FINANCIAL ASSETS - Financial Institutions and Markets by Fabozzi

CHAPTER 1

INTRODUCTION

FINANCIAL ASSETS

An asset is any possession that has value in an exchange.  It can be tangible or intangible, the latter being a financial asset.  Specifically, a financial asset is a claim to a future benefit.  For example, in the case of an automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows. 

Debt versus Equity Instruments

A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim) obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid. Some securities combine both debt and equity features, such as preferred stock or convertible debt.

Price of a Financial Asset and Risk

The price (or value) of any financial asset is equal to the present value of expected cash flows.  The return on an asset is the amount paid to the investor relative to the price paid by him.  Related to return is the degree of risk, namely the certainty of expected cash flows.  The degree of risk ranges from very low -- as in the case of payments on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds.  Uncertainty or risk takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign exchange risk.

Financial Assets versus Tangible Assets

Both types of assets are expected to generate cash flows to their owners.  They are also linked in the sense that tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial buildings.  The use of the offices generates income that helps pay off the loan.

Role of Financial Assets

The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings).

FINANCIAL MARKETS

Financial markets where financial assets are exchanged.  Delivery of the actual asset may occur immediately (spot or cash market) or in the future (future or forward market).

Role of Financial Markets

Financial markets provide the following functions.

1.  Price discovery process.  Price is determined by supply and demand, the interaction of buyers and sellers.  The returns provide signals for funds allocations among investments;

2.  Liquidity.  Well-developed markets provide an opportunity to convert a financial asset into cash at close to real value of the asset;

3.  Reduced transactions costs. In the price discovery process, searching for counter parties and information costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally efficient market exists when prices reflect all information known by market participants.

Classification of Financial Markets

There are various ways to classify financial markets.

Maturity of claim. Money market for financial instruments a year or less to maturity.  Capital market for securities longer than a year.

Seasoning of claim. Primary market is for new or first issue market.  Secondary market involves sales of previously marketed claims.

Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or cash market) or later (futures or forward market).

Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.  In intermediated markets, financial institutions sell their own securities issues to customers and invest the proceeds.

Market Participants

Participants run the full range, from households, non-financial business firms, financial institutions, and public regulators.

GLOBALIZATION OF FINANCIAL MARKETS

The existence of foreign financial markets permits raising and investing funds outside of the domestic market.  There is a trend toward integration of financial markets throughout much of the world.  The factors that have led to integration are:

1.  Deregulation or liberalization of markets to encourage competition;

2.  Technological advances permit more information flows and rapid execution of orders;

3.  Increased participation of financial institutions in global markets relative to individuals.  Such firms are more willing and able to transfer funds to diversify their portfolios and to take advantage of possible mis-pricing in markets.

Classification of Global Financial Markets

Financial markets can be classified as either internal or external.

Internal:  securities issued in the domestic or foreign markets.  Foreigners can issue securities in other country markets, subject to national regulations, e.g., Japanese firms can issue dollar-denominated securities in the United States, but they must follow U.S. regulations, which apply to nationals and foreigners alike.

External:  securities issued outside jurisdiction of any country, e.g., offshore or Eurodollar offerings can be dollar-denominated.  They thereby fall outside of foreign rules, which are designed to deal with domestic financial concerns. The external market is sometimes called the offshore market or Euromarket.

Motivation for Foreign and Eurodollar Markets

Some funds needs cannot be met in small country markets, e.g. giant firm Philips cannot raise all the funds it needs if it is restricted to the Dutch capital market.  Also, many underdeveloped nations simply do not have a sizeable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations as would be the case in the U.S. market.

DERIVATIVE MARKETS

A derivative instrument is a financial asset whose value derives from the value of some other asset, index, or interest rate. A futures transaction is a contract that exchanges an asset or commodity at a fixed price in the future. In an option, owner has right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. In a swap, parties exchange one form of cashflow for another, typically a fixed cashflow for a variable one.

Role of Derivative Instruments

Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2)  lower transactions costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash market.

ROLE OF THE GOVERNMENT IN FINANCIAL MARKETS

Justification for Regulation

The government plays a significant role in the financial markets. It regulates the financial markets. One justification for regulation is market failure, when the market’s pricing mechanism is incapable of maintaining all the requirements of a competitive, efficient market. Regulation has several purposes: (1) to prevent issuers of securities from defrauding investors; (2) to promote competition and fairness in trading; (3) to promote the stability of financial institutions; (4) to restrict the activities of foreign concerns in domestic markets and institutions; (5) to control the level of economic activity.

Disclosure regulation is the form of regulation that requires issuers of securities to make public a large amount of financial information to investors. This addresses the problem of asymmetric information and the problem of agency.

Financial activity regulation consists of rules on trading financial assets.

Regulation of financial institutions is that form of governmental monitoring that restricts these institutions’ activities in the vital areas of lending, borrowing and funding.

Regulation of foreign participants is that form of governmental activity that limits the roles foreign forms can have in domestic markets and their ownership or control of financial institutions. Authorities use banking and monetary regulation to try to control changes in a country’s money supply.

Regulation in the United States

Regulation in the United States is largely due to the stock market crash of 1929 and the Great Depression of the 1930s.

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines.  A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows.  The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal.  The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income.  He can receive funds only after other claimants are satisfied.  Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons.  These include accounting measures, possibility of default of the issuer, and embedded options in the security.  Interest payments can also change over time.  There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows.  These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds.  Funds providers share the risks of expected cash flows generated by tangible assets.

7.  In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a.      They make it possible for corporations and governmental units to raise capital.

b.      They help to allocate capital toward productive uses.

c.       They provide an opportunity for people to increase their savings by investing in them.

d.      They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.

e.       They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1.      “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2.      “they help to allocate capital toward productive uses” -- function 3;

3.      “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4.      “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5.      “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

8. Explain the difference between each of the following:

a.      money market and capital market

b.      primary market and secondary market

c.       domestic market and foreign market

d.      national market and Euromarket

a.       The money market is a financial market of short-term instruments having a maturity of one year or less.  The capital markets contain debt and equity instruments with more than one year to maturity;

b.      The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c.       The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded.  Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d.      In a national market securities are traded in only one country and are subject to the rules of that country.  In the Euromarket, securities are issued outside of the jurisdiction of any single country.  For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a.      General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b.      The U.S. Treasury issues a security with 10 years to maturity.

c.       Microsoft Corporation issues common stock.

d.      The State of Alaska issues a financial instrument with eight months to maturity.

a.       GMAC issue trades in the money market.

b.      U.S. security trades in the capital market.

c.       Microsoft stock trades in the capital market.

d.      State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement.  Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true.  There is no default (credit) risk of U.S. government securities.  However, it is not free of purchasing power or inflation risk.  There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14.       14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons.  These include:

a.       Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b.      Technological innovations to provide globally-available information and to speed transactions;

c.       Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a.       The two basic types of derivative instruments are futures and options contracts.  They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b.      The statement implies that derivative instruments can be used only for speculative purposes.  Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets. 

Financial Institution - Chapter No. 8 - INVESTMENT COMPANIES AND EXCHANGE TRADED FUNDS

CHAPTER 8

INVESTMENT COMPANIES

AND EXCHANGE-TRADED FUNDS

TYPE OF INVESTMENT COMPANIES

Open-End Funds (Mutual Funds)

More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem shares at a price based on net asset value, which is total asset value less liabilities. Prices are quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. The net asset value (NAV) per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors.

There are several important characteristics of open-end or mutual fund. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager actively manages the portfolio. Third, the share price is the NAV. Fourth, the NAV is determined only once each day, at the close of the day.

In the case of a load fund the offer price will exceed the bid price by the amount of a sales commission charged upon purchases of shares. Some funds have back-end loads, wherein commissions are charged upon redemption of funds within a few years. Others, known as Section 12b-1 funds, charge a small percentage of assets annually to cover sales costs. In any case, all funds earn small percentage annual fees to cover administrative costs. These funds comprise the third largest group of financial institutions, behind banks and insurance companies.

Closed-End Funds

These funds issue a limited number of shares and are very similar to shares of common stock. They are then sold on the open market like other securities. Investors pay a broker’s commission. The NAV of closed-ended funds is determined by supply and demand. The market price of these shares may thus differ from net asset value, often at a discount from it. The discount results from large tax liabilities on capital gains that swell the net asset value, while investors are pricing future after-tax distributions. Premiums can result because such funds often have inexpensive access to overseas stocks.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They make an IPO, and then their shares are traded on the secondary market, just like any corporate stock.

The relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and closed-end funds. ETFs are essentially hybrid closed-end vehicles, which trade on exchanges but typically trade very close to NAV.

Unit Trusts

 A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. They are different from closed-end funds in the following. First, they typically invest in bonds. Second, they do not trade. Third, a fixed amount of securities is assembled with a defined termination date. The major benefit of such funds is lower operating costs due to the absence of trading.

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

There are two types of costs borne by investors in mutual funds. The first is shareholders fee, usually called the sales charge. This type of charge is related to the way the fund is sold and distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund's expenses. The largest of which is for investing managements. Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. The sum of annual management fee, the annual distribution fee and other expenses is called the expense ratio.

Sales Charge

Sales charges on mutual funds are related to their method of distribution. The two types of distribution were sales force and direct. Sales force occurs via an intermediary agent. Direct distribution takes place without an intermediary. Funds with no sales charges are called no-load mutual funds. Some have speculated that load funds would eventually disappear, but the trend has gone the other way. Among the recent adaptations of the sales load are back-end loads.

Annual Operating Expenses (Expense Ratio)

The operating expense, also called the expense ratio, is debited annually from the investor’s fund balance by the fund sponsor. Operating expenses are deducted from NAV and therefore reduce the reported return. The management fee, also called the investment advisory fee, is the fee charged by the investment advisor for managing a fund’s portfolio. In 1980, the SEC approved the imposition of a fixed annual fee, called the 12b-1 fee, which intended to cover distribution costs. Such 12b-1 fees are now imposed by many mutual funds.

Multiple Share Classes

Share classes were first offered in 1989 following the SEC’s approval of multiple share class. Initially share classes were used primarily by sales-force funds to offer alternatives to front-end load as a means of compensating brokers. Later, some of the funds used additional share classes as a means of offering the same fund or portfolio through alternative distribution channels in which some fund expenses varied by channel.

ECONOMIC MOTIVATIONS FOR FUNDS

An investment company is a financial intermediary because it pools the funds of market participants and uses those funds to buy a portfolio of securities. They provide at least one of the following six economic functions: (1) risk reduction via diversification, (2) lower costs of contracting and processing information, (3) professional portfolio management, (4) liquidity, (5) variety, (6) payments mechanism.  

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

Investment funds tend to have a variety of investment objectives. In general, there are stock funds, bond funds, money market funds and others. They seek to accommodate a wide range of desires and needs, among them income, capital gains, growth, and income. Some funds specialize by securities, examples of which are indexed funds, government bond funds, municipal bond funds, corporate bond funds, money market mutual funds, and balanced funds--combination of bonds and stocks.

CONCEPT OF FAMILY OF FUNDS

Now many management companies offer investors a choice of numerous funds. Some firms provide a choice of funds and objectives. Changing from one to the other to reflect changing needs can then be accomplished at low or no cost to the investor. The funds in a family usually include choices ranging from money market funds to global funds, and funds devoted to particular industries such as medical technology or gold mining companies. Concentration in the mutual funds industry continues to increase.

INVESTMENT VEHICLES FOR MUTUAL FUNDS

Mutual funds may be included in different investment vehicles. An investment vehicle can be a non-qualified vehicle because it does not quality for tax advantages. The same fund can also be included in a retirement plan such as 401(k), Roth 401(k), IRA or Roth IRA. These retirement plans are called qualified plans.

MUTUAL FUND COSTS

From 1980 to 2006, the measure of mutual fund costs declined from 2.32% to 1.07% for stock funds and from 2.05% to 0.84% for bond funds. There were three reasons for this decline. First, loads in general declined. Second, no-load mutual funds grew. Third, mutual fund expenses have also declined due to economies of scale and intense competition.

TAXATION OF MUTUAL FUNDS

Mutual funds must distribute at least 90% of their net investments income earned, exclusive of realized capital gains or losses to shareholders to be considered a regulated investment company (RIC) and, thus not be required to pay taxes at the fund level prior to distribution to shareholders. Consequently, funds make these distributions. Capital gains distributions must occur annually, and typically occur late during the calendar year. New investors in the fund may assume a tax liability even though they have no gains. The investors must also pay ordinary income taxes on distribution of income.

REGULATION OF FUNDS

All investment companies are regulated under the Investment Company Act of 1940. They must register with the SEC and file periodic reports. No taxes are levied on funds, which distribute 90% of their income. There are minimum diversification and liquidity requirements as well as maximum fees that can be applied. Currently under consideration is a proposal allowing less redemption over a quarter, thus permitting funds to hold smaller proportions of liquid assets.

Among the recent SEC priorities, which directly affect mutual funds, are:

1.           Reporting after taxes.

2.           More complete reporting fee.

3.           More accurate and consistent reporting of investment performance.

4.           Requiring fund investment practices to be more consistent with the name of a fund to more accurately reflect their investment objectives.

5.           Disclosing portfolio practices such as "window dressing".

6.           Various rules to increase the effectiveness of independent fund boards.  

STRUCTURE OF A FUND

A mutual fund organization is structured as follows: (1) board of directors, (2) mutual fund, (3) investment advisor, (4) distributor, (5) other service providers. The role of the board of directors is to represent the fund shareholders. External advisers are called subadvisers, and they are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

Distribution Channels

Traditionally, funds were sold direct or through a sales force. However, funds have moved increasingly to nontraditional sources of sales.

Supermarkets: The organizer of a supermarket, like Charles Schwab, offers funds from a number of different mutual fund families.

Wrap programs: Wrap accounts are managed accounts, typically mutual funds or ETFs, wrapped in a service package. The service provided is often asset allocation counsel, i.e., advice on the mix of managed funds or ETFs.

Fee-based financial advisors: Fee-based financial advisors are independent financial planners who charge a fee rather than a transaction charge for investment services. These fees are typically a percentage of assets under management or alternatively an hourly fee or a fixed retainer.

Variable annuities: Variable annuities represent another distribution channel.

Changes in the Costs of Purchasing Mutual Funds

The purchase cost of mutual funds has declined significantly. In general, load funds responded to the competition of no-load funds by lowering distribution cost.

Mix and Match

The investors’ demands for choice and convenience, and also the distributors’ need to appear objective, have motivated essentially all institutional users of funds and distribution organizations to offer funds from other fund families in addition to their own.

Domestic Acquisitions in the US Funds Market

There merger and acquisition business in the US asset management business has been active. The US asset management business continues to grow and consolidate across the various types of asset management firms.

Internationalization of the US Funds Business

The combination of a US fund company and international asset manager could occur in either two directions, i.e., with either being the acquirer. But the dominant direction has been the acquisition of US funds by international institutions.

EXCHANGE TRADED FUNDS

While mutual funds have become very popular with investors, they are often criticized for two reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day (closing) price. The second relates’ to taxes and the investors’ control over taxes. Withdrawals by some shareholders may cause taxable realized capital gain for shareholders who maintain their positions.

Closed-end funds trade all during the day on stock exchange, but there is often a difference between the NAV and the price of the closed-end funds. Both mutual funds and closed-end funds are similar in that they are instruments based on the portfolio of their securities, but closed-end funds are transacted continuously throughout the day.

An investment that embodies a combination of the desirable aspects of mutual funds (open-end funds) and closed-end funds is the exchange-traded fund (ETF). These are mostly index funds. They are traded on an exchange, and they are like open-end funds in that the number of shares can change.

ETC Creation/Redemption Process

For ETCs, individuals do not deal directly with the provider of the ETF. That privilege is reserved for a few very large investors called authorized participants (AP) who are arbitragers. Authorized participants are mainly large institutional traders who have contractual agreements with ETF funds. They are the only investors who may create or redeem shares of an ETF with the ETF sponsor and then only in large specified quantities called creation/redemption units. These unit sizes range from approximately 50,000 to 100,000 ETF shares.

ETF Sponsors

Like mutual funds, ETFs require a company to sponsor them. The ETF sponsor must (1) develop the index, (2) retain the authorized participants, (3) provide seed capital to initiate the ETF, (4) advertise and market the ETF, (5) engage in other activities.

Mutual Funds versus ETFs: Their Relative Advantages

The following are ETF advantages. Mutual funds are priced only once a day. But ETFs are traded on an exchange and so there is continuous pricing. Both passive mutual funds and ETFs have low fees, but ETF fees tend to be somewhat lower. All ETFs trade on an exchange and incur commission. As to taxes, mutual funds may lead to capital gains taxes for investors who do not even liquidate their fund. Because of the unique structure of ETFs, ETFs can fund redemptions by in-kind transfers without selling their holdings, which have no tax consequences.

Mutual funds have the following advantages. While ETFs have been exclusively passive or indexes, mutual fund families offer many types of active funds as well as passive funds. Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or commissions.

Separately Managed Accounts

Many high net worth people object to mutual funds because (1) lack of control over taxes, (2) lack of any input into investment decision, (3) absence of services. The use of separately managed accounts responds to all these limitations of mutual funds.

ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding.

1. What is its NAV?
2. Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive?

a.       Net asset value = (Total assets minus liabilities) / numbers of shares

                                = 1,050,000 – 50,000 = $100

                                             10,000

b.      Net asset value = 2,100,000 – 0 = $210

10,000

No of shares = 5000 = 23.81 shares.

                                210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.” Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

     

4. Why do some closed-end funds use leverage to raise more funds rather than issue new shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus many funds become leveraged to raise more funds without issuing new (additional) shares.       

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV.

6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a specified number of years and then liquidated. The charges are low since there is no trading of securities or redemption prior to maturity.

7.

1. Describe the following: front-end load, back-end load, level load, 12b-l fee, management fee.
2. Is there a limit on the fees that a mutual fund may charge?

a.       Back-end load funds charge sales fees upon redemption within a period of a       few years. Front end is commissioned charged up front of the time of sale. A level load is amount of sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual sales fee of around 1.5% annually.

b.      Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors and their risk preferences. It permits the distributor and its client to select the type of load they prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns.

10.

1. What is meant by a target-date fund?
2. What is the motivation for the creation of such a fund?

a.       Target date funds are mutual funds that base their asset allocations on a specific date, the assumed retirement date for the investor, and then rebalance to a more conservative allocation as that date approaches.  

b.      These funds are designed to be “one-size-fits-all” portfolios for investors with a given number of years to retirement.  

11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees, selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the sales charge. This type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.  

15.

1. How can a fund qualify as a regulated investment company?
2. What is the benefit in gaming this status?

a.       A regulated investment company must provide information on its fees and its objectives. It must file financial reports and indicate amount of income distributed.

b.      A regulated investment company is exempt from taxation on all its ordinary and capital gains income as long as at least 90% of these funds are distributed to the stockholders. Such distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade like a stock on an exchange. The price is determined continuously rather than the closing price e.g. QQQ.

17. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds:

1. supermarket
2. wrap program
3. segregated managed accounts
4. family of funds

a.       Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company.

b.      Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package. The service provided is often asset allocation counsel; that is advice on the mix of managed funds.

c.       Segregated managed accounts: are in response to individuals who object to mutual funds because of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts.

d.      Family of funds: In the U.S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.