to Introduction Mutual Funds Basic Portfolio Mathematics
Week 3:
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An Example of A Mutual Fund
The largest mutual fund is the Fidelity Magellan Fund, with assets of $76.885 billion (31/1/2002). The fund has been in existence since May 1963. It is currently closed to most new investment. What type of a fund is it? It invests in large caps, and blend of growth and value. Given its style, what should its benchmark be? The appropriate benchmark, because of its emphasis on large caps, is the S&P 500. What kind of stocks would you buy if you were the manager of Magellan?
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Magellan's Stock Holding on 12/31/01
1.GENERAL ELECTRIC CO (4.76%) 2. CITIGROUP INC (3.95%) 3. MICROSOFT CORP 4. TYCO INTL LTD (2.69%) 5. AMER INTL GROUP INC (3%) 6. VIACOM INC CL B NON-VTG 7. EXXON MOBIL CORP (2.83%) 8. PFIZER INC 9. WAL MART STORES INC 10. HOME DEPOT INC
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Magellan vs. the S&P 500
29.50% of Magellan's holdings were in these top 10 stocks on 12/31/01. First, note that many of the stocks in the top holdings match the stocks with the highest weight in the S&P 500. Which stocks are missing from Fidelity's holdings Intel and IBM so it appears that Fidelity is underweighted in technology. Second, the weights are different. The S&P 500 had a weight of 22.09% in these 10 stocks. (Given these weights of Magellan, what do you estimate Magellan's performance, year to date, compared to its benchmark?).
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Magellan vs. S&P 500 vs. Average Fund in Group (as of 31 Dec 2001)
Last 1 year: Magellan = -11.65%. S&P 500 = -11.89%. Average Growth Fund = -16.76%. Last 5 years. Magellan = 10.95%. S&P 500 = 10.70%. Average Growth Fund = 8.56%. Last 10 years. Magellan = 12.90%. S&P 500 = 12.94%. Average Growth Fund = 11.19%. But Fidelity Magellan charges a "front-end load" a fee of 3% for entering the fund. The 1, 5, 10 year returns after the load are: -14.30%, 10.28%, 12.56%. So, after accounting for the load, Magellan underperforms the S&P 500 over each of these periods
http://personal300.fidelity.com/products/funds/mfl_frame.shtml? 316184100.
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What Magellan Charges for Managing Your Money
According to its annual report, 3/31/2001: Management fee Basic fee = $ 571,113,000. Performance adjustment = $139,203,000. Besides the management fee, the fund will charge other operational expenses. Total expenses, including management fee, added up to: 872,538,000. The ratio of expenses to net assets = 0.89%. If Magellan was open to new investment, it could have charged an additional fee, if necessary, called the 12B-1. This fee could be used for marketing purposes. Currently, Magellan has no 12B-1 fees. Finally, Magellan can charge a "load" either a front-end or a back-end load. Magellan has a 3% front-end load.
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Fidelity Magellan Year Ending 31/3/2001 NAV (Beginning of Year) Investment Operations Net Investment Income (dividends,etc.) Net Realized and Unrealized Gain on Investment Distributions Dividends Distributions from Capital Gains NAV( End of Year) (Net Assets of $80,190,261,000/ 767,360 shares) 2001 143.26 0.37 -34.17
-0.27 -4.69 $104.50
Ratios/Supplemental Data Ratio of Total Expenses to Average Net Asset Ratio of Net Investment Income to Average Net Assets Portfolio Turnover Rate
0.89% 0.59% 24%
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Understanding the Numbers (1/2)
New NAV: Old NAV + investment income + net realized and unrealized gain - all distributions. Distributions: To avoid taxation at the fund level, the fund must pass on any dividend or capital gains directly to the investors. The investors will now pay tax at their personal rate on both the dividends and capital gains. Fidelity has distributed $4.96 per share. Expense Ratio: This summarizes the operating expenses of the fund as a fraction of its NAV. The Magellan Fund has an expense ratio of 0.89%. This is comparable with other funds, but appear high relative to its size. As we saw, this is equal to $872 million.
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Understanding the Numbers
Portfolio Turnover Rate: This represents the fraction of the portfolio that is sold during the year. A turnover rate of 24% indicates that the average stock was held for 1/0.24=4.16 years. To see the effect of other potential charges, in particular loads and 12b-1 fees, let us consider another example.
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The Types of Fees Charged by Funds: Loads and Fees
Loads: front end or back end Fees: Management Fee 12B-1 Fees Other expenses Consider, as an example, the Oppenheimer Funds.
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Fund Fees: Loads (1/2):
Oppenheimer Growth Fund. Front End Load: A commission or sales charge paid when the shares of the fund are purchased. For example, Oppenheimer Funds have a typical front end load of 5.75% for their Class A shares. Back End Load: This is a redemption or exit fee that is paid when the funds are withdrawn. For example, Oppenheimer charges a 5% back end fee for its Class B shares, that decrease to 1% and is eliminated from 6th year onwards. Oppenheimer's Class B shares are converted automatically to Class A shares at the end of the 6th year.
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Fund Fees: Operating Expenses(2/2)
Annual Fund Operating Expenses: Management Fee + 12b-1 + Other operating expenses. 12b-1 Charges: The fund may charge a 12b-1 fee for marketing and advertising expenses, as well as commissions paid to brokers that sell the fund. This can be in addition to a front-end/back-end load. Oppenheimer charges a 12b-1 fee of 1% for both its Class B and C shares, and a fee of 0.25% for its Class A shares. Management Fee: This is a fee paid for the management of the funds. For Oppenheimer, it is 0.63% for all classes of shares. Other Expenses: The other operating expenses were 0.13% for Class A shares and 0.15% for B and C shares. Thus, the total operating expenses for this fund is 1.01% for its Class A shares, and 1.78% for B and C shares.
Oppenheimer converts Class A shares to Class B shares after 6 years, so expenses for B shares are 1.01% after the 6th year.
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Some Additional Notes on Calculation of Expenses and Loads
Back-End Load/Contingent Deferred Sales Load: (1) It is calculated as the lesser of the amount that represents a specified percentage of NAV at the time of purchase, or at the time of redemption. (2) It is not applied on shares purchased through reinvestment of dividends or capital gains distributions. (3) It is calculated as if shares that are not subject to a load are redeemed first. (4) Shares are redeemed in the order purchased, unless some other order can result in a lower redemption fee. Operating Expenses: It is applied daily as fraction of NAV.
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Impact of Costs on Investment Performance (1/5) Let us calculate the impact of the fees on the investor's return. We will use the Oppenheimer growth fund as an example. Consider an investor who starts with $10,000, and can choose between investing in either A, B or C class of shares. Suppose the investor expects that the fund will earn an average of 15% return every year, before expenses. Which class of shares should he invest in? Let us calculate the net return to the investor after costs for different investment horizons.
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Impact of Costs on Investment Performance (2/5)
Class A : 1-Year Horizon Front End Load of 5.75%, total operating expenses 1.01% (12b-1 fee of 0.25%, management fee of 0.63%, other operating expenses of 0.13%). Original investment = $10,000. Amount invested into fund on 1/1/2000 after front-end load = 10,000(1 - 0.0575)= 9,425. Total return before expenses = 15%. Return after expenses of 1.05% = 15-1.01=13.99%. Value of investment on 12/31/2000 = 9425(1+0.1399)=10,743.56 Net return over 1-year = 7.40%.
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Impact of Costs on Investment Performance (3/5)
Class B : 1-Year Horizon: Back End Load of 5.0%, total operating expenses 1.86%. Original investment = $10,000. Amount invested into fund on 1/1/2000 = $10,000. Total return before expenses = 15%. Return after expenses = 15-1.78=13.22%. Value of investment on 12/31/2000 before back-end load= 10000(1+0.1322)=11,322. If we assume that the backend load is applied to the initial amount of $10,000 Value of investment after back-end load of 5% = 11322 - 0.05x10000 = 10,822 Net return over 1-year = 8.22%.
*If we assume that the load applies to the final amount, then the value 16 of the fund will be 11322x(1-0.05)=10756, or you will earn 7.56%.
Impact of Costs on Investment Performance (4/5)
Class C: 1-Year Horizon: No front end load , total operating expenses 1.78%, backend load of 1% in first year. Original investment = $10,000. Amount invested into fund on 1/1/2000 = $10,000. Total return before expenses = 15%. Return after expenses of 1.05% = 15-1.78=13.22%. Value of investment at year-end before back-end load= 10000(1+0.1322)=11,322. Value of investment after back end load of 1% applied to initial investment* = 11322 - 0.01x10,000 = 11222. Net return over 1-year = 12.22%%.
(*If the backend load is applied to ending amount, then the value of the investment is 11322x0.99 = $11,209, so that the net return is 12.09%.).
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Comparing Performance Across Share Classes
Investment Annual ReturnsOperating Expenses Front End Load End Back 100 15.00% Class A Classes B&C 5.75% 5.00% 1.01% 1.78% 4.00% 3.00% 2.00% 1.00% Assumptions: Class B convert to Class A after 6th year. Horizon(Yr) Class A 1 107.435575 3 139.598779 5 181.3907461 6 206.7673115 10 349.0992337 20 1293.053315 Class B Class C 108.22 112.22 142.1340958 145.1340958 185.0440361 186.0440361 210.6390577 210.6390577 355.6361646 346.1238338 1317.265915 1198.017083
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Yet Another Example
Vanguard is a large fund family that is particularly known for its passive funds. However, it also has active funds - see the annual report on Vanguard's large cap growth fund: Vanguard US Growth Fund: Annual Report http://www.vanguard.com/funds/reports/usgrar.pdf Its expenses are lower than average, but so are its returns!
Moral: Lower expenses by themselves are not a reason to buy active managed funds.
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Passive Funds
Passive funds have much lower expenses as they are simply trying to replicate an index, and thus do not require costly support staff. Moreover, fund returns relative to the benchmark are very sensitive to expenses, and thus there is additional pressure to keep expenses under control. As an example, let us consider the Vanguard Index Trust 500 Fund (VFINX). Class A Net Assets on 31/1/2002 = $73.2B Management fee = 16 bps (0.16%) Total expenses = 18 bps. Return before taxes: -12.02% (1 yr), 1.06% (3 yrs), 10.66% (5 yrs), 12.84% (10 yrs) The next slide provides a comparison with the S&P 20 500.
Yearly Investment Return
Vanguard 500 Index Fund Inv Year Ended 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 Capital Income Total Return Return Return -13.11% 1.08% -12.02% -9.95% 0.90% -9.06% 19.70% 1.37% 21.07% 27.00% 1.61% 28.62% 31.11% 2.08% 33.19% 20.53% 2.35% 22.88% 34.35% 3.09% 37.45% -1.51% 2.69% 1.18% 7.06% 2.84% 9.89% 4.45% 2.97% 7.42% 3.94% 26.28% 30.22% -6.84% 3.52% -3.32% 26.67% 4.70% 31.36% 11.55% 4.67% 16.22% 2.27% 2.43% 4.71% 14.04% 4.02% 18.06% 26.09% 5.14% 31.23% 1.54% 4.68% 6.21% S&P 500 Total Return -11.89% -9.10% 21.04% 28.58% 33.36% 22.96% 37.58% 1.32% 10.08% 7.62% 30.47% -3.10% 31.69% 16.61% 5.26% 18.68% 31.75% 6.27%
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Exchange Traded Funds (ETF)
Although passive funds can be bought directly from the fund family, a recent innovation is to list a passive fund as an "Exchange Traded Fund" the fund's shares trade continuously on an exchange. (In principle, ETF can be for both active as well as passive funds.) The fund's price tracks the NAV because the ETF allows for redemptions. Exchange traded funds also have low expenses Barclay's charges about 9 bps (0.09%)! The fund saves on marketing costs, as ETF's are listed on an exchange, and thus can be bought and sold like a regular stock. Mostly traded on the AMEX:
http://www.amex.com/indexshares/index_shares_over.stm Examples: Barclay's Ishares, Vanguard's VIPER, SPDRs (S&P's Depository Receipts), WEBS (World Equity Benchmark Shares), QQQ (called "cubes,. track the NASDAQ 100)
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Vanguard's VIPER
VIPER: Vanguard Index Participation Equity Receipts Vanguard Total Stock Market VIPER: Tracks the Wilshire 5000 (Ticker: VTI). Expenses of 15 bps. Although it allows for redemptions at NAV, the price can, at times, differ from the NAV. The next page provides details of how much the price differs from NAV.
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Premium/Discount Since Inception (through 02/08/2002) Closing Price above or equal to NAV Basis Point Differential* 0 - 24 25 - 49 50 - 74 75 - 100 >100
Total
Closing Price below NAV Number of Days 55 9 0 0 1 65 % of Total Days 31% 5% 0% 0% 0% 36%
Number of Days 103 7
1 0 0
% of Total Days 58% 3%
0% 0% 0%
111
63%
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Exercises:
Please attempt all numerical exercises from the back of Chapter 4. The SEC has provided a calculator to help investors estimate the total cost over the lifetime of the fund: see http://www.sec.gov/mfcc/getstarted.html
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Chapter 8 (See Also Chapters 5-7)
Basic Portfolio Mathematics
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Road Map
1. Averaging: Geometric vs Arithmetic. 2. Calculation of Portfolio Returns and Variances. 3. Introduction to Asset Allocation
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Estimating the Mean Return (1/6)
We can estimate the mean return in two ways: Arithmetic Mean and Geometric Mean. Suppose you want to estimate the mean return over the last three years, when the returns were r1, r2,and r3. Arithmetic Average = (r1+r2+r3)/3 Geometric Average = [(1+r1)*(1+r2)*(1+r3)]^(1/3)-1
Note that the above method to calculate the geometric average is better than estimating is as [(r1)(r2)(r3)]^(1/3)
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Arithmetic Vs Geometric (2/6)
Consider the following examples: 1. r1=r2=r3=0.10 Arithmetic average = (0.1+0.1+0.1)/3=0.1 Geometric average = [(1.1)*(1.1)*(1.1)]^(1/3)-1 = 0.1 In this case, when all returns are identical, the arithmetic average is equal to the geometric average. In general, this is not true.
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Arithmetic Vs Geometric (3/6)
2. r1=0.10, r2=0.15, r3=0.05. Arithmetic average = (0.10+0.15+0.05)/3=0.10. Geometric Average = [(1.10)(1.15)(1.05)]^(1/3)1=0.09924 The arithmetic average is greater than the geometric average. Qt: which average to use?
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The Difference Between Geometric and Arithmetic Average (4/6)
There are two points to note: 1. The arithmetic average return will be always greater than or equal to the geometric average return. 2. The difference between the arithmetic and geometric return will depend on the volatility of the return. The greater the volatility, the greater will be the difference in the return. If the volatility is zero (or the returns in every period are the same) then both averages will be the same.*
*Approximately, AA - GA = 0.5 (vol^2)
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Choice Between Arithmetic and Geometric (5/6)
1. If you are simply trying to predict the next period's return, then the arithmetic average will be, statistically, the better choice. 2. If you are trying to calculate the cumulative return over the past 3-year period, the geometric average is better. For example, the arithmetic average of 0.10 estimates the total 3-year return as (1+0.10)^3-1=33.1%, while the geometric average estimates it as (1+0.09924)^3-1=32.825%. In comparison, the exact three year return is (1.1)(1.15) (1.05)-1=32.825%. Thus, if you know the geometric average, you can recover the cumulative return over the period. However, with the arithmetic average you will over-estimate the cumulative return.
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Geometric Vs Arithmetic: Past Historical Returns (6/6)
The difference between estimates of geometric (GA) and arithmetic average (AA) are quite substantial. Here are some estimates over the period 1926-1996 1. Large Cap:AA=12.5%/yr, GA=10.5%/yr 2. Small Cap: AA=19%/yr, GA=12.6%/yr
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Volatility and Correlations
We have already seen that we can easily estimate the volatility and correlation using Excel functions STDEV and CORREL. The variance is defined as the square of the volatility (or standard deviation). Similar to the case of the returns, it is conventional to express the volatility in an annual basis. Annual Volatility = sqrt(12) [Monthly Volatility]. Annual Volatility = sqrt(260)[Daily Volatility]. For example, a daily volatility of 1% implies an annual volatility of about 16%. Recently, we have been observing daily fluctuations of about 1.5% - what does that imply about the annual volatility?
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Portfolio Return and Variance
Suppose we have two assets, with weights w1 and w2, respectively. The weight of w1 is defined as the ratio of the dollar invested in asset 1, divided by the total $ investment. Thus, if you invest $100 in asset 1 and $400 in asset 2, then w1=0.2 and w2=0.8. Portfolio return = w1*r1 + w2*r2 Portfolio variance = (w1*w1)*(var of asset 1) + (w2*w2)*(var of asset2) + 2 (w1)(w2)(correlation)(vol of asset1)(vol of asset 2) To get the portfolio volatility, we take the square root of the portfolio variance.
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A Digression: On Re-balancing a Portfolio (1/3)
We have already observed that we can have different portfolios based on the way we choose the weights - in particular, we saw the equal weighted portfolio and the value weighted portfolio. Qt: How easy is it to maintain such portfolio weights as market prices change?
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Re-Balancing Cap-Weighted Portfolio (2/3)
Company A: #of shares=100, and Price = 20. Company B: # of shares=200, and Price = 40. Therefore: w_a=(100*20)/[100*20+200*40] = 0.20 and w_b=1 - w_a=0.80. Therefore, if you decide to invest a total of $1,000,000 you will buy $200,000 of A ...