Lesson 15: Liquidity

Gold
I use this image whenever I can. Just look at that sheen.

Imagine I come up to you and allow you a choice. Because I am a very generous, benevolent man I offer you either $100,000 in cash or gold bars worth $100,000. Which offer makes more sense to choose? The time value of money is not relevant in this instance as you will gain the assets at the same time.  Your gut may be leaning towards the cash. Ignoring the obvious allure of shiny gold, you may realize that gold isn’t that useful in terms of purchasing everyday goods and services. You may also realize that there are additional steps you will have to take to turn that gold into cash such as finding someone to buy that gold and give you cash in return.  This concept of transforming an asset (gold in this case) into cash is known as liquidity.

Key Points

  • Liquidity is defined as the ease in which an investment can be converted into cash with little to no loss of value.
  • Cash is the most liquid of all assets.
  • There is a hierarchy of liquidity when it comes to investments.
  • Markets play a key role in maintaining liquidity of investments.
  • Imbalanced markets can create liquidity problems.

What is Liquidity?

Liquidity is a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss in value. An investment which cannot be easily converted into cash or can only be converted to cash quickly with loss of value is said to be illiquid.  Though there is no established scale for measuring liquidity, a rough hierarchy can be built to compare different assets’ liquidity.

Cash is the Most Liquid Asset

River
The other “liquid asset”. Image courtesy of nature.org.

Cash is commonly like water in the world of finance. When valuing a company you may create financial models that measure future cash “flows”. Keeping with this comparison cash is the most “liquid” asset and thus is used as the basis for measuring liquidity

Why is the cash the most liquid asset? As I referenced to earlier if you walked into a shop or a restaurant and tried to pay with gold coins or a very valuable, rare painting, you may find yourself in an undesirable situation. Cash is the most liquid because it is the currency we use in everyday commerce.  If we instead used shells or cigarettes (both of which have been used as currencies in certain economies) as currency, the shells/cigarettes would be the most liquid asset you could possess.

What is the Hierarchy of Liquid Assets?

As we established above cash is the most liquid of all investments. The diagram below places other common investments along a rough scale of liquidity.

 

tri2
What Links Liquidity and Markets ?

These rankings beg the question “What determines whether an investment is liquid or illiquid?” The answer is really simple: Is there a well functioning market that puts buyers and sellers together to exchange the investments?

Near the top of the liquidity scale are assets that have large exchanges and are traded frequently (stocks, bond, ETFs). Further down the scale you come across assets that are not as widely traded or are highly specialized (financial derivatives, commodities, real estate). The least liquid assets are incredibly specialized or lack a centralized market (rare art, antiques, cars).

The presence of a market is not enough to make an asset liquid. The market must be efficient with relatively equal supply and demand. Said differently the market cannot be buyer or seller dominated. In this instance the investment may be sold at a high premium or a deep discount due to the abundance or scarcity of the investment.

Gold diamond
A gold diamond…close enough. Image courtesy of vivalididiamonds.

For example let’s assume there is a new type of gold discovered called “diamond gold”. Furthermore let’s assume that Diamond Gold Inc. is the sole supplier (seller) on the diamond gold market.  In this instance because Diamond Gold Inc. controls the supply of diamond gold it can charge a high price for the diamond gold, reducing the trading of diamond gold, and rendering it illiquid.

What happens to an asset’s liquidity if the market is dominated by people wanting to sell a certain type of asset? This question was answered in the real estate crash that accompanied the 2008 Recession.

Liquidity and Risk: A Lesson from the 2008 Recession?

Foreclosure
Now imagine an entire street full of these things. Image courtesy of vinafengshui.

While the 2008 Recession is deserving of its own website, let’s look at a small aspect of the 2008 recession: the real estate market.  When home values began to plummet home owners were desperate to try to get rid of the “hot potato” that was their
homes.This flooded the real estate with homes (many of which were previously foreclosed on). As simple economics would dictate with this flood of supply buyers could pay a deep discount for homes that under normal circumstance would have a much higher value.  

Remember the aspect of liquidity in which the asset is converted “without significant loss of value”? In a market flooded with supply this tenant is violated as assets can only be sold at significantly lower cash values. Though this is a simplification of the complex 2008 Recession the effect of illiquidity was easily noticeable in the pummeled real estate market of the time.

Definitions

  1. Liquidity: a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss of value
  2. Illiquid: a characteristic of an investment in which an investment cannot quickly or easily be converted into cash without loss of value
  3. Currency: a medium of exchange that has value and is used to purchase goods and services

Further Reading

Lesson 14: Financial Derivatives

L13.1 Chart
Image courtesy of investspec.com

Up to this point the assets discussed have been “real” assets.  Said differently the assets (stocks, bonds, commodities) had some level of intrinsic value because they represented some sort of claim either to ownership of a business (stock), debt to be repaid (bond), or some physical good (commodity). There are other assets that have value because they represent a claim to these “real” assets. These assets are known as financial derivatives and are some of the more interesting and colorful financial instruments.

Key Points

  • A financial derivative is a security whose price is determined or derived from the price of the underlying asset.
  • Common types of financial derivatives include options, swaps, futures, and forwards.
  • Financial derivatives are traded either on exchanges or in over-the-counter (OTC) markets.
  • The role of financial derivatives in the market is to help mitigate risk from entities who do not wish to bear risk to entities better suited to manage that risk.

What is a Financial Derivative?

Financial derivatives are a type of financial security whose price is derived from the price of the underlying asset it represents. As opposed to “real assets” whose value comes from the perceived increase in value or the cash flows generated by the real asset, a derivative represents some sort of claim on the real asset. By existing independently of the real asset, the derivative can be traded separately while its value is largely related to the value of the underlying asset.

A Story of Opals and Options

Behold the opulent opal. Image courtesy of stephen-universe.wikia

Let’s assume I, a rare gem seller, have a rare opal (a physical asset) for $1,000.  You want to purchase the gem but are concerned that you may not be able to sell the gem at a higher price and thus will not profit off of the transaction.

Along comes a man who doesn’t know whether the gem is worth more or less but thinks it is worth less than you bought it for. Let’s call him the Pessimistic Guy.  The Pessimistic Guy is willing to sell you a piece of paper saying that he will buy the gem for $800 despite what it’s true price is.  The cost of this piece of paper is $100.

The paper in this situation is commonly referred to as an option as it gives you the option (but not obligation) to sell the underlying physical asset.

So what are the possible outcomes in this scenario?

There are quite a few depending on whether you buy the option and whether the gem is worth more or less than the price you purchased it for as seen by the table below.

Opal table

One of the most notable trends in the table is that if the option is purchased the most you can lose is the difference between the agreed upon purchase price ($800) and the
original  purchase price ($1,000) minus the additional cost of the option ($100).

In this case having bought the option the most you can lose is $800 – $1,000 – $100 = -$300

Though a simple example this reveals one of the main uses of derivatives. In the situation where you bought the option there was an absolute limited loss. The concept of unlimited/limited loss will be discussed in the future as it is both key to understanding the role of derivatives and is a fascinating concept.

What are the Common Types of Financial Derivatives?

There are four primary types of financial derivatives. Though only briefly discussed here, each will receive a more in depth analysis in future lessons.

1.Options: As seen in the example an option is a type of contract that enables the holder to exercise an option (usually buy or sell) on an asset. In the example above you purchased a put option. A put option enables you to sell an asset (the opal) at an agreed upon price ($8) before a predetermined maturity date. In the example we did not set a maturity date for the sake of simplicity. The opposite of a put option is called a call option as it enables you to buy an option at an agreed upon price.

2. Swaps: A swap is a type of financial derivative in which two entities exchange some sort of financial good or instrument.  Though it may seem like commodities may commonly be used in these swaps the most common instrument involved in financial swaps is interest rates.  An interest rate swap is a derivative in which two entities exchange cash flows in order to guard interest rate risk or to participate in speculative finance.

3. Forwards: A forward is a contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date.  Forwards are commonly thought of as the simplest of the derivatives, though with modification can become complex. Forwards are commonly used in the commodity market and are used to hedge against price fluctuations.  For example I could agree to buy 1,000 bushels of wheat in three months for $50/bushel regardless of the market price of a bushel of wheat at that time.

4. Futures: A future is a highly standardized contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date. A future may seem very similar to a forward. It is! A future is simply a highly standardized forward that is traded on an exchange instead of an OTC market (as forwards are).  The purpose of futures is to eliminate a risk known as counterparty risk that is present in forward contracts.  This will be addressed in more detail but for now just know that with more standardization comes the ability for a future to eliminate a type of risk that forwards inherently possess.

How are Financial Derivatives Traded?

Like stocks and bonds financial derivatives trade on both exchanges and over-the-counter (OTC) markets.  The OTC is the larger of the two for trades involving derivatives because of its looser regulatory standards.  Derivatives traded on exchanges (mainly futures) are predetermined and standardized to eliminate counterparty risk. Counterparty risk is the risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation.  This risk is present in OTC contracts as the agreements are private agreements and lack an intermediary that can ensure the fulfillment of the contract.

Why Do Financial Derivatives Exist?

These very interesting and colorful financial instruments exist to satisfy one of the most important goals of finance, to minimize risk.  Through different arrangements an entity (business,person, bank, etc.) is able to essentially sell off some of its risk to some other entity that desires that specific risk.  This may seem abstract now but after some concrete examples in the next few lessons it will make sense why some entities benefit from the use of derivatives and why they have a place in the financial world.

Should I Invest in Financial Derivatives?

TwoPennies
These guys are back with advice.

Here’s the area where I throw in my $0.02 into the ring.

I DO NOT recommend most derivative trading for the average everyday investor.

The reasoning is very simple. Most individuals do not have the time or expertise to understand and dissect these at times incredibly esoteric investment vehicles. That being said there are a few derivatives that do make sense in some instances (a covered call option strategy is an example of one) in which a simple derivative can help minimize and hedge against risk. These instances will be covered in a later lesson.

Definitions

  1. Financial derivative: A type of financial security whose price is derived from the price of the underlying asset it represents
  2. Options: A type of financial derivative that enables the holder to exercise an option (usually buy or sell) on an asset
  3. Swaps: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  4. Forward: A forward is a type of financial derivative in which two entities agree to buy/sell an asset at an agreed upon price at a future date
  5. Future: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  6. Counterparty risk: The risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation

Further Reading

Lesson 13: Commodities

Gold bars
There’s a certain beauty to the color.

Ever wondered how the price of gold or oil is determined? No? Well let’s discuss it because you should know it anyway.  The prices of these and other goods are determined within large exchanges such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), but let’s first establish what makes a commodity a commodity.

Key Points

  • A commodity is a basic good which is nearly identical to other commodities of the same type and is commonly traded on exchanges.
  • Common commodities include metals, agricultural goods, and energy products.
  • Commodity prices are determined on commodity exchanges.
  • Trading commodities is much closer to speculation than investing.

What is a Commodity?

A commodity is a commonly traded good that is interchangeable with other goods of the same type. For example wheat grown in Iowa is for the most part indistinguishable from wheat grown in Kansas.  Agricultural products with their nearly perfect similarities  are a great example of commodities.  Whether the corn is grown in Iowa or Kansas it is still corn. Though commodities are interchangeable, different grades or quality of the commodity can be traded. For example, there are varying qualities of oil and natural gas traded.

Types of Commodities

The common classifications of commodities traded are metals, agricultural goods, and energy products.

  1. Metals: This group is composed both industrial and precious metals. Industrial metals include metals such as zinc, copper, and nickel that are commonly used  in the construction of many goods.  Precious metals include metals such as gold and silver that derive their value not by their industrial applications, rather for their intrinsic rarity.
  2. Cattle
    Delicious proto-steaks

    Agricultural Goods: This group is composed of both food products and livestock.  Food products includes foods such as corn, wheat, sugar, milk, and orange juice.  Livestock is comprised of lean hogs, live cattle, and feeder cattle.  (The difference between feeder cattle and live cattle? Feeder cattle is cattle that will be placed on a feedlot, fattened, then slaughtered to produce delicious steaks or burgers).

  3. Energy Products: This group is the most diverse of the three major groups.  It includes products such as ethanol, natural gas, propane, and gasoline.  Energy products have various uses including construction of petrochemical products to providing fuel for homes and vehicles.

Commodity Exchanges

Like stocks or bonds, commodities trade on long standing markets (most of which predate the largest stock and bond markets).  The largest commodity market in the U.S. is the Chicago Mercantile Exchange (CME) followed by the New York Mercantile Exchange (NMEX) which together account for the majority of commodity trades made in the U.S.A. There are also many large international commodity exchanges such as the London Metal Exchange (LME) based in London, UK and Euronext which is based in several major European cities.

How does an exchange ensure that the wheat or livestock being traded is actually worthwhile grain or animals and not disease ridden goods?  Exchanges establish a basis grade which establishes a minimum accepted standard that a tradable commodity.  Also called a “par grade” or “contract grade” the purpose of the basis grade is to ensure that when trading commodities it is truly “apples to apples” trades.

Trading Commodities

There are two primary ways to trade commodities: spot and futures markets.

  • Spot Markets: When trading commodities in the spot market an investor is buying or selling the commodities at that very moment.  This trading is done at the spot price, which is simply the market price of the goods at that time.  A different way to look at spot markets is that when trading in the spot market you are truly trading “on the spot”.  
  • Futures markets: When trading commodities in the futures market an investor is not buying or selling the commodities directly but is instead trading futures contracts.  For now just know that a futures contract is a  highly standardized contract that obligates the holder to buy or sell a set amount of goods at a set price. These contracts tend to greatly fluctuate in price based on the perceived value of the underlying assets and predictions of future market circumstances.

Speculation vs. Investing

TwoPennies
Pictured: My $0.02

Now that you are more informed about commodity trading here is where I throw my $0.02 in.

I DO NOT recommend commodity trading for the average everyday investor.

Commodity trading is a highly specialized field in which highly savvy and well informed traders and investors operate and seize on market opportunities. In addition most trades are made “on margin”. This means that losses and gains become greatly magnified as the transactions are highly leveraged. A final reason is simply the speculative nature of commodity trading.  There are limitless variables which can alter commodity prices and result in enormous volatility in the prices of commodity.

If as an investor you really want to invest in commodities, my recommendation is to get exposure through ETFs or mutual funds based in commodity-related businesses. For example an oil and gas mutual fund would own stock in different companies directly involved in the production and distribution processes.

 

Definitions

  1. Commodity:  A commonly traded good that is interchangeable with other goods of the same type.
  2. Basis grade: The minimum quality of a commodity that must be met in order to be traded and is established by the commodity exchange on which it will trade.
  3. Spot market: A market in which commodities or securities are traded for cash and settlement is immediately effective.
  4. Spot price:  The current market price at which an asset is bought or sold for immediate payment and delivery.
  5. Futures market: A market in which commodities or securities are traded via futures contracts for delivery on a specified future date.

 Further Reading

Lesson 12: ETFs

Mutual funds ETF Headingare great, but they have some drawbacks.  If you want to sell it, you have to wait to the end of the day. In addition mutual funds have some unavoidable costs and some limited functionality. In response to these shortcomings Exchange Traded Funds (ETFs) were created about 20 years ago and are one of the most recent and interesting financial innovations of the present day.

Key Points

  • An ETF is a type of hybrid investment company.
  • Creation is the process by which an ETF is created.
  • Redemption can be thought of as the reversal process of creation.
  • ETFs possess cost and functionality benefits compared to mutual funds.

What is an ETF?

An Exchange Traded Fund is a special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.  The investor receives profits on the assets owned (interest if bonds are tracked or dividends if stocks) on a pro rata share basis.  The easiest way to describe an ETF is to think of it simply as a mutual fund with some increased functions (if a mutual fund is a knife, an ETF is a Swiss army knife).   One of the most crucial differences between an ETF and a mutual fund relates to the method of trading.

As you may remember a mutual fund is priced once a day at the end of trading. Thus buy and sell orders are processed at the price (Net Asset Value) at the end of the day for mutual funds. This is not the case for ETF shares. You can trade ETF shares at any point during the day on an exchange.  To understand what makes an ETF valuable and why it has key benefits over a mutual fund, we first must see how these funds are constructed.

How is an ETF Constructed?

Two crucial processes in ETF functionality are construction and redemption. Let’s begin by analyzing construction, which as the name suggests is how an ETF is created.

Let’s assume that I want to create an ETF (Colby Duhon Superfund).  Thus the Colby Duhon Superfund is the sponsor of the ETF. My first decision is what asset do I want to track.  Tracking means I will possess this asset whose value can fluctuate.  My choices include indexes like the S&P 500, bonds, gold, etc.  For the sake of this example let’s assume the Superfund will track the S&P 500.  The problem is the Superfund does not have enough capital (money) to purchase all the stocks traded in the S&P 500. This creates the role of the Authorized Participant.

The Authorized Participant (AP) is a large market maker or financial institution with sufficient buying power to provide the ETF with the asset it desires. Basically the Authorized Participant is the rich relative who has the buying power to purchase the assets the sponsor wants to package up as a unit.  It is worth noting that in some cases the sponsor and AP can be the same entity.  For the sake of the Superfund example we will assume this is not the case.

Now that the AP knows that the Superfund wants to track the S&P 500, it will go out into the market and buy the shares that comprise the S&P 500 in the proportion that the shares make up the index.  Once the AP has the shares assembled, it now has a basket of securities.  The AP will then trade this basket of securities to the sponsor (Superfund) and in exchange receive a creation unit which usually represents 50,000 shares of the ETF.  The AP then sells the shares of the creation unit in the open market.  When you buy a share of an ETF, you are buying a piece of this creation unit.

Old Guy in Chair
“Back in my day we didn’t have cool widgets.” Image courtesy of bbc.com

An easy way to think about this is continuing with the rich relative metaphor. You (the sponsor) want to create a cool widget that would sell well but you need some parts to make it. You contact your rich uncle (AP) and ask him to buy all the parts in the market.  The rich uncle buys the parts (stocks) and gives them to you. You assemble the new widgets using the parts and in exchange for the parts give your uncle the widgets (creation unit). Your uncle now has cool widgets to sell while you keep the parts.

As a final note in our example we created an ETF that tracked the S&P 500. We could create an ETF that tracks other assets such as bonds or gold. In any case the process is similar with the AP purchasing the assets (bonds or gold) and the sponsor providing the creation unit to the AP to sell.

ETF Creation Diagram
ETF Creation Process

 

Redemption

Redemption can be thought of as the opposite of creation. In creation the AP gave the basket of assets to the sponsor and received the creation unit of shares. In redemption the AP returns the creation unit to the sponsor and receives the basic of assets back.

As I said before an ETF has many similarities to a mutual fund. So if presented with a mutual fund that tracks a market index and an ETF that does the same why would I choose the ETF? 1. Cost benefits 2. Functionality benefits.

Cost Benefit of ETF vs. Mutual Funds

  1. Cheaper operational fees: Due to the unique structure of the ETF, the ETF fund charges lower operational costs compared to that of a mutual fund. The difference lies in the presence of the AP when investing in an ETF. Due to this “middle man” the investing process is greatly simplified for the ETF fund and investor and this simplification translates into cost savings for the investor. For a direct comparison the average U.S. Equity Fund charges 1.46% in annual expenses where the average ETF Equity Fund charges 0.53%.1
  2. Favorable tax treatment: Most ETFs incur very few capital gains tax due to their unique creation process. ETFs and mutual funds are required to distribute capital gains to their investors, which will be subject to capital gain tax. Ouch. An ETF is able to avoid this problem by having a very low turnover ratio and avoiding the presence of a sale in the redemption process. The avoidance of a sale matters because if the ETF had to sell the shares it had to raise cash, this would be taxed. However a quick review of the redemption process reveals that when the ETF needs to raise more cash it does not “sell” the assets, but trades them to the AP for the equivalent creation unit. This structure enables ETFs to avoid unfavorable taxes.

Functionality Benefits of ETF vs. Mutual Funds

  1. Intraday Trading: As previously mentioned one of the crucial differences between an ETF and mutual fund is the ETF’s ability to trade intraday. Not having to wait till the end of the trading day could make a huge difference on your strategy in addition to being a nice convenience feature.
  2. The presence of options and other features: Though I haven’t discussed them yet, an ETF gets added functionality from the ability to purchase options on them. Options briefly are a form of derivative security that enables you the investor to buy or sell an underlying security for a set price.  What is necessary to understand is based on the presence of these, ETFs obtain a dimension of functionality unmatched by mutual funds.

 

Definitions

  1. Exchange Traded Fund (ETF): A special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.
  2. Creation: The process of creating an ETF or more specifically creating a creation unit whose shares will be traded on the open market.
  3. Creation unit: A block of shares (usually 50,000 shares) created by the ETF and whose individual shares are sold on the market.
  4. Redemption: The process of trading a creation unit for the underlying assets it represents.
  5. Sponsor: An entity that wishes to create an ETF.
  6. Authorized Participant (AP): A market maker or large financial institution that possesses the capital needed to purchase the underlying assets a sponsor wishes to transform into an ETF.

 

Further Reading

Lesson 11: Mutual Funds

Mutual fundsThere are a lot of investments out there. There are corporate bonds, municipal bonds, small-cap stocks, mid-cap stocks, large-cap stocks, growth stocks, value stocks, the list goes on and on.  How can an investor diversify when bonds par at $1,000 and stock prices can easily be in excess of $100? If there were some way that many individual investors could pool their money together to own investments, they could all reap the benefits of investing without any one investor taking on a significant amount of risk.  This is why mutual funds exist.

Key Points

  • A mutual fund is a type of investment company.
  • Net asset value (NAV) is an important metric when looking at funds.
  • Advantages of investing in a mutual fund include professional management, diversification, and low investment for entry.
  • Disadvantages of investing in a mutual fund include additional costs, risk, and taxes.

What is an Investment Company?

A mutual fund is a type of investment company.  This begs the question “What is an investment company?”  Put simply an investment company is any company that issues securities and is in the business of investing in securities. How it basically works is that an individual investor buys shares of the investment company or more accurately shares of a fund the investment company controls. With the money procured from individual investors the investment company purchases securities as dictated by the goal of the fund and pays out the returns to the investors.

An investment company is usually one of four primary types. There are open-end funds (mutual funds). close-end funds (CEFs), and Unit Investment Trusts (UITs). The fourth and fastest growing type of investment company called an Exchange Traded Fund (ETF) will be discussed next lesson once we have a clearer picture of how these different types of funds function.  It should also be noted that “investment company” and “fund” tend to be interchangeable terms.

 

L11.1 Graph of Investment Companies
Types of Investment Companies

 

Net Asset Value

Before we dive into the differences there is a key metric that is very relevant to both closed and open end funds is known as net asset value (or NAV). The most comparable but not perfect comparison is to think of the NAV of a fund as the stock price of a stock. The net asset value is calculated by the following

Net asset value (NAV) = (Total Assets in Fund – Total Liabilities)/ Total Fund Shares Outstanding

Let’s assume that in the CD Super Awesome Fund had $100 billion in assets, $20 billion in liabilities and 10 billion in shares outstanding. The NAV would be calculated as follows:

NAV = ($100 – $20)/ 10 = $80/10 = $8/share

Why does this number matter? It plays a significant role in the share value of open-end funds (mutual funds) which we discuss later.

 

What is a Mutual Fund (Open-End Fund)?

An open-end fund is an investment company which issues new shares to anyone willing to buy and will redeem (buy back) any shares from those wishing to sell back. The money received from investors is then used by the managers of the mutual fund to buy securities for the mutual fund.  It helps to think of a mutual fund as just another public company that sells and can buy back stock from investors.

What price is charged to investors or does the mutual fund have to pay to redeem shares? Remember the Net Asset Value (NAV)? The Net Asset Value represents the share price of the mutual fund.  So let’s return to the CD Super Awesome fund.  If I were an investor wanting to buy 100 shares of the fund I would pay $800 at the share price established above.  Likewise if I wanted to sell 100 shares back to the fund I would receive $800 for my shares.

100 shares of CD * $8/share = $800

A very notable difference between the common stock we discussed earlier and a mutual fund share is that while a share of common stock is priced constantly throughout the day a mutual fund’s NAV is calculated once at the end of the trading day. So you want to sell or buy a share at 10:00 A.M.? Too bad. You have to wait till after trade closes and the new NAV (share price) has been established.  Thus based on whether the mutual fund’s assets have increased or decreased in value will determine whether the NAV has increased or decreased.

 

What is a Close-End Fund (CEF)?

A closed-end fund is an investment company that issues a fixed number of fund shares in an initial public offering and uses these funds to invest in securities according to the purpose of the fund.  These fund shares are then traded on exchanges similar to common stock.

What is the main difference between close-end and open-end funds (mutual funds)? The biggest difference is the process in which the shares of the close-end fund are traded.  If you remember in a mutual fund the fund stood ready to buy or sell as many shares as needed. In a close-end fund the number of shares is fixed.

What effect does this fixed number of shares have on the price of the shares of the fund? These shares are now sold and bought by investors during the day on major security exchanges at values independent of the fund’s NAV. The NAV is now driven by market forces of supply and demand. This means at any time a share of a close-end fund can trade at a discount (less than) or a premium (greater than) the fund’s NAV.  Close-end fund have become less popular with the emergence of Exchange-Traded Funds but still exist.

 

Advantages of Investing in a Mutual Fund

  • Management by Professionals: The decisions of what investments in a mutual fund is not made by you. Instead a professional money manager is charged with investing in certain securities according to the goal and type of the mutual fund. This way while you can focus on doing your job the money manager is meanwhile researching opportunities to make your money work for you.
  • Diversification: If you remember our risk vs. return lessons, one of the main strategies to reduce risk is to diversify (hold securities whose performances are independent of each other). By having over a billion dollars worth of assets a mutual fund can hold hundreds to thousands of
  • Low Investment for Entry: Many mutual funds have a minimum deposit of $3,000 to participate but some can be low as $1,000. Without a mutual fund it would be nearly impossible to achieve the same level of diversification with the same level of funds.

 

Disadvantages of Investing in a Mutual Fund

  • Costs: By purchasing securities directly you avoid some of the fees present in using a mutual fund. These fees include sales-charges, 12b-1 fees, and management fees.
  • Risk: Unlike a savings account, there is the risk that the mutual fund’s assets could decrease in value and thus your return on the investment could be negative.
  • Taxes: Federal income taxes are due on both dividends and gains made by the fund and any profits made when the shares are sold. One exception is when the distributions are channeled into tax-deferred retirement accounts (IRAs)

Conclusion

One final note about mutual funds: there are a ton of these things. The broad three categories are stock, bond, or balanced funds which accordingly hold stock, bonds, or a mixture of the two.  Further classification includes capital appreciation stock funds, growth stock funds, international stock funds, sector funds, municipal bond funds, the list goes on and on.  Your goal and risk tolerance as an investor will dictate which type of fund best suits your needs.

L11.2 Mutual fund types
Mutual Fund Types and Relative Market Share. Image courtesy of teensguidetomoney.com

 

Definitions

  1. Investment company: A company that issues securities and is in the business of buying and selling securities as its primary activity.
  2. Open-end fund: An investment company who will issue new shares as required and whose share price is equal to the fund’s NAV.
  3. Close-end fund: An investment company that has a fixed number of outstanding shares whose value is commonly at a discount or premium to the fund’s NAV.
  4. Unit Investment Trust: An investment company that holds a very small number of securities that it does not actively sell and also has a limited life.
  5. Exchange Traded Fund: An investment company that does not issue securities directly to investors, but instead issue large shares known as “creation blocks”.
  6. Net Asset Value: A metric of an investment company that is equal to the sum of the fund’s assets minus its liabilities divided by shares outstanding.

 

Further Reading

 

 

Lesson 10: The Money Market

Stack of money
This is money. I am talking about the money market. You’re welcome.

The term money market is actually a great example of a misnomer. One might think that “money” in the form of currencies (Euros, U. S. dollars, Chinese Yen, etc.) are traded in this market.  This is incorrect. Instead the money market consists of highly liquid, short term debt investments.  The money market is the alternative to the capital markets which consist of longer term bonds and stocks.  An easy way to remember the difference is that if the asset is short term (it matures in one year), you are in the money market.  If the asset is long term (stocks, bonds, etc.) you are in the capital markets.

Financial Market Breakdown Chart
Here is a nifty breakdown to help remember.

Key Points

  • The money market is where short term debt instruments are traded.
  • Some of the key players in the money market include the U.S. Treasury, Federal Reserve, large companies, and individuals.
  • One of the main purposes of the money market is to house surplus funds and meet short term needs of funds.
  • Some of the securities traded in the money market include T-bills, commercial paper, federal funds, negotiable CDs, Eurodollars, and repurchase agreements.
  • The money market (mainly in the trading of T-bills) is where short term interest rates are determined.

What is the Money Market?

Say a company wants to build a new building or make a long term investment in a new product. A bond would be a perfect way for the company to raise a large amount of funds and pay it back over many years.  What if a company needs a smaller amount of cash for a quick payment (say to fill a small gap in the weekly payroll)? As the process for issuing bonds is very costly in terms of both dollar amount and time, it would be ineffective to issue bonds to address this small need of funds.  Thus in this case and others the money market instruments arose to fulfill the need of short term funds.

There are three common characteristics of money market instruments:

  1. Money market instruments mature in less than one year. Unlike bonds or stocks, money market instruments mature in less than one year than issue date whereas bonds mature in 5-10 years and stocks theoretically never mature.
  2. Money market instruments are highly liquid. The instruments in the money markets have high liquidity due to the large amount of participants and the large amount of funds that flow through the market.
  3. Money market instruments have low risk relative to the average risk of stocks and bonds. With their short maturities and high liquidity money market instruments in general possess very low risk when compared to their capital market counterparts.

Key Participants in the Money Market

The major participants in the money market include the U.S. Treasury, the U.S. Federal Reserve, large public companies, institutional investors, and individual investors.

  • U.S. Treasury: Remember those Treasury bonds that we mentioned in the bond market lesson? Well the U.S.
    Treasury Building
    This whimsical, fun looking building is the U.S. Treasury.

    Treasury also issues T-bills. We will discuss T-bill specifics later, but for now just now that the U.S. Treasury is the largest borrower of money market instruments which it uses to fund the federal debt.

  • Federal Reserve: The U.S. Federal Reserve (Fed) is the most influential player in the U.S. money market. It buys and sells vast amounts of T-bills to influence the money supply and short term interest rates in America.
  • Large Public Companies: Large companies participate in the money markets through buying and selling of securities.  One instrument associated with large companies in the money market is commercial paper which will be discussed later.
  • Institutional Investors: Due to their low risk many institutions (insurance companies, pension funds, etc.) will hold large amounts of money market instruments to generate investment returns while maintaining minimum risk.
  • Individual Investors: Primarily through the use of mutual funds (which we discuss in the next lesson) individual investors are able to participate in the buying and selling of the large dollar denomination securities in the money market.

Purpose of the Market

The primary purpose of the money markets is to provide a market that matches large amounts of excess funds from financial institutions to other firms and governments in need of short term funds.  Imagine a firm, let’s say Apple, has over $1 billion in excess cash.  What should Apple do with these funds? Furthermore let’s assume that the market for stocks and bonds has been volatile and therefore unusually risky lately.  One option is to buy money market instruments to generate higher return than the return that cash offers. (It is important to note that the return on cash is zero. Another way of thinking of this is cash in your wallet generates no return for you).  The money market allows Apple to invest in short term liquid securities that do not put Apple at significant risk and provides short term funds to other firms that need it.

Another way to think about the money market is imagine you as an individual have excess cash. One option you have is to go to a bank and put the money in a savings deposit.  The return on this account will be quite low. Now imagine there is a market where you can invest and get a slightly higher return with a corresponding slightly higher risk profile. You will provide the funds to institutions and businesses who have a short term need for funds and will compensate you with a higher rate for doing so.  This is the purpose of the money market.

Types of Money Market Instruments

  • T-bills: Treasury bills are issued by the U.S. Treasury Department and are used to finance the federal debt. The U.S. Treasury bill is arguably the most liquid and widely traded security in the world. As a result the interest rate offered on T-bills is used as a proxy for the short term risk-free rate.  T-bills do not pay interest and are instead sold at a discount and later matures at par value.  (Similar to the zero-coupon bonds discussed last chapter)
  • Federal Funds: Federal funds are short-term funds transferred between large financial institutions (usually larger commercial banks). Because banks must have minimum reserves relative to the amount of deposits they have, some banks need quick, overnight funds to avoid legal repercussions. As an investor you may hear the “federal funds rate” mentioned. This is the interest rate charged on these overnight bank loans.
  • Commercial Paper: Commercial paper are money market securities that are issued by corporations and mature in less than 270 days.  Commercial paper is offered directly from issuer to buyer and is used to fund the issuing companies’ activities.
  • Negotiable CDs: Negotiable certificates of deposit (CDs) are large, bank issued securities that range in value from $100,000- $10 million. Most individual investors will have little interaction with negotiable CDs, but it is worth noting that a negotiable CD is not the same instrument as the certificate of deposit that an individual can get at a consumer bank.
  • Repurchase agreements: Repurchase agreements (repos) occur when a firm sells Treasury securities and agrees to buy back the securities at a later date. In essence a repo is a short-term loan.  One firm sells the securities for quick funds and promises to rebuy the securities at a later date.  Repos are used by the Federal Reserve in conducting monetary policy.

The Risk Free Interest Rate

As mentioned above the T-bill is one of the most important securities within the financial markets.  The interest rate on the 3 month Treasury bill is commonly used as the “interest-free rate”. The interest free rate represents the return an investor should expect to earn on an investment with no risk. The T-bill is used for this theoretical rate because of its unparalleled liquidity and the ability of the U.S. Federal government to create more money to pay off the T-bill obligations as they come due.

 

Definitions

  1. Money market: The market for short term debt obligations used to facilitate short term borrowing and lending of excess funds.
  2. Interest free rate: The theoretical return an investor should earn on a security with zero risk. The interest rate on the 3-month Treasury bill is commonly used as a proxy for this theoretical rate.

Further Reading

Lesson 9: The Bond Market

L9.2 Barry Bonds Pic
Still not the type of Bond I will discuss. Image courtesy of milwaukeechiro.com.

The bond market is much larger in dollar amount than the stock market in the United States. This is mainly driven by the ability for governments (including federal, state, and local) to participate in the bond market to raise capital.  This large market also produces Treasury bond interest rates (or yields), which are closely monitored proxies for long term interest rates.  In short the bond market lacks the glamour of the stock market due to its slower moving nature, but it still holds a place of great importance in the U.S. capital markets.

Key Points

  • Bonds have many commonalities with the stock market including primary vs. secondary markets, OTC markets vs. exchanges, and brokers vs. dealers.
  • The two primary issuers of bonds are governments and corporations.
  • Treasury bonds are arguably the most important type of bond traded.
  • Municipal bonds are bonds issued by local, county, and state governments that have favorable taxation characteristics.
  • Corporate bonds have different characteristics than federal bonds.

The Similarities between the Bond and Stock Market

Before we delve into what separates the two it would be easier to identity what the bond and stock markets have in common. Both the stock and bond markets have primary and secondary markets. A primary market is where securities are issued for the first time (when offered to the investing public this is called an initial public offering (IPO)) whereas the secondary market is where securities are traded between investors.  In addition bonds can be traded either in over-the-counter (OTC) or organized exchanges with brokers and dealers providing liquidity to these markets.

The Differences between the Bond and Stock Market

Other than the obvious differences between the nature of the securities being traded (there is a lot more knowns with bonds compared to L9.3 Featured Image for Bondsstocks) the largest difference is between the market participants.  While only private corporations participate in the stock market, both corporations and government entities may raise capital in the bond market. The reason governments do not participate in the stock market is that they would be selling ownership claims (imagine a super bank owning a small foreign government…yikes). Governments still have to fund different activities such as infrastructure, defense, and social programs and thus may turn to bond debt to finance these activities.  This is what is referred to when people quote the “$3 trillion deficit” America possesses, its bond debt.

The Importance of Treasury Bonds

The 10-year Treasury bond plays a key role in the U.S. financial markets.  It is one of the main ways the U.S. government funds federal expenditures.  They also have very little risk associated with them as in theory the U.S. government can always print more money to pay these bonds off as they come due.

Because of the low amount of risk these securities possess, little return is offered. In fact in some years the rate of inflation has been higher than the interest rate (or yield) offered on 10-year Treasury Bonds.  It also noted that the interest rate offered on 20-year Treasury Bonds is consistently higher than the interest rate offered on 10-year Treasury Bonds. The reason for this is simple and ubiquitous. The 20-year Treasury Bond has a longer maturity than the 10-year Treasury Bond and thus has more inherent risk and as our risk vs. return principal dictates the higher this possibility of risk the more compensation that must be offered to investors.  The U.S. federal government is of course not the only government that can sell bonds and at any given time you can buy French, Russian, or Argentinian bonds.  Depending on the riskiness of the country issuing, different returns are offered.  Similar to corporate bonds, bonds offered by governments are rated by rating agencies.

L9.1 Inflation vs. 10 Year Treasury Yield
Graph of 10-Yr U.S. Treasury Yield vs. Inflation Over Time

 

Municipal Bonds

Municipal bonds are bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.  “Munis” have a small amount of default risk as a municipality can in fact default on its bonds. The two common types of municipal bonds are general obligation bonds and revenue bonds.  General obligation bonds are municipal bonds that do not have specific assets pledged as security for the bond and are instead supported by the “full faith and credit” of the issuer.  Bonds like this can also be referred to as unsecured bonds as there is no assets that serve as collateral for the bond.  A revenue bond is backed by the promised revenue of a project. An example of this would be charging fees to use a hospital or public port. These revenue streams provide funds to pay off the interest charges and principal of the outstanding bonds.  Revenues bonds can be referred to as secured bonds as there is an asset base supporting the repayment of the bonds.

One of the most important characteristics from an investor standpoint is that many municipalities place tax reductions or make the interest payments on the bond paid to the investor tax free, provided the investor is a resident of that municipality.  This is solely at the discretion of the issuing municipality, but for some high tax bracket investors muni’s present an opportunity to avoid large tax reductions from their investments.

Corporate Bonds

As a whole corporate bonds function similarly to government based bonds, but they have some differing characteristics. In general, corporate bonds pay a higher return than their government counterparts due to higher perceived risk of default on corporate. In the last lesson I discussed how the rating agencies rate the corporate bonds on the perceived risk of default the list of which I have provided again.  In addition corporate bonds are almost always issued in $1,000 par value, have the standard coupon payment structure, and may have a call provision which enables the issuing company to buy back (or “call”) the bond after a certain time period has elapsed.

Zero Coupon Bonds

A zero coupon bond is a type of bond that does not pay the investor interest payments but instead sells at a deep discount and is redeemed at maturity for a higher value.  In zero coupon bonds the investor forgoes the coupon payments in return for buying the bond at a discount and receiving a higher principal amount when the bond matures. For example you could buy a bond for $500 that in five years matures for $1,000 that offers no coupon payments. Many federal and municipal bonds function as zero coupon bonds.

Definitions

  1. Municipal bonds: Bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.
  2. General obligation bonds: Unsecured municipal bonds that are backed by the “full faith and credit” of the issuing municipality.
  3. Revenue bonds: Municipal bonds that are secured by the revenue stream that will result from the completion and operation of the project the bond is funding.
  4. Call provision: A provision on bonds that enables the issuer to buy back bonds for a fixed payment that results in ceased interest payments to the investor who owns the bonds.
  5. Zero coupon bonds: Bonds that do not offer interest payments but are instead issued far below par and mature at par. The difference between the issuance price and the maturity is the yield the investor receives.

Further Reading

Lesson 8: Let’s Talk Bonds

 

Bond actors
This is not the type of “bond” I will be discussing. Image courtesy of moviepilot.com

The bond market. You may think you haven’t heard about it.  You are probably wrong. In addition to occasionally hearing about “rallies” in the bond market most Americans has heard of the $3 trillion deficit the U.S. government currently faces.  What makes up this deficit? Treasury bonds. These bonds and other securities the U.S. Treasury issues help fund the activities of the U.S. Government and have an integral role in the bond market. The bond market is comprised of many different types of bonds which can greatly vary in features. Let’s explore some basic functionality.

Key Points

  • A bond is a debt security that obligates the borrower to pay a specified amount to the investor on a given date and usually includes coupon payments.
  • A bond offers investors returns through appreciation and interest (coupon) payments.
  • A bond has many distinguishing features including par value, maturity, coupon rate, issuer, credit rating.
  • There is an inverse relationship between bond yield and bond price.

Continue reading Lesson 8: Let’s Talk Bonds

Lesson 7: Stock Market Indices

Stock Chart Going Up
Lines Going Up = Good in Finance

In the last lesson I mentioned how my father would always mention to me how “the market was up”.  Knowing now that there thousands of companies traded in the equity markets you may wonder what my father meant by “the market”. Was it that on that day he saw more green, upward arrows on MSNBC than red, downward arrows? Was it that on that particular day his stocks were doing well and he wasn’t paying attention to the other stocks? He was most likely looking at stock market indices such as the DJIA, S&P 500, or Russell 2000. These indices (or indexes) are commonly used to describe the health of the overall stock market and as a result are closely monitored day in and day out.

Continue reading Lesson 7: Stock Market Indices

Lesson 6: The Stock Market

Now that we have some working knowledge about what a stock is and how it functions let’s discuss how it is traded. The stock market is one of the most often discussed things in everyday financial life. To this day in discussions with my aging father he sometimes makes the comment “Did you see what the market did today?”  The U.S. stock market is half of the size of the U.S. bond market. So why does the stock market get all of the glory, media attention, and yelling pundits? It gets this following because it is the place where people can go from rags to riches (or vice versa) very quickly, or to be blunt it’s exciting. You will see that much of the stock market is very jargon heavy so at any point remember that the definitions of the terms can be found at the post in case you need a quick refresher. So what are the mechanics of this wondrous machine?

Continue reading Lesson 6: The Stock Market