Complete the following Case Problems from Fundamentals of Investing:

· Case Problem 1.2: Preparing Carolyn Bowen’s Investment Plan, Questions A-E (page 36)

· Case Problem 2.1: Dara’s Dilemma: What to Buy?, Questions A-C (page 71)

· Case Problem 2.2: Ravi Dumar’s High-Flying Margin Account, Questions A-E (page 72)

· Case Problem 3.1: The Perezes’ Good Fortune, Questions A-E (page 119)

· Case Problem 12.1: Reverend Mark Thomas Ponders Mutual Funds, Questions A-C (page 508)

Format your submission consistent with APA guidelines.

Submit your assignment.

Case Problem 12.1 Reverend Mark Thomas Ponders Mutual Funds

1. LG 3

2. LG 5

The Reverend Mark Thomas is the minister of a church in the San Diego area. He is married, has one young child, and earns a “modest income.” Because religious organizations are not notorious for their generous retirement programs, the reverend has decided he should do some investing on his own. He would like to set up a program that enables him to supplement the church’s retirement program and at the same time provide some funds for his child’s college education (which is still some 12 years away). He is not out to break any investment records but wants some backup to provide for the long-run needs of his family.

Although he has a modest income, Mark Thomas believes that with careful planning, he can probably invest about $250 a quarter (and, with luck, increase this amount over time). He currently has about $15,000 in a savings account that he would be willing to use to begin this program. In view of his investment objectives, he is not interested in taking a lot of risk. Because his knowledge of investments extends to savings accounts, Series EE savings bonds, and a little bit about mutual funds, he approaches you for some investment advice.

Questions

a. In light of Mark’s long-term investment goals, do you think mutual funds are an appropriate investment vehicle for him?

b. Do you think he should use his $15,000 savings to start a mutual fund investment program?

c. What type of mutual fund investment program would you set up for the reverend? Include in your answer some discussion of the types of funds you would consider, the investment objectives you would set, and any investment services (e.g., withdrawal plans) you would seek. Would taxes be an important consideration in your investment advice? Explain.

Complete the following Case Problems from Fundamentals of Investing:

· Case Problem 1.2: Preparing Carolyn Bowen’s Investment Plan, Questions A-E (page 36)

· Case Problem 2.1: Dara’s Dilemma: What to Buy?, Questions A-C (page 71)

· Case Problem 2.2: Ravi Dumar’s High-Flying Margin Account, Questions A-E (page 72)

· Case Problem 3.1: The Perezes’ Good Fortune, Questions A-E (page 119)

· Case Problem 12.1: Reverend Mark Thomas Ponders Mutual Funds, Questions A-C (page 508)

Format your submission consistent with APA guidelines.

Submit your assignment.

Case Problem 1.2 Preparing Carolyn Bowen’s Investment Plan

1. LG 4

2. LG 5

Carolyn Bowen, who just turned 55, is employed as an administrative assistant for the Xcon Corporation, where she has worked for the past 20 years. She is in good health, lives alone, and has two grown children. A few months ago her husband died, leaving her with only their home and the proceeds from a $75,000 life insurance policy. After she paid medical and funeral expenses, $60,000 of the life insurance proceeds remained. In addition to the life insurance proceeds, Carolyn has $37,500 in a savings account, which she had accumulated over the past 10 years. Recognizing that she is within 10 years of retirement, Carolyn wishes to invest her limited resources so she will be able to live comfortably once she retires.

Carolyn is quite superstitious. After consulting with a number of psychics and studying her family tree, she is certain she will not live past 80. She plans to retire at either 62 or 65, whichever will allow her to meet her long-run financial goals. After talking with a number of knowledgeable individuals—including, of course, the psychics—Carolyn estimates that to live comfortably in retirement, she will need $45,000 per year before taxes. This amount will be required annually for 18 years if she retires at 62 or for 15 years if she retires at 65. As part of her financial plan, Carolyn intends to sell her home at retirement and rent an apartment. She has estimated that she will net $112,500 if she sells the house when she is 62 and $127,500 if she sells it when she is 65. Carolyn has no financial dependents and is not concerned about leaving a sizable estate to her heirs.

If Carolyn retires at age 62, she will receive from Social Security and an employer-sponsored pension plan a total of $1,359 per month ($16,308 annually); if she waits until age 65 to retire, her total retirement income will be $1,688 per month ($20,256 annually). For convenience, Carolyn has already decided to convert all her assets at the time of retirement into a stream of annual income and she will at that time purchase an annuity by paying a single premium. The annuity will have a life just equal to the number of years remaining until her 80th birthday. If Carolyn retires at age 62 and buys an annuity at that time, for each $1,000 that she puts into the annuity she will receive an annual benefit equal to $79 for the subsequent 18 years. If she waits until age 65 to retire, each $1,000 invested in the annuity will produce an annual benefit of $89.94 for the 15 years.

Carolyn plans to place any funds currently available into a savings account paying 6% compounded annually until retirement. She does not expect to be able to save or invest any additional funds between now and retirement. For every dollar that Carolyn invests today, she will have $1.50 by age 62; if she leaves the money invested until age 65, she will have $1.79 for each dollar invested today.

Questions

a. Assume that Carolyn places currently available funds in the savings account. Determine the amount of money Carolyn will have available at retirement once she sells her house if she retires at (1) age 62 and (2) age 65.

b. Using the results from item a, determine the level of annual income that will be provided to Carolyn through purchase of an annuity at (1) age 62 and (2) age 65.

c. With the results found in the preceding questions, determine the total annual retirement income Carolyn will have if she retires at (1) age 62 and (2) age 65.

d. From your findings, do you think Carolyn will be able to achieve her long-run financial goal by retiring at (1) age 62 or (2) age 65? Explain.

e. Evaluate Carolyn’s investment plan in terms of her use of a savings account and an annuity rather than other investments. Comment on the risk and return characteristics of her plan. What recommendations might you offer Carolyn? Be specific.

Case Problem 2.2 Ravi Dumar’s High-Flying Margin Account

1. LG 6

Ravi Dumar is a stockbroker who lives with his wife, Sasha, and their five children in Milwaukee, Wisconsin. Ravi firmly believes that the only way to make money in the market is to follow an aggressive investment posture—for example, to use margin trading. In fact, Ravi has built himself a substantial margin account over the years. He currently holds $75,000 worth of stock in his margin account, though the debit balance in the account amounts to only $30,000. Recently Ravi uncovered a stock that, on the basis of extensive analysis, he feels is about to take off. The stock, Running Shoes (RS), currently trades at $20 per share. Ravi feels it should soar to at least $50 within a year. RS pays no dividends, the prevailing initial margin requirement is 50%, and margin loans are now carrying an annual interest charge of 10%. Because Ravi feels so strongly about RS, he wants to do some pyramiding by using his margin account to purchase 1,000 shares of the stock.

Questions

a. Discuss the concept of pyramiding as it applies to this investment situation.

b. What is the present margin position (in percent) of Ravi’s account?

c. Ravi buys the 1,000 shares of RS through his margin account (bear in mind that this is a $20,000 transaction).

1. What will the margin position of the account be after the RS transaction if Ravi follows the prevailing initial margin (50%) and uses $10,000 of his money to buy the stock?

2. What if he uses only $2,500 equity and obtains a margin loan for the balance ($17,500)?

3. How do you explain the fact that the stock can be purchased with only 12.5% margin when the prevailing initial margin requirement is 50%?

d. Assume that Ravi buys 1,000 shares of RS stock at $20 per share with a minimum cash investment of $2,500 and that the stock does take off and its price rises to $40 per share in one year.

1. What is the return on invested capital for this transaction?

2. What return would Ravi have earned if he had bought the stock without margin—that is, if he had used all his own money?

e. What do you think of Ravi’s idea to pyramid? What are the risks and rewards of this strategy?

Case Problem 3.1 The Perezes’ Good Fortune

1. LG 2

2. LG 4

3. LG 6

Angel and Marie Perez own a small pool hall located in southern New Jersey. They enjoy running the business, which they have owned for nearly three years. Angel, a retired professional pool shooter, saved for nearly 10 years to buy this business, which he and his wife own free and clear. The income from the pool hall is adequate to allow Angel, Marie, and their children, Mary (age 10) and José (age 4), to live comfortably. Although he lacks formal education beyond the 10th grade, Angel has become an avid reader. He enjoys reading about current events and personal finance, particularly investing. He especially likes Money magazine, from which he has gained numerous ideas for better managing the family’s finances. Because of the long hours required to run the business, Angel can devote 3 to 4 hours a day (on the job) to reading.

Recently Angel and Marie were notified that Marie’s uncle had died and left them a portfolio of stocks and bonds with a current market value of $300,000. They were elated to learn of their good fortune but decided it would be best not to change their lifestyle as a result of this inheritance. Instead, they want their newfound wealth to provide for their children’s college educations as well as their own retirement. They decided that, like their uncle, they would keep these funds invested in stocks and bonds.

Angel felt that in view of this plan, he needed to acquaint himself with the securities currently in the portfolio. He knew that to manage the portfolio himself, he would have to stay abreast of the securities markets as well as the economy in general. He also realized that he would need to follow each security in the portfolio and continuously evaluate possible alternative securities that could be substituted as conditions warranted. Because Angel enjoyed using his spare time to follow the market, he strongly believed that with proper information, he could manage the portfolio. Given the amount of money involved, Angel was not too concerned with the information costs; rather, he wanted the best information he could get at a reasonable price.

Questions

a. Explain what role the Wall Street Journal and/or Barron’s might play in meeting Angel’s needs. What other general sources of economic and current event information would you recommend to Angel? Explain.

b. How might Angel be able to use the services of Standard & Poor’s Corporation, Mergent, and the Value Line Investment Survey to learn about the securities in the portfolio? Indicate which, if any, of these services you would recommend, and why.

c. Recommend some specific online investment information sources and tools to help Angel and Marie manage their investments.

d. Explain to Angel the need to find a good stockbroker and the role the stockbroker could play in providing information and advice. Should he consider hiring a financial advisor to manage the portfolio?

e. Give Angel a summary prescription for obtaining information and advice that will help to ensure the preservation and growth of the family’s newfound wealth.

Case Problem 2.1 Dara’s Dilemma: What to Buy?

1. LG 6

Dara Simmons, a 40-year-old financial analyst and divorced mother of two teenage children, considers herself a savvy investor. She has increased her investment portfolio considerably over the past five years. Although she has been fairly conservative with her investments, she now feels more confident in her investment knowledge and would like to branch out into some new areas that could bring higher returns. She has between $20,000 and $25,000 to invest.

Attracted to the hot market for technology stocks, Dara was interested in purchasing a tech IPO stock and identified 

NewestHighTech.com

, a company that makes sophisticated computer chips for wireless Internet connections, as a likely prospect. The 1-year-old company had received some favorable press when it got early-stage financing and again when its chip was accepted by a major cell phone manufacturer.

Dara also was considering an investment in 400 shares of Casinos International common stock, currently selling for $54 per share. After a discussion with a friend who is an economist with a major commercial bank, Dara believes that the long-running bull market is due to cool off and that economic activity will slow down. With the aid of her stockbroker, Dara researches Casinos International’s current financial situation and finds that the future success of the company may hinge on the outcome of pending court proceedings on the firm’s application to open a new floating casino on a nearby river. If the permit is granted, it seems likely that the firm’s stock will experience a rapid increase in value, regardless of economic conditions. On the other hand, if the company fails to get the permit, the falling stock price will make it a good candidate for a short sale.

Dara felt that the following alternatives were open to her:

· Alternative 1: Invest $20,000 in 
NewestHighTech.com
 when it goes public.

· Alternative 2: Buy Casinos International now at $54 per share and follow the company closely.

· Alternative 3: Sell Casinos short at $54 in anticipation that the company’s fortunes will change for the worse.

· Alternative 4: Wait to see what happens with the casino permit and then decide whether to buy or short sell the Casinos International stock.

Questions

a. Evaluate each of these alternatives. On the basis of the limited information presented, recommend the one you feel is best.

b. If Casinos International’s stock price rises to $60, what will happen under alternatives 2 and 3? Evaluate the pros and cons of these outcomes.

c. If the stock price drops to $45, what will happen under alternatives 2 and 3? Evaluate the pros and cons of these outcomes.

Investments and the Investment Process

1. LG 1

2. LG 2

You are probably already an investor. If you have money in a savings account, you already have at least one investment to your name.

A

n 

investment

 is simply any asset into which funds can be placed with the expectation that it will generate positive income and/or increase its value, and a collection of different investments is called a 

portfolio

.

Note

The Learning Goals shown at the beginning of the chapter are keyed to text discussions using these icons.

The rewards, or 

returns

, from investing come in two basic forms: income and increased value. Money invested in a savings account provides income in the form of periodic interest payments. A share of common stock may also provide income (in the form of dividends), but investors often buy stock because they expect its price to rise. That is, common stock offers both income and the chance of an increased value. In the United States since 1900, the average annual return on a savings account has been a little more than 3%. The average annual return on common stock has been about 9.6%. Of course, during major market downturns (such as the one that occurred in 2008), the returns on nearly all investments fall well below these long-term historical averages.

Is cash placed in a simple (no-interest) checking account an investment? No, because it fails both tests of the definition: It does not provide added income and its value does not increase. In fact, over time inflation erodes the purchasing power of money left in a non-interest-bearing checking account.

We begin our study of investments by looking at types of investments and at the structure of the investment process.

Attributes of Investments

When you invest, the organization in which you invest—whether it is a company or a government entity—offers you the prospect of a future benefit in exchange for the use of your funds. You are giving up the use of your money, or the opportunity to use that money to consume goods and services today, in exchange for the prospect of having more money, and thus the ability to consume goods and services, in the future. Organizations compete for the use of your funds, and just as retailers compete for customers’ dollars by offering a wide variety of products with different characteristics, organizations attempting to raise funds from investors offer a wide variety of investments with different attributes. As a result, investments of every type are available, from virtually zero-risk savings accounts at banks, which in recent years offered returns hovering barely above 0%, to shares of common stock in high-risk companies that might triple in value in a short time. The investments you choose will depend on your resources, your goals, and your willingness to take risk. We can describe a number of attributes that distinguish one type of investment from another.

Note

Investor Facts

offer interesting or entertaining tidbits of information.

Investor Facts

Art as an Asset Securities don’t necessarily perform better than property. Over the decade ending in 2011, fine art produced an average annual return of 4.6%, compared to about 3.0% for stocks in the S&P 500.

Sources: (1) 

http://www.artasanasset.com

; (2) “Paint by Numbers,” Time, January 30, 20

12

.

Securities or Property

Securities

 are investments issued by firms, governments, or other organizations that represent a financial claim on the resources of the issuer. The most common types of securities are stocks and bonds, but more exotic types such as stock options are available as well. One benefit of investing in securities is that they often have a high degree of 

liquidity

, meaning that you can sell securities and convert them into cash quickly without incurring substantial transaction costs and without having an adverse impact on the security’s price. Stocks issued by large companies, for example, tend to be highly liquid, and investors trade billions of shares of stock each day in the markets all over the world. The focus of this text is primarily on the most basic types of securities.

Property

, on the other hand, consists of investments in real property or tangible personal property. Real property refers to land, buildings, and that which is permanently affixed to the land. Tangible personal property includes items such as gold, artwork, antiques, and other collectibles. In most cases, property is not as easy to buy or sell as are securities, so we would say that property tends to be a relatively illiquid type of investment. Investors who want to sell a building or a painting may have to hire (and compensate) a real estate agent or an art dealer to locate a buyer, and it may take weeks or months to sell the property.

Direct or Indirect

A 

direct investment

 is one in which an investor directly acquires a claim on a security or property. If you buy shares of common stock in a company such as Apple Inc., then you have made a direct investment, and you are a part owner of that firm. An 

indirect investment

 is an investment in a collection of securities or properties managed by a professional investor. For example, when you send your money to a mutual fund company such as Vanguard or Fidelity, you are making an indirect investment in the assets held by these mutual funds.

Investor Facts

Smart people own stocks The stock market participation rate refers to the percentage of households who invest in stocks directly or indirectly. A study of investors from Finland found a remarkable connection between IQ and stock market participation— people with higher IQ scores were much more likely to invest in stocks than were people with lower IQ scores. More remarkable still, the IQ measure used in this study was the score on a test given to Finnish males when they were 19 or 20 years old as part of their induction to military service. IQ scores measured at that early age were a very strong predictor of whether these men would invest in stocks much later in life.

(Source: “IQ and Stock Market Participation,” Journal of Finance, 2011, Vol. 66, Issue 6, pp. 2121–2164.)

Direct ownership of common stock has been on the decline in the United States for many years. For example, in 1945 households owned (directly) more than 90% of the common stocks listed in the United States. Over time that percentage dropped to its 2013 level of about 14% (by comparison, 36% of U.S. households own a dog). The same trend has occurred in most of the world’s larger economies. In the United Kingdom, for example, households’ direct ownership of shares fell from roughly 66% to 14% in the last half century. Today, households directly hold less than one-quarter of outstanding shares in most of the world’s major stock markets, as 

Figure 1.1

 shows.

Just as direct stock ownership by households has been falling, indirect ownership has been rising. One way to examine this trend is to look at the

Figure 1.1 Direct Stock Ownership by Households

The figure shows the percentage of common stocks in each country that is owned directly by households. In most countries, households’ direct ownership accounts for less than one-quarter of listed common stocks in the country.

(Source: Data from “Government Policy and Ownership of Equity Securities, Journal of Financial Economics, 2014, Vol. 111, Issue 1, pp. 70–85.)

direct ownership held by institutions that manage money on behalf of households. In 1945 institutional investors such as pension funds, hedge funds, and mutual funds combined held just less than 2% of the outstanding stock in the United States, but today their direct ownership is approaching 70%.

Note

Watch Your

B

ehavior

boxes provide insights about common mistakes that investors make gleaned from research in the field of behavioral finance.

Tax policy helps to explain the decline in direct stock ownership by individuals and the related rise in direct ownership by institutions such as mutual funds and pension funds. Starting in 1978, section 401(k) of the Internal Revenue Code allowed employees to avoid paying tax on earnings that they elect to receive as deferred compensation, such as in a retirement savings plan. Since then, most large companies have adopted so-called 401(k) plans, which allow employees to avoid paying current taxes on the income that they contribute to a 401(k) plan. Employees are taxed on this income when they withdraw it during their retirement years. Typically, mutual fund companies such as T. Rowe Price and Franklin Templeton manage these 401(k) plans, so stocks held in these plans represent indirect ownership for the workers and direct ownership for the mutual fund companies.

Watch Your Behavior

Surprisingly Low Stock Ownership An important determinant in investment success is being willing to take some risk. One measure of risk-taking is stock ownership. Numerous studies have documented that only about 50% of U.S. households have direct or indirect investments in stocks. Given that stocks have historically earned a higher return than safer investments, such as bonds, households that avoid stocks altogether may not accumulate as much wealth over time as they could if they were willing to take more risk.

An important element of this trend is that individuals who trade stocks often deal with professional investors who sell the shares those individuals want to buy or buy what individuals want to sell. For instance, in 20

15

Fidelity had almost $2 trillion in assets in its various mutual funds, trusts, and other accounts, and the company employed approximately 41,000 people, many of whom had advanced investments training and access to a tremendous amount of information about the companies in which they invest. Given the preponderance of institutional investors in the market today, individuals are wise to consider the advantages possessed by the people with whom they are trading.

Note

Quick Response codes can be scanned with a smartphone to access additional information online related to the chapter’s topic.

Bonds vs. Stocks

Debt, Equity, or Derivative Securities

Most investments fall into one of two broad categories—debt or equity. 

Debt

 is simply a loan that obligates the borrower to make periodic interest payments and to repay the full amount of the loan by some future date. When companies or governments need to borrow money, they issue securities called bonds. When you buy a bond, in effect you lend money to the issuer. The issuer agrees to pay you interest for a specified time, at the end of which the issuer will repay the original loan.

Equity

 represents ongoing ownership in a business or property. An equity investment may be held as a security or by title to a specific property. The most common type of equity security is common stock.

Derivative securities

 are neither debt nor equity. Instead, they derive their value from an underlying security or asset. Stock options are an example. A stock option is an investment that grants the right to purchase (or sell) a share of stock in a company at a fixed price for a limited period of time. The value of this option depends on the market price of the underlying stock.

Low- or High-Risk Investments

Investments also differ on the basis of risk. 

Risk

 reflects the uncertainty surrounding the return that a particular investment will generate. To oversimplify things slightly, the more uncertain the return associated with an investment, the greater is its risk. One of the most important strategies that investors use to manage risk is 

diversification

, which simply means holding different types of assets in an investment portfolio.

As you invest over your lifetime, you will be confronted with a continuum of investments that range from low risk to high risk. For example, stocks are generally considered riskier than bonds because stock returns vary over a much wider range and are harder to predict than are bond returns. However, it is not difficult to find high-risk bonds that are riskier than the stock of a financially sound firm.

In general, investors face a tradeoff between risk and return—to obtain higher returns, investors usually have to accept greater risks. Low-risk investments provide a relatively predictable, but also relatively low, return. High-risk investments provide much higher returns on average, but they also have the potential for much larger losses.

Short- or Long-Term Investments

The life of an investment may be either short or long. 

Short-term investments

 typically mature within one year. 

Long-term investments

 are those with longer maturities or, like common stock, with no maturity at all.

Note

Discussions of international investing are highlighted by this icon.

Domestic or Foreign

As recently as 25 years ago, U.S. citizens invested almost exclusively in purely 

domestic investments

: the debt, equity, and derivative securities of U.S.–based companies and governments. The same could be said of investors in many other countries. In the past, most people invested the vast majority of their money in securities issued by entities located in their home countries. Today investors routinely also look for 

foreign investments

 (both direct and indirect) that might offer more attractive returns than purely domestic investments. Even when the returns offered by foreign investments are not higher than those found in domestic securities, investors may still choose to make foreign investments because they help them build more diversified portfolios, which in turn helps limit exposure to risk. Information on foreign companies is now readily available, and it is now relatively easy to make foreign investments.

The Structure of the Investment Process

How Much Debt Has the U.S. Government Issued?

The investment process brings together suppliers who have extra funds and demanders who need funds. Households, governments, and businesses are the key participants in the investment process, and each of these participants may act as a supplier or a demander of funds at a particular time. However, there are some general tendencies. Households who spend less than their income have savings, and they want to invest those surplus funds to earn a return. Households, then, are generally net suppliers of funds in the investment process. Governments, on the other hand, often spend more than they take in through tax revenue, so they issue bonds and other debt securities to raise additional funds. Governments are typically net demanders of funds. Businesses are also net demanders of funds most of the time. They issue debt or equity securities to finance new investments and other activities.

Suppliers and demanders of funds usually come together by means of a financial institution or a financial market. 

Financial institutions

 are organizations, such as banks and insurance companies, that pool the resources of households and other savers and use those funds to make loans and to invest in securities such as short-term bonds issued by the U.S. government. 

Financial markets

 are markets in which suppliers and demanders of funds trade financial assets, typically with the assistance of intermediaries such as securities brokers and dealers. All types of investments, including stocks, bonds, commodities, and foreign currencies, trade in financial markets.

The dominant financial market in the United States is the securities market. It includes stock markets, bond markets, and options markets. Similar markets exist in most major economies throughout the world. The prices of securities traded in these markets are determined by the interactions of buyers and sellers, just as other prices are established in other kinds of markets. For example, if the number of Facebook shares that investors want to buy is greater than the number that investors want to sell, the price of Facebook stock will rise. As new information about the company becomes available, changes in supply (investors who want to sell) and demand (investors who want to buy) may result in a new market price. Financial markets streamline the process of bringing together buyers and sellers so that investors can transact with each other quickly and without incurring exorbitant transaction costs. Financial markets provide another valuable function by establishing market prices for securities that are easy for market participants to monitor. For example, a firm that launches a new product may get an early indication of how that product will be received in the market by seeing whether investors drive the firm’s stock price up or down when they learn about the new product.

Figure 1.2

 is a diagram of the investment process. Note that the suppliers of funds may transfer their resources to the demanders through financial institutions, through financial markets, or in direct transactions. As the broken lines show, financial institutions can participate in financial markets as either suppliers or demanders of funds. For the economy to grow and prosper, funds must flow to those with attractive investment opportunities. If individuals began suddenly hoarding their excess funds rather than putting them to work in financial institutions and markets, then organizations in need of funds would have difficulty obtaining them. As a result, government spending, business expansion, and consumer purchases would decline, and economic activity would slow.

When households have surplus funds to invest, they must decide whether to make the investment decisions themselves or to delegate some or all of that responsibility to professionals. This leads to an important distinction between two types of investors in the financial markets. 

Individual investors

 manage their own funds to achieve their financial goals. Individual investors usually concentrate on earning a return on idle funds, building a source of retirement income, and providing security for their families.

Individuals who lack the time or expertise to make investment decisions often employ 

institutional investors

—investment professionals who earn their living by managing other people’s money. These professionals trade large volumes of securities for individuals, as well as for businesses and governments. Institutional investors include banks, life insurance companies, mutual funds, pension funds, and hedge funds. For example, a life insurance company invests the premiums it receives from policyholders to earn returns that will cover death benefits paid to beneficiaries.

Figure 1.2 The Investment Process

Financial institutions participate in the financial markets as well as transfer funds between suppliers and demanders. Although the arrows go only from suppliers to demanders, for some transactions (e.g., the sale of a bond or a college loan), the principal amount borrowed by the demander from the supplier (the lender) is eventually returned.

Both individual and institutional investors apply similar fundamental principles when deciding how to invest money. However, institutional investors generally control larger sums of money and have more sophisticated analytical skills than do most individual investors. The information presented in this text is aimed primarily at you—the individual investor. Mastering this material represents only the first step that you need to take to develop the expertise to become an institutional investor.

Concepts in Review

Answers available at 

http://www.pearsonhighered.com/smart

1. 1.1 Define the term investment, and explain why individuals invest.

2. 1.2 Differentiate among the following types of investments, and cite an example of each: (a) securities and property investments; (b) direct and indirect investments; (c) debt, equity, and derivative securities; and (d) short-term and long-term investments.

3. 1.3 What is the relation between an investment’s risk and its return?

4. 1.4 Define the term risk, and explain how risk is used to differentiate among investments.

5. 1.5 What are foreign investments, and what role do they play for the individual investor?

6. 1.6 Describe the structure of the overall investment process. Explain the role played by financial institutions and financial markets.

7. 1.7 Classify the roles of (a) government, (b) business, and (c) individuals as net suppliers or net demanders of funds.

8. 1.8 Differentiate between individual investors and institutional investors.

Note

The Concepts in Review questions at the end of each text section encourage you, before you move on, to test your understanding of the material you’ve just read.

Types of Investments

1. LG 3

A wide variety of investments is available to individual investors. As you have seen, investments differ in terms of risk, maturity, and many other characteristics. We devote the bulk of this text to describing the characteristics of different investments and the strategies that you may use when you buy and sell these investments. 

Table 1.1

 summarizes some basic information about the major types of investments that we will study.

Short-Term Investments

Short-term investments have a life of one year or less and usually (but not always) carry little or no risk. People buy these investments as a temporary “warehouse” for idle funds before transferring the money into a long-term investment. Short-term investments are also popular among conservative investors who may be reluctant to lock up their funds in riskier, long-term assets such as stocks or bonds.

Short-term investments also provide liquidity because they can be converted into cash quickly and with little or no loss in value. Liquidity is important to investors because it is impossible to know when an emergency or other unplanned event will make it necessary to obtain cash by selling an investment. At such a time, the speed at which the investment can be sold is particularly important. Of course, almost any investment can be sold quickly if the owner is willing to lower the price enough, but having to sell an investment at a bargain price only compounds the problem that led to the need to sell in the first place. Liquid investments give investors peace of mind that

Table 1.1 Major Types of Investments

Type

Description

Examples

Where Covered in This Book

Short-term investments

Savings instruments with lives of

1 year or less

. Used to warehouse idle funds and to provide liquidity.

Deposit accounts,

U.S. Treasury

bills (T-bills),

Certificates of deposit (CDs)

,

Commercial paper

, Money market mutual funds

Ch. 1

Common stock

Equity investments that represent ownership in a corporation.

Chs. 6
–
9

Fixed-income securities

Investments that make fixed cash payments at regular intervals.

Bonds, Convertible securities

Preferred stock

Chs. 

10

, 

11

Web 
Ch. 16

Mutual funds

Companies that pool money from many investors and invest funds in a diversified portfolio of securities.

Large-cap funds, Growth funds

Ch. 1

Exchange-traded funds

Investment funds, typically index funds, that are exchange listed and, therefore, exchange traded.

Stock index funds, Bond index funds

Ch. 12

Hedge funds

Alternative investments, usually in pools of underlying securities, available only to sophisticated investors, such as institutions and individuals with significant assets.

Long and short equities, Funds of funds

Ch. 12

Derivative securities

Securities that are neither debt nor equity but are structured to exhibit the characteristics of the underlying assets from which they derive their value.

Options

Futures

Ch. 14

Ch. 15

Other popular investments

Various other investments that are widely used by investors.

Tax-advantaged investments

Real estate

Tangibles

Web 
Ch. 17

Web 
Ch. 18

Web 
Ch. 18

they will be able to get their hands on cash quickly if they need it, without having to sell their investments at fire-sale prices.

Common Stock

Common stock

 is an equity investment that represents ownership in a corporation. Each share of common stock represents a fractional ownership interest in the firm. For example, if you buy 1 share of common stock in a corporation that has 10,000 shares outstanding, you would be a 1/10,000th owner in the firm. Today, roughly half of all U.S. households own some common stock, either directly or indirectly.

The return on investment in common stock comes from two sources: dividends and capital gains. 

Dividends

 are payments the corporation makes to its shareholders. Companies are not required to pay dividends to their shareholders, and most firms that are small or are growing very rapidly do not pay dividends. As firms grow and accumulate cash, they often start paying dividends, just as Dollar General did in 2015. Companies that pay dividends usually pay them quarterly. 

Capital gains

 occur when the stock price rises above an investor’s initial purchase price. Capital gains may be realized or unrealized. If you sell a stock for more than you paid for it, you have realized a capital gain. If you continue to hold the stock rather than sell it, you have an unrealized capital gain.

Example

Suppose you purchased a single share of Whirlpool Corporation common stock for $155 on January 2, 2014, the first day that the stock market was open for trading that year. During 2014 you received $2.87 in cash dividends. At the end of the year, you sold the stock for $195. You earned $2.87 in dividends and you realized a $40 capital gain ($195 sale price − $155 purchase price) for a total dollar return of $42.87. On a percentage basis, the return on Whirlpool shares in 2014 is calculated as $42.87 ÷ $155 = 0.277 or 27.7%$42.87 ÷ $155 = 0.277 or 27.7%. If you continued to hold the stock rather than sell it, at the end of the year you would have earned the same return but your capital gain would have been unrealized.

As mentioned earlier, since 1900 the average annual rate of return on common stocks has been about 9.6%, so 2014 was a good year for Whirlpool. As a producer of durable consumer products such as refrigerators, washing machines, and the iconic KitchenAid stand mixer, Whirlpool’s stock generally performs best when the economy is growing (as it was in 2014) and consumers are making major purchases of new appliances.

Fixed-Income Securities

Fixed-income securities

 are investments that offer a periodic cash payment that may be fixed in dollar terms or may vary according to a predetermined formula (for example, the formula might dictate that cash payments rise if a general rise in market interest rates occurs). Some offer contractually guaranteed returns, meaning that the issuer of the security (i.e., the borrower) must fulfill a promise to make payments to investors or risk being sued. Other fixed-income securities come with the expectation of regular payments even if a contractual obligation is absent. Because of their relatively predictable cash payments, fixed-income securities tend to be popular during periods of economic uncertainty when investors are reluctant to invest in riskier securities such as common stocks. Fixed-income securities are also attractive during periods of high interest rates when investors seek to “lock in” high returns. The most common fixed-income securities are bonds, convertible securities, and preferred stock.

Bonds

Bonds

 are long-term debt instruments (in other words, an IOU, or promise to pay) issued by corporations and governments. A bondholder has a contractual right to receive periodic interest payments plus return of the bond’s face, or par, value (the stated value given on the certificate) at maturity (typically 10 to 30 years from the date issued).

If you purchased a $1,000 bond paying 9% interest in semiannual installments, you would receive an interest payment equal to $1,000 × 9% × ½ year = $45$1,000 × 9% × ½ year = $45 every six months. At maturity you would also receive the bond’s $1,000 face value. Bonds vary a great deal in terms of liquidity, so they may or may not be easy to sell prior to maturity.

Since 1900 the average annual rate of return on long-term government bonds has been about 5%. Corporate bonds are riskier because they are not backed by the full faith and credit of the U.S. government and, therefore, tend to offer slightly higher returns than government bonds provide.

Convertible Securities

A 

convertible security

 is a special type of fixed-income investment. It has a feature permitting the investor to convert it into a specified number of shares of common stock. Convertibles provide the fixed-income benefit of a bond (interest) while offering the price-appreciation (capital gain) potential of common stock.

Preferred Stock

Like common stock, 

preferred stock

 represents an ownership interest in a corporation and has no maturity date. Unlike common stock, preferred stock has a fixed dividend rate. Firms are generally required to pay dividends on preferred shares before they are allowed to pay dividends on their common shares. Furthermore, if a firm is having financial difficulties and decides to stop paying preferred dividends, it must usually make up all of the dividend payments that it skipped before paying dividends on common shares. Investors typically purchase preferred stocks for the dividends they pay, but preferred shares may also provide capital gains.

Mutual Funds

A 

mutual fund

 is a portfolio of stocks, bonds, or other assets that were purchased with a pool of funds contributed by many different investors and that are managed by an investment company on behalf of its clients. Investors in a mutual fund own an interest in the fund’s collection of securities. Most individual investors who invest in stocks do so indirectly by purchasing mutual funds that hold stocks. When they send money to a mutual fund, investors buy shares in the fund (as opposed to shares in the companies in which the fund invests), and the prices of the mutual fund shares reflect the value of the assets that the fund holds. Mutual funds allow investors to construct well-diversified portfolios without having to invest a large sum of money. After all, it’s cheaper to buy shares in a fund that holds 500 stocks than it is to buy shares in 500 companies on your own. In the last three decades, the mutual fund industry has experienced tremendous growth. The number of equity mutual funds (i.e., funds that invest mainly or exclusively in common stock) has more than quadrupled since 1980.

Investor Facts

The Feeling’s Mutual! In 2014, the 8,974 mutual funds in the United States accounted for investment assets of $15 trillion. Mutual funds held 24% of all U.S. stocks, and managed 22% of all household financial assets.

(Source: 2014 Investment Company Factbook downloaded from 

http://www.icifactbook.org/

, accessed February 27, 2014.)

Most mutual managers follow one of two broad approaches when selecting specific securities for their funds. In an actively managed fund, managers try to identify and purchase securities that are undervalued and are therefore likely to perform particularly well in the future. Or managers try to identify overvalued securities that may perform poorly and simply avoid those investments. The goal of an actively managed fund is typically to earn a higher return than some sort of benchmark. For a mutual fund that invests in stocks, a common goal is to earn a return that is higher than the return on a market index like the Standard and Poor’s 500 Stock Index (S&P 500). In a passively managed fund, managers make no attempt to identify under or overvalued securities. Instead, they buy a diversified portfolio of stocks and try to mimic or match the return on a market index. Because these funds try to provide returns that are as close as possible to the returns on a market index, they usually referred to as index funds.

In return for the services that they provide, mutual funds (or rather the investment companies that run the mutual funds) charge investors fees, and some of those fees are rolled together in a figure known as the expense ratio. The expense ratio is a fee charged to investors based on a percentage of the assets invested in a fund. It accrues daily and represents one of the primary costs that investors pay when they purchase mutual fund shares. For example, if an individual has $10,000 invested in a mutual fund with an expense ratio of 1%, then the fund will charge $100 per year to manage the individual’s money.

Expense ratios are generally higher for funds that invest in riskier securities. For example, in 2014 the average expense ratio among mutual funds investing in stocks was

0.70%

, meaning that investors would pay expenses equal to $70 per $10,000 invested. For funds that invest in bonds, the average expense ratio was 0.57%. 

Money market mutual funds

 (also called 

money funds

) are mutual funds that invest solely in short-term investments. The average expense ratio for money market mutual funds in 2014 was just 0.13%.

Expense ratios also tend to be higher for actively managed funds than for index funds. That shouldn’t be surprising because actively managed funds are more expensive to operate. For many years, expense ratios have been on the decline. The average expense ratio for equity mutual funds fell 25 basis points (or one quarter of one percent) in the last decade, from 9.95% in 2004 to 0.70% in 2014. Falling expense ratios is good news for mutual fund investors. Even so, there is considerable variation in expense ratios from one fund to another, so investors need to pay close attention to expenses before they choose a fund.

In addition to the expense ratio, some funds charge a fee called a load. A load may be charged up front when the investor initially buys shares in the fund, in which case it is called a sales load. Alternatively, when investors sell their shares the fund may charge a fee known as a redemption fee or back-end load. Typically, redemption fees are reduced or waived entirely if investors keep their money in the fund for a long period of time.

Exchange-Traded Funds

Like mutual funds, 

exchange-traded funds (ETFs)

 hold portfolios of securities, and investors buy shares in the ETF. ETFs are very similar to mutual funds. They allow investors to form well-diversified portfolios with low initial investments, and the fees charged by ETFs are generally quite low. However, there are some important distinctions between these two popular investments. The main distinction is that ETFs trade on exchanges, so investors can buy and sell shares in an ETF at its current market price at any time during regular trading hours. Mutual fund shares are not traded on exchanges, and when an investor buys (or sells) shares in a fund from an investment company, the transaction occurs at the end of the trading day using the fund’s closing price. The mutual fund’s closing price is determined by adding up the values of all of the securities that the fund holds at the end of the day and dividing by the number of shares in the fund. If stock prices are rising or falling rapidly during the day, ETF investors may be able to take advantage of this by purchasing or selling their shares before prices hit their peak (or bottom). Investors in mutual funds have to wait until the end of the day to learn the price at which they can buy or sell shares in the fund.

Another important difference has to do with what happens to the money when investors buy or sell shares. When you buy shares in a mutual fund, the fund has more resources than it had before, so the fund’s managers will likely use those funds to invest in more securities. Similarly, if you sell shares in the fund, then the fund’s managers may have to sell some of the securities that the fund holds to raise the cash to pay you when you redeem your shares. If many investors want to sell their shares simultaneously, that may trigger a fire sale—the fund manager has to accept lower prices to quickly convert the fund’s assets into cash. In contrast, ETF shares represent a fixed number of claims on a fixed portfolio of securities. When you buy ETF shares, you are simply acquiring them from other investors who want to sell their shares. There is no net inflow or outflow of money into the company that manages the ETF, and therefore there is no need to buy or sell additional securities in response to investors’ transactions.

Launched in 1993, the very first ETF was a broad-based equity fund designed to track the Standard and Poor’s 500 Stock Index. Since then, both the number of ETFs and the amount of money invested in them has grown explosively. From 2003 to 2014, the number of ETFs grew by a factor of 12, and assets invested in those funds grew at a rate that exceeded 26% per year. Even so, for every $1 invested in ETFs today, about $9 are invested in mutual funds.

Hedge Funds

Like mutual funds, 

hedge funds

 are investment funds that pool resources from many different investors and invest those funds in securities. Hedge funds are generally open to a narrower group of investors than are mutual funds. For example, the minimum investment required by a mutual fund might be a few hundred dollars whereas the minimum investment required to participate in a hedge fund runs into the hundreds of thousands of dollars. Some hedge funds have a minimum investment of $1 million. Despite the high minimum investment, hedge funds have grown in importance in recent years, with assets under management approaching $3 trillion in 2015.

Hedge funds generally charge investors much higher fees than do mutual funds. Traditionally, hedge fund fees follow the “two and twenty” rule, which means that investors pay the hedge fund annual fees equal to 2% of the assets they manage plus 20% of any investment gains that the fund can achieve. The first component of the fee is known as the management fee and is independent of the fund’s performance. The second component is known as the incentive fee. Investors in hedge funds do not pay incentive fees if a fund earns a negative return in a particular year, and it is common for the incentive fee to have a feature known as the “high-water mark.” The high-water mark specifies that the incentive fee is not payable until a hedge fund passes its previous peak value. For example, if the hedge fund loses 6% in one year and earns 10% the following year, the incentive fee will not be paid on the second year’s entire 10% return. Instead, the fee will only apply to the increase in fund value above and beyond its previous peak. In other words, the fund has to earn back the 6% that it previously lost before new incentive fees kick in.

Hedge funds are not as closely regulated as are mutual funds, and they tend to invest in riskier and less liquid securities. The very name “hedge fund” suggests that these funds try to limit or hedge the risks that they take, and, indeed, some hedge funds do operate with that goal in mind. However, some hedge funds adopt very high-risk investment strategies. Nonetheless, the hedge fund industry experienced dramatic growth in the last decade.

Derivatives Securities

As the name suggests, derivative securities derive their value from an underlying security or asset. Many derivatives are among the most risky financial assets because they are designed to magnify price changes of the underlying asset. For example, when the price of oil moves up or down by $1 per barrel, the value of an oil futures contract (an agreement between two parties to trade oil on a future date at a specified price) moves $1,000 in the same direction. Investors may buy or sell derivatives to speculate on the future movements of another asset, but corporations also buy and sell derivatives to hedge against some of the risks they face. For example, a cereal company may purchase wheat futures contracts as a kind of insurance against the possibility that wheat prices will rise.

Options

Options
 are securities that give the investor an opportunity to sell or buy another security at a specified price over a given period of time. Investors purchase options to take advantage of an anticipated change in the price of common stock. However, the purchaser of an option is not guaranteed a return and could even lose the entire amount invested if the option does not become attractive enough to use. Two common types of options are calls and puts. Call options grant the right to buy another security at a fixed price, and put options grant the right to sell another security at a fixed price.

Futures

Futures

 are legally binding obligations stipulating that the seller of the futures contract will make delivery and the buyer of the contract will take delivery of an asset at some specific date and at a price agreed on at the time the contract is sold. Examples of commodities futures include soybeans, pork bellies, platinum, and cocoa contracts. Examples of financial futures are contracts for Japanese yen, U.S. Treasury securities, interest rates, and stock indexes. Trading in commodity and financial futures is generally a highly specialized, high-risk proposition.

Other Popular Investments

Because the U.S. federal income tax rate for an individual can be as high as

39.6%

, many investors look for 

tax-advantaged investments

. These are investments that provide higher after-tax returns by reducing the amount of taxes that investors must pay. For instance, municipal bonds, which are bonds issued by state and local governments, make interest payments that are not subject to federal income taxation. Because investors do not have to pay taxes on the interest they receive on municipal bonds, they will accept lower interest rates on these investments than they will on similar bonds that make taxable interest payments.

Real estate

 consists of assets such as residential homes, raw land, and a variety of forms of income property, including warehouses, office and apartment buildings, and condominiums. The appeal of real estate investment is the potential returns in the forms of rental income, tax write-offs, and capital gains.

Tangibles

 are investment assets, other than real estate, that can be seen or touched. They include gold and other precious metals, gemstones, and collectibles such as coins, stamps, artwork, and antiques. People purchase these assets as investments in anticipation of price increases.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 1.9 What are short-term investments? How do they provide liquidity?

2. 1.10 What is common stock, and what are its two sources of potential return?

3. 1.11 Briefly define and differentiate among the following investments. Which offer fixed returns? Which are derivative securities? Which offer professional investment management?

a. Bonds

b. Convertible securities

c. Preferred stock

d. Mutual funds

e. Hedge funds

f. Options

g. Futures

Making Your Investment Plan

1. LG 4

Investing can be conducted on a strictly intuitive basis or on the basis of plans carefully developed to achieve specific goals. Evidence favors the planned approach. Developing a well thought-out investment plan encourages you to follow a disciplined approach to managing money. That discipline will help you avoid many common investment mistakes by keeping you focused on your investment goals during market swings. A good investment plan is a reminder of the goals that you are trying to achieve with your money, and it provides a kind of strategic roadmap to guide investment decisions over a lifetime. We suggest that your investment plan should begin with an Investment Policy Statement.

Writing an Investment Policy Statement

Large corporations typically have an investment policy statement (IPS) that spells out how the corporation will invest funds in the company retirement plan. Financial advisors write them for their clients. Our view is that an IPS is equally important for individual investors like you. Writing such a statement forces you to think carefully about all aspects of your investment plan, a particularly useful exercise for a novice investor. If you have a spouse or partner, an IPS can help you work out (in advance) disagreements about how much money the two of you should save and how that money should be invested. In middle age, an IPS helps you assess the progress toward your long-term financial goals. Below we outline the major elements of a well-crafted IPS. Most of the tools and concepts covered in this text can be applied in a thorough IPS.

Summarize your current situation.

In the opening section of the IPS, list the assets that you currently own. Set a target for how much money you think you can save and invest each month. Describe where the money that you plan to invest will come from. Given your income and your current spending habits, is it reasonable to expect that you will have surplus funds to invest? What tax rate do you face today, and how do you expect that to change in the future? Establish some broad guidelines for the initial asset allocation in your portfolio. What percentage of your funds do you want to invest in stocks, bonds, and other types of investments? Ask yourself how much money you think you can afford to lose, both in the short term (over a few months) and the long term (over a few years), and articulate your action plan when losses occur. Will you sell some of your investments, simply hold onto them, or continue making new investments each month according to the plan? Try to define your investment horizon. Will you need to access the funds you are investing in a year, in a decade, or at the end of your working life? If you plan to enlist the help of a professional investment advisor, describe the process that you will use to select that person. If you have already selected an advisor, list that person’s contact information in your IPS and discuss the statement with him or her, perhaps even getting his or her signature on the document.

Specify your investment goals.

Once you have outlined your current situation, write out your investment goals. 

Investment goals

 are the financial objectives you wish to achieve by investing. Are you trying to reach a specific target savings goal, such as accumulating enough money to make a down payment on a house? Or do you have a goal that is further out in the future, such as saving enough money to send your children to college or even to provide enough income for your own retirement? Is your investment goal to generate more cash flow in the form of interest or dividends, or are you trying to shelter income from taxation? Achieving each of these goals may call for a different type of investment strategy. For each goal that you specify, try to determine how many years you will need to save and invest to achieve that goal, and how much money you need to invest each year to reach your goal.

Articulate your investment philosophy.

In this part of the IPS, you’ll want to spell out your investment philosophy, your views about the types of investments you’re willing to make, how often you are willing to adjust your portfolio through trading, and other matters that will shape your investment portfolio. Perhaps the most important aspect of your investment philosophy is your tolerance for risk. Your investment philosophy should indicate how much volatility in the value of your portfolio that you are willing to tolerate. For example, you might say that your portfolio should be designed in such a way that a loss in a single year of more than 20% is highly unlikely. Your policy should indicate how important diversification is to you and how many types of investments you plan to own. Your philosophy will specify certain types of investments that you are not willing to purchase. Perhaps you will choose not to invest in certain industries for ethical reasons, or you will declare that only “plain vanilla” investments like stocks and bonds should be part of your portfolio (no derivatives or exotic investments, please). If you are working with a financial advisor, you may want to specify how frequently you want to make changes in the portfolio by trading, or you may want to provide guidelines about the trading costs or (in the case of mutual funds and ETFs) the management fees you’re willing to pay. In this section of the IPS you may choose to articulate your assumptions about the returns that you expect different types of investments to earn over time.

Set investment selection guidelines.

For each type of investment, or asset class, that you expect to hold in your portfolio (e.g., stocks, bonds, mutual funds), establish guidelines for how specific investments in that asset class will be selected. For example, if you plan to hold mutual funds, will you invest in actively or passively managed funds? In your selection process, how much importance will you place on a fund’s track record (i.e., its past performance or the experience and education of the fund manager) and how much on its expense ratio and other costs of investing in the fund? If you plan to invest directly in stocks, will you focus on large, well-known companies, or are you more interested in emerging high-tech companies? Does it matter to you whether the stocks you invest in pay dividends? When you are deciding which bonds to invest in, will you focus more heavily on the creditworthiness of the bond issuer or on other features of the bond such as its maturity or the interest rate that it promises to pay?

Watch Your Behavior

Watch your investments, but not too closely. Researchers have uncovered an interesting aspect of investor behavior. Individuals who monitor their portfolios most frequently tend to invest less in risky assets. Almost by definition, risky investments will frequently experience periods of low or even negative returns, even though over long periods of time risky assets tend to earn higher returns than safe assets do. When investors check their portfolios frequently, they apparently find it uncomfortable to observe the periods when risky investments perform badly, so they simply take less risk. In the long run, taking very little risk leads to very low returns, so it is not clear that watching investments too closely is a good thing.

(Source: “Myopic Loss Aversion and the Equity Premium Puzzle,” Quarterly Journal of Economics, 1995, Vol. 110, pp. 75–92.)

Assign responsibility for selecting and monitoring investments.

In this part of the IPS, you indicate whether you will make your own investment selections or whether you will enlist the help of an advisor to do that. Likewise, you establish a plan for monitoring your investments. Do you plan to evaluate your investment performance quarterly, semiannually, or just once a year?

What criteria will you use to determine whether your investments are meeting your expectations or not? Any risky investment is bound to have periods when it performs poorly, so your IPS should provide some guidance about how long you are willing to tolerate subpar performance before making a change in the portfolio. Similarly, an investment that performs particularly well for a year or two will inevitably account for a rising fraction of the portfolio’s overall value. Your IPS may describe the conditions under which you might sell some of your better performing investments simply to rebalance the portfolio.

Considering Personal Taxes

Knowledge of the tax laws can help you reduce taxes and increase the amount of after-tax dollars you have for investing. Because tax laws are complicated and subject to frequent revision, we present only the key concepts and how they apply to popular investment transactions.

Basic Sources of Taxation

The two major types of taxes to consider when forming your investment plans are those levied by the federal government and those levied by state and local governments. The federal income tax is the major form of personal taxation. Federal rates currently range from 10% to 39.6% of taxable income, although with rising federal budget deficits, many experts believe that those tax rates will rise in the future.

State and local taxes vary from area to area. Top earners in California face a tax rate of 13.3%, and six other states have tax rates on high-income households that range from 8% to 11%. Some cities, especially large East Coast cities, also have local income taxes that typically range between 1% and 5%. In addition to income taxes, state and local governments rely heavily on sales and property taxes as a source of revenue.

Income taxes at the federal, state, and local levels have a great impact on the returns that investors earn from security investments. Property taxes can have a sizable impact on real estate and other forms of property investment.

Types of Income

The income of individuals is classified into three basic categories:

· Active income consists of everything from wages and salaries to bonuses, tips, pension income, and alimony. Active income is made up of income earned on the job as well as most other forms of noninvestment income.

· Portfolio income includes earnings generated from various types of investments. This category covers most (but not all) types of investments from savings accounts, stocks, bonds, and mutual funds to options and futures. For the most part, portfolio income consists of interest, dividends, and capital gains (the profit on the sale of an investment).

· Passive income is a special category of income composed chiefly of income derived from real estate, limited partnerships, and other forms of tax-advantaged investments.

Tax laws limit the amount of deductions (write-offs) that can be taken for each category, particularly for portfolio and passive income. The amount of allowable deductions for portfolio and passive income is limited to the amount of income derived from these two sources. For example, if you had a total of $380 in portfolio income for the year, you could deduct no more than $380 in investment-related interest expense. For deduction purposes, the portfolio and passive income categories cannot be mixed or combined with each other or with active income. Investment-related expenses can be used only to offset portfolio income, and (with a few exceptions) passive investment expenses can be used only to offset the income from passive investments.

Ordinary Income

Whether it’s classified as active, portfolio, or passive, ordinary income is taxed at the federal level at one of seven rates: 10%, 15%, 25%, 28%, 33%, 35%, or 39.6%. There is one structure of tax rates for taxpayers who file individual returns and another for those who file joint returns with a spouse. 

Table 1.2

 shows the 2015 tax rates and income brackets for these two categories. Note that the rates are progressive; that is, income is taxed in a tiered progression—the first portion of a taxpayer’s income is taxed at one rate, the next portion at a higher rate, and so on. An example will demonstrate how ordinary income is taxed.

Table 1.2 Federal Income Tax Rates and Brackets for Individual and Joint Returns (Due by April 15, 2015)

Taxable Income
Tax Rates	Individual Returns	Joint Returns
10.0%	$0 to $9,075	$0 to $18,150
15.0%	$9,076 to $36,900	$18,151 to $73,800
25.0%	$36,901 to $89,350	$73,801 to $148,850
28.0%	$89,351 to $186,350	$148,851 to $226,850
33.0%	$186,351 to $405,100	$226,851 to $405,100
35.0%	$405,101 to $406,750	$405,101 to $457,600
39.6%	Over $406,750	Over $457,600

Note

Excel Spreadsheet exercises at the end of each chapter will assist you in learning some useful applications of this tool in the personal investing process.

Example

Consider the Ellis sisters, Joni and Cara. Both are single. Joni’s taxable income is $25,000. Cara’s is $50,000. Using the tax rates and income brackets in 
Table 1.2
, we can calculate their taxes as follows:

Joni:

(0.10 × $9,075) + [0.15 × ($25,000 − $9,075)] = $907.50 + $2,388.75 = $3,296.25––––––––––––––––––––––(0.10 × $9,075) + [0.15 × ($25,000 − $9,075)] = $907.50 + $2,388.75 = $3,296.25__

Cara:

(0.10 × $9,075) + [0.15 × ($36,900 − $9,075)] + [0.25 × ($50,000 − $36,900) = $907.50 + $4,173.75 + $3,275 = $8,356.25––––––––––––––––––––––(0.10 × $9,075) + [0.15 × ($36,900 − $9,075)] + [0.25 × ($50,000 − $36,900) = $907.50 + $4,173.75 + $3,275 = $8,356.25__

Notice that Joni pays about 13.2% of her income in taxes ($3,296.25 ÷ $25,000) while Cara’s taxes amount to 16.7% of her income ($8,356.25 ÷ $50,000). The progressive nature of the federal income tax structure means that Cara pays a higher fraction of her income in taxes—although her taxable income is twice Joni’s, Cara’s income tax is about 2.5 times Joni’s. You can build a spreadsheet model like the one below to automate these calculations, so you can calculate the tax bill for an individual taxpayer with any income level.

Excel@Investing

Note

This icon indicates that there is a downloadable Excel file available on

MyFinanceLab

that matches the text’s content at the point where the icon appears.

Capital Gains and Losses

A capital asset is property owned and used by the taxpayer for personal reasons, pleasure, or investment. The most common types are securities and real estate, including one’s home. A capital gain represents the amount by which the proceeds from the sale of a capital asset exceed its original purchase price. How heavily capital gains should be taxed is a contentious political issue, so tax rates on gains change frequently, especially when political power shifts between parties, as it did in 2008. At the time this text was going to press in late 2015, several tax rates applied to capital gains income depending on the length of the investment holding period and the taxpayer’s income.

For assets held more than 12 months, capital gains are classified as long-term, and the capital gains tax rate is 0% for taxpayers in the 10% and 15% tax brackets. For taxpayers in the 25%, 28%, 33%, and 35% tax brackets, the tax rate on long-term capital gains income is 15%. For taxpayers in the 39.6% tax bracket, the tax rate on long-term capital gains is 20%. Dividends on stock in domestic corporations is essentially tax using the same rates that apply to long-term capital gains. If the asset is held for fewer than 12 months, then the amount of any capital gain realized is added to other sources of income, and the total is taxed at the rates given in 
Table 1.2
.

Example

For example, imagine that James McFail, a single person who has other taxable income totaling $75,000, sold 500 shares of stock at $12 per share. He purchased this stock at $10 per share. The total capital gain on this transaction was $1,000 [500 shares × ($12/share − $10/share)]. James’s taxable income totals $76,000, and he is in the 25% tax bracket (see 
Table 1.2
).

If the $1,000 capital gain resulted from an asset that was held for more than 12 months, the capital gain would be taxed at the maximum rate of 15%. His total tax would be calculated as follows:

Ordinary income ($75,000)

(0.10 × $9,075) + [0.15 × ($36,900 − $9,075)] + [0.25 × ($75,000 − $36,900)]=$907.50 + $4,173.75 + $9,525 = $14,606.25(0.10 × $9,075) + [0.15 × ($36,900 − $9,075)] + [0.25 × ($75,000 − $36,900)]=$907.50 + $4,173.75 + $9,525 = $14,606.25

Capital gain ($1,000)

(0.15 × $1,000) = $150(0.15 × $1,000) = $150

Total tax

$14,606.25 + $150 = $14,756.25––––––––––––––––––––––––$14,606.25 + $150 = $14,756.25__

James’s total tax would be $14,756.25. Had his other taxable income been below $36,900 (i.e., in the 15% bracket), the $1,000 capital gain would have been taxed at 0% rather than 15%. Had James held the asset for fewer than 12 months, his $1,000 capital gain would have been taxed as ordinary income, which in James’s case would result in a 25% rate.

Capital gains are appealing because they are not taxed until you actually realize them. For example, if you own a stock originally purchased for $50 per share that at the end of the tax year has a market price of $60 per share, you have a “paper gain” of $10 per share. This paper (unrealized) gain is not taxable because you still own the stock. Only realized gains are taxed. If you sold the stock for $60 per share during the tax year, you would have a realized—and therefore taxable—gain of $10 per share.

A 

capital loss

 results when a capital asset is sold for less than its original purchase price. Before taxes are calculated, all gains and losses must be netted out. Taxpayers can apply up to $3,000 of 

net losses

 against ordinary income in any year. Losses that cannot be applied in the current year may be carried forward and used to offset future income, subject to certain conditions.

A final tax issue arises from the Affordable Care Act’s Net Investment Income Tax. This tax applies to married taxpayers with incomes exceeding $250,000 and single taxpayers with incomes over $200,000. For these taxpayers, investment income that they receive is subject to an addition 3.8% tax rate.

Investments and Taxes

The opportunities created by the tax laws make tax planning important in the investment process. 

Tax planning

 involves looking at your earnings, both current and projected, and developing strategies that will defer and minimize the level of taxes. The tax plan should guide your investment activities so that over the long run you will achieve maximum after-tax returns for an acceptable level of risk.

Watch Your Behavior

Cut Your Taxes and Your Losses Several researchers have found that investors are very reluctant to sell stocks that have gone down in value, presumably because they hope to “get even” in the future. Holding losers rather than selling them is often a mistake because the tax code provides an incentive to sell these stocks. Investors can deduct investment losses (up to a point) against other forms of income, thereby lowering their tax liabilities.

For example, the fact that capital gains are not taxed until actually realized allows you to defer tax payments on them as well as control the timing of these payments. However, investments that are likely to produce the largest capital gains generally have higher risk than those that provide significant current income. Therefore, you should not choose investments solely on tax considerations. Instead you must strike a balance of tax benefits, investment returns, and risk. It is the after-tax return and associated risk that matter.

Tax-Advantaged Retirement Savings Plans

The federal government has established a number of plans that offer special tax incentives designed to encourage people to save for retirement. Those that are employer sponsored include profit-sharing plans, thrift and savings plans, and 401(k) plans. These plans allow employees to defer paying taxes on funds that they save and invest during their working years until they withdraw those funds during retirement. Individuals who are self-employed can set up their own tax-sheltered retirement programs such as Keogh plans and SEP-IRAs. Other savings plans with tax advantages are not tied directly to the employer. Almost anyone can set up an individual retirement arrangement (IRA), although the law limits the tax benefits of these plans for high-income taxpayers. In a traditional IRA, contributions to the plan as well as investment earnings generated on those contributions are not taxed until the participant withdraws funds during retirement. In a Roth IRA, contributions are taxed up front, but subsequent investment earnings and withdrawals are tax-free. For most investors, these plans offer an attractive way to both accumulate funds for retirement and reduce taxes.

Investing over the Life Cycle

Investors tend to follow different investment philosophies as they move through different stages of life. Generally speaking, most investors tend to be more aggressive when they’re young and more conservative as they grow older. Typically, investors move through these investment stages:

Most young investors in their twenties and thirties prefer growth-oriented investments that stress capital gains rather than current income. Often young investors don’t have much in the way of investable funds, so they view capital gains as the quickest (if not necessarily the surest) way to build capital. Young investors tend to favor growth-oriented and speculative investments, particularly high-risk common stocks.

An Advisor’s Perspective

Rick Loek, CEO, Calrima Financial and Insurance Agency

“There are three financial phases that we go through in life.”

MyFinanceLab

Note

An Advisor’s Perspective boxes consist of short video clips of professional investment advisors who share their practical insights about the material covered in this text.

As investors approach middle age, family demands and responsibilities such as educational expenses and retirement contributions become more important. The whole portfolio often shifts to a less aggressive posture. Stocks that offer a balance between growth and income—high-grade bonds, preferred stocks, convertibles, and mutual funds—are all widely used at this stage.

Finally, when investors approach their retirement years, preservation of capital and current income become the principal concerns. A secure, high level of income is paramount. Investors place less emphasis on growing their portfolio. Instead, they structure their portfolios to generate regular cash flow with relatively low exposure to risk. The investment portfolio now becomes highly conservative. It consists of low-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit (CDs), and other short-term investments. At this stage, investors reap the rewards of a lifetime of saving and investing.

Investing over the Business Cycle

Common stocks and other equity-related securities (convertible securities, stock mutual funds, stock options, and stock index futures) are highly responsive to conditions in the economy. The business cycle refers to the recurring sequence of growth and decline, boom and recession that characterizes economies around the world. The business cycle reflects the current status of a variety of economic variables, including gross domestic product (GDP), industrial production, personal disposable income, the unemployment rate, and more.

A strong economy is reflected in an expanding business cycle. Stocks tend to be a leading indicator of the business cycle, meaning that stock prices tend to rise prior to periods when business is good and profits are up. Growth-oriented and speculative stocks tend to do especially well in strong markets. To a lesser extent, so do low-risk and income-oriented stocks. In contrast, stock values often fall several months before periods when economic activity is declining. The reason that stocks tend to move ahead of changes in the business cycle is that stock prices reflect investors’ beliefs about the future prospects of companies. When investors believe that business conditions will deteriorate, stock prices will fall even before those poor business conditions materialize. Of course, the same thing happens in reverse when investors believe the economy will perform better. Stock prices rise in anticipation of strong future economic performance.

Bonds and other forms of fixed-income securities (bond funds and preferred stocks) are also sensitive to the business cycle because they are highly sensitive to movements in interest rates. In fact, interest rates represent the most important variable in determining bond price behavior and returns to investors. Interest rates and bond prices move in opposite directions (

Chapters 10

 and 
11
). Therefore, rising interest rates are unfavorable for bonds already held in an investor’s portfolio. Of course, high interest rates enhance the attractiveness of new bonds because these bonds must offer high returns to attract investors.

Watch Your Behavior

James Grant, Founder, Grant’s Interest Rate Observer

“The biggest mistake we investors make is being human.”

MyFinanceLab

If you had a crystal ball and could foresee the future, our advice to you would be to load up on high-risk investments each time the economy was nearing the end of a recession and to discard those investments in favor of safer assets near the end of each economic boom. Of course, no one has such a crystal

Famous Failures in Finance Ethical Failure––Massaging the Numbers

In recent years, business headlines were full of allegations of massive financial fraud committed by prominent business leaders. These allegations shocked the investment community and resulted in spectacular bankruptcies of large corporations. Civil and criminal charges against the key executives involved in the fraud soon followed. Among the list of business leaders charged or convicted of financial fraud were Bernie Madoff, Ramalinga Raju of Satyam Computer Services, Hank Greenberg of American International Group (AIG), and David Glenn of Freddie Mac.

In many cases, the primary weapon of fraudulent CEOs was the use of corporate accounting to report huge, fictitious profits or hide financial problems. To cite just one example, prior to its 2008 bankruptcy, the investment banking firm Lehman Brothers had repeatedly engaged in a transaction known as Repo 105. In this transaction, just before it issued a quarterly financial report, Lehman Brothers essentially borrowed money on a short-term basis (usually for 7 to 10 days) from another entity. However, on Lehman’s balance sheet that loan was recorded as an asset sale. On Lehman’s publicly released financial statements, this transaction made it appear that Lehman Brothers had more cash and less debt than it actually did. More than 13 years after the passage of the Sarbanes-Oxley Act, legislation designed to prevent this kind of corporate fraud, investors have learned the hard way that corporate fraud is a significant risk that remains difficult to anticipate or detect until it is too late.

Critical Thinking Question

1. Why do you think Lehman engaged in Repo 105 transactions?

ball, and unfortunately professional economic forecasters and investment professionals do not have a particularly strong record at predicting turns in the economy and financial markets. Perhaps the best advice that we can offer regarding investments and the business cycle is this: Do not overreact to the ups and downs that appear to be an unavoidable (and unpredictable) part of economic life. Investors who load up on risky assets after the market has already risen from its bottom and who dump their stocks after the market has begun a slide will probably perform worse than investors who apply a consistent investment strategy over many years through many business cycles.

Note

Famous Failures in Finance boxes highlight important problems that sometimes occur in the investments field. These problems may deal with ethical lapses, as in the box above, or they may involve various kinds of failures that take place in the marketplace.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 1.12 What should an investor establish before developing and executing an investment program? Briefly describe the elements of an investment policy statement.

2. 1.13 Define and differentiate among the following. Explain how each is related to federal income taxes.

A. Active income

B. Portfolio and passive income

C. Capital gain

D. Capital loss

E. Tax planning

F. Tax-advantaged retirement investments

3. 1.14 Describe the differing investment philosophies typically applied during each of the following stages of an investor’s life cycle.

c. Youth (ages 20 to 45)

c. Middle age (ages 46 to 60)

c. Retirement years (age 61 and older)

1. 1.15 Discuss the relation between stock prices and the business cycle.

Meeting Liquidity Needs with Short-Term Investments

1. LG 5

Liquidity is the ability to convert an investment into cash quickly with little or no loss in value. A checking account is highly liquid. Stocks and bonds are a little less liquid because there is no assurance that you will be able to quickly sell them without having to cut the price to attract a buyer and because selling these securities usually triggers various transactions costs. Real estate is even less liquid and may take weeks or months to sell even if you are willing to accept a very low price. Unexpected life events such as illness and unemployment sometimes require individuals to draw on their savings to meet daily expenses, so planning for and providing for adequate liquidity is an important part of an investment plan.

The Role of Short-Term Investments

Short-term investments represent an important part of most savings and investment programs. They generate income, although with the prevailing near-zero interest rates in recent years, the income provided by these investments has been quite low. However, their primary function is to provide a pool of reserves for emergencies or simply to accumulate funds for some specific purpose. As a rule of thumb, financial planners often suggest that you hold cash reserves equivalent to three to six months of your after-tax salary, and typically this type of emergency fund would be invested in safe, liquid, short-term investments.

Some individuals choose to hold short-term investments because they simply do not want to take the risk inherent in many types of long-term investments. Certainly there are periods when these low-risk investments perform better than stocks and bonds. Regardless of your motives for holding short-term investments, you should evaluate them in terms of their risk and return, just as you would longer-term investments.

Famous Failures in Finance A Run for the Money

During the Great Depression, individuals became fearful about the ability of banks to survive, and this prompted a great number of bank runs. One of these featured prominently in Frank Capra’s classic film, It’s A Wonderful Life. In a bank run many of a bank’s depositors attempt to withdraw money from their accounts at the same time. Because the bank holds only a small fraction of its deposits as cash in a vault, a run can cause a bank to run out of cash quickly and fail as a result. In fact, thousands of banks failed in the 1930s for this reason. To protect banks against runs, the U.S. government created a deposit insurance program via the Banking Act of 1933, which guaranteed that each depositor’s money (up to $2,500) would be returned to him or her in the event of a bank failure. This led to fewer bank runs and fewer bank failures. In 1934 only 9 banks failed, compared to more than 9,000 from 1929 to 1933.

In the recent financial crisis, depositors began to question the safety of banks and other financial institutions not only in the United States but also in many other countries. In an attempt to reassure depositors and to prevent a classic bank run, several countries increased the limit on their deposit insurance programs. In 2008 the Federal Deposit Insurance Corporation (FDIC) increased the amount of insured deposits from $100,000 to $250,000. Greece, Poland, Sweden, Denmark, and the United Kingdom all increased their limits on insured deposits. In Greece and Ireland the limit was entirely eliminated, committing those governments to cover 100% of customers’ deposits at insured financial institutions. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FDIC announced in 2010 that it would temporarily provide unlimited insurance for non-interest-bearing accounts at all FDIC-insured institutions. Today the deposit insurance limit is $250,000 per depositor at each bank.

Interest on Short-Term Investments

Short-term investments earn interest in one of two ways. Some investments, such as savings accounts, pay a stated rate of interest. In this case, you can easily find the interest rate—it’s the stated rate on the account.

Alternatively, some short-term investments earn interest on a 

discount basis

. This means that you buy the security at a price below its redemption value (or face value), and the difference between what you pay to acquire the asset and what you receive when it matures is the interest the investment will earn. U.S.

Treasury bills

(T-bills), for example, are issued on a discount basis.

Risk Characteristics

Short-term investments are generally not very risky. Their primary risk results from inflation risk—the potential loss of purchasing power that may occur if the rate of return on these investments is less than the inflation rate. Investors holding money in bank savings accounts have experienced this outcome in each of the last several years. The average interest rate on bank money market savings accounts has been below 0.5% since 2010, but over that same period, the average annual inflation rate has been about 2%. Usually, short-term investments provide rates of return that are slightly higher than the inflation rate, but actions by the U.S. Federal Reserve have kept short-term interest rates at historically low levels in recent years.

An Advisor’s Perspective

James Grant Founder, Grant’s Interest Rate Observer

“Low rates present many difficulties to the wary and the unwary.”

MyFinanceLab

The risk of default—nonpayment—is almost nonexistent with short-term investments. The reason is that issuers of most short-term investments are highly reputable institutions, such as the U.S. Treasury, large banks, and major corporations. In addition, government agencies insure deposits in commercial banks, savings and loans, savings banks, and credit unions for up to $250,000 per account. Finally, because the value of short-term investments does not change much in response to changing interest rates, exposure to capital loss is correspondingly low.

Advantages and Disadvantages of Short-Term Investments

As noted, the major advantages of short-term investments are their high liquidity and low risk. Most are available from local financial institutions and can be readily converted to cash with minimal inconvenience. Finally, because the returns on most short-term investments usually vary with inflation and market interest rates, investors can readily capture higher returns as rates move up. On the negative side, when interest rates go down, returns drop as well.

Although a decline in market rates has undesirable effects on most short-term investments, perhaps their biggest disadvantage is their relatively low return. Because these securities are generally so low in risk, you can expect the returns on short-term investments to average less than the returns on long-term investments.

Common Short-Term Investments

A variety of short-term investments are available to the individual investor. Some are deposit-type accounts where investors can place money, earn a relatively low rate of interest, and conveniently withdraw funds at their discretion. Part A of 

Table 1.3

 summarizes the popular deposit-type accounts. Another group of short-term investments are those issued by the federal government. Basic features of many of those instruments are summarized in Part B of 
Table 1.3
. The final group of short-term investments includes nongovernment instruments, typically issued by a financial institution or a corporation. Part C of 
Table 1.3
 summarizes these investments.

Investment Suitability

Individual investors use short-term investments for both savings and investment. When the savings motive is paramount, investors use these assets to maintain a

Table 1.3 Common Short-Term Investments

Description

Up to $250,000 per deposit.

Up to $250,000 per deposit.

Description

U.S. Treasury

Lowest, virtually risk free

Security

Issuer

Description

Initial Maturity

Risk and Return

Part A. Deposit-Type Accounts
Type of Account	Minimum Balance	Interest Rate	Federal Insurance
* The term bank refers to commercial banks, savings and loans (S&Ls), savings banks, and credit unions.
	Passbook savings account	Savings accounts offered by banks. *  Used primarily for convenience or if investors lack sufficient funds to purchase other short-term investments.	Typically none	0.25%–4% depending on economy			Up to $250,000 per deposit.
NOW (negotiated order of withdrawal) account	Bank checking account that pays interest on balances.	No legal minimum but often set at $500 to $1,000	At or near passbook rates
	Money market deposit account (MMDA)	Bank deposit account with limited check-writing privileges.	No legal minimum, but often set at about $2,500	Typically slightly above passbook rate
	Asset management account	Deposit account at bank, brokerage house, mutual fund, or insurance company that combines checking, investing, and borrowing. Automatically “sweeps” excess balances into short-term investments and borrows to meet shortages.	Typically $5,000 to $20,000	Similar to MMDAs	Up to $250,000 per deposit in banks. Varies in other institutions.
Part B. Federal Government Issues
	Security		Issuer		Initial Maturity		Risk and Return
	I bonds		U.S. Treasury	Savings bonds issued by the U.S. Treasury in denominations as low as $25; earn an interest rate that varies with the inflation rate; interest is exempt from state and local taxes.	30 years, but redeemable after 1 year		Lowest, virtually risk free
Treasury bills	Issued weekly at auction; sold at a discount; strong secondary market; exempt from local and state income taxes.	1 year or less
Part C. Nongovernment Issues
Certificates of deposit (CDs)	Commercial banks	Cash deposits in commercial banks; amounts and maturities tailored to investor’s needs.	1 month and longer	Higher than U.S. Treasury issues and comparable to commercial paper
Commercial paper	Corporation with a high credit standing	Unsecured note of issuer; large denominations.	3 to 270 days	Higher than U.S. Treasury issues and comparable to CDs
Banker’s acceptances	Banks	Analogous to a postdated check on an account with overdraft protection; a time draft drawn on a customer’s account, guaranteed by a bank; bank’s “acceptance” makes the trade a tradable instrument.	30 to 180 days	About the same as CDs and commercial paper but higher than U.S. Treasury issues
Money market mutual funds (money funds)	Professional portfolio management companies	Professionally managed portfolios of marketable securities; provide instant liquidity.	None—depends on wishes of investor	Vary, but generally higher than U.S. Treasury issues and comparable to CDs and commercial paper

desired level of savings that will be readily available if the need arises—in essence, to provide safety and security. For this purpose, an investment’s return is less important than its safety, liquidity, and convenience. Passbook savings accounts and

NOW account

s are examples of short-term investments that fulfill investors’ short-term savings needs.

When investors use short-term securities for investment purposes, the return that these instruments provide is often just as important as their liquidity. Most investors will hold at least a part of their portfolio in short-term, highly liquid securities, if for no other reason than to be able to act on unanticipated investment opportunities. Some investors, in fact, devote all or most of their portfolios to such securities.

Investors also use short-term securities as a temporary place to “park” funds before deciding where to invest the money on a long-term basis. For example, if you have just sold some stock but do not have a suitable long-term investment alternative, you might place the proceeds in a money fund until you find a longer-term use for them. Or if you feel that interest rates are about to rise sharply, you might sell some long-term bonds that you have and use the proceeds to buy T-bills. The securities offering the highest returns—like money market deposit accounts (MMDAs), CDs, commercial paper, banker’s acceptances, and money funds—are generally preferred for this warehousing function, as are asset management accounts at major brokerage firms.

To decide which securities are most appropriate for a particular situation, you need to consider such characteristics as availability, safety, liquidity, and rate of return. Although all investments we have discussed satisfy the basic liquidity demand, they do so to varying degrees. A NOW account is unquestionably the most liquid of all. You can write as many checks on the account as you wish and for any amount. A certificate of deposit, on the other hand, is not so liquid because early redemption involves an interest penalty. 

Table 1.4

 summarizes the key characteristics of the short-term investments described in 
Table 1.3
. The letter grade assigned for each characteristic reflects

Table 1.4 A Scorecard for Short-Term Investment

A+

Passbook savings account

A+

A+

Money market deposit account (MMDA)

B

A+

A

Asset management account

A

A+

B−

A−

0.20%

B−

A

B

B−

A−

B−

B

B

I bonds

A+

A++

Type of Investment	Availability	Safety	Liquidity	Typical Rate in 2015
NOW account			A−							A+	0.03%
			A	0.06%
Money market mutual fund (money fund)					B	A/A+	B+	0.07%
0.08%
				B−		0.20%
U.S. Treasury bill (1 year)		A++
Banker’s acceptance (90 day)	0.23%
Commercial paper (90 day)	0.50%
Certificate of deposit (1 year, large denomination)	A±	0.70%
C−	1.50%

an estimate of the investment’s quality in that area. For example, money market mutual funds (money funds) rate only a B+ on liquidity because withdrawals must usually be made in a minimum amount of $250 to $500. NOW accounts are somewhat better in this respect because a withdrawal can be for any amount. Rates on short-term investments tend to be low. Among the investments listed in 
Table 1.4
, the rates on NOW and passbook savings accounts are typically lowest, and the rates on I bonds are the highest. However, in 2015 as the economy continued its slow recovery from a recession, rates on all of these instruments were barely above zero. For example, a large, 1-year CD offered investors a return of 0.7%. You should note, though, that if an investment scores lower on availability, safety, or liquidity, it will generally offer a higher rate.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 1.16 What makes an asset liquid? Why hold liquid assets? Would 100 shares of IBM stock be considered a liquid investment? Explain.

2. 1.17 Explain the characteristics of short-term investments with respect to purchasing power and default risk.

3. 1.18 Briefly describe the key features and differences among the following deposit accounts.

a. Passbook savings account

b. NOW account

c. Money market deposit account

d. Asset management account

4. 1.19 Define, compare, and contrast the following short-term investments.

a. I bonds

b. U.S. Treasury bills

c. Certificates of deposit

d. Commercial paper

e. Banker’s acceptances

f. Money market mutual funds (money funds)

Careers in Finance

1. LG 6

Regardless of the job title, a career in finance requires you to understand the investment environment. The principles presented throughout this text will provide an initial foundation in investments essential to pursuing one of the many rewarding career paths within the field of finance. If you are well prepared and enthusiastic about a career in finance, you will find a wide variety of job opportunities. Many people who pursue a career in the investments field obtain one of two professional certifications: Certified Financial Planner (CFP®) or Chartered Financial Analyst (CFA). Each of these certifications can help advance your career, although the requirements and the focus of each certification are somewhat different.

Choosing an Index Fund

An Advisor’s Perspective

Bryan Sweet Founder and CEO, Sweet Financial Services

“The CFP gives you confidence when speaking to clients.”

MyFinanceLab

The CFP® program is primarily designed for people who want to work directly with clients, helping them develop investment plans and executing those plans. To obtain the CFP® credential, you must have a bachelor’s degree in finance or a related field. You must pass the six-hour CFP® Certification Exam, which in 2014 had a pass rate of 66%. The exam focuses heavily on aspects of the advisor-client relationship including establishing and defining client relationships, analyzing a client’s current financial position, and developing, communicating, implementing, and monitoring investment recommendations. In addition to passing the exam, to earn the CFP® you must have three years of professional work experience in financial planning, and you must agree to abide by a code of ethics established by the CFP® Board. People with the CFP® credential typically work as financial advisors, either in their own practice or as part of a larger team.

The CFA program’s focus is more appropriate for people who want to work as institutional investors, for example as a financial analyst on Wall Street. To earn the CFA credential, you must pass a series of three, grueling, six-hour exams (Level 1, Level 2, and Level 3), each of which usually requires hundreds of hours of study. Typically the pass rate on these exams is 50% or less. Examples of CFA exam questions appear scattered throughout this text and on MyFinanceLab. You also need a bachelor’s degree (in any field) simply to register for the exam. In addition, you must have four years of qualified investment work experience, and you must adhere to the CFA Institute’s Code of Ethics and Professional Conduct. The most common job held by CFAs is portfolio manager, but people with this certification also work as consultants, financial analysts inside corporations, traders, risk managers, and more.

Whether you hold any of these professional credentials, there are many career opportunities open to you if you are well trained in investments. Some of the industries with investments-oriented career opportunities are commercial banking, corporate finance, financial planning, insurance, investment banking, and investment management.

Commercial Banking

Commercial banks provide banking services to individuals and businesses alike. In spite of considerable consolidation within the banking sector, more people work in commercial banking than in any other area of the financial services industry.

Due to the vast range of services provided by commercial banks, banks offer a tremendous variety of finance career opportunities, many of which require training in investments. In a commercial bank you might find yourself working in mortgage lending, mortgage underwriting, corporate lending, asset management, leasing, consumer credit, trade credit, and international finance. Some of the job titles that you might hold in the commercial banking sector include personal banker, portfolio manager, short-term securities manager, financial analyst, credit analyst, home loan officer, corporate loan officer, and mortgage underwriter.

Corporate Finance

Within the corporate finance setting, you will find several rewarding job opportunities. Among other things, corporations require financial professionals to manage cash and short-term investments, raise and manage long-term financing, evaluate and undertake investments, and interface with investors and the financial community. These critical finance functions exist within virtually every firm regardless of size

The top finance job in a corporation is that of the chief financial officer (CFO). The CFO’s primary responsibilities are to manage the firm’s capital resources and capital investments. Investment principles are important to CFOs because so much of a CFO’s job revolves around communication with investors. A CFO must understand how investors view the firm and value the securities the firm has issued. A CFO’s job (and most other corporate finance jobs) is typically focused on increasing a firm’s value through successful business decisions. More so than other finance-related jobs, corporate finance jobs require a broad understanding of the various functional areas within the corporate setting (e.g., operations, marketing, and accounting) and how these areas contribute to the corporate finance goals.

Financial Planning

A financial planner counsels clients on how to deal with their specific situations and meet their particular goals, both short-term and long-term. As a personal financial planner, you provide financial advice relating to education, retirement, investment, insurance, tax, and estate planning. You may be consulted by business owners for advice on issues such as cash flow management, investment planning, risk management and insurance planning, tax planning, and business succession planning.

An ability to clarify objectives, assess risks, and develop strategic plans is essential for financial planners. For example, if a client desires to send a child to college someday, what savings or investment strategies are best suited to meet that client’s goals? Financial planners can work within a large financial services company such as ING, within a small practice, or for themselves.

Insurance

The insurance business is a trillion-dollar industry that serves both individual and business clients. There are two prominent finance jobs in insurance. The first involves providing individuals or businesses with products that provide cash payments when unfavorable events (e.g., sickness, death, property damage due to fire or natural disaster) occur, and the second involves investing the premiums that customers pay when they buy insurance. Individuals and businesses purchase insurance products in order to protect themselves from catastrophic losses or to guarantee certain outcomes. Insurers collect premiums and fees for the services they provide and they invest those funds in assets so that when customers submit claims, the insurance company will have the cash to fulfill the financial promises they made to their customers. The insurance industry has vast sums under management and therefore requires highly trained investment specialists.

Investment Banking

Investment banks assist firms and governments when issuing financial securities, such as stocks and bonds, and they facilitate the purchase of securities by both institutional and retail investors. Their in-house security analysts provide research on both equity and fixed-income securities. Investment banks also make markets for financial securities (e.g., stocks and bonds) and provide financial advice to and manage financial assets for high net worth individuals, firms, institutions, and governments. Investment banks even provide their clients with quantitative analysis or program trading and consultation on mergers and acquisitions.

The investment banking industry changed dramatically during the 2008 financial crisis. Many investment banks invested heavily in securities tied to U.S. real estate values, and when home prices began to drop, the losses on banks’ investments began to mount. Several prominent investment banks either went bankrupt or were acquired by other banks. Since then, the industry has recovered to a degree, but there are fewer professionals working in investment banks today than there were a decade ago.

Investment Management

As the name implies, investment management is all about managing money for clients. The role of an investment manager includes elements of financial analysis, asset selection, security (e.g., stock or bond) selection, and investment implementation and monitoring. Most investment management is done on behalf of a pool of investors whose investments comprise a fund. Some common examples of managed funds are bank trust funds, pension funds, mutual funds, exchange-traded funds, and hedge funds.

Money managers often specialize in managing a portfolio of a particular type of security. Some money managers buy and hold fixed-income securities, including mortgage-backed securities, corporate bonds, municipal bonds, agency securities, and asset-backed securities. Others focus on equities, including small stocks, large caps, and emerging market stocks. Some managers invest only in domestic securities while others buy securities in markets all over the world.

Table 1.5

 lists average salaries and required years of experience for a variety of jobs in the commercial banking, corporate finance, investment banking, and

Table 1.5 Average Salaries for Various Finance Jobs (2015)

(Source: Data from 

Salary.com

; Data for Investment banking from 

http://www.forbes.com/sites/kenrapoza/2013/03/13/how-much-do-wall-streeters-really-earn/

)

 0

 7

 7

 7

 0

10

 2

 7

Job Title	Salary	Years of Experience
Commercial Banking
Commercial credit analyst, Jr.	$ 43,254			0
Commercial credit analyst, Sr.	$  8 5,532					7
Lending office, Jr.	$ 81,713	8
Lending officer, Sr.	$151,722	12
Corporate Finance
Financial analyst, Jr.	$  5 1,848
Financial analyst, Sr.	$ 93,724
Assistant controller	$112,876
Investor relations director	$145,796		10
Treasurer	$179,029
Chief financial officer	$300,571	15
Investment Banking
Analyst	$ 85,300
Associate	$120,000	3
Managing director	$273,400
Investment Management
Securities analyst	$ 62,780		2
Investment specialist	$ 78,757
Portfolio manager	$101,031	5
Investment operations manager	$125,366

investment management fields. Many of these jobs have an investments focus, but not all do. Keep in mind that there is substantial variation around these averages. Larger firms and firms in areas with higher costs of living tend to pay more. For entry-level positions, an individual’s salary might be higher or lower than the average reported here based on the candidate’s undergraduate major, grade point average, extracurricular activities, or simply how they handle a job interview. Salaries reported in 
Table 1.5
 also do not include bonuses, which can be considerable in certain industries (such as investment banking). Bonuses tend to account for a larger fraction of total pay in jobs that require more experience. Still, the table conveys the idea that job opportunities in finance are quite attractive.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 1.20 Why is an understanding of investment principles important to a senior manager working in corporate finance?

2. 1.21 Why do insurance companies need employees with advanced training in investments?

MyFinanceLab

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know and where to go when you need to practice.

What You Should Know	Key Terms	Where to Practice
NOTE The end-of-chapter summaries restate the chapter’s Learning Goals and review the key points of information related to each goal.	NOTE A list of Key Terms gathers in one place the new vocabulary presented in each chapter.
LG 1 Understand the meaning of the term investment and list the attributes that distinguish one investment from another. An investment is any asset into which investors can place funds with the expectation of generating positive income and/or increasing their value. The returns from investing are received either as income or as increased value. Some of the attributes that distinguish one type of investment from another include whether the investment is a security or property; direct or indirect; debt, equity, or derivative; low risk or high risk; short-term or long-term; and domestic or foreign.	1. debt , p.  4 2. derivative securities , p.  4 3. direct investment , p.  3 4. domestic investments , p.  5 5. equity , p.  4 6. foreign investments , p.  5 7. indirect investment , p.  3 8. investment , p.  2 9. liquidity , p.  2 10. long-term investments , p.  5 11. portfolio , p.  2 12. property , p.  3 13. returns , p.  2 14. risk , p.  4 15. securities , p.  2 16. short-term investments , p.  5	MyFinanceLab Study Plan 1.1
LG 2 Describe the investment process and types of investors. Financial institutions and financial markets bring together suppliers and demanders of funds. The dominant U.S. financial market is the securities market for stocks, bonds, and other securities. The participants in the investment process are government, business, and individuals. Only individuals are net suppliers of funds. Investors can be either individual investors or institutional investors.	1. diversification , p.  4 2. financial institutions , p.  5 3. financial markets , p.  5 4. individual investors , p.  6 5. institutional investors , p.  6	MyFinanceLab Study Plan 1.2
LG 3 Discuss the principal types of investments. Short-term investments have low risk. They are used to earn a return on temporarily idle funds, to serve as a primary investment for conservative investors, and to provide liquidity. Common stocks offer dividends and capital gains. Fixed-income securities—bonds, convertible securities, and preferred stock—offer fixed periodic returns with some potential for gain in value. Mutual funds allow investors to buy or sell interests in a professionally managed, diversified group of securities. Exchange-traded funds are similar to mutual funds except that they can be bought and sold on an exchange during the trading day. Hedge funds are also similar to mutual funds except that they are open only to relatively wealthy investors, they tend to make riskier investments, and they are subject to less regulation than mutual funds. Derivative securities such as options and futures are high-risk investments. Options offer an opportunity to buy or sell another security at a specified price over a given period of time. Futures are contracts between a seller and a buyer for delivery of a specified commodity or financial instrument, at a specified future date, at an agreed-on price. Other popular investments include tax-advantaged investments, real estate, and tangibles.	1. bonds , p.  9 2. capital gains , p.  8 3. common stock , p.  8 4. convertible security , p.  9 5. dividends , p.  8 6. exchange-traded funds (ETF) , p.  11 7. fixed-income securities , p.  9 8. futures , p.  13 9. hedge funds , p.  12 10. money funds , p.  11 11. money market mutual funds , p.  11 12. mutual fund , p.  10 13. options , p.  12 14. preferred stock , p. 10 15. real estate , p.  13 16. tangibles , p.  13 17. tax-advantaged investments , p.  13	MyFinanceLab Study Plan 1.3
LG 4 Describe the purpose and content of an investment policy statement, review fundamental tax considerations, and discuss investing over the life cycle. Investing should be driven by well-developed plans established to achieve specific goals. A good place to begin an investment plan is to create a written investment policy statement. Investors must also consider the tax consequences associated with various investments and strategies. The key dimensions are ordinary income, capital gains and losses, tax planning, and tax-advantaged retirement plans. The investments selected are affected by the investor’s stage in the life cycle and by economic cycles. Younger investors tend to prefer growth-oriented investments that stress capital gains. As they age, investors move to less risky securities. As they approach retirement, they become even more conservative. Some investments, such as stocks, behave as leading indicators of the state of the economy.	1. capital loss , p.  18 2. investment goals , p.  14 3. net losses , p.  19 4. tax planning , p.  19	MyFinanceLab Study Plan 1.4 Video Learning Aid for Problems P1.1, P1.2
LG 5 Describe the most common types of short-term investments. Liquidity needs can be met by investing in various short-term investments, which can earn interest at a stated rate or on a discount basis. They typically have low risk. Banks, the government, and brokerage firms offer numerous short-term investments. Their suitability depends on the investor’s attitude toward availability, safety, liquidity, and rate of return.	1. discount basis , p.  23	MyFinanceLab Study Plan 1.5
LG 6 Describe some of the main careers open to people with financial expertise and the role that investments play in each. Exciting and rewarding career opportunities in finance are available in many fields such as commercial banking, corporate finance, financial planning, insurance, investment banking, and money management.	MyFinanceLab Study Plan 1.6
Log into MyFinanceLab, take a chapter test, and get a personalized Study Plan that tells you which concepts you understand and which ones you need to review. From there, MyFinanceLab will give you further practice, tutorials, animations, videos, and guided solutions. Log into  http://www.myfinancelab.com

The Mutual Fund Concept

1. LG 1

2. LG 2

Questions of which stock or bond to select, how best to build a diversified portfolio, and how to manage the costs of building a portfolio have challenged investors for as long as there have been organized securities markets. These concerns lie at the very heart of the mutual fund concept and in large part explain the growth that mutual funds have experienced. Many investors lack the know-how, time, or commitment to manage their own portfolios. Furthermore, many investors do not have sufficient funds to create a well-diversified portfolio, so instead they turn to professional money managers and allow them to decide which securities to buy and sell. More often than not, when investors look for professional help, they look to mutual funds.

Basically, a 

mutual fund

 (also called an investment company) is a type of financial services organization that receives money from a group of investors and then uses those funds to purchase a portfolio of securities. When investors send money to a mutual fund, they receive shares in the fund and become part owners of a portfolio of securities. That is, the investment company builds and manages a portfolio of securities and sells ownership interests—shares—in that portfolio through a vehicle known as a mutual fund.

An Advisor’s Perspective

Catherine Censullo Founder, CMC Wealth Management

“Mutual funds are pools of assets.”

MyFinanceLab

Portfolio management deals with both asset allocation and security selection decisions. By investing in mutual funds, investors delegate some, if not all, of the security selection decisions to professional money managers. As a result, investors can concentrate on key asset allocation decisions—which, of course, play a vital role in determining long-term portfolio returns. Indeed, it’s for this reason that many investors consider mutual funds the ultimate asset allocation vehicle. All that investors have to do is decide in which fund they want to invest—and then let the professional money managers at the mutual funds do the rest.

An Overview of Mutual Funds

Mutual funds have been a part of the investment landscape in the United States for 9

1 year

s. The first one started in Boston in 1924 and is still in business. By 1940 the number of mutual funds had grown to 68, and by 2015 there were more than 9,300 of them. To put that number in perspective, there are more mutual funds in existence today than there are stocks listed on all the major U.S. stock exchanges combined. As the number of fund offerings has increased, so have the assets managed by these funds, rising from about $135 billion in 1980 to $

15.

8 trillion by the end of 20

14.

Compared to less than 6% in 1980, 4

3%

of U.S. households (90 million people) owned mutual funds in 2014. The mutual fund industry has grown so much, in fact, that it is now the largest financial intermediary in this country—even ahead of banks.

Mutual funds are big business in the United States and, indeed, all over the world. Worldwide there were more than 79,000 mutual funds in operation in 2014, which collectively held $31.4 trillion in assets. U.S. mutual funds held roughly half of those assets. Measured by the number of funds or by assets under management, U.S. stock funds hold the largest share of mutual fund assets. 

Figure 

12.

1

 shows the major types of mutual funds and their share of total assets under management. Funds that invest primarily in U.S. stocks (domestic equity) managed 42% of assets held by mutual funds in 2014, and funds investing in foreign stocks held another 14% of industry assets. The share of mutual fund assets invested in domestic and world stocks has been rising in recent years, while the share of assets invested in fixed-income securities such as bonds and money market instruments has fallen. The decline in assets invested in fixed-income instruments reflects the historically low interest rates that have prevailed in the market in recent years.

Figure 12.1U.S. Mutual Fund Assets under Management by Type of Fund

The chart shows the distribution of mutual fund assets under management by type of fund. Funds that invested in either domestic or foreign stocks managed 56% of industry assets, while funds that invested in fixed-income assets such as bonds and money market instruments managed 36% of industry assets. Just three years earlier, equity and fixed-income funds held roughly an equal share of industry assets, but with interest rates stuck at historically low levels, investors have been moving out of bonds and into stocks.

(Source: Data from the 2015 Investment Company Institute Factbook, 

https://www.ici.org/pdf/2015_factbook

.)

How Mutual Funds Get Started

Mutual funds appeal to investors from all walks of life and all income levels. Both inexperienced and highly experienced investors hold mutual funds in their portfolios. All of these investors have a common view: Each has decided, for one reason or another, to turn over at least a part of his or her investment management activities to professionals.

Pooled Diversification

The mutual fund concept is based on the simple idea of combining money from a group of people with similar investment goals and investing that money in a diversified portfolio. This idea is called 

pooled diversification

. Mutual funds make it easy for investors to hold well-diversified portfolios, even if the amount of money that they can invest is relatively small. It’s not uncommon for a single mutual fund to hold hundreds of different stocks or bonds. For example, as of March 2015 Fidelity Contrafund held 335 different securities, while the Dreyfus GNMA fund held 830 securities. That’s far more diversification than most individual investors could ever hope to attain by purchasing individual securities on their own. Yet each investor who owns shares in a fund is, in effect, a part owner of that fund’s diversified portfolio of securities.

No matter what the size of the fund, as the securities it holds move up and down in price, the market value of the mutual fund shares moves accordingly. When the fund receives dividend and interest payments, they too are passed on to the mutual fund shareholders and distributed on the basis of prorated ownership. Thus, if you own 1,000 shares in a mutual fund and that represents 1% of shares outstanding, you will receive 1% of the dividends paid by the fund. When the fund sells a security for a profit, it also passes the capital gain on to fund shareholders on a prorated basis.

Active versus Passive Management

Broadly speaking, mutual funds fall into one of two categories based on how they decide which securities to buy. In an 

actively managed fund

, a professional portfolio manager conducts an analysis to determine which securities are likely to exhibit above-average future performance. The portfolio manager might conduct fundamental analysis by combing through companies’ financial reports and developing complex valuation models to estimate the intrinsic value of many different securities. The manager would then invest in those securities whose intrinsic values were greater than their market prices. Alternatively, the manager might use technical analysis to try to spot trends that predict the direction in which securities prices will move in the near future. In either case, the manager’s goal is to identify and invest in securities that will achieve superior performance.

Comparing the portfolio’s performance to a benchmark assesses whether the manager succeeds or fails in that task. The benchmark to which a particular fund is compared should have a similar risk profile as the fund. For example, if a particular fund’s objective is to invest in large, blue-chip companies, that fund’s benchmark might be the S&P 500 stock index. The fund manager’s goal is to generate higher returns, after fees, than the S&P 500 Index. On the other hand, if a particular fund focuses on investing in small-cap stocks, the S&P 500 would be a poor benchmark because small-cap stocks are riskier than the large-cap firms in that index. Instead, an index like the Russell 2000 Index would be an appropriate benchmark.

Consider the consequences of setting an inappropriate benchmark for a fund. Suppose a fund investing in small-cap stocks sets the S&P 500 as its benchmark. Because stocks in the S&P 500 are less risky than small-cap stocks, over time we would expect returns on the S&P 500 to be lower than returns on a small-cap portfolio. In other words, a small-cap fund should outperform the S&P 500, not because the fund manager is skillful, but because the fund invests in riskier assets. To the extent that fund managers are judged based on their ability to earn a return above some benchmark, there will be at least some incentive for the fund to compare its performance to a less risky benchmark.

Watch Your Behavior

Beating the Benchmarks Investment companies that offer a variety of mutual funds often advertise that a high fraction of their funds outperform their benchmarks. Investors should be wary of these claims. Mutual fund families often close funds that trail their benchmarks (or merge them into other funds outperforming the benchmark). This “survivorship bias” artificially raises the percentage of mutual funds in a particular family outperforming a benchmark. Numerous studies have shown that without the benefit of survivorship bias, most mutual funds trail their benchmarks.

In a passively managed fund, managers make no attempt to select a portfolio that will outperform a benchmark. Instead, passively managed funds are designed to mimic the performance of a particular benchmark or stock index. The Vanguard S&P 500 Index fund described at the beginning of this chapter is a perfect example of a passively managed fund. In these funds, the manager’s goal is to track the performance of the index as closely as possible while keeping expenses as low as possible. Indeed, the management fees charged by passively managed funds are, on average, a small fraction of the fees charged by actively managed funds. Purveyors of passively managed funds appeal to investors by arguing that actively managed funds offer only the possibility of earning superior returns, but their higher expenses are a certainty.

Attractions and Drawbacks of Mutual Fund Ownership

Among the many reasons for owning mutual funds, one of the most important is the portfolio diversification that they can offer. As we saw above, fund shareholders can achieve diversification benefits by spreading fund holdings over a wide variety of industries and companies, thus reducing risk. Because they buy and sell large quantities of securities, mutual funds generally pay lower transactions costs than individual investors would pay to trade the same securities. Another appeal of mutual funds is full-time professional management. In the case of actively managed funds, investors delegate the task of selecting securities to a highly trained fund manager, but even in a passively managed fund, there are record-keeping chores and other routine tasks that fund managers can perform more efficiently than can individual investors. Still another advantage is that most mutual fund investments can be started with a modest amount of investment capital. With a few thousand dollars an investor can purchase a claim on a portfolio containing hundreds of different securities. The services that mutual funds offer also make them appealing to many investors. These services include automatic reinvestment of dividends and capital gains, record keeping for taxes, and exchange privileges. Finally, mutual funds offer convenience. They are relatively easy to buy and sell, and investors can easily find up-to-date information about a fund’s price and its recent performance.

There are, of course, some costs associated with mutual fund ownership. Mutual funds charge a variety of fees which, in some cases, can be quite significant. Some funds carry a “sales load,” which is an up-front fee that investors pay to acquire shares in the fund (like a commission). Funds charge other fees to cover the expenses of running the fund. These expenses include the compensation of the portfolio manager and staff, advertising expenses, and other administrative and operating costs. Collectively, these fees (excluding the separate sales load) are known as the fund’s 

expense ratio

. The expense ratio is a charge, expressed as a percentage of assets managed by a fund, that fund investors pay each year. Investors pay these expenses each year regardless of whether the fund has a good year or a bad year. Expense ratios vary a great deal from one fund to another. The expense ratio for the median (mean) actively managed fund was 1.25% (0.86%) in 2014. If you invest $10,000 in a fund charging a 1.25% expense ratio, you will pay $125 per year in fees regardless of how the fund’s investments perform. The expense ratios charged by passively managed funds are typically much lower. The median (mean) expense ratio for passive funds was 0.44% (0.11%) in 2014. Some mutual funds justify higher fees by claiming that their managers will generate superior returns, but investors should be wary of those claims. There is not much evidence that mutual funds on average earn above-average returns. There are some notable exceptions, of course, but most actively managed funds do little more than keep up with the market. In many cases, they don’t even do that. For example, 82% of actively managed large-cap equity funds trailed their benchmark over the 10-year period ending in 2014. The spotty performance record and relatively high fees of actively managed funds have drawn more and more investors to passively managed funds over time.

Investor Facts

Passive Funds Gaining Ground In 2014, U.S. equity funds that were passively managed received $166.6 billion of new money from investors, while actively managed equity funds had $98.4 billion in withdrawals. This is part of a long-term trend which has seen the share of passively managed equity funds grow from 9.4% in 2000 to 20.2% in 2014.

(Source: 2015 Investment Company Institute Factbook, 

http://www.icifactbook.org/pdf/2015_factbook

)

Performance of Mutual Funds

For an actively managed fund, the goal is to earn a return that exceeds the fund’s benchmark by more than enough to cover the fund’s fees. But how successful are professional fund managers at achieving this goal? 

Figure 12.2

 provides some evidence on that question. The figure shows the percentage of mutual funds in various categories that were outperformed by their benchmark over a five-year period from 2009 to 2014. The figure focuses on a five-year investment horizon in part to smooth out the volatility of year-to-year performance but also because investors want to know whether actively managed funds can deliver superior performance consistently. Unfortunately, the news in 
Figure 12.2
 is not good for portfolio managers. Across a wide variety of funds, a majority of portfolio managers trail their benchmark. Looking at all U.S. equity funds, 74% of managers failed to earn a higher five-year return than their benchmark. Bond fund managers fared worse, with

85%

of junk bond funds and 96% of long-term bond funds trailing their benchmarks. The only group in which a majority of fund managers beat their benchmark was the short-term bond category, and even there 49% of funds trailed the

Figure 12.2 Percentage of Mutual Funds Outperformed by Their Benchmarks from 2009 to 2014

Even with the services of professional money managers, it’s tough to outperform the market. In this case, only one fund category had a majority of funds that succeeded in beating the market during the five-year period from 2009 to 2014.

(Source: SPIVA U.S Scorecard, mid-year 2014, 

http://www.spindices.com/documents/spiva/spiva-us-mid-year-2014

)

benchmark while 51% exceeded it. The message is clear: Consistently beating the market is no easy task, even for professional money managers. Although a handful of funds have given investors above-average and even spectacular rates of return, most mutual funds simply do not meet those levels of performance. This is not to say that the long-term returns from mutual funds are substandard or that they fail to equal what you could achieve by putting your money in, say, a savings account or some other risk-free investment outlet. Quite the contrary. The long-term returns from mutual funds have been substantial (and perhaps even better than what many individual investors could have achieved on their own), but a good deal of those returns can be traced to strong market conditions and/or to the reinvestment of dividends and capital gains.

How Mutual Funds Are Organized and Run

Athough it’s tempting to think of a mutual fund as a single large entity, that view is not really accurate. Funds split their various functions—investing, record keeping, safekeeping, and others—among two or more companies. To begin with, there’s the fund itself, which is organized as a separate corporation or trust. It is owned by the shareholders, not by the firm that runs it. In addition, there are several other major players:

· A management company runs the fund’s daily operations. Management companies are the firms we know as Fidelity, Vanguard, T. Rowe Price, American

Famous Failures in Finance When Mutual Funds Behaved Badly

For the 90 million Americans who own them, mutual funds are a convenient and relatively safe place to invest money. So it came as a big shock to investors in September 2003 when New York Attorney General Eliot Spitzer shook the mutual fund industry with allegations of illegal after-hours trading, special deals for large institutional investors, market timing in flagrant violation of funds’ written policies, and other abuses. Nearly 20 companies, including several large brokerages, were dragged into scandals.

Some of the abuses stemmed from market timing, a practice in which short-term traders seek to exploit differences between hours of operations of various global markets. An example best illustrates this practice. Suppose a U.S. mutual funds holds Japanese stocks. The Japanese market closes approximately 14 hours before the U.S. market does, but the net asset value of the mutual fund will be calculated at 4:00 p.m. when the U.S. market closes. Suppose on a Monday the U.S. market has a strong rally. Investors know that this means it is very likely that stocks will open higher on Tuesday morning in Japan, but by purchasing shares in the mutual fund, they can essentially buy Japanese stocks at prices that are “stale,” meaning that the prices do not reflect the good news that the U.S market rallied on Monday. Instead, the fund’s net asset value reflects the prices in Japan 14 hours earlier. By purchasing shares in the mutual fund on days when the U.S. market goes up and selling them on days when the U.S. market goes down, traders can earn profits that are far above normal. Most funds prohibit this kind of activity, yet exceptions were made for large institutional investors who traded millions of dollars’ worth of fund shares. According to the regulators, this practice resembles betting on a winning horse after the horse race is over.

More recently, investigations have uncovered abuses having to do with a mutual fund known as a “funds of funds.” Some large investment companies that offer many different funds give investors the option of investing in a fund that only holds shares of the investment company’s other funds. The manager of such a fund does not select individual securities, but instead decides how to allocate investors’ dollars across different mutual funds operated by the same fund family. Suppose that one of the investment company’s funds is hit by an unexpected, large request for withdrawals. Such an event could force the fund to conduct a fire sale, selling securities at discount prices to raise cash and lowering the fund’s return as a result. In steps the fund of funds manager. She simply reallocates some of the dollars under her control by purchasing shares in the fund hit with withdrawals and selling shares in other funds not facing pressure to distribute cash to shareholders. This practice benefits the fund family as a whole but not the shareholders in the fund of funds. They are effectively providing liquidity to other funds in the family hit by redemption requests without being compensated for doing so.

Critical Thinking Question

1. How are shareholders in a “fund of funds” harmed if their fund manager purchases shares in another fund that has been hit by unexpected investor withdrawals?

Century, and Dreyfus. They are the ones that create the funds in the first place. Usually, the management firm also serves as investment advisor.

· An investment advisor buys and sells stocks or bonds and otherwise oversees the portfolio. Usually, three parties participate in this phase of the operation: (1) the money manager, who actually runs the portfolio and makes the buy and sell decisions; (2) securities analysts, who analyze securities and look for viable investment candidates; and (3) traders, who buy and sell big blocks of securities at the best possible price.

· A distributor sells the fund shares, either directly to the public or through authorized dealers (like major brokerage houses and commercial banks). When you request a prospectus and sales literature, you deal with the distributor.

· A custodian physically safeguards the securities and other assets of the fund, without taking a role in the investment decisions. To discourage foul play, an independent party (usually a bank) serves in this capacity.

· A transfer agent keeps track of purchase and redemption requests from shareholders and maintains other shareholder records.

This separation of duties is designed to protect mutual fund shareholders. You can lose money as a mutual fund investor (if your fund’s stock or bond holdings go down in value), but that’s usually the only risk of loss you face with a mutual fund. Here’s why: In addition to the separation of duties noted above, one of the provisions of the contract between the mutual fund and the company that manages it is that the fund’s assets—stocks, bonds, cash, or other securities in the portfolio—can never be in the hands of the management company. As still another safeguard, each fund must have a board of directors, or trustees, who are elected by shareholders and are charged with keeping tabs on the management company. Nevertheless, as the Famous Failures in Finance box nearby explains, some mutual funds have engaged in some improper trading, which imposed losses on their investors.

Open- or Closed-End Funds

Some mutual funds, known as 

open-end funds

, regularly receive new infusions of cash from investors, and the funds use that money to purchase a portfolio of securities. When investors send money to an open-end fund, they receive new shares in the fund. There is no limit to the number of shares that the mutual fund can issue, and as long as new money flows in from investors, the portfolio of securities grows. Of course, investors are free to withdraw their money from the fund, and when that happens the fund manager redeems investors’ shares in cash. Sometimes, withdrawal requests by fund shareholders may force the fund manager to sell securities (thus reducing the size of the portfolio) to obtain the cash to distribute to investors. In extreme cases, when investor withdrawals are unexpectedly large and the securities held by the fund are illiquid, the fund may have to conduct a 

fire sale

. A fire sale occurs when a fund must sell illiquid assets quickly to raise cash to meet investors’ withdrawal requests. In a fire sale, the fund may have to substantially reduce the price of the securities it wants to sell to attract buyers. In such an instance, the buyers are essentially providing liquidity to the fund, and the discounted price that buyers receive on the securities that they purchase from the fund is effectively a form of compensation that they earn for providing that liquidity. To avoid having to sell securities at fire-sale prices and to reward investors who leave their money in the fund for a long time, some funds charge redemption fees. A 

redemption fee

 is a charge that investors pay if they sell shares in the fund only a short time after buying them. Unlike other fees that mutual funds charge, the redemption fees are reinvested into the fund and do not go to the investment company. All open-end mutual funds stand behind their shares and buy them back when investors decide to sell. There is never any trading of shares between individuals. The vast majority of mutual funds in the United States are open-end funds.

When investors buy and sell shares of an open-end fund, those transactions are carried out at prices based on the current market value of all the securities held in the fund’s portfolio and the number of shares the fund has issued. These transactions occur at a price known as the fund’s 

net asset value (NAV)

. The NAV equals the total market value of securities held in the fund divided by the fund’s outstanding shares. Open-end funds usually calculate their NAVs at the end of each day, and it is at that price that withdrawals from or contributions to the fund take place. Of course, a fund’s NAV changes throughout the day as the prices of the securities that the fund holds change. Nevertheless, transactions between open-end funds and their customers generally occur at the end-of-day NAV.

Example

If the market value of all the assets held by XYZ mutual fund at the end of a given day equaled $10 million, and if XYZ on that particular day had 500,000 shares outstanding, the fund’s net asset value per share would be $20($10,000,000 ÷ 500,000)$20 ($10,000,000 ÷ 500,000). Investors who want to put new money into the fund obtain one new share for every $20 that they invest. Similarly, investors who want to liquidate their investment in the fund receive $20 for each share of the fund that they own.

An Introduction to Closed-End Funds

Closed-End Investment Companies

An alternative mutual fund structure is the closed-end fund. 

Closed-end funds

 operate with a fixed number of shares outstanding and do not regularly issue new shares of stock. The term closed means that the fund is closed to new investors. At its inception, the fund raises money by issuing shares to investors, and then it invests that pool of money in securities. No new investments in the fund are permitted, nor are withdrawals allowed. So how do investors acquire shares in closed-end funds, and how do they liquidate their investments in closed-end funds? Shares in closed-end investment companies, like those of any other common stock, are actively traded in the secondary market. Unlike open-end funds, all trading in closed-end funds is done between investors in the open market and not between investors and the fund itself. In other words, when an investor in a closed-end fund wants to redeem shares, he or she does not return them to the fund company for cash, as would be the case with an open-end fund. Instead, the investor simply sells the shares on the open market to another individual who wants to invest in the fund. In this respect, buying and selling shares in closed-end funds is just like trading the shares of a company like Apple or ExxonMobil. Investors who want to acquire shares in a particular fund must buy them from other investors who already own them.

An important difference between closed-end and open-end funds arises because investors in closed-end funds buy and sell their shares in the secondary market. For both open- and closed-end funds, the NAV equals the market value of assets held by the fund divided by the fund’s outstanding shares. However, whereas investors in open-end funds can buy or sell shares at the NAV at the end of each day, closed-end fund investors trade their shares during the trading day at the fund’s current market price. Importantly, in closed-end funds, the price of shares in the secondary market may or may not (in fact, usually does not) equal the fund’s NAV. When a closed-end fund’s share price is below its NAV, the fund is said to be trading at a discount, and when the share price exceeds the fund’s NAV, the fund is trading at a premium. We will have more to say later about how closed-end fund discounts and premiums can affect investors’ returns.

Because closed-end funds do not need to deal with daily inflows and outflows of cash from investors, the capital at their disposal is fixed. Managers of these funds don’t need to keep cash on hand to satisfy redemption requests from investors, nor must they constantly search for new investment opportunities simply because more investors want to be part of the fund.

Most closed-end investment companies are traded on the New York Stock Exchange, although a few are traded on other exchanges. As of 2014, the 568 closed-end funds operating in the United States managed $289 billion in assets, and 60% of the assets in closed-end funds were held in bond funds.

Exchange-Traded Funds

A relatively new form of investment company called an exchange-traded fund, or ETF for short, combines some of the operating characteristics of an open-end fund with some of the trading characteristics of a closed-end fund. An exchange-traded fund (ETF) is a type of open-end fund that trades as a listed security on one of the stock exchanges. Exchange-traded funds are also sometimes referred to as exchange-traded portfolios, or ETPs. As the beginning of the chapter described, the first ETF was created in 1993, and it was designed to track the movements of the S&P 500 stock index. Nearly all ETFs were structured as index funds up until 2008 when the SEC cleared the way for actively managed ETFs, which, like actively managed mutual funds, create a unique mix of investments to meet a specific investment objective.

In terms of how shares are created and redeemed, ETFs function in essentially the opposite way that mutual funds do. Mutual funds receive cash from investors, and then they invest that cash in a portfolio of securities. An ETF is created when a portfolio of securities is purchased and placed in a trust, and then shares are issued that represent claims against that trust.

An Advisor’s Perspective

Joseph A. Clark Managing Partner, Financial Enhancement Group

“Mutual funds made sense right up until the invention of Excel.”

MyFinanceLab

To be more precise, suppose a company called Smart Investors wants to create an ETF. Smart Investors, the ETF sponsor, decides that it wants its ETF to track the S&P 500 stock index. Smart Investors contacts an entity known as an authorized participant (AP), which is usually a large institutional investor of some kind. The essential trait of an AP is that it has the ability to acquire a large quantity of shares relatively quickly. The AP acquires a portfolio of shares in which all of the companies in the S&P 500 Index are represented (and in proportions that match those of the index) and delivers those shares to Smart Investors, who then places the shares in a trust. In exchange, Smart Investors gives the AP a block of equally valued shares in the ETF. This block of shares is called a creation unit. The number of ETF shares in one creation unit may vary, but 50,000 shares per creation unit is a common structure. Therefore, each ETF share represents a 1/50,000th claim against the shares held in trust by Smart Investors. The AP takes the shares that it receives and sells them to investors so the shares can begin trading freely on the secondary market. 

Figure 12.3

 illustrates the relationships of the ETF, the authorized participant, and investors.

Example

An authorized participant has acquired a portfolio of stocks that includes all stocks in the S&P 500 Index. The total market value of these stocks is $100 million. The AP transfers these shares to Smart Investors, who in turn issues 100 creation units containing 50,000 ETF shares each to the AP. Therefore, the AP holds a total of 5,000,000 ETF shares. The AP sells the shares to investors at a price of $20 each, so the total value of ETF shares outstanding equals the value of the shares held in trust. Each day the ETF share price will move in sync with changes in the value of the securities held in the trust.

ETFs provide liquidity to investors just as closed-end funds do. That is, investors in ETFs can buy or sell their shares at any time during trading hours. But unlike closed-end funds, an ETF does not necessarily have a fixed number of shares. Going back to our example of the Smart Investors ETF that tracks the S&P 500 Index, if investor demand for this ETF is strong, then Smart Investors can work with the authorized participant to purchase a larger block of shares, creating additional creation units and

Figure 12.3 How an ETF Works

An ETF is created when an authorized participant delivers a portfolio of securities to the ETF sponsor, which in turn delivers ETF shares to the authorized participant. Those shares are then sold to investors and traded on an exchange.

issuing new ETF shares. The process can also work in reverse. If at some point in time interest in the S&P 500 ETF wanes, the authorized participant can buy up 50,000 ETF shares in the open market and then sell those shares back to Smart Investors in exchange for some of the shares held in trust (remember, 50,000 ETF shares equals 1 creation unit). So the number of outstanding ETF shares may ebb and flow over time, unlike a closed-end fund’s fixed number of shares.

Because authorized participants can create new ETF shares or redeem outstanding shares, the ETF share price generally matches the NAV of shares held in trust. In other words, ETFs generally do not trade at a premium or a discount as closed-end funds do. For example, suppose at a particular point in time the share price of an S&P 500 ETF is trading below the NAV (i.e., below the value of the shares held in trust). In this case, the authorized participant can simply buy up ETF shares on the open market, deliver them back to the sponsor (e.g., Smart Investors) who created the ETF, and reclaim the shares from the trust. The authorized participant would make a profit on this transaction because the value of the ETF shares that they purchased was less than the value of the shares that they received. Of course, as the authorized participants begin buying up ETF shares to execute this transaction, they would put upward pressure on the ETF price. In short, the actions of authorized participants help to ensure that ETF prices closely, if not perfectly, match the NAVs of the securities held in trust.

A Behavioral Difference between ETFs and Mutual Funds

Investors seem to be pleased with the advantages that ETFs provide. 

Figure 12.4

 documents the explosive growth in ETFs since 1995. Starting from less than $1 billion in 1994, assets invested in ETFs totaled almost $2 trillion in 2014, a compound annual growth rate of roughly 50%! As you would expect, the variety of ETFs has dramatically increased as well. In 1995 there were just two ETFs available on U.S. markets, but by 2014 that number had skyrocketed to 1,411 ETFs. Of these, the vast majority were index ETFs. With so many index ETFs available, it is not surprising that investors can find an ETF to track almost any imaginable sector

Figure 12.4Assets Invested in Exchange-Traded Funds

Assets invested in exchange-traded funds grew from roughly $1 billion to $2 trillion from 1995 to 2014.

(Source: Data from 2015 Investment Company Institute Factbook, p. 10, http://www.icifactbook.org/2012_factbook .)

of the stock market including technology stocks, utilities, and many others. There are also ETFs that focus on other asset classes such as bonds, commodities, real estate, and currencies. By far the most common type of ETF is one that focuses on large-cap U.S. stocks.

ETFs combine many of the advantages of closed-end funds with those of traditional (open-end) funds. As with closed-end funds, you can buy and sell ETFs at any time of the day by placing an order through your broker (and paying a standard commission, just as you would with any other stock). In contrast, you cannot trade a traditional open-end fund on an intraday basis; all buy and sell orders for those funds are filled at the end of the trading day, at closing prices. ETFs can also be bought on margin, and they can be sold short. Moreover, because index ETFs are passively managed, they offer many of the advantages of any index fund, including low costs and low taxes. In fact, the fund’s tax liability is kept very low because ETFs rarely distribute any capital gains to shareholders.

Thus, you could hold index ETFs for decades and never pay a dime in capital gains taxes (at least not until you sell the shares).

Some Important Considerations

When you buy or sell shares in a closed-end investment company (or in ETFs, for that matter), you pay a commission, just as you would with any other listed or OTC stock. This is not the case with open-end mutual funds. The cost of investing in an open-end fund depends on the fees and load charges that the fund levies on its investors.

Load and No-Load Funds

The load charge on an open-end fund is the commission you pay when you buy shares in a fund. Generally speaking, the term 

load fund

 describes a mutual fund that charges a commission when shares are bought. (Such charges are also known as front-end loads.) A 

no-load fund

 levies no sales charges. Although load charges have fallen over time, they can still be fairly substantial. The average front load charge in an equity fund has fallen from 7.9% in 1980 to around 5.4% in 2014. However, many funds offer discounts on their sales loads. Some funds charge no sales load for investments made automatically each month through a retirement account, and others offer discounts for large investments. On average, the sales load that investors actually pay has fallen from about 3.9% in 1990 to 0.9% in 2014. Funds that offer these types of discounts are known as 

low-load funds

.

Occasionally, a fund will have a 

back-end load

. This means that the fund levies commissions when shares are sold. These loads may amount to as much as 5% of the value of the shares sold, although back-end loads tend to decline over time and usually disappear altogether after five or six years from date of purchase. The stated purpose of back-end loads is to enhance fund stability by discouraging investors from trading in and out of the funds over short investment horizons.

Investor Facts

Falling Fund Expenses The expenses that mutual funds charge investors have fallen considerably since 1980. The average expense charge paid by investors in stock funds in 1980 equaled 2.32% of fund assets. This figure fell nearly 60% to 0.70% by the end of 2014. Growing popularity of index funds, which have low expenses, partly accounts for this trend, but expenses have fallen even among actively managed funds. Bond funds experienced a similar decline in fees and expenses.

Although there may be little or no difference in the performance of load and no-load funds, the cost savings with no-load funds tend to give investors a head start in achieving superior rates of return. Unfortunately, the true no-load fund is becoming harder to find, as more and more no-loads are charging 12(b)-1 fees.

Known appropriately as hidden loads, 

12(b)-1 fees

 are designed to help funds cover their distribution and marketing costs. They can amount to as much as 1% per year of assets under management. In good markets and bad, investors pay these fees right off the top, and that can take its toll. Consider, for instance, $10,000 invested in a fund that charges a 1% 12(b)-1 fee. That translates into a charge of $100 per year—certainly not an insignificant amount of money. The 12(b)-1 fee is included with a fund’s other operational fees as part of the fund’s expense ratio.

Watch Your Behavior

You Don’t Always Get What You Pay For Intuitively you might expect that mutual funds that perform better would charge higher fees, but in fact the opposite is true—funds with lower performance charge higher fees. Apparently, underperforming funds target their marketing at investors who are relatively insensitive to fund performance, and the funds charge high fees to those rather inattentive investors. This is why it is important for investors to watch a fund’s performance and its fees very closely.

(Source: Javier Gil-Bazo and Pablo Ruiz-Verdu, “The Relation Between Price and Performance in the Mutual Fund Industry,” Journal of Finance, October 2009.)

To try to bring some semblance of order to fund charges and fees, the Financial Industry Regulatory Authority (FINRA) instituted a series of caps on mutual fund fees. According to the latest regulations, a mutual fund cannot charge more than 8.5% in total sales charges and fees, including front- and back-end loads as well as 12(b)-1 fees. Thus, if a fund charges a 5% front-end load and a 1% 12(b)-1 fee, it can charge a maximum of only 2.5% in back-end load charges without violating the 8.5% cap. In addition, FINRA set a 1% cap on annual 12(b)-1 fees and, perhaps more significantly, stated that true no-load funds cannot charge more than 0.25% in annual 12(b)-1 fees. If they do, they must drop the no-load label in their sales and promotional material.

Other Fees and Costs

Another cost of owning mutual funds is the management fee. This is the compensation paid to the professional managers who administer the fund’s portfolio. You must pay this fee regardless of whether a fund is load or no-load and whether it is an open- or closed-end fund or an exchange-traded fund. Unlike load charges, which are one-time costs, investment companies levy management and 12(b)-1 fees annually, regardless of the fund’s performance. In addition, there are the administrative costs of operating the fund. These are fairly modest and represent the normal cost of doing business (e.g., the commissions paid when the fund buys and sells securities). The various fees that funds charge generally range from less than 0.2% to as much as 2% of average assets under management. In addition to these management fees, some funds charge an exchange fee, assessed whenever you transfer money from one fund to another within the same fund family, or an annual maintenance fee, to help defer the costs of providing service to low-balance accounts.

The SEC requires the mutual funds themselves to fully disclose all of their fees and expenses in a standardized, easy-to-understand format. Every fund profile or prospectus must contain, up front, a fairly detailed fee table, much like the one illustrated in 

Table 12.1

. This table has three parts. The first specifies all shareholder transaction costs. This tells you what it’s going to cost to buy and sell shares in the mutual fund. The next section lists the annual operating expenses of the fund. Showing these expenses as a percentage of average net assets, the fund must break out management fees, 12(b)-1 fees, and any other expenses. The third section provides a rundown of the total cost over time of buying, selling, and owning the fund. This part of the table contains both transaction and operating expenses and shows what the total costs would be over hypothetical 1-, 3-, 5-, and 10-year holding periods. To ensure consistency and comparability, the funds must follow a rigid set of guidelines when constructing the illustrative costs.

Other Types of Investment Companies

In addition to open-end, closed-end, and exchange-traded funds, other types of investment companies are (1) real estate investment trusts, (2) hedge funds, (3) unit investment trusts, and (4) annuities. Unit investment trusts, annuities, and hedge funds are similar to mutual funds to the extent that they, too, invest primarily in marketable securities, such as stocks and bonds. Real estate investment trusts, in contrast, invest primarily in various types of real estate–related investments, like mortgages. We’ll look at real estate investment trusts and hedge funds in this section.

Table 12.1 Mutual Fund Fee Table (Required by Federal Law)

The following table describes the fees and expenses that are incurred when you buy, hold, or sell shares of the fund.

None

None

None

Shareholder Fees (Paid by the Investor Directly)
Maximum sales charge (load) on purchases (as a % of offering price)	3%
Sales charge (load) on reinvested distributions				None
Deferred sales charge (load) on redemptions
Exchange fees
Annual account maintenance fee (for accounts under $2,500)	$12.00
Annual Fund Operating Expenses (Paid from Fund Assets)
Management fee	0.45%
Distribution and service 12(b)-1 fee
Other expenses	0.20%
Total Annual Fund Operating Expenses	0.65%
Example

This example is intended to help an investor compare the cost of investing in different funds. The example assumes a $10,000 investment in the fund for 1, 3, 5, and

10 years

and then redemption of all fund shares at the end of those periods. The example also assumes that an investment returns 5% each year and that the fund’s operating expenses remain the same. Although actual costs may be higher or lower, based on these assumptions an investor’s costs would be:

1 year	$      364
3 years	$      502
5 years	$      651
10 years	$1,086

An Advisor’s Perspective

Phil Putney Owner, AFS Wealth Management

“A REIT is a way that an investor can invest in commercial-grade real estate.”

MyFinanceLab

Real Estate Investment Trusts

A 

real estate investment trust (REIT)

 is a type of closed-end investment company that invests money in mortgages and various types of real estate investments. A REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. The investor, therefore, owns a part of the real estate portfolio held by the real estate investment trust. The basic appeal of REITs is that they enable investors to receive both the capital appreciation and the current income from real estate ownership without all the headaches of property management. REITs are also popular with income-oriented investors because of the very attractive dividend yields they provide.

There are three basic types of REIT. First is the property REIT or equity REIT. These are REITs that invest in physical structures such as shopping centers, hotels, apartments, and office buildings. The second type is called a mortgage REIT, so called because they invest in mortgages, and the third type is the hybrid REIT, which may invest in both properties and mortgages. Mortgage REITs tend to be more income-oriented. They emphasize their high current yields, which is to be expected from a security that basically invests in debt. In contrast, while equity REITs may promote their attractive current yields, most of them also offer the potential for earning varying amounts of capital gains (as their property holdings appreciate in value). In early 2015 there were 177 equity REITs, which together held $846 billion in various real estate assets. Equity REITs dominated the market. There were only 39 mortgage REITs with assets valued at $61 billion, and hybrid REITs had all but disappeared from the market.

REITs must abide by the Real Estate Investment Trust Act of 1960, which established requirements for forming a REIT, as well as rules and procedures for making investments and distributing income. Because they are required to pay out nearly all their earnings to the owners, REITs do quite a bit of borrowing to obtain funds for their investments. A number of insurance companies, mortgage bankers, and commercial banks have formed REITs, many of which are traded on the major securities exchanges. The income earned by a REIT is not taxed, but the income distributed to the owners is designated and taxed as ordinary income. REITs have become very popular in the past five to ten years, in large part because of the very attractive returns they offer. Comparative average annual returns are listed below; clearly, REITs have at least held their own against common stocks over time:

Period	REITs*	S&P 500	Nasdaq Composite
5-yr. (2009–2014)	16. 6%	15.4%	15.8%
10-yr. (2002–2012)	7. 5%	7.7%	8.1%
(*Source: National Association of Real Estate Investment Trusts, REIT Watch, January 2015,  https://www.reit.com/sites/default/files/reitwatch/RW1501 )

In addition to their highly competitive returns, REITs offer desirable portfolio diversification properties and very attractive dividend yields (around 4.0%), which are generally well above the yields on common stock.

What Is a Hedge Fund?

Hedge Funds

First of all, in spite of the name similarities, it is important to understand that hedge funds are not mutual funds. They are totally different types of investment products! 

Hedge funds

 are set up as private entities, usually in the form of limited partnerships and, as such, are largely unregulated. The general partner runs the fund and directly participates in the fund’s profits—often taking a “performance fee” of 10% to 20% of the profits, in addition to a base fee of 1% to 2% of assets under management. The limited partners are the investors and consist mainly of institutions, such as pension funds, endowments, and private banks, as well as high-income individual investors. Because hedge funds are unregulated, they can be sold only to “accredited investors,” meaning the individual investor must have a net worth in excess of $1 million and/or an annual income (from qualified sources) of at least $200,000. Many hedge funds are, by choice, even more restrictive, and limit their investors to only very-high-net-worth individuals. In addition, some hedge funds limit the number of investors they’ll let in (often to no more than 100 investors).

These practices, of course, stand in stark contrast to the way mutual funds operate. While hedge funds are largely unregulated, mutual funds are very highly regulated and monitored. Individuals do not need to qualify or be accredited to invest in mutual funds. Although some mutual funds do have minimum investments of $50,000 to $100,000 or more, they are the exception rather than the rule. Not so with hedge funds—many of them have minimum investments that can run into the millions of dollars. Also, mutual fund performance is open for all to see, whereas hedge funds simply do not divulge such information, at least not to the general public. Mutual funds are required by law to provide certain periodic and standardized pricing and valuation information to investors, as well as to the general public, whereas hedge funds are totally free from such requirements. The world of hedge funds is very secretive and about as non-transparent as you can get.

Investor Facts

Hedge Funds Fudge the Numbers A recent study found that hedge funds misreport their returns when they lose money. The study found an unusually low frequency of small losses and an unusually high frequency of small gains in self-reported hedge fund returns. This pattern suggests that when hedge funds lose money, as long as the loss is not too large, they will fudge their results to report a small gain instead.

Hedge funds and mutual funds are similar in one respect, however: Both are pooled investment vehicles that accept investors’ money and invest those funds on a collective basis. Put another way, both sell shares (or participation) in a professionally managed portfolio of securities. Most hedge funds structure their portfolios so as to reduce volatility and risk while trying to preserve capital (i.e., “hedge” against market downturns) and still deliver positive returns under different market conditions. They do so by taking often very complex market positions that involve both long and short positions, the use of various arbitrage strategies (to lock in profits), as well as the use of options, futures, and other derivative securities. Indeed, hedge funds will invest in almost any opportunity in almost any market as long as impressive gains are believed to be available at reasonable levels of risk. Thus, these funds are anything but low-risk, fairly stable investment vehicles.

Concepts in Review

Answers available at 

http://www.pearsonhighered.com/smart

1. 12.1 What is a mutual fund? Discuss the mutual fund concept, including the importance of diversification and professional management.

2. 12.2 What are the advantages and disadvantages of mutual fund ownership?

3. 12.3 Briefly describe how a mutual fund is organized. Who are the key players in a typical mutual fund organization?

4. 12.4 Define each of the following:

a. Open-end investment companies

b. Closed-end investment companies

c. Exchange-traded funds

d. Real estate investment trusts

e. Hedge funds

5. 12.5 What is the difference between a load fund and a no-load fund? What are the advantages of each type? What is a 12(b)-1 fund? Can such a fund operate as a no-load fund?

6. 12.6 Describe a back-end load, a low load, and a hidden load. How can you tell what kinds of fees and charges a fund has?

Types of Funds and Services

1. LG 3

2. LG 4

Some mutual funds specialize in stocks, others in bonds. Some have maximum capital gains as an investment objective; some have high current income. Some funds appeal to speculators, others to income-oriented investors. Every fund has a particular investment objective, and each fund is expected to conform to its stated investment policy and objective. Categorizing funds according to their investment policies and objectives is a common practice in the mutual fund industry. The categories indicate similarities in how the funds manage their money and also their risk and return characteristics. Some of the more popular types of mutual funds are growth, aggressive growth, value, equity-income, balanced, growth-and-income, bond, money market, index, sector, socially responsible, asset allocation, and international funds.

Of course, it’s also possible to define fund categories based on something other than stated investment objectives. For example, Morningstar, the industry’s leading research and reporting service, has developed a classification system based on a fund’s actual portfolio position. Essentially, it carefully evaluates the makeup of a fund’s portfolio to determine where its security holdings are concentrated. It then uses that information to classify funds on the basis of investment style (growth, value, or blend), market segment (small-, mid-, or large-cap), or other factors. Such information helps mutual fund investors make informed asset allocation decisions when structuring or rebalancing their own portfolios. That benefit notwithstanding, let’s stick with the investment-objective classification system noted above and examine the various types of mutual funds to see what they are and how they operate.

Types of Mutual Funds

Growth Funds

The objective of a 

growth fund

 is simple: capital appreciation. They invest principally in well-established large- or mid-cap companies that have above-average growth potential. They offer little (if anything) in the way of dividends because the companies whose shares they buy reinvest their earnings rather than pay them out. Growth funds invest in stocks that have greater than average risk.

Aggressive-Growth Funds

Aggressive-growth funds are the so-called performance funds that tend to increase in popularity when markets heat up. 

Aggressive-growth funds

 are highly speculative with portfolios that consist mainly of “high-flying” common stocks. These funds often buy stocks of small, unseasoned companies, and stocks with relatively high price/earnings multiples. They often invest in companies that are recovering from a period of very poor financial performance, and they may even use leverage in their portfolios (i.e., buy stocks on margin). Aggressive-growth funds are among the most volatile of all mutual funds. When the markets are good, aggressive-growth funds do well; conversely, when the markets are bad, these funds often experience substantial losses.

Value Funds

Value funds confine their investing to stocks considered to be undervalued by the market. That is, the funds look for stocks whose prices are trading below intrinsic value. In stark contrast to growth funds, value funds look for stocks with relatively low price-to-earnings ratios, high dividend yields, and moderate amounts of financial leverage.

Value investing is not easy. It involves extensive evaluation of corporate financial statements and any other documents that will help fund managers estimate stocks’ intrinsic values. The track record of value investing is quite good. Even though value investing is regarded by many as less risky than growth investing, the long-term return to investors in value funds is competitive with that from growth funds and even aggressive-growth funds. Thus, value funds are often viewed as a viable investment alternative for relatively conservative investors who are looking for the attractive returns that common stocks have to offer without taking too much risk.

Equity-Income Funds

Equity-income funds

 purchase stocks with high dividend yields. Capital preservation is also an important goal of these funds, which invest heavily in high-grade common stocks, some convertible securities and preferred stocks, and occasionally even junk bonds or certain types of high-grade foreign bonds. As far as their stock holdings are concerned, they lean heavily toward blue chips, public utilities, and financial shares. In general, because of their emphasis on dividends and current income, these funds tend to hold higher-quality securities that are subject to less price volatility than the market as a whole. They’re generally viewed as a fairly low-risk way of investing in stocks.

Balanced Funds

Balanced funds

 tend to hold a balanced portfolio of both stocks and bonds for the purpose of generating a balanced return of both current income and long-term capital gains. They’re much like equity-income funds, but balanced funds usually put more into fixed-income securities. The bonds are used principally to provide current income, and stocks are selected mainly for their long-term growth potential. Balanced funds tend to be less risky than funds that invest exclusively in common stocks.

Growth-and-Income Funds

Growth-and-income funds

 also seek a balanced return made up of both current income and long-term capital gains, but they place a greater emphasis on growth of capital. Unlike balanced funds, growth-and-income funds put most of their money into equities. In fact, it’s not unusual for these funds to have 80% to 90% of their capital in common stocks. They tend to confine most of their investing to quality issues, so growth-oriented blue-chip stocks appear in their portfolios, along with a fair amount of high-quality income stocks. Part of the appeal of these funds is the fairly substantial returns many have generated over the long haul. These funds involve a fair amount of risk, if for no other reason than the emphasis they place on stocks and capital gains. Thus, growth-and-income funds are most suitable for those investors who can tolerate the risk and price volatility.

Bond Funds

As the name implies, 

bond funds

 invest exclusively in various types and grades of bonds—from Treasury and agency bonds to corporate and municipal bonds and other debt securities such as mortgage-backed securities. Income from the bonds’ interest payments is the primary investment objective.

There are three important advantages to buying shares in bond funds rather than investing directly in bonds. First, the bond funds are generally more liquid than direct investments in bonds. Second, they offer a cost-effective way of achieving a high degree of diversification in an otherwise expensive asset class. (Most bonds carry minimum denominations of $1,000 to $5,000.) Third, bond funds will automatically reinvest interest and other income, thereby allowing you to earn fully compounded rates of return.

Bond funds are generally considered to be a fairly conservative form of investment, but they are not without risk. The prices of the bonds held in the fund’s portfolio fluctuate with changing interest rates. In today’s market, investors can find everything from high-grade government bond funds to highly speculative funds that invest in nothing but junk bonds or even in highly volatile derivative securities. Here’s a list of the different types of domestic bond funds available to investors and their chief investment types.

· Government bond funds invest in U.S. Treasury and agency securities.

· High-grade corporate bond funds invest chiefly in investment-grade securities rated BBB or better.

· High-yield corporate bond funds are risky investments that buy junk bonds for the yields they offer.

· Municipal bond funds invest in tax-exempt securities. These are suitable for investors who seek tax-free income. Like their corporate counterparts, municipal bond funds can be packaged as either high-grade or high-yield funds. A special type of municipal bond fund is the so-called single-state fund, which invests in the municipal issues of only one state, thus producing (for residents of that state) interest income that is exempt from both federal and state taxes (and possibly even local/city taxes as well).

· Mortgage-backed bond funds put their money into various types of mortgage-backed securities of the U.S. government (e.g., GNMA issues). These funds appeal to investors for several reasons: (1) They provide diversification; (2) they are an affordable way to get into mortgage-backed securities; and (3) they allow investors to reinvest the principal portion of the monthly cash flow, thereby enabling them to preserve their capital.

· Convertible bond funds invest primarily in securities that can be converted or exchanged into common stocks. These funds offer investors some of the price stability of bonds, along with the capital appreciation potential of stocks.

· Intermediate-term bond funds invest in bonds with maturities of 10 years or less and offer not only attractive yields but relatively low price volatility as well. Shorter (two- to five-year) funds are also available; these shorter-term funds are often used as substitutes for money market investments by investors looking for higher returns on their money, especially when short-term rates are way down.

Clearly, no matter what you’re looking for in a fixed-income security, you’re likely to find a bond fund that fits the bill. According to the 2015 Investment Company Fact Book, bond funds account for approximately 21% of U.S. mutual fund and exchange-traded fund assets.

Money Market Funds

Money market mutual funds

, or 

money funds

 for short, apply the mutual fund concept to the buying and selling of short-term money market instruments—bank certificates of deposit, U.S. Treasury bills, and the like. These funds offer investors with modest amounts of capital access to the high-yielding money market, where many instruments require minimum investments of $100,000 or more. At the close of 2014, money market funds held approximately 15% of U.S. mutual fund assets, a figure that had been shrinking for several years due to the extraordinarily low interest rates on short-term securities available since the 2008 recession.

There are several kinds of money market mutual funds:

· General-purpose money funds invest in any and all types of money market investment vehicles, from Treasury bills and bank CDs to corporate commercial paper. The vast majority of money funds are of this type.

Famous Failures in Finance Breaking the Buck

Traditionally, investors have viewed money market mutual funds as the safest type of mutual fund because they generally invest in low-risk, short-term debt securities. These funds generally maintain their share price at $1, and they distribute the interest they earn on short-term securities to investors. The very first money market mutual fund, The Reserve Fund, was formed in 1971. Unfortunately, when Lehman Brothers filed for bankruptcy on September 15, 2008, the Reserve Fund was caught holding $785 million in short-term loans to Lehman. Those holdings were suddenly worthless, and that caused The Reserve Fund’s share price to “break the buck” by falling to $0.97. Investors in the fund became worried about the fund’s other holdings, and a flood of redemption requests poured in. Ultimately, the fund could not satisfy all of the redemption requests that it received, so the fund ceased operations and liquidated its assets. In response to this event and others during the financial crisis, the SEC imposed new restrictions on money market funds, forcing them to hold securities with higher credit ratings and greater liquidity than had been required in the past.

· Government securities money funds effectively eliminate any risk of default by confining their investments to Treasury bills and other short-term securities of the U.S. government or its agencies.

· Tax-exempt money funds limit their investing to very short (30- to 90-day) tax-exempt municipal securities. Because their income is free from federal income taxes, they appeal predominantly to investors in high tax brackets.

Just about every major brokerage firm has at least four or five money funds of its own, and hundreds more are sold by independent fund distributors. Because the maximum average maturity of their holdings cannot exceed 90 days, money funds are highly liquid investment vehicles, although their returns do move up and down with interest-rate conditions. They’re also nearly immune to capital loss because at least 95% of the fund’s assets must be invested in top-rated/prime-grade securities. In fact, with the check-writing privileges they offer, money funds are just as liquid as checking or savings accounts. Many investors view these funds as a convenient, safe, and (reasonably) profitable way to accumulate capital and temporarily store idle funds.

Index Funds

“If you can’t beat ’em, join ’em.” That saying pretty much describes the idea behind index funds. Essentially, an 

index fund

 buys and holds a portfolio of stocks (or bonds) equivalent to those in a market index like the S&P 500. Rather than try to beat the market, as most actively managed funds do, index funds simply try to match the market. They do this through low-cost investment management. In fact, in most cases, a computer that matches the fund’s holdings with those of the targeted index runs the whole portfolio almost entirely.

Investor Facts

A Long Investing Voyage One fund that takes an extreme approach to passive investing is the Voya Corporate Leader Trust. Established with a portfolio of 30 stocks in 1935, the fund is prohibited from adding new companies to its portfolio. Over the years, stocks dropped out of the fund due to mergers, spinoffs, or bankruptcies, so by 2015 the fund held just 21 stocks. However, in the decade from 2005 to 2015, the fund handily outperformed the S&P 500 Index.

The approach of index funds is strictly buy-and-hold. Indeed, about the only time an index-fund portfolio changes is when the targeted market index alters its “market basket” of securities. A pleasant by-product of this buy-and-hold approach is that the funds have extremely low portfolio turnover rates and, therefore, very little in realized capital gains. As a result, aside from a modest amount of dividend income, these funds produce very little taxable income from year to year, which leads many high-income investors to view them as a type of tax-sheltered investment. Index funds have grown in popularity over the years. Since 1999, equity index funds have increased their market share (relative to all equity mutual funds) from 9.4% to 20.2%. In other words, for every $5 that investors place in stock mutual funds, they invest $1 in indexed funds. The most popular index funds are those tied to the S&P 500, accounting for roughly 33% of all assets held in indexed mutual funds.

Sector Funds

A 

sector fund

 is a mutual fund that restricts its investments to a particular sector (or segment) of the market. For example, a health care sector fund would focus on stocks issued by drug companies, hospital management firms, medical suppliers, and biotech concerns. Among the more popular sector funds are those that concentrate in technology, financial services, real estate (REITs), natural resources, telecommunications, and health care. The overriding investment objective of a sector fund is usually capital gains. A sector fund is generally similar to a growth fund and should be considered speculative, particularly because it is not well diversified.

Socially Responsible Funds

For some, investing is far more than just cranking out financial ratios and calculating investment returns. To these investors, the security selection process also includes the active, explicit consideration of moral, ethical, and environmental issues. The idea is that social concerns should play just as big a role in investment decisions as do financial matters. Not surprisingly, a number of funds cater to such investors. Known as 

socially responsible funds

, they actively and directly incorporate ethics and morality into the investment decision. Their investment decisions, in effect, revolve around both morality and profitability.

Socially responsible funds consider only certain companies for inclusion in their portfolios. If a company does not meet the fund’s moral, ethical, or environmental tests, fund managers simply will not buy the stock, no matter how good the bottom line looks. These funds refrain from investing in companies that derive revenues from tobacco, alcohol, gambling, weapons, or fossil fuels. In addition, the funds tend to favor firms that produce “responsible” products or services, that have strong employee relations and positive environmental records, and that are socially responsive to the communities in which they operate.

Asset Allocation Funds

Studies have shown that the most important decision an investor can make is how to allocate assets among different types of investments (e.g., between stocks and bonds). Asset allocation deals in broad terms (types of securities) and does not focus on individual security selection. Because many individual investors have a tough time making asset allocation decisions, the mutual fund industry has created a product to do the job for them. Known as 

asset allocation funds

, these funds spread investors’ money across different types of asset classes. Whereas most mutual funds concentrate on one type of investment—whether stocks, bonds, or money market securities—asset allocation funds put money into all these assets. Many of them also include foreign securities, and some even include inflation-resistant investments, such as gold, real estate, and inflation-indexed bonds.

Investor Facts

Age and Asset Allocation Although there are several important factors to consider when determining the right asset allocation, an old guideline bases the decision on age. The rule says that the percentage of a portfolio invested in stocks should equal 100 minus the investor’s age. For example, a 25-year-old’s portfolio would be 75% invested in stock, but as the investor ages, the rule shifts the allocation from riskier stocks to less risky fixed-income securities. However, since people are living longer now and their money has to last longer in retirement, many financial planners recommend subtracting the investor’s age from 110 or 120 to determine their stock allocation.

These funds are designed for people who want to hire fund managers not only to select individual securities but also to allocate money among the various markets. Here’s how a typical asset allocation fund works. The money manager establishes a desired allocation mix for the fund, which might look something like this: 50% to U.S. stocks, 30% to bonds, 10% to foreign securities, and 10% to money market securities. The manager purchases securities in these proportions, and the overall portfolio maintains the desired mix. As market conditions change over time, the asset allocation mix changes as well. For example, if the U.S. stock market starts to soften, the fund may reduce the (domestic) stock portion of the portfolio to, say, 35%, and simultaneously increase the foreign securities portion to 25%. There’s no assurance, of course, that the money manager will make the right moves at the right time.

One special type of asset allocation fund is known as a target date fund. A 

target date fund

 follows an asset allocation plan tied to a specific target date. In the beginning, the fund’s asset allocation is heavily tilted toward stocks, but as time passes and the fund’s target date approaches, the portfolio becomes more conservative with the allocation shifting away from stocks toward bonds. These funds appeal to investors who want to save money for retirement. For example, a 25-year-old worker might choose a fund with a target date of 2055, whereas a 45-year-old might select a fund with a target date of 2035. By choosing target dates that correspond (at least roughly) to their expected retirement dates, both investors can be assured that the fund managers will gradually lower the risk profile of their investments as retirement approaches.

International Funds

In their search for more diversification and better returns, U.S. investors have shown a growing interest in foreign securities. Sensing an opportunity, the mutual fund industry has been quick to respond with 

international funds

—mutual funds that do all or most of their investing in foreign securities. A lot of people would like to invest in foreign securities but simply do not have the know-how to do so. International funds may be just the vehicle for such investors, provided they have at least a fundamental understanding of international economics issues and how they can affect fund returns.

Technically, the term international fund describes a type of fund that invests exclusively in foreign securities. Such funds often confine their activities to specific geographic regions (e.g., Mexico, Australia, Europe, or the Pacific Rim). In contrast, global funds invest in both foreign securities and U.S. companies—usually multinational firms. Regardless of whether they’re global or international (we’ll use the term international to apply to both), you can find just about any type of fund you could possibly want. There are international stock funds, international bond funds, and even international money market funds. There are aggressive-growth funds, balanced funds, long-term growth funds, and high-grade bond funds. There are funds that confine their investing to large, established markets (like Japan, Germany, and Australia) and others that stick to emerging markets (such as Thailand, Mexico, Chile, and even former Communist countries like Poland). In 2014 about 25% of all assets invested in stock mutual funds were invested in international funds.

Investor Services

Investors obviously buy shares in mutual funds to make money, but there are other important reasons for investing in mutual funds, not the least of which are the valuable services they provide. Some of the most sought-after mutual fund services are automatic investment and reinvestment plans, regular income programs, conversion privileges, and retirement programs.

Automatic Investment Plans

It takes money to make money. For an investor, that means being able to accumulate the capital to put into the market. Mutual funds have come up with a program that makes savings and capital accumulation as painless as possible. The program is the 

automatic investment plan

. This service allows fund shareholders to automatically funnel fixed amounts of money from their paychecks or bank accounts into a mutual fund. It’s much like a payroll deduction plan.

This fund service has become very popular because it enables shareholders to invest on a regular basis without having to think about it. Just about every fund group offers some kind of automatic investment plan for virtually all of its stock and bond funds. To enroll, you simply fill out a form authorizing the fund to siphon a set amount (usually a minimum of $25 to $100 per period) from your bank account at regular intervals. Once enrolled, you’ll be buying more shares on a regular basis. Of course, if it’s a load fund, you’ll still have to pay normal sales charges on your periodic investments, though many load funds reduce or eliminate the sales charge for investors participating in automatic investment plans. You can get out of the program at any time, without penalty, by simply calling the fund. Although convenience is perhaps the chief advantage of automatic investment plans, they also make solid investment sense. One of the best ways of building up a sizable amount of capital is to add funds to your investment program systematically over time. The importance of making regular contributions to your investment portfolio cannot be overstated. It ranks right up there with compound interest.

Automatic Reinvestment Plans

An automatic reinvestment plan is another of the real draws of mutual funds and is offered by just about every open-end fund. Whereas automatic investment plans deal with money you are putting into a fund, automatic reinvestment plans deal with the dividends the funds pay to their shareholders. The 

automatic reinvestment plans

 of mutual funds enable you to keep your capital fully employed by using dividend and/or capital gains income to buy additional shares in the fund. Most funds do not charge commissions for purchases made with reinvested funds. Keep in mind, however, that even though you may reinvest all dividends and capital gains distributions, the IRS still treats them as cash receipts and taxes them as investment income in the year in which you received them.

Automatic reinvestment plans enable you to earn fully compounded rates of return. By plowing back profits, you can put them to work in generating even more earnings. Indeed, the effects of these plans on total accumulated capital over the long run can be substantial. 

Figure 12.5

 shows the long-term impact of reinvested dividend and capital gain income for the S&P 500 Index. In the illustration, we assume that the investor starts with $10,000 in January 1988. The upper line shows how much money accumulates if the investor keeps reinvesting dividends as they arrive, and the lower line shows what happens if the investor fails to do so. Over time, the difference in these two approaches becomes quite large. With reinvested dividends, the investor would have had a portfolio worth $149,223 by July 2015, but if the investor had failed to reinvest dividends, the portfolio value would have reached just $80,787.

Regular Income

Automatic investment and reinvestment plans are great for the long-term investor. But what about the investor who’s looking for a steady stream of income? Once again, mutual funds have a service to meet this need. Called a 

systematic withdrawal plan

, it’s offered by most open-end funds. Once enrolled, an investor automatically receives a predetermined amount of money every month or quarter. Most funds require a minimum investment of $5,000 or more to participate, and the size of the minimum payment normally must be $50 or more per period (with no limit on the maximum). The funds will pay out the monthly or quarterly income first from dividends and realized capital gains. If this source proves to be inadequate and the shareholder so authorizes, the fund can then tap the principal or original paid-in capital to meet the required periodic payments.

Conversion Privileges

Sometimes investors find it necessary to switch out of one fund and into another. For example, your objectives or the investment climate itself may have changed. 

Conversion (or exchange) privileges

 were devised to meet such needs

Figure 12.5 The Effects of Reinvesting Dividends

Reinvesting dividends can have a tremendous impact on one’s investment position. This graph shows the results of investing $10,000 in the S&P 500 in January 1988 with and without reinvestment of dividends.

(Source: Author’s calculations and Yahoo!Finance.)

conveniently and economically. Investment management companies that offer a number of different funds—known as 

fund families

—often provide conversion privileges that enable shareholders to move money from one fund to another, either by phone or via the Internet. The only constraint is that the switches must be confined to the same family of funds. For example, you can switch from a Dreyfus growth fund to a Dreyfus money fund, or any other fund managed by Dreyfus.

Conversion privileges are usually considered beneficial because they allow you to meet ever-changing long-term goals, and they also permit you to manage your mutual fund holdings more aggressively by moving in and out of funds as the investment environment changes. Unfortunately, there is one major drawback. For tax purposes, the exchange of shares from one fund to another is regarded as a sale transaction followed by a subsequent purchase of a new security. As a result, if any capital gains exist at the time of the exchange, you are liable for the taxes on that profit, even though the holdings were not truly “liquidated.”

Retirement Programs

As a result of government legislation, self-employed individuals are permitted to divert a portion of their pretax income into self-directed retirement plans (SEPs). Also, U.S. workers are allowed to establish individual retirement arrangements (IRAs). Indeed, with legislation passed in 1997, qualified investors can now choose between deductible and nondeductible (Roth) IRAs. Even those who make too much to qualify for one of these programs can set up special nondeductible IRAs. Today all mutual funds provide a service that allows individuals to set up tax-deferred retirement programs as either IRA or Keogh accounts—or, through their place of employment, to participate in a tax-sheltered retirement plan, such as a 401(k). The funds set up the plans and handle all the administrative details so that the shareholder can easily take full advantage of available tax savings.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 12.7 Briefly describe each of the following types of mutual funds:

a. Aggressive-growth funds

b. Equity-income funds

c. Growth-and-income funds

d. Bond funds

e. Sector funds

f. Socially responsible funds

2. 12.8 What is an asset allocation fund and how does it differ from other types of mutual funds? How does a target date fund work?

3. 12.9 If growth, income, and capital preservation are the primary objectives of mutual funds, why do we bother to categorize funds by type? Do you think such classifications are helpful in the fund selection process? Explain.

4. 12.10 What are fund families? What advantages do fund families offer investors? Are there any disadvantages?

5. 12.11 Briefly describe some of the investor services provided by mutual funds. What are automatic reinvestment plans, and how do they differ from automatic investment plans?

Investing in Mutual Funds

1. LG 5

2. LG 6

Suppose you are confronted with the following situation. You have money to invest and are trying to select the right place to put it. You obviously want to pick a security that meets your idea of acceptable risk and will generate an attractive rate of return. The problem is that you must make the selection from a list containing thousands of securities. That’s basically what you’re facing when trying to select a suitable mutual fund. However, if you approach the problem systematically, it may not be so formidable a task. First, it might be helpful to examine more closely the various investor uses of mutual funds. With this background, we can then look at the selection process and at several measures of return that you can use to assess performance. As we will see, it is possible to whittle down the list of alternatives by matching your investment needs with the investment objectives of the funds.

Investor Uses of Mutual Funds

Mutual funds can be used in a variety of ways. For instance, performance funds can serve as a vehicle for capital appreciation, whereas bond funds can provide current income. Regardless of the kind of income a mutual fund provides, investors tend to use these securities as (1) a way to accumulate wealth, (2) a storehouse of value, or (3) a speculative vehicle for achieving high rates of return.

Accumulation of Wealth

This is probably the most common reason for using mutual funds. Basically, the investor uses mutual funds over the long haul to build up investment capital. Depending on your goals, a modest amount of risk may be acceptable, but usually preservation of capital and capital stability are considered important. The whole idea is to form a “partnership” with the mutual fund in building up as big a pool of capital as possible. You provide the capital by systematically investing and reinvesting in the fund and the fund provides the return by doing its best to invest your resources wisely.

Storehouse of Value

Investors also use mutual funds as a storehouse of value. The idea is to find a place where investment capital can be fairly secure and relatively free from deterioration yet still generate a relatively attractive rate of return. Short- and intermediate-term bond funds are logical choices for such purposes, and so are money funds. Capital preservation and income over the long term are very important to some investors. Others might seek storage of value only for the short term, using, for example, money funds as a place to “sit it out” until a more attractive opportunity comes along.

Speculation and Short-Term Trading

Although speculation is becoming more common, it is still not widely used by most mutual fund investors. The reason, of course, is that most mutual funds are long-term in nature and thus not meant to be used as aggressive trading vehicles. However, a growing number of funds (e.g., sector funds) now cater to speculators. Some investors have found that mutual funds are, in fact, attractive for speculation and short-term trading.

One way to do this is to aggressively trade in and out of funds as the investment climate changes. Load charges can be avoided (or reduced) by dealing in families of funds offering low-cost conversion privileges and/or by dealing only in no-load funds. Other investors might choose mutual funds as a long-term investment but seek high rates of return by investing in funds that follow very aggressive trading strategies. These are usually the fairly specialized, smaller funds such as leverage funds, option funds, emerging-market funds, small-cap aggressive-growth funds, and sector funds. In essence, investors in such funds are simply letting professional money managers handle their accounts in a way they would like to see them handled: aggressively.

The Selection Process

When it comes to mutual funds, there is one question every investor has to answer right up front. Why invest in a mutual fund to begin with—why not “go it alone” by buying individual stocks and bonds directly? For beginning investors and investors with little capital, the answer is simple: With mutual funds, you are able to achieve far more diversification than you could ever obtain on your own. Plus, you get the help of professional money managers at a very reasonable cost. For more seasoned investors, the answers are probably more involved. Certainly, diversification and professional money management come into play, but there are other reasons as well. The competitive returns mutual funds offer are a factor, as are the services they provide. Many seasoned investors simply have decided they can get better returns by carefully selecting mutual funds than by investing on their own. Some of these investors use part of their capital to buy and sell individual securities on their own and use the rest to buy mutual funds that invest in areas they don’t fully understand or don’t feel well informed about. For example, they’ll use mutual funds to get into foreign markets or buy mortgage-backed securities.

Watch Your Behavior

Index fund fees Because index funds are designed to mimic the return of a market index, they typically do not invest resources in trying to identify over- or undervalued stocks. As a consequence, index fund fees tend to be quite low, averaging just 11 basis points in 2014 according to the Investment Company Institute. Yet some investors continue to invest in index funds with fees that are 10 to 20 times higher than the fees charged by a typical fund. Predictably, investors in these funds tend to earn much lower returns than investors who buy shares in index funds that charge lower fees.

(Sources: 2015 Investment Company Institute Factbook, 

http://www .icifactbook.org/pdf/2015_factbook

; Edwin J. Elton, Martin J. Gruber, Jeffrey A. Busse, “Are Investors Rational? Choices Among Index Funds,” Journal of Finance, 2004, Vol. 59, Issue 1, pp. 261–288.)

Once you have decided to use mutual funds, you must decide which fund(s) to buy. The selection process involves putting into action all you know about mutual funds in order to gain as much return as possible from an acceptable level of risk. It begins with an assessment of your investment needs. Obviously, you want to select from those thousands of funds the one or two (or six or eight) that will best meet your total investment needs.

Objectives and Motives for Using Funds

The place to start is with your investment objectives. Why do you want to invest in a mutual fund, and what are you looking for in a fund? Obviously, an attractive rate of return would be desirable, but there is also the matter of a tolerable amount of risk exposure. Probably, when you look at your own risk temperament in relation to the various types of mutual funds available, you will discover that certain types of funds are more appealing to you than others. For instance, aggressive-growth or sector funds are usually not attractive to individuals who wish to avoid high exposure to risk.

Another important factor is the intended use of the mutual fund. Do you want to invest in mutual funds as a means of accumulating wealth, as a storehouse of value, or to speculate for high rates of return? This information puts into clearer focus the question of what you want to do with your investment dollars. Finally, there is the matter of the services provided by the fund. If you are particularly interested in certain services, be sure to look for them in the funds you select.

What the Funds Offer

Just as each individual has a set of investment needs, each fund has its own investment objective, its own manner of operation, and its own range of services. These elements are useful in helping you to assess investment alternatives. Where do you find such information? One obvious place is the fund’s profile, or its prospectus. Publications such as the Wall Street Journal, Barron’s, Money, Fortune, and Forbes also provide a wealth of operating and performance statistics.

There are also a number of reporting services that provide background information and assessments on funds. Among the best in this category are Morningstar Mutual Funds and Value Line Mutual Fund Survey (which produces a mutual fund report similar to its stock report). There also are all sorts of performance statistics available on the Internet. For example, there are scores of free finance websites, like Yahoo! Finance, where you can obtain historical information on a fund’s performance, security holdings, risk profile, load charges, and purchase information.

Whittling Down the Alternatives

At this point, fund selection becomes a process of elimination. You can eliminate a large number of funds from consideration simply because they fail to meet your specified needs. Some funds may be too risky; others may be unsuitable as a storehouse of value. Thus, rather than try to evaluate thousands of different funds, you can narrow down the list to two or three types of funds that match your investment needs. From here, you can whittle down the list a bit more by introducing other constraints. For example, because of cost considerations, you may want to consider only no-load or low-load funds (more on this topic below). Or you may be seeking certain services that are important to your investment goals.

Another attribute of a fund that you may want to consider is its tax efficiency. As a rule, funds that have low dividends and low asset turnover do not expose their shareholders to high taxes and therefore have higher tax-efficiency ratings. And while you’re looking at performance, check out the fund’s fee structure. Be on guard for funds that charge abnormally high management fees.

Another important consideration is how well a particular fund fits into your portfolio. If you’re trying to follow a certain asset allocation strategy, then be sure to take that into account when you’re thinking about adding a fund to your portfolio. In other words, evaluate any particular fund in the context of your overall portfolio.

Finally, how much weight should you give to a fund’s past performance when deciding whether you want to invest? Although it may seem intuitive that funds with good past performance should make better investments, remember superior past performance is no guarantee of future success. In fact, we would make the stronger statement that past performance has almost no correlation with future performance. Accordingly, we recommend that you place more weight on other factors such as the fund’s investment objective and its costs when making your investment decisions.

Stick with No-Loads or Low-Loads

There’s a long-standing “debate” in the mutual fund industry regarding load funds and no-load funds. Do load funds add value? If not, why pay the load charges? As it turns out, empirical results generally do not support the idea that load funds provide added value. Load-fund returns, on average, do not seem to be any better than the returns from no-load funds. In fact, in many cases, the funds with abnormally high loads and 12(b)-1 charges often produce returns that are far less than what you can get from no-load funds. In addition, because of compounding, the differential returns tend to widen with longer holding periods. These results should come as no surprise because big load charges and/or 12(b)-1 fees reduce your investable capital—and therefore the amount of money you have working for you. In fact, the only way a load fund can overcome this handicap is to produce superior returns, which is no easy thing to do year in and year out. Granted, a handful of load funds have produced very attractive returns over extended periods of time, but they are the exception rather than the rule.

Obviously, it’s in your best interest to pay close attention to load charges (and other fees). As a rule, to maximize returns, you should seriously consider sticking to no-load funds or to low-loads (funds that have total load charges, including 12(b)-1 fees, of 3% or less). There may well be times when the higher costs are justified, but far more often than not, you’re better off trying to minimize load charges. That should not be difficult to do because there are thousands of no-load and low-load funds from which to choose. What’s more, most of the top-performing funds are found in the universe of no-loads or low-loads. So why would you even want to look anywhere else?

Investing in Closed-End Funds

The assets of closed-end funds (CEFs) represent just over 1.5% of the $18 trillion invested in open-end mutual funds. Like open-end funds, CEFs come in a variety of types and styles, including funds that specialize in municipal bonds, taxable bonds, various types of equity securities, and international securities, as well as regional and single-country funds. Historically, unlike the open-end market, bond funds have accounted for the larger share of assets in closed-end funds. In 2014 there was $170 billion worth of bond CEFs assets, or 59% of CEFs assets. Equity CEFs totaled $119 billion in assets for 2014.

Some Key Differences between Closed-End and Open-End Funds

Because closed-end funds trade like stocks, you must deal with a broker to buy or sell shares, and the usual brokerage commissions apply. Open-end funds, in contrast, are bought from and sold to the fund operators themselves. Another difference between open- and closed-end funds is their liquidity. You can buy and sell relatively large dollar amounts of an open-end mutual fund at its net asset value (NAV) without worrying about affecting the price. However, a relatively large buy or sell order for a CEF could easily bump its price up or down. Like open-end funds, most CEFs offer dividend reinvestment plans, but in many cases, that’s about it. CEFs simply don’t provide the full range of services that mutual fund investors are accustomed to.

An Advisor’s Perspective

Bryan Sweet Owner, Sweet Financial Services

“Sometimes the price and the NAV are not equal.”

MyFinanceLab

All things considered, probably the most important difference is the way these funds are priced in the marketplace. As we discussed earlier in the chapter, CEFs have two values—a market value (or stock price) and an NAV. They are rarely the same because CEFs typically trade at either a premium or a discount. A premium occurs when a fund’s shares trade for more than its NAV; a discount occurs when the fund’s shares trade for less than its NAV. As a rule, CEFs trade at discounts. Exactly why CEFs trade at a discount is not fully understood, and financial experts sometimes refer to this tendency as the closed-end fund puzzle. The puzzle is that closed-end fund share prices are priced lower than the corresponding NAVs. It’s as if when you buy shares in a CEF, you are buying the underlying stocks in the fund at a discount. Some of the possible reasons that CEFs trade at a discount include the following.

· Investors anticipate that the fund’s future performance may be poor, so they pay less for shares in the fund up front.

· Shares held by the fund are illiquid, so if they are ever sold, they will sell for less than their current market prices.

· Shares held by the fund have built-in unrealized capital gains, and because investors will eventually be required to pay taxes on those gains, they are unwilling to pay the full NAV when they purchase fund shares.

· Investor sentiment may cause fund prices to deviate from NAVs; when sentiment is positive, fund shares trade at a premium, but when investors are more pessimistic, fund shares trade at a discount.

Information about CEFs is widely available in print and online sources. 

Figure 12.6

 illustrates some of the free CEF information that you can find at Morningstar’s website. In addition to each fund’s name, you can quickly determine whether it currently trades at a discount or a premium relative to NAV. Morningstar also provides the year-to-date return based on the performance of the fund’s share price as well as the return based on the fund’s NAV.

The premium or discount on CEFs is calculated as follows:

Premium (or discount)=(Share price−NAV)÷NAVPremium (or discount)=(Share price−NAV)÷NAVEquation12.1

Example

Suppose Fund A has an NAV of $

10.

If its share price is $8, it sells at a 20% discount. That is,

Premium (or discount)=($8−$10)/$10=−$2/$10=−0.20=20%Premium (or discount)=($8−$10)/$10=−$2/$10=−0.20=20%

This negative value indicates that the fund is trading at a discount (or below its NAV). On the other hand, if this same fund were priced at $12 per share, it would be trading at a premium of 20%—that is, ($12−$10)/$10=$2/$10=0.20($12−$10)/$10=$2/$10=0.20.

Figure 12.6 Selected Performance of CEFs

The figure demonstrates information about closed-end funds available at no cost from the Morningstar website.

(Source: 

http://news.morningstar.com/CELists/CEReturns.html

, accessed July 4, 2015. Courtesy of Morningstar, Inc. Used with permission.)

What to Look for in a Closed-End Fund

If you know what to look for and your timing and selection are good, you may find that some deeply discounted CEFs provide a great way to earn attractive returns. For example, if a fund trades at a 20% discount, you pay only 80 cents for each dollar’s worth of assets. If you can buy a fund at an abnormally wide discount (say, more than 10%) and then sell it when the discount narrows or turns to a premium, you can enhance your overall return. In fact, even if the discount does not narrow, your return will be improved because the yield on your investment is higher than it would be with an otherwise equivalent open-end fund.

Example

Suppose a CEF trades at $8, a 20% discount from its NAV of $10. If the fund distributed $1 in dividends for the year, it would yield 12.5% ($1 divided by its $8 price). However, if it was a no-load, open-end fund, it would be trading at its higher NAV and therefore would yield only 10% ($1 divided by its $10 NAV).

Thus, when investing in CEFs, pay special attention to the size of the premium and discount. In particular, keep your eyes open for funds trading at deep discounts because that feature alone can enhance returns. One final point to keep in mind about closed-end funds. Stay clear of new issues (IPOs) of closed-end funds and funds that sell at steep premiums. Never buy new CEFs when they are brought to the market as IPOs. Why? Because IPOs are nearly always brought to the market at hefty premiums, which are necessary to cover the underwriter spread. Thus, you face the almost inevitable fate of losing money as the shares fall to a discount, or at the minimum, to their NAVs within a month or two.

For the most part, except for the premium or discount, you should analyze a CEF just like any other mutual fund. That is, check out the fund’s expense ratio, portfolio turnover rate, past performance, cash position, and so on. In addition, study the history of the discount. Also, keep in mind that with CEFs, you probably will not get a prospectus (as you might with an open-end fund) because they do not continuously offer new shares to investors.

Measuring Performance

As in any investment decision, return performance is a part of the mutual fund selection process. The level of dividends paid by the fund, its capital gains, and its growth in capital are all-important aspects of return. Such return information enables you to judge the investment behavior of a fund and to appraise its performance in relation to other funds and investments. Here, we will look at different measures that investors can use to assess mutual fund returns. Also, because risk is so important in defining the investment behavior of a fund, we will examine mutual fund risk as well.

Sources of Return

An open-end mutual fund has three potential sources of return: (1) dividend income, (2) capital gains distribution, and (3) change in the price (or net asset value) of the fund. Depending on the type of fund, some mutual funds derive more income from one source than from another. For example, we would normally expect income-oriented funds to have much higher dividend income than capital gains distributions.

Open-end mutual funds regularly publish reports that recap investment performance. One such report is the Summary of Income and Capital Changes, an example of which appears in 

Table 12.2

. This statement, found in the fund’s profile or prospectus,

Table 12.2 A Report of Mutual Fund Income and Capital Changes (For a Share Outstanding throughout the Year)

	2016		2015		2014
* Portfolio turnover rate relates the number of shares bought and sold by the fund to the total number of shares held in the fund’s portfolio. A high turnover rate (in excess of 100%) means the fund has been doing a lot of trading.
1.	Net asset value, beginning of period		$24.47	$27.03	$24.26
2.	Income from investment operations
3.	Net investment income	$ 0.60	$ 0.66	$ 0.50
4.	Net gains on securities (realized and unrealized)	6.37	(1.74)	3.79
5.	Total from investment operations		$ 6.97	($ 1.08)	$ 4.29
6.	Less distributions:
7.	Dividends from net investment income	( $ 0.55 )	($ 0.64)	($ 0.50)
8.	Distributions from realized gains	(1.75)	(0.84)	(1.02)
9.		Total distributions	($ 2.30)	($ 1.48)	($ 1.52)
10.	Net asset value, end of period	$29.14	$ 24.47	$ 27.03
11.		Total return	28.48%	(4.00%)	17.68%
12.	Ratios/supplemental data
13.	Net assets, end of period ($000)	$307,951	$153,378	$108,904
14.	Ratio of expenses to average net assets	1.04%	0.85%	0.94%
15.	Ratio of net investment income to average net assets	1.47%	2.56%	2.39%
16.	Portfolio turnover rate *	85%	144%	74%

gives a brief overview of the fund’s investment activity, including expense ratios and portfolio turnover rates. Of interest to us here is the top part of the report (which runs from “Net asset value, beginning of period” to “Net asset value, end of period”—lines 1 to 10). This part reveals the amount of dividend income and capital gains distributed to the shareholders, along with any change in the fund’s net asset value.

Dividend income

 (see line 7 of 
Table 12.2
) is derived from the dividend and interest income earned on the security holdings of the mutual fund. It is paid out of the net investment income that’s left after the fund has met all operating expenses. When the fund receives dividend or interest payments, it passes these on to shareholders in the form of dividend payments. The fund accumulates all of the current income for the period and then pays it out on a prorated basis. Thus, if a fund earned, say, $2 million in dividends and interest in a given year and if that fund had one million shares outstanding, each share would receive an annual dividend payment of $2. Because the mutual fund itself is tax exempt, any taxes due on dividend earnings are payable by the individual investor. For funds that are not held in tax-deferred accounts, like IRAs or 401(k)s, the amount of taxes due on dividends will depend on the source of such dividends. That is, if these distributions are derived from dividends earned on the fund’s common stock holdings, then they are subject to a preferential tax rate of 15%, or less. However, if these distributions are derived from interest earnings on bonds, dividends from REITs, or dividends from most types of preferred stocks, then such dividends do not qualify for the preferential tax treatment, and instead are taxed as ordinary income.

Capital gains distributions

 (see line 8) work on the same principle, except that these payments are derived from the capital gains actually earned by the fund. It works like this: Suppose the fund bought some stock a year ago for $50 and sold that stock in the current period for $75 per share. Clearly, the fund has achieved capital gains of $25 per share. If it held 50,000 shares of this stock, it would have realized a total capital gain of $1,250,000 (i.e., $25×50,000=$1,250,000$25×50,000=$1,250,000). Given that the fund has one million shares outstanding, each share is entitled to $1.25 in the form of a capital gains distribution. (From a tax perspective, if the capital gains are long-term, then they qualify for the preferential tax rate of 15% or less; if not, then they’re treated as ordinary income.) Note that these (capital gains) distributions apply only to realized capital gains (that is, the security holdings were actually sold and the capital gains actually earned).

Unrealized capital gain (or paper profits)

 are what make up the third and final element of a mutual fund’s return. When the fund’s holdings go up or down in price, the net asset value of the fund moves accordingly. Suppose an investor buys into a fund at $10 per share and sometime later the fund’s NAV is quoted at $12.50. The difference of $2.50 per share is the unrealized capital gain. It represents the profit that shareholders would receive (and are entitled to) if the fund were to sell its holdings. (Actually, as 
Table 12.2
 shows, some of the change in net asset value can also be made up of undistributed income.)

For closed-end investment companies, the return is derived from the same three sources as that for open-end funds, and from a fourth source as well: changes in price discounts or premiums. But because the discount or premium is already embedded in the share price of a fund, for a closed-end fund, the third element of return—change in share price—is made up not only of change in net asset value but also of change in price discount or premium.

Measures of Return

A simple but effective measure of performance is to describe mutual fund returns in terms of the three major sources noted above: dividends earned, capital gains distributions received, and change in price. When dealing with investment horizons of one year or less, we can convert these fund payoffs into a return figure by using the standard holding period return (HPR) formula. The computations are illustrated here using the 2016 figures from 
Table 12.2
. In 2016 this hypothetical no-load, open-end fund paid 55 cents per share in dividends and another $1.75 in capital gains distributions. It had a price at the beginning of the year of $24.47 that rose to $29.14 by the end of the year. Thus, summarizing this investment performance, we have

$24.47

Total return

$ 6.97

Price (NAV) at the beginning of the year (line 1)
Price (NAV) at the end of the year (line 10)	$29.14
Net increase	$   4.67
Return for the year:
Dividends received (line 7)	$ 0.55
Capital gains distributions (line 8)	$  1.75
Net increase in price (NAV)	$ 4.67
Holding period return (HPR) (Total return/beginning price)	28.48%

This HPR measure is comparable to the procedure used by the fund industry to report annual returns: This same value can be seen in 
Table 12.2
, line 11, which shows the fund’s “Total return.” It not only captures all the important elements of mutual fund return but also provides a handy indication of yield. Note that the fund had a total dollar return of $6.97, and on the basis of a beginning investment of $24.47, the fund produced an annual return of nearly 28.5%.

HPR with Reinvested Dividends and Capital Gains

Many mutual fund investors have their dividends and/or capital gains distributions reinvested in the fund. How do you measure return when you receive your (dividend/capital gains) payout in additional shares of stock rather than cash? With slight modifications, you can continue to use holding period return. The only difference is that you must keep track of the number of shares acquired through reinvestment.

To illustrate, let’s continue with the example above. Assume that you initially bought 200 shares in the mutual fund and also that you were able to acquire shares through the fund’s reinvestment program at an average price of $26.50 a share. Thus, the $460 in dividends and capital gains distributions [(

$0.55

 + $1.75)×200][($0.55 + $1.75)×200] provided you with another 17.36 shares in the fund (i.e., $460/$26.50). The holding period return under these circumstances would relate the market value of the stock holdings at the beginning of the period with the holdings at the end.

Holding period return=(Number of shares at end of period×Ending price)−(Number of shares at beginning of period×Initial price)(Number of shares at beginning of period×Initial price)Holding period return=(Number of shares at end of period×Ending price)−(Number of shares at beginning of period×Initial price)(Number of shares at beginning of period×Initial price)Equation12.2

Thus, the holding period return on this investment would be

Holding period return=(217.36×$29.14)−(200×$24.47)(200×$24.47)=($6,333.87)−($4,894.00)($4,894.000)=29.4%––––––––––––––Holding period return=(217.36×$29.14)−(200×$24.47)(200×$24.47)=($6,333.87)−($4,894.00)($4,894.000)=29.4%__

This holding period return, like the preceding one, provides a rate-of-return measure that you can use to compare the performance of this fund to those of other funds and investment vehicles.

Measuring Long-Term Returns

Rather than use one-year holding periods, it is sometimes necessary to assess the performance of mutual funds over extended periods of time. In these cases, using the holding period return as a measure of performance would be inappropriate because it ignores the time value of money. Instead, when faced with multiple-year investment horizons, we can use the present value–based internal rate of return (IRR) procedure to determine the fund’s average annual compound rate of return.

To illustrate, refer once again to 
Table 12.2
. Assume that this time we want to find the annual rate of return over the full three-year period (2014 through 2016). We see that the mutual fund had the following annual dividends and capital gains distributions:

2016

2015

2014

Total distributions

Item
Annual dividends paid	$0.55	$0.64	$0.50
Annual capital gains distributed	$1.75	$0.84	$1.02
$2.30		$1.48		$1.52

Given that the fund had a price of $24.26 at the beginning of the period (1/1/14) and was trading at $29.14 at the end of 2016 (three years later), we have the following time line of cash flows.

$1.52

$1.48

(Distributions)

Subsequent Cash Flows
Initial Cash Flow	Year 1	Year 2	Year 3
$24.26	$2.30 + $29.14$2.30 + $29.14
(Beginning Price)		(Distributions)	(Distributions + Ending Price)

We want to find the discount rate that will equate the annual dividends/capital gains distributions and the ending price in year 3 to the beginning (2014) price of the fund ($24.26).

Using standard present value calculations, we find that the mutual fund in 
Table 12.2
 provided an annual rate of return of 13.1% over the three-year period. That is, at 13.1%, the present value of the cash flows in years 1, 2, and 3 equals the beginning price of the fund ($24.26). Such information helps us assess fund performance and compare the return performance of various investments.

According to SEC regulations, if mutual funds report historical returns, they must do so in a standardized format that employs fully compounded, total-return figures similar to those obtained from the above present value–based calculations. The funds are not required to report such information, but if they do cite performance in their promotional material, they must follow a full-disclosure manner of presentation that takes into account not only dividends and capital gains distributions but also any increases or decreases in the fund’s NAV that have occurred over the preceding 1-, 3-, 5-, and 10-year periods.

Returns on Closed-End Funds

The returns of CEFs have traditionally been reported on the basis of their NAVs. That is, price premiums and discounts were ignored when computing return measures. However, it is becoming increasingly common to see return performance expressed in terms of actual market prices, a practice that captures the impact of changing market premiums or discounts on holding period returns. As you might expect, the greater the premiums or discounts and the greater the changes in these values over time, the greater their impact on reported returns. It’s not at all uncommon for CEFs to have different market-based and NAV-based holding period returns. Using NAVs, you find the returns on CEFs in exactly the same way as you do the returns on open-end funds. In contrast, when using actual market prices to measure return, all you need do is substitute the market price of the fund (with its embedded premium or discount) for the corresponding NAV in the holding period or internal rate of return measures.

Some CEF investors like to run both NAV-based and market-based measures of return to see how changing premiums (or discounts) have affected the returns on their mutual fund holdings. Even so, as a rule, NAV-based return numbers are generally viewed as the preferred measures of performance. Because fund managers often have little or no control over changes in premiums or discounts, NAV-based measures are felt to give a truer picture of the performance of the fund itself.

The Matter of Risk

Because most mutual funds are so diversified, their investors are largely immune to the unsystematic risks normally present with individual securities. Even with extensive diversification, however, most funds are still exposed to a considerable amount of systematic risk or market risk. In fact, because mutual fund portfolios are so well diversified, they often tend to perform very much like the market—or like the segment of the market that the fund targets. Although a few funds, like gold funds, tend to be defensive (countercyclical), market risk is still an important ingredient for most types of mutual funds, both open- and closed-end. You should be aware of the effect the general market has on the investment performance of a mutual fund. For example, if the market is trending downward and you anticipate that trend to continue, it might be best to place any new investment capital into something like a money fund until the market trend reverses.

Another important risk consideration revolves around the management practices of the fund itself. If the portfolio is managed conservatively, the risk of a loss in capital is likely to be much less than that for aggressively managed funds. Alternatively, the more speculative are the investment goals of the fund, the greater the risk of instability in the net asset value. But, a conservatively managed portfolio does not eliminate all price volatility. The securities in the portfolio are still subject to inflation, interest rate, and general market risks. However, these risks are generally less with funds whose investment objectives and portfolio management practices are more conservative.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 12.12 How important is the general behavior of the market in affecting the price performance of mutual funds? Explain. Does the future behavior of the market matter in the selection process? Explain.

2. 12.13 What is the major/dominant type of closed-end fund? How do CEFs differ from open-end funds?

3. 12.14 Identify three potential sources of return to mutual fund investors and briefly discuss how each could affect total return to shareholders. Explain how the discount or premium of a closed-end fund can also be treated as a return to investors.

4. 12.15 Discuss the various types of risk to which mutual fund shareholders are exposed. What is the major risk exposure of mutual funds? Are all funds subject to the same level of risk? Explain.

MyFinanceLab

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know and where to go when you need to practice.

What You Should Know	Key Terms	Where to Practice
LG 1 Describe the basic features of mutual funds and note what they have to offer as investments. Mutual fund shares represent ownership in a diversified, professionally managed portfolio of securities. Many investors who lack the time, know-how, or commitment to manage their own money turn to mutual funds. Mutual funds’ shareholders benefit from a level of diversification and investment performance they might otherwise find difficult to achieve. They also can invest with a limited amount of capital and can obtain investor services not available elsewhere.	1. actively managed fund , p.  471 2. expense ratio , p.  472 3. mutual fund , p.  469 4. passively managed fund , p.  471 5. pooled diversification , p.  470	MyFinanceLab Study Plan 12.1
LG 2 Distinguish between open- and closed-end funds, ETFs, and other types of professionally managed investment companies, and discuss the various types of fund loads, fees, and charges. Open-end funds have no limit on the number of shares they may issue. Closed-end funds have a fixed number of shares outstanding and trade in the secondary markets like shares of common stock. Exchange-traded funds (ETFs) possess characteristics of both open-end and closed-end funds. Other types of investment companies are unit investment trusts, hedge funds (private, unregulated investment vehicles available to institutional and high-net-worth individuals), REITs (which invest in various types of real estate), and variable annuities. Mutual fund investors face an array of loads, fees, and charges, including front-end loads, back-end loads, annual 12(b)-1 charges, and annual management fees. Some of these costs are one-time charges (e.g., front-end loads). Others are paid annually (e.g., 12(b)-1 and management fees). Investors should understand fund costs, which can drag down fund performance and return.	1. back-end load , p.  480 2. closed-end fund , p.  476 3. fire sale , p.  475 4. hedge fund , p.  482 5. load fund , p.  480 6. low-load fund , p.  480 7. net asset value (NAV) , p.  475 8. no-load fund , p.  480 9. open-end fund , p.  475 10. real estate investment trust (REIT) , p.  482 11. redemption fee 12(b)-1 fee , p.  475	MyFinanceLab Study Plan 12.2
LG 3 Discuss the types of funds available and the variety of investment objectives these funds seek to fulfill. Each fund has an established investment objective that determines its investment policy and identifies it as a certain type of fund. Some popular types of funds are growth, aggressive-growth, value, equity-income, balanced, growth-and-income, asset allocation, index, bond, money, sector, socially responsible, and international funds. The different categories of funds have different risk-return characteristics.	1. aggressive-growth fund , p.  484 2. asset allocation fund , p.  488 3. automatic investment plan , p.  489 4. automatic reinvestment plan , p.  490 5. balanced fund , p.  485 6. bond fund , p.  485 7. conversion (exchange) privilege , p.  490 8. equity-income fund , p.  485 9. fund families , p.  491	MyFinanceLab Study Plan 12.3
LG 4 Discuss the investor services offered by mutual funds and how these services can fit into an investment program. Mutual funds also offer special services, such as automatic investment and reinvestment plans, systematic withdrawal programs, low-cost conversion and phone-switching privileges, and retirement programs.	1. growth-and-income fund , p.  485 2. growth fund , p.  484 3. index fund , p.  486 4. international fund , p.  489 5. money market mutual fund (money fund) , p.  486 6. sector fund , p.  488 7. socially responsible fund , p.  488 8. systematic withdrawal plan , p.  490 9. target date fund value fund , p.  489 10. value fund, p.  484	MyFinanceLab Study Plan 12.4
LG 5 Describe the investor uses of mutual funds along with the variables to consider when assessing and selecting funds for investment purposes. Investors can use mutual funds to accumulate wealth, as a storehouse of value, or as a vehicle for speculation and short-term trading. Fund selection generally starts by assessing the investor’s needs and wants. The next step is to consider what the funds have to offer with regard to investment objectives, risk exposure, and investor services. The investor then narrows the alternatives by aligning his or her needs with the types of funds available and, from this short list of funds, applies the final selection tests: fund performance and cost.	1. capital gains distributions , p.  499 2. dividend income , p.  499	MyFinanceLab Study Plan 12.5
LG 6 Identify the sources of return and compute the rate of return earned on a mutual fund investment. The payoff from investing in a mutual fund includes dividend income, distribution of realized capital gains, growth in capital (unrealized capital gains), and—for closed-end funds—the change in premium or discount. Various measures of return recognize these elements and provide simple yet effective ways of gauging the annual rate of return from a mutual fund. Risk is also important to mutual fund investors. A fund’s extensive diversification may protect investors from business and financial risks, but considerable market risk still remains because most funds tend to perform much like the market, or like that segment of the market in which they specialize.	1. unrealized capital gains (paper profits) , p.  499	MyFinanceLab Study Plan 12.6 Video Learning Aid for Problems P12.11, P12.16
Log into MyFinanceLab, take a chapter test, and get a personalized Study Plan that tells you which concepts you understand and which ones you need to review. From there, MyFinanceLab will give you further practice, tutorials, animations, videos, and guided solutions. Log into  http://www.myfinancelab.com

Securities Markets

1

. LG 1

2

. LG 2

3

. LG 3

Securities markets

 are markets that allow buyers and sellers of securities to make financial transactions. Their goal is to permit such transactions to be made quickly and at a fair price. In this section we will look at the various types of securities markets and their general characteristics.

Types of Securities Markets

In general, securities markets are broadly classified as either 

money markets

 or 

capital markets

. The money market is the market where short-term debt securities (with maturities less than one year) are bought and sold. Investors use the money market for short-term borrowing and lending. Investors turn to the capital market to buy and sell long-term securities (with maturities of more than one year), such as stocks and bonds. In this text we will devote most of our attention to the capital market. There investors can make transactions in a wide variety of financial securities, including stocks, bonds, mutual funds, exchange-traded funds, options, and futures. Capital markets are classified as either primary or secondary, depending on whether securities are being sold initially to investors by the issuer (primary market) or resold among investors (secondary market).

Before offering its securities for public sale, the issuer must register them with and obtain approval from the 

Securities and Exchange Commission (SEC)

. This federal regulatory agency must confirm both the adequacy and the accuracy of the information provided to potential investors. In addition, the SEC regulates the securities markets.

The Primary Market

The market in which new issues of securities are sold to investors is the 

primary market

. In the primary market, the issuer of the equity or debt securities receives the proceeds of sales. The most significant transaction in the primary market is the 

initial public offering (IPO)

, which marks the first public sale of a company’s stock and results in the company’s taking on a public status. The primary markets also provide a forum for the sale of additional stock, called seasoned equity issues, by already public companies.

Table 2.1

 shows that only

21

operating companies sold stock to the public for the first time in the primary market in the United States during

200

8

, the first full year of the Great Recession, a period considered by many economists to be the worst economic downturn since the Great Depression of the 1

93

0s. That number is less than one-twentieth the number of IPOs in

1999

, the end of the technology-stock-driven bull market. When recovery from the Great Recession began in

2009

, the number of IPOs per year also began to rebound, producing nearly twice as many IPOs relative to the previous year. Over the next five years, as the economy continued to rebound, so did IPO volume, reaching

20

6

IPOs in

201

4

. Seasoned equity offerings (SEOs) follow a similar pattern. The low point for SEO volume also occurred in 2008, though SEO deals have picked up since then.

Hear about Shake Shack’s IPO

To sell its securities in the primary market, a firm has three choices. It may make (1) a 

public offering

, in which the firm offers its securities for sale to public investors; (2) a 

rights offering

, in which the firm offers shares to existing stockholders on a pro rata basis (each outstanding share gets an equal proportion of new shares); or (3) a 

private placement

, in which the firm sells securities directly without SEC registration to select groups of private investors such as insurance companies, investment management funds, and pension funds.

Going Public: The IPO Process

Most companies that go public are small, fast-growing companies that require additional capital to continue expanding. For example, Shake Shack, a company that originated from a hot dog cart setup in

2001

to support the rejuvenation of New York City’s Madison Square Park, raised about $98 million when it went public on January 30, 201

5

, at $21 per share. But not every IPO fits the typical start-up profile. Large companies may decide to spin off a unit into a separate public corporation. The media and entertainment company Time Warner did this when it spun off its magazine business, Time, Inc., in June 2014.

When a company decides to go public, it first must obtain the approval of its current shareholders, the investors who own its privately issued stock. Next, the company’s auditors and lawyers must certify that all financial disclosure documents for the company are legitimate. The company then finds an investment bank willing to underwrite the offering. This bank is the lead underwriter and is responsible for promoting the company’s stock and facilitating the sale of the company’s IPO shares. The lead underwriter often brings in other investment banking firms to help underwrite and market the company’s stock. We’ll discuss the role of the investment banker in more detail in the next section.

The underwriter also assists the company in filing a registration statement with the SEC. One portion of this statement is the 

prospectus

. It describes the key aspects of the securities to be issued, the issuer’s management, and the issuer’s financial position. Once a firm files a prospectus with the SEC, a quiet period begins, during which the firm faces a variety of restrictions on what it can communicate to investors. While waiting for the registration statement’s SEC approval, prospective investors may receive a preliminary prospectus. This preliminary version is called a 

red herring

 because a notice printed in red on the front cover indicates the tentative nature of the offer. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company—that which is presented in the preliminary prospectus—but not to any unpublished data that might provide an unfair advantage. The quiet period ends when the SEC declares the firm’s prospectus to be effective. The cover of the preliminary prospectus describing the 2015 stock issue of Shake Shack, Inc., appears in 

Figure 2.1

. Notice that the preliminary prospectus has a blank where the offering price of the stock should be, just under the header that has the company name. Note also the warning, often referred to as the red herring, printed across the top of the front page.

During the registration period and before the IPO date, the investment bankers and company executives promote the company’s stock offering through a road show, which consists of a series of presentations to potential investors—typically institutional investors—around the country and sometimes overseas. In addition to providing investors with information about the new issue, road shows help the investment bankers gauge the demand for the offering and set an expected price range. Once all of the issue terms have been set, including the price, the SEC must approve the offering before the IPO can take place.

Table 2.1
 highlights several interesting features of the IPO market over the last 16 years. First, the table shows the number of IPOs each year. As mentioned earlier, the number of IPOs per year moves dramatically as economic conditions change and as the stock market moves up and down. Generally speaking, more companies go public when the economy is strong and stock prices are rising. Second, the table shows the average first-day return for IPOs each year. An IPO’s first-day return is simply the percentage change from the price of the IPO in the prospectus to the closing price of the stock on its first day of trading. For example, when the details of Shake Shack’s IPO were finalized, shares were offered to investors in the final prospectus at $21 per share.

Figure 2.1 Cover of a Preliminary Prospectus for a Stock Issue

Some of the key factors related to the 2015 common stock issue by Shake Shack Inc., are summarized on the cover of the prospectus. The disclaimer statement across the top of the page is normally printed in red, which explains its name, “red herring.”

(Source: Shake Shack Inc., “Form S-1 Registration Statement,” December 29, 2014, p. 2.)

At the end of the stock’s first trading day, its price had risen to $45.90, a one-day return of 118%! You can see in 
Table 2.1
 that the average first-day return for all IPOs is positive in every year from 1999 to 2014, ranging from

6.4%

in 2008 to

7

1.1%

in 1999. Because IPO shares typically go up in value as soon as they start trading, we say that IPOs are underpriced on average. IPO shares are underpriced if they are sold to investors at a price that is lower than what the market will bear. In the Shake Shack offering, investors were apparently willing to pay $45.90 per share (based on the value of the shares once trading began), but shares were initially offered at just $21. We could say then that Shake Shack shares (say that three times fast) were underpriced by $24.90. 
Table 2.1
 indicates that the average first-day return is closely connected to the number of IPOs. Average first-day returns are higher in years when many firms choose to go public (as in 1999), and first-day returns are lower in years when few firms conduct IPOs (as in 2008).

Shake Shack sold 5.75 million shares in its IPO for $21 per share, so the gross proceeds from the offer were $120.7 million, which equals 5.75 million shares times $21 per share. This is the third feature of the IPO market highlighted in 
Table 2.1
. Total gross proceeds from IPOs ranged from $9.5 billion in

2003

to $65 billion in 1999. The last column in 
Table 2.1
 lists total “money left on the table.” Money left on the table represents a cost that companies bear when they go public if their shares are underpriced (as most IPOs are). For example, Shake Shack underpriced its offering by $143.2 million, which comes from multiplying 5.75 million shares sold times $24.90 underpricing per share. It shouldn’t be a surprise that in the IPO market, aggregate money left on the table peaked at the same time that underpricing did. In 1999 the

477

companies that went public left

$37.1

billion on the table by underpricing their shares. Given that the gross proceeds of IPOs that year (i.e., the total money paid by investors in the primary market to acquire IPO shares) were $65 billion, it seems that companies left more than half as much money on the table as they raised by going public in the first place. Put differently, if shares had not been underpriced at all in 1999, companies would have raised $102.1 billion rather than

$65.0

billion, a difference of 57%.

Investing in IPOs is risky business, particularly for individual investors who can’t easily acquire shares at the offering price. Most of those shares go to institutional investors and brokerage firms’ best clients. Although news stories may chronicle huge first-day gains, IPO stocks are not necessarily good long-term investments.

The Investment Banker’s Role

Most public offerings are made with the assistance of an investment banker. The 

investment banker

 is a financial intermediary that specializes in assisting companies issuing new securities and advising firms with regard to major financial transactions. In the context of IPOs, the main activity of the investment banker is 

underwriting

. This process involves purchasing the securities from the issuing firm at an agreed-on price and bearing the risk of reselling them to the public. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue.

In the case of large security issues, the lead or originating investment banker brings in other bankers as partners to form an 

underwriting syndicate

. The syndicate shares the financial risk associated with buying the entire issue from the issuer and reselling the new securities to the public. The lead investment banker and the syndicate members put together a 

selling group

, normally made up of themselves and a large number of brokerage firms. Each member of the selling group is responsible for selling a certain portion of the issue and is paid a commission on the securities it sells. The selling process for a large security issue is depicted in 

Figure 2.2

.

Table 2.1 U.S. Annual IPO Data, 1999–2014

(Source: “Initial Public Offerings: Updated Statistics,” 

http://bear.warrington.ufl.edu/ritter/IPOs2014Statistics

, Table 1, accessed February 26, 2015.)

159

$29.8

157

Year	Number of IPOs	Average First-Day Return	Aggregate Gross Proceeds (billions)	Aggregate Money Left on the Table (billions)
1999	477	71.1%	$65.0	$37.1
2000	3 81	56.3%	$64.9		$29.8
2001	79	14.2%	$34.2	$ 3.0
2002	66	9.1%	$22.0	$ 1.1
2003	63	11.7%	$ 9.5	$ 1.0
2004	173	12.3%	$ 31.2	$ 3.9
2005		159	10.3%	$28.2	$ 2.6
2006		157	12.1%	$30.5	$ 4.0
2007	14.0%	$35.7	$ 5.0
2008	21	6.4%	$22.8	$ 5.7
2009	41	9.8%	$13.2	$ 1.5
2010	91	9.4%	$ 1.8
2011	81	13.3%	$ 27.0	$ 3.2
2012	93	17.9%	$ 31.1	$ 2.8
2013	21.1%	$38.8	$ 8.6
2014	206	15.5%	$42.2	$ 5.4

The relationships among the participants in this process can also be seen on the cover of the December 29, 2014, preliminary prospectus for the common stock offering for Shake Shack, Inc., in 
Figure 2.1
. The layout of the prospectus cover indicates the roles of the various participating firms. Placement and larger typefaces differentiate the originating underwriters (J.P. Morgan and Morgan Stanley) from the underwriting syndicate members (Goldman, Sachs & Co., Barclays, Jefferies, William Blair, and Stifel), whose names appear in a smaller font below. J.P. Morgan and Morgan Stanley are acting as joint-lead investment banks for Shake Shack’s IPO.

Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, in the Shake Shack IPO, the investment bank, acting as a lead underwriter (say J.P. Morgan), might pay Shake Shack $19.50 for stock that investors will ultimately purchase for $21. Having guaranteed the issuer $19.50 per share, the lead underwriter may then sell the shares to the underwriting syndicate members for $19.75 per share. The additional 25 cents per share represents the lead underwriter’s management fee. Next the underwriting syndicate members sell the shares to members of the selling group for 85 cents more, or $20.60 per share. That 85 cent difference represents the underwriters’ discount, which is their profit per share. Finally, members of the selling group earn a selling concession of 40 cents per share when they sell shares to investors at $21 per share. The $1.50 difference between the price per share paid to Shake Shack ($19.50) and that paid by the investor ($21) is the gross spread, which comprises the lead underwriter’s management fee ($0.25), the syndicate underwriters’ discounts ($0.85), and the selling group’s selling concession ($0.40). Although the issuer places (or sells) some primary security offerings directly, the majority of new issues are sold through public offering via the process just described.

Figure 2.2 The Selling Process for a Large Security Issue

The lead investment banker hired by the issuing firm may form an underwriting syndicate. The underwriting syndicate buys the entire security issue from the issuing corporation at an agreed-on discount to the public offering price. The investment banks in the underwriting syndicate then bear the risk of reselling the issue to the public at a public offering price. The investment banks’ profit is the difference between the price they guaranteed the issuer and the public offering price. Both the lead investment bank and the other syndicate members put together a selling group to sell the issue on a commission basis to investors.

The Secondary Market

The 

secondary market

, or the aftermarket, is the market in which securities are traded after they have been issued. Unlike the primary market, secondary-market transactions do not involve the corporation that issued the securities. Instead, the secondary market permits an investor to sell his or her holdings to another investor. The secondary market provides an environment for continuous pricing of securities that helps to ensure that security prices reflect the securities’ true values on the basis of the best available information at any time. The ability to make securities transactions quickly and at a fair price in the secondary market provides securities traders with liquidity.

One major segment of the secondary market consists of various national securities exchanges, which are markets, registered with the SEC, in which the buyers and sellers of listed securities come together to execute trades. There are 18 national securities exchanges registered with the SEC under Section 6(a) of the Exchange Act. The 

over-the-counter (OTC) market

, which involves trading in smaller, unlisted securities, represents the other major segment of the secondary market. The Financial Industry Regulatory Authority (FINRA) regulates securities transactions in the OTC market. FINRA is the largest independent regulator of securities firms doing business in the United States. FINRA’s mission is to protect investors by making sure that the thousands of brokerage firms, tens of thousands of branch offices, and hundreds of thousands of registered securities representatives it oversees operate fairly and honestly.

Figure 2.3 Broker and Dealer Markets

On a typical trading day, the secondary market is a beehive of activity, where literally billions of shares change hands. The market consists of two distinct parts—the broker market and the dealer market. As shown, each of these markets is made up of various exchanges and trading venues.

Broker Markets and Dealer Markets

Historically, the secondary market has been divided into two segments on the basis of how securities are traded: broker markets and dealer markets. 

Figure 2.3

 depicts the makeup of the secondary market in terms of broker or dealer markets. As you can see, the 

broker market

 consists of national and regional securities exchanges, whereas the 

dealer market

 is made up of the

Nasdaq

OMX and OTC trading venues.

Before we look at these markets in more detail, it’s important to understand that probably the biggest difference in the two markets is a technical point dealing with the way trades are executed. That is, when a trade occurs in a broker market, the two sides to the transaction, the buyer and the seller, are brought together—the seller sells his or her securities directly to the buyer. With the help of a broker, the securities effectively change hands on the floor of the exchange.

In contrast, when trades are made in a dealer market, buyers’ orders and sellers’ orders are never brought together directly. Instead, their buy/sell orders are executed by 

market makers

, who are securities dealers that “make markets” by offering to buy or sell a certain amount of securities at stated prices. Essentially, two separate trades are made: The seller sells his or her securities (for example, in Intel Corp.) to a dealer, and the buyer buys his or her securities (in Intel Corp.) from another, or possibly even the same, dealer. Thus, there is always a dealer (market maker) on one side of a dealer-market transaction.

As the secondary market continues to evolve, the distinction between broker and dealer markets continues to fade. In fact, since the 21st century began there has been unprecedented consolidation of trading venues and their respective trading technologies to the point where most exchanges in existence today function as broker-dealer markets. Broker-dealer markets seamlessly facilitate both broker and dealer functions as necessary to provide liquidity for investors in the secondary market.

Broker Markets

If you’re like most people, when you think of the stock market, the first thing that comes to mind is the New York Stock Exchange (NYSE), which is a national securities exchange. Known as “the Big Board,” the NYSE is, in fact, the largest stock exchange in the world. In 2015 more than 2,400 firms with an aggregate market value of greater than $19 trillion listed on the NYSE. Actually, the NYSE has historically been the dominant broker market. Also included in broker markets are the NYSE Amex (formally the American Stock Exchange), another national securities exchange, and several so-called regional exchanges. Regional exchanges are actually national securities exchanges, but they reside outside New York City. The number of securities listed on each of these exchanges is typically in the range of

100

to 500 companies. As a group, they handle a very small fraction (and a declining fraction) of the shares traded on organized exchanges. The best known of these are the Chicago Stock Exchange, NYSE Arca (formally the Pacific Stock Exchange), Nasdaq OMX PHLX (formally the Philadelphia Stock Exchange), Nasdaq OMX BX (formally the Boston Stock Exchange), and National Stock Exchange. These exchanges deal primarily in securities with local and regional appeal. Most are modeled after the NYSE, but their membership and listing requirements are considerably more lenient. To enhance their trading activity, regional exchanges often list securities that are also listed on the NYSE.

Other broker markets include foreign stock exchanges that list and trade shares of firms in their own foreign markets (we’ll say more about these exchanges later in this chapter). Also, separate domestic exchanges exist for trading in options and in futures. Next we consider the basic structure, rules, and operations of each of the major exchanges in the broker markets.

The New York Stock Exchange

Most organized securities exchanges were originally modeled after the New York Stock Exchange. Before the NYSE became a for-profit, publicly traded company in 2006, an individual or firm had to own or lease 1 of the 1,366 “seats” on the exchange to become a member of the exchange. The word seat comes from the fact that until the 1870s, members sat in chairs while trading. On December 30, 2005, in anticipation of becoming a publicly held company, the NYSE ceased having member seats. Now part of the NYSE Euronext group of exchanges, the NYSE sells one-year trading licenses to trade directly on the exchange. As of January 1, 2015, a one-year trading license cost $40,000 per license for the first two licenses and $25,000 per additional license held by a member organization. Investment banks and brokerage firms comprise the majority of trading license holders, and each typically holds more than one trading license.

See the NYSE’s iPad App

Firms such as Merrill Lynch designate officers to hold trading licenses. Only such designated individuals can make transactions on the floor of the exchange. The two main types of floor broker are the commission broker and the independent broker. Commission brokers execute orders for their firm’s customers. An independent broker works for herself and handles orders on a fee basis, typically for smaller brokerage firms or large firms that are too busy to handle their own orders.

Trading Activity

The floor of the NYSE is an area about the size of a football field. It was once a hub of trading activity, and in some respects it looks the same today as it did years ago. The NYSE floor has trading posts, and certain stocks trade at each post. Electronic gear around the perimeter transmits buy and sell orders from brokers’ offices to the exchange floor and back again after members execute the orders. Transactions on the floor of the exchange occur through an auction process that takes place at the post where the particular security trades. Members interested in purchasing a given security publicly negotiate a transaction with members interested in selling that security. The job of the 

designated market maker (DMM)

—an exchange member who specializes in making transactions in one or more stocks—is to manage the auction process. The DMM buys or sells (at specified prices) to provide a continuous, fair, and orderly market in those securities assigned to her. Despite the activity that still occurs on the NYSE trading floor, the trades that happen there account for a tiny fraction of trading volume. Most trading now occurs through electronic networks off the floor.

Listing Policies

To list its shares on a stock exchange, a domestic firm must file an application and meet minimum listing requirements. Some firms have 

dual listings

, or listings on more than one exchang

e. Listing requirements

have evolved over time, and as the NYSE has come under competitive pressure, it has relaxed many of its listing standards. Companies that sought a listing on the NYSE were once required to have millions in pretax earnings. Today, the NYSE will list companies with $750,000 in pretax earnings, or in some cases, with no pretax earnings at all. The NYSE does require that a listed firm have a minimum stock price of $2 to $3, and usually the market value of a company’s public float (the value of shares available for trading on the exchange) must be $15 million or more. Still, an NYSE listing does not have the prestige that it once did.

Regional Stock Exchanges

Most regional exchanges are modeled after the NYSE, but their membership and listing requirements are more lenient. Trading costs are also lower. The majority of securities listed on regional exchanges are also listed on the NYSE. About 100 million NYSE shares pass through one of the regional exchanges on a typical trading day. This dual listing may enhance a security’s trading activity.

Options

Exchanges

Options allow their holders to sell or to buy another security at a specified price over a given period of time. The dominant options exchange is the Chicago Board Options Exchange (CBOE). Options are also traded on the NYSE, on Nasdaq OMX BX, NYSE Arca, and Nasdaq OMX PHLX exchanges, and on the International Securities Exchange (ISE). Usually an option to sell or buy a given security is listed on many of the exchanges.

Futures

Exchanges

Futures are contracts that guarantee the delivery of a specified commodity or financial instrument at a specific future date at an agreed-on price. The dominant player in the futures trading business is the CME Group, a company comprised of four exchanges (CME, CBOT, NYMEX, and COMEX) known as designated contract markets. Some futures exchanges specialize in certain commodities and financial instruments rather than handling the broad spectrum of products.

Dealer Markets

One of the key features of the dealer market is that it has no centralized trading floors. Instead it is made up of a large number of market makers who are linked via a mass electronic network. Each market maker is actually a securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid/ask prices. The 

bid price

 and 

ask price

 represent, respectively, the highest price offered to purchase a given security and the lowest price offered to sell a given security. An investor pays the ask price when buying securities and receives the bid price when selling them. The dealer market is made up of both the Nasdaq OMX and the OTC markets. As an aside, the primary market is also a dealer market because all new issues—IPOs and 

secondary distributions

, which involve the public sale of large blocks of previously issued securities held by large investors—are sold to the investing public by securities dealers acting on behalf of the investment banker.

Nasdaq

The largest dealer market is made up of a large list of stocks that are listed and traded on the National Association of Securities Dealers Automated Quotation System, typically referred to as Nasdaq. Founded in 1971, Nasdaq had its origins in the OTC market but is today considered a totally separate entity that’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formally recognized by the SEC as a national securities exchange, giving it pretty much the same stature and prestige as the NYSE.

To be traded on Nasdaq, all stocks must have at least two market makers, although the bigger, more actively traded stocks, like Cisco Systems, have many more than that. These dealers electronically post all their bid/ask prices so that when investors place market orders, they are immediately filled at the best available price.

The Nasdaq listing standards vary depending on the Nasdaq listing market. The 1,200 or so stocks traded on the Nasdaq Global Select Market meet the world’s highest listing standards. Created in 2006, the Global Select Market is reserved for the biggest and the “bluest”—highest quality—of the Nasdaq stocks. In 2012 Facebook elected to list on Nasdaq Global Select rather than on the NYSE, further cementing Nasdaq’s position as the preferred listing exchange for leading technology companies.

The listing requirements are also fairly comprehensive for the roughly 1,450 stocks traded on the Nasdaq Global Market. Stocks included on these two markets are all widely quoted, actively traded, and, in general, have a national following. The big-name stocks traded on the Nasdaq Global Select Market, and to some extent, on the Nasdaq Global Market, receive as much national visibility and are as liquid as those traded on the NYSE. As a result, just as the NYSE has its list of big-name players (e.g., ExxonMobil, GE, Citigroup, Walmart, Pfizer, IBM, Procter & Gamble, Coca-Cola, Home Depot, and UPS), so too does Nasdaq. Its list includes companies like Microsoft, Intel, Cisco Systems, eBay, Google, Yahoo!, Apple, Starbucks, and Staples. Make no mistake: Nasdaq competes head-to-head with the NYSE for listings. In 2015, 13 companies with a combined market capitalization of $82 billion moved their listings from the NYSE to Nasdaq. Some well-known companies that moved to Nasdaq include Viacom, Kraft Foods, and Texas Instruments. The Nasdaq Capital Market is still another Nasdaq market; it makes a market in about 600 or 700 stocks that, for one reason or another, are not eligible for the Nasdaq Global Market. In total, 48 countries are represented by approximately 3,000 securities listed on Nasdaq as of 2015.

The Over-the-Counter Market

The other part of the dealer market is made up of securities that trade in the over-the-counter (OTC) market. These non-Nasdaq issues include mostly small companies that either cannot or do not wish to comply with Nasdaq’s listing requirements. They trade on either the OTC Bulletin Board (OTCBB) or OTC Markets Group. The OTCBB is an electronic quotation system that links the market makers who trade the shares of small companies. The OTCBB provides access to more than 3,300 securities, includes more than 230 participating market makers, and electronically transmits real-time quote, price, and volume information in traded securities. The Bulletin Board is regulated by the FINRA, which, among other things, requires all companies traded on this market to file audited financial statements and comply with federal securities law.

The OTC Markets is an unregulated segment of the market, where the companies are not even required to file with the SEC. This market is broken into three tiers. The biggest is OTC Pink, which is populated by many small and often questionable companies that provide little or no information about their operations. Securities in the OTC QB tier must provide SEC, bank, or insurance reporting and be current in their disclosures. The top tier, OTC QX, albeit the smallest, is reserved for companies that choose to provide audited financial statements and other required information. If a security has been the subject of promotional activities and adequate current information concerning the issuer is not publicly available, OTC Markets will label the security “Caveat Emptor” (buyers beware). Promotional activities, whether they are published by the issuer or a third party, may include spam e-mail or unsolicited faxes or news releases.

Alternative Trading Systems

Some individual and institutional traders now make direct transactions outside of the broker and dealer markets in the third and fourth markets. The 

third market

 consists of over-the-counter transactions made in securities listed on the NYSE, the NYSE Amex, or one of the other exchanges. These transactions are typically handled by market makers that are not members of a securities exchange. They charge lower commissions than the exchanges and bring together large buyers and sellers. Institutional investors, such as mutual funds, pension funds, and life insurance companies, are thus often able to realize sizable savings in brokerage commissions and to have minimal impact on the price of the transaction.

The 

fourth market

 consists of transactions made through a computer network, rather than on an exchange, directly between large institutional buyers and sellers of securities. Unlike third-market transactions, fourth-market transactions bypass the market maker. 

Electronic communications networks (ECNs)

 are at the heart of the fourth market. Archipelago (part of the NYSE Arca), Bloomberg Tradebook, Island, Instinet, and MarketXT are some of the many ECNs that handle these trades. As with the exchanges, ECNs have undergone much consolidation. For example, in 2002 Island was merged with Instinet, and then in 2005 Instinet was acquired by Nasdaq.

ECNs are most effective for high-volume, actively traded securities, and they play a key role in after-hours trading, discussed later in this chapter. They automatically match buy and sell orders that customers place electronically. If there is no immediate match, the ECN, acting like a broker, posts its request under its own name on an exchange or with a market maker. The trade will be executed if another trader is willing to make the transaction at the posted price.

ECNs can save customers money because they charge only a transaction fee, either per share or based on order size. For this reason, money managers and institutions such as pension funds and mutual funds with large amounts of money to invest favor ECNs. Many also use ECNs or trade directly with each other to find the best prices for their clients.

General Market Conditions: Bull or Bear

Conditions in the securities markets are commonly classified as “bull” or “bear,” depending on whether securities prices are rising or falling over time. Changing market conditions generally stem from changes in investor attitudes, changes in economic activity, and government actions aimed at stimulating or slowing down economic activity. 

Bull markets

 are normally associated with rising prices, investor optimism, economic recovery, and government stimulus. 

Bear markets

 are normally associated with falling prices, investor pessimism, economic slowdown, and government restraint. The beginning of 2003 marked the start of a generally bullish market cycle that peaked before turning sharply bearish in October 2007. The bearish market bottomed out in March 2009 and was generally bullish for the next several years. Since posting a return of almost −37% in 2008, the Standard and Poor’s 500 Stock Index earned a positive return in each year from 2009 to 2014.

In general, investors experience higher (or positive) returns on common stock investments during a bull market. However, some securities perform well in a bear market and fare poorly in a bull market. Market conditions are notoriously difficult to predict, and it is nearly impossible to identify the bottom of a bear market or the top of a bull market until months after the fact.

Concepts in Review

Answers available at 

http://www.pearsonhighered.com/smart

1. 2.1 Differentiate between each of the following pairs of terms.

a. Money market and capital market

b. Primary market and secondary market

c. Broker market and dealer market

2. 2.2 Briefly describe the IPO process and the role of the investment banker in underwriting a public offering. Differentiate among the terms public offering, rights offering, and private placement.

3. 2.3 For each of the items in the left-hand column, select the most appropriate item in the right-hand column.

a. Prospectus	1. Trades unlisted securities
b. Underwriting	2. Buying securities from firms and reselling them to investors
c. NYSE	3. Conditions a firm must meet before its stock can be traded on an exchange
d. Nasdaq OMX BX	4. A regional stock exchange
e. Listing requirements	5. Describes the key aspects of a security offering
f. OTC	6. The largest stock exchange in the world

4. 2.4 Explain how the dealer market works. Be sure to mention market makers, bid and ask prices, the Nasdaq market, and the OTC market. What role does the dealer market play in initial public offerings (IPOs) and secondary distributions?

5. 2.5 What are the third and fourth markets?

6. 2.6 Differentiate between a bull market and a bear market.

Globalization of Securities Markets

1. LG 4

Today investors, issuers of securities, and securities firms look beyond the markets of their home countries to find the best returns, lowest costs, and best international business opportunities. The basic goal of most investors is to earn the highest return with the lowest risk. This outcome is achieved through 

diversification

—the inclusion of a number of different securities in a portfolio to increase returns and reduce risk. An investor can greatly increase the potential for diversification by holding (1) a wider range of industries and securities, (2) securities traded in a larger number of markets, and (3) securities denominated in different currencies, and the diversification is even greater if the investor does these things for a mix of domestic and foreign securities. The smaller and less diversified an investor’s home market is, the greater the potential benefit from prudent international diversification. However, even investors in the United States and other highly developed markets can benefit from global diversification.

In short, globalization of the securities markets enables investors to seek out opportunities to profit from rapidly expanding economies throughout the world. Here we consider the growing importance of international markets, international investment performance, ways to invest in foreign securities, and the risks of investing internationally.

Growing Importance of International Markets

Securities exchanges now operate in over 100 countries worldwide. Both large (Tokyo Stock Exchange) and small (South Pacific Stock Exchange), they are located not only in the major industrialized nations such as Japan, Great Britain, Canada, and Germany but also in emerging economies such as Brazil, Chile, India, South Korea, Malaysia, Mexico, Poland, Russia, and Thailand. The top four securities markets worldwide (based on dollar volume) are the NYSE, Nasdaq, London Stock Exchange, and Tokyo Stock Exchange. Other important foreign exchanges include the Shanghai Stock Exchange, Osaka Securities Exchange, Toronto Stock Exchange, Montreal Exchange, Australian Securities Exchange, Hong Kong Exchanges and Clearing Ltd., Swiss Exchange, and Taiwan Stock Exchange Corp.

The economic integration of the European Monetary Union (EMU), along with pressure from financial institutions that want an efficient process for trading shares across borders, is changing the European securities market environment. Instead of many small national exchanges, countries are banding together to create cross-border markets and to compete more effectively in the pan-European equity-trading markets. The Paris, Amsterdam, Brussels, and Lisbon exchanges, plus a derivatives exchange in London, merged to form Euronext, and the Scandinavian markets formed Norex. In mid-2006 Euronext and the NYSE Group—the NYSE parent—signed an agreement to combine their businesses in a merger of equals. Some stock exchanges—for example, Tokyo and Australian—are forming cooperative agreements. Others are discussing forming a 24-hour global market alliance, trading the stocks of selected large international companies via an electronic order-matching system. Nasdaq, with joint ventures in Japan, Hong Kong, Canada, and Australia, plans to expand into Latin America and the Middle East. The increasing number of mergers and cooperative arrangements represent steps toward a worldwide stock exchange.

Bond markets, too, have become global, and more investors than ever before regularly purchase government and corporate fixed-income securities in foreign markets. The United States dominates the international government bond market, followed by Japan, Germany, and Great Britain.

International Investment Performance

A motive for investing overseas is the lure of high returns. In fact, only once since 1980 did the United States stock market post the world’s highest rate of return. For example, in 2014, a good year for U.S stocks, investors would have earned higher returns in many foreign markets. During that year the Standard and Poor’s Global Index reported returns (translated into U.S. dollars) of 32% in India, 26% in Egypt, 20% in Indonesia, and 14% in Turkey. By comparison, the U.S. stock price index increased about 11%. Of course, foreign securities markets tend to be riskier than U.S. markets. A market with high returns in one year may not do so well in the next. However, even in 2008, one of the worst years on record for stock market investors, more than a dozen foreign exchanges earned returns higher than the NYSE Euronext.

Investor Facts

U.S. Market Share Even though the U.S. securities markets lead the world in terms of market share, the United States accounts for only

30%

of the market value of companies in the worldwide equity markets.

(Source: World Federation of Stock Exchanges, http://www.world-exchanges.org/statistics/annual.)

Investors can compare activity on U.S. and foreign exchanges by following market indexes that track the performance of those exchanges. For instance, the Dow Jones averages and the Standard & Poor’s indexes are popular measures of the U.S. markets, and indexes for dozens of different stock markets are available.

Ways to Invest in Foreign Securities

Investors can make foreign security transactions either indirectly or directly. One form of indirect investment is to purchase shares of a U.S.-based multinational corporation with substantial foreign operations. Many U.S.-based multinational firms, such as Accenture, Facebook, Google, IBM, Intel, McDonald’s, Dow Chemical, Coca-Cola, and Nike, receive more than

50%

of their revenues from overseas operations. By investing in the securities of such firms, an investor can achieve a degree of international diversification. Purchasing shares in a mutual fund or exchange-traded fund that invests primarily in foreign securities is another way to invest indirectly. Investors can make both of these indirect foreign securities investment transactions through a stockbroker.

To make direct investments in foreign companies, investors have three options. They can purchase securities on foreign exchanges, buy securities of foreign companies that trade on U.S. exchanges, or buy American Depositary Shares (ADSs).

The first way—purchasing securities on foreign exchanges—involves additional risks because foreign securities do not trade in U.S. dollars and, thus, investors must cope with currency fluctuations. This approach is not for the timid or inexperienced investor. Investors also encounter different securities exchange rules, transaction procedures, accounting standards, and tax laws in different countries. Direct transactions are best handled either through brokers at major Wall Street firms with large international operations or through major banks, such as JPMorgan Chase and Citibank, that have special units to handle foreign securities transactions. Alternatively, investors can deal with foreign broker-dealers, but such an approach is more complicated and riskier.

The second form of direct investment is to buy the securities of foreign companies that trade on both organized and over-the-counter U.S. exchanges. Transactions in foreign securities that trade on U.S. exchanges are handled in the same way as exchange-traded domestic securities. These securities are issued by large, well-known foreign companies. Stocks of companies such as Barrick Gold Corporation (Canada), General Steel Holdings (China), Cosan Ltd. (Brazil), Paragon Shipping (Greece), Manchester United (United Kingdom), and Tyco International (Switzerland) trade directly on U.S. exchanges. In addition, 

Yankee bonds

, U.S. dollar–denominated debt securities issued by foreign governments or corporations and traded in U.S. securities markets, trade in both broker and dealer markets.

Finally, foreign stocks also trade on U.S. exchanges in the form of 

American depositary shares (ADSs)

. These securities have been created to permit U.S. investors to hold shares of non-U.S. companies and trade them on U.S. stock exchanges. They are backed by 

American depositary receipts (ADRs)

, which are U.S dollar–denominated receipts for the stocks of foreign companies that are held in the vaults of banks in the companies’ home countries. Today more than 3,700 ADRs representing more than 100 home countries are traded on U.S. exchanges. About one-fourth of them are actively traded. Included are well-known companies such as Daimler, Fujitsu, LG Electronics, Mitsubishi, Nestle, and Royal Dutch Shell.

Risks of Investing Internationally

Investing abroad is not without pitfalls. In addition to the usual risks involved in any security transaction, investors must consider the risks of doing business in a particular foreign country. Changes in trade policies, labor laws, and taxation may affect operating conditions for the country’s firms. The government itself may not be stable. You must track similar environmental factors in each foreign market in which you invest. This is clearly more difficult than following your home market.

U.S. securities markets are generally viewed as highly regulated and reliable. Foreign markets, on the other hand, may lag substantially behind the United States in both operations and regulation. Additionally, some countries place various restrictions on foreign investment. Saudi Arabia and China only recently opened their stock markets to foreign investors, and even then only to a limited extent. Mexico has a two-tier market, with certain securities restricted from foreigners. Some countries make it difficult for foreigners to get their funds out, and many impose taxes on dividends. For example, Swiss taxes are about 35% on dividends paid to foreigners. Other difficulties include illiquid markets and an inability to obtain reliable investment information because of a lack of reporting requirements.

Furthermore, accounting standards vary from country to country. Differences in accounting practices can affect a company’s apparent profitability, conceal assets (such as the hidden reserves and undervalued assets that are permitted in many countries), and facilitate failure to disclose other risks. As a result, it is difficult to compare the financial performance of firms operating in different countries. Although the accounting profession has agreed on a set of international accounting standards, it will be years until all countries have adopted them and even longer until all companies apply them.

Another concern stems from the fact that international investing involves securities denominated in foreign currencies. Trading profits and losses are affected not only by a security’s price changes but also by fluctuations in currency values. The price of one currency in terms of another is called the 

currency exchange rate

. The values of the world’s major currencies fluctuate with respect to each other daily, and these price movements can have a significant positive or negative impact on the return that you earn on an investment in foreign securities.

For example, on January 2, 2015, the exchange rate for the European Monetary Union euro (€) and the U.S. dollar (US$) was expressed as follows:

US$=�0.8324�=US$1.2013US$=�0.8324�=US$1.2013

This means that 1 U.S. dollar was worth 0.8324 euros, or equivalently, 1 euro was worth 1.2013 U.S. dollars. On that day, if you had purchased 100 shares of Heineken, which was trading for €57.72 per share on Euronext Amsterdam, it would have cost you $6,933.90 (i.e., 100×57.72×1.2013100×57.72×1.2013).

Four months later, the value of the euro had fallen relative to the dollar. On April 14, 2015, the euro/US$ exchange rate was 0.9386, which meant that during the first four months of 2015, the euro depreciated relative to the dollar (and therefore the dollar appreciated relative to the euro). On April 14 it took more euros to buy $1 (€0.9386 in April versus €0.8324 in January), so each euro was worth less in dollar terms (one euro was worth $1.0654 in April versus $1.2013 in January). Had the European Monetary Union euro instead appreciated (and the dollar depreciated relative to the euro), each euro would have been worth more in dollar terms.

Currency exchange risk

 is the risk caused by the varying exchange rates between the currencies of two countries. For example, assume that on April 14, 2015, you sold your 100 shares of Heineken, which was trading for €75.82 per share on Euronext Amsterdam; sale proceeds would have been $8,077.86 (i.e., 75.82×100×1.065475.82×100×1.0654).

In this example you had a win-lose outcome. The price of Heineken stock rose 31.4% (from €57.72 to €75.82), but the value of the euro declined 11.3% (falling from 1.2013 to 1.0654). You made money on the investment in Heineken, but to purchase Heineken shares, you also had to purchase euros. Because the euro depreciated from January to April, you lost money on that part of the transaction. On net you realized a gain of 16.5% because you invested $6,933.90 in January and you received $8,077.86 in April. Put another way, the increase in the value of Heineken shares more than offset the currency loss that you experienced, so your overall return was positive. If the depreciation in the euro had been greater, it could have swamped the increase in Heineken shares, resulting in an overall negative rate of return. Similarly, if the euro had appreciated, that would have magnified the return on Heineken stock. Investors in foreign securities must be aware that the value of the foreign currency in relation to the dollar can have a profound effect on returns from foreign security transactions.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 2.7 Why is globalization of securities markets an important issue today? How have international investments performed in recent years?

2. 2.8 Describe how foreign security investments can be made, both indirectly and directly.

3. 2.9 Describe the risks of investing internationally, particularly currency exchange risk.

Trading Hours and

Regulation of Securities Markets

1. LG 5

Understanding the structure of domestic and international securities markets is an important foundation for developing a sound investment program. We’ll begin with an overview of the trading hours and regulations that apply to U.S. securities markets.

Trading Hours of Securities Markets

Traditionally, the regular trading session for organized U.S. exchanges ran from 9:30 a.m. to 4:00 p.m. eastern time. However, trading is no longer limited to these hours. Most securities exchanges and ECNs offer extended trading sessions before and after regular hours. Most of the after-hours markets are 

crossing markets

, in which orders are filled only if they can be matched. That is, buy and sell orders are filled only if they can be matched with identical opposing sell and buy orders at the desired price. If an investor submits an order to buy shares but no matching sell order is posted, then the buy order is not filled. As you might expect, the liquidity of the market during extended hours is less than it is during the day. On the other hand, extended hours allow traders to respond to information that they receive after the official 4:00 p.m. market close. Extended hours allow U.S. securities markets to compete more effectively with foreign securities markets, in which investors can execute trades when U.S. markets are closed. ECNs were off limits to individual investors until 2003, but now both individuals and institutions can trade shares outside the traditional 9:30 to 4:00 trading day. For example, Nasdaq has its own extended-hours electronic-trading sessions from 4:00 a.m. to 9:30 a.m. and from 4:00 p.m. to 8:00 p.m.

Watch Your Behavior

 Overreacting to News A recent study found that when the prices of exchange-traded funds (ETFs) moved sharply during normal trading hours, those movements were often quickly reversed, suggesting that the initial move might have been caused by investors overreacting to news. During after-hours trading, the same pattern was not evident, suggesting that the traders who buy and sell after regular trading hours are less prone to overreaction.

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Regulation of Securities Markets

U.S. securities laws protect investors and participants in the financial marketplace. A number of state and federal laws require that investors receive adequate and accurate disclosure of information. Such laws also regulate the activities of participants in the securities markets. State laws that control the sale of securities within state borders are

Table 2.2 Important Federal Securities Laws

Act	Brief Description
Securities Act of 1933	Passed to ensure full disclosure of information about new security issues. Requires the issuer of a new security to file a registration statement with the Securities and Exchange Commission (SEC) containing information about the new issue. The firm cannot sell the security until the SEC approves the registration statement, which usually takes about 20 days. Approval of the registration statement by the SEC merely indicates that the facts presented in the statement appear to reflect the firm’s true position.
Securities Exchange Act of 1934	Formally established the SEC as the agency in charge of administering federal securities laws. The act gave the SEC the power to regulate the organized exchanges and the OTC market; their members, brokers, and dealers; and the securities traded in these markets.
Maloney Act of 1938	An amendment to the Securities Exchange Act of 1934, it provided for the establishment of trade associations to self-regulate the securities industry and led to the creation of the National Association of Securities Dealers (NASD). Today the Financial Industry Regulatory Authority (FINRA) has replaced the NASD as the industry’s only self-regulatory body.
Investment Company Act of 1940	Established rules and regulations for investment companies (e.g., mutual funds) and authorized the SEC to regulate their practices. It required investment companies to register with the SEC and to fulfill certain disclosure requirements.
Investment Advisors Act of 1940	Requires investment advisors, persons hired by investors to advise them about security investments, to disclose all relevant information about their backgrounds, conflicts of interest, and any investments they recommend. Advisors must register and file periodic reports with the SEC.
Securities Acts Amendments of 1975	Requires the SEC and the securities industry to develop a competitive national system for trading securities. First, the SEC abolished fixed-commission schedules, thereby providing for negotiated commissions. Second, it established the Intermarket Trading System (ITS), an electronic communications network linking 9 markets and trading over 4,000 eligible issues, which allowed trades to be made across these markets wherever the network shows a better price for a given issue.
Insider Trading and Act of 1988	Established penalties for insider trading. Insiders include anyone who obtains nonpublic information, typically a company’s directors, officers, major shareholders, bankers, investment bankers, accountants, and attorneys. The SEC requires corporate insiders to file monthly reports detailing all transactions made in the company’s stock. Recent legislation substantially increased the penalties for insider trading and gave the SEC greater power to investigate and prosecute claims of illegal insider-trading activity.
Regulation Fair Disclosure (2000)	Reg FD required companies to disclosure material information to all investors at the same time.
Sarbanes-Oxley Act of 2002	Passed to protect investors against corporate fraud, particularly accounting fraud. It created an oversight board to monitor the accounting industry, tightened audit regulations and controls, toughened penalties against executives who commit corporate fraud, strengthened accounting disclosure requirements and ethical guidelines for financial officers, established corporate board structure and membership guidelines, established guidelines for analyst conflicts of interest, and increased the SEC’s authority and budgets for auditors and investigators. The act also mandated instant disclosure of stock sales by corporate executives.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010	Passed in the wake of the 2007–2008 financial crisis. Its stated aim was to promote the financial stability of the United States by improving accountability and transparency. It created the Bureau of Consumer Financial Protection and other new agencies.

commonly called blue sky laws because they are intended to prevent investors from being sold nothing but “blue sky.” These laws typically establish procedures for regulating both security issues and sellers of securities doing business within the state. Most states have a regulatory body, such as a state securities commission, that is charged with enforcing the related state statutes. 

Table 2.2

 summarizes the most important securities laws enacted by the federal government (listed in chronological order).

The intent of these federal securities laws is to protect investors. Most of these laws were passed in response to some type of crisis or scandal in the financial markets. In recent decades, Congress passed two major laws in response to public concern over corporate financial scandals: The Sarbanes-Oxley Act of 2002 focuses on eliminating corporate fraud related to accounting and other information releases. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in the wake of the 2007–2008 financial crisis. It sought to improve the financial stability of the U.S. economy through improved accountability and transparency in the financial system. The act created new financial regulatory agencies and merged or eliminated some existing agencies. Both of these acts heightened the public’s awareness of 

ethics

—standards of conduct or moral judgment—in business. The government and the financial community are continuing to develop and enforce ethical standards that will motivate market participants to adhere to laws and regulations. Ensuring that market participants adhere to ethical standards, whether through law enforcement or incentives, remains an ongoing challenge.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 2.10 How are after-hours trades typically handled? What is the outlook for after-hours trading?

2. 2.11 Briefly describe the key requirements of the following federal securities laws:

a. Securities Act of 1933

b. Investment Company Act of 1940

c. Investment Advisors Act of 1940

d. Insider Trading and Fraud Act of 1988

e. Regulation Fair Disclosure (2000)

f. Sarbanes-Oxley Act of 2002

g. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Basic Types of Securities Transactions

1. LG 6

An investor can make a number of basic types of security transactions. Each type is available to those who meet the requirements established by government agencies as well as by brokerage firms. Although investors can use the various types of transactions in a number of ways to meet investment objectives, we describe only the most popular use of each transaction here, as we consider the long purchase, margin trading, and short selling.

Long Purchase

The 

long purchase

 is a transaction in which investors buy securities, usually in the hope that they will increase in value and can be sold at a later date for profit. The object, then, is to buy low and sell high. A long purchase is the most common type of transaction. Because investors generally expect the price of a security to rise over the period of time they plan to hold it, their return comes from any dividends or interest received during the ownership period, plus the difference (capital gain or loss) between the purchase and selling prices. Transaction costs, of course, reduce this return.

Ignoring dividends and transaction costs, we can illustrate the long purchase by a simple example. After studying Varner Industries, you are convinced that its common stock, which currently sells for $20 per share, will increase in value over the next few years. You expect the stock price to rise to $30 per share within two years. You place an order and buy 100 shares of Varner for $20 per share. If the stock price rises to, say, $40 per share, you will profit from your long purchase. If it drops below $20 per share, you will experience a loss on the transaction. Obviously, one of the major motivating factors in making a long purchase is an expected rise in the price of the security.

Margin Trading

Security purchases do not have to be made on a cash basis; investors can use funds borrowed from brokerage firms instead. This activity is referred to as 

margin trading

. It is used for one basic reason: to magnify returns. As peculiar as it may sound, the term margin refers to the amount of equity (stated as a percentage) in an investment, or the amount that is not borrowed. If an investor uses

75%

margin, for example, it means that 75% of the investment position is being financed with the person’s own funds and the balance (25%) with borrowed money.

The Federal Reserve Board (the “Fed”) sets the 

margin requirement

, specifying the minimum amount of equity that must be the margin investor’s own funds. The margin requirement for stocks has been at 50% for some time. By raising and lowering the margin requirement, the Fed can depress or stimulate activity in the securities markets. Brokers must approve margin purchases. The brokerage firm then lends the purchaser the needed funds and retains the purchased securities as collateral. It is important to recognize that margin purchasers must pay interest on the amount they borrow.

With the use of margin, you can purchase more securities than you could afford on a strictly cash basis and, thus, magnify your returns. However, the use of margin also presents substantial risks. Margin trading can only magnify returns, not produce them. One of the biggest risks is that the security may not perform as expected. If the security’s return is negative, margin trading magnifies the loss. Because the security being margined is always the ultimate source of return, choosing the right securities is critical to this trading strategy. In the next section, we will look at how margin trading can magnify returns and losses.

An Advisor’s Perspective

Ryan McKeown Senior VP—Financial Advisor, Wealth Enhancement Group

“Margin trading allows an investor to leverage up their investments.”

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Essentials of Margin Trading

Investors can use margin trading with most kinds of securities. They regularly use it, for example, to buy common and preferred stocks, most types of bonds, options, warrants, and futures. It is not normally used with tax-exempt municipal bonds because the interest paid on such margin loans is not deductible for income tax purposes. It is also possible to use margin on certain foreign stocks and bonds that meet prescribed criteria. Foreign stocks eligible for margin trading must trade on an exchange located in a FTSE Global Index recognized country (there are roughly 50 such countries), and the companies issuing the shares must have a market capitalization of at least $500 million. These stocks must have daily price quotations that are made available to a U.S. broker continuously via an electronic quote system, and they must have median daily trading volume of 100,000 shares or $500,000.

Magnified Profits and Losses

The idea of margin trading is to employ 

financial leverage

—the use of debt financing to magnify investment returns. Here is how it works: Suppose you have

$5,000

to invest and are considering the purchase of 100 shares of stock at $50 per share. If you do not margin, you can buy exactly 100 shares of the

Excel@Investing

Table 2.3 The Effect of Margin Trading on Security Returns

100

100

100

$5,000

$5,000

$5,000

$5,000

$8,000

$8,000

$8,000

−$5,000

−$5,000

−$5,000

$3,000

$3,000

$3,000

Value of stock

$2,000

$2,000

$2,000

Less: Cost of investment

−$5,000

−$5,000

−$5,000

−$5,000

−$3,000

−$3,000

−$3,000

Without Margin (100% Equity)	With Margins of
80%	65%					50%
*  Both the capital loss and the return on investor’s equity are negative, as noted by the parentheses.
Number of $50 shares purchased				100
Cost of investment							$5,000
Less: Borrowed money	−$    0	−$1,000	−$1,750	− $2,500
Equity in investment	$4,000	$3,250		$2,500
A. Investor’s position if price rises by $30 to $80/share
	Value of stock				$8,000
	Less: Cost of investment								−$5,000
Capital gain				$3,000
Return on investor’s equity (capital gain/equity in investment)	60%	75%	92.3%	120%
B. Investor’s position if price falls by $30 to $20/share
				$2,000
Capital loss *				−$3,000
Return on investor’s equity (capital loss/equity in investment) *	(60%)	(75%)	(92.3%)	(120%)

stock (ignoring brokerage commissions). If you margin the transaction—for example, at 50%—you can acquire the same $5,000 position with only $2,500 of your own money. This leaves you with $2,500 to use for other investments or to buy on margin another 100 shares of the same stock. Either way, by margining you will reap greater benefits from the stock’s price appreciation.

Table 2.3

 illustrates the concept of margin trading. It shows a nonmargined (100% equity) transaction, along with the same transaction using various margins. For simplicity, we assume here that the investor pays no interest on borrowed funds, but in reality investors do pay interest, and that would lower returns throughout Table 2.3. Remember that the margin rates indicate the investor’s equity in the investment. When the investment is not margined and the price of the stock goes up by $30 per share (see 
Table 2.3
, part A), the investor enjoys a very respectable 60% rate of return. However, observe how the rate of return goes up when margin is used. For example, consider an investor who buys 100 shares using 80% margin. This means that to pay for the $5,000 cost of the shares, the investor uses 80% of her own money ($4,000) and borrows 20% ($1,000) to pay for the rest. Now suppose that the stock price rises from $50 to $80 per share. The shares are worth $8,000, so the investor earns a $3,000 capital gain. The gain, relative to the investor’s initial investment of $4,000, represents a 75% rate of return. In other words, margin allowed the investor to earn 75% when the underlying stock only increased by 60%. It is in this sense that margin magnifies an investor’s rate of return. In part A of 
Table 2.3
, the rate of return ranges from 75% to 120%, depending on the amount of equity in the investment. The more the investor borrows, the greater her rate of return. This occurs because the dollar gain is the same ($3,000) regardless of how the investor finances the transaction. Clearly, as the investor’s equity in the investment declines (with lower margins), the rate of return increases accordingly. Given this example, you might ask why an investor would ever buy a stock without borrowing money. The answer is that trading on margin also magnifies losses. Look at part B of 
Table 2.3
. Suppose the investor uses 80% margin to buy 100 shares of the stock at $50 per share, but then the price of the stock falls to $20. In that case, the investor experiences a $3,000 capital loss. Relative to the initial $4,000 investment, the investor earns a −75% rate of return, whereas the decline in the stock price was just 60%.

Three important lessons about margin trading emerge from the table:

· Movements in the stock’s price are not influenced by the method used to purchase the stock.

· The lower the amount of the investor’s equity in the position, the greater the rate of return the investor will enjoy when the price of the security rises.

· The loss is also magnified when the price of the security falls (see 
Table 2.3
, part B).

Note that 
Table 2.3
 has an Excel@Investing icon. Throughout the text, tables with this icon indicate that the spreadsheet is available on 

http://www.myfinancelab.com

. The use of electronic spreadsheets in finance and investments, as well as in all functional areas of business, is pervasive. We use spreadsheets from time to time throughout the text to demonstrate how the content has been constructed or calculated. As you know, we include Excel spreadsheet exercises at the end of most chapters to give you practice with spreadsheets and help you develop the ability to clearly set out the logic needed to solve investment problems.

Advantages and Disadvantages

of Margin Trading

A magnified return is the major advantage of margin trading. The size of the magnified return depends on both the price behavior of the security and the amount of margin used. Another, more modest benefit of margin trading is that it allows for greater diversification of security holdings because investors can spread their limited capital over a larger number of investments.

The major disadvantage of margin trading, of course, is the potential for magnified losses if the price of the security falls. Another disadvantage is the cost of the margin loans themselves. A 

margin loan

 is the official vehicle through which the borrowed funds are made available in a margin transaction. All margin loans are made at a stated interest rate, which depends on prevailing market rates and the amount of money being borrowed. This rate is usually 1% to 3% above the 

prime rate

—the interest rate charged to creditworthy business borrowers. For large accounts, the margin loan rate may be at the prime rate. The loan cost, which investors pay, will increase daily, reducing the level of profits (or increasing losses) accordingly.

Making Margin Transactions

To execute a margin transaction, an investor must establish a 

margin account

 with a minimum of $2,000 in equity or 100% of the purchase price, whichever is less, in the form of either cash or securities. The broker will retain any securities purchased on margin as collateral for the loan.

The margin requirement established by the Federal Reserve Board sets the minimum amount of equity for margin transactions. Investors need not execute all margin transactions by using exactly the minimum amount of margin; they can use more than the minimum if they wish. Moreover, it is not unusual for brokerage firms and the major exchanges to establish their own margin requirements, which are more restrictive than those of the Federal Reserve. Brokerage firms also may have their own lists of especially volatile stocks for which the margin requirements are higher. There are basically two types of margin requirement: initial margin and maintenance margin.

Table 2.4 

Initial Margin

Requirements for Various Types of Securities

50%

50%

50%

Security	Minimum Initial Margin (Equity) Required
Listed common and preferred stock
Nasdaq OMX stocks
Convertible bonds
Corporate bonds	30%
U.S. government bills, notes, and bonds	10% of principal
U.S. government agencies	24% of principal
Options	Option premium plus 20% of market value of underlying stock
Futures	2% to 10% of the value of the contract

Initial Margin

The minimum amount of equity that must be provided by the investor at the time of purchase is the 

initial margin

. Because margin refers to the amount of equity in a trade, establishing a minimum margin requirement is equivalent to establishing a maximum borrowing limit. Initial margin requirements therefore place some restraint on how much risk investors can take through margin trading. All securities that can be margined have specific initial requirements, which the governing authorities can change at their discretion. 

Table 2.4

 shows initial margin requirements for various types of securities. The more stable investments, such as U.S. government issues, generally have substantially lower margin requirements and thus offer greater opportunities to magnify returns. Stocks traded on the Nasdaq OMX markets can be margined like listed securities.

As long as the margin in an account remains at a level equal to or higher than prevailing initial requirements, the investor may use the account in any way he or she wants. However, if the value of the investor’s holdings declines, the margin in his or her account will also drop. In this case, the investor will have what is known as a 

restricted account

, one whose equity is less than the initial margin requirement. It does not mean that the investor must put up additional cash or equity. However, as long as the account is restricted, the investor may not make further margin purchases and must bring the margin back to the initial level when securities are sold.

Maintenance Margin

The absolute minimum amount of margin (equity) that an investor must maintain in the margin account at all times is the 

maintenance margin

. When an insufficient amount of maintenance margin exists, an investor will receive a 

margin call

. This call gives the investor a short period of time, ranging from a few hours to a few days, to bring the equity up above the maintenance margin. If this doesn’t happen, the broker is authorized to sell enough of the investor’s margined holdings to bring the equity in the account up to this standard.

Margin investors can be in for a surprise if markets are volatile. When the Nasdaq stock market fell 14% in one day in early April 2000, brokerages made many more margin calls than usual. Investors rushed to sell shares, often at a loss, to cover their margin calls—only to watch the market bounce back a few days later.

The maintenance margin protects both the brokerage house and investors. Brokers avoid having to absorb excessive investor losses, and investors avoid being wiped out. The maintenance margin on equity securities is currently 25%. It rarely changes, although it is often set slightly higher by brokerage firms for the added protection of brokers and customers. For straight debt securities such as government bonds, there is no official maintenance margin except that set by the brokerage firms themselves.

The Basic Margin Formula

The amount of margin is always measured in terms of its relative amount of equity, which is considered the investor’s collateral. A simple formula can be used with all types of long purchases to determine the amount of margin in the transaction at any given time. Basically, only two pieces of information are required: (1) the prevailing market value of the securities being margined and (2) the 

debit balance

, which is the amount of money being borrowed in the margin loan. Given this information, we can compute margin according to 

Equation 2.1

.

Margin=Value of securities −Debit balanceValueofsecuritiesMargin = Value of securities − Debit balanceValue of securitiesEquation2.1

=V−DV=V−DVEquation2.1a

To illustrate, consider the following example. Assume you want to purchase 100 shares of stock at $40 per share at a time when the initial margin requirement is 70%. Because 70% of the transaction must be financed with equity, you can finance the (30%) balance with a margin loan. Therefore, you will borrow 0.30×$4,0000.30×$4,000, or $1,200. This amount, of course, is the debit balance. The remaining $2,800 needed to buy the securities represents your equity in the transaction. In other words, equity is represented by the numerator (V − D) in the margin formula.

What happens to the margin as the value of the security changes? If over time the price of the stock moves to $65, the margin is then

Margin=V−DV=$6,500−$1,200$6,500=0.815=81.5%––––––––––––––Margin = V−DV=$6,500−$1,200$6,500=0.815=81.5%__

Note that the margin (equity) in this investment position has risen from 70% to 81.5%. When the price of the security goes up, your margin also increases.

On the other hand, when the price of the security goes down, so does the amount of margin. For instance, if the price of the stock in our illustration drops to $30 per share, the new margin is only 60% [i.e., ($3,000−$1,200)÷$3,000($3,000−$1,200)÷$3,000]. In that case, we would be dealing with a restricted account because the margin level would have dropped below the prevailing initial margin of 70%.

Finally, note that although our discussion has been couched largely in terms of individual transactions, the same margin formula applies to margin accounts. The only difference is that we would be dealing with input that applies to the account as a whole—the value of all securities held in the account and the total amount of margin loans.

Return on Invested Capital

When assessing the return on margin transactions, you must take into account the fact that you put up only part of the funds. Therefore, you are concerned with the rate of return earned on only the portion of the funds that you provided. Using both current income received from dividends or interest and total interest paid on the margin loan, we can apply 

Equation 2.2

 to determine the return on invested capital from a margin transaction.

Return on invested capital from a margin transaction = Total current income received − Total interest paid on margin loan + Market value of securities at sale − Market value of securities at purchaseAmount of equity at purchaseReturn on invested capital from a margin transaction = Total current income received − Total interest paid on margin loan + Market value of securities at sale − Market value of securities at purchaseAmount of equity at purchaseEquation2.2

We can use this equation to compute either the expected or the actual return from a margin transaction. To illustrate: Assume you want to buy 100 shares of stock at $50 per share because you feel it will rise to $75 within six months. The stock pays $2 per share in annual dividends, and during your 6-month holding period, you will receive half of that amount, or $1 per share. You are going to buy the stock with 50% margin and will pay 10% interest on the margin loan. Therefore, you are going to put up $2,500 equity to buy $5,000 worth of stock that you hope will increase to

$7,500

in six months. Because you will have a $2,500 margin loan outstanding at 10% for six months, the interest cost that you will pay is calculated as $2,500×0.10×6÷12$2,500×0.10×6÷12 which is $125. We can substitute this information into 
Equation 2.2
 to find the expected return on invested capital from this margin transaction:

Return on invested capital from a margin transaction = $100−$125+$7,500−$5,000$2,500=$2,475$2,500=0.99=99%––––––––––Return on invested capital from a margin transaction = $100−$125+$7,500−$5,000$2,500=$2,475$2,500=0.99=99%__

Keep in mind that the 99% figure represents the rate of return earned over a 6-month holding period. If you wanted to compare this rate of return to other investment opportunities, you could determine the transaction’s annualized rate of return by multiplying by 2 (the number of six-month periods in a year). This would amount to an annual rate of return of 198% (i.e.,99×2=198)(i.e., 99 × 2 = 198).

Uses of Margin Trading

Investors most often use margin trading in one of two ways. As we have seen, one of its uses is to magnify transaction returns. The other major margin tactic is called pyramiding, which takes the concept of magnified returns to its limits. 

Pyramiding

 uses the paper profits in margin accounts to partly or fully finance the acquisition of additional securities. This allows investors to make such transactions at margins below prevailing initial margin levels, sometimes substantially so. In fact, with this technique it is even possible to buy securities with no new cash at all. Rather, they can all be financed entirely with margin loans. The reason is that the paper profits in the account lead to 

excess margin

—more equity in the account than required. For instance, if a margin account holds $60,000 worth of securities and has a debit balance of $20,000, it is at a margin level of 66.6% [i.e.,($60,000−$20,000)÷$60,000][i.e., ($60,000 − $20,000) ÷ $60,000]. This account would hold a substantial amount of excess margin if the prevailing initial margin requirement were only 50%.

The principle of pyramiding is to use the excess margin in the account to purchase additional securities. The only constraint—and the key to pyramiding—is that when the additional securities are purchased, your margin account must be at or above the prevailing required initial margin level. Remember that it is the account, not the individual transactions, that must meet the minimum standards. If the account has excess margin, you can use it to build up security holdings. Pyramiding can continue as long as there are additional paper profits in the margin account and as long as the margin level exceeds the initial requirement that prevailed when purchases were made. The tactic is somewhat complex but is also profitable, especially because it minimizes the amount of new capital required in the investor’s account.

In general, margin trading is simple, but it is also risky. Risk is primarily associated with possible price declines in the margined securities. A decline in prices can result in a restricted account. If prices fall enough to cause the actual margin to drop below the maintenance margin, the resulting margin call will force you to deposit additional equity into the account almost immediately. In addition, losses (resulting from the price decline) are magnified in a fashion similar to that demonstrated in 
Table 2.3
, part B. Clearly, the chance of a margin call and the magnification of losses make margin trading riskier than nonmargined transactions. Only investors who fully understand its operation and appreciate its pitfalls should use margin.

Short Selling

In most cases, investors buy stock hoping that the price will rise. What if you expect the price of a particular security to fall? By using short selling, you may be able to profit from falling security prices. Almost any type of security can be “shorted,” including common and preferred stocks, all types of bonds, convertible securities, listed mutual funds, options, and warrants. In practice, though, the short-selling activities of most investors are limited almost exclusively to common stocks and to options. (However, investors are prohibited from using short-selling securities that they already own to defer taxes, a strategy called shorting-against-the-box.)

The Basics of Short Selling Explained

Essentials of Short Selling

Short selling

 is generally defined as the practice of selling borrowed securities. Unusual as it may sound, selling borrowed securities is (in most cases) legal and quite common. Short sales start when an investor borrows securities from a broker and sells these securities in the marketplace. Later, when the price of the issue has declined, the short seller buys back the securities and then returns them to the lender. A short seller must make an initial equity deposit with the broker, subject to rules similar to those for margin trading. The deposit plus the proceeds from sale of the borrowed shares assure the broker that sufficient funds are available to buy back the shorted securities at a later date, even if their price increases. Short sales, like margin transactions, require investors to work through a broker.

Making Money When Prices Fall

Making money when security prices fall is what short selling is all about. Like their colleagues in the rest of the investment world, short sellers are trying to make money by buying low and selling high. The only difference is that they reverse the investment process: They start the transaction with a sale and end it with a purchase.

Table 2.5

 shows how a short sale works and how investors can profit from such transactions. (For simplicity, we ignore transaction costs.) The transaction results in a net profit of $2,000 as a result of an initial sale of 100 shares of stock at $50 per share (step 1) and subsequent covering (purchase) of the 100 shares for $30 per share (step 2). The amount of profit or loss generated in a short sale depends on the price at which the short seller can buy back the stock. Short sellers earn profits when the proceeds from the sale of the stock are higher than the cost of buying it back.

Who Lends the Securities?

Acting through their brokers, short sellers obtain securities from the brokerage firm or from other investors. (Brokers are the principal source of

Excel@Investing

Table 2.5 The Mechanics of a Short Sale

$5,000

$2,000

Step 1. Short sale initiated
100 shares of borrowed stock are sold at $50/share:
Proceeds from sale to investor
Step 2. Short sale covered
Later, 100 shares of the stock are purchased at $30/share and returned to broker from whom stock was borrowed:
Cost to investor	−$3,000
Net profit

borrowed securities.) As a service to their customers, brokers lend securities held in their portfolios or in street-name accounts. It is important to recognize that when the brokerage firm lends street-name securities, it is lending the short seller the securities of other investors. Individual investors typically do not pay fees to the broker for the privilege of borrowing the shares; in exchange, investors do not earn interest on the funds they leave on deposit with the broker.

Margin Requirements and Short Selling

To make a short sale, the investor must make a deposit with the broker that is equal to the initial margin requirement (currently 50%) applied to the short-sale proceeds. In addition, the broker retains the proceeds from the short sale.

To demonstrate, assume that you sell short 100 shares of Smart, Inc., at $50 per share at a time when the initial margin requirement is 50% and the maintenance margin on short sales is 30%. The values in lines 1 through 4 in column A in 

Table 2.6

 indicate that your broker would hold a total deposit of $7,500 on this transaction. Note in columns B and C that regardless of subsequent changes in Smart’s stock price, your deposit with the broker would remain at $7,500 (line 4).

By subtracting the cost of buying back the shorted stock at the given share price (line 5), you can find your equity in the account (line 6) for the current (column A) and two subsequent share prices (columns B and C). We see that at the initial short sale price of $50 per share, your equity would equal $2,500 (column A). If the share price subsequently drops to $30, your equity would rise to $4,500 (column B). If the share price subsequently rises to $70, your equity would fall to $500 (column C). Dividing these account equity values (line 6) by the then-current cost of buying back the stock

Famous Failures in Finance Short Sellers Tip 60 Minutes

On March 1, 2015, the television news program, 60 Minutes, ran a story alleging that Lumber Liquidators, a retail purveyor of home flooring products, was selling Chinese-made flooring that contained formaldehyde in concentrations that were up to 20 times greater than the legal limit in California. The day after the story was aired, Lumber Liquidators stock fell by 25%. Where did the producers at 60 Minutes get the idea to investigate Lumber Liquidators? Apparently Whitney Tilson, manager of the hedge fund Kase Capital, approached 60 Minutes after he had conducted his own investigation and concluded that Lumber Liquidators was indeed selling flooring products that did not meet regulatory standards. Prior to giving 60 Minutes the idea for the story, Tilson shorted 44,676 shares of Lumber Liquidators. Within days of the 60 Minutes program being aired, Tilson had earned a profit on his short sale of $1.4 million.

Table 2.6 Margin Positions on Short Sales

$5,000

$ 7,500

$2,500

50%

OK

A	B	C
Line	Item	Initial Short Sale Price	Subsequent Share Prices
*  Investor must either (a) deposit at least an additional $1,600 with the broker to bring the total deposit to $9,100 (i.e.,$7,500+$1,600)(i.e., $7,500+$1,600), which would equal the current value of the 100 shares of $7,000 plus a 30% maintenance margin deposit of $2,100 (i.e.,0.30×$7,000)(i.e., 0.30×$7,000) or (b) buy back the 100 shares of stock and return them to the broker.
1	Price per share	$ 50	$ 30	$ 70
2	Proceeds from initial short sale [(1)×100shares][(1)×100 shares]
3	Initial margin deposit [0.50×(2)][0.50×(2)]	$2,500
4	Total deposit with broker [(2)+(3)][(2)+(3)]	$7,500		$ 7,500
5	Current cost of buying back stock [(1)×100shares][(1)×100 shares]	$5,000	$3,000	$7,000
6	Account equity [(4)−(5)][(4)−(5)]	$ 4,500	$ 500
7	Actual margin [(6)÷(5)][(6)÷(5)]	150%	7.14%
8	Maintenance margin position [(7)>30%?][(7)>30%?]		OK	Margin call *

(line 5), we can calculate the actual margins at each share price (line 7). We see that at the current $50 price the actual margin is 50%, whereas at the $30 share price it is 150%, and at the $70 share price it is 7.14%.

As indicated in line 8, given the 30% maintenance margin requirement, your margin would be okay at the current price of $50 (column A) or lower (column B). But at the $70 share price, the 7.14% actual margin would be below the 30% maintenance margin, thereby resulting in a margin call. In that case (or whenever the actual margin on a short sale falls below the maintenance margin), you must respond to the margin call either by depositing additional funds with the broker or by buying the stock and covering (i.e., closing out) the short position.

If you wished to maintain the short position when the share price has risen to $70, you would have to deposit an additional $1,600 with the broker. Those funds would increase your total deposit to $9,100 (i.e.,$7,500+$1,600)(i.e., $7,500+$1,600)—an amount equal to the $7,000 value of the shorted stock plus the 30% maintenance margin, or $2,100. Buying back the stock to cover the short position would cost $7,000, thereby resulting in the return of the $500 of equity in your account from your broker. Clearly, margin requirements tend to complicate the short-sale transaction and the impact of an increase in the shorted stock’s share price on required deposits with the broker.

Advantages and Disadvantages

The major advantage of selling short is, of course, the chance to profit from a price decline. The key disadvantage of many short-sale transactions is that the investor faces limited return opportunities along with high-risk exposure. The price of a security can fall only so far (to zero or near zero), yet there is really no limit to how far such securities can rise in price. (Remember, a short seller is hoping for a price decline; when a security goes up in price, a short seller loses.) For example, note in 
Table 2.5
 that the stock in question cannot possibly fall by more than $50, yet who is to say how high its price can go?

A less serious disadvantage is that short sellers never earn dividend (or interest) income. In fact, short sellers owe the lender of the shorted security any dividends (or interest) paid while the transaction is outstanding. That is, if a dividend is paid during the course of a short-sale transaction, the short seller must pay an equal amount to the lender of the stock. (The mechanics of these payments are taken care of automatically by the short seller’s broker.)

Uses of Short Selling

Investors sell short primarily to seek speculative profits when they expect the price of a security to drop. Because the short seller is betting against the market, this approach is subject to a considerable amount of risk. The actual procedure works as demonstrated in 
Table 2.5
. Note that had you been able to sell the stock at $50 per share and later repurchase it at $30 per share, you would have generated a profit of $2,000 (ignoring dividends and brokerage commissions). However, if the market had instead moved against you, all or most of your $5,000 investment could have been lost.

Concepts in Review

Answers available at 
http://www.pearsonhighered.com/smart

1. 2.12 What is a long purchase? What expectation underlies such a purchase? What is margin trading, and what is the key reason why investors sometimes use it as part of a long purchase?

2. 2.13 How does margin trading magnify profits and losses? What are the key advantages and disadvantages of margin trading?

3. 2.14 Describe the procedures and regulations associated with margin trading. Be sure to explain restricted accounts, the maintenance margin, and the margin call. Define the term debit balance, and describe the common uses of margin trading.

4. 2.15 What is the primary motive for short selling? Describe the basic short-sale procedure. Why must the short seller make an initial equity deposit?

5. 2.16 What relevance do margin requirements have in the short-selling process? What would have to happen to experience a margin call on a short-sale transaction? What two actions could be used to remedy such a call?

6. 2.17 Describe the key advantages and disadvantages of short selling. How are short sales used to earn speculative profits?

MyFinanceLab

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know and where to go when you need to practice.

What You Should Know	Key Terms	Where to Practice
LG 1 Identify the basic types of securities markets and describe their characteristics. Short-term investments trade in the money market; longer-term securities, such as stocks and bonds, trade in the capital market. New security issues are sold in the primary market. Investors buy and sell existing securities in the secondary markets.	1. ask price  , p.  46 2. bear markets  , p.  48 3. bid price,  p.  46 4. broker market,  p.  44 5. bull markets,  p.  48 6. capital market,  p.  38 7. dealer market,  p.  44 8. designated market maker (DMM),  p.  46 9. dual listing,  p. 46 10. electronic communications network (ECN),  p.  48 11. fourth market,  p.  48 12. initial public offering (IPO),  p.  38 13. investment banker,  p.  41 14. market makers,  p.  44 15. money market,  p.  38	MyFinanceLab Study Plan 2.1
LG 2 Explain the initial public offering process. The first public issue of a company’s common stock is an IPO. The company selects an investment banker to sell the IPO. The lead investment banker may form a syndicate with other investment bankers and then create a selling group to sell the issue. The IPO process includes filing a registration statement with the Securities and Exchange Commission, getting SEC approval, promoting the offering to investors, pricing the issue, and selling the shares.	MyFinanceLab Study Plan 2.2
LG 3 Describe broker markets and dealer markets, and discuss how they differ from alternative trading systems. In dealer markets, buy/sell orders are executed by market makers. The market makers are securities dealers who “make markets” by offering to buy or sell certain securities at stated bid/ask prices. Dealer markets also serve as primary markets for both IPOs and secondary distributions. Over-the-counter transactions in listed securities take place in the third market. Direct transactions between buyers and sellers are made in the fourth market. Market conditions are commonly classified as “bull” or “bear,” depending on whether securities prices are generally rising or falling. Broker markets bring together buyers and sellers to make trades. Included are the New York Stock Exchange, the NYSE Amex, regional stock exchanges, foreign stock exchanges, options exchanges, and futures exchanges. In these markets the forces of supply and demand drive transactions and determine prices. These securities exchanges are secondary markets where existing securities trade.	1. over-the-counter (OTC) market,  p.  43 2. primary market,  p.  38 3. private placement,  p.  38 4. prospectus,  p.  39 5. public offering,  p.  38 6. red herring,  p.  39 7. rights offering,  p.  38 8. secondary distributions,  p.  47 9. secondary market,  p.  43 10. Securities and Exchange Commission (SEC),  p.  38 11. securities markets,  p.  38 12. selling group,  p.  41 13. third market,  p.  48 14. underwriting,  p.  41 15. underwriting syndicate,  p.  41	MyFinanceLab Study Plan 2.3
LG 4 Review the key aspects of the globalization of securities markets, and discuss the importance of international markets. Securities exchanges operate in over 100 countries—both large and small. Foreign security investments can be made indirectly by buying shares of a U.S.-based multinational with substantial foreign operations or by purchasing shares of a mutual fund that invests primarily in foreign securities. Direct foreign investment can be achieved by purchasing securities on foreign exchanges, by buying securities of foreign companies that are traded on U.S. exchanges, or by buying American depositary shares. International investments can enhance returns, but they entail added risk, particularly currency exchange risk.	1. American depositary receipts (ADRs),  p.  51 2. American depositary shares (ADSs),  p.  51 3. currency exchange rate,  p.  52 4. currency exchange risk,  p.  52 5. diversification,  p. 49 6. Yankee bonds,  p. 51	MyFinanceLab Study Plan 2.4 Video Learning Aid for Problem P2.3
LG 5 Discuss trading hours and the regulation of securities markets. Investors now can trade securities outside regular market hours (9:30 a.m. to 4:00 p.m., eastern time). Most after-hours markets are crossing markets, in which orders are filled only if they can be matched. Trading activity during these sessions can be quite risky. The securities markets are regulated by the federal Securities and Exchange Commission and by state commissions. The key federal laws regulating the securities industry are the Securities Act of 1933, the Securities Exchange Act of 1934, the Maloney Act of 1938, the Investment Company Act of 1940, the Investment Advisors Act of 1940, the Securities Acts Amendments of 1975, the  Insider Trading  and Fraud Act of 1988, the Sarbanes-Oxley Act of 2002, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.	1. crossing markets,  p.  53 2. ethics,  p.  55 3. insider trading,  p.  54	MyFinanceLab Study Plan 2.5
LG 6 Explain long purchases, margin transactions, and short sales. Most investors make long purchases—that is, they buy securities—in expectation of price increases. Many investors establish margin accounts to use borrowed funds to enhance their buying power. The Federal Reserve Board establishes the margin requirement—the minimum investor equity in a margin transaction. The return on capital in a margin transaction is magnified for both positive returns and negative returns. Paper profits can be used to pyramid a margin account by investing its excess margin. The risks of margin trading are the chance of a restricted account or margin call and the consequences of magnified losses due to price declines. Short selling is used when a decline in security prices is anticipated. It involves selling securities, typically borrowed from the broker, to earn a profit by repurchasing them at a lower price in the future. The short seller makes an initial equity deposit with the broker. If the price of a shorted stock rises, the investor may receive a margin call and must then either increase the deposit with the broker or buy back the stock to cover the short position. The major advantage of selling short is the chance to profit from a price decline. The disadvantages of selling short are the unlimited potential for loss and the fact that short sellers never earn dividend (or interest) income. Short selling is used primarily to seek speculative profits.	1. debit balance,  p.  60 2. excess margin,  p.  61 3. financial leverage,  p.  56 4. initial margin,  p.  59 5. maintenance margin,  p.  59 6. long purchase,  p.  55 7. margin account,  p.  58 8. margin call,  p.  59 9. margin loan,  p.  58 10. margin requirement,  p.  56 11. margin trading,  p.  56 12. prime rate,  p.  58 13. pyramiding,  p.  61 14. restricted account,  p.  59 15. short selling,  p.  62	MyFinanceLab Study Plan 2.6 Excel  Tables 2.3 ,  2.5 Video Learning Aid for Problem P2.19
Log into MyFinanceLab, take a chapter test, and get a personalized Study Plan that tells you which concepts you understand and which ones you need to review. From there, MyFinanceLab will give you further practice, tutorials, animations, videos, and guided solutions. Log into  http://www.myfinancelab.com

Investment Research and

Planning

1. LG 1

Facebook’s IPO Frenzy

Not too long ago, when investors wanted to buy or sell securities or to conduct research on different investment options, they called their full-service stockbrokers.

T

hose brokers charged relatively high (by today’s standards) commissions for processing customers’ orders, but they also had access to a great deal of information that was either very expensive or completely impossible for individual investors to acquire. The fees that customers paid compensated their brokers not only for executing trades but also for providing access to information and research.

Today the Internet is a major force in the investing environment. It offers an extremely low-cost means for executing trades and provides access to tools formerly restricted to professionals. With these tools you can find and process a wealth of information and trade many types of securities. This information ranges from real-time stock prices to securities analysts’ research reports to techniques for investment analysis. The time and money savings from online investing are huge. Instead of wading through reams of paper, you can quickly sort through vast databases to determine appropriate investments, make securities transactions to acquire your investments, and monitor the progress of your investments—all without leaving your computer. In this section, we introduce the wide range of options that you have for conducting investment research.

Getting Started in Investment Research

Although exceedingly valuable, the vast quantity of investment information available can be overwhelming and intimidating. The good news is that this chapter can help you begin to work through the maze of information and become a more informed investor. Educational sites are a good place to start. By mastering the basic concepts presented by these sites, you will be better prepared to identify the types of information that you will need to improve your investment decision-making skills.

Investment Education Sites

The Internet offers many articles, tutorials, and online classes to educate the novice investor. Even experienced investors can find sites that will expand their investing knowledge. Here are a few good sites that feature investing fundamentals.

· Investing Online Resource Center (

http://www.investingonline.org

) provides abundant information for those getting started online as well as those already investing. It includes an online quiz that, based on your answers, will categorize your readiness for trading. There is even an investment simulator that creates an interactive learning experience that allows the user to “test drive” online trading.

·

InvestorGuide.com

 (

http://www.investorguide.com

) offers InvestorGuide University, which is a collection of educational articles about investing and personal finance. In addition, the site provides access to quotes and charts, portfolio tracking software, research, news and commentary, and an extensive glossary of investment-related terms.

· The Motley Fool (

 http://www.fool.com

) has sections on investing basics, mutual fund investing, choosing a broker, and investment strategies and styles, as well as lively discussion boards and more.

· Investopedia (

 http://www.investopedia.com

) features tutorials on numerous basic and advanced investing and personal finance topics, a dictionary of investing terms, and other useful investment aids.

·

WSJ.com

 (

 http://www.wsj.com

), a free site from the Wall Street Journal, is an excellent starting place to learn what the Internet can offer investors.

· Nasdaq (

 http://www.nasdaq.com

) has both an Investing and a Personal Finance section that provide links to a number of investment education resources.

Other good educational resources include leading personal finance magazines such as Money, Kiplinger’s Personal Finance Magazine, and Smart Money.

Investment Tools

Once you are familiar with investing basics, you can begin to develop financial plans and set investment goals, find securities that meet your objectives, analyze possible investments, and organize your portfolio. Many tools once used only by professional investment advisors are now free online. You can find financial calculators and worksheets, screening and charting tools, and stock quotes and portfolio trackers at general financial sites and at the sites of larger brokerage firms. You can even set up a personal calendar that notifies you of forthcoming earnings announcements and can receive alerts when one of your stocks has hit a predetermined price target.

Planning

Online calculators and worksheets help you find answers to your financial planning and investing questions. Using them, you can determine how much to save each month for a particular goal, such as the down payment for your first home, a college education for your children, or a comfortable retirement at age 65. For example, the brokerage firm Fidelity has a number of planning tools: college planning, retirement planning, and research tools. One of the best sites for financial calculators is the Financial Industry Regulatory Authority (FINRA). It includes numerous tools that enable investors to perform tasks such as evaluating mutual funds, determining how much money to save for college expenses or retirement, or calculating the monthly payment on a loan. 

Figure 3.1 

shows the Tools & Calculators page of FINRA’s website. For example, if you click the Loan Calculator link, the site will ask you to submit a loan amount, an interest rate, and a term for the loan (in months), and then you simply click the CALCULATE button to find the monthly loan payment.

Screening

With screening tools, you can quickly sort through huge databases of stocks, bonds, and mutual funds to find those that have specific characteristics. For stocks, you can select stocks based on their price-to-earnings ratios, market capitalizations, dividend yields, revenue growth rates, debt-to-equity ratios, and many other characteristics. For bonds, you can create screens based on the bond issuer’s industry, as well as the bond’s maturity date or yield. For mutual funds, you might identify funds based on the required minimum investment, a particular industry or geographic sector, or the fees that a fund investor must pay. For example, one tool asks you to specify the type of stock or fund, performance criteria, cost parameters, or other characteristics and then it provides a list of securities that meet your investment criteria. Each screening tool uses a different method to sort. If necessary you can do additional research on the individual stocks, bonds, or mutual funds to determine which ones best meet your investment objectives.

Zacks Investment Research provides some of the best free tools on its website. 

Figure 3.2 

shows the opening page of Zacks “Stock Screener” and some of the ways you can sort stocks based on their characteristics. For example, you could identify a set of very large, dividend-paying companies by using the “Market Cap” item to select only those companies with a market capitalization (price per share times number of shares outstanding) greater than $100 billion and the “Div. Yield %” item

Figure 3.1 FINRA Tools & Calculators

At sites like 

http://www .finra.org

 you’ll find many tools and calculators that you can use to solve specific investment problems. Below is the Tools & Calculators screen from the Financial Industry Regulatory Authority’s website that offers several investment-related calculators.

(Source: ©2015 FINRA. All rights reserved. FINRA is a registered trademark of the Financial Industry Regulatory Authority, Inc. Reprinted with permission from FINRA.)

Figure 3.2 Zacks Stock Screener

Search for stocks based on a wide variety of characteristics such as a stock’s market capitalization, price/earnings ratio, and dividend yield. Zacks’s stock-screening tool will give you a list of stocks that meet your specifications.

(Source: Zacks, 

http://www.zacks .com

. ©Zacks Investment Research, Inc. Reprinted with permission.)

to include only those companies with a dividend yield greater than some small figure (say 0.25%).

Google

also offers a stock screener that allows you to select stocks based on dozens of characteristics and includes a graphic interface that shows the distribution of each characteristic (for example, the price/earnings ratio) across all of the stocks in Google’s database. You can search by entering numerical values for particular characteristics or selecting an upper or lower boundary from the distribution.

Yahoo!

Finance and Morningstar offer screening tools for stocks, mutual funds, and bonds.

Charting

Charting is a technique that plots the performance of securities over a specified time period, from a single day to a decade or longer. By creating charts, you can compare one company’s price performance to that of other companies, industries, sectors, or market indexes, over almost any time period. Several good sites are Yahoo! Finance (

 http://finance.yahoo.com

), Barchart (

 http://barchart .com

), BigCharts (

 http://bigcharts.marketwatch.com

), and Stock Charts (

 http://stockcharts.com

).

Stock Quotes and Portfolio Tracking

Almost every investment-related website includes stock quotations and portfolio-tracking tools. Simply enter the stock symbol to get the price, either in real time or delayed several minutes. Once you create a portfolio of stocks in a portfolio tracker, the tracker automatically updates your portfolio’s value every time you check. Usually, you can even link to more detailed information about each stock; many sites let you set up multiple portfolios. The features, quality, and ease of use of stock and portfolio trackers vary, so check several to find the one that meets your needs. Yahoo! Finance, MSN Money, and Morningstar have portfolio trackers that are easy to set up and customize.

An Advisor’s Perspective

Ryan McKeown Senior VP–Financial Advisor, Wealth Enhancement Group

“Technology on the Internet allows us to trade much faster.”

MyFinanceLab

Pros and Cons of the Internet as an Investment Tool

The power of the Internet as an investing tool is alluring. Do-it-yourself investing is readily available to the average investor, even to novices who have never before bought and sold securities. However, always remember that investing involves risk. Trading on the Internet requires that investors exercise the same caution as they would if they were getting information from and placing orders with a human broker. In fact, more caution is better because you don’t have the safety net of a live broker suggesting that you rethink your trade. The ease of point-and-click investing may tempt inexperienced investors to trade too often, thereby driving up their transaction costs. Drawn by stories of others who have made lots of money, many novice investors take the plunge before they acquire an understanding of both the risks and the rewards of investing—sometimes with disastrous results.

The basic rules for smart investing are the same whether you trade online or through a broker. Do your homework to be sure that you understand the risks of any investment that you make. Be skeptical. If an investment sounds too good to be true, it probably is. Always do your own research; don’t accept someone else’s word that a security is a good buy. Perform your own analysis before you buy, using the skills you will develop as you work through this text.

Investor Facts

Too Much of a Good Thing Researchers studied the investment performance of a group of individual investors who switched from trading by phone to trading online in the mid-1990s. As phone traders, these investors did very well, earning returns that were well above average. But after switching to online trading, they traded more often and more aggressively, generating much higher transactions costs in the process. As a result, their returns after going online dropped by roughly 5% per year.

(Source: Brad M. Barber & Terrance Odean. (2002). “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15(2), 455–487.)

Here is some additional advice:

· Don’t let the speed and ease of making transactions blind you to the realities of online trading. More frequent trades mean higher total transaction costs. Although some brokers advertise costs as low as $3 per trade, the average online transaction fee is higher (generally about $10 to $15). If you trade often, it will take longer to recoup your costs. Studies reveal that the more often you trade, the harder it is to beat the market. In addition, on short-term trades of less than one year, you’ll pay taxes on profits at the higher, ordinary income tax rates, not the lower capital gains rate.

· Don’t believe everything you read. It’s easy to be impressed with a screen full of data touting a stock’s prospects or to act on a hot tip you read on a discussion board or see on an investment-oriented television show. Ask yourself, what do I know about the person who is recommending this investment? When conducting your research, stick to the sites of major brokerage firms, mutual funds, academic institutions, and well-known business and finance publications.

· If you get bitten by the online buying bug, don’t be tempted to use margin debt to increase your stock holdings. As noted in 

Chapter 2 

, you may instead magnify your losses.

We will return to the subject of online investment fraud and scams and will discuss guidelines for online transactions in subsequent sections of this chapter.

Concepts in Review

Answers available at 

http://www.pearsonhighered.com/smart

1. 3.1 Discuss the impact of the Internet on the individual investor and summarize the types of resources it provides.

2. 3.2 Identify the four main types of online investment tools. How can they help you become a better investor?

3. 3.3 What are the pros and cons of using the Internet to choose and manage your investments?

Types and Sources of Investment Information

1. LG 2

As you learned in 

Chapter 1

, becoming a successful investor starts with developing investment plans and meeting your liquidity needs. Once you have done that, you can search for the right investments to implement your investment plan and monitor your progress toward your goals. Whether you use the Internet or print sources, you should examine various kinds of investment information to formulate expectations of the risk and return behaviors of possible investments. This section describes the key types and sources of investment information.

Investment information can be either descriptive or analytical. 

Descriptive information

 presents factual data on the past behavior of the economy, the market, the industry, the company, or a given investment. 

Analytical information

 presents projections and recommendations about possible investments based on current data. The sample page from Yahoo! Finance included in 

Figure 3.3

 provides descriptive and analytical information on

McDonald’s Corporation

. The figure highlights that McDonald’s is a very large company, with a market capitalization of nearly $93 billion (as of April 15, 2015), revenues in excess of $27 billion, and net income available to common stockholders (i.e., net profits) of $4.76 billion. Notice that McDonald’s stock has a beta of 0.76, which is less than the average stock’s beta of 1.0. Beta is an important measure of risk, specifically systematic or market risk, that we will discuss how to develop and use later in this text, but until then it is nice to know that various financial websites provide security betas online.

Some forms of investment information are free; others must be purchased individually or by annual subscription. You’ll find free information on the Internet, in newspapers, in magazines, at brokerage firms, and at public, university, and brokerage firm libraries. Alternatively, you can subscribe to free and paid services that provide periodic reports summarizing the investment outlook and recommending certain actions. Many Internet sites now offer free e-mail newsletters and alerts. You can even set up your own personalized home page at many financial websites so that stock quotes, portfolio tracking, current business news, and other information on stocks of interest to you appear whenever you visit the site or are sent automatically to you via e-mail. Other sites charge for premium content, such as brokerage research reports, whether in print or online.

Although free information is more widely available today than ever before, it may still make sense to pay for services that save you time and money by gathering and processing relevant investment information for you. But first consider the value of information: For example, paying $40 for information that increases your return by $27 would not be economically sound. The larger your investment portfolio, the easier it is to justify information purchases because they are usually applicable to a number of investments.

Figure 3.3 A Report Containing Descriptive Information

The Yahoo! Finance report on McDonald’s Corporation from April 15, 2015, contains descriptive information drawn from the company’s financial statements as well as the stock’s price performance.

(Source: Courtesy of Yahoo! Inc.)

Types of Information

Investment information can be divided into five types, each concerned with an important aspect of the investment process.

· Economic and current event information includes background and forecast data related to economic, political, and social trends on both domestic and global scales. Such information provides a basis for assessing the environment in which decisions are made.

· Industry and company information includes background and forecast data on specific industries and companies. Investors use such information to assess the outlook for a given industry or a specific company. Because of its company orientation, it is most relevant to stock, bond, or options investments.

· Information on alternative investments includes background and forecast data for securities other than stocks, bonds, and cash, such as real estate, private equity, and commodities.

· Price information includes price quotations on investment securities. These quotations are commonly accompanied by statistics on the recent price behavior of the security.

· Information on personal investment strategies includes recommendations on investment strategies or specific purchase or sale recommendations. In general, this information tends to be educational or analytical rather than descriptive.

Sources of Information

The discussion in this section focuses on the most common online and traditional sources of information on economic and current events, industries and companies, and prices, as well as other online sources. Beyond the discussion in this section, however, there are countless sources of investment information available to investors.

An Advisor’s Perspective

Mary Kusske President, Kusske Financial Management

“I want you to steer clear of the nighttime news.”

MyFinanceLab

Economic and Current Event Information

Investors who are aware of current economic, political, and business events tend to make better investment decisions. Popular sources of economic and current event information include financial journals, general newspapers, institutional news, business periodicals, government publications, and special subscription services. These are available in print and online versions; often the online versions are free but may have limited content. Most offer free searchable archives and charge a nominal fee for each article downloaded.

Financial Journals

The 
Wall Street Journal
 is the most popular source of financial news. Published daily Monday through Saturday in U.S., European, and Asian editions, the Journal also has an online version called WSJ Online, which is updated frequently throughout the day including the weekends. In addition to giving daily price quotations on thousands of investment securities, the Journal reports world, national, regional, and corporate news. Both the published and online versions of the WSJ contain a column called “Heard on the Street” that focuses on specific market and company events both in the United States and abroad. The WSJ also includes articles that address personal finance issues in the Family Finances section. WSJ Online includes features such as quotes and news that provide stock and mutual fund charting, company profiles, financials, and analyst ratings, article searches, special online-only articles, and access to the Dow Jones article archives.

A second popular source of financial news is 
Barron’s
 , which is published weekly. Barron’s generally offers lengthier articles on a variety of topics of interest to individual investors. Probably the most popular column in Barron’s is “Up & Down Wall Street,” which provides a critical, and often humorous, assessment of major developments affecting the stock market and business. Barron’s also includes current price quotations and a summary of statistics on a range of investment securities. Subscribers to WSJ Online also have access to Barron’s online edition because both are published by Dow Jones & Company (a subsidiary of Rupert Murdoch’s News Corporation).

Investor’s Business Daily is a third national business newspaper published Monday through Friday. It is similar to the Wall Street Journal but contains more detailed price and market data. Its website has limited free content. Another source of financial news is the Financial Times, with U.S., U.K., European, and Asian editions.

General Newspapers

Major metropolitan newspapers such as the New York Times, Washington Post, Los Angeles Times, and Chicago Tribune provide investors with a wealth of financial information in their print and online editions. Most major newspapers contain stock price quotations for major exchanges, price quotations on stocks of local interest, and a summary of the major stock market averages and indexes. Local newspapers are another convenient source of financial news. In most large cities, the daily newspaper devotes at least a few pages to financial and business news.

Another popular source of financial news is USA Today, the national newspaper published daily Monday through Friday. It is available in print and online versions. Each issue contains a “Money” section devoted to business and personal financial news and to current security price quotations and summary statistics. On Mondays the “Money” section publishes an interesting graphic showing the performance of different industry groups against the S&P 500 index.

Investor Facts

Beware the Spin Companies sometimes hire outside investor relations (IR) firms to help generate media coverage of their press releases. A recent study found that IR firms tend to “spin” company news by generating more media coverage when companies disclose favorable information, and that the spin created by IR firms increased the stock prices of their clients on days when press releases occurred. However, when these same IR clients released their earnings, a type of hard, quantitative news that is hard to spin, their stock returns were worse than those of companies that did not hire IR firms to help disseminate information.

(Source: “Selective Publicity and Stock Prices,” Journal of Finance, Vol. 67, Issue 2, pp. 599–638.)

Institutional News

The monthly economic letters of the nation’s leading banks, such as

Bank of America

(based in Charlotte, North Carolina), Northern Trust (Chicago), and

Wells Fargo

(San Francisco), provide useful economic information. Wire services such as Dow Jones, Bloomberg Financial Services, AP (Associated Press), and UPI (United Press International) provide economic and business news feeds to brokerages, other financial institutions, and websites that subscribe to them. Bloomberg has its own comprehensive site. Websites specializing in financial news include CNNMoney and MarketWatch.

Business Periodicals

Business periodicals vary in scope. Some present general business and economic articles, others cover securities markets and related topics, and still others focus solely on specific industries. Regardless of the subject matter, most business periodicals present descriptive information, and some also include analytical information. They rarely offer recommendations.

The business sections of general-interest periodicals such as Newsweek, Time, and U.S. News & World Report cover business and economic news. Strictly business- and finance-oriented periodicals, including Business Week, Fortune, and The Economist, provide more in-depth articles. These magazines also have investing and personal finance articles.

Some financial periodicals specialize in securities and marketplace articles. The most basic, commonsense articles appear in Forbes, Kiplinger’s Personal Finance, Money, Smart Money, and Worth. Published every two weeks, Forbes is the most investment oriented. Kiplinger’s Personal Finance, Money, Smart Money, and Worth are published monthly and contain articles on managing personal finances and on investments.

All these business and personal finance magazines have websites with free access to recent, if not all, content. Most include a number of other features. For example, Smart Money has interactive investment tools, including a color-coded “Market Map 1000” that gives an aerial view of 1,000 U.S. and international stocks so that you can see the sectors and stocks whose prices are rising (or falling).

Government Publications

A number of government agencies publish economic data and reports useful to investors. The annual Economic Report of the President, which can be found at the U.S. Government Printing Office, provides a broad view of the current and expected state of the economy. This document reviews and summarizes economic policy and conditions and includes data on important aspects of the economy.

The Federal Reserve Bulletin, published monthly by the Board of Governors of the Federal Reserve System, and periodic reports published by each of the 12 Federal Reserve District Banks provide articles and data on various aspects of economic and business activity. Visit 

http://www.federalreserve.gov

 to read many of these publications.

A useful Department of Commerce publication is the Survey of Current Business. Published monthly, it includes indicators and data related to economic and business conditions. A good source of financial statement information on all manufacturers, broken down by industry and asset size, is the 

Quarterly

Financial Report for U.S. Manufacturing, Mining, and Wholesale Trade Corporations published by the Department of Commerce.

Special

Subscription Services

Investors who want additional insights into business and economic conditions can subscribe to special services. These reports include business and economic forecasts and give notice of new government policies, union plans and tactics, taxes, prices, wages, and so on. One popular service is the Kiplinger Washington Letter, a weekly publication that provides a wealth of economic information and analyses.

Industry and Company Information

Of special interest to investors is information on particular industries and companies. Many trade magazines provide in-depth coverage of business trends in just one industry. Trade publications such as Chemical Week, American Banker, Computerworld, Industry Week, Oil and Gas Journal, and Public Utilities Fortnightly provide highly focused industry and company information. For example, Red Herring, CIO Magazine, Business 2.0, and Fast Company are magazines that can help you keep up with the high-tech world; all have good websites. Often, after choosing an industry in which to invest, an investor will want to analyze specific companies. General business periodicals such as Business Week, Forbes, the Wall Street Journal, and Fortune carry articles on the activities of specific industries and individual companies. In addition, company websites typically offer a wealth of information about the company—investor information, annual reports, filings, and financial releases, press releases, and more. 

Table 3.1 

presents several free and subscription resources that emphasize industry and company information.

Fair Disclosure Rules

In August 2000 the SEC passed the 

fair disclosure rule

, known as 

Regulation FD

, requiring senior executives to disclose material information such as earnings forecasts and news of mergers and new products simultaneously to investment professionals and the public via press releases or SEC filings. Companies may choose to limit contact with professional stock analysts if they are unsure whether the particular

Table 3.1 Online Sources for Industry and Company Information

Free

Free

	Website		Description	Cost
Hoover’s Online ( http://www.hoovers.com )	Reports and news on public and private companies with in-depth coverage of 43,000 of the world’s top firms.	Varies according to level of service
CNET ( http://news.cnet.com )	One of the best sites for high-tech news, analysis, and breaking news. Has great search capabilities and links.			Free
	Yahoo! Finance ( http://finance.yahoo.com )	Provides information on companies gathered from around the web: stock quotes, news, investment ideas, research, financials, analyst ratings, insider trades, and more.
Market Watch ( http://www.marketwatch.com )	Latest news from various wire services. Searchable by market or industry. Good for earnings announcements and company news.

information requires a press release. However, Regulation FD does not apply to communications with journalists and securities ratings firms like Moody’s Investors Service and Standard & Poor’s. In other words, firms may disclose information to members of the media without simultaneously disclosing it publicly via a press release. The law takes the view that the media has a mission to disclose the information that they learn from companies, not to trade on that information as analysts might. Violations of the rule carry injunctions and fines but are not considered fraud.

Stockholders’ Reports

An excellent source of data on an individual firm is the 

stockholders’ report

, or 

annual report

, published yearly by publicly held corporations. These reports contain a wide range of information, including financial statements for the most recent period of operation, along with summarized statements for several prior years. These reports are free and are usually also available on a company’s website. An excerpt from

AT&T

’s 2014 Annual Report appears in 

Figure 3.4

. These pages show AT&T’s growth rates and revenues for their different lines of business, and detailed financial statements are also available elsewhere in this report. If you don’t want to search for annual reports one company at a time, 

AnnualReports.com

 boasts having “the most complete and up-to-date listing of annual reports on the Internet.”

Tesla Motors 2014 Annual Meeting

In addition to the stockholders’ report, many serious investors review a company’s 

Form 10-K

, which is a statement that firms with securities listed on a securities exchange or traded in the OTC market must file annually with the SEC. Finding 10-K and other SEC filings is now a simple task, thanks to SEC/EDGAR (Electronic Data Gathering and Analysis Retrieval), which has reports filed by all companies traded on a major exchange. You can read them free either at the SEC’s website or at EDGAR’s FreeEdgar site.

Comparative Data Sources

Sources of comparative data, typically broken down by industry and firm size, are a good tool for analyzing the financial condition of companies. Among these sources are Dun & Bradstreet’s Key Business Ratios, RMA’s Annual Statement Studies, the Quarterly Financial Report for U.S. Manufacturing, Mining, and Wholesale Trade Corporations (cited earlier), and the Almanac of Business & Industrial

Figure 3.4 Pages from AT&T’s Stockholders’ Report

The excerpt from AT&T’s 2014 Annual Report quickly acquaints the investor with some key information on the firm’s operations over the past year.

(Source: AT&T annual report, 

http://www.att.com/gen/ investor-relations?pid=9186

, April 15, 2015.)

Financial Ratios. These sources, which are typically available in public and university libraries, provide useful benchmarks for evaluating a company’s financial condition.

Subscription Services

A variety of subscription services provide data on specific industries and companies. Generally, a subscriber pays a basic fee to access the service’s information and can also purchase premium services for greater depth or range. The major subscription services provide both descriptive and analytical information, but they generally do not make recommendations. Most investors, rather than subscribe to these services, access them through their stockbrokers or a large public or university library. The websites for most services offer some free information and charge for the rest.

The dominant subscription services are those offered by Standard & Poor’s, Bloomberg, Mergent, and Value Line. 

Table 3.2

 summarizes the most popular services of these companies. 

Standard & Poor’s Corporation (S&P)

 offers a large number of financial reports and services. Through its acquisition of Business Week, Bloomberg

Table 3.2 Popular Offerings of the Major Subscription Services

Annually with updates throughout the year

Monthly

Monthly

Subscription Service/Offerings	Coverage	Frequency of Publication
Standard & Poor’s Corporation (http://www.standardandpoors.com)
Corporation Records	Detailed descriptions of publicly traded securities of public corporations.		Annually with updates throughout the year
Stock Reports	Summary of financial history, current finances, and future prospects of public companies.
Stock Guide	Statistical data and analytical rankings of investment desirability for major stocks.			Monthly
Bond Guide	Statistical data and analytical rankings of investment desirability of bonds.
The Outlook	Analytical articles with investment advice on the economy, market, and investments.	Weekly magazine
Mergent (http://www.mergent.com)
Mergent’s Manuals	Eight reference manuals—Bank and Finance, Industrial, International, Municipal and Government, OTC Industrial, OTC Unlisted, Public Utility, and Transportation—with historical and current financial, organizational, and operational data on major firms.	Annually with monthly print updates (weekly online updates)
Handbook of Common Stocks	Common stock data on NYSE-listed companies.	Quarterly
Dividend Record	Recent dividend announcements and payments on publicly listed securities.	Twice weekly, with annual summary
Bond Record	Price and interest rate behavior of bond issues.
Value Line Investment Survey (http://www.valueline.com)
Includes three reports:	Weekly
Ratings and Reports	Full-page report including financial data, descriptions, analyses, and ratings for stocks.
Selection and Opinion	A 12- to 16-page report featuring a discussion of the U.S. economy and the stock market, sample portfolios for different types of investors, and an in-depth analysis of selected stocks.
Summary and Index	A listing of the most widely held stocks. Also includes a variety of stock screens.

offers an excellent resource for individual investors to complement its products for institutional investors. Although basic news and market commentary is free, Business Week subscribers obtain access to premium online services. Mergent (formerly Moody’s Financial Information Services Division) also publishes a variety of material, including its equity and bond portraits, corporate research, well-known reference manuals on eight industries, and numerous other products. The 
Value Line Investment Survey
 is one of the most popular subscription services used by individual investors. It is available at most libraries and provides online access to additional services including data, graphing, portfolio tracking, and technical indicators.

Brokerage Reports

Brokerage firms often make available to their clients reports from the various subscription services and research reports from their own securities analysts. They also provide clients with prospectuses for new security issues and 

back-office research reports

. As noted in 

Chapter 2

, a prospectus is a document that describes in detail the key aspects of the issue, the issuer, and its management and financial position. The cover of the preliminary prospectus describing the 2015 stock issue of Shake Shack is shown in 

Figure 2.1

. 

Back-office research reports

 include the brokerage firm’s analyses of and recommendations on prospects for the securities markets, specific industries, or specific securities. Usually a brokerage firm publishes lists of securities classified by its research staff as “buy,” “hold,” or “sell.” Brokerage research reports are available on request at no cost to existing and prospective clients.

Securities analysts’ reports are now available on the web, either from brokerage sites or from sites that consolidate research from many brokerages. At 

Reuters.com

, a leading research site, analysts’ reports on companies and industries from most brokerage and research firms are available. Investors can use Zacks’s Investment Research to find and purchase analyst reports on widely followed stocks or to read free brokerage report abstracts with earnings revisions and recommendations.

Investment Letters

Investment letters

 are newsletters that provide, on a subscription basis, the analyses, conclusions, and recommendations of experts in securities investment. Some letters concentrate on specific types of securities; others are concerned solely with assessing the economy or securities markets. Among the more popular investment letters are Blue Chip Advisor, Dick Davis Digest, The Dines Letter, Dow Theory Letters, and The Prudent Speculator. Most investment letters come out weekly or monthly. Advertisements for many of these investment letters can be found in Barron’s and in various business periodicals. The Hulbert Financial Digest monitors the performance of investment letters. It is an excellent source of objective information on investment letters and a good place to check out those that interest you.

Price Information

Price information about various types of securities is contained in their 

quotations

, which include current price data and statistics on recent price behavior. The web makes it easy to find price quotes for actively traded securities. Most of these sites ask you to locate a stock by entering its ticker symbol. 

Table 3.3

 lists the ticker symbols for some well-known companies.

Investors can easily find the prior day’s security price quotations in the published news media, both nonfinancial and financial. They also can find delayed or real-time quotations for free at numerous websites, including financial portals (described below), most business periodical websites, and brokerage sites. The website for CNBC TV has real-time stock quotes, as do sites that subscribe to their news feed.

Other Online Investment Information Sources

Many other excellent websites provide information of all sorts to increase your investment knowledge and skills. Let’s now

Table 3.3 Symbols for Some Well-Known Companies

Company

Symbol

	Company		Symbol
Amazon.com	AMZN	Lucent Technologies	LU
Apple	AAPL	McDonald’s Corporation	MCD
AT&T	T	Microsoft	MSFT
	Bank of America	BAC	Nike	NKE
Cisco Systems	CSCO	Oracle	ORCL
The Coca-Cola Company	KO	PepsiCo, Inc.	PEP
Dell	D EL L	Ralph Lauren	RL
Estee Lauder Companies	EL	Sears Holdings	SHLD
ExxonMobil	XOM	Starbucks	SBUX
FedEx	FDX	Target	TGT
General Electric	GE	Texas Instruments	TXN
Google	GOOG	Time Warner	TWX
Hewlett-Packard	HPQ	United Parcel Service	UPS
Intel	INTC	Walmart Stores	WMT
Int’l. Business Machines	IBM	Yahoo!	YHOO

look at financial portals, sites for bonds and mutual funds, international sites, and investment discussion forums. 

Table 3.4

 lists some of the most popular financial portals, bond sites, and mutual fund sites. We’ll look at online brokerage and investment advisor sites later in the chapter.

Financial Portals

Financial portals

 are supersites that bring together a wide range of investing features, such as real-time quotes, stock and mutual fund screens, portfolio trackers, news, research, and transaction capabilities, along with other personal finance features. These sites want to be your investing home page.

Some financial portals are general sites, such as Yahoo! Finance and Google Finance, that offer a full range of investing features along with their other services, or they may be investing-oriented sites. You should check out several to see which suits your needs because their strengths and features vary greatly. Some portals, to motivate you to stay at their site, offer customization options so that your start page includes the data you want. Although finding one site where you can manage your investments is indeed appealing, you may not be able to find the best of what you need at one portal. You’ll want to explore several sites to find the ones that meet your needs. 
Table 3.4
 summarizes the features of several popular financial portals.

Bond Sites

Although many general investment sites include bond and mutual fund information, you can also visit sites that specialize in these investments. Because individuals generally do not trade bonds as actively as they trade stocks, there are fewer resources focused on bonds for individuals. Some brokerage firms are starting to allow clients access to bond information that formerly was restricted to investment professionals. In addition to the sites listed in 
Table 3.4
, other good sites for bond and interest rate information include Bloomberg and the Wall Street Journal.

The sites of the major bond ratings agencies—Moody’s, Standard & Poor’s, and Fitch—provide ratings lists, recent ratings changes, and information about how they determine ratings.

Table 3.4 Popular Investment Websites

The following websites are just a few of the thousands of sites that provide investing information. Unless otherwise mentioned, all are free.

Website

Description

Financial Portals

Daily Finance (
http://dailyfinance.com
)

Includes investing and personal finance areas containing business news, market and stock quotes, stocks, mutual funds, investment research, retirement, saving and planning, credit and debt, banking and loans, and more.

MSN Money (
http://www.money.msn.com
)

More editorial content than many sites; good research and interactive tools. Can consolidate accounts in portfolio tracker.

Motley Fool (
http://www.fool.com
)

Comprehensive and entertaining site with educational features, research, news, and message boards. Model portfolios cover a variety of investment strategies. Free but offers premium services such as its Stock Advisor monthly newsletter for a fee.

Yahoo! Finance (
http://finance.yahoo.com
)

Simple design, content-rich; easy to find information quickly. Includes financial news, price quotes, portfolio trackers, bill paying, personalized home page, and a directory of other major sites.

Yodlee (
http://www.yodlee.com
)

Aggregation site that collects financial account data from banking, credit card, brokerage, mutual fund, mileage, and other sites. One-click access saves time and enables users to manage and interact with their accounts. Offers e-mail accounts; easy to set up and track finances. Security issues concern potential users; few analytical tools.

Bond Sites

Investing in Bonds (http://www.investinginbonds.com)

Developed by the Securities Industry and Financial Markets Association; good for novice investors. Bond education, research reports, historical data, and links to other sites. Searchable database.

BondsOnline (http://www.bondsonline.com)

Comprehensive site for news, education, free research, ratings, and other bond information. Searchable database. Some charges for newsletters and research.

CNN Money (
http://www.money.cnn.com
)

Individual investors can search for bond-related news, market data, and bond offerings.

Bureau of the Public Debt Online (
http://www.publicdebt.treas.gov
)

Run by U.S. Treasury Department. Information about U.S. savings bonds and Treasury securities. Can buy Treasury securities online through Treasury Direct program.

Mutual Fund Sites

Morningstar (
http://www.morningstar.com
)

Profiles mutual funds with ratings; screening tools, portfolio analysis and management; fund manager interviews, e-mail newsletters; educational sections. Advanced screening and analysis tools are available for a fee.

Mutual Fund Investor’s Center (
http://www.mfea.com
)

Not-for-profit, easy-to-navigate site from the Mutual Fund Education Alliance with investor education, search feature, and links to profiles of funds, calculators for retirement, asset allocation, and college planning.

Mutual Fund Observer (

Mutual Funds

)

A free, independent site offering information and analysis of mutual funds and the fund industry.

MAXfunds (
http://www.maxfunds.com
)

Offers several custom metrics and data points to help find the best funds and give investors tools other than past performance to choose funds. Covers more funds than any other on- or offline publication. MAXadvisor Powerfund Portfolios, a premium advisory service, is available for a fee.

IndexFunds.com
 (
http://www.indexfunds.com
)

Comprehensive site covering only index funds.

Personal Fund (

Home

)

Especially popular for its Mutual Fund Cost Calculator that shows the true cost of ownership, after fees, brokerage commissions, and taxes. Suggests lower-cost alternatives with similar investment objectives.

Mutual Fund Sites

With thousands of mutual funds, how do you find the ones that match your investment goals? The Internet makes this task much easier, offering many sites not tied to specific fund companies with screening tools and worksheets. Every major mutual fund family has its own site as well. Some allow visitors to hear interviews or participate in chats with fund managers. Fidelity has one of the most comprehensive sites, with educational articles, fund selection tools, fund profiles, and more. Portals and brokerage sites also offer these tools. 
Table 3.4
 includes some independent mutual fund sites that are worth checking out.

International Sites

The international reach of the Internet makes it a natural resource to help investors sort out the complexity of global investing, from country research to foreign currency exchange. Site-By-Site! International Investment Portal & Research Center is a comprehensive portal just for international investing. Free daily market data, news, economic insights, research, and analysis and commentary covering numerous countries and investment vehicles are among this site’s features. For more localized coverage, check out 

Euroland.com

, 

UK-Invest.com

, 

Latin-Focus.com

, and similar sites for other countries and regions. J P. Morgan provides a site devoted exclusively to American Depositary Receipts (ADRs), one of the most popular ways for investors to diversify their portfolios internationally. For global business news, the Financial Times gets high marks. Dow Jones’s MarketWatch has good technology and telecommunications news, as well as coverage of global markets.

Investment Discussion Forums

Investors can exchange opinions about their favorite stocks and investing strategies at the online discussion forums (message boards and chat rooms) found at most major financial websites. However, remember that the key word here is opinion. You don’t really know much about the qualifications of the person posting the information. Always do your own research before acting on any hot tips! The Motley Fool’s discussion boards are among the most popular, and Fool employees monitor the discussions. Message boards at Yahoo! Finance are among the largest online, although many feel that the quality is not as good as at other sites. The Raging Bull includes news and other links along with its discussion groups. Technology investors flock to Silicon Investor, a portal site whose high-tech boards are considered among the best.

Avoiding Scams

The ease with which information is available to all investors today makes it easier for scam artists and others to spread false news and manipulate information. Anyone can sound like an investment expert online, posting stock tips with no underlying substance. As mentioned earlier, you may not know the identity of the person touting or panning a stock on the message boards. The person panning a stock could be a disgruntled former employee or a short seller. For example, the ousted former chief executive of San Diego’s Avanir Pharmaceuticals posted negative remarks on stock message boards, adversely affecting the firm’s share price. The company sued and won a court order prohibiting him from ever posting derogatory statements about the company.

In the fast-paced online environment, two types of scams turn up frequently: “pump-and-dump” and “get-rich-quick” scams. In pump-and-dump scams, perpetrators buy select stocks and then falsely promote or hype the stocks to the public. The false promotion tends to push up the stock price, at which point the scam artist dumps the stock at an inflated price. In get-rich-quick scams, promoters sell worthless investments to naïve buyers.

One well-publicized pump-and-dump scam demonstrates how easy it is to use the Internet to promote stocks. In December 2011 the SEC charged Daniel Ruettiger, the man who inspired the film Rudy, in a pump-and-dump scam involving his company, Rudy Nutrition. Ruettiger’s company promoted a sports drink called “Rudy,” which was designed to compete with Gatorade. The SEC alleged that Ruettiger sent false e-mails claiming that his sports drink outperformed Gatorade and Powerade by a 2-to-1 margin in taste tests. The SEC further alleged that Ruettiger engaged in manipulative trading to artificially inflate his company’s stock price while selling unregistered securities to investors.

To crack down on cyber-fraud, in 1998 the SEC formed the Office of Internet Enforcement, which was merged into the Office of Market Intelligence in 2010. Its staff members quickly investigate reports of suspected hoaxes and prosecute the offenders. At 

http://www.sec.gov

, you can find specific instructions about how to spot and avoid Internet investment scams. Among other pieces of advice, the SEC recommends that you ask the following five key questions before making any investment.

· Is the seller licensed? Do some research on the background of the person recommending an investment to you. For example, you can investigate a broker’s background at FINRA.

· Is the investment registered? You can learn whether an investment is registered by searching the SEC’s EDGAR database.

· How do the risks compare with the potential rewards? Investment opportunities pitched as offering high potential returns without much risk are likely to be frauds.

· Do you understand the investment? A good rule of thumb, one followed even by sophisticated investors such as Warren Buffett, is to never invest in something that you do not understand.

· Where can you turn for help? The SEC urges investors to conduct investment research on the SEC’s website, as well as sites provided by FINRA and state securities regulators.

Asking these questions cannot ensure that you will never fall victim to an investment scam, but it tilts the odds in your favor.

Concepts in Review

Answers available at 

www.pearsonhighered.com/smart

1. 3.4 Differentiate between descriptive information and analytical information. How might one logically assess whether the acquisition of investment information or advice is economically justified?

2. 3.5 What popular financial business periodicals would you use to follow the financial news? General news? Business news? Would you prefer to get your news from print sources or online, and why?

3. 3.6 Briefly describe the types of information that the following resources provide.

a. Stockholders’ report

b. Comparative data sources

c. Standard & Poor’s Corporation

d. Mergent

e. Value Line Investment Survey

4. 3.7 How would you access each of the following types of information, and how would the content help you make investment decisions?

a. Prospectuses

b. Back-office research reports

c. Investment letters

d. Price quotations

5. 3.8 Briefly describe several types of information that are especially well suited to publication on the Internet. What are the differences between the online and print versions, and when would you use each?

Understanding Market Averages and Indexes

1. LG 3

The investment information we have discussed in this chapter helps investors understand when the economy is moving up or down and how individual investments have performed. You can use this and other information to formulate expectations about future investment performance. It is also important to know whether market behavior is favorable or unfavorable. The ability to interpret various market measures should help you to select and time investment actions.

A widely used way to assess the behavior of securities markets is to study the performance of market averages and indexes. These measures allow you to conveniently (1) gauge general market conditions; (2) compare your portfolio’s performance to that of a large, diversified (market) portfolio; and (3) study the market’s historical performance and use that as a guide to understand future market behavior. Here we discuss key measures of stock and bond market activity. In later chapters, we will discuss averages and indexes associated with other investment securities. Like price quotations, measures of market performance are available at many websites.

Stock Market Averages and Indexes

Stock market averages and indexes measure the general behavior of stock prices over time. Although the terms average and index tend to be used interchangeably when people discuss market behavior, technically they are different types of measures. 

Averages

 reflect the arithmetic average price behavior of a representative group of stocks at a given point in time. 

Indexes

 measure the current price behavior of a representative group of stocks in relation to a base value set at an earlier point in time.

Averages and indexes provide a convenient method of capturing the general mood of the market. Investors can also compare these measures at different points in time to assess the relative strength or weakness of the market. Current and recent values of the key averages and indexes are quoted daily on financial websites, in the financial news, in most local newspapers, and on many radio and television news programs.

The Dow Jones Averages

The S&P Dow Jones Indices prepares four different stock averages and several stock indexes. The most well known of these is the 

Dow Jones Industrial Average (DJIA)

. This average is made up of 30 stocks, most of which are issued by large, well-respected companies with long operating histories. The DJIA represents a broad sample of the U.S. economy and includes stocks from sectors such as technology, transportation, banking, energy, health care, consumer products, and many others. The DJIA is a price-weighted index, meaning that stocks with higher prices get more weight in the index than do stocks with lower prices.

Occasionally, a merger or bankruptcy causes a change in the makeup of the average. For example, Kraft Foods replaced American International Group (AIG) in September 2008 after AIG experienced a liquidity crisis and required an $85 billion credit facility from the U.S. Federal Reserve. Kraft was replaced in 2012 by UnitedHealth Group after Kraft announced plans to spin off its North American Grocery Business. Changes to the 30 stocks also occur when Dow Jones believes that the average does not reflect the broader market. In 2015, AT&T was dropped from the average in favor of Apple. In part this change reflected Apple’s tremendous growth. By 2015, Apple had become the largest U.S. company measured by its market capitalization. But Apple’s addition to the index was also influenced by the company’s decision in 2014 to split its stock 7-for-1. After the split, Apple’s stock price was roughly one-seventh of what it had been before the split when its shares traded for roughly $600 each. Because the Dow is a price-weighted index, a stock with a price as high as $600 would have a disproportionate influence on the index, so the index almost never includes companies with extremely high stock prices. When a new stock is added to the Dow, the average is adjusted so that it continues to behave in a manner consistent with the immediate past.

The value of the DJIA is calculated each business day by substituting the closing share prices of each of the 30 stocks in the DJIA into the following equation:

DJLA=ClosingsharepriceClosingsharepriceClosingshareprice++⋅⋅⋅+ofstock1ofstock2ofstock30DJLAdivisorDJLA=Closing share priceClosing share priceClosing share price++  ⋅⋅⋅  +of stock 1of stock 2of stock 30DJLA divisorEquation3.1

The value of the DJIA is merely the sum of the closing share prices of the 30 stocks included the Dow, divided by a “divisor.” The purpose of the divisor is to adjust for stock splits, company changes, or other events that have occurred over time. Without the divisor, whose calculation is very complex, the DJIA value would be totally distorted. The divisor makes it possible to use the DJIA to track the performance of the 30 stocks on a consistent basis over time. On April 15, 2015, the DJIA divisor was 0.14985889030177, and the sum of the closing prices of the Dow 30 stocks that day was 2,702.96. Using 

Equation 3.1

, you can divide the sum of the closing prices of the 30 industrials by the DJIA divisor and arrive at that day’s DJIA closing value of 18,036.70.

Because the DJIA results from summing the prices of the 30 stocks, higher-priced stocks tend to affect the index more than do lower-priced stocks. For example, a 5% change in the price of a $50 stock (i.e., $2.50) has less impact on the index than a 5% change in a $100 stock (i.e., $5.00) or a 5% change in a $600 stock (i.e., $30). Many experts argue that because the Dow is price weighted, it is not a particularly good indicator of the direction of the overall stock market. In spite of this and other criticisms leveled at the DJIA, it remains the most widely cited stock market indicator.

The actual value of the DJIA is meaningful only when compared to earlier values. For example, the DJIA on April 15, 2015, closed at 18,112.61. This value is meaningful only when compared to the previous day’s closing value of 18,036.70, a change of about 0.42%. Many people mistakenly believe that one DJIA “point” equals $1 in the value of an average share. Actually, 1 point currently translates into about 0.25 cents in average share value, but that figure varies widely over time.

Three other widely cited Dow Jones averages are the transportation, utilities, and composite. The Dow Jones Transportation Average is based on 20 stocks, including railroads, airlines, freight forwarders, and mixed transportation companies. The Dow Jones Utilities Average is computed using 15 public-utility stocks. The Dow Jones Composite Average is made up of the 30 industrials, the 20 transportations, and the 15 utilities. Like the DJIA, each of the other Dow Jones averages is calculated using a divisor to allow for continuity of the average over time. The transportation, utilities, and 65-stock composite are often cited along with the DJIA.

Dow Jones also publishes numerous indexes including the U.S. Total Stock Market Index, which tracks the performance of all equities with readily available prices. Dow Jones also publishes indexes for various sectors based on company size (e.g., large cap, mid cap, small cap) or industry. Dow Jones’s index products are not limited to U.S. markets. The company provides indexes that track the global equities market, developed and emerging stock markets, and regional markets in Asia, Europe, the Americas, the Middle East, and Africa.

Standard & Poor’s Indexes

Standard & Poor’s Corporation, another leading financial publisher, publishes six major common stock indexes. One oft-cited S&P index is the 

S&P 500 Stock Index,

 which is calculated each business day by substituting the closing market value of each stock (closing price × number of shares outstanding) into the following equation:

S & P 500 Index=Current closing market value of stock 1+Current closing market value of stock 2+…+Current closingmarket value of last stockDivisorS & P 500 Index=Current closing market value of stock 1+Current closing market value of stock 2 + …+ Current closing market value of last stockDivisorEquation3.2

The value of the S&P 500 Index is found by dividing the sum of the market values of all stocks included in the index by a divisor. The divisor is a number that serves two functions. First, it provides a scaling factor to make the index value easier to work with. The scaling factor works by measuring the current market value of stocks in the index relative to a base period value (for the S&P 500, the base period is 1941–1943). For example, the total market value of all stocks in the S&P 500 Index is several trillion dollars. No one wants to work with an index in the trillions, so the divisor brings the index value down to a more manageable value (for example, the S&P 500 Index value was 2,106.63 on April 15, 2015). The divisor’s second function is to adjust the index to account for changes in the composition of the S&P 500 stocks, such as when a company in the index is deleted due to a merger or bankruptcy and another company is added in its place. In these instances, the index value should not “jump” simply because the list of companies in the index changed. Likewise, certain corporate events such as new share issues or share repurchases can change the market value of a firm in the index. The divisor is calculated in a manner such that these events by themselves do not cause movement in the S&P 500 Index.

Investor Facts

Google Not “All in” S&P 500 Standard & Poor’s does not count all of a company’s shares as part of the S&P 500 Index if some shares are not publicly traded. For example, Google has a class of shares (Class B) with special voting rights that is not publicly traded and is held by the company’s founders, Sergey Brin and Larry Page. These shares are not counted in the S&P 500 Index calculation, so Google’s weight in the index is actually less than its true market capitalization.

Certain of the S&P indexes contain many more shares than the Dow averages do, and all of them are based on the market values (shares outstanding price per share) of the companies in the indexes rather than the share prices. Therefore, many investors feel that the S&P indexes provide a more broad-based and representative measure of general market conditions than do the Dow averages. Although some technical computational problems exist with these indexes, they are widely used—frequently as a basis for estimating the “market return,” an important concept that we introduce later.

Some of the widely followed stock indexes published by Standard & Poor’s are the following:

· The S&P 500 Index comprises 500 large companies (but not necessarily the largest 500).

· The S&P 100 Index comprises 100 large companies, each of which must have stock options available for investors to trade.

· The S&P 400 MidCap Index comprises 400 medium-sized companies, accounting for about 7% of the U.S. equity market.

· The S&P 600 SmallCap Index comprises 600 small-sized companies, accounting for about 3% of the U.S. equity market.

Figure 3.5The DJIA Average Compared to the S&P 500 Index from April 16, 2013, to April 15, 2015

During this period, both indexes followed a rising trend, with the DJIA gaining about 23% and the S&P 500 gaining about 34%.

(Source: Yahoo! Finance screenshot, 

http://www.finance.yahoo.com

.)

· The S&P Total Market Index comprises all stocks listed on the NYSE (including NYSE Arca and NYSE MKT) and Nasdaq (including NASDAQ Global Select Market, the NASDAQ Global Market, and the NASDAQ Capital Market).

Although the Dow Jones averages and S&P indexes tend to behave in a similar fashion over time, their day-to-day magnitude and even direction (up or down) can differ significantly because of the differences in how the indexes are constructed. 

Figure 3.5

 plots the performance of the DJIA and the S&P 500 from April 16, 2013, to April 15, 2015. During this period, both indexes followed a rising trend, with the DJIA gaining about 23% while the S&P 500 gained about 34%. This figure highlights that the two indexes do not move perfectly in sync, but they experience similar movements more often than not.

NYSE, NYSE MKT, and Nasdaq Indexes

Three indexes measure the daily results of the New York Stock Exchange (NYSE), the NYSE MKT Exchange (formally the American Stock Exchange), and the National Association of Securities Dealers Automated Quotation (Nasdaq) system. Each reflects the movement of stocks listed on its exchange.

Famous Failures in Finance PIIGS Feast on Wall Street

In the summer of 2011 an economic crisis gripped Europe, particularly Portugal, Italy, Ireland, Greece, and Spain, the so-called PIIGS nations. Their fiscal problems made investors doubt that governments would be able to repay their debts without massive cuts in government spending, and investors feared that deep budget cuts might trigger a recession that might sweep across the globe. The DJIA fell by nearly 15% in less than two weeks before a series of rescue packages from the European Union nations reassured investors, at least temporarily. That story repeated itself on a smaller scale in October 2014 when the Dow fell 5.2% over a span of less than two weeks.

The 

NYSE Composite Index

 includes about 1,900 or so stocks listed on the “Big Board.” In addition to the composite index, the NYSE publishes indexes for financial and other subgroups. The behavior of the NYSE composite index is normally similar to that of the DJIA and the S&P 500 indexes. The NYSE MKT Composite Index reflects the price of all shares traded on the NYSE MKT Exchange. Although it does not always closely follow the S&P and NYSE indexes, the NYSE MKT index tends to move in the general direction they do.

The 

Nasdaq Stock Market indexes

 reflect Nasdaq stock market activity. The most comprehensive of the Nasdaq indexes is the composite index, which is calculated using the almost 3,000 common stocks traded on the Nasdaq stock market. The index includes other types of securities such as real estate investment trusts (REITs) and American Depositary Receipts. Also important is the Nasdaq 100, which includes 100 of the largest domestic and international nonfinancial companies listed on Nasdaq. The other two commonly quoted Nasdaq indexes are the biotech and computer 

indexes

. The Nasdaq indexes tend to move in the same direction at the same time as the other major indexes, but movements in Nasdaq indexes are often sharper than those of the other major indexes. The companies listed on the Nasdaq tend to be smaller and operate in riskier industries (such as technology) than those included in indexes such as the DJIA and the S&P 500.

Value Line Indexes

Value Line publishes a number of stock indexes constructed by equally weighting the price of each stock included. This is accomplished by considering only the percentage changes in stock prices. This approach eliminates the effects of varying market price and total market value on the relative importance of each stock in the index. The 

Value Line Composite Index

 includes the nearly 1,700 stocks in the Value Line Investment Survey that are traded on the NYSE, NYSE MKT, and OTC markets. In addition to its composite index, Value Line publishes other specialized indexes.

Other Averages and Indexes

A number of other indexes are available. Frank Russell Company, a pension advisory firm, publishes three primary indexes. The Russell 1000 includes the 1,000 largest companies, the most widely quoted Russell 2000 includes 2,000 small to medium-sized companies, and the Russell 3000 includes all 3,000 companies in the Russell 1000 and 2000.

In addition, the Wall Street Journal publishes a number of global and foreign stock market indexes. Included are Dow Jones indexes for countries in the Americas, Europe, Africa, Asia, and the Pacific region. About 35 foreign stock market indexes are also given for major countries, including a World Index and the Europe/Australia/Far East (EAFE MSCI) Index. Like the purely domestic averages and indexes, these international averages and indexes measure the general price behavior of the stocks that are listed and traded in the given market. Useful comparisons of the market averages and indexes over time and across markets are often made to assess both trends and relative strengths of foreign markets throughout the world.

Bond Market Indicators

A number of indicators are available for assessing the general behavior of the bond markets. However, there are fewer indicators of overall bond market behavior than of stock market behavior. In part this is because many bonds do not trade as actively as stocks do. Even so, it is not hard to find several useful measures related to bond-market performance. The key measures of overall U.S. bond market behavior are bond yields and bond indexes.

Famous Failures in Finance Bond Yields Hit Historic Lows

Concerns about disappointing retail sales in the U.S economy pushed the yield on the 30-year U.S. Treasury bond to a record low of 2.395% in January 2015. Investors who purchased Treasury bonds at these yields earned almost nothing, so why would they invest? One answer is safety. Investors have long viewed U.S. Treasury bonds as the safest investment in the world, so when fears of a recession or other economic crisis grip the market, investors will buy Treasury bonds even if the return that they offer is barely above zero. Monetary policy may also push interest rates down when policy makers want to encourage investors to hold riskier assets. An extreme example of this occurred in the spring of 2015 when government bonds in countries such as Switzerland, Germany, and Denmark were sold with negative yields. Investors who bought these bonds were paying the government for the privilege to hold their bonds.

Bond Yields

A 

bond yield

 is the return an investor would receive on a bond if it were purchased and held to maturity. Bond yields are reported as annual rates of return, and they reflect both the interest payments that bond investors receive as well as any gain or loss in the bond’s value from the date the bond is purchased until it is redeemed. For example, a bond with a yield of 5.50% would provide its owner with a total return (including interest and capital gains or losses) that would be equivalent to a 5.50% annual rate of earnings on the amount invested (i.e., the bond’s purchase price), if the bond were purchased and held to maturity.

Typically, bond yields are quoted for a group of bonds that are similar with respect to type and quality. For example, Barron’s quotes the yields on the Dow Jones bond averages of 10 high-grade corporate bonds, 10 medium-grade corporate bonds, and a confidence index that is calculated as a ratio of the high-grade to medium-grade indexes. In addition, like the Wall Street Journal, it quotes numerous other bond indexes and yields, including those for Treasury and municipal bonds. Similar bond yield data are available from S&P, Moody’s, and the Federal Reserve. Like stock market averages and indexes, bond yield data are especially useful when viewed over time.

Bond Indexes

There is a variety of bond indexes. The 

Dow Jones Corporate Bond Index

, which is an equal-weighted index of U.S.-issued corporate bonds, includes 96 bonds—48 industrial, 36 financial, and 12 utility bonds. It reflects the simple mathematical average of the closing prices for the bonds. Dow Jones’s stated objective for the index is to represent the market performance, on a total-return basis, of investment-grade bonds issued by leading U.S. companies and to minimize the pricing and liquidity problems associated with most corporate bond indexes. The index is published daily in the Wall Street Journal and summarized weekly in Barron’s.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 3.9 Describe the basic philosophy and use of stock market averages and indexes. Explain how the behavior of an average or index can be used to classify general market conditions as bull or bear.

2. 3.10 List each of the major averages or indexes prepared by (a) Dow Jones & Company and (b) Standard & Poor’s Corporation. Indicate the number and source of the securities used in calculating each average or index.

3. 3.11 Briefly describe the composition and general thrust of each of the following indexes.

a. NYSE Composite Index

b. NYSE MKT Composite Index

c. Nasdaq Stock Market indexes

d. Value Line Composite Index

4. 3.12 Discuss each of the following as they are related to assessing bond market behavior.

a. Bond yields

b. Bond indexes

Making Securities Transactions

1. LG 4

2. LG 5

Now that you know how to find information to help you locate attractive security investments, you need to understand how to make securities transactions. Whether you decide to start a self-directed online investment program or to use a traditional stockbroker, you must first open an account with a brokerage service. In this section, we will look at the role stockbrokers play and how that role has changed in recent years. We will also explain the basic types of orders you can place, the procedures required to make regular and online securities transactions, the costs of investment transactions, and investor protection.

The Role of Stockbrokers

Stockbrokers

—also called account executives, investment executives, and financial consultants—act as intermediaries between buyers and sellers of securities. They typically charge a commission to facilitate these securities transactions. Stockbrokers must be licensed by both the SEC and the securities exchanges, and they must follow the ethical guidelines of those bodies.

Although the procedures for executing orders in different stock markets may vary, stock trades often start the same way: An investor places an order with his or her stockbroker. The broker works for a brokerage firm that maintains memberships on the securities exchanges, and members of the securities exchange execute orders that the brokers in the firm’s various sales offices transmit to them. For example, one of the largest U.S. brokerage firms, Bank of America’s

Merrill Lynch

, transmits orders for listed securities from its offices in most major cities throughout the country to the main office of Merrill Lynch and then to the floor of an exchange, such as the NYSE, where Merrill Lynch exchange members execute the orders. Confirmation of the order goes back to the broker placing the order, who relays it to the customer. This process can take a matter of seconds with the use of sophisticated telecommunications networks and Internet trading.

For securities transactions in markets such as Nasdaq, brokerage firms typically transmit orders to market makers. Normally, these transactions are executed rapidly, since there is considerable competition among dealers for the opportunity to execute brokerage orders. The revenue that market makers generate from executing orders is offset by the cost of maintaining inventories of the securities in which they deal.

Brokerage Services

The primary activity of stockbrokers is to route clients’ buy and sell orders to the markets where they will be executed at the best possible price. The speed with which brokers can get clients’ orders executed is enhanced by the fact that brokerage firms typically hold their clients’ security certificates for safekeeping. Securities kept by the firm in this manner are held in 

street name

. Because the brokerage house issues the securities in its own name and holds them in trust for the client (rather than issuing them in the client’s name), the firm can transfer the securities at the time of sale without the client’s signature. Street name is actually a common way of buying securities because most investors do not want to be bothered with the handling and safekeeping of stock certificates. In such cases, the brokerage firm records the details of the client’s transaction and keeps track of his or her investments through a series of bookkeeping entries. Dividends and notices received by the broker are forwarded to the client who owns the securities.

In addition to order routing and certificate storage, stockbrokers offer clients a variety of other services. For example, the brokerage firm normally provides free information about investments. Quite often, the firm has a research staff that periodically issues reports on economic, market, industry, or company behavior and makes recommendations to buy, sell, or hold certain securities. Clients also receive a statement describing their transactions for the month and showing commission and interest charges, dividends and interest received, and detailed listings of their current holdings.

Today most brokerage firms invest surplus cash left in a client’s account in a money market mutual fund, allowing the client to earn a reasonable rate of interest on these balances. Such arrangements help the investor earn as much as possible on temporarily idle funds.

Types of Brokerage Firms

Just a few years ago, there were three distinct types of brokerage firm: full-service, premium discount, and basic discount. No longer are the lines between these categories clear-cut. Most brokerage firms, even the most traditional ones, now offer online services. And many discount brokers now offer services, like research reports for clients, that were once available only from a full-service broker.

The traditional broker, or 

full-service broker

, in addition to executing clients’ transactions, offers investors a full array of brokerage services: providing investment advice and information, holding securities in street name, offering online brokerage services, and extending margin loans.

Investors who wish merely to make transactions and are not interested in taking advantage of other services should consider either a premium or basic discount broker.

Premium discount brokers

 focus primarily on making transactions for customers. They charge low commissions and provide limited free research information and investment advice. The investor visits the broker’s office, calls a toll-free number, or accesses the broker’s website to initiate a transaction. The broker confirms the transaction in person or by phone, e-mail, or regular mail. Premium discount brokers like

Charles Schwab

, the first discount broker, now offer many of the same services that you’d find at a full-service broker. Other premium discounters are similar.

Basic discount brokers

, also called online brokers or electronic brokers, are typically deep-discount brokers through whom investors can execute trades electronically online via a commercial service, on the Internet, or by phone. The investor accesses the basic discount broker’s website to open an account, review the commission schedule, or see a demonstration of the available transactional services and procedures. Confirmation of online trades can take mere seconds, and most trades occur within one minute. Most basic discount brokers operate primarily online but also provide telephone and live broker backup in case there are problems with the website or the customer is away from his or her computer. In response to the rapid growth of online investors, most brokerage firms now offer online trading. These firms usually charge higher commissions when live broker assistance is required.

Table 3.5 Select Full-Service, Premium Discount, and Basic Discount Brokers

Bank of America

Full-Service Broker	Premium Discount Broker	Basic Discount Broker
Morgan Stanley	Firstrade
Merrill Lynch	Charles Schwab	Scottrade
UBS Financial Services	E*Trade	Thinkorswim
Wells Fargo	Fidelity.com	TradeKing
TD Ameritrade	Wall Street*E
Wells Trade

The rapidly growing volume of business done by both premium and basic discount brokers attests to their success. Today, many full-service brokers, banks, and savings institutions are making discount and online brokerage services available to their customers and depositors who wish to buy stocks, bonds, mutual funds, and other investment securities. Some of the full-service, premium discount, and basic discount brokers are listed in 

Table 3.5

. (Brokerage Review (

http://brokerage-review.com

) is a good online source for finding the right brokerage service to fit your needs.)

The SEC’s Advice on Selecting a Broker

Selecting a Stockbroker

If you decide to start your investing activities with the assistance of either a full-service or premium discount stockbroker, select the person you believe best understands your investment goals. Choosing a broker whose disposition toward investing is similar to yours is the best way to establish a solid working relationship. Your broker should also make you aware of investment possibilities that are consistent with your objectives and attitude toward risk.

You should also consider the cost and types of services available from the firm with which the broker is affiliated, in order to receive the best service at the lowest possible cost to you. The premium discount brokerage service is primarily transactional, and the basic discount brokerage service is purely transactional. Contact with a broker for advice or research assistance is generally only available at a higher price. Investors must weigh the added commissions they pay a full-service broker against the value of the advice they receive because the amount of available advice is the only major difference among the three types of brokers.

Referrals from friends or business associates are a good way to begin your search for a stockbroker. (Don’t forget to consider the investing style and goals of the person making the recommendation.) However, it is not important—and often not even advisable—to know your stockbroker personally. In this age of online brokers, you may never meet your broker face to face. A strictly business relationship eliminates the possibility that personal concerns will interfere with the achievement of your investment goals. For an example of how a stockbroker got into trouble through a personal relationship with a friend, see the following Famous Failures in Finance feature.

Your broker’s main interest should not be commissions. Responsible brokers do not engage in 

churning

—that is, causing excessive trading of their clients’ accounts to increase commissions. Churning is both illegal and unethical under SEC and exchange rules, although it is often difficult to prove.

Opening an Account

To open an account, you will fill out various forms that establish a legal relationship between you and the brokerage firm. The stockbroker should have

Famous Failures in Finance Hello, I Am Tim, an Insider Trader

In May 2012 the SEC charged stockbroker Timothy McGee with using inside information to buy shares in Philadelphia Consolidated Holding Corporation (PHLY) just before the company was acquired by Tokio Marine. McGee purchased 10,250 shares of PHLY for less than $39 per share. One day later, after Tokio announced its plan to buy the company, PHLY’s stock price jumped to almost $60, leaving Mr. McGee with a profit of more than $200,000. In addition, federal prosecutors alleged that McGee passed along information about the acquisition to a friend, who also bought Philadelphia Consolidated stock.

McGee learned about the impending takeover after attending an Alcoholics Anonymous meeting with a friend who was an executive at PHLY. In its indictment, the SEC claimed that McGee owed the executive “fiduciary and other duties of trust and confidence” stemming from their long friendship through Alcoholics Anonymous. To obtain an insider trading conviction, the government would have to prove that the person conveying the information and the person receiving it had a history of maintaining confidentiality regarding other personal or professional matters. This point is crucial because it is not illegal to trade based on material, nonpublic information unless doing so involves a breach of fiduciary duty to someone or a breach of trust and confidence. For the first time, the government hoped to prove that such a breach had occurred based on a shared membership in Alcoholics Anonymous.

(Source: Based on Alan Farnham, “Insider Trading Case Involves Secrets Shared Among AA Members,” March 15, 2012, 

http://abcnews.com

.)

Critical Thinking Question

1. Suppose you are on an airplane and you overhear two executives of a company talking about a merger that is about to take place. If you buy stock based on what you overheard, are you committing insider trading?

a reasonable understanding of your personal financial situation to assess your investment goals—and to be sure that you can pay for the securities purchased. You also provide the broker with instructions regarding the transfer and custody of securities. Customers who wish to borrow money to make transactions must establish a margin account (described following). If you are acting as a custodian, a trustee, an executor, or a corporation, the brokerage firm will require additional documents.

Investors may have accounts with more than one stockbroker. Many investors establish accounts at different types of firms to obtain the benefit and opinions of a diverse group of brokers and to reduce their overall cost of making buy and sell transactions.

Next you must select the type of account best suited to your needs. We will briefly consider several of the more popular types.

Single or Joint

A brokerage account may be either single or joint. Joint accounts are most common between husband and wife or parent and child. The account of a minor (a person younger than 18 years) is a 

custodial account

, in which a parent or guardian must be part of all transactions. Regardless of the form of the account, the name(s) of the account holder(s) and an account number are used to identify it.

Cash or Margin

A 

cash account

, the more common type, is one in which the customer can make only cash transactions. Customers can initiate cash transactions via phone or online and are given three business days in which to transmit the cash to the brokerage firm. The firm is likewise given three business days in which to deposit the proceeds from the sale of securities in the customer’s cash account.

A 

margin account

 is an account in which the brokerage firm extends borrowing privileges to a creditworthy customer. By leaving securities with the firm as collateral, the customer can borrow a prespecified proportion of the securities’ purchase price. The brokerage firm will, of course, charge the customer a stated rate of interest on borrowings.

Wrap

The 

wrap account

 (also called a managed account) allows brokerage customers with large portfolios (generally $100,000 or more) to shift stock selection decisions conveniently to a professional money manager, either in-house or independent. In return for a flat annual fee, commonly between 1% and 3% of the portfolio’s total asset value, the brokerage firm helps the investor select a money manager, pays the manager’s fee, and executes the money manager’s trades. Initially the investor, broker, and/or manager discuss the client’s overall goals.

Wrap accounts are appealing for a number of reasons other than convenience. The annual fee in most cases covers commissions on all trades, virtually eliminating the chance of the broker churning the account. In addition, the broker monitors the manager’s performance and provides the investor with detailed reports, typically quarterly.

Odd-Lot and Round-Lot Transactions

Investors can buy stock in either odd or round lots. An 

odd lot

 consists of fewer than 100 shares of a stock. A 

round lot

 is a 100-share unit. You would be dealing in an odd lot if you bought, say, 25 shares of stock, but in round lots if you bought 200 shares. A trade of 225 shares would be a combination of one odd lot and two round lots.

Transactions in odd lots once required either additional processing by the brokerage firm or the assistance of a specialist, but now computerized trading systems make trading odd lots much easier. As a result, trading odd lots usually does not trigger higher fees, as was once the case. Small investors in the early stages of their investment programs are primarily responsible for odd-lot transactions since they often lack the financial resources to purchase round lots.

Basic Types of Orders

Investors can use different types of orders to make security transactions. The type placed normally depends on the investor’s goals and expectations. The three basic types of orders are the market order, the limit order, and the stop-loss order.

Market Order

An order to buy or sell stock at the best price available at the time the investor places the order is a 

market order

. It is generally the quickest way to fill orders because market orders are usually executed as soon as they reach the exchange floor or are received by the market maker. Because of the speed with which market orders are executed, the buyer or seller of a security can be sure that the price at which the order is transacted will be very close to the market price prevailing at the time the order was placed.

Limit Order

A 

limit order

 is an order to buy at or below a specified price (a limit buy order) or to sell at or above a specified price (a limit sell order). When the investor places a limit order, the broker transmits it to a market maker dealing in the security. The market maker notes the number of shares and price of the limit order in his or her book and executes the order as soon as the specified limit price (or better) exists. The market maker must first satisfy all other orders with precedence—similar orders received earlier, buy orders at a higher specified price, or sell orders at a lower specified price. Investors can place a limit order in one of the following forms:

· A fill-or-kill order, which is canceled if not immediately executed.

· A day order, which if not executed is automatically canceled at the end of the day.

· A good-’til-canceled (GTC) order, which generally remains in effect for 30 to 90 days unless executed, canceled, or renewed.

Example

Suppose that you place a limit order to buy, at a limit price of $30, 100 shares of a stock currently selling at $30.50. Once the specialist clears all similar orders received before yours, and once the market price of the stock falls to $30 or lower, he or she executes your order. It is possible, of course, that your order might expire before the stock price drops to $30.

Although a limit order can be quite effective, it can also keep you from making a transaction. If, for instance, you wish to buy at $30 or less and the stock price moves from its current $30.50 price to $42 while you are waiting, you have missed the opportunity to make a profit of $11.50 per share. If you had placed a market order to buy at the best available price of $30.50, the profit of $11.50 would have been yours. Limit orders for the sale of a stock are also disadvantageous when the stock price closely approaches but does not attain the minimum sale price limit before dropping substantially. Generally speaking, limit orders are most effective when the price of a stock fluctuates greatly because there is then a better chance that the order will be executed.

Stop-Loss Order

When an investor places a 

stop-loss order

, or 

stop order

, the broker tells the market maker to sell a stock when its market price reaches or drops below a specified level. Stop-loss orders are suspended orders placed on stocks; they are activated when and if the stock reaches a certain price. The stop-loss order is placed on the market maker’s book and becomes active once the stock reaches the stop price. Like limit orders, stop-loss orders are typically day or GTC orders. When activated, the stop order becomes a market order to sell the security at the best price available. Thus it is possible for the actual price at which the sale is made to be well below the price at which the stop was initiated. Investors use these orders to protect themselves against the adverse effects of a rapid decline in share price.

Example

Assume you own 100 shares of Ballard Industries, which is currently selling for $35 per share. Because you believe the stock price could decline rapidly at any time, you place a stop order to sell at $30. If the stock price does in fact drop to $30, the market maker will sell the 100 shares at the best price available at that time. If the market price declines to $28 by the time your stop-loss order comes up, you will receive less than $30 per share. Of course, if the market price stays above $30 per share, you will have lost nothing as a result of placing the order because the stop order will never be initiated. Often investors raise the level of the stop as the price of the stock rises. Such action helps to lock in a higher profit when the price is increasing.

Investors can also place stop orders to buy a stock, although buy orders are far less common than sell orders. For example, you may place a stop order to buy 100 shares of MJ Enterprises, currently selling for $70 per share, once its price rises to, say, $75 (the stop price). These orders are commonly used either to limit losses on short sales (discussed in 
Chapter 2
) or to buy a stock just as its price begins to rise.

An Advisor’s Perspective

Ryan McKeown Senior VP–Financial Advisor, Wealth Enhancement Group

“I encourage clients to use limit and stop-loss orders.”

MyFinanceLab

To avoid the risk of the market moving against you when your stop order becomes a market order, you can place a stop-limit order rather than a plain stop order. This is an order to buy or sell stock at a given or better price once a stipulated stop price has been met. For example, in the Ballard Industries example, had a stop-limit order been in effect, then when the market price of Ballard dropped to $30, the broker would have entered a limit order to sell your 100 shares at $30 a share or better. Thus you would have run no risk of getting less than $30 a share for your stock—unless the price of the stock kept right on falling. In that case, as is true for any limit order, you might miss the market altogether and end up with stock worth much less than $30. Even though the stop order to sell was triggered (at $30), the stock will not be sold, with a stop-limit order, if it keeps falling in price.

Online Transactions

The competition for your online business increases daily as more players enter an already crowded arena. Brokerage firms are encouraging customers to trade online and offering a variety of incentives to get their business, including free trades! However, low cost is not the only reason to choose a brokerage firm. As with any financial decision, you must consider your needs and find the firm that matches them. One investor may want timely information, research, and quick, reliable trades from a full-service broker like Bank of America or a premium discounter like Charles Schwab or TD Ameritrade. Another, who is an active trader, will focus on cost and fast trades rather than research and so will sign up with a basic discounter like Firstrade or Wall Street*E. Ease of site navigation is a major factor in finding a basic discount broker to use in executing online transactions. Some online brokers also offer online trading of bonds and mutual funds.

Day Trading

For some investors, online stock trading is so compelling that they become day traders. The opposite of buy-and-hold investors with a long-term perspective, 

day traders

 buy and sell stocks quickly throughout the day. They hope that their stocks will continue to rise in value for the very short time they own them—sometimes just seconds or minutes—so they can make quick profits. Some also sell short, looking for small price decreases. True day traders do not own stocks overnight—hence the term “day trader”—because they believe that the extreme risk of prices changing radically from day to day will lead to large losses.

Day trading is not illegal or unethical, but it is highly risky. To compound their risk, day traders usually buy on margin in order to leverage their potential profits. But as we already know, margin trading also increases the risk of large losses.

Because the Internet makes investment information and transactions accessible to the masses, day trading has grown in popularity. It’s a very difficult task—essentially a very stressful, full-time job. Although sales pitches for day trading make it seem like an easy route to quick riches, quite the reverse is more generally true. About twice as many day traders lose money as make money. In addition, they have high expenses for brokerage commissions, training, and computer equipment. They must earn sizable trading profits annually to break even on fees and commissions alone. Some never achieve profitability.

Technical and Service Problems

As the number of online investors increases, so do the problems that beset brokerage firms and their customers. During the past few years most brokerage firms have upgraded their systems to reduce the number of service outages. But the potential problems go beyond the brokerage sites. Once an investor places a trade at a firm’s website, it goes through several other parties to be executed. Most online brokers don’t have their own trading desks and have agreements with other trading firms to execute their orders on the New York Stock Exchange or Nasdaq Stock Market. Slowdowns at any point in the process can create problems confirming trades. Investors, thinking that their trades had not gone through, might place the order again—only to discover later that they have bought the same stock twice. Online investors who don’t get immediate trade execution and confirmation use the telephone when they can’t get through online or to solve other problems with their accounts, and they often face long waiting times on hold.

Tips for Successful Online Trades

Successful online investors take additional precautions before submitting their orders. Here are some tips to help you avoid some common problems:

Watch Your Behavior

What’s in a Name? Confusion over ticker symbols can cause investors to make embarrassing and costly mistakes. One study discovered that investors who intended to buy shares in a company called MCI Communications (which was widely known simply by the initials MCI but traded under the ticker symbol MCIC) mistakenly purchased shares in Massmutual Corporate Investors. The reason for this error was that Massmutual’s ticker symbol is MCI. More recently, FINRA changed the ticker symbol of Tweeter Home Entertainment Group, which previously had been TWTRQ, to avoid confusion with Twitter. Just after Twitter announced its plan to go public in an IPO, trading in TWTRQ soared and its price rose 1,400%.

(Source: “Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC),” Journal of Finance, October 2001.)

· Know how to place and confirm your order before you begin trading. This simple step can keep you from having problems later.

· Verify the stock symbol of the security you wish to buy. Two very different companies can have similar symbols. Some investors have bought the wrong stock because they didn’t check before placing their order.

· Use limit orders. The price you see on your computer screen may not be the one you get. With a limit order, you avoid getting burned in fast-moving markets. Although limit orders cost more, they can save you thousands of dollars. For example, it is not uncommon for customers eager to get shares of a hot IPO stock to place market orders. Instead of buying the stock near the offering price in the IPO prospectus, these customers may be shocked to find that their orders are filled at much higher prices during the stock’s first trading day. Investors who learn of the price run-up and try to cancel orders may not always be able to get through to brokers. Because of this, some brokers accept only limit orders for online IPO purchases on the first day of trading.

· Don’t ignore the online reminders that ask you to check and recheck. It’s easy to make a typo that adds an extra digit to a purchase amount.

· Don’t get carried away. It’s easy to churn your own account. In fact, new online investors trade about twice as much as they did before they went online. To control impulse trading, have a strategy and stick to it.

· Open accounts with two brokers. This protects you if your online brokerage’s computer system crashes. It also gives you an alternative if one brokerage is blocked with heavy trading volume.

· Double-check orders for accuracy. Make sure each trade was completed according to your instructions. It’s very easy to make typos or use the wrong stock symbol, so review the confirmation notice to verify that the right number of shares was bought or sold and that the price and commissions or fees are as quoted. Check your account for “unauthorized” trades.

Transaction Costs

Making transactions through brokers or market makers is considerably easier for investors than it would be to negotiate directly, trying to find someone who wants to buy what you want to sell (or vice versa). To compensate the broker for executing the transaction, investors pay transaction costs, which are usually levied on both the purchase and the sale of securities. When making investment decisions, you must consider the structure and magnitude of transaction costs because they affect returns.

Since the passage of the Securities Acts Amendments of 1975, brokers have been permitted to charge whatever brokerage commissions they deem appropriate. Most firms have established 

fixed commissions

 that apply to small transactions, the ones most often made by individual investors. On large institutional transactions, the client and broker may arrange a negotiated commission—a commission to which both parties agree. 

Negotiated commissions

 are also available to individual investors who maintain large accounts, typically above $50,000. The commission structure varies with the type of security and the type of broker. In subsequent chapters we’ll describe the basic commission structures for various types of securities.

Because of the way brokerage firms charge commissions on stock trades, it is difficult to compare prices precisely. Traditional brokers generally charge on the basis of number of shares and the price of the stock at the time of the transaction. Internet brokers usually charge flat rates, often for transactions up to 1,000 shares, with additional fees for larger or more complicated orders. However, many traditional brokerage firms have reduced their commissions on broker-assisted trades and have instituted annual flat fees (on wrap accounts) set as a specified percentage of the value of the assets in the account. Unless you are a very active trader, you are probably better off paying commissions on a per-transaction basis.

Obviously, premium and basic discount brokers charge substantially less than full-service brokers for the same transaction. However, some discounters charge a minimum fee to discourage small orders. The savings from the discounter can be substantial. Depending on the size and type of transaction, premium and basic discount brokers can typically save investors between 30% and 80% of the commission charged by the full-service broker.

Investor Protection: SIPC and Arbitration

Although most investment transactions take place safely, it is important to know what protection you have if things don’t go smoothly. As a client, you are protected against the loss of the securities or cash held by your broker. The 

Securities Investor Protection Corporation (SIPC)

, a nonprofit membership corporation, was authorized by the Securities Investor Protection Act of 1970 to protect customer accounts against the consequences of financial failure of the brokerage firm. The SIPC currently insures each customer’s account for up to $500,000, with claims for cash limited to $250,000 per customer. Note that SIPC insurance does not guarantee that the investor will recover the dollar value of the securities. It guarantees only that the securities themselves will be returned. Some brokerage firms also insure certain customer accounts for amounts in excess of $500,000. Certainly, in light of the diversity and quality of services available among brokerage firms, this may be an additional service you should consider when you select a firm and an individual broker.

The SIPC provides protection in case your brokerage firm fails. But what happens if your broker gave you bad advice and, as a result, you lost a lot of money on an investment? Or what if you feel your broker is churning your account? In either case, the SIPC won’t help. It’s not intended to insure you against bad investment advice or churning. Instead, if you have a dispute with your broker, the first thing you should do is discuss the situation with the managing officer at the branch where you do business. If that doesn’t resolve the problem, then contact the firm’s compliance officer and the securities regulator in your home state.

If you still don’t get any satisfaction, you can use litigation (judicial methods in the courts) to resolve the dispute. Alternative dispute-resolution processes that may avoid litigation include mediation and arbitration. 

Mediation

 is an informal, voluntary approach in which you and the broker agree to a professional mediator, who facilitates negotiations between the two of you to resolve the case. The mediator does not impose a solution on you and the broker. The Financial Industry Regulatory Authority and securities-related organizations encourage investors to mediate disputes rather than arbitrate them because mediation can reduce costs and time for both investors and brokers.

If mediation is not pursued or if it fails, you may have no choice but to take the case to 

arbitration

, a formal process whereby you and your broker present the two sides of the argument before an arbitration panel. The panel then decides the case. Many brokerage firms require you to resolve disputes by binding arbitration; in this case, you don’t have the option to sue. You must accept the arbitrator’s decision, and in most cases you cannot go to court to resolve your case. Before you open an account, check whether the brokerage agreement contains a binding-arbitration clause.

Mediation and arbitration proceedings typically cost less and are resolved more quickly than litigation. Recent legislation has given many investors the option of using either securities industry panels or independent arbitration panels such as those sponsored by the American Arbitration Association (AAA). Independent panels are considered more sympathetic toward investors. In addition, only one of the three arbitrators on a panel can be connected with the securities industry. On its website, FINRA reports that in 2014 it brought 1,397 disciplinary actions against registered brokers and firms, levied $134 million in fines, and ordered $32.3 million in restitution to harmed investors.

Probably the best thing you can do to avoid the need to mediate, arbitrate, or litigate is to select your broker carefully, understand the financial risks involved in the broker’s recommendations, thoroughly evaluate the advice he or she offers, and continuously monitor the volume of transactions that he or she recommends and executes. Clearly, it is much less costly to choose the right broker initially than to incur later the financial and emotional costs of having chosen a bad one.

If you have a problem with an online trade, immediately file a written—not e-mail—complaint with the broker. Cite dates, times, and amounts of trades, and include all supporting documentation. File a copy with the Financial Industry Regulatory Authority (

http://www.finra.org

) and with your state securities regulator. If you can’t resolve the problems with the broker, you can try mediation and then resort to arbitration, with litigation being the last resort.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 3.13 Describe the types of services offered by brokerage firms, and discuss the criteria for selecting a suitable stockbroker.

2. 3.14 Briefly differentiate among the following types of brokerage accounts:

a. Single or joint

b. Custodial

c. Cash

d. Margin

e. Wrap

3. 3.15 Differentiate among market orders, limit orders, and stop-loss orders. What is the rationale for using a stop-loss order rather than a limit order?

4. 3.16 Differentiate between the services and costs associated with full-service, premium discount, and basic discount brokers. Be sure to discuss online transactions.

5. 3.17 What is day trading, and why is it risky? How can you avoid problems as an online trader?

6. 3.18 In what two ways, based on the number of shares transacted, do brokers typically charge for executing transactions? How are online transaction fees structured relative to the degree of broker involvement?

7. 3.19 What protection does the Securities Investor Protection Corporation (SIPC) provide for securities investors? How are mediation and arbitration procedures used to settle disputes between investors and their brokers?

Investment Advisors and

Investment Clubs

1. LG 6

Many investors feel that they have neither the time nor the expertise to analyze financial information and make decisions on their own. Instead, they turn to an 

investment advisor

, an individual or firm that provides investment advice, typically for a fee. Alternatively, some small investors join 

investment clubs

. Here we will discuss using an investment advisor and then briefly cover the key aspects of investment clubs.

Using an Investment Advisor

The “product” provided by an investment advisor ranges from broad, general advice to detailed, specific analyses and recommendations. The most general form of advice is a newsletter published by the advisor. These letters comment on the economy, current events, market behavior, and specific securities. Investment advisors also provide complete individualized investment evaluation, recommendation, and management services.

Regulation of Advisors

The Investment Advisors Act of 1940 ensures that investment advisors make full disclosure of information about their backgrounds, conflicts of interest, and so on. The act requires professional advisors to register and file periodic reports with the SEC. A 1960 amendment permits the SEC to inspect the records of investment advisors and to revoke the registration of those who violate the act’s provisions. However, financial planners, stockbrokers, bankers, lawyers, and accountants who provide investment advice in addition to their main professional activity are not regulated by the act. Many states have also passed similar legislation, requiring investment advisors to register and to abide by the guidelines established by the state law.

Be aware that the federal and state laws regulating the activities of professional investment advisors do not guarantee competence. Rather, they are intended to protect the investor against fraudulent and unethical practices. It is important to recognize that, at present, no law or regulatory body controls entrance into the field. Therefore, investment advisors range from highly informed professionals to totally incompetent amateurs. Advisors who possess a professional designation are usually preferred because they have completed academic courses in areas directly or peripherally related to the investment process. Such designations include CFA (Chartered Financial Analyst), CIMA (Certified Investment Management Analyst), CIC (Chartered Investment Counselor), CFP® (Certified Financial Planner™), ChFC (Chartered Financial Consultant), CLU (Chartered Life Underwriter), and CPA (Certified Public Accountant).

Online Investment Advice

You can also find investment advice online. Whether it’s a retirement planning tool or advice on how to diversify your assets, automated investment advisors may be able to help you. If your needs are specific rather than comprehensive, you can find good advice at other sites. For example, T. Rowe Price has an excellent college planning section (

http://www.troweprice.com/college

). Financial Engines (

http://www .financialengines.com

), AdviceAmerica (

http://www.adviceamerica.com

), and DirectAdvice (

http://www.directadvice.com

) are among several independent advice sites that offer broader planning capabilities. Many mutual fund websites have online financial advisors. For example, The Vanguard Group (

http://www.vanguard.com

) has a personal investors section that helps you choose funds for specific investment objectives, such as retirement or financing a college education.

Investor Facts

You can lead a horse to water, but you can’t make it drink In an interesting experiment, a large German brokerage house offered free, unbiased (i.e., unrelated to the brokerage’s monetary incentives) financial advice to a pool of more than 8,000 randomly selected clients. Only 5% of the firm’s clients accepted the offer, and on average they were wealthier than clients who didn’t accept the offer. In other words, it appears that the investors who most needed financial advice were least likely to accept it.

(Source: “Is Unbiased Financial Advice to Retail Investors Sufficient? Answers from a Large Field Study,” Review of Financial Studies, Vol. 25, Issue 4, pp. 975–1032.)

The Cost and Use of Investment Advice

The annual costs of obtaining professional investment advice typically run between 0.25% and 3% of the dollar amount of money being managed. For large portfolios, the fee is typically in the range of 0.25% to 0.75%. For small portfolios (less than $100,000), an annual fee ranging from 2% to 3% of the dollar amount of funds managed would not be unusual. These fees generally cover complete management of a client’s money. The cost of periodic investment advice not provided as part of a subscription service could be based on a fixed-fee schedule or quoted as an hourly charge for consultation. Online advisors are much less expensive; they either are free or charge an annual fee.

Whether you choose a traditional investment advisory service or decide to try an online service, some are better than others. More expensive services do not necessarily provide better advice. It is best to study carefully the track record and overall reputation of an investment advisor before purchasing his or her services. Not only should the advisor have a good performance record, but he or she also should be responsive to your personal goals.

How good is the advice from online advisors? It’s very hard to judge. Their suggested plans are only as good as the input. Beginning investors may not have sufficient knowledge to make wise assumptions on future savings, tax, or inflation rates or to analyze results thoroughly. A good face-to-face personal financial planner will ask lots of questions to assess your investing expertise and explain what you don’t know. Automated tools for these early-stage questions may take too narrow a focus and not consider other parts of your investment portfolio. For many investors, online advisors lack what leads them to get help in the first place—the human touch. They want personal guidance, expertise, and encouragement to follow through on their plans.

Investment Clubs

Another way to obtain investment advice and experience is to join an investment club. This route can be especially useful for those of moderate means who do not want to incur the cost of an investment advisor. An investment club is a legal partnership binding a group of investors (partners) to a specified organizational structure, operating procedure, and purpose. The goal of most clubs is to earn favorable long-term returns by making investments in accordance with the group’s investment objectives.

Individuals with similar goals usually form investment clubs to pool their knowledge and money in a jointly owned and managed portfolio. Certain members are responsible for obtaining and analyzing data on a specific investment strategy. At periodic meetings, the members present their findings for discussion and further analysis by the members. Once discussed, the group decides whether to pursue the proposed strategy. Most clubs require members to make scheduled contributions to the club’s treasury, thereby regularly increasing the pool of investable funds. Although most clubs concentrate on investments in stocks and bonds, some may concentrate on specialized investments such as options or futures. Membership in an investment club provides an excellent way for the novice investor to learn the key aspects of portfolio construction and investment management while (one hopes) earning a favorable return on his or her funds.

Investor Facts

Too Many Cooks? Though investment clubs are a popular way to learn about investing, research shows that investment clubs, on average, do not perform especially well. One study examined the results of 166 investment clubs and found that they earned average returns that trailed broad market indexes by 3% per year.

(Source: Brad M. Barber & Terrance Odean, 2000. “Too Many Cooks Spoil the Profits: The Performance of Investment Clubs.” Financial Analyst Journal (January/February 2000), 17–25.)

As you might expect, investment clubs have also joined the online investing movement. By tapping into the Internet, clubs are freed from geographical restrictions. Now investors around the world, many who have never met, can form a club and discuss investing strategies and stock picks just as easily as if they gathered in person. Finding a time or place to meet is no longer an issue. Some clubs are formed by friends. Other clubs are made up of people who have similar investing philosophies and may have met online. Online clubs conduct business via e-mail or set up a private website. Members of the Better Investing Community, a not-for-profit organization, have access to educational materials, investment tools, and other investment features.

Better Investing, which has over 200,000 individual and club investors and over 16,000 investment clubs, publishes a variety of useful materials and also sponsors regional and national meetings. To learn how to start an investment club, visit the Better Investing website.

Concepts in Review
Answers available at 
http://www.pearsonhighered.com/smart

1. 3.20 Describe the services that professional investment advisors perform, how they are regulated, online investment advisors, and the cost of investment advice.

2. 3.21 What benefits does an investment club offer the small investor? Would you prefer to join a regular or an online club, and why?

MyFinanceLab

Here is what you should know after reading this chapter. will help you identify what you know and where to go when you need to practice.

What You Should Know	Key Terms	Wheat to Practice
LG 1 Discuss the growth in online investing and the pros and cons of using the Internet as an investment tool. The Internet has empowered individual investors by providing information and tools formerly available only to investing professionals and by simplifying the investing process. The time and money it saves are huge. Investors get the most current information, including real-time stock price quotes, market activity data, research reports, educational articles, and discussion forums. Tools such as financial planning calculators, stock-screening programs, charting, stock quotes, and portfolio tracking are free at many sites. Buying and selling securities online is convenient, relatively simple, inexpensive, and fast.	MyFinanceLab Study Plan 3.1
LG 2 Identify the major types and sources of investment information. Investment information, descriptive or analytical, includes information about the economy and current events, industries and companies, and alternative investment vehicles, as well as price information and personal investment strategies. It can be obtained from financial journals, general newspapers, institutional news, business periodicals, government publications, special subscription services, stockholders’ reports, comparative data sources, subscription services, brokerage reports, investment letters, price quotations, and electronic and online sources. Most print publications also have websites with access to all or part of their content. Financial portals bring together a variety of financial information online. Investors will also find specialized sites for bond, mutual fund, and international information, as well as discussion forums that discuss individual securities and investment strategies. Because it is hard to know the qualifications of those who make postings on message boards, participants must do their own homework before acting on an online tip.	1. analytical information,  p.  80 2. back-office research reports,  p.  89 3. Barron’s,  p.  83 4. descriptive information,  p.  80 5. fair disclosure rule (Regulation FD),  p.  84 6. financial portals,  p.  90 7. Form 10-K,  p.  85 8. investment letters,  p.  89 9. Mergent,  p.  89 10. quotations,  p.  89 11. Standard & Poor’s Corporation (S&P),  p.  88 12. stockholders’ (annual) report,  p.  85 13. Value Line Investment Survey,  p.  89 14. Wall Street Journal,  p.  82	MyFinanceLab Study Plan 3.2
LG 3 Explain the key aspects of the commonly cited stock and bond market averages and indexes. Investors commonly rely on stock market averages and indexes to stay abreast of market behavior. The most often cited are the Dow Jones averages, which include the Dow Jones Industrial Average (DJIA). Also widely followed are the Standard & Poor’s indexes, the NYSE Composite Index, the NYSE MKT Composite Index, the Nasdaq Stock Market indexes, and the Value Line indexes. Numerous other averages and indexes, including a number of global and foreign market indexes, are regularly reported in financial publications. Bond market indicators are most often reported in terms of bond yields and bond indexes. The Dow Jones Corporate Bond Index is among the most popular. Yield and price index data are also available for various types of bonds and various domestic and foreign markets. Both stock and bond market statistics are published daily in the Wall Street Journal and summarized weekly in Barron’s.	1. averages,  p.  94 2. bond yield,  p.  99 3. Dow Jones Corporate Bond Index,  p.  99 4. Dow Jones Industrial Average (DJIA),  p.  94 5. indexes,  p.  94 6. Nasdaq Stock Market indexes,  p.  98 7. NYSE Composite Index,  p.  98 8. Standard & Poor’s 500 Stock Index,  p.  96 9. Value Line Composite Index,  p.  98	MyFinanceLab Study Plan 3.3 Video Learning Aid for Problem P3.2
LG 4 Review the role of stockbrokers, including the services they provide, selection of a stockbroker, opening an account, and transaction basics. Stockbrokers facilitate buying and selling of securities, and provide other client services. An investor should select a stockbroker who has a compatible disposition toward investing and whose firm offers the desired services at competitive costs. Today the distinctions among full-service, premium discount, and basic discount (online) brokers are blurring. Most brokers now offer online trading capabilities, and many no-frills brokers are expanding their services to include research and advice. Investors can open a variety of types of brokerage accounts, such as single, joint, custodial, cash, margin, and wrap. Transactions take place in odd lots (less than 100 shares) or round lots (100 shares or multiples thereof).	1. basic discount broker,  p.  101 2. cash account,  p.  103 3. churning,  p.  102 4. custodial account,  p.  103 5. full-service broker,  p.  101 6. margin account,  p.  103 7. odd lot,  p.  104 8. premium discount broker,  p.  101 9. round lot,  p.  104 10. stockbrokers,  p.  100 11. street name,  p.  101 12. wrap account,  p.  104	MyFinanceLab Study Plan 3.4
LG 5 Describe the basic types of orders, online transactions, transaction costs, and the legal aspects of investor protection. A market order is an order to buy or sell stock at the best price available. A limit order is an order to buy at a specified price or below, or to sell at a specified price or above. Stop-loss orders become market orders as soon as the minimum sell price or the maximum buy price is hit. Limit and stop-loss orders can be placed as fill-or-kill orders, day orders, or good-’til-canceled (GTC) orders. On small transactions, most brokers have fixed commission schedules; on larger transactions, they will negotiate commissions. Commissions also vary by type of security and type of broker. The Securities Investor Protection Corporation (SIPC) insures customers’ accounts against the brokerage firm’s failure. Mediation and arbitration procedures are frequently employed to resolve disputes. These disputes typically concern the investor’s belief that the broker either gave bad advice or churned the account.	1. arbitration,  p.  109 2. day trader,  p.  106 3. fixed commissions,  p.  108 4. limit order,  p.  104 5. market order,  p.  104 6. mediation,  p.  109 7. negotiated commissions,  p.  108 8. Securities Investor Protection Corporation (SIPC),  p.  108 9. stop-loss (stop) order,  p.  105	MyFinanceLab Study Plan 3.5 Video Learning Aid for Problem P3.10
LG 6 Discuss the roles of investment advisors and investment clubs. Investment advisors charge an annual fee ranging from 0.25% to 3% of the dollar amount being managed and are often regulated by federal and state law. Websites that provide investment advice are now available as well. Investment clubs provide individual investors with investment advice and help them gain investing experience. Online clubs have members in various geographical areas and conduct business via e-mail or at a private website.	1. investment advisor,  p.  110 2. investment club,  p.  110	MyFinanceLab Study Plan 3.6

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