FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 3

Indirect Investing

Alternative to direct investment

Accomplishes essentially the same thing as direct investing

Refers to buying and selling the shares of intermediaries that hold security portfolios

Shares represent ownership in the security portfolio

Shareholders pay expenses and management fee

Investment Companies

Firms that sell shares and use the proceeds to invest in marketable securities

Act as a conduit for distribution of dividends, interest, and realized gains

Offer professional management

Regulated but not insured or guaranteed by any federal agency

Shareholders pay taxes as if they directly owned securities

Company Types 1

Unit Investment Trusts (U I Ts)

Typically hold an unmanaged, fixed-income portfolio

Relatively small share of market

Closed-End Investment Companies

Actively managed portfolio

Fixed number of shares

Trade on stock exchanges like other stocks

Company Types 2

Exchange Traded Funds (E T Fs)

Portfolio of assets that tracks a sector, region, or market

Trade like individual equities on exchange

Extremely low operating expenses

Typically unmanaged portfolios

Tax efficiency

Investor has greater control over realization of capital gains/losses than with a mutual fund

Company Types 3

Mutual Funds (Open-end Investment Cos.)

Investors buy fund shares from, and sell shares to, the investment company, not sold on exchanges

Number of shares outstanding changes constantly (unlike closed-end funds)

Offer diversification, divisibility, professional management, other services

Popular with investors, especially in retirement plans

Mutual Fund Categories 1

Money Market - hold money market securities

Equity:

Income (Value) - high yielding, low risk stocks

Growth - low yielding, high risk stocks

Small, Mid, Large-Cap

Bond - invest in fixed income securities

Balanced - hold a combination of bonds and stocks, generally low risk securities

Mutual Fund Categories 2

Index - track a market index such as the S&P 500

International - invest in foreign securities from various parts of the world

Other Miscellaneous -

Country, continent, or region of the world

Industry or sector

Tax exempt securities

Mutual Fund Categories 3

Money Market Funds (M M Fs)

Invest in money market securities

Taxable or tax-exempt

Investors pay a management fee, but no load

Not insured by the federal government

Attempt to keep price above $1/share

Offer broad diversification, great liquidity and a way to earn going money market rate

Index Funds

Mutual funds designed to match a market index

Unmanaged portfolio, typically with a low expense ratio

Expenses vary widely, though, so investors need to be sure expenses are reasonable

Often outperform actively managed mutual funds

Mutual Fund Charges

Front-end load - sales charge when purchased

Back-end load - fee incurred when shares sold

Operating expenses - costs incurred in managing the portfolio

12B-1 charges - costs incurred for advertising, fund reports, brokerage commissions etc.

No-load funds: no front- or back-end loads

Net Asset Value Per Share (N A V)

N A V is per share value of securities in a fund

N A V equals market value of securities, minus any liabilities, divided by shares outstanding

Changes daily and is calculated after markets close at 4 p.m.

N A V is price investors pay (receive) when a fund is purchased (sold)

This assumes the fund is a no-load fund

The Details of Indirect Investing 1

Closed-end funds

Market price often differs from N A V

Price may be less than N A V (discount) or more than N A V (premium)

Portfolio’s return calculated based on N A V

Shareholder’s return is based on fund price

Individual investors should avoid purchasing newly offered shares of closed-end funds

The Details of Indirect Investing 2

Mutual Funds

Investors can purchase directly or indirectly

Often require a small minimum investment

Investors can redeem shares anytime

Investors purchase/redeem at N A V ± sales fee

Fund’s prospectus discloses fees and expenses

Load funds charge a sales fee

No-load funds do not charge a sales fee

The Details of Indirect Investing 3

Mutual Fund Share Classes

Gives investors choice over fees

Each class has same claim on portfolio, same N A V

No-load funds

Purchased at N A V from investment company

No sales force expense to cover

Investors must seek out fund

Operating expenses paid from fund income

All funds charge an expense ratio

The Details of Indirect Investing 4

Exchange-Traded Funds (E T Fs)

Can be bought or sold any time during the trading day

Can be bought on margin or sold short

Have much lower expenses than actively managed funds

Can weight indexes differently, which can affect return

Exchange Traded Notes (E T Ns)

Exchange traded notes – a senior, unsecured debt security issued by a financial firm (G S, U B S etc.)

Linked to the performance of a benchmark (an index)

Objective is similar to E T Fs; provide exposure to an underlying asset

May not own the underlying asset

Fund Performance

Reported on a regular basis in popular press

Price performance not the same as total return

Total return includes price changes and dividend income

Costs and taxes should also be considered

Expenses may be the best indicator of a fund’s performance

International Funds

Some funds specialize in international securities

Often have higher costs

International funds differ from global funds

Single-country funds concentrate on one country

Some funds match foreign indexes

May or may not hedge against currency risk

The Future of Indirect Investing 1

Mutual fund “supermarkets”

Investors can buy/sell funds from various mutual fund families through a single source

Schwab and Fidelity are largest supermarkets

Offer fee and no-fee “aisles”

Management fee covers two levels of provider

The Future of Indirect Investing 2

Hedge Funds:

Relatively unregulated, pooled-investments

Invest primarily in publicly traded securities Employ combinations of long and short positions with alternative levels of leverage

Typical approach is to hedge general market conditions and focus on security selection

Returns accrue from long, short, and cash position

Hedge Funds

Common strategy is long/short strategy

Attempt to be market neutral

Broaden ability to capitalize on manager’s security selection skills

Higher unsystematic risk than long only funds

Unlimited loss on shorts

Reported performance is relatively good

Diversification potential

Major Types of Hedge Funds

Equity market neutral

Fixed-income arbitrage

Global macro

Hedged equity

Distressed securities

Merger arbitrage

Fund of funds

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