A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.
In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. Read the rest of this entry »
An investor who lends funds by purchasing a bond issue is exposed to three types of credit risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk.
Traditionally, credit risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk is called default risk. If a default does occur, this does not mean the investor loses the entire amount invested because the investor can expect to recover a portion of the investment. Read the rest of this entry »
Finally, the structure of the currency markets may work against elimination of the forward rate bias. Note that the forward rates depend only on the spot rate and the difference in interest rates. For arbitrage reasons, the forward rate cannot depend on anything else (see the discussion of interest rate parity in “Description,” above). However, an exchange rate between two currencies reflects the relative state of the two economies. If the U.S. economy is expected to do better than the Japanese economy, then the spot exchange rate will reflect that. Any changes in growth expectations will promptly cause a change in the spot exchange rate and thereby in the forward exchange rate. For example, the dollar strengthened from 1995 to 2000 because of the relative strength of the U.S. economy. During 2002 and early part of 2003, when expectations about U.S. economic growth were constantly revised downward, the dollar kept losing ground to other currencies. Read the rest of this entry »
To give you a sense of how fund shareholders are serviced, let’s follow a typical series of transactions beginning immediately after a prospective customer decides to purchase fund shares. In the first step, the customer completes and returns an application for opening a new account to the transfer agent. The application may be returned in a number of ways, including by mail, at a branch office (if one exists locally) or through the Internet. Once the transfer agent receives the application, the transfer agent determines whether it is in good order. Although the definition of “in good order” can vary somewhat among fund complexes, many core elements are consistent. The transfer agent always makes certain to obtain a social security number or taxpayer identification number (in the case of corporate accounts) for tax reporting purposes. The transfer agent also ensures that the initial funding amount complies with any account minimums specified in the fund’s prospectus. If there is any issue with the application, the application is considered to be “not in good order.” In that event, the establishment of the account and the purchase of fund shares may be delayed until the issue can be resolved with the customer. Read the rest of this entry »
The Class B structure creates challenging financial issues for the fund sponsor This structure carries inherent risk in that the fund’s NAV could decline substantially, decreasing the amount of 126-1 fees and CDSCs received by the sponsor, possibly below the amount it advanced to the broker-dealer. This is especially a risk for an equity fund sponsor, since equity assets are more volatile than other asset types. In recent years, many fund sponsors have sought relief from the risk that the CDSC arrangement entails by taking advantage of new methods of financial engineering developed by banks and investment banks. These methods enable fund sponsors to reduce or eliminate this risk by securitizing and selling the future cash flows from 12b-1 fees and CDSCs. For example, consider a fund sponsor that has just paid a broker a 4% commission for selling Class B shares of a growth find. Rather than wait to recoup this commission via 12b-1 fees and/or CDSCs, the sponsor may sell the rights to these future cash flows to an unrelated party in exchange for a modestly lower payment today. This sale effectively protects the sponsor against the risk associated with a possible downturn in the equities market and consequential decline in cash flows from 12b-1 fees and CDSCs. Read the rest of this entry »
Over the past few years, the merger activity in the mutual fund industry has sharply accelerated. Some of the mergers involved fund companies trying to fill out their line of products. An illustration is the acquisition of Templeton’s management company, which has a strong reputation for international stock funds, by Franklin’s management company, with its heavy emphasis on bond funds. Other mergers involved institutionally oriented securities firms seeking more distribution to retail investors. An illustration is the acquisition of Dean Witter, a retail wire house, by Morgan Stanley, with its institutional client base. Still others involve banks that want to gain a foothold in the mutual fund industry. An illustration is the acquisition of Dreyfus, an investment manager for a broad line of mutual funds, by Mellon National Bank. The following case study discusses several mergers in the mutual fund industry and the early results of the consolidations. Read the rest of this entry »
James M. Clash
A wave of consolidation is washing over the mutual fund business. So far this year funds totaling more than $125 billion in assets have changed hands. To hear the consolidators tell it, mergers are good because they bring fund investors economies of scale and breadth of choice within a fund family. Will these promises be fulfilled? It is instructive to consider some of the bigger recent mergers. The results are not encouraging.
Take the Dreyfus funds, purchased in December 1993 by Pittsburgh’s Mellon Bank. In the three years before the merger, the 12 domestic stock funds at Dreyfus performed, on average, on a par with the S&P 500 index. In the three years since, these funds, on average, have underperformed the index by a stunning seven percentage points a year.
Then there’s the American Capital/Van Kampen merger in August 1994. In the 26 months prior to the marriage, the 11 stock funds here outperformed the S&P 500 index by an average of two points annually. In the 26 months since the merger, the funds have underperformed, Read the rest of this entry »
Is your advisor or broker honest with you about his motivation and how he is compensated? Beware of brokers who try and sell you that their superior performance and low annual fees will more than compensate you for a 5 percent upfront charge. You should not pay a load or sales charge when buying a mutual fund, but people routinely do.
Similarly, steer clear of advisors who use “soft dollar” commissions to pay for their bills. These commissions encourage advisors to trade your account and create more revenue for their firms. Finally, run from brokers and advisors who push their own in-house funds. They are given incentives to push these funds without regard to their fees or performance. This doesn’t mean that all in-house funds are bad, only that these brokers and advisors are not always considering if they’re the best investments for you.
Sloth can cause you to give any of these advisors a pass or fail to realize what they’re up to. You may also lust after advisors with great reputations and who offer promises of incredible performance, overlooking their fees or questionable tactics. The best way to honor your financial advisor is by choosing one whose only fee is based on a fixed percentage of the assets you have under management and evaluate this individual based on comparisons with a reasonable benchmark. Read the rest of this entry »
Anger becomes a deadly investing sin when it isn’t managed. Anger in itself isn’t a problem; the actions it prompts you to take, though, can cause major losses. To help you prevent these losses, here are two sets of tips. The first relates to monitoring your investing moods; the second involves avoiding specific, anger-induced investing mistakes.
Mood Monitor
If you’re vulnerable to the sin of wrath, you need to be vigilant for signs of anger in all its forms when you’re contemplating your investments. Be alert for the following emotions and take the suggested precautions if you spot them:
1. A red-hot desire for vengeance. You want revenge against the market in general or a broker who you feel gave you bad advice or the media for ruining a great investment. When you’re contemplating a given investment, all you can think about is how the “enemy” will rue the day they crossed you. Your goal is not financial as much as it is that sweet feeling of defeating your adversary. Read the rest of this entry »
Sooner or later, the market humbles everyone. This doesn’t mean you should approach investing with fear and uncertainty, but a wise investor recognizes that even the pros make mistakes and that a willingness to cut.
It losses quickly and absorb and analyze information will serve him well. Walking the fine line between humility and confidence—and between pride and self-questioning—can be difficult for everyone, but especially for investors guilty of this sin. To make it a bit easier, try following these steps:
1. Make a concerted effort to seek advice and knowledge, and try to take pride in your ability to discern useful from useless information.
As a professional investment advisor, I experience moments when I wonder if it’s worth it to seek additional information and opinions. After all, I’ve been investing for many years, I’ve been very successful, why not just trust my experience and instincts to guide my recommendations. In these moments, I remind myself of a few simple facts: Thousands of U.S. stocks are traded on various exchanges; adding in foreign markets and just considering equity and fixed income vehicles, an infinite number of ways to build a portfolio exist. Read the rest of this entry »
If everything you’ve read up to this point describes your investing behaviors, you should also know that the simple remedy to this sin is trading less and enjoying it more. Reducing the frequency of trading may sound easy to those who aren’t guilty of this sin, but to investing gluttons, it seems antithetical to their entire investing philosophy. If you’re a glutton, you firmly believe that highly active trading is the key to success. If you want to stop being a glutton and stop losing money, then you should be aware of two studies that will disabuse you of your belief in hyperactive trading.
The first study was completed in 1998 by Brad M. Barber and Terrance Odean, professors at the graduate school of management at the University of California at Davis. They examined the trading activity of 78,000 investors over a six-year period and found that the average investor turned over the stocks in his portfolio 80 percent annually, which may explain why individuals usually don’t perform as well as the overall stock market. More significantly, Professors Barber and Odean broke down households into groups based on how frequently they turn over their portfolios. The low turnover group averaged just 1.5 percent turnover per year, meaning that they rarely traded out of stocks. Read the rest of this entry »
Certain types of investing seem to trigger anger in certain investors, and if you’re vulnerable to this sin, you should do everything possible to avoid these types. Specifically, don’t:
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SEEK HIGHLY VOLATILE, MICROCAP STOCK INVESTMENTS
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BACKGROUND AND PURPOSE
The primary purpose of regulations is to protect investors, and the roots of governmental regulation of mutual funds in the longer-established markets are often associated with major scandals and market crashes.
In the USA, the stock market crash of 1929 prompted an extensive investigation by Congress into the securities industry. It revealed that overselling, or ‘ramming’ of shares, particularly radio company shares, had created unrealistic expectations and false, overvalued markets. The investigation resulted finally in the Investment Company Act 1940, which established the Securities and Exchange Commission (SEC) - this Act remains the cornerstone of US mutual fund regulation - and the Investment Advisers Act 1940. Along with two Acts passed into Federal law in the 1930s - the Securities Act 1933 and the Securities Exchange Act 2934 - these four Acts provide the bulk of federal powers over the activities of US investment companies. In fact, the only addition to US legislation affecting all companies since 1940 is the Sarbanes-Oxley Act of 2002 and that has only an indirect bearing on mutual funds themselves, being more concerned with accounting, auditing and disclosure practices of trading companies, following the Enron and Worldcom scandals. Read the rest of this entry »
South Africa - the Collective Investment Schemes Control Act, which updated and replaced previously existing unit trust legislation, was enacted in 2002 and in place at the start of 2003. This Act moved legislation more in line with international best practice and was the subject of negotiation between the trade association and regulatory authorities for some years. The Financial Advisory and Intermediary Services Act (FATS), which became law towards the end of 2002, had as its purpose the regulation of financial planners and advisers, as well as product suppliers, in the giving of advice and the conduct of their business in all areas where other industry legislation did not make specific provision. During its passage as a Bill, it had an impact in terms of how and what advisers were selling, in anticipation of the law. The Financial Intelligence Centre Act, aimed at combating rnoney-laundering activities, brought South Africa into line with international best practice and the subordinate legislation enabling effective practical implementation was in place by year-end 2002. In spite of its name, the Securities Services Act 2004 does not apply to collective investment schemes, nor to activities regulated under FATS, and the Financial Markets Advisory Board, established by the Financial Markets Control Act 1989, continues.
Each mutual fund has one or more investment objectives. For example, to provide an above-average and increasing income and a yield about 50% higher than the relevant index. It is the investment manager’s task to achieve these objectives, by pursuing a stated investment policy. Each investment management company will adopt an appropriate policy for each of its funds hut will tend to have an overall ‘house style’ or strategy. Two contrasting approaches are:
- Bottom up’. Known as stock-picking. The manager looks for outstanding individual companies. They can be identified from research reports or from personal knowledge of their products, services and management.
- Top<down’. Starts with asset allocation. The manager reviews world or national economy trends first, determines his asset allocation model in terms of geographic and industrial spread, then examines industries in detail and finally selects companies that will benefit from the trends.
Another contrast in styles between different houses is between passive and active management. passive management occurs when portfolio changes are made cannot be breached by the investment manager, Regulations usually will specify also that the investment objectives and policy as set out in scheme documents cannot be changed materially without approval by vote of the share- or unit holders. Read the rest of this entry »
