Advanced Investments

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• Advanced Investments
• Week 2 Mutual Funds and Hedge Funds

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Investment Organizations

• Managed Investment Companies (like mutual funds)
• Open-End
• Closed-End
• Other investment organizations
• REITs
• Hedge funds
• CTAs (commodity trading advisors)

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Open-End and Closed-End Funds Key Differences

• Shares Outstanding
• Closed-end no change unless new stock is
  offered.
• Open-end changes when new shares are sold or old
  shares are redeemed.
• Pricing
• Open-end Net Asset Value(NAV)
• Closed-end Premium or discount to NAV

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Figure 4.1 Closed-End Mutual Funds
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Figure 4.2 Listing of Mutual Fund Quotations
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Investment Strategies

• Money Market
• Fixed Income
• Equity
• Balance Income
• Asset Allocation
• Indexed
• Specialized Sector

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Table 4.1 U.S. Mutual Funds by Investment
Classification, December 2004
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What Is a Mutual Fund?

• Financial intermediaries that pool the financial
  resources of investors and invest those resources
  in diversified portfolios of assets
• Why do we hold diversified portfolios?
• In mid-2006, more than 8,100 mutual funds held
  total assets of 9.5 trillion

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Why Invest in a Mutual Fund?

• Diversification
• Professional management
• Economies of scale lower transaction costs and
  commissions
• Variety, liquidity, affordability, and
  convenience
• Administration and ease of recordkeeping
• Strict government regulation and full disclosure

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Shareholder Sentiment

• recent trading scandal and bear market

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History

• First mutual fund established in 1924
• Advent of MMMF in 1972 as investors looked for
  ways to earn market rates on short-term funds
• Tax-exempt MMMF introduced in 1979
• Special-purpose equity, bond, emerging market,
  and derivative funds exploded on the scene during
  the 1990s bull market

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Growth of the Mutual Fund Market
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How many households own mutual funds?

• 92 million individuals in 53.9 million U.S.
  households (48.1 percent of all)
• U.S. Household Ownership of Mutual Funds,
  1998-2004 (in millions)

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Types of Mutual Funds Owned by Fund Shareholders,
2004

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Investor Returns from Mutual Fund Ownership

• The return for the investor reflects three
  aspects of the underlying portfolio of mutual
  fund assets
• portfolio earns income and dividends on those
  assets
• experiences capital gains at the fund level
• capital appreciation in the underlying values of
  its existing assets adds to the value of mutual
  fund shares
• Daily marking to market - asset and balance sheet
  values are adjusted to reflect current market
  prices
• 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

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Example 1

• An investor purchases a mutual fund share for
  100
• 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 105.
• Net rate of return(25-1.55)/10010.5

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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
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Example 2

• 100 shares of IBM 37.49
• 200 shares of Microsoft 29.31
• 100 shares outstanding
• NAV (37.4910029.31200)/10096.11

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Mutual Fund Costs

• Mutual funds charge shareholders a price or fee
• Three types of fees are incurred by investors
• Load versus No-load Funds
• Load fund - a mutual fund with an up-front sales
  or commission charge that the investor must pay
• 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
• Fund Operating Costs
• annual fees charged to cover all fund level
  expenses experienced as a percent of fund assets
• 12 b-1 charges
• distribution costs paid by the fund
• Alternative to a load

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Mutual Fund Fee Table Required by Federal Law
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Table 4.2 Impacts of Costs on Investment
Performance
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Calculating Cost Basis

• Example
• Buy 100 shares of Pioneer Fund at 10 each and
  paid an up-front sales charge of 2 percent, or
  20, on the purchase.
• The cost basis for each share 10.20 (1,020
  divided by 100).
• If you later sell the 100 shares for 1,500, your
  capital gain will be 480 (1,500 - 1,020).

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Key Considerations About Performance

• Past performance cannot predict future results.
• Short-term returns may not tell the whole story.
• The Risk of Inflation
• - Think of inflation as an invisible tax that
  erodes the purchasing power of any investment.

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A First Look at Fund Performance

• Benchmark Wilshire 5000
• Results
• Most funds underperform (Figure 4.3)
• Not fair comparison because of costs and cash
  position
• Adjusted benchmark Wilshire 5000 with passive
  management costs considered.
• The majority of funds still under-perform.

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Figure 4.3 Diversified Equity Funds versus
Wilshire 5000 Index
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Consistency of Fund Performance

• Do some mutual funds consistently outperform?
• Evidence suggests that some funds show consistent
  stronger performance.
• Depends on measurement interval
• Depends on time period
• Evidence shows consistent poor performance.

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Table 4.4 Consistency of Investment Results
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Sources of Information on Mutual Funds

• Wiesenbergers Investment Companies
• Morningstar
• Investment Company Institute
• Popular press
• Investment services
• Center for Research in Security Prices
• http//gsbwww.uchicago.edu/research/crsp

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Growth of Hedge Funds 1990-2003
Growth of Hedge Funds 1990 to 2003

Source Hedge Fund Research
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Number of Hedge Funds 1990-2003
Number of Hedge Funds1990 to 2003

Source Hedge Fund Research
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The History of Hedge Fund (I)

• The first hedge fund was created in 1949 by
  Alfred Winslow Jones. Jones longed the undervalue
  stocks and shorted the overvalued stock
• In 1966, Carol Loomis mentioned the spectacular
  performance of Jones fund in the Fortune
  Magazine.
• In 1986, the Institutional Investor cited the
  superior performance (43 per year for the first
  6 years) of Julian Robertsons Tiger Fund
• In 1992, George Soros Quantum Fund made a famous
  attack on the British Sterling and made a profit
  of 1 billion BP.
• In 1997, hedge funds were accused for responsible
  for the Asian currency crisis.

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The History of Hedge Fund (II)

• In 1998, Long-Term Capital Management (LTCM) lost
  90 of their money and was bailed out by a dozen
  Wall Street firms.
• In 2004, the SEC has passed the rule for hedge
  funds to register as investment advisors.
• In Feb. 2006, the SEC required major hedge funds
  to register as investment advisers
• In June, 2006, the U.S. Court of Appeals for the
  District of Columbia Circuit vacated the SEC rule
  changes

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Hedging

• Strategy used to offset investment risk. A
  perfect hedge is one eliminating the possibility
  of future gain or loss.
• 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.

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Investment Strategies-Mutual Funds

• Equity
• Small cap, medium cap, large cap
• Growth vs. value
• Bond
• Low quality, medium quality, high quality
• Short term, intermediate term, long term
• Hybrid
• Balanced portfolio between stocks and bonds
• Buy-and-hold strategies

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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
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Evolution of Hedge Fund Strategies
Evolution of Hedge Fund Strategies
Source HFR
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Hedge Funds Characteristics
Hedge Fund Characteristics

• One of the fastest growing sectors in finance
• Private partnership or off-shore corporation
• Managers personal investment
• Levered-up (50 times of equity for LTCM)
• High minimum investment requirement (10 million
  for LTCM)
• Not regulated by the SEC
• Long lock-up period (1 year for LTCM)
• Incentive fee structure (20 of profits)
• Absolute performers instead of relative
  performers
• Dynamic trading strategy (vs. buy-and-hold)
• Estimated number of funds over 8,000
• Estimated fund assets over 800 billion

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The New Startup Eton Park

• See the WSJ on Nov. 3, 2004
• Founder Eric Mindich, 37, a former star trader
  at Goldman Sachs
• Startup assets more than 3 billion-one of the
  largest start-up funds in history
• Redemption fee 6 if withdraw money within 4.5
  years.
• Minimum investment 5
• Management fee 2
• Incentive fee 20
• 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.
• Investors Goldman Sachs Asset Management,
  former Goldman partners, Harvard University, and
  other large investors

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The Debacle of LTCM

• The best finance faculty in the world
• Bet on converging credit spreads on different
  bonds
• In August 1998, the default on Russian debt
  caused credit spread to widen
• Lost more than 90 of its 4.7 billion assets
  (at one time the position was more than 100
  billion)
• In September 1998, 14 financial institutions
  infused 3.625 billion to bailout the hedge fund
  giant, with the help from the Fed
• Lesson
• Hedge funds should be hedged
• High leverage ratio is extremely risky (margin
  calls)
• Lenders should be more careful in granting loans
  (they should be more informed)
• More disclosure on hedge funds?
• More regulation?

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Hedge Funds vs. Mutual Funds
Hedge Funds vs. Mutual Funds

• Hedge fund Mutual fund
• Structure Private partnership/ Public funds
• Offshore Corporation
• Regulation Not required for registration SEC
  registration/Prospectus
• Investor Wealthy (accredited)/institutional Small
  /institutional Up to 500 investors
• Min. investment 250,000 0
• Compensation Incentive fee plus Management fee
  only
• Management fee
• Watermark Yes No
• Hurdle rate Yes No
• Lockup period 3 months None
• Advance notice 1 month None
• Leverage Yes Rare
• Short selling Yes Rare
• Derivatives Yes Some
• Concentrated position Yes Rare

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Hedge Funds vs. Mutual Funds
Fund of Hedge Funds

• Provides
• Diversification lower value at risk
• Smaller unit size of investment
• Professional management / Due diligence
• Access to otherwise closed funds

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Fees on Fees in Fund of Funds
Fees on Fees in Funds of Funds
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Hedge Fund Performance

• For the past ten years ending Sept. 30, 2004
• The US stock mutual funds have averaged 9.4
• The SP 500 has gained 11.1
• Hedge funds rose about 11.9 however, as a
  group, the risk of hedge funds are not as high as
  the SP 500.

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Hedge Funds vs. the SP
Hedge Funds vs. the SP 500
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Regulation

• 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.
• Hurdle minimum assets of 30 million which
  allow redemptions within two years.
• Prior to that, hedge funds are largely
  unregistered due to the nature of partnership and
  accredited investors.
• Some funds are registered with CFTC (Commodity
  Futures Trading Commission)

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Resources at Isenberg

• The Center for International Securities and
  Derivatives Market (CISDM) http//cisdm.som.umass.
  edu/
• Journal of Alternative Investments
• http//www.iijournals.com/JAI/default.asp
• Chartered Alternative Investment Analysts (CAIA)
  http//www.caia.org/
• Professors Ben Branch, Hossein Kazemi, Bing
  Liang, Tom Schneeweis, Mila Sherman

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Useful Websites
http//cisdm.som.umass.edu/ https//www.hfr.com/ h
ttp//www.tremont.com/ http//hedgefund.net http/
/vanhedge.com/ http//hedgeworld.com/ http//ssrn.
com/