1.

• Advanced Investments

Week 2: Mutual Funds and Hedge Funds

2.

Managed Investment Companies(like mutual funds)

• Open-End

• Closed-End

Other investment organizations

• REITs

• Hedge funds

• CTAs (commodity trading advisors)

Investment Organizations 3.

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

Open-End and Closed- End Funds: Key Differences 4. Figure 4.1 Closed-End Mutual Funds 5. Figure 4.2 Listing of Mutual Fund Quotations 6.

Money Market

Fixed Income

Equity

Balance & Income

Asset Allocation

Indexed

Specialized Sector

InvestmentStrategie s 7. Table 4.1 U.S. Mutual Funds by Investment Classification, December 2004 8. What Is a Mutual Fund?

F inancial 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-200 6 , more than 8, 1 00 mutual funds held total assets of $ 9.5trillion

9. Why Invest in a Mutual Fund?

D iversification

P rofessional management

E conomies of scale :lower transaction costs and commissions

V ariety ,l iquidity ,a ffordability ,and c onvenience

Administration and e ase of recordkeeping

S t r ict government regulation and full disclosure

10. Shareholder Sentiment

recent trading scandal and bear market

11. Histor y

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

12. Growth of the Mutual Fund Market 13. How manyhousehold s 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)

14. Types of Mutual Funds Owned by Fund Shareholders, 2004 15. 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 gainsat 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

16. 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 $10 5 .

Net rate of return=(2+5-1.5+ 5 )/100=1 0 .5%

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 ofshares is not fixed but can increase or decrease daily withpurchases and redemptions of shares Closed-end investment companies- specialized investmentcompanies that have a fixed supply of outstanding sharesbut 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. Example 2

100 shares ofIBM$37.49

200 shares of Microsoft$29.31

100 shares outstanding

NAV =(37.49*100+29.31*200)/100= $ 96.11

19. Mutual Fund Costs

Mutual funds charge shareholders a price or fee

Threetypes 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

20. Mutual Fund Fee Table Required by Federal Law 21. Table 4.2 Impacts of Costs on Investment Performance 22. Calculating Cost Basis

Example

Buy100 shares ofPioneerFund 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).

23. 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.

24. A First Look at Fund Performance

Benchmark: Wilshire 5000

Results

• Most funds underperform(Figure 4.3)

• Not fair comparison because of costsand cash position

Adjustedb enchmark: Wilshire 5000 with passive management costs considered.

• The majority of funds still under-perform.

25. Figure 4.3 Diversified Equity Funds versus Wilshire 5000 Index 26. 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.

27. Table 4.4 Consistency of Investment Results 28.

Wiesenbergers Investment Companies

Morningstar

Investment Company Institute

Popular press

Investment services

Center for Research in Security Prices

http://gsbwww.uchicago.edu/research/crsp

Sources of Information on Mutual Funds 29. Growth of Hedge Funds: 1990 to 2003 Source: Hedge Fund Research Growth of Hedge Funds: 1990-2003 30. Number of Hedge Funds:1990 to 2003 Source: Hedge Fund Research Number of Hedge Funds: 1990-2003 31. 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.

32. 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

33. 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.

34. 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

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. Evolution of Hedge Fund Strategies Source: HFR Evolution of Hedge Fund Strategies 37. Hedge Funds: 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

Hedge Fund Characteristics 38. 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

39. 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?

40. Hedge Funds vs. Mutual Funds

Hedge fund Mutual fund

Structure Private partnership/ Public funds

Offshore Corporation

Regulation Not required for registrationSEC 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

Hedge Funds vs. Mutual Funds 41. Hedge Funds vs. Mutual Funds

Provides

• Diversification lower value at risk

• Smaller unit size of investment

• Professional management / Due diligence

• Access to otherwise closed funds

Fund of Hedge Funds 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. Hedge Fund Performance

For the past ten years ending Sept. 30, 2004

The US stock mutual funds have averaged 9.4%

The S&P 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 S&P 500.

44. Hedge Funds vs. the S&P Hedge Funds vs. the S&P 500 45. 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)

46. 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

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/