1

Mutual Funds and Hedge Funds

Services of Investment Companies Types of Investment Companies Types of Mutual Funds Cost of Mutual funds Return of Mutual Funds Exchange Traded Funds Hedge Funds and Their strategies

2

Services of Investment Companies

Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs

3

Net Asset Value

Used as a basis for valuation of investment company shares Selling new shares Redeeming existing shares

NAV=

Market Value of Assets - Liabilities

Shares Outstanding

4

Types of Investment Organizations

Unit Trusts Managed Investment Companies

Open-End Closed-End

Other investment organizations Commingled funds REITs Hedge Funds

5

Open-End and Closed-End Funds

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

6

Investment Policies

Money Market Equity Specialized Sector Bond Balance & Income Asset Allocation Indexed International

7

Costs of Investing in Mutual Funds

Fee Structure Front-end load Back-end load

Operating expenses 12 b-1 charges

distribution costs paid by the fund Alternative to a load

Fees and performance

8

Example

An open-end fund has a total asset of $120 million and a liability of $10 million. It has 10 million shares outstanding. What is its NAV? It is sold with a front-end load of 5%. What is its offering price?

9

Fund Returns

Page 106

10

Table 4.2 Impacts of Costs on Investment Performance

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Exchange Traded Funds

ETF allow investors to trade index portfolios like shares of stock

Examples - SPDRs and Webs Potential advantages

Trade continuously Lower taxes Lower costs

Potential disadvantages

12

First Look at Mutual Fund Performance

Average mutual fund performance is generally less than broad market performance

Over certain horizons there is persistence in positive performance Evidence is not conclusive Some inconsistencies

13

Figure 4.3 Diversified Equity Funds versus Wilshire 5000 Index

14

Sources of Information on Mutual Funds

Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (biz.yahoo.com / funds) Investment Company Institute (www.ici.org) Popular press Investment services

15

Hedge Funds vs. Mutual Funds

Hedge Fund Transparency: Limited

Liability Partnerships that provide only minimal disclosure of strategy and portfolio composition

No more than 100 “sophisticated”, wealthy investors

Mutual Fund Transparency: Regulations

require public disclosure of strategy and portfolio composition

Number of investors is not limited

16

Hedge Funds vs. Mutual Funds

Hedge Fund Investment strategy: Very

flexible, funds can act opportunistically and make a wide range of investments

Often use shorting, leverage, options

Liquidity: Often have lock-up periods, require advance redemption notices

Mutual Fund Investment strategy:

Predictable, stable strategies, stated in prospectus

Limited use of shorting, leverage, options

Liquidity: Can often move more easily into and out of a mutual fund

17

Hedge Funds vs. Mutual Funds

Hedge Fund Compensation structure:

Typically charge a management fee of 1-2% of assets and an incentive fee of 20% of profits

Mutual Fund Compensation structure:

Fees are usually a fixed percentage of assets, typically 0.5% to 1.5%

18

Hedge Fund Strategies

Directional Bets that one sector or another will

outperform other sectors Non-directional

Exploit temporary misalignments in relative valuation across sectors

Buy one type of security and sell another Strives to be market neutral

1926-19

Table 26.1 Hedge Fund Styles

20

Statistical Arbitrage

Uses quantitative systems that seek out many temporary and modest misalignments in prices

Involves trading in hundreds of securities a day with short holding periods

Pairs trading: Pair up similar companies whose returns are highly correlated but where one is priced more aggressively

Data mining to uncover systematic pricing patterns

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Portable Alpha

1. Invest wherever you can find alpha.

2. Hedge the systematic risk of the investment to isolate its alpha.

3. Establish exposure to desired market sectors by using passive products such as indexed mutual funds or ETFs.

Transfer alpha from the sector where you find it to the asset class in which you ultimately establish exposure.