Advanced Investments Week 2: Mutual Funds and Hedge Funds

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Advanced Investments Week 2: Mutual Funds and Hedge Funds

  1. 1. <ul><li>Advanced Investments </li></ul><ul><li>Week 2: Mutual Funds and Hedge Funds </li></ul>
  2. 2. <ul><li>Managed Investment Companies (like mutual funds) </li></ul><ul><ul><li>Open-End </li></ul></ul><ul><ul><li>Closed-End </li></ul></ul><ul><li>Other investment organizations </li></ul><ul><ul><li>REITs </li></ul></ul><ul><ul><li>Hedge funds </li></ul></ul><ul><ul><li>CTAs (commodity trading advisors) </li></ul></ul>Investment Organizations
  3. 3. <ul><li>Shares Outstanding </li></ul><ul><li>Closed-end: no change unless new stock is offered. </li></ul><ul><li>Open-end: changes when new shares are sold or old shares are redeemed. </li></ul><ul><li>Pricing </li></ul><ul><li>Open-end: Net Asset Value(NAV) </li></ul><ul><li>Closed-end: Premium or discount to NAV </li></ul>Open-End and Closed- End Funds: Key Differences
  4. 4. Figure 4.1 Closed-End Mutual Funds
  5. 5. Figure 4.2 Listing of Mutual Fund Quotations
  6. 6. <ul><li>Money Market </li></ul><ul><li>Fixed Income </li></ul><ul><li>Equity </li></ul><ul><li>Balance & Income </li></ul><ul><li>Asset Allocation </li></ul><ul><li>Indexed </li></ul><ul><li>Specialized Sector </li></ul>Investment Strategie s
  7. 7. Table 4.1 U.S. Mutual Funds by Investment Classification, December 2004
  8. 8. What Is a Mutual Fund? <ul><li>F inancial intermediaries that pool the financial resources of investors and invest those resources in diversified portfolios of assets </li></ul><ul><li>Why do we hold diversified portfolios? </li></ul><ul><li>In mid-200 6 , more than 8, 1 00 mutual funds held total assets of $ 9.5 trillion </li></ul>
  9. 9. Why Invest in a Mutual Fund? <ul><li>D iversification </li></ul><ul><li>P rofessional management </li></ul><ul><li>E conomies of scale : lower transaction costs and commissions </li></ul><ul><li>V ariety , l iquidity , a ffordability , and c onvenience </li></ul><ul><li>Administration and e ase of recordkeeping </li></ul><ul><li>S t r ict government regulation and full disclosure </li></ul>
  10. 10. Shareholder Sentiment <ul><li>recent trading scandal and bear market </li></ul>
  11. 11. Histor y <ul><li>First mutual fund established in 1924 </li></ul><ul><li>Advent of MMMF in 1972 as investors looked for ways to earn market rates on short-term funds </li></ul><ul><li>Tax-exempt MMMF introduced in 1979 </li></ul><ul><li>Special-purpose equity, bond, emerging market, and derivative funds exploded on the scene during the 1990’s bull market </li></ul>
  12. 12. Growth of the Mutual Fund Market
  13. 13. How many household s own mutual funds? <ul><li>92 million individuals in 53.9 million U.S. households (48.1 percent of all) </li></ul><ul><li>U.S. Household Ownership of Mutual Funds, 1998-2004 ( in millions) </li></ul>
  14. 14. Types of Mutual Funds Owned by Fund Shareholders, 2004
  15. 15. Investor Returns from Mutual Fund Ownership <ul><li>The return for the investor reflects three aspects of the underlying portfolio of mutual fund assets </li></ul><ul><ul><li>portfolio earns income and dividends on those assets </li></ul></ul><ul><ul><li>experiences capital gains at the fund level </li></ul></ul><ul><ul><li>capital appreciation in the underlying values of its existing assets adds to the value of mutual fund shares </li></ul></ul><ul><li>Daily marking to market - asset and balance sheet values are adjusted to reflect current market prices </li></ul><ul><li>NAV - the net asset value of a mutual fund -- equal to the market value of the assets in the mutual fund portfolio divided by number of shares outstanding </li></ul>
  16. 16. Example 1 <ul><li>An investor purchases a mutual fund share for $100 </li></ul><ul><li>The fund pays dividends of $2, distributes a capital gains of $5, and charge a fee of $1.5 when the fund is sold one year later for $10 5 . </li></ul><ul><li>Net rate of return=(2+5-1.5+ 5 )/100=1 0 .5% </li></ul>
  17. 17. Calculation of NAV; Classes of Funds Calculation of NAV on an Open-End Mutual Fund NAV = Total market value of assets under management Number of mutual fund shares outstanding Open-end mutual fund - a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares Closed-end investment companies - specialized investment companies that have a fixed supply of outstanding shares but invest in the securities and assets of other firms REIT - a closed-end investment company that specializes in investing in mortgages, property, or real estate shares
  18. 18. Example 2 <ul><li>100 shares of IBM $37.49 </li></ul><ul><li>200 shares of Microsoft $29.31 </li></ul><ul><li>100 shares outstanding </li></ul><ul><li>NAV =(37.49*100+29.31*200)/100= $ 96.11 </li></ul>
  19. 19. Mutual Fund Costs <ul><li>Mutual funds charge shareholders a price or fee </li></ul><ul><li>Three types of fees are incurred by investors </li></ul><ul><ul><li>Load versus No-load Funds </li></ul></ul><ul><ul><ul><li>Load fund - a mutual fund with an up-front sales or commission charge that the investor must pay </li></ul></ul></ul><ul><ul><ul><li>No-load fund - a mutual fund that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors </li></ul></ul></ul><ul><ul><li>Fund Operating Costs </li></ul></ul><ul><ul><ul><li>annual fees charged to cover all fund level expenses experienced as a percent of fund assets </li></ul></ul></ul><ul><ul><li>12 b-1 charges </li></ul></ul><ul><ul><ul><li>distribution costs paid by the fund </li></ul></ul></ul><ul><ul><ul><li>Alternative to a load </li></ul></ul></ul>
  20. 20. Mutual Fund Fee Table Required by Federal Law
  21. 21. Table 4.2 Impacts of Costs on Investment Performance
  22. 22. Calculating Cost Basis <ul><li>Example </li></ul><ul><li>Buy 100 shares of Pioneer Fund at $10 each and paid an up-front sales charge of 2 percent, or $20, on the purchase. </li></ul><ul><li>The cost basis for each share = $10.20 ($1,020 divided by 100). </li></ul><ul><li>If you later sell the 100 shares for $1,500, your capital gain will be $480 ($1,500 - $1,020). </li></ul>
  23. 23. Key Considerations About Performance <ul><li>Past performance cannot predict future results. </li></ul><ul><li>Short-term returns may not tell the whole story. </li></ul><ul><li>The Risk of Inflation </li></ul><ul><li>- Think of inflation as an invisible tax that erodes the purchasing power of any investment. </li></ul>
  24. 24. A First Look at Fund Performance <ul><li>Benchmark: Wilshire 5000 </li></ul><ul><li>Results </li></ul><ul><ul><li>Most funds underperform (Figure 4.3) </li></ul></ul><ul><ul><li>Not fair comparison because of costs and cash position </li></ul></ul><ul><li>Adjusted b enchmark: Wilshire 5000 with passive management costs considered. </li></ul><ul><ul><li>The majority of funds still under-perform. </li></ul></ul>
  25. 25. Figure 4.3 Diversified Equity Funds versus Wilshire 5000 Index
  26. 26. Consistency of Fund Performance <ul><li>Do some mutual funds consistently outperform? </li></ul><ul><li>Evidence suggests that some funds show consistent stronger performance. </li></ul><ul><ul><li>Depends on measurement interval </li></ul></ul><ul><ul><li>Depends on time period </li></ul></ul><ul><li>Evidence shows consistent poor performance. </li></ul>
  27. 27. Table 4.4 Consistency of Investment Results
  28. 28. <ul><li>Wiesenberger’s Investment Companies </li></ul><ul><li>Morningstar </li></ul><ul><li>Investment Company Institute </li></ul><ul><li>Popular press </li></ul><ul><li>Investment services </li></ul><ul><li>Center for Research in Security Prices </li></ul><ul><li>http://gsbwww.uchicago.edu/research/crsp </li></ul>Sources of Information on Mutual Funds
  29. 29. Growth of Hedge Funds: 1990 to 2003 Source: Hedge Fund Research Growth of Hedge Funds: 1990-2003
  30. 30. Number of Hedge Funds:1990 to 2003 Source: Hedge Fund Research Number of Hedge Funds: 1990-2003
  31. 31. The History of Hedge Fund (I) <ul><li>The first hedge fund was created in 1949 by Alfred Winslow Jones. Jones longed the undervalue stocks and shorted the overvalued stock </li></ul><ul><li>In 1966, Carol Loomis mentioned the spectacular performance of Jones’ fund in the Fortune Magazine. </li></ul><ul><li>In 1986, the Institutional Investor cited the superior performance (43% per year for the first 6 years) of Julian Robertson’s Tiger Fund </li></ul><ul><li>In 1992, George Soros’ Quantum Fund made a famous attack on the British Sterling and made a profit of 1 billion BP. </li></ul><ul><li>In 1997, hedge funds were accused for responsible for the Asian currency crisis. </li></ul>
  32. 32. The History of Hedge Fund (II) <ul><li>In 1998, Long-Term Capital Management (LTCM) lost 90% of their money and was bailed out by a dozen Wall Street firms. </li></ul><ul><li>In 2004, the SEC has passed the rule for hedge funds to register as investment advisors. </li></ul><ul><li>In Feb. 2006, the SEC required major hedge funds to register as investment advisers </li></ul><ul><li>In June, 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated the SEC rule changes </li></ul>
  33. 33. Hedging <ul><li>Strategy used to offset investment risk. A perfect hedge is one eliminating the possibility of future gain or loss. </li></ul><ul><li>Example: You own 100 shares of XYZ stock, selling at $70 per share. You can hedge your position by buying a put option giving you the right to sell 100 shares of XYZ stock at $70 per share. If the stock falls, you can exercise your option to sell the stocks while preserving your holding. </li></ul>
  34. 34. Investment Strategies-Mutual Funds <ul><li>Equity </li></ul><ul><ul><li>Small cap, medium cap, large cap </li></ul></ul><ul><ul><li>Growth vs. value </li></ul></ul><ul><li>Bond </li></ul><ul><ul><li>Low quality, medium quality, high quality </li></ul></ul><ul><ul><li>Short term, intermediate term, long term </li></ul></ul><ul><li>Hybrid </li></ul><ul><ul><li>Balanced portfolio between stocks and bonds </li></ul></ul><ul><ul><li>Buy-and-hold strategies </li></ul></ul>
  35. 35. Investment Strategies-Hedge Funds Hedge Funds Equity market neutral Market timing Risk arbitrage Global macro Convertible arbitrage Short seller Fund of funds Emerging markets Fixed income arbitrage Distressed securities Event driven Multi-strategy Dynamic trading strategies
  36. 36. Evolution of Hedge Fund Strategies Source: HFR Evolution of Hedge Fund Strategies
  37. 37. Hedge Funds: Characteristics <ul><li>One of the fastest growing sectors in finance </li></ul><ul><li>Private partnership or off-shore corporation </li></ul><ul><li>Managers’ personal investment </li></ul><ul><li>Levered-up (50 times of equity for LTCM) </li></ul><ul><li>High minimum investment requirement ($10 million for LTCM) </li></ul><ul><li>Not regulated by the SEC </li></ul><ul><li>Long lock-up period (1 year for LTCM) </li></ul><ul><li>Incentive fee structure (20% of profits) </li></ul><ul><li>Absolute performers instead of relative performers </li></ul><ul><li>Dynamic trading strategy (vs. buy-and-hold) </li></ul><ul><li>Estimated number of funds: over 8,000 </li></ul><ul><li>Estimated fund assets: over $800 billion </li></ul>Hedge Fund Characteristics
  38. 38. The New Startup: Eton Park <ul><li>See the WSJ on Nov. 3, 2004 </li></ul><ul><li>Founder: Eric Mindich, 37, a former star trader at Goldman Sachs </li></ul><ul><li>Startup assets: more than $3 billion-one of the largest start-up funds in history </li></ul><ul><li>Redemption fee: 6% if withdraw money within 4.5 years. </li></ul><ul><li>Minimum investment: $5 </li></ul><ul><li>Management fee: 2% </li></ul><ul><li>Incentive fee: 20% </li></ul><ul><li>Strategy: equity long/short-70% money in traditional equity in US, Latin America, Eastern Europe, and South Africa, and 30% in less liquid “private” transactions. </li></ul><ul><li>Investors: Goldman Sachs Asset Management, former Goldman partners, Harvard University, and other large investors </li></ul>
  39. 39. The Debacle of LTCM <ul><li>“ The best finance faculty in the world” </li></ul><ul><li>Bet on converging credit spreads on different bonds </li></ul><ul><li>In August 1998, the default on Russian debt caused credit spread to widen </li></ul><ul><li>Lost more than 90% of its $4.7 billion assets (at one time the position was more than $100 billion) </li></ul><ul><li>In September 1998, 14 financial institutions infused $3.625 billion to bailout the hedge fund giant, with the help from the Fed </li></ul><ul><li>Lesson: </li></ul><ul><li>Hedge funds should be “hedged” </li></ul><ul><li>High leverage ratio is extremely risky (margin calls) </li></ul><ul><li>Lenders should be more careful in granting loans (they should be more informed) </li></ul><ul><li>More disclosure on hedge funds? </li></ul><ul><li>More regulation? </li></ul>
  40. 40. Hedge Funds vs. Mutual Funds <ul><li>Hedge fund Mutual fund </li></ul><ul><li>Structure Private partnership/ Public funds </li></ul><ul><li>Offshore Corporation </li></ul><ul><li>Regulation Not required for registration SEC registration/Prospectus </li></ul><ul><li>Investor Wealthy (accredited)/institutional Small/institutional Up to 500 investors </li></ul><ul><li>Min. investment $250,000 0 </li></ul><ul><li>Compensation Incentive fee plus Management fee only </li></ul><ul><li>Management fee </li></ul><ul><li>Watermark Yes No </li></ul><ul><li>Hurdle rate Yes No </li></ul><ul><li>Lockup period 3 months None </li></ul><ul><li>Advance notice 1 month None </li></ul><ul><li>Leverage Yes Rare </li></ul><ul><li>Short selling Yes Rare </li></ul><ul><li>Derivatives Yes Some </li></ul><ul><li>Concentrated position Yes Rare </li></ul>Hedge Funds vs. Mutual Funds
  41. 41. Hedge Funds vs. Mutual Funds <ul><li>Provides </li></ul><ul><ul><li>Diversification – lower value at risk </li></ul></ul><ul><ul><li>Smaller unit size of investment </li></ul></ul><ul><ul><li>Professional management / Due diligence </li></ul></ul><ul><ul><li>Access to otherwise closed funds </li></ul></ul>Fund of Hedge Funds
  42. 42. Fees on Fees in Fund of Funds Fees on Fees in Funds of Funds Hedge fund 1 Hedge Fund 2 Hedge Fund 3 Fund of Fund Start of year ($M) $1.00 $1.00 $1.00 $3.00 Annual Return 20% 40% -75% -5% End of year ($M) $1.20 $1.40 $0.25 $2.85 Incentive fee ($M) $0.04 $0.08 $0.00 $0.12 After fee return 16% 32% -75% -9%
  43. 43. Hedge Fund Performance <ul><li>For the past ten years ending Sept. 30, 2004 </li></ul><ul><li>The US stock mutual funds have averaged 9.4% </li></ul><ul><li>The S&P 500 has gained 11.1% </li></ul><ul><li>Hedge funds rose about 11.9%; however, as a group, the risk of hedge funds are not as high as the S&P 500. </li></ul>
  44. 44. Hedge Funds vs. the S&P Hedge Funds vs. the S&P 500
  45. 45. Regulation <ul><li>On July 28, 2004, the Securities Exchange Commission (SEC) published for comment in the Federal Register rules to require hedge fund advisers to register with the SEC under the Investment Advisers Act of 1940. </li></ul><ul><li>Hurdle: minimum assets of $30 million which allow redemptions within two years. </li></ul><ul><li>Prior to that, hedge funds are largely unregistered due to the nature of partnership and accredited investors. </li></ul><ul><li>Some funds are registered with CFTC (Commodity Futures Trading Commission) </li></ul>
  46. 46. Resources at Isenberg <ul><li>The Center for International Securities and Derivatives Market (CISDM) http://cisdm.som.umass.edu/ </li></ul><ul><li>Journal of Alternative Investments </li></ul><ul><li>http://www.iijournals.com/JAI/default.asp </li></ul><ul><li>Chartered Alternative Investment Analysts (CAIA) http://www.caia.org/ </li></ul><ul><li>Professors Ben Branch, Hossein Kazemi, Bing Liang, Tom Schneeweis, Mila Sherman </li></ul>
  47. 47. Useful Websites http://cisdm.som.umass.edu/ https://www.hfr.com/ http://www.tremont.com/ http://hedgefund.net http://vanhedge.com/ http://hedgeworld.com/ http://ssrn.com/

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