Investment Banking: Asset Management Tools - dummies

Investment Banking: Asset Management Tools

By Matt Krantz, Robert R. Johnson

Some investment banking firms actually make more money on asset management than on traditional investment banking functions. To become a full-service, one-stop shop for everything financial, investment banking firms have developed a plethora of asset management tools. Here are three of the most common: stock mutual funds, bond mutual funds, and exchange-traded funds.

Stock mutual funds

Most full-service investment banking firms offer their own mutual funds as an asset management tool to clients. A stock mutual fund is a professionally managed pool of money that simply takes clients’ money and invests in a wide variety of companies. The big advantages of mutual funds are diversification (investors’ funds are spread across many companies) and professional management. Investment banks earn management fees for managing mutual funds.

Mutual funds are also very liquid securities. Open-end mutual funds must stand willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day.

Closed-end mutual funds, on the other hand, trade in the secondary market (the active buying and selling of stocks on an exchange) and may trade at a premium or discount to net asset value. The share value of a closed-end fund is determined by the interaction of buyers and sellers in the marketplace — by supply and demand — much like the value of a share of stock itself is determined.

The only limit to the variety of mutual funds is the creativity of investment bankers. Here are some of the most common types of stock mutual funds:

  • Sector or industry funds: Invest in firms within a particular segment of the market such as healthcare or technology.

  • International funds: Invest in stocks from around the world.

  • Emerging-market funds: Invest in stocks from developing countries.

  • Country funds: Confine investments to stock within a particular country.

  • Growth funds: Invest in stocks forecast to have above-average growth prospects.

  • Value funds: Invest in stocks that appear to be undervalued based upon fundamental investment metrics, such as price-to-earnings or price-to-book ratio.

  • Index funds: Instead of being actively managed — that is, with professional managers making decisions on which stocks to buy and sell — the holdings simply mirror the composition of an index such as the S&P 500 or the Dow Jones Industrial Average.

  • Cap-based funds: Limit their holdings to stocks within certain market capitalization (the value of the entire equity of the firm) ranges. Large-cap, mid-cap, and small-cap funds have become very popular for investors to focus on the market segment they desire.

Bond mutual funds

Bond mutual funds are structured in an identical fashion to stock mutual funds and are popular asset management vehicles created by investment banks. Bond mutual funds allow investors to diversify across many holdings — something difficult to achieve outside of bonds funds because bonds generally trade in larger denominations than stocks.

Here are the most common types of bond mutual funds:

  • Investment-grade funds: Invest only in the debt of highly rated creditworthy companies.

  • High-yield funds: Invest in the debt of below-investment-grade companies.

  • Municipal funds: Invest in the debt issues of state, county, city, or other nongovernmental agencies.

  • International funds: Invest in debt issues of companies and sovereign issuers outside the United States. A variety of international bond funds invest in the debt of emerging markets.

  • Treasury-Inflation Protected Securities (TIPS): Bonds issued by the U.S. Treasury that pay a rate of interest that is adjusted on a semiannual basis with the rate of the Consumer Price Index (a measure of inflation).

Exchange-traded funds

An exchange-traded fund (ETF) is much like a mutual fund; it’s invested in a diversified number of individual securities. However, unlike a mutual fund, an ETF actively trades on a stock exchange, much like stocks. Although mutual funds provide investors with liquidity on a daily basis, exchange-traded funds provide the investor with immediate liquidity.

Most ETFs are index funds, but since 2008 the Securities and Exchange Commission (SEC) has allowed the creation and marketing of actively managed ETFs. Investment bankers have created ETFs on stocks, bonds, and commodities.

The popularity of ETFs has increased dramatically in recent years. Some of the more popular ETFs are the sector SPDRs sponsored by State Street Global Advisors, which follow the sectors of the S&P Index. Another popular issue are the iShares ETFs sponsored by BlackRock, which track many country and industry indexes.