Unit 6: Practical Aspects

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
a) Mutual Funds and ETFs

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
 Investment Companies

• Pool funds of individual investors and invest

in a wide range of securities or other assets.
• Services provided:
– Administration & record keeping
– Diversification & divisibility
– Professional management
– Reduced transaction costs

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 Types of Investment Companies

• Managed Investment Companies

– Open-End
• Fund issues new shares when investors buy in and
redeems shares when investors cash out
• Priced at Net Asset Value (NAV)
• Includes ETFs and most mutual funds
– Closed-End
• No change in shares outstanding; old investors cash out
by selling to new investors
• Priced at premium or discount to NAV

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Types of Investment Companies

Source: Investment Company Factbook 2022

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 Types of Investment Companies

• Unit Investment Trusts

– Fixed portfolio of uniform assets
– Unmanaged
– Total assets have declined from $105 billion in
1990 to $29 billion in 2009
• Other
– Commingled funds
– REITs
– Hedge Funds
– Islamic Investment Funds
– Sovereign Wealth Funds
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 Net Asset Value

• Calculation:
Market Value of Assets – Liabilities
Shares Outstanding
• Example
– Value of Securities: $120m
– Fund owes $4m to advisors and $1m for misc.
– 5 million shares outstanding
– NAV = ($120m-$5m)/5m = $23 per share

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 Mutual Funds: Open-End
Investment Companies

• Money Market
• Equity
• Sector
• Bond
• Balanced
• Asset Allocation and Flexible
• Index
• International

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U.S. Mutual Funds Types

Source: Investment Company Factbook 2022

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Money Flows to Mutual Funds

Source: Investment Company Factbook 2022

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 How Funds Are Sold

• Direct-marketed funds
• Sales force distributed
– Revenue sharing on sales force distributed
– Potential conflicts of interest
• Financial Supermarkets

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 Taxation of Mutual Fund Income

• Pass-through status under the tax code in

most countries
– Taxes are paid only by the investor
– Fund investors do not control the timing of the
sales of securities from the portfolio
• High portfolio turnover leads to tax
inefficiency

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 Information on Mutual Funds

• Fund’s prospectus describes:

– investment objectives
– Fund investment adviser and portfolio manager
– Fees and costs
• Fund’s annual report

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 Mutual Fund Scandal: Late
Trading

• Late trading – accepting buy or sell orders

after the market closes and NAV is
determined
• Net effect is to transfer value from ordinary
shareholders to privileged traders
• Mutual funds penalized for improper trading.
New rules to prevent these practices

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 Costs of Investing in Mutual
Funds
• Fees must be disclosed in the prospectus
– Often Share classes with different fee combinations
• Fee Structure: Four types
– Operating expenses
– Front-end load
– Back-end load
– 12 b-1 charge (in the U.S.)
• (Total) Expense Ratio
– Total cost for operating + managing the fond / total assets
– “Typically it includes the annual management charge, plus
other charges incurred in running the fund. These can
include share registration fees, legal fees, custodian fees
etc. Trading costs are not included” (ft.com/lexicon)

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 Fees and Mutual Fund Returns:
An Example
• Assumptions
– Initial NAV = $20
– Income distributions of $.15
– Capital gain distributions of $.05
– Ending NAV = $20.10
– Total Expense Ratio TER = 1%
• Rate of Return:
NAV1 − NAV0 + Income and capital gain distributions
– Gross: Rate of return =
NAV0

$20.10 - $20.00 + $.15 + $.05

Rate of Return = = 1.5%
$20.00

– Net: Gross RoR – TER = 1.5%-1% = 0.5%

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Exemplary Fund Fees

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 Impacts of Costs on Investment
Performance
• Assumptions
– Investor starts with $10,000 and has 20 year horizon
– Annual fund gross return of 12%
• Terminal wealth without any fees: $96,463
• Terminal wealth with fees:

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Expense Ratios (bps) of Actively
Managed and Index Funds

Source: Investment Company Factbook 2022

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 Mutual Fund Investment
Performance
• Performance of actively managed funds:
– below the return on the Wilshire index in 23 of the 39 years from
1971 to 2009
– Evidence for persistent superior performance (due to skill and not
just good luck) is weak; bad performance more likely to persist
• Jensen 1968, JF
– Tests the abnormal performance of 115 mutual funds, using
annual data between 1955 and 1964
– Abnormal return measured net of costs was –1.1% per year
– This suggests that on the average the funds were not able to
forecast future security prices well enough to cover expenses
• Kosowski et al. 2006, JF
– On average negative alpha
– But: sizable minority of managers pick stocks well enough to
more than cover their costs

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Diversified Equity Funds versus
Wilshire 5000 Index

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Consistency of Investment
Results

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 Exchange Traded Funds

• ETFs are a recent innovation to help keep transaction costs

down while offering diversification
• Represent a basket of securities
• Traded on a major exchange
• Index ETFs index to a specific portfolio (e.g., the S&P 500)
– Fees are generally low (e.g., compared to actively managed
funds)
– On average low tracking error
– Actively managed ETFs as special form
• Exact content of basket is known, so valuation is certain
– Full replication vs swaps
• Grew rapidly over the last decade
– More than 1,500 index ETFs

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 Exchange Traded Funds

• Potential advantages:
– Trade continuously like stocks
– Can be sold short or purchased on margin
– Low costs
– Tax efficient
• Potential disadvantages:
– Prices can depart by small amounts from NAV
– Must be purchased from a broker
– May have a negative impact on information
efficiency of markets

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Growth of ETFs ...

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... is continuing

Source: Investment Company Factbook 2022

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Flows to Mutual Funds vs ETFs

Source: Investment Company Factbook 2022

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b) Portfolio Evaluation

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
 Adjusting Returns for Risk

• We want to learn about the skills of a portfolio

manager
– Why can we not simply look at (past) portfolio returns?
Think about what we already know about risk and return!
• The simplest and most popular way to adjust
returns for risk:
– Compare the portfolio’s return with the returns on a
comparison universe
– This comparison universe is a benchmark composed of a
group of funds or portfolios with similar risk characteristics,
such as growth stock funds or high-yield bond funds.

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Universe Comparison

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 Risk Adjusted Performance
Measures
1. Sharpe Measure
– Measures reward to total volatility trade-off
(r − r )
– Defined as: P f
P
– The bars indicate that these are averages over the sample
period

2. Treynor Measure
– Similar to the Sharpe Measure, but it uses systematic risk
instead of total risk
(rP − rf )
– Defined as:
P
– Beta is the weighted average beta of the portfolio

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 Risk Adjusted Performance
Measures - continued
3. Jensen’s Measure
– Captures the average return above that predicted by the
CAPM
– Jension’s Measure is the portfolio’s alpha
– Defined as: a P = rP −  rf +  P (rM − rf ) 
4. Information ratio
– Divides alpha by the nonsystematic risk
– Abnormal return per unit of risk that could be diversified
away
– Defined as: ap / (ep)

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 Risk Adjusted Performance
Measures - continued

5. M2 Measure
– Developed by Modigliani and Modigliani
– Create an adjusted portfolio (P*) that has the
same standard deviation as the market index.
– Because the market index and P* have the same
standard deviation, their returns are comparable:
M = rP* − rM
2

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 2
M Measure: Example

• Managed Portfolio:
– return = 35%
– standard deviation = 42%
• Market Portfolio:
– return = 28%
– standard deviation = 30%
• T-bill return = 6%
• P* Portfolio:
– 30/42 = .714 in P and (1-.714) in T-bills
– The return on P* is (.714) (.35) + (.286) (.06) = 26.7%
• M2 Measure: 26.7%-28%=-1.3%
– This indicated that the return is less than the market; thus,
the managed portfolio underperformed.

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 2
M Measure: Example

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 Which Measure is Appropriate?

• Case 1: Portfolio represents entire risk investment

– Consider an investor who thinks about investing her entire
funds in one single portfolio
– Thus, the benchmark is the market index
– We only need to check whether the portfolio has the
highest Sharpe ratio!
• Case 2: Portfolio is one of many combined into a
larger investment fund
– Consider an investment manager who thinks about adding
an additional sub-portfolio to her investment portfolio
– We should use the Treynor measure
• The Treynor measure is appealing because it weighs excess returns
against systematic risk.

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 Which Measure is Appropriate?

• Assume that both portfolios can be mixed with T-

Bills
• Is Q better than P to mix with an existing well-
diversified portfolio?

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Which Measure is Appropriate?

Treynor’s measure?

(rP − rf )
= Slope
P

Why Beta?

because it’s only part of

a large PF, so firm-
specific risk does not
matter!

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 Style Analysis

• Introduced by William Sharpe

• Regress fund returns on indexes
representing a range of asset classes.
• The regression coefficient on each index
measures the fund’s implicit allocation to
that “style.”
• R–square measures return variability due to
style or asset allocation.
• The remainder is due either to security
selection or to market timing.
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Style Analysis Example

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 Evaluating Performance
Evaluation

• Performance evaluation has two key

problems:
1. Many observations are needed for
significant results.
2. Shifting parameters when portfolios are
actively managed makes accurate
performance evaluation all the more
elusive.

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c) Optimal Portfolio Construction

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
 Diversification versus Alpha

Should we simply buy the market index M?

– From a diversification perspective, it seems optimal to buy
the most broadly diversified portfolio – the market index
that consist of all assets
– But: What if we can use equity valuation to develop private
forecasts of the expected returns for each security?
– If we can find stocks with nonzero Alpha, we would not
simply invest in the stock market index M!
• Rather, we would follow an active investment strategy, which is
typical for fund managers
– But how exactly should we invest then?
• Should we only buy positive Alpha stock(s)?
• Or should we buy positive Alpha stock(s) and the market index?

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 The Optimal Risky Portfolio

• What is the optimal risky portfolio if we found

over/undervalued securities?
– Intuition
• If we can identify some securities with nonzero alpha, we want to hold
them
• The cost of that is a departure from efficient diversification, so we
have to trade-off search for alpha against efficient diversification
– It turns out the the optimal risky portfolio is a combination of
• (1) an active portfolio A with n securities that have nonzero Alpha and
• (2) the market index M, the (n+1)th asset which will improve
diversification
– Simple case: A has Beta of 1
𝛼𝐴
• Optimal weight proportional to
𝜎 2 (𝑒𝐴 )
• Contribution of A, i.e., Alpha, against contribution to PF
variance

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 The Optimal Risky Portfolio

• The Sharpe ratio of an optimally constructed risky

portfolio will exceed that of the index portfolio (the
passive strategy):
2
 aA 
s P = s M +  (eA ) 
2 2

– Sharpe ratio depends on the Sharpe ratio of M and the

information ratio
• The contribution of the active portfolio depends on the ratio of Alpha
to its residual standard deviation.
• The information ratio measures the extra return we can obtain from
security analysis.
– If we cannot find securities with positive Alpha, the Sharpe
ratio does not increase
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