FIN 3050

9 Mutual Find Categories - Classification by Investment Objective

Market Cap 1. Large 2. Medium 3. Small Style 1. Growth 2. Blend 3. Value

Performance evaluation

is a term for assessing how well a money manager achieves a balance between high returns and acceptable risks.

Open End Mutual Fund

stands ready at all times to sell or buy back shares (Continually issue and redeem shares.)- # of shares outstanding fluctuates through time -trade at their NAV

Balance Fund

stocks and bonds

Treynor Ratio and Jensen's Alpha

-Appropriate for the evaluation of securities or portfolios for possible inclusion into an existing portfolio. -Both are similar, the only difference is that the Treynor ratio standardizes returns, including excess returns, relative to beta. -Both require a beta estimate (and betas from different sources can differ a lot).

Management Fees

-Based on size of fund (.25-1.0%)

Closed End Mutual Fund

-has a fixed number of shares -Purchasers and sellers of shares must trade with each other -Shares are bought from the fund at inception only -Fund does not stand ready to buy the shares back from investors -Closed-end funds trade in securities markets at a discount or premium from Net Asset Value (NAV)- bought and sold in the stock market

No load fund

-no sales commission; buy directly from the mutual fund company, sold at NAV

4 Basic Types of Mutual Funds Fees and Expenses

1. 12-b 1 Fees 2. Management Fees 3. Expense Ratio 4. Trading Costs (Turnover Ratio)

What are David & Tom Gardner's criteria for investing in small cap stocks?

1. Rising demand for their products 2. Great business models 3. Firm financial foundations 4. Forthright managers who hold a significant ownership stake in their business 5. High and rising rates of return on equity 6. Stock prices trading at low multiples to owners earnings 7. Little analyst coverage 8. Scant institutional ownership

What asset allocation of your investable assets is suggested for small-cap stocks?

10-40%

Net Asset Value (NAV)

=(Total Value of Securites-Liabilties)/(Shares Outstanding) -NAV is computed at the end of each day for a fund -75-80% of closed-end funds trade at 10-15% below actual value

What is a common weakness of Jensen's alpha and the Treynor Ratio?

A common weakness of both the Jensen alpha and the Treynor ratio is that both require an estimate of beta, which can differ a lot depending on the source, which in turn can lead to a mismeasurement of risk adjusted return.

What are one advantage and one disadvantage of the Sharpe Ratio?

An advantage of the Sharpe ratio is that a beta estimate is not required; however, the Sharpe ratio is not appropriate when evaluating individual stocks because it uses total risk rather than systematic.

What is an efficient portfolio?

An efficient portfolio is one that has the highest return for its level of risk.

ETFs and index mutual funds hold similar underlying assets. Why might an investor prefer one over the other?

ETFs are very popular with active traders since they allow an investor to use margin to purchase the asset. They also provide the ability to short sell, and they are continuously priced. In contrast, mutual funds have only end-of-day pricing. For periodic investors who are investing small amounts, mutual funds may be a better choice since the commissions associated with investing in ETFs would be costly.

True or False: If two stocks have the same standard deviation of 45 percent, then any portfolio of the two stocks will also have a standard deviation of 45 percent.

False. Remember the principle of diversification—correlation matters. This statement is true, however, if the correlation between the two stocks is exactly +1.

Most sources report alpha and other metrics relative to a standard benchmark, such as the S&P 500. When might this method be an inappropriate comparison?

For sector funds or investments that only cover a portion of the market (e.g., value or growth), a more specific index may provide a better standard for judging performance.

Style:

Growth - rapidly rising sales and earnings Blend - both growth and value characteristics Value - undervalued company

Four Quadrants for Mutual Fund Investing: Suggested Allocation

Growth Stocks, International Stocks, Growth & Income Stocks, Aggressive Growth Stocks •What percent of your net income goes into 401(k) investing via mutual funds: 15% •Get rid of car loans and your home mortgage •By investing $100 per month from age 25 to 65, you will accumulate over $1 million. With no debt you can retire and live very well.

What is The Million Dollar Portfolio's nickname for small cap stocks?

Hidden Gems

If the returns on two stocks are highly correlated, what does this mean? If they have no correlation? If they are negatively correlated?

If the returns on two stocks are highly correlated, they have a strong tendency to move up and down together. If they have no correlation, there is no particular connection between the two. If they are negatively correlated, they tend to move in opposite directions.

An open-end mutual fund typically keeps a percentage, often around 5 percent, of its assets in cash or liquid money market assets. How does this affect the fund's return in a year in which the market increases in value? How about during a bad year? Closed-end funds do not typically hold cash. What is it about the structure of open-end and closed-end funds that would influence this difference?

In an up market, the cash balance will reduce the overall return since the fund is partly invested in assets with a lower return. In a down market, a cash balance should help reduce the negative returns from stocks or other instruments. An open-end fund typically keeps a cash balance to meet shareholder redemptions. A closed-end fund does not have shareholder redemptions so very little cash, if any, is kept in the portfolio.

Explain the relationship between Jensen's alpha and the security market line (SML) of the capital asset pricing model (CAPM).

Jensen's alpha is the difference between a stock's or a portfolio's actual return and that which is predicted by the CAPM. A positive alpha implies abnormal returns above the SML line (as drawn using the CAPM).

Are small companies more or less dependent on their managers?

More dependent

best-known mutual fund advisory service

Morningstar

Who actually owns a mutual fund? Who runs it?

Mutual funds are owned by fund shareholders. A fund is run by the fund manager, who is hired by the fund's directors. The fund's directors are elected by the shareholders.

Are small cap stocks closely followed by investment banks?

No

Over a 25 year investment horizon, how does the performance of small cap stocks compare to other asset classes?

Performed better than T-bills, Real Estate, and Stocks Performed better than Large-Cap (Professor French- more than double the return)

Over a 25-year investment horizon, which performed better small-cap growth or small-cap value?

Small-cap value performed better 14.9% Small-cap growth 9.9%

Appropriate Performance Benchmarks

Stock- S&P 500 Index Aggressive Growth- Value Line Composite Index Small Company Growth- Russell 2000 Index Medium Size Company- S&P 400 Index International Stock- EAFE Index Taxable Bond- Barclays Capital aggregate bond index

Is it true that the NAV of a money market fund never changes? How is this possible?

The NAV of a money market mutual fundis never supposedto change; it is supposed to stay at a constant $1. It never rises; only in very rare instances does it fall. Maintaining a constant NAV is possible by simply increasing the number of shares as needed such that the number of shares is always equal to the total dollar value of the fund.

Explain the difference between the Sharpe Ratio and the Treynor Ratio?

The Sharpe ratio is calculated as a portfolio's risk premium, or excess return, divided by the standard deviation of the portfolio's return. The Treynor ratio is the portfolio risk premium divided by the portfolio's beta coefficient.

Why should younger investors be willing to hold a larger amount of equity in their portfolios?

The common answer might be that over time volatility cancels out; however, this is incorrect and is an example of the time diversification fallacy. The more appropriate response is that younger investors have a greater ability to modify their work flow, time, etc. to offset the loss. Older investors are less able to withstand a large one-time loss.

True or False: If two stocks have the same expected return of 12 percent, then any portfolio of the two stocks will also have an expected return of 12 percent.

True. Remember, portfolio return is simply a weighted average of individual returns.

What advantage do you have as an individual investor over Warren Buffett

an ability to negotiate into the tiny, inefficient crevasses of the market (small caps), WB has too much money to make money

Class A shares

charge a fee or sales commission when you invest -front end

How does David & Tom Gardner define small cap?

companies valued between $200 million and $2 billion market capitalization

Back end load

fee charged upon redemption, CDSC

Front end load

fee charged when purchasing, expressed as a percentage of the offering price

Blend Fund

growth stocks and value stocks

Low load funds

have lower sales charges, approx. 2-3%.

What are the two greatest risks for small-cap investors?

pricing volatility and the threat of defaults

Mutual Fund Services

•Automatic reinvestment of dividends •Automatic investment programs •Check writing on money market funds •Exchange privileges in mutual fund families •Periodic statements on #shares owned and their worth

Fidelity Freedom Funds - Target Date Funds

•Fidelity Freedom Income Fund •Fidelity Freedom 2017 Fund •Fidelity Freedom 2020 Fund •Fidelity Freedom 2025 Fund •Fidelity Freedom 2030 Fund •Fidelity Freedom 2035 Fund •Fidelity Freedom 2040 Fund

Market Cap:

•Large - market value > $8.3 billion Medium- mkt value btwn. $1.2 biland $8.3 bil Small- market value < $1.2 billion

Diamonds

•Ticker symbol "DIA" - based on Dow Jones Industrial Average

Midcap Spiders

•Ticker symbol "MDY" - based on S&P 400 Midcap 400 Index

Look at the three-year performance for the funds list. Why do you suppose there are so few poor performers?

While the particular time period was a strong one, the bigger issue here is "survivorship" bias. Funds that accumulate a long record of poor performance tend to not attract investors. They are often simply merged into other funds. This is a type of survivor bias, meaning that a mutual fund family's typical long-term track record may look pretty good, but only because the poor performing funds did not survive. In fact, several hundred funds disappear each year.

Advantages of Investing in Mutual Funds

•Diversification •Professional management •Ease of buying and selling shares •Small amount of money often required to open a mutual fund account •Multiple withdrawal options •Distribution or reinvestment of income and capital gains •Switching privileges within the same fund family •Services that include toll-free telephone numbers, complete records of all transactions, money market accounts

Disadvantages of Investing in Mutual Funds

•Purchase/withdrawal costs •Ongoing management fees and 12b-1 fees •Poor performance that does not match the Standard & Poor's 500 Stock Index or some other index •Inability to control when capital gain distributions occur and complicated tax-reporting issues •Potential market risk associated with all investments •Some sales personnel are aggressive and/or unethical

Cubes

•Ticker symbol "QQQ" - based on NASDAQ 100 Index (large cap stocks of NASDAQ)

Spiders

•Ticker symbol "SPY" - based on S&P 500

Trading Costs (Turnover Ratio)

-How much trading a fund does; 1.0 means a fund sold off its entire portfolio and replaced it once -measures how much trading a mutual fund has done =(Lesser of total purchases or sales during the year)/(Average daily assets) -Higher turnover à greater capital gains distribution=pay more taxes -Higher turnover indicates more frequent trading and higher trading costs

ETF (exchange traded fund)

-Is basically an index fund. -Trades like a closed-end fund (without the discount phenomenon). -An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes. -NAV changes all day long, trades like a stock, mutual fund's NAV only change at the end of the day

12-b 1 Fees

-Pay for advertising and direct mailing costs (up to 1.25%), SEC Rule,

Other Performance Evaluation Measures

-R-Squared

Correlation

-Recall that correlation measures how returns for a particular security move relative to returns for another security. -Correlation also plays a key role in performance measurement.

Well-Known Performance Evaluation Measures

-The Sharpe Ratio -The TreynorRatio -Jensen's Alpha

Load Funds

-a fund which charges a commission for the sale of its shares. -Commission may be as high as 8.50% -The NAV is different from the offer price because the commission must be paid.

Class B shares

-back end load, deferred sales charge or surrender charge; If you stay invested in the fund for typically 5 years or more, you will not pay a back end load.

Sharpe ratio

-is a reward-to-risk ratio that focuses on total risk -It is computed as a portfolio's risk premium divided by the standard deviation of the portfolio's return -Appropriate for the evaluation of an entire portfolio. -Penalizes a portfolio for being undiversified, because, in general, total risk »systematic risk only for relatively well-diversified portfolios. -A risk-adjusted measure calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe Ratio, the better the fund's historical risk-adjusted performance. -=(Annualized mean of monthly returns-Average 90 day risk free rate)/(Annualized standard deviation of returns using monthly data) •*Annualized mean of monthly returns = Mean of monthly returns multiplied by 12. •*Average 90-day risk-free rate = Average 90-day risk-free rate of 12-month period. -higher the better

Treynor ratio

-is a reward-to-risk ratio that looks at systematic risk only -It is computed as a portfolio's risk premium divided by the portfolio's beta coefficient -Same as Sharpe, but divided by beta instead

Leveraged ETFs

-potentially dangerous -The fund managers of a leveraged ETF create a portfolio designed to provide a return that tracks the underlying index. -But, by also using derivative contracts, the managers can magnify, or leverage, the return on the underlying. -The Fund Manager can also use derivatives to generate returns opposite, or inverse, of the index return. -Leveraged funds are designed to have twice the return on an index, say the S&P 500. -In other words, if the S&P 500 return on a given day is one percent, the leveraged fund should provide a return of three percent. -Danger is that leverage works both ways:Losses are also magnified by 3

Jensen's Alpha

-the excess return above or below the security market line -It can be interpreted as a measure of by how much the portfolio "beat the market."

R-Squared

-the squared correlation of the fund to the market. -For example, if this fund's correlation with the market was .60, then the R-squared value is .36. -R-squared represents the percentage of the fund's movement that can be explained by movements in the market. -Because correlation ranges only from -1 to +1, R-squared values will range from 0 to 100 percent. -An R-squared of 100 indicates that all movements in the security are driven by the market, indicating a correlation of -1 or +1. -A high R-squared value (say greater than .80) might suggest that the performance measures (such as alpha) are more representative of potential longer term performance. 20% is driven by risk specific to the portfolio's individual holdings

How to Select a Mutual Fund

1. Look for no-load funds. Look for no 12b-1 fee. 2. Consider funds with low expense ratios 3. Low turnover ratios 4. Research the fund manager 5. Diversify 6. Consider index funds 7. Calculate how fees affect your returnwww.kiplinger.com/calc/calchome.html 8. Read the reviews 9. Evaluate performance 10. Dollar-cost average 11. Stay the course START NOW!!

What are 12b-1 fees intended to cover? Many closed-end mutual funds charge a 12b-1 fee. Does this make sense to you? Why or why not?

12b-1 feesare designed to pay for marketing and shareholder service costs. It does not really make sense that a closed-end fund charges 12b-1 fees because there is no need to market the fund once it has been sold at the IPO and there are no distributions necessary for the fund since the shares are sold on the secondary market.

What is the difference between a money market deposit account and a money market mutual fund? Which is riskier?

A money market deposit accountis essentially a bank savings account. A money market mutual fund is a true mutual fund. A bank deposit is insured by the FDIC, so it is safer, at least up to the maximum insured amount.

Given the no-load funds are widely available, why would a rational investor pay a front-end load? More generally, why don't fund investors always seek out funds with the lowest loads, management fees, and other fees?

A rational investor might pay a load because he or she desires a particular type of fund or fund manager for which a no-load alternative does not exist. (This is rarely the case.) More generally, some investors feel you get what you pay for and are willing to pay more. Whether they are correct or not is a matter of some debate, although research tends to support the relative outperformance of no-load funds (particular when controlling for fees). Other investors simply are not aware of the full range of alternatives, particularly if their advisors are recommending only load funds.

Assume you are a very risk-averse investor. Why might you still be willing to add an investment with high volatility to your portfolio?

An investment with high volatility could actually reduce the risk of the overall portfolio if its correlation to the existing assets is very low.

If you are building a small-cap portfolio, how many stocks should you own for diversification?

At least a dozen

Based on market history, what is the average annual standard deviation of return for a single, randomly chosen stock? What is the average annual standard deviation for an equally weighted portfolio of many stocks?

Based on market history, the average annual standard deviation of return for a single, randomly chosen stock is about 50 percent. The average annual standard deviation for an equally-weighted portfolio of many stocks is about 20 percent.

What is a cap rate? What cap rate are you looking for?

Capitalization rate- company's pre-tax earnings divided by its enterprise value looking -essentially a P/E that takes into account debt -looking for- exceeding 10%

Leveraged ETFs 2

Levered ETFs seem to track their underlying indexes on a short-term basis, i.e., day by day. Over longer periods of time, however, their performance is probably not what you would expect. -For example, trading in leveraged ETFs offered by Direxion Investments, a reputable firm, began in November2008. -The Bull 3X Fund (SPXL) was designed to earn three times the S&P 500 index return. -The Bear 3X Fund (SPXS) was designed to earn the opposite of three the S&P 500 Index return. Over the next two years, the S&P 500 index gained 33 percent. -Given its objective, the SPXL Fund should have gained 99 percent. -Over this two-year period, however, the SPXL gained only 50 percent.

Large-Cap Funds

On Slide Deck

What does David & Tom Gardner say the greatest wealth-generating action you can take is?

Owning Stocks

Global Investment Performance Standards (GIPS) from the CFA Institute Goal

Provide a consistent method to report portfolio performance to prospective (and current) clients -By standardizing the way portfolio performance is reported, GIPS provide investors with the ability to make comparisons across managers. -Firms are not required by law to comply with GIPS, compliance is voluntary. -Firms that do comply, however, are recognized by the CFA Institute.

Target Date Mutual Funds

Structured to protect investors by: -Reducing exposure to stocks -Increasing bond holdings as people get closer to retirement (or their "target year") Are the "default option" in many retirement plans, so investors may have their savings in target-date funds without actively choosing them. Can be good tools for investors who don't know where to start Vary in their asset allocations The fund doesn't know if you are a 62 year old retiree or an 85 year old

Target Date Mutual Funds Examples

Vanguard Group, Fidelity Investments, & T. Rowe Price Group do not charge a broader management fee & expense ratio. Other funds charge two sets of expenses Example -Vanguard Target Retirement 2020 (VTWNX) -Target date: 2016-2020 -Not all investors fit the average risk tolerance profile

Target Date Mutual Funds Performance

Watch out for performance. -The average 2015 target date fund returned 2% a year over the past 5 years -Most financial planning models assure annual returns of 6% Strategy to generate bigger returns -Choose a target-date fund with a later date and greater exposure to riskier assets

What is "the inefficient pond theory"?

When a big chunk of the market isn't even fishing in the pond where you're casting lines, you can find sound companies at ridiculously cheap prices -small-caps- inefficiency- not many ready buyers

How does a high-water mark constrain hedge fund managers from earning excess performance management fees?

With a high water mark, the fund manager must overcome any losses before performance fees can be taken. So, a "bad" return year is not ignored.

Are there many small cap stocks to choose from?

Yes, more than 5,000

If you were concerned about the liquidity of mutual fund shares that you held, would you rather hold shares in a closed-end fund or an open-end fund? Why?

You should probably buy an open-end fund because the fund stands ready to buy back shares at NAV. With a closed-end fund another buyer must make the purchase, so it may be more difficult to sell at NAV.

Expense Ratio

administrative costs, Vanguard is .19%

Functions of ETFs

•Track an index •Trade on Amex •Buy via broker or online •Very low management fees •Minimal stock turnover •Have outperformed actively managed mutual funds •No end-of-year capital gains distribution •For dollar-cost averaging approaches - buy index mutual funds instead