Stocks, Indices, Funds

Equity, Stocks, and Shares

• Equity: This refers to the net value of a company, calculated as the total value of the company’s assets minus its liabilities (debts, payments to suppliers, employee wages, etc.). Equity represents the ownership interest in the company.
• Stocks: When a company divides its equity into smaller units, these units are called stocks or shares. Stocks represent ownership in the company. The terms “stocks” and “shares” are often used interchangeably, although “stocks” usually refer to ownership in multiple companies, while “shares” refer to ownership in a specific company.
• Shares: When you own shares, you own a portion of the company’s equity. This gives you certain rights, such as voting on company decisions and receiving a portion of the profits, usually in the form of dividends.

Example: If a company is valued at $1,000,000 and it issues 100,000 shares, each share represents 1/100,000th of the company’s equity. If you buy 1,000 shares, you own 1% of the company.

Buying Stocks

• When an investor buys stocks, they are purchasing partial ownership of a company’s equity. This means they now own a piece of the company and can potentially benefit from the company’s growth and profits.

Receiving Shares as Compensation

• Sometimes, companies offer shares to employees as part of their compensation package. This means that instead of just receiving a salary, employees are given ownership stakes in the company. This aligns employees’ interests with the company’s success, as the value of their shares can increase if the company performs well.

Example: If you receive 500 shares from your employer as part of your compensation, and the company’s stock price rises, the value of your shares increases, effectively boosting your total earnings.

Understanding Indices

• Index: An index is a metric that represents the aggregated value of a group of stocks as a single number. It’s a way to track the performance of a particular section of the market, such as the technology sector or the overall market.
• Examples of Indices:
  • S&P 500 (USA): Tracks the performance of 500 large companies listed on stock exchanges in the United States.
  • Dow Jones Industrial Average (USA): Tracks 30 significant publicly traded companies in the U.S.
  • FTSE 100 (UK): Tracks 100 companies listed on the London Stock Exchange.
  • Nikkei 225 (Japan): Tracks 225 large, publicly traded companies in Japan.

Why Indices Matter: Indices give investors a quick snapshot of the market’s performance. For example, if the S&P 500 index rises, it indicates that, on average, the large U.S. companies are doing well.

Indices as Virtual Portfolios

• An index is like a “fantasy portfolio” that includes selected stocks. However, unlike an actual portfolio, no real money is invested directly in the index. It serves as a reference point or a benchmark for the performance of the market or a sector.

Analogy: Think of an index as a fantasy sports team. Just as the team’s performance is tracked based on the individual performance of players, an index tracks the overall performance of a group of stocks.

Indices Describe the Market

• Indices can be used to track specific sectors (e.g., technology, financials) or regions (e.g., U.S., Europe, Asia). By following these indices, investors can assess the health of different markets or industries quickly.
• Professional investors often use indices as benchmarks to evaluate their investment strategies. Their goal might be to match or exceed the performance of a relevant index.

Market Capitalization (Market Cap)

• Definition: Market capitalization, or market cap, is the total market value of a company’s outstanding shares. It is calculated by multiplying the number of shares outstanding by the current share price.
• Formula: $$\text{Market Cap}=\text{Number of Shares Outstanding}\times \text{Price per Share}$$
• Categories:
  • Large-Cap: Companies with a large market cap, typically over $10 billion. These are often established companies with a stable market presence.
  • Mid-Cap: Companies with a market cap between $2 billion and $10 billion. They might be in a growth phase but are more established than small-cap companies.
  • Small-Cap: Companies with a market cap under $2 billion. These are often newer companies with higher growth potential but also higher risk.

Example: If a company has 50 million shares outstanding, and each share is priced at $20, the market cap is:

$$\text{Market Cap}=50,000,000\times 20=\$1,000,000,000$$

This company would be classified as a mid-cap company.

Growth vs. Value Stocks

• Growth Stocks:

  • Characteristics: These companies have high potential for future growth in sales or earnings. They often operate in innovative sectors like technology or renewable energy. Because of their growth potential, they might have higher stock prices relative to their current earnings or sales.
  • Example: A startup developing cutting-edge AI technology might be considered a growth stock because investors expect its earnings to grow rapidly in the future.

• Value Stocks:

  • Characteristics: These are typically mature companies with stable sales, revenues, and earnings. They may be undervalued by the market, meaning their stock prices are lower relative to their fundamentals. Value stocks are often found in industries like utilities, consumer goods, or banking.
  • Example: A company that produces essential household products might be a value stock because it generates consistent earnings but doesn’t have significant growth potential.

Key Financial Ratios

Financial ratios help determine whether a stock is more likely a growth or value stock. Here are the key ratios used:

• Price-to-Earnings (P/E) Ratio:

  • Formula: $$\text{P/E Ratio}=\frac{\text{Price per Share}}{\text{Earnings per Share (EPS)}}$$
  • Interpretation: A high P/E ratio suggests that investors expect high growth in the future, typical of growth stocks. A lower P/E ratio might indicate a value stock, which could be undervalued relative to its earnings.

• Price-to-Sales (P/S) Ratio:

  • Formula: $$\text{P/S Ratio}=\frac{\text{Price per Share}}{\text{Sales per Share}}$$
  • Interpretation: This ratio helps assess how much investors are willing to pay for each dollar of the company’s sales. Growth stocks usually have higher P/S ratios.

• Price-to-Book (P/B) Ratio:

  • Formula: $$\text{P/B Ratio}=\frac{\text{Price per Share}}{\text{Book Value per Share}}$$
  • Book Value: The book value is the net value of a company’s assets (assets minus liabilities). It represents the company’s intrinsic value.
  • Interpretation: A high P/B ratio may indicate that investors expect high growth, while a lower P/B ratio could suggest a value stock that might be undervalued by the market.

Example of Growth vs. Value:

• Growth Stock: A tech startup with a P/E ratio of 50, a P/S ratio of 10, and a P/B ratio of 8. Investors are willing to pay a premium because they expect the company’s earnings to grow rapidly.
• Value Stock: A utility company with a P/E ratio of 10, a P/S ratio of 1, and a P/B ratio of 1.5. The stock might be undervalued compared to its stable earnings and assets.

Sector and Industry Variations

• Financial ratios can vary significantly between industries. For example, technology companies often have higher P/E ratios due to their growth potential, while companies in more stable sectors like agriculture or construction tend to have lower P/E ratios.

S&P Index Categories: Market Cap and Growth vs. Value Classification

• Market Cap-Based Indices:
  • The S&P Family includes different indices based on market capitalization:
    • S&P 500: Contains large-cap stocks like Lockheed Martin.
    • S&P MidCap 400: Includes mid-cap stocks such as Delphi Technologies.
    • S&P SmallCap 600: Consists of small-cap stocks like The New York Times.
  • Within each index, stocks are further classified as growth or value based on financial ratios like price-to-earnings (P/E), price-to-sales (P/S), and price-to-book (P/B) ratios. These subgroups help investors target specific types of stocks within a given market cap category.
  • Example: The S&P SmallCap 600 is divided into the S&P SmallCap 600 Growth Index and the S&P SmallCap 600 Value Index based on these classifications.

Price Weighting in Indices

• Price-Weighted Index:

  • In a price-weighted index, each stock’s influence on the index is proportional to its share price. The index value is calculated by summing the share prices of all included stocks.
  • Example: The Nikkei 225 and Dow Jones Industrial Average are price-weighted indices. If the share price of a high-priced stock increases, it has a greater impact on the index than a low-priced stock, even if the latter represents a larger company in terms of market cap.

• Rescaling: Index creators often rescale the index number to keep it manageable, but the core concept remains that the index reflects the sum of share prices.

Market Cap Weighting in Indices

• Market-Cap Weighted Index:
  • In a market-cap weighted index, stocks are weighted according to their market capitalization. Larger companies have a greater impact on the index.
  • Example: The Wilshire 5000 Index is market-cap weighted. If Nvidia (with a market cap of $160 billion) and iRobot (with a market cap of $1.8 billion) both experience a 1% price change, Nvidia’s price change will have a much larger effect on the Wilshire 5000 Index.
  • Major indices like the S&P 500, FTSE, Hang Seng, and EURO STOXX use market cap weighting to reflect the influence of large companies on the market.

Adding or Removing Stocks from an Index

• Index Additions and Deletions:
  • Companies may be added to or removed from an index due to significant events like mergers, acquisitions, or bankruptcies.
  • Example: In 2018, Monsanto was removed from the S&P 500 after being acquired by Bayer, and Twitter was added. This process is called “index rebalancing.”
  • Rebalancing: When the list of companies in an index changes, the weights of each stock are recalculated based on the new total market cap. Rebalancing can occur at regular intervals (monthly, quarterly, or annually) or in response to specific events.

How an Index Is Constructed and Updated

• Index Construction:

  • An index is constructed by selecting a group of stocks and summing their market capitalizations. The initial sum is often set to a base value (e.g., 100 points).
  • Example: The Hang Seng Index was set to 100 points in 1969 based on the total market cap of the 50 largest companies on the Hong Kong Stock Exchange.

• Daily Index Update:

  • Each trading day, the index is updated by calculating the percentage change in the total market cap from the previous day.
  • Example: If the total market cap of the Hang Seng Index was 100 billion HKD on Day 1 and increased to 102 billion HKD on Day 2, the index would increase by 2%, making the Day 2 index value 102 points.

Hang Seng Index: Capped Free Float Adjusted Market Cap

The Hang Seng Index (HSI) is described as a capped free float adjusted market cap weighted index. Let’s break this down:

• Free Float Adjusted Market Cap:

  • Market Cap is calculated by multiplying the total number of a company’s outstanding shares by the current price per share. However, not all of these shares are available for trading in the market.
  • Free Float refers to the shares that are readily available for trading. Some shares are restricted from being sold due to legal or contractual reasons, such as lock-up periods (e.g., after an IPO or before an earnings report).
  • Free Float Adjusted Market Cap considers only the free-floating shares to provide a more accurate reflection of a company’s market value that can actually be traded. This adjustment excludes shares that are not readily tradable, offering a clearer picture of how the market perceives a company.
  • Example: If a company has 10 billion shares outstanding and 90% of them are free float, only 9 billion shares are considered when calculating the market cap for the index.

• Capped:

  • The term “capped” refers to a limit on how much any single company can influence the index. Even if a company has a very high market cap, its weight in the index may be capped to ensure diversification and prevent the index from being overly dependent on a few large companies.

Index Adjustments: Adds and Deletes

When an index like the S&P 500 undergoes changes due to adding or removing companies, the overall calculation of the index needs to be adjusted accordingly.

• Scenario: Monsanto was removed from the S&P 500 and replaced by Twitter.
  • Market Cap Before and After:
    • Monsanto had a market cap of about $50 billion.
    • Twitter, which replaced Monsanto, had a market cap of about $30 billion at the time of replacement.
  • Placeholder Example: Imagine a placeholder company called “MonsanTwitter” representing Monsanto before and Twitter after the change. The market cap of MonsanTwitter changes from $50 billion to $30 billion overnight.
  • Index Calculation:
    • To adjust the index, we calculate the percentage change in the total market cap caused by the swap.
    • If the total market cap decreases from $50 billion to $30 billion, this represents a significant drop.
    • The percentage change is then applied to the previous index value to determine the new index level.

Example Calculation:

• Suppose the S&P 500 index value was 2500 before the replacement.
• The market cap change is from $50 billion to $30 billion, which is a 40% decrease.
• The new index value would be calculated by multiplying the previous index value by the percentage change: $$\text{New Index Value}=\text{Previous Index Value}\times \left(1-\frac{50\text{ billion}-30\text{ billion}}{50\text{ billion}}\right)$$ $$\text{New Index Value}=2500\times \left(1-0.4\right)=2500\times 0.6=1500$$
• The index would now reflect this change in the market composition and provide a new number that incorporates the impact of replacing Monsanto with Twitter.

Investment Funds

An investment fund is a pool of money collected from multiple investors, managed by a professional who allocates the funds into a portfolio of assets. The goal of this portfolio is to provide benefits such as diversification. But why not just invest in a few stocks?

Benefits of Diversification:

• Risk Reduction: Diversification allows investors to spread risk across various assets, reducing the impact of any single stock’s poor performance.
• Optimized Returns: A well-diversified portfolio can potentially provide higher returns for the same level of risk compared to holding individual stocks.
• Sharpe Ratio: This ratio measures how much return you’re getting per unit of risk. By investing in a portfolio, you can optimize this ratio, either reducing risk or enhancing returns. We’ll dive deeper into the Sharpe ratio in later lessons.

Types of Investment Funds

1. Active vs. Passive Fund Management

• Active Fund Management:

  • Goal: To outperform a market index.
  • Example: Fidelity Contrafund targets large-cap growth stocks aiming to exceed the S&P 500’s performance.
  • Strategy: Fund managers actively select stocks, trying to beat the benchmark.

• Passive Fund Management:

  • Goal: To match the performance of a market index.
  • Example: Vanguard 500 Index Fund, which tracks the S&P 500.
  • Strategy: The fund holds the same stocks as the index in the same proportions, aiming to replicate the index’s performance.

2. Alpha and Beta Funds

• Alpha Fund (Active Funds):

  • Objective: Generate returns above the market’s excess return (returns beyond the risk-free rate).
  • Alpha: In finance, alpha represents the extra return that the fund generates compared to the market, independent of the market’s movement.

• Beta Fund (Passive Funds):

  • Objective: Match the returns of the market.
  • Beta: The beta coefficient measures the sensitivity of the fund’s returns to the market. A beta of 1 means the fund’s returns move in sync with the market.

Smart Beta: A Hybrid Approach

• Smart Beta: Combines elements of both active and passive management. It begins with a passive strategy, such as tracking an index, but then makes adjustments to the asset weights to improve returns or reduce risk.
• Example: Imagine starting with an index fund and then slightly adjusting the weights of the stocks within that fund to try to achieve better performance—this is Smart Beta.

Overview of Mutual Funds and Hedge Funds

Mutual Funds

Mutual Funds are investment vehicles accessible to everyday investors. They have specific characteristics:

• Investment Strategy: Typically, mutual funds are long only, meaning they invest in assets (like stocks) with the expectation of future growth. They generally avoid strategies like shorting stocks or using derivatives.
• Liquidity: Investors can usually buy or sell shares of mutual funds on any business day, without facing lock-up periods that restrict withdrawals.
• Examples:
  • Vanguard Equity Income Fund
  • T. Rowe Price Blue Chip Growth Fund
  • BlackRock Technology Opportunities Fund

Hedge Funds

Hedge Funds are more flexible investment vehicles with different characteristics:

• Investment Strategy: Hedge funds have fewer restrictions and can engage in a variety of strategies, including:
  • Short Selling: Betting that a stock’s price will decline.
  • Derivatives: Using options or futures to hedge or speculate.
• Investor Requirements: Typically, hedge funds accept investments from high-net-worth individuals or institutional investors.
• Minimum Investment and Lock-up Periods: They often require a higher minimum investment and may impose lock-up periods during which investors cannot withdraw their funds.

Why Are Hedge Funds Called Hedge Funds?

Consider this question:

• A: Are hedge funds named after hedgehogs, who play in the hedges of a rose garden?
• B: Are hedge funds named after hedging strategies designed to limit portfolio risk?

---

Relative vs. Absolute Returns

Relative Returns

• Definition: Relative returns measure a fund’s performance compared to a benchmark, usually an index.
• Example:
  • Benchmark: S&P 500 Index
  • S&P 500 Return: 2%
  • Fund Return: 3%
  • Relative Return: 3% - 2% = 1%
  • Active Return: For actively managed funds, this relative return is also known as the active return.
  • Passively Managed Fund: If the fund returns the same as the benchmark (e.g., 2%), the relative return is 0%. The tracking error, which measures the deviation from the benchmark, is also 0%.

Absolute Returns

• Definition: Absolute returns measure a fund’s performance without comparison to a benchmark.
• Benchmark: Often uses cash interest rates, such as the US three-month Treasury rate or LIBOR.
• Example:
  • Hedge Fund Returns: 8.5% in 2017, 5.4% in 2016 (source: Hedge Fund Research group)
  • Measurement: Evaluates the fund’s returns in isolation from market benchmarks.

Hedging Strategies

• Objective: Achieve market-neutral returns, meaning the portfolio’s performance is less affected by overall market movements.
• Method: Use derivatives like options or futures to reduce exposure to price fluctuations.
• Example:
  • Situation: Holding 100 shares of Daimler.
  • Hedge: Buy 100 put options with a strike price of 60 euros per share.
  • Outcome: If Daimler’s market price drops to 50 euros, you can buy shares at 50 euros and sell them at 60 euros using the put options. This results in a profit of 10 euros per share, offsetting the loss on your existing shares.

Net Asset Value (NAV)

• Definition: The value of a fund’s share, calculated as:
  • NAV Formula: $$\text{NAV}=\frac{\text{Assets Under Management (AUM)}-\text{Expenses}}{\text{Number of Shares}}$$
  • Components:
    • Assets Under Management (AUM): Total value of investments.
    • Expenses: Costs of running the fund (e.g., salaries, transaction costs, taxes).
    • Number of Shares: Total shares issued by the fund.

Expense Ratios

• Gross Expense Ratio: The total expenses as a percentage of assets under management.
• Net Expense Ratio: The expense ratio after discounts, usually offered to attract new investors. This is often lower initially but might not be permanent.
• Consideration: Gross expense ratio provides a better indication of long-term costs for investors.

Overview of Open-End Mutual Funds

How Open-End Mutual Funds Work

1. Initial Investment and Share Issuance

   • Investors purchase shares of the fund, which are initially priced at $100 per share.
   • The fund uses this money to invest in a portfolio of assets (e.g., stocks).
   • Example: With 10 investors each buying 1 share at $100, the fund collects $1,000 in assets under management (AUM).

2. Price Fluctuation and New Investments

   • If the value of the portfolio increases, the price per share rises.
   • Example: After a month, the portfolio’s value increases to $1,200, making each share worth $120.
   • A new investor buys a share for $120. The fund now has $1,320 in total assets and 11 shares outstanding.

Handling Withdrawals

1. Maintaining Cash Reserves

   • Open-end funds need to keep a portion of their assets in cash to handle potential withdrawals.
   • Example: If a fund with 10 shares valued at $100 each must pay out $100 for a share redemption, it must have cash available.

2. Impact on Fund’s Asset Value

   • When shares are redeemed, the number of shares outstanding decreases, and the fund’s total assets decrease accordingly.
   • Example: If one share is redeemed, the fund’s total assets drop to $900, and it has 9 shares remaining.

Impact of Cash Reserves on Returns

1. Cash vs. Investment Returns

   • Holding cash affects the overall return of the fund because cash typically earns a lower return compared to invested assets.
   • Example: A fund with $1 million in total assets, where half is invested in equities (earning 10%) and half in cash (earning 2%).

2. Calculating Total Return

   • Weighted average return is calculated based on the proportion of assets in different investments.

   • Calculation:

     • Return from equities: $0.5 \times 10% = 5%$
     • Return from cash: $0.5 \times 2% = 1%$
     • Total return: $5% + 1% = 6%$

   • The total return of the fund is 6%, which is lower than the 10% return from equities alone.

Closed-End Mutual Funds

Concept: Closed-end mutual funds were created to avoid the need for cash reserves required by open-end funds. Here’s how they work:

• Fund Structure: Closed-end funds raise capital through an initial public offering (IPO) and issue a fixed number of shares. After the IPO, the fund does not issue new shares or redeem existing ones.
• Investment Strategy: Since the fund doesn’t need to manage redemptions, the portfolio managers can fully invest the fund’s capital into their strategies, potentially leading to higher returns.
• Trading: Investors buy and sell shares of closed-end funds on the stock exchange. This is similar to trading stocks, so investors can get their cash back by selling their shares to other investors rather than waiting for the fund to redeem them.
• Pricing: The share price of closed-end funds is determined by market demand and supply, which may cause the shares to trade at a premium or discount to the fund’s net asset value (NAV). The NAV is the value of the underlying portfolio divided by the number of shares outstanding.

. Transaction Costs

Concept: Transaction costs are the expenses incurred when buying or selling stocks. These include:

• Commissions: Fees paid to brokers or investment banks.
• Market Impact: The effect of large trades on stock prices. Large purchases can drive up prices, making subsequent purchases more expensive.

Strategies for Minimizing Costs:

• Breaking Orders: Traders often split large orders into smaller trades to avoid moving the market price.
• Trading Frequency: Strategies that require frequent trading based on daily price movements incur higher transaction costs compared to strategies based on less frequent triggers like quarterly reports.
• Portfolio Rebalancing: Adjusting a portfolio can be costly. Managers might skip trades if the transaction costs outweigh the benefits of rebalancing.
• Internal Trading: Large institutions might trade internally between their own funds to reduce transaction costs.