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Understanding Mutual Funds & Hedge Funds: Overview, Regulation, Growth Trends

Explore the activities, size, and regulation of mutual funds & hedge funds. Learn about their growth trends, market structure, and balance sheets. Discover key types of funds, costs, returns, and regulatory changes in the industry.

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Understanding Mutual Funds & Hedge Funds: Overview, Regulation, Growth Trends

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  1. 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

  2. Mutual Funds • Diversification opportunities enhanced for small investors • Economies of scale • Predominantly open-ended funds

  3. 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

  4. 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

  5. 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

  6. 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.

  7. 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

  8. Number of Mutual Funds

  9. Interest Rate Spread and Net New Cash Flow to MMMFs

  10. 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

  11. 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).

  12. Web Resources • For information on the performance of mutual funds, visit: Morningstar www.morningstar.com

  13. 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.

  14. 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

  15. 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.

  16. 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.

  17. 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.

  18. 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

  19. 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

  20. 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

  21. 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

  22. Hedge Funds • Near collapse of Long-Term Capital Management • $3.6 billion bailout • Precipitated SEC scrutiny of hedge funds

  23. 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

  24. Offshore Hedge Funds • Major centers include Cayman Islands, Bermuda, Dublin, Luxembourg. • Rules • Generally not burdensome • Anonymity • Tax advantages

  25. 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

  26. 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

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