Lecture 14


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Lecture 14

  1. 1. Portfolio Theory and Financial Engineering FIN 428 Lecture Thirteen: Professional Asset Management Tuesday, February 27, 2007
  2. 2. The Asset Management Industry: Structure and Evolution <ul><li>Two Organization Forms </li></ul><ul><ul><li>Contract directly with a management and advisory firm </li></ul></ul><ul><ul><li>Commingling of investment capital of several clients in an investment company </li></ul></ul><ul><li>Differences between These Two Forms </li></ul><ul><ul><li>Private management and advisory firms develop a personal relationship with clients </li></ul></ul><ul><ul><li>A Investment company offers a general solution </li></ul></ul>
  3. 3. The Asset Management Industry: Structure and Evolution <ul><li>Contract directly with a management and advisory firm </li></ul><ul><ul><li>relationship with client </li></ul></ul><ul><ul><li>assets under management (AUM) </li></ul></ul><ul><ul><li>separate accounts </li></ul></ul><ul><ul><li>customized </li></ul></ul>
  4. 4. The Asset Management Industry: Structure and Evolution <ul><li>Commingling of investment capital of several clients in an investment company </li></ul><ul><ul><li>invest a pool of funds belonging to many individuals in a single portfolio of securities </li></ul></ul><ul><ul><li>issue new shares representing the proportional ownership of the fund. </li></ul></ul>
  5. 5. Private Management and Advisory Firms <ul><li>Much Smaller </li></ul><ul><li>Focus on a particular niche of the market </li></ul><ul><li>Investment Strategy </li></ul><ul><ul><li>Each client’s assets are held in a separate account. </li></ul></ul><ul><ul><li>The security portfolio are likely to be guided by the firm’s overall investment philosophy. </li></ul></ul>
  6. 6. Organization and Management of Investment Companies <ul><li>Major duties </li></ul><ul><ul><li>Investment research </li></ul></ul><ul><ul><li>Management of the portfolio </li></ul></ul><ul><ul><li>Administrative duties </li></ul></ul><ul><ul><ul><li>Issue securities </li></ul></ul></ul><ul><ul><ul><li>Handle redemptions and dividends </li></ul></ul></ul><ul><li>Start funds with different characteristics to achieve economics of scale </li></ul>
  7. 7. Valuating Investment Company Shares <ul><li>The NAV for an investment company is analogous to the share price of a corporation’s common stock. </li></ul><ul><li>The NAV of the fund shares will increase as the value of the underlying assets (the fund security portfolio) increases. </li></ul>
  8. 8. Closed-End Versus Open-End Investment Companies <ul><li>Differ in the way each operates after the initial public offering </li></ul><ul><li>Closed-end investment company </li></ul><ul><ul><li>Stock trades on secondary market </li></ul></ul><ul><ul><li>Net asset value (NAV) is computed twice daily, but market price determined by supply and demand </li></ul></ul><ul><ul><li>Many Funds sell at discounts to NAV </li></ul></ul><ul><li>Open-end investment companies </li></ul><ul><ul><li>Mutual funds </li></ul></ul><ul><ul><li>Sell and redeem shares at NAV </li></ul></ul>
  9. 9. Load versus No-Load Open-End Fund <ul><li>The offering price for a share of a load fund equals the NAV of the share plus a sale charge. </li></ul><ul><li>A no-load fund imposes no initial sales charge so it sells shares at the NAV. </li></ul><ul><li>Several variations exist between the full-load fund and the pure no-load fund </li></ul><ul><ul><li>Low-load fund </li></ul></ul><ul><ul><li>12b-1 plan </li></ul></ul><ul><ul><li>Funds have contingent, deferred sales loads </li></ul></ul>
  10. 10. Fund Management Fees <ul><li>Charge annual management fees to compensate professional managers of the fund </li></ul><ul><li>Management fees are a major factor driving the creation of new funds. </li></ul>
  11. 11. Investment Company Portfolio Objectives <ul><li>Four broad fund objective categories </li></ul><ul><ul><li>Common stock funds </li></ul></ul><ul><ul><li>Hybrid funds </li></ul></ul><ul><ul><li>Bond funds </li></ul></ul><ul><ul><li>Money market fund </li></ul></ul>
  12. 12. Hedge Funds <ul><li>Form a portfolio that combines both long and short position in the equity market with the use of financial leverage to enhance return </li></ul><ul><li>Better able to produce superior returns than traditional investment structures, such as mutual funds </li></ul>
  13. 13. Hedge Fund Strategies <ul><li>Equity-based strategies </li></ul><ul><ul><li>Long-short equity </li></ul></ul><ul><ul><li>Equity market neutral </li></ul></ul><ul><li>Arbitrage-based Strategies </li></ul><ul><ul><li>Fixed-income arbitrage </li></ul></ul><ul><ul><li>Convertible arbitrage </li></ul></ul><ul><ul><li>Merger (risk) arbitrage </li></ul></ul><ul><li>Opportunistic Strategies </li></ul><ul><ul><li>High yield and distressed </li></ul></ul><ul><ul><li>Global macro </li></ul></ul><ul><ul><li>Managed futures </li></ul></ul><ul><ul><li>Special situations </li></ul></ul><ul><li>Multiple strategies </li></ul><ul><ul><li>Fund of funds </li></ul></ul>
  14. 14. Risk Arbitrage Investing <ul><li>Take equity positions in companies that are the target of a merger or takeover attempt </li></ul><ul><li>Require managers to compare their own subjective judgment about the success of the proposed takeover with the success probability implied by the market price of the target firm’s stock following the announcement of the prospective deal </li></ul><ul><li>If the manager thinks the takeover is more likely to occur than the market does, he or she will buy target firm shares. </li></ul><ul><li>The manager might short sell the target firm shares if he or she thinks the proposed deal is less likely to be completed </li></ul>
  15. 15. Hedge Fund Performance <ul><li>Not all hedge funds are the same when it comes to their risk and return profiles </li></ul><ul><li>The returns to these strategies show a high degree of variability on a year-to year basis, in both an absolute and a relative sense. </li></ul>
  16. 16. Ethics and Regulation in the Professional Asset Management Industry <ul><li>Agency problem </li></ul><ul><li>Regulation in the asset management industry </li></ul><ul><ul><li>Principal securities laws that govern investment companies </li></ul></ul><ul><ul><ul><li>The Investment Company Act of 1940 </li></ul></ul></ul><ul><ul><ul><li>The Securities Act of 1933 </li></ul></ul></ul><ul><ul><ul><li>The Securities Exchange Act of 1934 </li></ul></ul></ul><ul><ul><ul><li>The Investment Advisers Act of 1940 </li></ul></ul></ul><ul><ul><li>Regulatory agencies </li></ul></ul><ul><ul><ul><li>U.S. Department of Labor </li></ul></ul></ul><ul><ul><ul><li>NASDR </li></ul></ul></ul><ul><ul><ul><li>U.S. Commodity and Futures Trading Commission </li></ul></ul></ul><ul><ul><ul><li>U.S. Internal Revenue Service </li></ul></ul></ul>
  17. 17. Ethics and Regulation in the Professional Asset Management Industry <ul><li>Standards for Ethical Behavior </li></ul><ul><ul><li>The CFA Institute Code of Ethics </li></ul></ul><ul><ul><li>The CFA Institute Standards of Professional Conduct </li></ul></ul><ul><li>The CFA Institute’ Centre for Financial Market Integrity </li></ul><ul><ul><li>Asset Manager Code of Professional Conduct </li></ul></ul>
  18. 18. Ethics and Regulation in the Professional Asset Management Industry <ul><li>Examples of Ethical Conflicts </li></ul><ul><ul><li>Incentive Compensation Schemes </li></ul></ul><ul><ul><li>Soft Dollar Arrangements </li></ul></ul><ul><ul><li>Marketing Investment Management Services </li></ul></ul>
  19. 19. What Do You Want from a Professional Asset Manger? <ul><li>1. Help determine your investment objectives and develop a portfolio that is consistent with them. </li></ul><ul><li>2. Diversify your portfolio to eliminate unsystematic risk. </li></ul><ul><li>3. Maintain your portfolio diversification and your desired risk class while allowing flexibility so you could shift between alternative investment instruments as desired. </li></ul><ul><li>4. Attempt to achieve a risk-adjusted performance level that is superior to that of your relevant benchmark. </li></ul><ul><li>5. Administer the account, keep records of costs and transactions, provide timely information for tax purposes, and reinvest dividends if desired. </li></ul><ul><li>6. Maintain ethical standards of behavior at all times. </li></ul>
  20. 20. Next Class <ul><li>Reading </li></ul><ul><ul><li>RB Chapter 25 (pp. 1064-1079) </li></ul></ul><ul><ul><li>Davis article </li></ul></ul><ul><ul><li>Brown, Harlow and Starks article </li></ul></ul><ul><li>Topics to be discussed in the next class </li></ul><ul><ul><li>Evaluation of Portfolio Performance (pt 1) </li></ul></ul>