Accounting Fundamentals for Financial Institutions Midterm
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MutualandHedgeFunds.pptxAsset and Liability Management
Fin6102
Ferriter – Spring 2018
Overview
This chapter discusses mutual funds and hedge funds:
Activities of mutual funds
Size, structure, and composition
Balance sheets and recent trends
Regulation of mutual funds
Global issues
Activities of hedge funds
Regulation of hedge funds
Ch 5-2
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Mutual Funds
Diversification opportunities enhanced for small investors
Economies of scale
Predominantly open-ended funds
Ch 5-3
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Mutual Funds Continued
Rapid growth in funds during the 1990s
Slower rate of growth in the industry in early 2000s than in 1990s
Trading abuses and loss of confidence contributed to slowdown
20 percent drop in assets during 2008 financial crisis
Ch 5-4
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Mutual Funds Concluded
2015:
More than 7,600 stock and bond mutual companies
Total assets of $13.22 trillion
More than 8,100 firms and $15.94 trillion if money market mutual funds included
Ch 5-5
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Size, Structure, and Composition
First mutual fund: Boston, 1924
Slow industry growth, initially
Factors contributing to dramatic growth
Advent of money market mutual funds, 1972
Tax-exempt money market mutual funds, 1979
Special-purpose equity, bond, emerging market, and derivative funds
Ch 5-6
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Size, Structure, and Composition Continued
Total net assets in mutual funds:
1940: $0.5 billion
1990: $1,065.2 billion
2000: $6,964.6 billion
2007: $12,001.5 billion
2008: $9,603.6 billion
2009: $11,113.0 billion
2010: $11,831.9 billion
2012: $13,052.2 billion
2015: $15,944.6 billion
Ch 5-7
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Structure
Institutional funds
80 percent of retirement plan investments
Low costs
No additional distribution fees; bargaining power of retirement plan
Risk levels set by retirement plan sponsors
Low barriers to entry in US mutual fund industry
Allows new entrants to offer funds and compete for investors
Ch 5-8
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Size, Structure, and Composition Concluded
By asset size, mutual fund industry second most important FI group
Recent interest by commercial banks and insurance companies
Mellon purchase of Dreyfus
As of 2015, banks managed approximately 5% of mutual fund assets
State Farm (more than 9,000 agents)
As of 2015, insurance companies managed approximately 5% of mutual fund assets
Ch 5-9
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Ch 5-10
Assets of Major FIs: 1990, 2007, 2015
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Types of Mutual Funds
Types of long-term funds:
Bond funds, equity funds, hybrid funds
Volatility of long-term funds share:
74.3% of mutual fund assets, 1999
2002, long-term funds dropped to 62.1% of assets, losing ground to MMMFs
72.1% in 2007, 59.1% in 2008
68.1% in 2009, 77.4% in 2015
Ch 5-11
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Share of Long Term Funds
If MMMFs uninsured:
Higher returns
September 2008:
Risk aversion of investors changed
Run on Reserve Primary Fund (due to Lehman Brothers link)
Temporary extension of government insurance to MMMFs during the crisis
Ch 5-12
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Mutual Funds Continued
Money market mutual funds
25.7% of assets, 1999
37.9% of assets, 2002
27.9% in 2007, 40.9% in 2008
31.9% in 2009, 22.6% in 2015
As of 2015, 43 percent of US households owned mutual funds
Down from 52 percent in 2001
Ch 5-13
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Ch 5-14
Interest Rate Spread and Net New Cash Flow to MMMFs
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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
Investment grade bond
High-yield bond
World bond
Government bond
Ch 5-15
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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)
Ch 5-16
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Web Resources
For information on the performance of mutual funds, visit:
Morningstar www.morningstar.com
Ch 5-17
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Types of Funds
Open-end fund
Comparable to most corporate securities traded on stock exchanges
Closed-end investment companies
Fixed number of shares outstanding
Example: REITs
May trade at premium or discount
Exchange traded funds (ETFs)
Load versus no-load funds
Ch 5-18
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Types of Funds Continued
Ch 5-19
Exchange traded funds (ETFs)
Fixed number of shares outstanding
May be bought/sold through broker or in brokerage account
Registered with SEC as investment companies
Retail investor cannot purchase/redeem shares directly from the ETF
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Ch 5-20
Load versus No-Load: Share of Assets
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Mutual Fund Costs
Load versus no-load funds:
Sales loads
Generally, negative effect on performance outweighs benefits
Short term versus long term investment horizon 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
Creation of new rules by SEC
Sweeping decreases in fees, 2005 and 2006
Ch 5-21
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Balance Sheet and Trends
Money Market Funds (MMFs)
Key assets are short-term securities (consistent with deposit-like nature)
2015: $1,804.2 billion (86.8% of total assets)
2008: flight to safety, out of corporate and foreign bonds
Most consumer-oriented shares have values fixed at $1 and adjust number of shares owned by the investor
Significant liquidity risk highlighted during crisis
Ch 5-22
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Balance Sheet and Trends Continued
Long-term funds
Stocks comprised over 70.0 % of long-term mutual fund asset portfolios in 2007 versus 55.5% in 2008
Credit market instruments next most popular assets
Shift to other securities, such as credit market instruments, when equity markets are not performing as well
Ch 5-23
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Regulation of Mutual Funds
Heavily regulated due to management and investment of small investors’ savings
Primary regulator: SEC
Emphasis on full disclosure and anti-fraud measures to protect small investors
NASD supervises mutual fund share distributions
Ch 5-24
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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
Ch 5-25
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Further Regulatory Changes
Increase in requirements for disclosure
Enhanced transparency
Requirement for firms to have a chief compliance officer, 2004
Hard closing deadline of 4 PM eastern, intended to mitigate late trading abuses
Ch 5-26
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Compliance Officer
Reports directly to mutual fund directors, not executives of the fund
Responsible for reporting any wrongdoings
Policing personal trading of fund managers
Ensuring accuracy or reporting to regulators/investors
Reviewing fund business practices
Ch 5-27
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Legislation
Securities Act, 1933
Securities Exchange Act,1934
Investment Advisers Act, 1940
Investment Company Act, 1940
Insider Trading and Securities Fraud Enforcement Act,1988
Market Reform Act,1990
Allows SEC to halt trading by use of circuit breakers
Ch 5-28
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Legislation Continued
National Securities Markets Improvement Act,1996
Exempts mutual fund sellers from state securities regulatory oversight
Sarbanes-Oxley Act of 2002
Ch 5-29
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Global Issues
Worldwide growth in mutual fund investment curtailed by financial crisis
$4.545 trillion in 1999 to $14.130 trillion in 2007
Over 211% growth
Decrease to $9.316 trillion in 2008
Ch 5-30
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Global Issues
Greatest development in countries with most advanced securities markets
Japan, France, Germany, Australia, and UK
Efforts to reduce barriers for U.S. mutual fund sponsors
Europe, China and other Asian countries
Ch 5-31
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Hedge Funds
Not technically mutual funds
Exempt from a variety of regulatory constraints imposed on mutual funds for the protection of individuals
Prior to 2010, not subject to SEC regulation
Bernard L. Madoff Investment Securities, Bear Stearns High Grade Structured Credit Strategies Fund
Concern over systemic threats
High returns in 1990s
Ch 5-32
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Hedge Funds
Near collapse of Long-Term Capital Management (LTCM)
$3.6 billion bailout
Precipitated SEC scrutiny of hedge funds
Ch 5-33
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Types of Hedge Funds
More risky
Market directional
Moderate risk
Market neutral or value orientation
Risk avoidance
Market neutral; moderate, consistent returns with low risk as objectives
Associated fees
Management fees
Performance fees
Ch 5-34
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Offshore Hedge Funds
Major centers include Cayman Islands, Bermuda, Dublin, and Luxembourg
Rules:
Generally not burdensome
Anonymity
Tax advantages
Ch 5-35
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Regulation of Hedge Funds
Prior to 2010: Generally unregulated
Exemption for less than 100 investors
Exemption if accredited
Scandals:
Illegal trading with mutual funds
2007: UBS Securities, Morgan Stanley
2008: Bernard Madoff’s “Ponzi” scheme
2009: Galleon Group LLC
Resulted in heightened scrutiny
Ch 5-36
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Regulation of Hedge Funds Continued
2010 Wall Street Reform and Consumer Protection Act:
Register with SEC if assets > $100 million
States will oversee if assets < $100 million
Reports to SEC
Federal Reserve oversight if fund is too risky (or too large)
Ch 5-37
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Pertinent Websites
American Funds
Federal Reserve
Fidelity Investments
Investment Co. Institute
Morningstar, Inc.
NASD
SEC
Vanguard
Wall Street Journal
Ch 5-38
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