

31. When a closed-end fund is started, its share price typically • sells at a premium to NAV, but soon trades at a discount. The • share price converges to the NAV when the fund is liquidated • at its termination date. • The present value of management expenses could explain • part of the discount. Managers fight takeovers and early • liquidation, making arbitrage difficult.

32. Hedge Funds • Hedge funds are loosely regulated intermediaries that invest the funds of wealthy individuals and institutions. Most are structured as limited partnerships or limited liability companies. • To qualify as a hedge fund, so that it is not subject to the 1940 Investment Company Act, its individual investors must have a net worth of at least $5 m and its institutional investors must have capital of at least $25 m. An investor’s minimum initial investment is usually at least $250,000. • Compared to mutual funds, hedge funds have more freedom in selecting their portfolios. They can borrow (e.g., from banks), short sell securities, and buy and sell derivative securities. Investors cannot withdraw or invest new funds on demand, but only at times specified by the hedge fund’s manager.

33. The first hedge fund was organized in 1949 by Alfred Winslow Jones. Its objective was to be “market-neutral,” that is, its returns would be hedged from overall movements in the stock market. It attempted to do this by buying (short-selling) stocks it thought were undervalued (overvalued). • Today, there are a great variety of investment strategies pursued by different hedge funds. However, most of these funds try to limit risk by hedging using derivatives or short sales. Some, but not all, attempt to be market-neutral. • A hedge fund’s manager typically receives an annual fee of 1% to 2% of the total invested funds. In addition, the manager receives a bonus incentive fee of 15% to 20 % of the annual profits earned by the hedge fund’s investors.

34. However, this annual incentive bonus is received by the manager only if the investor’s profits over the entire life of her investment exceeds a “high-water mark.” • A high-water mark is an absolute minimum level of performance that must be reached before any incentives are paid. It ensures that a manager does not receive incentive fees for the current year’s profits that merely recover losses in previous years. • Because a hedge fund manager’s compensation is based on absolute returns (rather than returns relative to a benchmark return which is common in pension fund management), hedge fund managers have an incentive to produce returns that are independent of overall market conditions.

35. Hedge fund strategies: • Market-neutral: low correlation with overall stock market. • Directional: a bet on anticipating a specific market movement (e.g. up or down). • Hedge fund’s security selection can be systematic (based on computer models) or discretionary (based on subjective personal decisions). • As of year-end 2003, there were about 5,000 hedge funds world-wide controlling total assets of around $700 B. • Similar to mutual fund conflicts, the SEC is investigating “capital introductions” in which a brokerage firm introduces wealthy investors to a hedge fund. The hedge fund receiving the new money compensates the broker by directing trading its way.