AF5353: Security Analysis &

Portfolio Management
Lecture 2
Instructor: Yong (Jimmy) JIN (jimmy.jin@polyu.edu.hk)
Office: M507D, Li Ka Shing Tower
Office Hour: Tuesday 17:20 to 18:20, 21:30 to 22:30; Friday 13:00 to 15:00
 Agenda
• Types of investment companies
• Mutual funds
– Open-end funds
– Closed-end funds
– ETFs
• Hedge funds
Hedge fund managers’ life
http://www.youtube.com/watch?v=N8PDwdlNkEQ
• Difference between hedge funds and mutual funds

• Trading costs
• Buyer on margin
• Short sales
 Investment companies
• Functions
• Record keeping and administration
• Diversification
• Professional management
• Lower transaction costs

• Definitions
• Investment company: Financial intermediaries
• Net asset value (NAV): Assets minus liabilities per
share
 Investment companies
• The value of each share is called:
Net Asset Value (NAV)

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑁𝐴𝑉 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Examples: assets: 3,352.8 liabilities: 270.3

shares outstanding: 110.2
What is the NAV? (3352.8-270.3)/110.2=27.97
 Types of investment companies
• Unit Investment Trusts
• Money pooled from many investors is invested in
portfolio fixed for life of fund
• Managed Investment Companies
• Open-end fund: Issues or redeems shares at net
value
• Closed-end fund: Shares can’t be redeemed, are
traded at prices different than NAV
• Load: Sales commission charged on mutual fund
 Types of investment companies
• Open-End and Closed-End Funds: Key
Differences
• Shares Outstanding
• Closed-end: No change
• Open-end: Changes when new shares are sold or old
shares are redeemed
• Pricing
• Open-end: Fund share price = Net asset value (NAV)
• Closed-end: Fund share price may trade at premium or
discount to NAV
 Types of investment companies
• Other Investment Organizations
• Commingled Funds
• Partnership of investors pooling funds; designed for
trusts/larger retirement accounts to get professional
management for fee
• Real Estate Investment Trusts (REITs)
• Similar to closed-end funds, invests in real estate/real
estate loans
• Hedge Funds
• Private speculative investment pool, exempt from SEC
regulation
 Mutual Funds
• Accounts for more than 90% of investment company assets
– U.S. mutual fund industry has approx $10 trillion in AUM

• Types of mutual funds--Investment Policies

• Money market funds
• Commercial paper, repurchase agreements, CDs
• Equity funds
• Invest in stock, some fixed-income, or other securities
• Specialized sector funds
• Concentrate on particular industry
• Bond funds
• Specialize in fixed-income (bonds) sector
 Mutual Funds
• Types of mutual funds--Investment Policies
• International funds
• Global funds invest in securities worldwide, including U.S.
• Balanced funds
• Hold both equities and fixed-income securities in stable
proportion
• Asset allocation and flexible funds
• Stocks and bonds—proportion varies according to market
forecast
• Index funds
• Try to match performance of broad market index
 Mutual Funds
Assets ($ billion) Percent of Total Assets Number of Funds
Equity Funds
Capital appreciation focus 2,912 24.2% 3,037
World/international 1,660 13.8% 968
Total return 1,950 16.2% 762
Total equity funds 6,522 54.2% 4,767
Bond Funds
Corporate 301 2.5% 293
High yield 157 1.3% 206
World 84 0.7% 122
Government 203 1.7% 301
Strategic income 560 4.7% 370
Single-state municipal 156 1.3% 451
National municipal 218 1.8% 224
Total bond funds 1,679 14.0% 1,967

Hybrid (bond/stock) funds 713 5.9% 488

Money market funds
Taxable 2,642 22.0% 548
Tax-exempt 465 3.9% 259
Total money market funds 3,107 25.8% 807

Total 12,021 100.0% 8,029

 Mutual Funds
• Cost of investing in Mutual funds
• Fee Structure
• Operating expenses: Costs incurred by mutual fund in
operating portfolio
• Front-end load: Commission or sales charge paid when
purchasing shares
• Back-end load: “Exit” fee incurred when selling shares
• 12b-1 charges: Annual fees charged by mutual fund to
pay for marketing/distribution costs
 Mutual Funds
• Rate of return

𝑁𝐴𝑉1 − 𝑁𝐴𝑉0 + 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑛𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑁𝐴𝑉0

• Which costs does this include?

• Operating expenses
• 12b-1 expenses
• Which costs does this ignore?
• Front-end and back-end loads
 Question
• A mutual fund with $200mm in assets and 10mm shares
outstanding
• Dividend income: $2mm
• Price appreciation: 8%
• No capital gain distribution
• 12-b1 fee is 1% and deducted from portfolio assets at year
-end
NAV0=200/10=20 HKD/share
What is NAV at the end of the year?
NAV1=NAV0(1+8%)-1%NAV0=20.14
rate of return=(NAV1+0.2-NAV0)/NAV0

What is the rate of return?

 Question
• Start of year NAV =
Market value of assets － Market value of liabilities
=
Shares outstanding

• End of year NAV is based on the 8% price gain, less the 1% 12b-1 fee:
• End of year NAV =

• Given the dividends per share is $0.20, we can calculate the rate of
return using the following equation:
Δ(NAV) ＋ Distributions
• Rate of return = =
Start of year NAV
 Closed-end Funds
• Initially offered as an Initial Public Offering (IPO)
– Typically at a price 10% above the NAV due to
investment banking fees charged to the fund
• Can issue new shares through reinvestment plans
or public stock offerings
• Dividends and interest received from the
securities in the portfolio are paid out to the
shareholders
• Shares trade on stock exchange
• See http://www.etfconnect.com for information
about closed-end funds
 Closed-end Funds
• Price determined by the market – need not equal
its NAV
• Typically sell at a discount of about 5% of their
NAV
• IPOs issued at NAV plus cost of issuance. Price
eventually drops below NAV to a discount.
• Size of the discount varies substantially across
funds
• Why do closed-end funds trade at discount to
NAV?
 Closed-end Funds vs Open-end Funds

• Closed-end Open-end
• Traded on stock • Trade once a day –
exchanges at close
• Can be shorted • Buy directly from
the funds
• Trade between
• Cannot be shorted
investors
• Buy at NAV
• Typically trade at a
discount to NAV
 Exchange-Traded Funds
• Exchange-Traded Funds: Offshoots of mutual
funds that allow investors to trade index
portfolios
• Potential Advantages
• Trade continuously throughout day
• Can be sold or purchased on margin
• Potentially lower tax rates
• Lower costs (no marketing, lower fund
expenses)
 Exchange-Traded Funds
• Assets in ETFs
 Hedge Funds
• A private investment pool for alpha-seeking
activities
• Only open to institutional investors and
wealthy individuals
• Less liquid and much more risky
 Hedge Funds versus Mutual Funds
Mutual Funds Hedge Funds
Transparency Public info on portfolio Info provided only to
composition investors

Investors Unlimited < 100, high dollar

minimums

Strategies Must adhere to No limitations

prospectus, limited short
selling & leverage, limited
derivatives usage
 Hedge Funds versus Mutual Funds
Mutual Funds Hedge Funds
Liquidity Redeem shares on demand Multiple year lock-up
periods typical
Fees Fixed percentage of assets; Fixed percentage of assets;
typically .5% to 2% typically 1% to 2% plus
incentive fee = 20% of
gains above threshold
return
 Hedge Funds Strategies
• Hedge funds are classified in various ways by
different sources
• “Style-based” asset class
 Hedge Funds Strategies
• Directional and Non-directional Strategies
• Market neutral (directional)
• Designed to exploit relative mispricing within market;
hedged to avoid taking stance on direction on broad
market
• Pure plays (non-directional)
• Bets on particular mispricing across two or more
securities; extraneous sources of risk hedged away
Hedge Funds Strategies
 Hedge Fund Structure
• Management fee
– Usually 1% to 2% of assets under management (AUM)
• Incentive fee (Performance fee)
– Usually 20% of its return
• High water marks
– Avoid incentive fee double-dipping
For example: 100120(incentive fee)80110(no
incentive fee)130(greater than HWM 120, incentive
fee)
 Hedge Funds Structure
• Lock-up period
– Limit withdrawals by requiring a minimum
investment period
– Usually 1-3 years
 Fund of hedge funds
• A hedge fund that consists of several, usually 10-30
hedge funds
• Good entry-level investment
• Better indicator of aggregate hedge funds
performance than the typical hedge fund index
because less survivorship bias and backfill bias
• Disadvantage: second-layer of fees

• An extension: Managers of Managers (MOM)

 Hedge fund performance evaluation
• Monthly Returns
– Reported monthly returns
𝑉1
– −1
𝑉0
• Moving average monthly returns (average
trailing 12 months)
 Trading costs
• Commission: Fee paid to broker for making
transactions
• Spread: Cost of trading with dealer
• Bid: Price at which dealer will buy from you

• Ask: Price at which dealer will sell to you

• Spread: Ask — bid

 Trading costs
• Full service brokers vs. discount brokers
Full service brokers: Discount brokers:
• General economic forecasts • Buy/sell
• Industrial analysis • Offer margin loans
• Company condition analysis • Facilitate short sells
• Buy/sell recommendations
• Buy/sell transactions
(discretionary accounts)
• Offer margins loans
• Facilitate short sales
 Trading costs
• Top full service brokers and discount brokers
Full service brokers: Discount brokers:
• Edward Jones • Ameritrade
• UBS • Tradeking
• Raymond James • Scotttrade
• Merrill Lynch • Trademonster
• Wells Fargo • Interactive Brokers
• Morgan Stanley Smith Barney
 Buying on margin
• Margin: Describes securities purchased with money
borrowed in part from broker
• Net worth of investor's account

• Initial Margin Requirement (IMR)

• Minimum set by Federal Reserve under Regulation T,
currently 50% for stocks
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can borrow
 Buying on margin
• Equity
• = Position value - Borrowing + Additional cash

• Maintenance Margin Requirement (MMR)

• Minimum amount equity can be before additional funds
must be put into account
• Exchanges require a minimum 25%

• Margin Call
• Notification from broker that you must put up additional
funds or have position liquidated
 Buying on margin
• If Equity / Market value  MMR, then margin call
occurs
• https://www.youtube.com/watch?v=pABVbSlmPSU

• A margin call will occur when:

• (Market value – Borrowed) / Market Value  MMR

 Buying on margin
• Margin Trading: Initial Conditions
• X Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
 Buying on margin
• Stock price falls to $60 per share
• Position value = Borrowing + Additional cash

• Margin %: $25,000/$60,000 =42%>40%

• How far can price fall before margin call?

• (1000*P-35000)/1000P=0.4 1000P=58,333
New Position
Stock 1000P Borrowed 35,000
Equity 1000P-
35000
 Buying on margin
• With 1,000 shares, stock price for margin call is
$58,333/1,000 = $58.33
• Margin % = $23,333/$58,333 = 40%
• To restore IMR, equity = ½ x $58,333 = $29,167

New Position
Stock 58,333 Borrowed 35,000
Equity 23,333
 Question
• You are bullish on Telecom stock. The current market price is
$50 per share, and you have $5,000 of your own to invest. You
borrow an additional $5,000 from your broker and invest
$10,000 in the stock. The maintenance margin is 30%.

• How far does the price of Telecom stock have to fall for you to
get a margin call?

• If the price falls to 40 per share, will you receive a margin call?
 Question
(1) The value of the 200 shares is 200P. Equity is
(200P – $5,000), and the required margin is 30%.
200P －$5,000
Solving 200P
= 0.30, we get P = $35.71.
You will receive a margin call when the stock price
falls below $35.71.

(2) since 40>35.71, you won’t receive a margin call

 Buying on margin
• Why do investors buy securities on margin?

• Do not have enough money to invest

• Greater upside potential

• Leverage Effect - Greater downside risk

 Short sales
• Sale of shares not owned by investor but
borrowed through broker and later purchased to
replace loan
• Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin in
margin account (you cannot withdraw proceeds until
you “cover”)
• Covering or closing out position: Buy stock; broker
returns title to party from which it was borrowed
 Short sales
• Round Trips
• Long position
• Buy first, sell later
• Bullish
• Short position
• Sell first, buy later
• Bearish
• “Round trip” is a purchase and a sale
Short sales
 Short sales
• Required initial margin: Usually 50%
• More for low-priced stocks

• Liable for any cash flows

• Dividend on stock

• Zero tick, uptick rule

• Eliminated by SEC in July 2007
 Short sales
• Example
• You sell 100 short shares of stock at $60 per share

• $6,000 must be pledged to broker

• You must also pledge 50% margin
• You put up $3,000; now you have $9,000 in
margin account
• Short sale equity = Total margin account – Market
value
 Short sales
• Example
• Maintenance margin for short sale of stock with
price =60 is 30% market value
• 30% x $6,000 = $1,800

• You have $1,200 excess margin

• What price for margin call?

(remember the investor is bearish on the market)

 Short sales
• Example
• When equity  (.30 x Market value), you get a
margin call
• Equity = Total margin account – Market value (1)

• Equity=market value*MMR (2)

• (9000-100P)=0.3*100P (1)=(2)

• Price for margin call: P=9000/130 = $69.23

 Question
• You are bearish on Telecom and decide to sell
short 100 shares at the current market price of
$50 per share.
• How much in cash or securities must you put into your
brokerage account if the broker’s initial margin
requirement is 50% of the value of the short position?
• How high can the price of the stock go before you get a
margin call if the maintenance margin is 30% of the
value of the short position?
 Question
(1) Initial margin is 50% of $5,000, which is $______

(2) Total assets are $7,500 ($5,000 from the sale of the stock
and $2,500 put up for margin). Liabilities are 100P. Therefore,
net worth is ($7,500 – 100P).

Solving = 0.30, we get P = $_____

A margin call will be issued when the stock price reaches

$_____ or higher.