Notes

Preface

1. All data in Preface from Investment Company Institute, 2010 Investment Company Fact Book (2010).

Chapter 1: Investing through Mutual Funds

1. Except as noted, all statistics in Chapter in text, figures, and tables are from the Investment Company Institute. See 2010 Investment Company Fact Book (2010), “The U.S. Retirement Market, 2009,” “Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet, 2009,” and “Profile of Mutual Fund Shareholders, 2009.”

2. Brian K. Bucks et al., “Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances,” Federal Reserve Bulletin 95 (February 2009): A1.

3. John Campbell et al., “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk,” Journal of Finance 56 (1) (February 2001); Dale L. Domian, David A. Louton, and Marie D. Racine, “Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough,” The Financial Review 42 (4) (November 2007); and Zakri Bello, “How Diversified are Equity Mutual Funds?” North American Journal of Finance and Banking Research 1 (1) (2007).

4. For more on the history of mutual funds, see Matthew P. Fink, The Rise of Mutual Funds, (New York: Oxford University Press, 2008).

5. Pioneer Fund, Inc., “Policies Objectives Management Record” (1952), quoted in Philip L. Carret, Classic Carret (Boston: The Pioneer Group, Inc., 1998), 86.

6. Inflation adjustment based on the Consumer Price Index from the U.S. Bureau of Labor Statistics; real gross domestic product from the U.S. Bureau of Economic Analysis.

7. Before the legislation was passed, the interest income from municipal bonds held in a mutual fund was subject to tax.

8. Net investments in funds include new cash and reinvested dividends. Funds are defined as mutual funds (including those held in variable annuities), exchange-traded funds, and closed-end funds.

9. These are median figures. The average household invested $180,000 in six different funds.

10. Securities and Exchange Commission, “The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation,” www.sec.gov/about/whatwedo.shtml (accessed December 30, 2009).

11. The action against Goldman Sachs involved its marketing of investments related to the subprime mortgage market. In 2004, there were actually two split decisions. The first instance involved a proposal requiring hedge fund managers to register with the SEC; the second involved a proposal requiring that the chair of a mutual fund board of directors be independent of the management company. Though adopted by the Commission, both proposals were nullified by subsequent lawsuits.

12. FINRA, “Get to Know Us,” www.finra.org/web/groups/corporate/@corp/@about/documents/corporate/p118667.pdf (accessed June 1, 2010).

13. See www.opensecrets.org.

Chapter 2: How Mutual Funds Work

1. Mutual funds may be either a corporation or a business trust. While there are technical differences between the two formats, they are—for all practical purposes—identical in all but name. We’ll refer only to the corporate form throughout the book.

2. Funds reserve the right to make payment for redemptions in kind—by distributing some of the investments that the fund holds—rather than in cash. They very rarely invoke this authority, and then only for very large investors who agree to receive the securities proffered.

3. Matthew P. Fink, The Rise of Mutual Funds (New York: Oxford University Press, 2008), 26.

4. Investment Company Institute, 2010 Investment Company Fact Book (2010), 195.

5. If the fund is formed as a business trust, it’s called a board of trustees, though its function is identical to that of a board of directors. Again, to keep things simple, we use the term directors throughout this book.

6. Median size was seven members. Source: Investment Company Institute and Independent Directors Council, “Overview of Fund Governance Practices: 1994–2008”: 7.

7. Gartenberg v. Merrill Lynch Asset Management, Inc. 694 F.2d 923 (2d Cir. 1982).

8. The 1940 Act requires that only 40 percent of directors be independent, but the SEC does not permit funds to engage in certain activities unless they comply with its more stringent rules on board composition and procedures. As a result, virtually every fund conforms to the SEC’s rules.

9. Management Practice Inc. reports that in 2008 directors for a fund family with $9 billion to $25 billion in assets earned median compensation of $117,500. The comparable figure for fund families with more than $100 billion in assets was $191,820. See Meyrick Payne & Jay Keeshan, “2008 Director Compensation Survey,” www.mpiweb.com/content/view/70/ (accessed June 3, 2010).

10. Investment Company Institute and Independent Directors Council, “Overview of Fund Governance Practices: 1994–2008”: 1.

11. In the past, the term Chinese wall was often used instead of firewall.

12. FINRA prohibits individuals registered with FINRA from giving gifts valued at more than $100. (See Chapter for an introduction to FINRA registration requirements.) Investment adviser codes of ethics generally extend this policy to all employees and to both the giving and the receiving of gifts.

13. Securities and Exchange Commission, Compliance Programs of Investment Companies and Investment Advisers, (IA-2204, December 2003), I.C.2.

14. FormulaInvesting, AlphaClone, FolioInvesting, Wealthfront (formerly kaChing) and Covestor, respectively.

15. There are other types of commingled investment vehicles, but these are not available for direct purchase by individuals. Bank common trust funds are available for investment only when the bank serves as “trustee, executor, administrator or guardian,” per the Code of Federal Regulations § 9.18(a)(1). A particular subset of bank common trust funds, collective trust funds, may be used only within ERISA-regulated plans, such as 401(k) plans. We talk more about these accounts in Chapter. Insurance company separate accounts provide investment options for life and annuity products only. (As an aside, mutual funds are often used as the investment option within these accounts.) Other commingled funds support defined benefit pension plans. Consumers generally do not have direct ownership of the assets in these accounts. On the contrary, to receive distributions from a defined benefit plan, individuals must meet a series of tests with regard to age and tenure at the sponsoring company.

16. Statistics on closed-end funds, exchange-traded funds, and unit investment trusts in this section are from Investment Company Institute, 2010 Investment Company Fact Book (2010).

Chapter 3: Researching Funds: The User Guides

1. More precisely, funds that use tax-exempt in their name must invest in securities that generate income that is exempt from both ordinary income taxes and the alternative minimum tax. Securities in funds using municipal in their name may be subject to AMT. If a fund uses a state name along with tax-exempt or municipal, income must be exempt from that state’s tax as well.

2. Investment Company Institute, “Shareholder Assessment of Risk Disclosure Method” (Spring 1996).

3. After-tax returns are not required if a fund is sold only as a part of an investment vehicle that is not subject to tax, such as a 401(k) plan or variable annuity.

4. Investment Company Institute, “Understanding Investor Preferences for Mutual Fund Information” (2006), 6.

5. Cited in Securities and Exchange Commission, Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies (33-8861, November 21, 2007), 6.

6. NewRiver, Inc., “New River Summary Prospectus Index as of April 30, 2010,” http://www1.newriver.com/documents/NewRiverSummaryProspectusIndex_043.pdf (accessed June 3, 2010).

7. Advertisers who have never previously filed with FINRA must submit materials 10 days before first use for one year.

8. FINRA, “Communications with the Public,” Rule 2210(d)(1).

9. A few funds report to shareholders quarterly, but these are exceptions.

10. Specifically, all funds except money market funds are required to list their top 50 holdings, plus any other holdings that exceed 1 percent of net assets. A full list of holdings must also be filed with the SEC quarterly, although some funds release information about holdings more frequently. The shareholder report explains how you can access holdings data.

Chapter 4: Comparing Mutual Funds

1. This calculation is referred to as the Sharpe measure of risk.

2. Diane Del Guercio and Paula A. Tkac, “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows,” Federal Reserve Bank of Atlanta, Working Paper 2001-15, August 2001 (updated January 2007).

3. Russel Kinnel, “The Star Rating at Its Best and Worst,” Morningstar Fund Spy (November 30, 2009), http://news.morningstar.com/articlenet/article.aspx?id=317169 (accessed March 21, 2010) and “How Expense Ratios and Star Ratings Predict Success”, Morningstar Fund Spy (August, 9. 2010), http://news.morningstar.com/articlenet/article.aspx?id=347327&part=2 (accessed September 13, 2010).

4. For more information, go to www.imoneynet.com.

5. Lipper, “U.S. Open-End, Closed-End, Variable Annuity, and Overseas Fund Classification Descriptions” (April 2010).

6. Source: Morningstar. Excludes sector funds and funds with expense ratios of 0.0 percent. Total of 184 index funds and 1,931 actively managed funds on June 20, 2010.

7. For a review of the literature on performance persistence, see Eero J. Pätäri, “Do Hot Hands Warm the Mutual Fund Investor? The Myth of Performance Persistence Phenomenon,” International Research Journal of Finance and Economics 34 (2009).

8. Researchers attribute the persistence of negative performance to investor inertia. Some investors will just not sell fund shares at a loss, no matter how consistently bad long-term results have been.

9. W. V. Harlow and Keith C. Brown, “The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management,” Journal of Investment Management 4 (4) (2006).

10. Investment Company Institute, 2010 Investment Company Fact Book (2010).

11. Convertible securities funds invest in bonds or preferred stocks that can be exchanged, or converted, into stocks. These securities may behave like either bonds or stocks, depending on market conditions and the specific terms of the security. We discuss conversion features in the Appendix to Chapter.

Chapter 5: Portfolio Management of Stock Funds

1. Stock is also often referred to as common stock to distinguish it from preferred stock, an investment much closer to a bond than a stock. Like bonds, preferred stocks appeal to income-oriented investors because they pay out a fixed amount annually, though in the form of dividends rather interest. They do not carry any ownership or voting rights. There are, however, two critical differences between preferred stocks and bonds. First, the income payments on preferreds are made at the discretion of management and are not contractual commitments, as are interest payments; companies in financial difficulty will suspend preferred stock dividends before stopping payment of bond interest. Also, preferreds are perpetual, meaning that they have no maturity date; they remain outstanding until the company takes steps to redeem them.

2. In a notable exception, Google initially sold its stock to the public directly, without the intermediation of an investment bank.

3. Any subsequent sales of shares by the company are often dubbed secondary offerings, though the term can also refer to the sale of a large amount of stock by a single shareholder.

4. The model for this example was provided by Phil Roth of Miller Tabak + Co.

5. Technical analysis is often used in commodity and currency investing, where price trends are particularly important.

6. The accrual anomaly, as it’s called, was first documented by Richard G. Sloan in 1996. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” The Accounting Review 71 (3): (1996).

7. AIM Basic Value Fund, Annual Report to Shareholders (December 31, 2009), 5.

8. Columbia Acorn Fund, Columbia Acorn Family of Funds Annual Report (December 31, 2009), 8.

9. T. Rowe Price Growth Stock Fund, Annual Report (December 31, 2009), 2.

10. This effect has become less pronounced in recent years. See Standard & Poor’s, “The Shrinking Index Effect” (November 2008), http://www2.standardandpoors.com/spf/pdf/index/The_Shrinking_Index_Effect.pdf (accessed March 21, 2010).

11. This is the popular definition of alpha. A quant will note that, technically, alpha is the difference between portfolio return and beta-adjusted market return, which equals the market return times the portfolio’s beta.

12. Portfolio managers often casually refer to weighting decisions as bets.

13. Distinct portfolios only. Excludes index and sector funds.

14. If all the funds in a fund family buy a large proportion of a company’s shares, it becomes more difficult to sell those shares simply because of a lack of other buyers. Also, if the holdings of a fund complex in a company exceed 15 percent of its voting shares, the funds involved run increased risk of becoming subject to filing or other requirements under various federal and state laws.

Chapter 6: Portfolio Management of Bond Funds

1. Effective maturity, which reflects mortgage prepayments, puts, and coupon adjustments.

2. Those guarantees turned out to be very costly to the agencies when home values were falling during the credit crisis of 2008.

3. For a full discussion, see Michael Lewis, The Big Short (New York: Norton, 2010).

4. The issuer was Sperry Lease Finance Corporation.

5. Most ABS are overcollateralized, meaning that there are more loans in the underlying pool than are needed to pay all investors. As a result, Tranche D would experience losses only after the cushion was exhausted.

6. The creator, or originator, of the ABS also retains the rights to any excess income above and beyond what is needed to pay obligations to the tranches. This is referred to as the seller’s interest; it technically absorbs the first set of losses, before the junior tranche is affected.

7. Inside Mortgage Finance data, cited in Robert Pozen, Too Big to Save? (Hoboken, NJ: John Wiley & Sons, 2010), 11.

8. Drexel Burnham Lambert went bankrupt as a result. Michael Milken served time in prison after pleading guilty to charges that he violated securities laws.

9. Eurodollar bonds are issued and traded outside the United States, Yankee bonds within.

10. Yield to worst.

Appendix To Chapter 6: Bond Basics

11. SIFMA, Fact Book 2009 (2009). Excludes money market securities.

12. The illustration assumes annual coupon payments.

13. For more information on the credit ratings, visit: www.fitchratings.com, www.moodys.com, and www.standardandpoors.com.

Chapter 7: Portfolio Management of Money Market Funds

1. This was due to Regulation Q, which prohibited banks from paying interest on checking accounts and limited the interest payable on savings accounts. See Chapter.

2. Rule 2a-7 was adopted in 1982, when the SEC decided to codify the guidance it had previously given to money market funds through “no action” letters. The rule has been expanded to reflect the creation of new security types and strengthened to prevent a recurrence of credit quality issues that have arisen at times.

3. The cost basis is adjusted for amortization of premium or discount, which is essentially the accretion in zero coupon securities. (See the appendix to Chapter for a definition of accretion.)

4. There is significant concern within the fund industry that removing the references to credit agency ratings could increase the risks for at least some money market funds. Many insiders believe that the ratings helped ensure consistency across funds and that, without them, it will be easier for fund managers to boost yields by buying securities of less than the highest quality.

5. This is a demand, or put feature. A put gives the holder of the security the right to sell the security back to the issuer at any time at a set price.

6. Congress increased the limit on deposit insurance from $100,000 to $250,000 in October 2008 as one of the measures designed to stem the credit crisis. The Dodd-Frank financial reform legislation made the temporary increase permanent.

7. With non-U.S. government securities, more than 102 percent collateral would ordinarily be required.

8. The bonds may be held directly with the issuer, or they may held in an asset-backed structure sponsored by a third party. The latter is a synthetic VRDN.

9. Check writing is usually provided by a bank on behalf of a money market fund.

Chapter 8: Implementing Portfolio Decisions: Buying and Selling Investments

1. John Chalmers, Roger M. Edelen, and Gregory B. Kadlec, “An Analysis of Mutual Fund Trading Costs” (November 1999), in SSRN, http://ssrn.com/ abstract=195849 (accessed June 11, 2010).

2. Cited in Securities and Exchange Commission, Concept Release on Equity Market Structure (34-61358, January 2010), 6.

3. The name initially stood for “National Association of Securities Dealers Automated Quotations.” It was an electronic version of a pre-existing dealers’ market that did business over the telephone and through the publication of paper pink sheets.

4. The order handling rule, adopted by the SEC in 1996, requires that market makers include customer orders in bids and offers, if those customer orders are at a price equal to or better than the market maker’s own bid or offer.

5. The regional exchanges, such as the Boston and the Philadelphia Stock Exchanges, serve almost as adjuncts to the NYSE. The American Stock Exchange was acquired by NYSE Arca in 2008.

6. This rule technically applies only to market makers whose trading exceeds 1 percent of nationwide trading volume in a stock.

7. James J. Angel, Lawrence E. Harris, and Chester S. Spatt, Equity Trading in the 21st Century (February 2010), 8, www.knight.com/newsRoom/pdfs/EquityTradinginthe21stCentury.pdf (accessed June 11, 2010).

8. BATS originally stood for Better Alternative Trading System, although the exchange now uses the acronym exclusively.

9. Technically, a broker arranges trades for its clients, charging a commission for its services. It does not take ownership of the securities as part of the transaction. A dealer, in contrast, buys and sells securities for its own account; it expects to earn a spread when it trades. Many firms are broker-dealers that can engage in both activities.

10. Angel, Harris, and Spatt, 14.

11. The market circuit breakers were implemented after a similar computer program–driven crash in 1987.

12. Mao Ye, “A Glimpse into the Dark: Price Formation, Transaction Cost and Market Share of the Crossing Network” (January 2010), in SSRN, http://ssrn.com/abstract=1521494 (accessed June 11, 2010).

13. Confusingly, sometimes the term soft dollar research is used to refer only to research sourced from third parties.

Chapter 9: Mutual Funds as Institutional Investors

1. While mutual funds are also substantial owners of corporate bonds, bondholders generally do not have voting rights at the companies that issue the bonds. Therefore, this chapter does not address the role of mutual funds as institutional investors in corporate bonds.

2. Mutual funds include exchange-traded and closed-end funds. Pension plans include private pension funds, state and local government retirement funds, and federal government retirement funds. Other includes broker-dealers, state and local governments, savings institutions, and commercial banks.

3. As discussed in Chapter, open-end mutual funds are an exception to this rule. Closed-end funds must hold a proxy vote annually.

4. Shareholders have the right to amend bylaws that bind the company, but there is controversy regarding the use of bylaw amendments to take away the board’s discretion to manage the company.

5. Investment Company Institute, “Proxy Voting by Registered Investment Companies: Promoting the Interests of Fund Stockholders,” Research Perspective (July 2008), 3.

6. See Tom Lauricella, “Mutual Funds Get Mad,” Wall Street Journal, October 2, 2007.

7. Diane Del Guercio, Laura Cole, and Tracie Woidtke, “Do Boards Pay Attention When Institutional Investor Activists ‘Just Vote No’?” (January 2008), in SSRN: http://ssrn.com/abstract=575242.

8. Social Investment Forum, “Socially Responsible Investing Facts,” www.socialinvest.org/resources/sriguide/srifacts.cfm (accessed June 12, 2010) and Investment Company Institute, 2010 Investment Company Fact Book (2010).

Chapter 10: Retail Sales

1. This 75 percent includes the more than 17 percent of industry assets in individual retirement accounts, which we discuss in detail in the next chapter.

2. One study documenting this effect is Ronald T. Wilcox, “Bargain Hunting or Star Gazing? Investors’ Preferences for Stock Mutual Funds,” Journal of Business 76 (4) (2003): 645–663.

3. Diane Del Guercio and Paula A. Tkac, “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows,” Federal Reserve Bank of Atlanta, Working Paper 2001-15, (August 2001, updated January 2007).

4. Investors appear to be less sensitive to differences in the annual expense ratio than to sales loads. See Brad M. Barber, Terrance Odean, and Lu Zheng, “Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows,” Journal of Business 78 (6) (2005).

5. Prem Jain and Joanna Wu, “Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows,” Journal of Finance 55 (April 2000): 937–958. This study does not consider whether the profits from the incremental sales exceed the cost of advertising.

6. Investment Company Institute, “Understanding Investor Preferences for Mutual Fund Information” (2006).

7. Mutual fund supermarkets include distribution through discount brokers.

8. Virtually all larger money managers are registered with the SEC as investment advisers, but they are not normally referred to as RIAs. The term is reserved for firms serving individual clients directly.

9. All the licensing programs are administered by FINRA.

10. There’s one other difference between financial advisers and registered investment advisers. Only FAs can engage in principal trades with clients. (See Chapter for an explanation of principal trading.)

11. According to an Investment Company Institute survey (see note 5), 40 percent of investors prefer to receive fund information from advisers in person.

12. Insurance companies previously used proprietary accounts as investment options in variable annuities.

13. Statistics on variable annuities are from Insured Retirement Institute, 2010 Annuity Fact Book (2010).

14. Variable annuities can be sold in an unbundled format with a menu of choices. This means that the insurance contract that comes with the VA may be fairly basic in regard to coverage. Then the client has the option of adding—and paying for—additional features, such as guaranteed levels of retirement payments.

15. Data on sales loads are from Investment Company Institute, “Trends in the Fees and Expenses of Mutual Funds, 2009,” Research Fundamentals 19 (2) (April 2010).

16. When Rule 12b-1 was adopted in 1980, funds were experiencing significant redemptions as a result of a severe economic recession. Increasing fund assets was seen as a way to reduce fund expenses through greater economies of scale—helping both shareholders and fund management companies.

17. Class B shares have fallen out of favor partly because they create significant financial risk for fund management companies. As explained, a fund distributor pays the load to the intermediary up front, earning it back only over time through 12b-1 fees and contingent deferred sales charges. The risk: The payback period can be extended significantly. That may happen if fund assets fall because of a decline in the market or if the fund’s board of directors suspends the 12b-1 program, maybe because the fund has become very large and is no longer accepting new investments. To reduce the risk, many fund sponsors chose to sell the rights to future 12b-1 payments at a discount to a third party. However, as noted, many firms no longer offer B shares and therefore avoid the risk altogether.

18. One fund complex has introduced another class of shares—Class N—specifically for retirement plans. This class is limited to retirement plans with assets exceeding $500,000 and typically charge a 0.50 percent 12b-1 fee and a 1 percent contingent deferred sales charge on redemptions made within 18 months of purchase. This Class N is used by fund complexes which sell through intermediaries and should not be confused with the Class N used by no-load fund complexes.

19. For load funds, these are usually Class A shares with the load waived. For no-load funds, this is usually Class N.

20. Both UTMA and UGMA are model state laws. Most states have adopted the newer UTMA statute, replacing preexisting UGMA laws.

21. Mutual fund companies establish nonprofits that hold the contributions from donors and establish guidelines for donations. Generally, these guidelines permit donations to 501(c)(3) public charities and to other donor-advised funds, such as community foundations. Donations to private foundations are severely restricted.

Chapter 11: Retirement Plans and Mutual Funds

1. Defined contribution plans and individual retirement accounts each accounted for roughly the same percentage of mutual fund assets. Retirement plans account for 50 percent of household investments in non–money market funds. Investment Company Institute, 2010 Investment Company Fact Book (2010).

2. These are the tax benefits for traditional 401(k) plans. Roth 401(k)s are also available, although few of these plans have been established; they provide tax benefits that are similar to those of the Roth IRAs that we review in a moment.

3. Sometimes, but rarely, employees also make contributions to defined benefit plans.

4. Technically, to be fully funded, a defined benefit plan must have sufficient assets—considering both current value and expected investment earnings—to pay out all benefits accrued to that date, excluding promised benefits for future service.

5. ERISA also applies to many other employee benefit programs, including health care plans.

6. Median job tenure in 2008 according to the Bureau of Labor Statistics, September 26, 2008.

7. Employers who have been unable to terminate a defined benefit plan for tax or contractual reasons often convert them to cash balance plans, which are hybrids of defined benefit and defined contribution plans. These plans don’t guarantee a specified level of income throughout retirement. Instead, they agree to pay workers a specific lump sum upon retirement—or possibly upon termination of employment before retirement—based on contributions to the plan and an assumed rate of return. Employers prefer cash balance plans to traditional DB plans because they reduce their exposure to investment risk. Plan conversions have been controversial because benefits for older workers may be reduced in the process, an effect called wear away. In 2007, less than 10 percent of DB plans were cash balance plans, but these plans covered 25 percent of the workers participating in those plans. Statistics are from the U.S. Department of Labor, Employee Benefits Security Administration, Private Pension Plan Bulletin: Abstract of 2007 Form 5500 Annual Reports (2010) and Private Pension Plan Bulletin: Sixth Edition, 1993.

8. The Pew Center on the States, The Trillion Dollar Gap (2010).

9. Ronald Snell, National Conference of State Legislatures, “State Retirement System Defined Contribution Plans” (September 2009), www.ncsl.org/Portals/1/Documents/employ/StateGovtDCPlansSept2009.pdf (accessed May 20, 2010).

10. J. Mark Iwry, Peter R. Orszag, and William G. Gale, “The Automatic 401(k): A Simple Way to Strengthen Retirement Savings,” The Retirement Security Project 2500-1, www.brookings.edu/papers/2005/03saving_gale.aspx (accessed June 28, 2010).

11. Under the antidiscrimination rules, the average contribution rates for highly compensated employees, or HCEs, and for non–highly compensated employees, or NHCEs, must be calculated and compared by the 401(k) plan administrator each year. The plan passes the antidiscrimination test if HCEs contribute at an average rate no more than 125 percent higher than that for NHCEs, or if the average contribution rate for HCEs is less than two percentage points greater than the average rate for NHCEs. Catch-up contributions are excluded from the calculation. The antidiscrimination rules do not apply to 403(b) or 457 plans.

12. Collective trust funds were originally designed to allow banks to commingle assets of smaller defined benefit plans in a single group trust. The bank offering the CTF acts as the group trustee of the assets held in the pool on behalf of the investors in the pool.

13. The manager of a mutual fund may be exempt from those requirements.

14. Investment Company Institute, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2008,” Research Perspective 15 (2) (2009): 26.

15. Plan sponsors generally prefer stable value pools over guaranteed investment contracts because they provide greater protection against the bankruptcy of the issuer. GICs are issued by insurance companies and are secured only by its corporate assets; if the insurer should fail, the investors in the GIC could lose everything. Stable value pools can be issued by many different financial institutions, including insurers. While backed by that institution, investors have recourse to a segregated set of assets that has provided the pool’s annual income should the issuer go bankrupt.

16. SEP, or Simplified Employee Pension, Plan individual retirement accounts are also designed for small employers. SIMPLE IRAs more closely resemble 401(k) plans since they allow for both employer and employee contributions; SEP IRAs involve employer contributions only. Congress had previously authorized SAR-SEP (Salary Reduction Simplified Employee Pension Plan) IRAs; employers may no longer establish new SAR-SEP plans, although existing ones may continue to be used. SIMPLE plans can be structured as 401(k) plans or IRAs; virtually all employers have chosen IRAs because of their greater simplicity.

17. Patrick Purcell, “Retirement Savings and Household Wealth in 2007,” Congressional Research Service 7-5700, April 2009.

18. Seasonal or part-time work is defined as fewer than 1,000 hours per year.

19. SIMPLE plan participants are eligible for the Saver’s Credit.

20. Jason Furman, Policy Basics: Top Ten Facts on Social Security’s 70th Anniversary (August 2005), www.cbpp.org/cms/index.cfm?fa=view&id=531 (accessed June 28, 2010).

Chapter 12: The Competition from Exchange-Traded Funds and Hedge Funds

1. Data derived from Cerulli Associates, Inc., The Cerulli Report: Exchange-Traded Funds: Threat or Threatened? (2009) and Investment Company Institute, 2010 Investment Company Fact Book (2010).

2. See “Leland O’Brien Rubinstein Associates Inc.: SuperTrust,” Harvard Business School Case Study 9-294-050 (1995) for an account of the challenges faced in the development of the first exchange-traded fund.

3. In 2010, some discount brokers eliminated commissions on ETF trades. At the time this chapter was written, it’s unclear whether this is a temporary promotion or a permanent change.

4. This investment return is often structured to be taxed at more favorable capital gains rates. The IRS is currently reviewing the tax treatment of this income.

5. National Stock Exchange, ETF Data: Monthly ETF Reports, Month End April 2010; www.nsx.com/content/etf-assets-list (accessed May 11, 2010).

6. The redemption basket is based on the portfolio at the time of the next calculation of NAV.

7. U.S. Commodity Futures Trading Commission and U.S. Securities & Exchange Commission, Preliminary Findings Regarding the Market Events of May 6, 2010 (May 2010), 5–6.

8. Tracking error is defined here as the difference between the performance of the NAV and the performance of the index. Some analysts define it as the difference between share performance and index performance, which would reflect changes in the premium or discount of the share price versus the NAV.

9. Mutual funds are limited in the amount of exchange-traded fund shares they may purchase. Under the 1940 Act, a fund may not invest more than 5 percent of its assets in any other single mutual fund or more than 10 percent of its assets in other mutual funds in total. Also, it may not acquire more than 3 percent of the shares of another fund. These rules prevent fee pyramiding. Target date funds and other funds of funds must request an exemption from this rule from the SEC.

10. Richard A. Ferri, The ETF Book: All You Need to Know About Exchange-Traded Funds (John Wiley & Sons, 2009).

11. Selling short before borrowing shares is called naked shorting and is prohibited in the United States.

12. See Burton G. Malkiel and Atanu Saha, “Hedge Funds: Risk and Return,” Financial Analysts Journal 61 (6): 80–88 (November-December 2005), and Roger G. Ibbotson and Peng Chen, “The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs,” Yale ICF Working Paper No. 06-10 (September 2006).

13. Stephen J. Brown and William N. Goetzmann, “Fees on Fees in Funds of Funds,” Yale ICF Working Paper No. 02-33 (June 2004).

14. The Global Investment Performance Standards—or GIPS standards—are designed to minimize backfill and survivorship bias in an investment firm’s performance reporting. Firms that adhere to the standards must keep historical records of the performance of all portfolios managed by the firm. The CFA Institute created and administers the standards.

15. A growing number of investment managers are offering hedge fund strategies in mutual fund structures. This is most common in Europe, as we see in Chapter. Some of these funds seek to replicate the returns of a hedge fund not available to the average investor. On the plus side, these replication products offer lower initial investment thresholds, lower fees, greater transparency, and more frequent liquidity. On the negative side, these funds generally do not offer genuine access to star managers and may have high fees.

16. For more, see Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000).

17. Smaller hedge fund managers—those with less than $150 million in assets—still need not register with the SEC if they have fewer than 15 clients and do not publicly market their services. However, smaller hedge fund managers may be subject to state-level investment adviser regulation.

Chapter 13: Customer Service

1. Under the Securities Exchange Act of 1934, the transfer agent must register with the SEC.

2. Investment Company Institute, 2010 Investment Company Fact Book (2010).

3. A few fund management companies have established a network of branch offices, and prospective investors may hand in completed applications at these branches.

4. Transfer agents generally do not send confirmations for purchases made through systematic investment plans; these transactions will be included only in quarterly statements.

5. The effective date of the new law varies by type of investment, and it applies only to shares acquired after that date. For stocks, the new requirements kick in for shares acquired after January 1, 2011. For mutual funds, the relevant date is January 1, 2012. For other securities, there’s no impact until January 1, 2013.

6. BNY Mellon Asset Servicing was PNC Global Investment Servicing before it was acquired by BNY Mellon in mid-2010. Before joining the PNC financial group, it was PFPC.

Chapter 14: Portfolio Recordkeeping and Valuation

1. There is an exception to the T+1 rule: institutional money market funds post transactions—both securities trades and capital stock activity—on the trade date, or T+0.

2. Under “Fair Value Measurements and Disclosures (Topic 820),” under the new Financial Accounting Standards Board codification system. When it was initially adopted, this guidance was referred to as Financial Accounting Standard 157, or FAS 157.

3. Intermediaries using omnibus accounts, including many 401(k) plans, may need time to total the day’s orders after the market close and therefore must submit them to the fund after 4 P.M. This practice is acceptable if the intermediary has a written contract with the fund that requires it to affirm that no trades have been placed by investors after 4 P.M.

4. Includes PNC Global Investment Servicing, which was acquired by BNY Mellon in 2010.

5. Fund managers are not legally required to reimburse funds for losses incurred as the result of errors, but most do so as a matter of practice.

Chapter 15: The Financial Dynamics of the Fund Management Industry

1. This group includes BlackRock, Eaton Vance, Federated Investors, Franklin Resources, Invesco, Janus Capital, Legg Mason, T. Rowe Price, and Waddell & Reed. Source: Morningstar, Inc.

2. Russel Kinnel, “How Expense Ratios and Star Ratings Predict Success”, Morningstar Fund Spy, (August, 9. 2010), http://news.morningstar.com/articlenet/article.aspx?id=347327&part=2 (accessed September 13, 2010).

3. For a detailed review of the debate over mutual fund fees, see R. Glenn Hubbard et al., The Mutual Fund Industry: Competition and Investor Welfare (New York: Columbia University Press, 2010).

4. John P. Freeman and Stuart B. Brown, “Mutual Fund Advisory Fees: The Cost of Conflicts of Interest,” The Journal of Corporate Law 26:609–674 (2001).

5. Brad M. Barber, Terrance Odean, and Lu Zheng, “Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows,” Journal of Business 78 (6) (2005).

6. Sean Collins, “The Expenses of Defined Benefit Pension Plans and Mutual Funds,” Investment Company Institute Perspective, December 2003.

7. Current name used for substantially similar firms.

8. Also, at least 75 percent of the directors of the funds must remain independent for at least three years after the transfer of the advisory contract.

Chapter 16: Cross-Border Investing

1. For a comprehensive study of the benefits of trade and investment liberalization, see Organisation for Economic Co-Operation and Development, “Open Markets Matter: The Benefits of Trade and Investment Liberalization,” OECD Policy Brief (October 1999) and Trade, Investment and Development: Reaping the Full Benefits of Open Markets (Paris, France: Organisation for Economic Co-Operation and Development, 1999).

2. John Rea, “U.S. Emerging Market Funds: Hot Money or Stable Source of Investment Capital?” ICI Perspective 2 (6) (December 1996) and Mitchell A. Post and Kimberlee Miller, “U.S. Emerging Market Equity Funds and the 1997 Crisis in Asian Financial Markets,” ICI Perspective 4 (2) (June 1998).

3. The encaje was increased to 30 percent in 1992. In mid-1998, it was reduced to 10 percent, and the early withdrawal penalty was lowered to 1 percent. It was eliminated entirely in September 1998. Direct investment was subject to different restrictions. From 1982 through 1991, direct investment needed to stay in the country for 10 years. The required holding period was reduced to three years in 1991 and one year in 1993. See Christopher J. Neely, “An Introduction to Capital Controls,” Federal Reserve Bank of St. Louis Review (November-December 1999).

4. These last countries are sometimes informally referred to as the PIIGS, for Portugal, Ireland, Italy, Greece, and Spain. They are the least well-off of the countries using the euro as a currency and experienced significant financial stress as a result of the credit crisis.

5. Piero Cinquegrana and Willem Pieter de Groen, ECMI Statistical Package 2009, www.eurocapitalmarkets.org/?q=node/408 (accessed June 23, 2010).

6. See Amir Andrew Amadi, “Equity Home Bias: A Disappearing Phenomenon?” (May 5, 2004), in SSRN: http://ssrn.com/abstract=540662, and Bong-Chan Kho, Francis E. Warnock, and Rene M. Stulz, “Financial Globalization, Governance, and the Evolution of the Home Bias,” BIS Working Paper No. 220 (June 2007), in SSRN: http://ssrn.com/abstract=911595.

7. See Peter F. Christoffersen, Vihang R. Errunza, Kris Jacobs, and Xisong Jin, “Is the Potential for International Diversification Disappearing?” (March 16, 2010). In SSRN: http://ssrn.com/abstract=1573345, and Roberto Ribogon, “International Financial Contagion: Theory and Evidence in Evolution” Research Foundation Publications (August 2002).

8. Barry Eichengreen and Michael Bordo, “Crisis Now and Then: What Lesson from the Last Era of Financial Globalization,” NBER Working Paper No. 8716 (January 2002).

9. Burhan F. Yavas, PhD, “Benefits of International Portfolio Diversification,” Graziadio Business Report 10 (2) (2007), http://gbr.pepperdine.edu/072/diversification.html (accessed June 23, 2010).

10. “Custody of Investment Company Assets Outside the United States,” Rule 17f-5 promulgated under the Investment Company Act of 1940.

Chapter 17: Cross-Border Asset Gathering

1. Ajay Khorana, Henri Servaes, and Peter Tufano, “Explaining the Size of the Mutual Fund Industry Around the World,” Darden School of Business Working Paper No. 03-04; Harvard NOM Working Paper No. 03-23; EFA 2003 Annual Conference Paper No. 804 (January 2004), in SSRN: http://ssrn.com/abstract=573503.

2. Ajay Khorana, Henri Servaes, and Peter Tufano, “Mutual Funds Fees Around the World,” HBS Finance Working Paper No. 901023 (July 2007), in SSRN: http://ssrn.com/abstract=901023.

3. Data for Switzerland are as of December 2008.

4. A UCITS fund may be either a SICAV, which stands for société d’investissement à capital variable, meaning “investment society with variable capital,” or an FCP, for fond commun de placement. A SICAV is a separate legal entity, roughly equivalent to a U.S. open-end mutual fund, while an FCP is established by contract between the management company and the custodian.

5. Information on cross-border registrations in this section is from PricewaterhouseCoopers, Global Fund Distribution 2010 (2010). Cross-border funds are defined as those registered in at least three countries.

6. European fund market share data from EFAMA, “Trends in the European Investment Fund Industry in the Fourth Quarter of 2009 and Results for the Full Year 2009,” Quarterly Statistical Release 40 (March 2010), www.efama.org/index.php?option=com_docman&task=cat_view&gid=72&Itemid=-99 (accessed September 16, 2010).

7. The original UCITS directive was adopted in 1985. A proposed amendment to the original directive—which was to have been known as UCITS II—was abandoned before it was implemented. This failed amendment was modified and adopted as UCITS III in 2002.

8. Alternative mutual funds include absolute/total return, commodity, property, infrastructure, specialty funds (includes 130/30, private equity, and funds investing primarily in derivatives), fund of hedge funds, and hedge funds deemed UCITS-compliant.

9. John C. Coates IV, “Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis” (December 30, 2008): 50, in SSRN, http://ssrn.com/abstract=1311945 (accessed June 27, 2010).

10. BAKred is short for Bundesaufsichtsamt für das Kreditwesen, while BAV is the acronym for Bundesaufsichtsamt für das Versicherungswesen.

11. Fédération Européenne des Conseils et Intermédiaires Financiers, Annual White Book – December 2008, www.fecif.org/library/FECIF%20white%20book%202008%20FINAL.pdf.

12. McKinsey & Company, The Asset Management Industry in 2010, www.mckinsey.com/clientservice/bankingsecurities/latestthinking/The_Asset_Management_Industry_in_2010.pdf (accessed June 17, 2010).

13. Axel H. Börsch-Supan and Christina Wilke, “The German Pension System: How It Will Become an NDC Look-Alike,” Pension Reform (World Bank, 2006).

14. Statistics on contributions from each of the three pillars are from Axel Oster, Risk-Based Pension Supervision—German Approach (March 2006), www.oecd.org/dataoecd/43/52/36344245.pdf (accessed June 25, 2010).

15. The Social Protection Committee of the European Commission, Privately Managed Funded Pension Provision and their Contribution to Adequate and Sustainable Pensions (2008) and Synthesis Report on Adequate and Sustainable Pensions (2006), http://ec.europa.eu/employment_social/spsi/adequacy_sustainability_en.htm (accessed July 6, 2010).

Chapter 18: The Market for Investment Funds: Beyond the United States and Europe

1. U.S. dollar fund asset figures in this chapter are from the Investment Company Institute, 2010 Investment Company Fact Book (2010). GDP figures are from the Central Intelligence Agency, The World Factbook.

2. U.S.-registered mutual funds are included in the 10 percent represented by non-UCITS funds. Taiwan is one of the few countries that permit their distribution.

3. Before Hong Kong’s Consumer Council took steps to limit fees in 2007, expenses on some funds were as high as 4 percent a year.

4. Statistics on Singapore from Monetary Authority of Singapore, 2009 Singapore Asset Management Industry Survey, www.mas.gov.sg/resource/eco_research/surveys/AssetMgmt09.pdf (accessed August 4, 2010).

5. Capgemini and Merrill Lynch, Asia-Pacific Wealth Report 2008 (2008).

6. Foreign investors wishing to purchase investments in China must register as qualified foreign institutional investors, or QFIIs. See Chapter for more on the QFII regime.

7. Chinese retirement system information from Robert C. Pozen, An American Perspective on the Chinese Pension System, EBRI Notes 27 (8) (August 2006) and Stuart P. Leckie, A Review of the National Social Security Fund in China, www.actuaries.org/PBSS/Colloquia/Tokyo/LECKIE_StuartP.pdf (accessed July 3, 2010).

8. Of countries with a population of at least one million. Central Intelligence Agency, The World Factbook.

9. Publicly offered investment trusts of the contractual type.

10. The law has been likened to Sarbanes-Oxley in the United States and is often referred to as J-SOX.

11. Carol Wood, “Special Delivery: Japan Post to be Privatized,” in Bloomberg Businessweek, www.businessweek.com/investor/content/apr2006/pi20060405_205672.htm (accessed July 4, 2010).

12. Individuals who are not covered by a defined benefit plan may contribute ¥552,000 (or roughly $5,200) to a defined contribution plan annually. Contributions for others are capped at ¥276,000 (or $2,600).

13. For the history of Japan’s retirement system, see David Rajnes, “The Evolution of Japanese Employer-Sponsored Retirement Plans,” Social Security Bulletin 67 (3) (2007), www.ssa.gov/policy/docs/ssb/v67n3/v67n3p89.html (accessed July 4, 2010).

14. Assets fell to US$74 billion in 2008 during the credit crisis, but have since rebounded. Not all workers are included in the program. For example, military personnel and the self-employed are exempt. For more information on the Chilean system, see Superintendency of Pension Fund Administrators, The Chilean Pension System, Fourth Edition, www.safp.cl/573/article-3523.html (accessed July 4, 2010).

15. Citi recently announced plans to sell its indirect stake in an AFP to focus on its core banking business in Chile.

16. Canadian Institutional Investment Network, 2009 Cap Benchmark Report (2009).

17. Canadians are also covered by a pay-as-you-go system, which provides a modest level of benefits.

18. Brooke Smith, “Closing the Gap,” Benefits Canada (December 2009).

19. Before the restrictions were removed, clone funds used derivatives to replicate the performance of foreign markets while complying with the local content laws.

20. Ajay Khorana, Henri Servaes, and Peter Tufano, “Mutual Funds Fees Around the World,” HBS Finance Working Paper No. 901023 (July 2007), in SSRN: http://ssrn.com/abstract=901023.