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Chapter 5 Mutual Funds, Hedge Funds, and Pension Funds.docx

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Department
Finance
Course
FIN 701
Professor
Patricia Mc Graw
Semester
Fall

Description
FIN701 Financial Institutions Management CHAPTER 5 Mutual Funds, Hedge Funds, and Pension Funds  Fund – FI whose primary purpose is to acquire and manage financial assets (e.g., bonds, shares, money market securities) or its owners o Mutual fund – FI that pools financial resources of individuals and companies and invests in diversified portfolios of assets, targeting a specific level of risk o Hedge fund – FI that pools financial resources of sophisticated investors and invests in a diversified pool of assets, usually high risk o Pension fund – FI that pools retirement savings of individuals, invests in diversified portfolio of assets, and pays an income to its owners after retirement  Funds provide opportunity for small savers to invest in financial securities, diversify risk, and generate greater economies of scale by incurring lower transaction costs and commissions  Growth in savings, from employee benefits (pension fund, firm-operated or government operated) or through individual efforts (RRSP and RESP), created FIs whose liability side is all OE  Provides wealth management services and are subject to interest rate risk, market risk, foreign exchange risk, and off- balance-sheet risk MUTUAL FUNDS  Open-end mutual fund stands ready to sell new shares to investors and to redeem outstanding shares on demand at their fair market value  Legally required to provide investors with prospectus that outlines fund’s investment strategy and its costs  2008: more than 2000 different mutual companies held total assets of $507b Size, Structure, and Composition of the Industry Historical Trends  1998-2008: average of 85% of assets under management with number of mutual funds increased from 1130 to 2015 and accounts increases from 32.8m to over 50m  Comparison of net sales over the years may be misleading due changes in the markets (e.g., limits on foreign content in RRSPs)  Clone fund – mutual fund that is RRSP-eligible and that creates returns equivalent to a foreign stock portfolio using derivatives  Funds of funds – mutual funds that invest in other mutual funds  Regulated at provincial/territorial level to protect investors by ensuring disclosure of information and market transparency o Majority of Canadian mutual funds regulated by Ontario Securities Commission (OSC) and harmonizes regulations through the Canadian Securities Administrators (CSA)  Top 15 mutual funds represents 93% of the $470b mutual fund assets reported; Big Six banks represent 47% of net mutual fund assets of $237b Different Types of Mutual Funds  Long term funds include: o Bond funds – funds that contain fixed income capital market debt securities with maturity over one year o Equity funds – fund that contain primarily common stock securities o Balanced funds – funds that contain bonds and stock (common and preferred) securities  Short-term funds include: o Money market mutual funds that are invested in short term paper, usually with maturities of less than six months  Long-term funds dominate, with short-term money market funds making up only 14% of total assets Investor Returns from Mutual Fund Ownership  Return from investing in mutual fund shares reflects three aspects of the underlying portfolio of mutual fund assets i. Income and dividends are earned on those assets ii. Capital gains occur when assets are sold by mutual fund at prices higher than the purchase price iii. Capital appreciation in underlying values of the assets held in fund’s portfolio add to the value of mutual fund shares  Marketed-to-market – adjusting asset and balance sheet value to reflect current market price o Net asset value (NAV) or net asset value per share (NAVPS) - net asset value of mutual fund is equal to the market value of the assets in mutual fund portfolio divided by number of shares outstanding FIN701 Financial Institutions Management  It is the price investors get when selling back shares to the fund that day or buying any new shares in the fund that day  Open-end – supply of shares in fund is not fixed but can increase or decrease daily with purchases and redemptions of shares; has fixed number of outstanding shares at any given time  Closed-end investment companies – specialized investment companies that invest in securities and assets of other firms but have a fixed supply of shares outstanding themselves o Income trusts – income fund/trust set up to own assets whose earnings (income) are passed on to the unit holders monthly or quarterly and taxed on hand o Real estate investment trusts (REITs) –specialize in investment in real estate company shares and/or buying mortgages  Since number of shares available for purchase is fixed, NAV determined by value of underlying share and demand for investment company share Mutual Fund Costs Load versus No-Load Funds  Load fund – mutual fund with an up-front sales or commission charge that has to be paid by investor o Provides more personal attention and advice  No-load fund – mutual fund that does not change up-front fees or commission changes on sale of mutual fund shares to investors Fund Operating Expenses  Annual fees charged to cover all fund-level expenses experienced as a percentage of fund assets  Management fee – amount paid to an investment manager for operating a mutual fund, such as administration and shareholder services, excluding brokerage fees  Mutual funds require small percentage (or fee) of investable funds to meet fund-level marketing and distribution costs  Management expense ratio (MER) – ratio of all operating costs expressed as a percentage of its total average assets o MER increases by inclusion of trailer fee (also called trailer commission), which is an amount paid monthly or quarterly to investment advisor (person who sells the fund to the investor) as long as the investor owns the fund o Fees may amount to 0.5% per year of amount of assets owned by investor Regulation  Mutual funds are members of self-regulating organizations (SROs) such as Investment Industry Association of Canada and Mutual Fund Dealers Association of Canada (MFDA)  Securities and Exchange Commission (SEC) investigates violations of mutual fund o Market timing – excessive buying and selling of securities to take advantage of opportunities between different markets  Common in international funds since traders can exploit differences in time zones o Late trading (called backward pricing) – illegally buying or selling securities submitted after closing time at that day`s price o Brokerage fees – fees paid to brokerage firms for promoting a stock or mutual fund GLOBAL ISSUES  Worldwide investments in mutual funds have increased over 120% from $11.65t (2001) to $26.1t (2007), but declined to $18.97t (2008)  Mutual fund industry has worked to lower barriers that prevent mutual fund firms from marketing their services more widely and to improve competition in the often diverse fund markets around the world HEDGE FUNDS History, Size, Structure, and Composition of the Industry  Not subject to regulatory oversight globally because of small number of investors permitted in each fund and the fact that investors are viewed as being sophisticated so they do not need protection o Sold without a prospectus and does not require published financial statements  191 Canadian hedge funds with assets of $26.6b; $14.1b represents Canadian-sponsored assets  Global hedge fund peaked $1.93t in mid-2008 and by the end of 2008, reached $525b due to losses and withdrawals  Uses aggressive strategy unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading  Non-directional strategy – arbitrage position that allows hedge fund to benefit whether market prices go up or down FIN701 Financial Institutions Management  Event driven strategy – hedge designed to take advantage of potential occurrence in market such as purchase of shares of a merger target or an investment in distressed debt  Opportunistic strategy – hedge designed to take advantage of temporary pricing discrepancies in markets Types of Hedge Funds  Hedge fund managers follow variety of investment strategies and are s
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