securities firms (i) (ch23) – bus322 1 securities firms mutual funds overview –mutual funds...

Securities Firms (I) (ch23) – BUS322 1

Securities Firms

• Mutual Funds Overview– Mutual Funds Basics– Performance Evaluations– Hedge Funds

• Underwriting

• Brokerage Service


Overview of Securities Firms’ Business

– Investment Banking Business

– Brokage Service

– Investment Funds—Mutual Funds—Hedge Funds


Mutual Fund Overview• Management/investment company

– e.g., Fidelity Management and Research Corporation, a subsidiary of Fidelity Investments

– Providing investment advice

• Mutual Funds independent directors– Have independent directors– Transfer agent (servicing existing fund shareholders)– Underwriter/distributor (selling funds)– Fund Managers

• Fund brokers• Fund custodians


Fund Types

• Open-end funds versus close-end funds Open-end Fund: shares can be redeemed at any time at a price

that is tied to the asset value of the fund (net asset value, abbreviated as NAV). When we talk about mutual fund, we usually refer to open end fund

Closed-end fund: a fixed number of nonredeemable shares are sold at an initial offering and then traded in OTC market like a common stock. Price of share could be different from NAV.

UIT

Exchange-traded funds.


Fund Types

• Based on investment objectives (way to create peer group)– Morningstar has 48 categories (Morningstar

StyleMap)– Lipper has 91 categories (Lipper Style box

classification)– Means to compare fund performance

—Is a fund necessarily good if it consistently outperforms S&P 500 for 5 years?


Mutual Fund Types

• Balanced Funds

• Bond Funds

• Value Funds – low P/E, P/B, M/B ratio

• Growth Funds – high growth, P/E, P/B, M/B

• Growth and Income Funds – high Div payout

• Index Funds – low fee, diversified

- exchange traded funds (ETFs)

• Money Market Mutual Funds – low risk, high liquidity

- T Rowe Price Associate


Fee Structure

No-Load Funds

funds without sales commissions/front-end charges

Load Funds

funds with sales commissions/front-end charges


Fees in addition to Front loadsBack-end load/Redemption fee/deferred load

– Contingent deferred sales charge (CDSC)

12b-1 fee– Covering distribution costs, advertising and marketing expense,

limited to 1% per year

Operating expense– Costs incurred in operating the portfolio, measured by expense

ratio (0.2-2%)—Management fee—12b-1 fees

Exchange feeAccount maintenance fee


Fund Classes• Funds from alternative classes have the same portfolio of securities but

impose different combination of fees. Investors select the best combination of fees

• Class A shares sold with front-end loads of 4%-5%, no 12b-1 fee• Class B shares impose 12b-1 charges and back-end loads• Class C shares don’t impose back-end redemption fees, but have 12b-1

fees higher than those in class B (1%)• Class D shares include front end loads and 12-1 charges of 0.25%• Class I shares: institutional shares (no front-end charge and low annual

operating expense)• Fee and loads contingent on scale of investment

– Breakpoint: Dollar levels of investment in a fund that qualify you for reduced sales charges.


Break Points

Class A shares have a front-end load 8.5% while decrease depending on the amount of money you initially invest– 0 – 9,999 8.5%

– 10,000 – 24,999 7.75%

– 25,000 - 49,999 6.25%

– 50,000 – 99,999 4.00%

– 100,000 – and up 0.00%


Disclosure RequirementFunds are registered with SEC, providing

Prospectus: (1) objective

(2) fees and expenses

(3) investment strategy and risk

(4) how to buy and sell

Shareholder Report

(1) fund performance

(2) fund financial statement

(3) required to report semiannually


Calculating Mutual Fund Return

Net Asset Value (NAV) Total value of the mutual fund’s stocks, bonds, cash,

and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding.

Return

0

01ReNAV

IncomesNAVNAVt


Fund NAV and Return

Stocks $35,000,000Bonds $15,000,000Cash $3,000,000

Total value of assets $53,000,000Liabilities -$800,000

Net worth $52,200,000Outstanding shares 15 millionNAV =


Now suppose value of stocks increases to $40 million, and that of bonds increases to 20 million, while other things being equal what is new NAV? What is return of the fund?

Stocks

Bonds

Cash

total value of assets

liabilities

net worth

shares


Performance measures

• Sharpe ratio:

• Treynor measure:

• Jensen measure:

p

fp rr

p

fp rr

)]([ fmf rrrrp


Hedge Funds1. Take advantage of unusual spreads between security prices

• Long undervalued securities, short overvalued securities• Market-neutral investment

2. Often highly leveraged – Using leverage to increase ROE

3. Strong managerial incentive– Fund managers receive 1% annual management fee, 14% annual profit when fund return exceeds “high water mark”

4. Relatively unregulated– Domestic hedge fund (fewer than 100 investors, limited partnership)– Offershore hedge funds (non-U.S. corporations), not subject to SEC regulations


Investment Banking

• Investment banks’ major responsibility is to assist in the initial sale of securities in the primary market, namely, underwriting stocks and bonds– Include both IPOs and seasoned offers

• Glass-Steagall Act separates commercial banking from investment banking


Underwriting Stocks and BondsGiving Advice

When to offer?At what price?

Filing DocumentsSECRegistration statementProspectus

UnderwritingSyndicate

Tombstones

Marketing OutcomesFully subscribed Undersubscribed

Oversubscribed Best Efforts


Ten Largest Underwriters in the U.S.


Other Investment Banking Service

• Private Placement

• Mergers and Acquisitions– Active in this market since 1960s– Serves both acquirers and target firms


Securities Brokers and DealersBrokerage Service

a. Securities Orders Market OrderLimit Order – buy with maximum acceptable

price and sell with minimum price short sell

b. Other ServicesMargin Credit

brokage-based cash management accountc. Full-Service Brokers – provide research and investment

adviced. Discount Brokers – execute trades on request

Securities DealersMarket Makers – increase market liquidity


Box 1: Using the Limit-Order Book

Unfiled Circuit City Limit Orders

__________________________________

Buy Orders Sell Orders

37 100

37.125 300

37.25 100

37.375 200

37.50 500

37.625 100

Any deal now?


Orders

1. 200-share market buy order

2. 300-share limit sell order at 37.125

3. 500-share limit buy order at 36.875

The order book is:


Short-selling – borrow shares

Joel shorts 200 shares of IBM stocks at $50/share. Later on the stock price goes to $40/share. How much profit/loss Joel has made in this transaction?


Buy-on-margin – borrow money

Amy bought 10,000 shares of IBM stocks at $50/shares with her margin account. The IBM price increases to $60 later. How much profits/losses Amy could make?