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FE 445 - Investment Analysis and Portfolio Management: Fall 2020

This document provides an overview of asset classes and investment companies. It discusses real assets that are used to produce goods and services versus financial assets which are claims on real assets or claims on asset income. It then reviews the balance sheet of US households and their holdings of real estate, consumer durables, deposits, life insurance, pensions, equities, mutual funds and debt securities. It also discusses the roles of financial markets in facilitating consumption timing and risk allocation. The document then defines different classes of securities including money market instruments, bonds, equities and derivatives. It provides examples of various money market instruments and discusses repo markets and commercial paper.

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0% found this document useful (0 votes)

71 views41 pages

FE 445 - Investment Analysis and Portfolio Management: Fall 2020

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kate ng

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FE 445 – Investment Analysis and Portfolio

Management
Fall 2020

Farzad Saidi

Boston University | Questrom School of Business

Lecture 2: Asset/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

1
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

2
Roles of financial markets

• Informational role and capital allocation

• Do prices reflect value? (more later)
• Can markets put money to best use?
• 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 savings when old and retired
• Allocation of risk
• Investors can choose a desired risk level and risk type
• Separation of ownership and management
• Think about large firms

3
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

4
Money market instruments

• A subsector 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: interest rate charged for short-term
borrowing/lending with collateral
• LIBOR: average interest rate the banks charge one another for short
term uncollateralized borrowing/lending
• Federal funds rate: rate for borrowing/lending balances kept at the
Federal Reserve
• Commercial paper (CP)

5
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, i.e., 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
• Put simply, a repo transaction is a collateralized loan

6
A repo transaction

• At time t, a trader wants to take a long position until time T

• Pt is the (invoice) price of the bond
• Haircut (HC ): 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 )

7
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

8
Commercial-paper breakdown
V.V. Acharya et al. / J. Finan. Intermediation 30 (2017) 1–34 3

Fig. 1. Adapted from Acharya et al. (2013). The red line is the level of the S&P 500 at close; the blue line is the total amount
of ABCP outstanding in billions USD; the green line indicates August 9, 2007, when BNP Paribas suspended withdrawals from
3 subprime mortgage backed funds; the purple line indicates December 12, 2007, when the Federal Reserve announced the
TAF to alleviate pressure in short-term funding markets. (For interpretation of the references to color in this ﬁgure legend, the
reader is referred to the web version of this article.)
• The red line is the level of the S&P 500 at close
freeze and relative to non-USD loans, foreign banks with ABCP exposure charged higher spreads on
• The bluesyndicated
line loans is the total
denominated amount
in US dollars offollowing
in the period ABCP the ABCPoutstanding
freeze of August 2007
through mid-December 2007. This ﬁnding is particularly striking because this period is one of relative
in $bn
calm for large corporations in the United States, whose syndicated loans we study, as evinced by
• The greenthe line indicates August 9, 2007, when BNP Paribas
remarkably
Fig. 1).
stable behavior of the S&P500 index between August 9 and mid-December 2007 (See

suspended withdrawals from in3USDsubprime mortgage-backed

Formally, we design a difference-in-differences test to study the terms (spread, maturity and
amount) of syndicated loans denominated and in euros or pounds (we will refer to these funds
loans as “euro” loans for simplicity). We exploit several types of differences-in-differences, the ﬁrst

• The purple line indicates December 12, 2007, when the Federal
difference being between USD- and euro- loans, the second between foreign banks and US banks,
and the third difference being between after and before August of 2007 (in order to exploit within-
ﬁrm variation). Our difference-in-differences approach helps control for variation in characteristics
Reserve across
announcedbanks, differences the
in banksTerm Auction
between before Facility
and after the shock, (TAF)
and between USD and non-
USD-denominated syndicated loans for a given bank (allowing us to hold constant the bank solvency
to alleviate
shock, if any). At the same time, the approach allows us to exploit the variation among banks due to
pressure funding
in short-term funding
shocks (ABCP-exposed versus not exposedmarkets
banks) and due to differential access to funding in
the USD markets (foreign versus US banks).
Our difference-in-differences test reveals that the contractual feature of bank credit that is affected
is mainly the spread (rather than maturity or amount).7 Besides documenting an important dollar 9
funding risk for foreign banks engaged in maturity transformation in the United States, our results
suggest that the transmission channel of the ABCP freeze when studied just for US banks may under-
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 funds rate

LIBOR (London interbank offer rate):

• Rate at which large banks in London can borrow from one another,
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

10
Which interest rate?

• To price financial contracts, we need a risk-free rate

• For financial institutions, the LIBOR or swap yield curve provides
the appropriate rate
• Treasury rates are too low – banks cannot finance themselves at this
rate
• The overnight indexed swap (OIS) is a swap where a fixed rate is
exchanged for the geometric average of overnight rates during the
period, where the overnight rates are the rates at which banks
borrow/lend excess reserves (Fed funds rate in the US)
• The OIS allows overnight borrowing/lending to be swapped for a
fixed rate
• The LIBOR-OIS spread is an indicator for stresses in the financial
sector

11
TED Spread = 3m LIBOR - 3m T-Bill

TED Spread

3.5

3.0

2.5

2.0
Percent

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/mbKw

12
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

13
Net Asset Value

• Investors buy shares in investment companies.

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

Market value of asets − Liabilities

NAV =
Shares outstanding
• For NAV values see: http://finance.yahoo.com/funds

14
Example: NAV calculation

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

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

15
Example: NAV calculation

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

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

$120m − $5m
NAV = = $23 per share
5m shares

15
Managed investment companies

Management company manages the portfolio for an annual fee that

typically ranges from 0.2% to 1.5% of assets

• Open-end funds: a pool of funds collected from many investors for

the purpose of investing in securities such as stocks, bonds, money
market instruments, and similar assets
• Shares are bought from and redeemed by the fund (unlimited no. of
shares)
• Prices are equal to NAV
• Traded through investment companies
• $10.1tn in 2010, $15tn in early 2014
• Closed-end funds:
• Shares are bought and sold among investors
• Prices can differ from NAV
• Traded on organized exchanges
• $242bn in 2010

16
Example: closed-end funds

Fund NAV Mrkt price Prem/Disc %

Adams Diversified Equity 15.45 13.48 -12.75
Boulder Growth & Income 12.77 10.62 -16.84
Central Securities Corp 31.99 26.13 -18.32
Cohen & Steers CE Oppty 12.26 11.38 -7.18

Retrieved from WSJ (online) on November 23, 2018

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

and NAV
• Why do all the funds trade at a discount?

17
More investment companies

• 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
• $2tn in 2008, $3tn in 2015
• Exchange-traded funds: a marketable security that tracks an
index, a commodity, bonds, or a basket of assets like an index fund.
• $1.71tn in 2011
• More later

18
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

19
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

20
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
21
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
distributed capital gains at the beginning of the investment period
• If we denote the NAV at the start and end of the investment period
as NAV0 and NAV1 , then
NAV1 − NAV0 + income and capital gain
rate of return =
NAV0
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?

22
Fees and mutual fund returns

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

$20.1 − $20 + $0.15 + $0.05

rate of return = = 1.5%
$20

22
But we ignored commissions!

23
But we ignored commissions!

• Consider a fund with $100m in assets at the start of the year and
with 10m 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 $100m/10m 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, so the
rate of return is only 9%

23
Share classes: example

You have $1,000 to invest, and consider buying shares from equity funds

• Class A shares:
• Front-end load 6%
• Class B shares:
• 12b-1 fee 0.5% annually
• Back-end load of 5% which falls by 1% after each full year the
investor holds the portfolio (until the fifth year)
• Portfolio return net of operating expenses: 10% per year

If you plan to sell after 4 full years, which shares should you choose?

24
Share classes: example

• The initial investment in Class A shares is $940 net of the front-end

load

25
Share classes: example

• The initial investment in Class A shares is $940 net of the front-end

load
• After 4 years, portfolio value = $940 × 1.104 = $1, 376.25

25
Share classes: example

• The initial investment in Class A shares is $940 net of the front-end

25
Share classes: example

• The initial investment in Class A shares is $940 net of the front-end

load
• After 4 years, portfolio value = $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 (5% − 4% =) 1% back-end load fee if you sell after 4 years
• Therefore, the portfolio value after 4 years will be
$1, 000 × 1.0954 = $1, 437.66
• And after paying the back-end load fee:
$1, 437.66 × 0.99 = $1, 423.28 > $1, 376.25

25
Share classes: example