FE445 Investment Analysis and Portfolio Management

Spring 2020

Yunjeen Kim

Boston University | Questrom School of Business

Lecture 2: Asset and Security
Classes, and Investment
Companies
Real vs. Financial Assets

• Real Assets:
• Used to produce goods and services:
land, buildings, equipment, and knowledge.
• Financial Assets:
• Claims on real assets or claims on asset income.
• Ultimate owners of all real assets:
• Households, non-profits, government, financial institutions
• Net wealth of an economy: aggregate all balance sheets
→ only real assets remain.
• All financial assets are offset by financial liabilities.

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Balance Sheet U.S. Households 2014

Assets Liabilities and Net Worth

$ Billion % Total $ Billion % Total
Real assets
Real estate 22,820 23.88% Mortgages 9,551 10.00%
Consumer durables 5,041 5.28% Consumer credit 3,104 3.25%
Other 468 0.49% Bank and other loans 493 0.52%
Total real assets 28,330 29.65% Security credit 352 0.37%
Other 286 0.30%
Financial assets Total liabilities 13,786 14.43%
Deposits 9,783 10.24%
Life insurance reserves 1,257 1.32%
Pension reserves 19,766 20.69%
Corporate equity 13,502 14.13%
Equity in noncorp. Business 8,869 9.28%
Mutual fund shares 7,059 7.39%
Debt securities 5,263 5.51%
Other 1,720 1.80%
Total financial assets 67,219 70.35% Net worth 81,763 85.57%
Total 95,549 100.00% 95,549 100.00%

Source: U.S. Federal Reserve, Flow of Funds

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Functions of Financial Markets

1. Informational role and capital allocation

• Do prices reflect value? (more later)
2. Consumption timing
• People tend to smooth consumption over time.
• Save for unexpected expenses: unemployment, medical treatment
• Most common savings motive: life-cycle
• Borrow when young.
• Invest in working age (mid-life).
• Draw down saving when old and retired.
3. Allocation of risk
• Investors can choose a desired risk level and risk type
4. Separation of ownership and management
• Think about large firms.

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Classes of Financial Securities

• Debt (fixed-income securities): pay a specified cash flow (coupons,

principal) over a specific period.
• Money market instruments.
• Cash-like instruments: very low risk
• Bonds (capital market): safe unless firm goes bankrupt.
• Less risky
• Equity: pay an unspecified cash flow (dividends)
• Common stock: Ownership stake, residual cash flow after paying
back debt.
• More risky
• Derivatives:
• Contract whose value is derived from some other assets.

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Money Market Instruments

• A sub-sector of the debt market.

• Very low risk and normally very liquid
• Easy to convert back into cash (e.g., deposits)
• Easy to sell on the market (marketable)
• Very short-term (maturity less than 1 year)
• Types:
• Treasury Bills (T-bills): proxy for risk-free security
• Certificates of Deposit (CD): a bank time deposit
• Repos and Reverses
• Commercial Paper (CP)
• Federal Funds

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Repo Markets

• We often talk about buying and shorting securities. In fixed income

markets, this is accomplished via the repo market.
• A Repurchase Agreement (Repo) is an agreement to sell some
securities to another party and buy them back at a fixed date and
for a fixed amount. The price at which the security is bought back is
greater than the selling price and the difference implies an interest
called Repo Rate.
• A Reverse Repo is the opposite transaction, namely, it is the
purchase of the security for cash with the agreement to sell it back
to the original owner at a predetermined price, determined, once
again, by the Repo Rate.
• In simple words: A repo transaction is a short-term (overnight to 48
hours), collateralized loan.

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Schematic Repo Transaction

• At time t, a trader wants to take a long position in a bond. Pt is

the (invoice) price of the bond.
• Haircut: Difference between Pt and amount trader can borrow.

time t

buy bond at Pt deliver bond

MARKET TRADER REPO DEALER
pay Pt get Pt −haircut

time T = t + n days

sell bond at PT get the bond

MARKET TRADER REPO DEALER
get PT n
pay (Pt −haircut) × (1+repo rate× 360 )

• Why do the participants agree to this trade?

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Commercial Paper

• Issued by large creditworthy corporations.

• Short maturity: less than 1 or 2 months.
• Quite liquid.
• Default risk low: unsecured loan
• Unlikely to default within a few months.
• Asset Backed Commercial Paper (ABCP, more later)
• Recent innovation: issued by financial firms.
• Backed by a loan or security.
• Invest in other assets, subprime mortgages. Used as collateral.
• Mid-2007: collapsed when subprime collateral values fell.

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Other Key Interest Rates

Federal Funds Rate:

• Banks with excess Fed funds lend to those with a shortage.

• Lending rate in this market is called Federal fund rate.

LIBOR (London Interbank Offer Rate):

• Rate at which large banks in London can borrow from each other;
i.e., interbank loans
• Is available in 5 currencies: USD, EUR, GBP, JPY, and CHF at
seven different maturities.
• World’s most widely used reference rate in the money market.

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TED Spread = 3m LIBOR - 3m T-Bill

TED Spread

4.0

3.5

3.0

2.5
Percent

2.0

1.5

1.0

0.5

0.0
1990 1995 2000 2005 2010 2015

Shaded areas indicate U.S. recessions Source: Federal Reserve Bank of St. Louis myf.red/g/l62J

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Investment Companies

• Investment companies: financial intermediaries that collect funds

from individual investors and invest those funds in a potentially wide
range of securities or other assets.
• Functions:
• Diversification
• Professional management
• Lower research costs (shared with others)
• Portfolio managed according to certain objectives
• Professionals to find undervalued securities
• Reduced transaction costs (e.g. commissions)
• due to size of fund
• Administration & record keeping

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Assets Held in Investment Companies

12
Net Asset Value

• Investors buy shares in investment companies.

• Net Asset Value (NAV): the value of each share.

Market Value of Assets − Liabilities

NAV =
Shares Outstanding
• For NAVs see: http://finance.yahoo.com/funds

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NAV Calculation: Example 1

• Market Value Securities = $550 millions

• Cash & Receivables = $75 millions
• Current Liabilities = $20 millions
• Number of Fund Shares = 20 millions
• What is its NAV?

$550 million + $75 million − $20 million

NAV = = $30.25 per share
20 million shares

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NAV Calculation: Example 2

• Consider a mutual fund that manages a portfolio of securities worth

$120 million.
• Suppose the fund owes $4 million to its investment advisors and owes
another $1 million for rent, wages due, and miscellaneous expenses.
• the fund has 5 million shares.
• What is its net asset value?

$120 million − $5 million

NAV = = $23 per share
5 million shares

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Types of Investment Companies

Investment companies are classified by the Investment Company Act of

1940.

• Open-end Funds:
• Shares are bought from and redeemed by the fund
(Unlimited number of shares).
• Prices are equal to NAV
• Traded through companies.
• $10.1 trillion in 2010, $15 trillion in early 2014
• Closed-end Funds:
• Fixed number of shares are bought and sold among investors.
• Prices can differ from NAV
• Traded on exchanges.
• $242 billion in 2010

Management company manages the portfolio for an annual fee that

typically ranges between 0.2% to 1.5% of assets.
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Closed End Funds: Example

Fund NAV Mrkt price Prem/Disc %

Adams Diversified Equity 18.54 15.78 -14.89
Advent/Clay Enhanced Growth 9.53 8.6 -9.77
Boulder Growth & Income 13.64 11.59 -15.03
Central Securities Corp 34.35 28.65 -16.59
Cohen & Steers CE Oppty 14.23 13.33 -6.32

Retrieved from WSJ (online) 19 January 2018

• Prem/Disc is defined as the percentage difference between the price

and NAV.
• Why do all the share prices differ from NAV?

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Investment Companies cont’d

• Hedge Funds: are managed much more aggressively than their

mutual fund counterparts.
• Lightly regulated by SEC: they are able to take speculative positions
in derivative securities such as options and have the ability to short
sell stocks.
• Lock-ups: able to invest in illiquid assets.
• $2 trillion in 2008, $3 trillion in 2015.

• ETF(Exchange Traded Funds): a marketable security that tracks an

index, a commodity, bonds, or a basket of assets like an index fund.
• $1.71 trillion in 2011
• More later

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U.S. Mutual Funds by Investment Classification, 2014

Assets ($ bn) Percent of Total Assets Number of Funds

Equity funds
Capital appreciation focus 1,725 11.50% 1,329
World/international 2,034 13.50% 1,345
Total return 4,004 26.70% 1,866

Total equity funds 7,764 51.70% 4,540

Bond funds
Investment grade 1,451 9.70% 594
High yield 412 2.70% 225
World 339 2.30% 270
Government 239 1.60% 214
Multisector 327 2.20% 143
Single-state municipal 145 1.00% 331
National municipal 353 2.40% 229

Total bond funds 3,265 21.70% 2,006

Hybrid (bond/stock) funds 1,270 8.50% 606
Money market funds
Taxable 2,448 16.30% 382
Tax-exempt 271 1.80% 173

Total money market funds 2,718 18.10% 555

TOTAL 15,018 100.00% 7,707

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Costs of Investing in Mutual Funds

Fee Structure (fixed when buying)

• Front-end load
• A commission when you buy the shares (might go to brokers).
• Back-end load (known as “contingent deferred sales charge”)
• A redemption fee when you sell the shares soon.
• Operating expenses (typically 0.2-2%)
• Commissions, administration, management fees.
• Paid to investment managers
• Deducted from the assets of the fund periodically.
• 12 b-1 Charges SEC allows funds to use fund assets to pay for
distribution costs (not always: max. 1% )
• Marketing and distribution costs.
• Most importantly: Commissions to brokers.
• Assessed annually.

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Different Classes of Fund Shares: Example

Class A Class B Class I

Front-end load 5.75%a 0% 0%
Back-end load 0% 1% 0%b
12b-1 feesc 0.25% 1% 0%
Expense Ratio 1.1% 1.1% 1.1%
a: depending on size of fund
b: depending on years until holdings are sold
c: including service fee of 0.25%

• Expense ratio = Annual Expenses / Average NAV

• Best alternative may depend on:
• Amount invested
• Expected holding period
• E.g.: www.americanfunds.com/funds/prospectuses.htm
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Fees and Mutual Fund Returns

• The rate of return in a mutual fund is measured as the increase or

decrease in NAV plus income distributions such as dividends or
distributions of capital gains at the beginning of the investment
period.
• Investors are taxed on capital gain and dividend distributions, even if
reinvested in the fund.
• If we denote the NAV at the start and end of the investment period
as NAV0 and NAV1 , then
NAV1 − NAV0 + DIST
Rate of Return =
NAV0

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Fees and Mutual Fund Returns: Example

A fund has an initial NAV of $20 at the start of the month, makes
income distributions of $0.15 and capital gains of $0.05, and ends the
month with a NAV of $20.10. What is the monthly return?

$20.1 − $20 + $0.15 + $0.05

Rate of Return = = 1.5%
$20

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But we ignored commissions!

• Consider a fund with $100 million in assets at the start of the year
and with 10 million shares outstanding.
• The fund invests in a portfolio of stocks that increased in value by
10%.
• The expense ratio, including 12b-1 fees, is 1%.
• What is the rate of return now?

The initial NAV is $100 million/10 million shares = $10 per share.
In the absence of expenses, the NAV grows to $11 per share.
The expense ratio is 1%, which lowers the NAV to $10.90. Hence the
rate of return is only 9% which equals the gross return on the underlying
portfolio minus the total expense ratio.

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Exchange Traded Funds

Potential advantages:

• Trade continuously throughout the day.

• Can be sold short or purchased on margin.
• No redemptions, but large investors can exchange ETF shares for
shares in the underlying portfolio.
→ links NAV to underlying asset value
• Lower costs (expenses)

Potential disadvantages:

• Small deviations from NAV possible.

• Must pay a brokerage commission to buy an ETF.

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Assets in ETFs

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Summary

This Class:

• Investment companies are helpful especially for small investors to

create portfolio but charge high fees.

Next Class:

• Performance of securities
• Compounding
• Nominal vs. Real returns

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Problem 4.25

• Class A shares:
• Front-end load 4%
• Class B shares:
• 12b-1 fee 0.5%
• Back-end load of 5% which falls by 1% after each full year the
investor holds the portfolio (until the 5th year).
• Portfolio return net of operating expenses: 10% per year.

If you plan to sell after 4 full years, which is better?

Suppose you have $1,000 to invest.
The initial investment in Class A shares is $940 net of the front-end load.
After 4 years, your portfolio will be worth: $940 × 1.104 = $1, 376.25
Class B shares allow you to invest the full $1,000, but your investment
performance net of 12b-1 fees will be only 9.5%, and you will pay a 1%
back-end load fee if you sell after 4 years. Your redemption value after 4
years: $1, 000 × 1.0954 × 0.99 = $1, 423.28 28
Problem 4.25 cont’d

• Class A shares:
• Front-end load 4%
• Class B shares:
• 12b-1 fee 0.5%
• Back-end load of 5% which falls by 1% after each full year the
investor holds the portfolio (until the 5th year)
• Portfolio return net of operating expenses: 10% per year

If you plan to sell after 15 full years, which is better?

Class A: $940 × 1.1015 = $3, 926.61
Class B: $1, 000 × 1.09515 = $3, 901.32

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