Capital markets, Part II

Prepared by Pamela Peterson Drake, Ph.D., CFA

I. Overview ...... 1 II. Direct investing ...... 1 A. Money securities ...... 3 B. securities ...... 5 C. Derivatives ...... 9 III. Indirect investing ...... 10 A. Investment companies ...... 10 B. Hedge funds ...... 15 IV. Further reading ...... 17 V. Index ...... 17

I. Overview An may invest directly in securities or indirectly. Direct investing involves the purchase of a . In this case, the investor controls the purchase and sale of each security in their portfolio. Indirect investing involves investing in vehicles that owned securities, such as mutual funds, closed- end funds, or exchange-traded funds. In this case, the investor does not control the composition of the fund’s investment; the investor only controls whether to buy or sell the shares of the fund. II. Direct investing We’ll introduce you to alternative investment vehicles in this module, but we will reinforce this descriptive material throughout the course as we examine current events in the markets. We can classify most direct securities into the following types:

1. securities e.g., Treasury bills, 2. Capital market securities e.g., Municipal bonds, corporate bonds, 3. Derivatives e.g., Options, futures

We provide a summary of the prevalence of the money and capital markets securities in Exhibit 1. As you can see in this exhibit, the mortgage and other asset backed securities made up approximately 24% of the market in 1995, whereas these securities make up over 31% of the market in 2005. During the same period, the prevalence of U.S. government issued securities declined from 29% to 16%.

Capital Markets II 1 Exhibit 1 Prevalence of securities in the U.S., 1995-2005, by type

Part A Total amounts outstanding

$30,000 $25,000 $20,000 Billions of $15,000 dollars $10,000 $5,000 $0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 U.S. Treasury securities Federal Municipal Mortgage-backed securities Asset-backed securities Money market instruments Corporate debt

Part B Percentage of amounts outstanding

100%

80%

Proportion 60% of securities 40% issued 20%

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 U.S. Treasury securities Federal agency debt Municipal Mortgage-backed securities Asset-backed securities Money market instruments Corporate debt Source: 2007 Statistical Abstract of the United States, U.S. Census Bureau

The yields on the different securities reflect the , risk, and other features of the security:

. Securities with more risk will have higher expected returns. In periods of economic slowdowns, the spread between the yields of securities with different risks widens. . In most economic environments, the curve is upward sloping; hence, longer-maturity securities have higher yields. In periods preceding a slow down, the may be flat or slope downward. . Securities with more seniority over other securities of the same issuer have lower expected rates of return.

You can see some of these characteristics on yields in Exhibit 2. You will notice that the spread between the yields on these instruments widens during recessionary environments.

Capital Markets II 2

Exhibit 2 Yields on different securities, 1998-2008

Corporate AAA Corporate BBB 10% Federal funds rate 90-day U.S. Treasury 6-month Certificates of deposit 30-year conventional mortgage 9% 8% 7% 6% Annualized yield 5% 4% 3% 2% 1%

0%

01 06

99 00 02 04 05 07

00 05

00 05

98 98 99 03 03 04 08 08

01 06

98 03 08

02 07

- -

------

- -

- -

------

- -

- - -

- -

Jul Jul

Apr Oct Apr Oct

Jan Jun Jan Jun Jan Jun

Feb Mar Feb Mar

Nov Dec Nov Dec Nov

Sep Aug Sep Aug

May May

Month

Source of data: FRED II, Federal Reserve of St. Louis

The yield curve A. Money market securities Money market securities are -term, highly- The yield curve is the relation between maturity and yield. The normal yield curve is one in which the liquid, low-risk debt of governments, , or securities with longer maturities are associated with corporations. These include: higher yields.

. U.S. Treasury bills (T-Bills) Yield . Negotiable certificates of deposit (CDs) . Commercial paper . Eurodollar deposits . Repurchase agreements Maturity . Bankers’ acceptances However, inverted yield curves do occur, such that i) U. S. Treasury bills shorter-term securities have higher yields.

A U. S. Treasury bill, or T-bill, is a short-term Yield obligation of the U.S. government. Many securities and lending arrangements use the rate on U.S. Treasury bills as a reference rate -- that is, a benchmark for quoting and analyzing rates.1 For Maturity example, if the rate on the U.S. T-Bill is 3.5% and the rate on a specific certificate of deposit (CD) is The inverted yield curve is often a pre-cursor of a 4.2%, we say that there is a spread of 70 basis recessionary economic period. points (bp). The spread is simply the difference

1 Another common reference rate is the London InterBank Offer Rate (LIBOR).

Capital Markets II 3 between the rate on the CD and the rate on the T-Bill, quoted in terms of basis points, where one basis point (bp) is 1% of 1% (or in other words, there are 100 bp in a 1% yield).

There are two different methods that are commonly used in quoting T-Bill rates, the discount yield basis and the investment yield basis. T-Bills are sold at a discount and do not pay , so what you earn on the T-Bill is the difference between what you paid and what you get at maturity. The discount yield basis is the conventional method for quoting T-Bill rates, but this method tends to understate the true yield: Face- Purchase value price 360 Discount =x yield Face value Maturity of bill in days

The investment yield basis is useful in comparing T-bill yields with those of other short-term securities: Face- Purchase value price 365 Investment=x yield Purchase price Maturity of bill in days

The two primary differences between these yields are that: Example: Yields on Treasuries

Problem 1. the denominator in the first term is different (face value for are discount Consider a 182-day Treasury bill that has a price of $9,835 per basis, purchase price for the $10,000 face value. investment yield), and 1. What is the discount yield? 2. the number of days used for 2. What is the investment yield? annualization (360 for the discount yield, 365 for the investment yield). Answer $10,000-$9,835 360 Discount=x Does it make a difference? It is important yield 1. $10,000 182 to be precise in all communications Discount=0.0165 x 1.97802 = 0.032637 or 3.2637% regarding pricing and yields, so it is yield important to understand the difference $10,000-$9,835 365 between these two methods of stating Investment=x yield yields. If you would like to compare the 2. $9,835 182 discount basis and investment yields, Investment=0.01678 x 2.0055 = 0.033646 or 3.3646% check out the recent rates for U.S. T-Bills yield at the Bureau of Public Debt web site, http://wwws.publicdebt.treas.gov/AI/OFBil ls. ii) Negotiated certificates of deposit A certificate of deposit (CD) is issued by a financial institution, indicating that a specified amount of funds have been deposited with the financial institution. A negotiated certificate of deposit (NCD) is a large-denominated certificate of deposit at a bank, which has a specific maturity date. The NCD is a highly liquid security, but the depositor or investor cannot cash it in before its maturity. Though the minimum amount of the NCD is $100,000, NCDs are typically $1 million or more. iii) Commercial paper Commercial paper notes have denominations (face values) starting at $25,000 each, although most have denominations of $100,000 or larger. Commercial paper is unsecured, so the lender (the party buying the commercial paper) is counting on the borrower being able to pay the face amount of the note

Capital Markets II 4 at maturity. Nevertheless, almost all commercial paper is backed by a line of from a bank. If commercial paper is backed and the borrower is unable to pay the lender at maturity, the bank stands ready (for a fee) to lend the borrower funds to pay off the maturing paper.

Most commercial paper issued in the U.S. has a maturity from 3 to 270 days. Though these maturities are relatively short, some firms tend to use commercial paper for financing over longer periods of time by rolling over the paper; that is, as the paper matures, they issue new commercial paper to pay off the maturing commercial paper.

The interest on commercial paper is generally stated as discount interest, though in recent years some commercial paper with single payment interest -- interest bearing -- has been issued. The interest is quoted on the basis of a 360-day year and is fixed for the maturity of the paper. iv) Eurodollar deposits Eurodollar deposits are deposits in U.S. dollars that deposited at bank branches outside of the United States. The popularity of Eurodollar deposits began in response of non-U.S. companies’ concerns over having their deposits in U.S. banks frozen. Eurodollar deposits were a way to have U.S. dollar- denominated deposits that were not within the regulation of the U.S. government or the Federal Reserve. Because these deposits do not reside in the U.S., the interest rates that paid on these deposits can surpass those of deposits in the U.S. v) Repurchase agreement A repurchase agreement (sometimes referred to as a "repo") has two parts: a sale of a marketable security and the subsequent repurchase of that same security from the purchaser. The agreement involves borrowing funds for a period shorter than the maturity of the marketable securities used in the agreement. Suppose you need funds for twenty days and you own U.S. Treasury Bills that mature in forty days. You can sell your T-Bills with a repurchase agreement, promising to buy them back within twenty days.

This is a secured since the T-bills are marketable securities; the T-bills are the collateral. If you fail to repurchase them the buyer takes ownership of them. The value of the collateral exceeds the cash paid in the initial sale -- the loan is over-collateralized -- this difference is referred to as the "". The cost of a repurchase agreement is the difference between what you sell the securities for and what you pay to buy them back. vi) Bankers acceptances A bankers' acceptance is a bank's commitment to pay someone else's promise to pay a specified amount at a specified date. With a bankers' acceptance, the bank is committing itself to make the specified payment at the maturity of the draft if the issuer of the draft does not pay. Bankers’ acceptances are typically used in international trade, though they may be used domestically as well. They generally have maturities less than 270 days.

Although there are a variety of ways a banker's acceptance are arranged, the basic idea behind all of them is that a letter of credit is transformed into a security that can be bought and sold in the .

B. Capital market securities i) -term debt Long-term debt securities consist of notes and bonds, which are legal obligations for the issuer to repay the borrowed funds. Notes and bonds are long-term debt securities issued by governments,

Capital Markets II 5 governmental agencies, municipalities, or corporations. Notes typically have maturities of two to ten years, whereas bonds typically have maturities of seven to thirty years – or more.

Debt securities are characterized by a face value (the amount due at maturity) and an (unless they are specifically a zero ). Debt instruments may have additional features; they may be convertible (that is, exchangeable into another security) or callable (that is, they may be bought back by the issuer). They also may be secured or unsecured. A secured bond is backed by specific collateral, whereas an unsecured bond (also known as a ) is backed by the general credit of the issuer.

U.S. Treasury bonds are debt of the federal government. These are interest-bearing securities that have maturities ranging from ten to thirty years. They are generally sold at face value and pay interest; some Treasury bonds are -indexed, such as Treasury Inflation Protected Securities (TIPS).

There are also government and government-sponsored agency securities. These agencies include:

. Government National Mortgage Association (GNMA, Ginnie Mae) . Federal National Mortgage Association (FNMA, Fannie Mae) – home mortgages . Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac) – home mortgages . Federal Home Loan Bank (FHLB) -- home mortgages . Farm Credit System (FCS) – farm credit . SLMA (Sallie Mae) – student

Municipal securities are bonds and notes sold by state, county, or city governments, or any other governmental body (e.g., airport authority). These securities are either general obligation bonds, which are backed by “full faith and credit” of the government, or revenue bonds, which are repaid with revenues generated by the financed project (e.g., municipal airport). Because municipal securities are often tax free with respect to federal taxation, must convert a municipal yield into an equivalent taxable yield in order to compare investments. The tax-equivalent yield (TEY) is calculated by taking the yield on the tax-free security and dividing it by 1 minus the marginal tax rate:,

Tax-exempt municipal yield Taxable equivalent yield = (1 - marginal tax rate) where the marginal tax rate is the investor’s tax rate on his/her next dollar of income.

Corporate notes and bonds are obligations of Examples of tax equivalent yields corporations, which most often have fixed Assuming a marginal tax rate of 35% ... maturity and have seniority with respect to claims on income and assets over any ownership Tax-exempt Taxable equivalent , such as common . municipal yield yield 10% 15.385%

5% 7.692% Another debt investment is the corporate note or 3% 4.615% bond. Corporate notes and bonds typically pay 4% 6.154% interest and may have conversion or call features. A is a bond that allows the investor to exchange it for another security, such as shares of stock of the company, at a predetermined rate. In other words, a convertible bond is a bond with an embedded : the investor has a put option, allowing the exchange of the bond for another security (typically stock). A is a bond in which the issuer has the option to buy the bond back from the investor at a predetermined price (the call price). The callable bond therefore has an : the issuer has the option to “call” (that is, buy) the bond back from the investor.

Capital Markets II 6 A bond rating reflects the credit quality of corporate bonds. These ratings reflect the characteristics of the issuer, as well as the characteristics of the issue (e.g., whether a bond is secured). There are three major rating services:

1. Moodys, 2. Standard & Poor’s, and 3. Fitch Ratings

We list the Standard & Poor’s bond ratings in Exhibit 4. Bonds in the top two classes are referred to as high-quality bonds. Bonds in the top four classes are referred to as investment grade debt. Bonds rated lower than in the top four classes are speculative debt, which is also referred to as high-yield debt, or junk bonds.

Exhibit 3 Standard & Poor’s bond ratings

Investment grade AAA Highest quality. Ability to pay interest and principal very strong. AA High quality. Ability to pay interest and principal strong. A Medium to high quality. Ability to pay interest and principal, but more susceptible to changes in circumstances and the economy. BBB Medium quality. Adequate ability to pay, but highly susceptible to adverse circumstances.

Speculative grade BB Speculative. Less near-term likelihood of default relative to other speculative issues. B Current capacity to pay interest and principal, but highly susceptible to changes in circumstances. CCC Likely to default, where payment of interest and principal is dependent on favorable circumstances. CC Debt subordinate to rated CCCC Debt subordinate to senior debt rated CCCD Currently in default, where interest or principal has not been made as promised.

Source: Standard & Poor's CREDITWEEK, "Long-term Rating Definitions," February 11, 1991, p. 128.

The bond rating agencies have been criticized for the slowness in revising bond ratings for deteriorating corporate situations (e.g., Enron and Kmart). The SEC has been looking at the role of bond rating agencies and whether there should be a closer scrutiny of rating agencies. (See Spotlight on Credit Rating Agencies, for example).

What’s a ?

A yield spread is the difference between the yield on a debt instrument and the yield on a similar-maturity default- free bond (that is, a government bond). For example, if 10-year has a yield of 5.41% and the yield on a 10-year U.S. government bond is 4.74%, the yield spread is the difference: 5.41% - 4.74% or 0.67%. However, yield spreads are always quoted using basis points (bp). A basis point is 1/100 of 1%. In other words 1% is 100 bp. This means that the yield spread in this example is 67 bp.

Because the difference between a 10-year corporate bond and a 10-year U.S. government bond is the possibility of default, the yield spread is a proxy for risk: the greater the yield spread, the greater the risk.

Capital Markets II 7 In response to the lag between company events and the ratings revision, rating services now have implied ratings, also known as market implied ratings. The rating service uses the yield spread of a company’s bonds relative to that of the similar-maturity government bond to back into the perceived risk of the company by investors, and then associates this perceived risk with a rating. The rating services disclose both the assigned bond rating and the implied bond rating for securities that it rates. ii) Equity securities An equity security is an ownership interest in a corporation, represented by a of stock. There are two types of stock that corporations issue: and . Preferred stock has preference over common stock with respect to income and claims on assets. Common stock is the residual ownership of the company.

Exhibit 4 Google’s IPO

Volume Close $350 25,000,000

$300 20,000,000 Volume Price $250 of shares per 15,000,000 traded share $200

$150 10,000,000 $100 5,000,000 $50

$0 0

1/3/05 2/7/05 8/1/05

10/25/04 8/19/04 9/20/04 11/29/04 3/14/05 4/18/05 5/23/05 6/27/05

Source of data: Yahoo! Finance

When a company first goes public (that is, it is selling shares to the public, becoming a publicly-traded corporation), this transaction is referred to as an initial (IPO). There is usually a lot of fanfare when a large, privately-held corporation has an . Consider Google, which went public August 13, 2004 by offering 19.6 million of its Class A shares at $85 per share. In the first day of trading, the stock rose to $100 per share. Since the offering, Google stock has risen to over three times its offering price, as we show in Exhibit 4.

Cash flows to shareholders are , whereas additional shares given to shareholders are stock dividends. If the board of directors of a company feels the price of the stock is too high, it may split the stock in a forward , or more commonly referred to as simply a stock split. A forward stock split is a proportionate increase in the number of , e.g., 2:1 or 3:1. If a company feels its stock is too low, it may perform a . A reverse stock split is a proportionate decrease in the number of shares outstanding (e.g., 1:2 or 1:3).

Exhibit 5 payment time line

Capital Markets II 8 Cash dividends are not an obligation of a corporation, but rather are determined at the discretion of the board of directors. The Two business days board will declare on the declaration date that a specified dividend be paid on the payment date to shareholders as of | . . . ----|-- . . . -- | declaration record payment the record date. The exchanges then specify the ex-dividend date date date date based on the record date as two business days prior to the ex-dividend date record date. These dates are show in the time line in Exhibit 5. If an investor buys the stock on the ex-dividend date, they do not receive the forthcoming dividend; if he/she buys the stock the day before the ex-dividend date, he/she will receive the forthcoming dividend.

C. Derivatives Derivatives are not themselves equity interests or debt securities, but rather represent a right or obligation related to another asset, such as equity or debt securities. Forwards, futures, and options are types of derivative securities. These securities are derivatives because they “derive” their value from another asset – the underlying asset (or simply “the underlying”). For example, an option on a stock is a right to buy a stock, so its value depends on the price of the underlying – the stock. i) Options An option is a contract that gives its owner the right, but not the obligation, to conduct a transaction involving an underlying asset at a predetermined future date and at a predetermined price (exercise or strike price):

. A call option is the right to buy the underlying . A put option is the right to sell the underlying

“Writing” an option is taking the opposite . ii) Warrants A on stock is a type of derivative, specifically an equity derivative that issued by a company. A warrant is a security that gives the owner the right to buy specified stock at a specified price. A warrant may perpetual – in which case there is no limit in time at which this option can be exercised – or it may have a fixed date. Warrants are often attached to a security, used as a sweetener to entice investors to buy that specific stock or bond, and can sometimes be detached from the security to trade on an exchange or over-the-counter. Many companies going public issue warrants to encourage investors to buy their new offerings or stock and/or debt. iii) Forwards and futures A is a contract that gives the contract holder the right and the legal obligation to conduct a transaction for a specified quantity of an asset at a specific time in the future. A is a standardized forward contract. Though futures contracts originated in agricultural commodities and metals, there is now an active market in futures related to financial instruments, such as the S&P500 futures contracts. iv) Asset-backed securities Another type of derivative is one in which a securities are created by pooling of assets. In , a dealer buys assets (e.g., mortgages, credit card receivables, or equipment leases), pools these assets, and then creates . A tranch is a set of rights to the pool, which are then sold in the form of securities. The tranches have different rights and seniority, and hence different risks and values. We refer to the securities that represent these tranches as asset-backed securities (ABS). If the pool of assets supporting the securities consists of mortgages, we refer to these as mortgage backed

Capital Markets II 9 securities (MBS). If the pool of assets consists of residential mortgages, we refer to these as residential mortgage backed securities (RMBS).

In some cases, the dealer bought insurance to support the more senior tranches (the “super-senior” tranches), increasing their quality ratings and hence reducing the required that investors demanded. This insurance is a , which financial guarantee insurers, such as MBIA or Ambac, provide.

We diagram a typical asset backed securitization in Exhibit 6.

Exhibit 6 Securitization

Originator Dealer Bond insurer Mortgage Investor 1  Credit  enhancement A

Mortgage Investor 2 B Tranche 

Mortgage  Investor 3

 C Tranche Pool of   Mortgage mortgages in Investor 4

trust  D Tranche

Mortgage Investor 5   Z Tranche

Mortgage  Investor 6

Mortgage Investor 7

III. Indirect investing

Exhibit 7 Share of the market for indirect investing, 2007 A. Investment companies Investment companies are Mutual funds Unit trusts organizations that hold portfolios of 92.5% 0.4% securities, such as Fidelity, Janus, or T. Closed end funds Rowe Price. These investment companies 2.4% provide an opportunity for investors to own a part of a fund’s portfolio. There are several different types of funds: Exchange traded funds . Unit investment trust (UIT), which 4.7% is an unmanaged, portfolio. . Closed-end investment company, which is an offering like stock; the fund’s shares trades like stock in Source of data: Investment Company Institute, www.ici.org

Capital Markets II 10 . . Open-end investment company (a.k.a. mutual fund), which is open-ended (that is, the fund accepts additional investors’ funds). This type of fund is managed and marketed aggressively. . Exchange traded fund (ETF), which is a passively managed fund designed to mimic an index.

As you can see in Exhibit 7, the mutual funds are the largest form of indirect investing in terms of amount invested in funds. i) Unit investment trusts A unit investment trust, (UIT) is created from a one-time offering of a fixed number of units. The offering is in the form of an initial public offering. The UIT is a portfolio that is fixed and passively- managed – that is, a strategy. UITs have a fixed termination date, which may be one year, thirty years, or more.

The UIT portfolios may consist of equity investments, fixed income investments, or some combination. There are thousands of UITs, with many specializing in sector investments. UITs distribute any dividend or interest income to investors, but there are no capital gain consequences until the investor buys or sells their shares.

A unit is typically $1,000 initially and is Example: sold by brokers. Units of a UIT are valued at the net asset value and redeemable at The value of a share in a mutual fund or UIT is determined by the the NAV, though the sponsor may create a funds’ net asset value. Mutual funds and UIT calculate NAV each limited secondary market for the units. day and report the NAV based on a single share. The net asset value (NAV) is the value of the assets the fund, less any liabilities, Example: suppose the fund owns three investments: divided by the number of shares in the fund. value A $12,000 The popularity of unit investment trusts B $10,000 has been declining over the past 15 years C $8,000 as mutual funds and ETFs have increased, Total value of fund $30,000 and the type of UIT investors prefer has Number of shares of fund 1,000 changed from tax-free debt trusts to NAV $30 per share equity trusts.

Unit investment trusts Advantages Disadvantages . Diversified portfolio . Portfolio does not change with market . Buy-and-hold strategy (minimize fees) conditions. . Can sell units at any time at NAV. . Low administrative costs ii) Closed end funds Closed end funds are created with a fixed number of shares are sold at one time, using an initial public offering. The shares of the fund then trade in secondary market (e.g., , NYSE). The price of the fund share is determined by the market, and this price may be greater or less than the shares’ NAV. Shares of closed end funds are not redeemable; that is, an investor cannot “cash out” of the fund shares, but rather must sell the shares to another investor in the secondary market.

Capital Markets II 11 Registered investment advisers manage these funds. Because investors are not able to redeem shares, the fund is able to invest in illiquid securities. Closed-end funds have increased in popularity in the past few years.

Closed-end funds Advantages Disadvantages . Investors can sometimes buy shares at a . Investors pay taxes on income and capital discount from the NAV and sell shares at a gains annually. premium. . Fixed number of shares, hence less . Do not have to sell shares to meet redemption liquidity demands. . Distributions according to prescribed schedule. . Lower fees than most mutual funds. iii) Mutual funds Mutual funds (a.k.a. open-end funds) purchase investments using the pooled funds of the investors. The fund may invest in stocks, bonds, and many other investments. There are over 8,000 mutual funds at the end of 2006.2 There are large fund “families,” such as Fidelity, Vanguard, Janus, and T. Rowe Price, that will maintain many different types of funds, with different purposes and different portfolio managers. In 2006, the top five mutual fund families managed approximately 38 percent of the mutual fund assets.3 The investment adviser of the fund (the fund manager) directs the investments according to the fund’s objectives.

Exhibit 8 Mutual fund growth, 1984-2007

Equity funds 9,000 Hybrid funds 8,000 Bond funds Money market funds 7,000 Number 6,000 of mutual 5,000 funds 4,000 3,000 2,000 1,000 0 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Year

Source of data: Investment Company Institute, www.ici.org

2 Investment Company Institute. 3 Investment Company Institute, 2007 Investment Company Fact Book, Chapter 2.

Capital Markets II 12 Investors purchase mutual fund shares at prices at the close of the day, but not during the day. Any dividends and interest are passed through to investors in the form of an income distribution. If there are any capital gains (net of losses), these are also are passed through to investors in the form of a capital gains distribution.

There are many different types of mutual funds, which may be classified as follows:

. Money market funds . Bond funds (domestic taxable; domestic non-taxable) . Global . Equity funds (domestic; global) . Hybrid funds

Investors’ interest in mutual funds has grown over the past twenty years, and the number of mutual funds has grown to satisfy this interest, as shown in Exhibit 0.

Mutual funds Advantages Disadvantages . Diversification . No guarantees . Professional management . Fees . Liquidity . Tax effect . Convenience

iv) Exchange-traded funds (ETFs) An exchange-traded fund (ETF) is an indexed fund; its composition matches the specified index. The first exchange traded fund (ETF) was in 1993, which is a Standard & Poor’s Depositary Receipts (SPDRs) ETF, created by the AMEX. Examples of ETFs include QQQs, IShares, SPDRs and Diamonds. I show the growth of these funds in Exhibit 9.

Exhibit 9 Exchange-Traded Funds by type of fund, 1993-2007

$700,000 $600,000 Bond $500,000 Global equity Assets $400,000 Domestic equity in millions $300,000 $200,000 $100,000 $0 1993 1995 1997 1999 2001 2003 2005 2007 Year

Source of data: Investment Company Institute, www.ici.org The management fee of an ETF is low, approximately 12bp, and an ETF’s price is generally close to its NAV.4 Exchange traded funds, while a currently a small portion of the indirect investment market, have been growing in popularity.

4 100 basis points (BP) is equivalent to 1%. Therefore, 12 bp is 0.12%.

Capital Markets II 13

Exchange-traded funds Advantages Disadvantages . Tax advantage vis-à-vis mutual funds [i.e., . Transactions fees for buying and selling tax efficient] . Low turnover within the fund (and hence lower fees). . Investors can buy or sell ETFs any time during market hours.

v) Mutual fund fees and performance One of the current issues regarding funds is the fee structure and disclosure of these funds. Many funds are not forthcoming in disclosing their fees to investors, which has caused concerns.

Funds may be load or no-load funds. The distinction between load and no-load is with respect to whether the fund has a sales load, which is a charge either up front or when the investor redeems the shares (that is, a deferred sales charge). Loads (that is, sales charges) range from 1% to 9% of the investment’s value.

Whether a fund is a no-load or load fund, there are still many other types of fees that the investor may incur, including: o Redemption fee, paid to fund to defray costs associated with sale of shares (SEC limits to 2%); o Purchase fee, paid to the fund (not broker) to defray fund’s cost associated with purchase; o Exchange fee, paid when an investor transfers his/her funds to another fund in the same group. o Account fee, which is a separate fee associated with the maintenance of the fund; o Management fees, which are paid out of fund assets to adviser for services; and o 12b-1 fee, which is a distribution fees for marketing and selling shares [NASD limits to 0.75% per year].

There is no evidence that load funds do better than no-load funds. Performance of a fund is dependent on the management of the portfolio and the fees other than the loads that the fund may charge. Current issues regarding mutual funds

Funds that invest in stocks tend to outperform the 1. Mutual fund governance. The Securities market by 1.3% per year, before considering and Exchange Commission is proposing that expenses and returns on non-stock investments. The mutual funds adopt governance such that the net returns on funds under-perform the market by Board of Directors is comprised of 75% 1%. Of this difference, 0.7% is due to independent directors and chaired by an independent director. underperformance of non-stock holdings and 1.6% is due to expenses and transactions costs. 2. Redemption fee rule. The Securities and Exchange Commission is proposing amendments For more information, check out the SEC’s guide to to the redemption fee rule that would provide mutual funds and mutual fund fees. For news or data more transparency for mutual funds regarding on mutual funds, check out: the investments made by accounts held by broker-dealers for clients. This is in response to . CNN Money Mutual Funds site problems revealed in 2005. . Mutual Funds: Investing in America’s Future, Investment Company Institute . Morningstar.com . Yahoo! Finance Mutual Funds Center

Capital Markets II 14 B. Hedge funds There are many investment vehicles that allow investors to invest in a pool of assets through the purchase of stock or unit of ownership. For example, an investor can buy a share in a closed-end fund, an interest in a unit investment trust, or shares in a mutual fund. An alternative investment pool is the hedge fund. i) What is a hedge fund? A hedge fund is an investment pool in which investors’ funds are invested in different investments. The objective of a hedge fund, as with any investment fund, is to generate positive returns on the investment. Unlike a mutual fund, hedge funds are largely unregulated and are not required to register with the Securities and Exchange Commission.5 Therefore, there is no uniform method of reporting to investors and there is no regulatory oversight. In other words, there are few protections for investors from federal and state laws in the case of hedge funds.

Because of their unregulated nature, the funds are generally limited to what are referred to as accredited investors. These accredited investors include corporations and partnerships with assets over $5 million, an individual with a net worth over $1 million, banks, insurance companies, and employee benefit plans.6 Many hedge funds further limit individual investors by requiring significant investment minimums, such as $1 million.

The fee arrangements of hedge funds are a bit different from those of mutual funds. The fund managers typically receive between 1 and 2 percent of the fund’s value in fees and also a 15-20 percent performance fee based on returns.

One of the concerns about hedge funds is that there is no oversight of these funds and the persons managing them. In the case of a mutual fund, the fund managers must be registered and the books are subject to inspection. This is not the case in hedge funds – there is no requirement that the hedge fund managers be registered.

Another concern is that hedge funds are often invested in illiquid investments in which values are estimated by the hedge fund managers themselves. Any reporting of financial information is voluntary on the part of hedge funds and there is no uniform method of disclosure, which may result in overstated returns (especially in the presence of the significant performance fees). It is often difficult to determine the true value of the hedge fund assets until it is too late.

So, if the hedge funds take on so much risk, does this mean that they generate huge returns? Yes and no. Hedge funds are characterized by two factors: (1) frenetic trading that generates significant commissions that reduce potential returns to investors, and (2) speculative investments. This means that such a fund is capable of high returns, but even more capable of generating huge losses. It is difficult to state whether hedge funds outperform, say, the market on a risk-adjusted basis because it is impossible to get reliable data on hedge fund returns.7 However, what limited data exists suggests that hedge funds

5 The Securities and Exchange Commission had issued a rule in December of 2004 [RIN3235-AJ25] that would require hedge funds to register with the SEC, but this was overturned in June 23, 2006 by a U.S. Appeals Court. 6 This is based on the requirements of the National Securities Markets Improvement Act of 1996. 7 In “Hedge Funds: Risk and Return,” Burton G. Malkiel and Atanu Saha [Financial Analysts Journal, Vol. 61, No. 6, pp. 80-88], explore the hedge fund returns that are reported in hedge fund databases. They found that biases in how these indexes of hedge fund returns are calculated result in overstatement of the returns to hedge funds. They also find that while hedge funds offer some benefit from diversification because their returns have low correlation to traditional equity and bond investments, there is a “substantial risk of selecting a dismally performing fund, or worse, a failing one.” (p. 88).

Capital Markets II 15 outperform the market some times and underperform the market at other times. This is what you would expect if these funds take on more risk than that of the market as a whole.

Though there are concerns about the non-regulated nature of hedge funds, many argue that there should be no such regulation because these funds help complete the markets, providing capital for higher risk ventures that would otherwise not be able to raise capital. In other words, these funds provide liquidity to the market. It is also argued that the fast-paced transactions that seek out pricing discrepancies may help the market, but this is countered by the fact that there may be too many funds chasing these few arbitrage opportunities, possibly resulting in mis-valuations instead of proper market valuations. Those that argue for no regulation rely on the banks and other institutions that lend to the hedge funds to monitor these activities.

And, yes, there have been problems with some hedge funds and some huge failures, including the $300 million Eifuku Master Fund failure in 2003, the Manhattan Fund collapse in 2000 resulting in a loss of $400 million, the infamous Long-term Capital Management fund near-failure in 1998, and the Granit Fund’s $600 million failure in 1994.8

Also hedge funds have been associated with a large amount of short selling, amounting to naked short selling, which may be, effectively, manipulating some stocks’ prices.

There is no argument that hedge funds have significant risk because of the type of investment, the use of leveraging, and the use of instruments such as derivatives. These funds are not for the faint of heart or anyone who cannot lose their entire investment. ii) What is a fund of a hedge fund? Investors who do not meet the minimums to qualify as an accredited investor may invest in a fund of hedge funds (also referred to as a fund of funds), which are investment pools that invest in hedge funds. The entry minimum into these funds is much smaller than the direct investment, and may be as small as $25,000. Some funds of hedge funds must register with the SEC, others do not.

Though in some cases a fund of a hedge fund offers some regulatory oversight, there is ultimately the risk associated with the hedge fund that the fund of hedge funds invests in. There is also the issue of fees: the hedge funds themselves impose fees, reducing returns to investors, and the fund of the hedge fund imposes fees (1-2 percent management fee, plus 10-20 percent performance fee), reducing the returns much further.

If you want even more complexity (and another layer of fees), consider that there are even funds of funds of hedge funds.

8 Many of these cases are referred to in the Securities and Exchange Commission “Registration Under the Advisers Act of Certain Hedge Fund Advisers: Final Rule,” Vol. 69, No. 237, December 10, 2004. See also “Japan: Fallen hedges,” by Benjamin Beasley-Murray, Global Finance, May 2003.

Capital Markets II 16 Mutual fund v. Hedge fund Mutual Hedge fund fund Must register with the SEC? Yes No NASD oversees advertisements? Yes No Subject to Internal Revenue Service requirements for distribution of earnings? Yes No Subject to the Investment Advisers Act Yes No Fees subject to limits? Yes No Must cover positions? Yes No Shares/interests redeemed at any time? Yes No Quotations available on a daily basis? Yes No

Resources for learning more about hedge funds:

. Baker Library, Harvard Business School, “The Baker Library Guide to Hedge Funds,” http://www.library.hbs.edu/guides/hedgefunds/ . National Public Radio, radio broadcast of U.S. Senate hedge fund hearings, http://www.npr.org/templates/story/story.php?storyId=5518267 . Securities and Exchange Commission, “Hedging Your Bets” A Heads Up on Hedge Funds and Funds of Hedge Funds,” http://www.sec.gov/answers/hedge.htm . Securities and Exchange Commission, “Spotlight on Hedge Funds,” http://www.sec.gov/spotlight/hedgefunds.htm . Wikipedia, “Hedge fund,” http://en.wikipedia.org/wiki/Hedge_fund IV. Further reading 1. American Association of Individual Investors, AAII Investor Guides, The Individual Investor’s Guide to Investment Information. 2. Federal Reserve Bank of San Francisco, About the Fed. 3. Federal Reserve Bank of San Francisco, What is the relationship between the discount rate and mortgage rates? 4. Investment Company Institute, 2007 Investment Company Fact Book. 5. Securities and Exchange Commission, Invest Wisely: An Introduction to Mutual Funds,. 6. Securities and Exchange Commission, Investment Choices.

V. Index

12b-1 fee, 15 Closed end funds, 12 ABS. See Asset-backed security Closed-end investment company, 11 Account fee,, 15 Commercial paper, 5 Accredited investors, 16 Common stock, 8 Asset-backed securities (ABS), 10 Convertible bond, 7 Bankers' acceptance, 5 Corporate bond, 7 Basis point, 4, 8 Corporate note, 7 Bond, 6 credit enhancement, 10 bp. See Basis point Debenture, 6 Call option, 9 Declaration date, 9 Call price, 7 Deferred sales charge, 15 Callable, 6 Derivatives, 9 Callable bond, 7 Direct investing, 1 CD. See Certificate of deposit Discount yield basis, 4 Certificate of deposit, 4 Dividends, 9

Capital Markets II 17 Equity security, 8 Municipal securities, 6 ETF. See exchange-traded fund, See Exchange traded Mutual fund, 11 fund Mutual funds, 13 Eurodollar deposits, 5 NAV. See Net asset value Exchange fee, 15 NCD. See Negotiated certificate of deposit Exchange traded fund, 12 Negotiated certificate of deposit (NCD), 4 Exchange-traded fund, 14 net asset value, 12 Ex-dividend date, 9 Net asset value, 12 Face value, 6 No-load funds, 15 Farm Credit System (FCS), 6 Note, 6 Federal Home Loan Bank (FHLB), 6 Open-end funds, 13 Federal Home Loan Mortgage Corporation (FHLMC, Open-end investment company, 11 Freddie Mac), 6 Option, 9 Federal National Mortgage Association, 6 Preferred stock, 8 FHLB. See Federal Home Loan Bank Purchase fee, 15 FHLMC. See Federal Home Loan Mortgage Put option, 9 Corporation Record date, 9 FNMA. See Federal National Mortgage Association Redemption fee, 15 Forward contract, 10 Reference rate, 3 Forward stock split,, 9 repo, 5 Fund of funds, 17 Repurchase agreement, 5 Fund of hedge funds, 17 Residential mortgage backed securities (RMBS), 10 Funds of funds of hedge funds, 18 Revenue bonds, 6 Futures contract, 10 Reverse stock split, 9 General obligation bonds, 6 RMBS. See Residential mortgage-backed security Ginnie Mae. See Government National Mortgage Sales load, 15 Association Secured bond, 6 GNMA. See Government National Mortgage SLMA (Sallie Mae), 6 Association Speculative debt, 7 Government National Mortgage Association), 6 Stock dividends, 9 Hedge fund, 16 Stock split, 9 High quality bonds, 7 Tax-equivalent yield (TEY), 6 High yield debt, 7 T-bill. See U.S. Treasury Bill Implied ratings, 8 TEY. See Tax equivalent yield Indirect investing, 1 TIPS. See Treasury Inflation Protected Securities Initial public offering, 9 Tranch, 10 Investment companies, 11 Treasury Inflation Protected Securities (TIPS), 6 Investment grade debt, 7 U. S. Treasury bill, 3 Investment yield basis, 4 U.S. Treasury bond, 6 IPO. See Initial Public Offering UIT. See Unit investment trust Junk bonds, 7 Unit investment trust, 11, 12 Load, 15 Unsecured bond, 6 London InterBank Offer Rate (LIBOR), 3 Warrant, 9 Marginal tax rate, 7 Yield curve, 3 Market implied ratings, 8 Yield spread, 8 MBS. See Mortgage-backed securities Zero coupon bond, 6 Money market securities, 3

Capital Markets II 18