Week 1 Notes Chapter 4: Mutual Funds + Chapter 26: Hedge Funds
Mutual Funds
= intermediary (institution) to manage other people’s money
Specialized skills and (asset specific) knowledge
Cost efficiency
Diversification and liquidity
Why are mutual funds important?
Asset management of pension funds often delegated to mutual funds
Primary way of individuals to invest
Delegation of stock selection and risk management to asset managers
→ US Stock market ≈ 5000 company stock but also 5000 equity mutual funds!
Types of investment companies
➔ Unit Investment Trust
≡ fixed portfolio of uniform assets deposited in a trust fund
≡ trust fund sells shares of its trust = redeemable trust certificates
No trading or change in composition
Investors invest in unit trust to gain exposure to certain pool of assets within
their broader portfolios
, ➔ Open-end mutual funds
Company sets up a fund (with specified target industry) → board of directors elect a fund manager (in-house or
contracted) → fund management invests capital and is paid management fees
Open-end: no restriction on the amount of shares the fund can issue
If the trust wants to issue more shares it must buy more of the underlying assets
Redeemable trust certificated (trust shares) are priced at NAV net asset value
= if an investor wants to cash out, the fund must buy it back at NAV
➔ Close-end mutual funds
Fixed amount of trust shares issued and outstanding
Traded on the stock market just like stocks
Price of trust share relative to its NAV can vary (premium or discount)
= if an investor wants to cash out another investor needs to buy the shares from him
➔ Exchange traded funds ETFs
Mix of closed and open-end funds
No restrictions on the shares issued and outstanding
Advantages: Disadvantages
• Can trade marginally above or below NAV
• Trade continuously like stocks + low cost • Must be purchased from a broker
• Can be sold or purchased on margin
• Tax efficient (when investors buy and sell to and
from each other, no capital gain tax triggered for
ETF provider)
Zero-fee funds make money by:
- Lending out assets to short sellers
- Spillover effects to funds with higher fee structure
,Performance of Mutual funds
→ always take the lesser of purchases and sales
Costs of Mutual funds
Expense ratio (operating expenses) → administrative and advisory fees
Marketing and distribution costs → pay brokers of advisors
Front-end load → sales charge when investors first buy the fund (around 6%)
Back-end load → sales charge when you exit the fund (starts at 5-6%, reduced by 1% each year)
→ Goal is to tether investors to the fund
12b-1 charge → compensation for distribution costs and commissions paid to brokers
A Mutual fund can issue different classes of redeemable shares
Difference = fee structure
Expense ratio is very important in the long run because of
cumulative and re-invested distributed capital gains and dividends
Performance measurement
Implications for investors
o After fees, active investing is a negative sum game
o Pay attention to poor benchmarking and reaching-for-yield behavior
o Pay attention to fees
,Performance on Active Investors
Empirical evidence: 1% underperformance BEFORE FEES to Wilshire 5000
index (= total public equity market)
Evidence for persistent superior performance (due to skill not just luck) us
weak but suggestive
Bad performance is more likely to persist
Hedge Funds
≡ Not constrained to using leverage (mutual funds are restricted)
≡ Only institutional investors or high net worth individuals
≡ Very important to market efficiency
≡ Hedging = market neutral strategies, making money in every market condition
≡ Lower share ratio than S&P 500
Fee Structure
- Management fee typically 2% of assets under management
- Incentive (performance) fee = 20% of investment returns above benchmark (hurdle rate)
- High water mark: performance fees only must be paid when hedge funds exceeds its highest value (new all-time
high) after a loss-making period, this ensures that commissions are not paid when the hedge fund is doing poorly
, Hedge Fund Style 1: Statistical Arbitrage
= market-neutral strategy on pairs trading (using to highly correlated stocks) to identify temporary mispricing
Using quantitative research tools such as data mining and automated trading with algorithms
Based on the law of large numbers: more than 50% of positions will be profitable
Hedge Fund Style 2: Portable Alpha
Based on a single risk type (pure play) with all other risk hedged away
Step 1: invest wherever you can find alpha (long position)
Step 2. Hedge the systemic risk of an investment (beta = 0) to isolate its alpha
Step 3: establish exposure to desired market sectors by using passive products
Example:
An investor wants to invest in a stock with positive alpha but the S&P500 is expected to decline
➔ Hedge beta exposure by selling S&P 500 futures contracts
Hedge Ratio
Performance measurement of Hedge funds
7-factor models
4 market factors: equity market, equity size, bond market, credit spread
3 trends: bonds, commodities, currencies
Mutual Funds
= intermediary (institution) to manage other people’s money
Specialized skills and (asset specific) knowledge
Cost efficiency
Diversification and liquidity
Why are mutual funds important?
Asset management of pension funds often delegated to mutual funds
Primary way of individuals to invest
Delegation of stock selection and risk management to asset managers
→ US Stock market ≈ 5000 company stock but also 5000 equity mutual funds!
Types of investment companies
➔ Unit Investment Trust
≡ fixed portfolio of uniform assets deposited in a trust fund
≡ trust fund sells shares of its trust = redeemable trust certificates
No trading or change in composition
Investors invest in unit trust to gain exposure to certain pool of assets within
their broader portfolios
, ➔ Open-end mutual funds
Company sets up a fund (with specified target industry) → board of directors elect a fund manager (in-house or
contracted) → fund management invests capital and is paid management fees
Open-end: no restriction on the amount of shares the fund can issue
If the trust wants to issue more shares it must buy more of the underlying assets
Redeemable trust certificated (trust shares) are priced at NAV net asset value
= if an investor wants to cash out, the fund must buy it back at NAV
➔ Close-end mutual funds
Fixed amount of trust shares issued and outstanding
Traded on the stock market just like stocks
Price of trust share relative to its NAV can vary (premium or discount)
= if an investor wants to cash out another investor needs to buy the shares from him
➔ Exchange traded funds ETFs
Mix of closed and open-end funds
No restrictions on the shares issued and outstanding
Advantages: Disadvantages
• Can trade marginally above or below NAV
• Trade continuously like stocks + low cost • Must be purchased from a broker
• Can be sold or purchased on margin
• Tax efficient (when investors buy and sell to and
from each other, no capital gain tax triggered for
ETF provider)
Zero-fee funds make money by:
- Lending out assets to short sellers
- Spillover effects to funds with higher fee structure
,Performance of Mutual funds
→ always take the lesser of purchases and sales
Costs of Mutual funds
Expense ratio (operating expenses) → administrative and advisory fees
Marketing and distribution costs → pay brokers of advisors
Front-end load → sales charge when investors first buy the fund (around 6%)
Back-end load → sales charge when you exit the fund (starts at 5-6%, reduced by 1% each year)
→ Goal is to tether investors to the fund
12b-1 charge → compensation for distribution costs and commissions paid to brokers
A Mutual fund can issue different classes of redeemable shares
Difference = fee structure
Expense ratio is very important in the long run because of
cumulative and re-invested distributed capital gains and dividends
Performance measurement
Implications for investors
o After fees, active investing is a negative sum game
o Pay attention to poor benchmarking and reaching-for-yield behavior
o Pay attention to fees
,Performance on Active Investors
Empirical evidence: 1% underperformance BEFORE FEES to Wilshire 5000
index (= total public equity market)
Evidence for persistent superior performance (due to skill not just luck) us
weak but suggestive
Bad performance is more likely to persist
Hedge Funds
≡ Not constrained to using leverage (mutual funds are restricted)
≡ Only institutional investors or high net worth individuals
≡ Very important to market efficiency
≡ Hedging = market neutral strategies, making money in every market condition
≡ Lower share ratio than S&P 500
Fee Structure
- Management fee typically 2% of assets under management
- Incentive (performance) fee = 20% of investment returns above benchmark (hurdle rate)
- High water mark: performance fees only must be paid when hedge funds exceeds its highest value (new all-time
high) after a loss-making period, this ensures that commissions are not paid when the hedge fund is doing poorly
, Hedge Fund Style 1: Statistical Arbitrage
= market-neutral strategy on pairs trading (using to highly correlated stocks) to identify temporary mispricing
Using quantitative research tools such as data mining and automated trading with algorithms
Based on the law of large numbers: more than 50% of positions will be profitable
Hedge Fund Style 2: Portable Alpha
Based on a single risk type (pure play) with all other risk hedged away
Step 1: invest wherever you can find alpha (long position)
Step 2. Hedge the systemic risk of an investment (beta = 0) to isolate its alpha
Step 3: establish exposure to desired market sectors by using passive products
Example:
An investor wants to invest in a stock with positive alpha but the S&P500 is expected to decline
➔ Hedge beta exposure by selling S&P 500 futures contracts
Hedge Ratio
Performance measurement of Hedge funds
7-factor models
4 market factors: equity market, equity size, bond market, credit spread
3 trends: bonds, commodities, currencies
