Chapter 4 Study Notes on Mutual Funds and Hedge Funds

CHAPTER 4 Mutual Funds and Hedge Funds

  • Mutual funds and hedge funds: investment vehicles that pool money from various investors to meet defined investment objectives.

  • Mutual Funds:

    • Intended for small investors, providing opportunities for diversification.

    • Regulated more heavily compared to hedge funds. Must detail investment policies in a prospectus.

    • Funds managed by professionals.

  • Hedge Funds:

    • Target wealthy investors and institutions like pension funds.

    • Subject to less regulation and can employ more diverse trading strategies, often keeping operations confidential.

4.1 MUTUAL FUNDS

  • Diversification Opportunities:

    • Essential for reducing investment risk; however, individual investors may struggle to achieve adequate diversification.

    • Mutual funds allow small investors to pool resources, facilitating diversified investment portfolios at a lower cost.

  • Growth of Mutual Funds:

    • Significant growth since WWII, with U.S. mutual fund assets surpassing $15 trillion by 2014.

    • Approximately 46% of U.S. households own mutual funds.

  • Types of Institutions Offering Mutual Funds:

    • Specialized asset management firms (e.g., Fidelity).

    • Banks (e.g., JPMorgan Chase).

    • Insurance companies (e.g., State Farm began offering mutual funds in 2001).

Money Market Mutual Funds

  • Invest in short-term interest-bearing instruments (e.g., Treasury bills, commercial paper).

  • Typically higher interest rates than insured bank accounts.

  • Some funds allow check-writing facilities.

Long-term Mutual Funds

  • Three Main Types:

    1. Bond Funds: Invest in fixed-income securities with maturities exceeding one year.

    2. Equity Funds: Invest in common and preferred stocks.

    3. Hybrid Funds: Invest in a mix of stocks, bonds, and other securities.

  • Open-End vs. Closed-End Funds:

    • Open-end funds have variable shares; share amount adjusts based on investor transactions. NAV calculated daily.

    • Closed-end funds operate with a fixed number of shares, are traded on exchanges.

  • Transaction Costs and Tax Implications:

    • Investors typically incur taxes as if they directly owned the securities in the fund.

    • Capital gains/losses deemed realized when fund transactions occur regardless of share sale by the investor.

Index Funds

  • Designed to track specific equity indices (e.g., S&P 500).

  • Methods of tracking can include:

    • Purchasing all underlying stocks in proportion to their index weight.

    • Sampling representative stocks to mimic index performance.

    • Utilizing index futures.

  • Notable success: Vanguard 500 Index Fund, launched December 31, 1975, after initially being met with skepticism. Achieved $100 billion assets by November 1999.

Costs Associated with Mutual Funds

  • Include management expenses, sales commissions, accounting fees, and transaction costs.

  • Types of Fee Structures:

    • Front-End Load: Charged at initial purchase of shares (limited to < 8.5% in the U.S.).

    • Back-End Load: Charged when selling shares; often decreases over time.

Average Costs by Country (Table 4.2):

  • Delivery Costs Over Five Years (% of Assets):

    • Australia Bond: 0.75%, Equity: 1.41%

    • U.S. Bond: 1.05%, Equity: 1.53% (Lowest in the dataset).

Closed-End Funds

  • Trade on exchanges like corporations with limited shares.

  • Price often differs from NAV (market value of portfolio divided by outstanding shares).

Exchange-Traded Funds (ETFs)

  • Established in the U.S. since 1993, ETFs often track an index.

  • Allow transactions throughout the trading day; promote transparency (holdings disclosed).

  • ETF trading characteristics allow flexibility compared to traditional mutual funds:

    • No limit on buying/selling during market hours.

    • Shorting capability similar to stocks.

4.2 HEDGE FUNDS

  • Subject to minimal regulation, hedge funds accept money only from accredited investors.

  • Strategies include:

    • Expanding investment options; hedge against market movements.

Historical Perspective

  • The first hedge fund, A.W. Jones & Co., was founded by Alfred Winslow Jones in 1949, employing both long and short strategies.

  • High-profile pioneers include George Soros, Julian Robertson, and Warren Buffett, who established successful strategies despite regulatory concerns.

Performance Fees

  • Average annual management fee (1% - 3%) with incentive fees (15% - 30% net profits).

  • Fee structure follows “2 and 20” format: e.g., 2% management fee plus 20% of profits.

  • Additional clauses may exist to mitigate incentives for undue risk-taking (e.g., high-water mark, clawback clauses).

Risks and Incentives

  • Fund managers gain a call option on the fund assets, incentivizing risk-taking for higher potential profits.

  • Example illustrates how fees can lead to net negative investor returns despite positive fund performance.

Role of Prime Brokers

  • Banks providing management services to hedge funds, including lending, trade execution, and risk management.

  • Important for leveraging; crucial to monitoring hedge fund activities.

4.3 HEDGE FUND STRATEGIES

  • Hedge Fund strategies differ significantly and may overlap across various funds.

Common Strategies:

  1. Long/Short Equity:

    • Involves simultaneous long positions in undervalued stocks and short positions in overvalued ones.

    • Aims for capital gained from both market directions.

  2. Dedicated Short Managers:

    • Focus exclusively on shorting overvalued stocks.

  3. Distressed Securities:

    • Investing in low-rated bonds with high yields, contingent on company recovery.

  4. Merger Arbitrage:

    • Profiting from price discrepancies post-merger announcement.

  5. Convertible Arbitrage:

    • Shorting stock while investing in convertible bonds to hedge risks.

  6. Fixed Income Arbitrage:

    • Buying undervalued bonds while shorting overvalued ones.

  7. Emerging Markets:

    • Focus on stocks and bonds in developing countries, capitalizing on arbitrage opportunities.

  8. Global Macro:

    • Based on overarching economic and geopolitical analysis to generate returns.

  9. Managed Futures:

    • Predicting commodity price movement, sometimes using technical indicators.

4.4 HEDGE FUND PERFORMANCE

  • Hedge fund performance metrics vary; data reporting often lacks comprehensiveness.

  • Hedge funds tend to perform similarly or worse than mutual funds once fees are accounted for.

  • Regulatory limitations impact performance reporting and can bias results.

Comparison to S&P 500

  • Hedge funds have yielded varying results versus the S&P 500 across several years (see Table 4.5).

SUMMARY

  • Mutual funds serve a crucial role for small investors aiming for broader market exposure via diversified and regulated investment methods.

  • Hedge funds showcase more aggressive, yet less regulated investment strategies, leading to uniquely structured high fees.

Mutual Funds vs. Hedge Funds

  • Mutual Funds:

    • Highly regulated, offering transparency in operations.

    • Typical structure: open-end funds where shares fluctuate with investor contributions.

  • Hedge Funds:

    • Operate with fewer restrictions, targeting sophisticated investors.

    • High fee structures incentivize risk-taking behaviors among managers.

Key Concepts

  1. NAV (Net Asset Value): Calculated daily for funds based on underlying asset prices.

  2. Alpha: Refers to excess returns and portfolio performance.

FURTHER READING

  • Jensen, M. C. (1969). "Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios."

  • Khorana et al. (2009). "Mutual Fund Fees Around the World."

  • Lhabitant, F.-S. (2006). Handbook of Hedge Funds.

  • Ross, S. (2002). "Neoclassical Finance, Alternative Finance, and the Closed End Fund Puzzle."