Investment Funds: Dr. Andrea Lu

Overview Managed Funds ETFs Super funds Hedge funds Next week
Investment Funds
Dr. Andrea Lu
Lecture 5
FNCE90047: Financial Markets and Instruments
Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 1 / 39

Critical Concepts
Today’s topics
Investment funds
◦ Managed funds
◦ Exchange traded funds (ETFs)
◦ Superannuation funds
◦ Hedge funds
Readings
Kidwell, Chapter 17

Investment Funds
Investment funds = collective investment vehicles through which the
pooled savings of individuals are invested.
Managed by professional investment managers.
Offer investors the opportunity to use investment products that
otherwise may not be available.
◦ denominations intermediation.
◦ risk intermediation by asset diversification.
◦ economies of scale, i.e., lower costs.
The main categories of investment funds in Australia:

◦ Managed funds
- Open- and close-end managed funds
◦ Exchange traded funds
◦ Superannuation funds
◦ Hedge funds

Managed Funds
The main distinction in the structure of these various types of funds
is that between closed-end and open-end.
A closed-end fund is a fund that initially sells its shares to the

public to obtain cash to invest and then operates with a fixed
number of shares outstanding.
An open-end fund is a collective investment fund that allows
additional investment from existing and new investors, and allows
existing investors to withdraw funds.
◦ New investment: create new units in the fund.
◦ Withdrawal: units redemption.

Closed-end Funds
Similar to shares in a company.
◦ Shares are initially issued by the fund.
◦ After initial offer, number of shares stays constant with no sales or
purchases of fund shares by the fund company.
Shares may be traded on the secondary market (exchange traded or

OTC).
Market value of portfolio−Liabilities
◦ Net asset value (NAV) or book value = Number of shares outstanding
◦ The market price of a share = secondary market price determined by
the demand and supply for the fund.
◦ NAV may not equal price of a share: the market price often varies
from 10 percent above to 20 percent below NAVs → Redemption
risk!
- market inefficiency.
- rational explanations: manager’s skills, access to investment...
- market sentiment.

Closed-end Funds
Legal structure
◦ Listed investment companies (LICs)
- incorporated as companies, paying franked dividend.
◦ Listed unit trusts (LITs)
- incorporated as trusts, pay distributions.
Fees
◦ management fees.
◦ operating expenses.
Portfolio choice
◦ must obey strategy and rules laid out in the charter.
◦ can access very illiquid assets and use significant leverage.
- e.g. real estate assets.
Entry and exist are instantaneous and continuous (must pay
brokerage commissions).

Open-end Funds
Open-end investment funds were started to alleviate the redemption
problem associated with close-end funds.
Open-end funds allow new investments and/or withdrawals to be
made on any given day, at the closing net asset value.
No limit to the number of shares/units, other than market demand.
Investors own a pro-rata share of the entire portfolio.
Legal structure
◦ Unlisted unit trusts.
◦ ASX provides mFund settlement services to buy/sell units in
these unlisted unit trusts.

Open-end Funds
Fees
◦ management fees
◦ operating expenses
◦ loads: commissions for selling; can be charged on entry (front-end)
or exit (back-end).
Portfolio choice
◦ Must obey strategy and rules laid out in the charter.
◦ Some cash holdings are need to hold cash in order to maintain
liquidity (for redemption) without sacrificing performance: cash
holding ranging from 4 - 10% of total asset holdings.
Entry and exit are not instantaneous - investors must give notice.
◦ Directly with the trusts, or via brokers.
◦ NAV can change between notice and execution.

Investment Strategies: Investment Style

Investment strategy of a managed fund determines the mix of assets held by
the fund.
It is largely influenced by the terms of the trust deed under which the fund
is established.
It defines its risk and return profile.
Here are some examples of fund strategies:
Fund strategy risk features
Cash management low access to wholesale money market
Fixed income low access to wholesale capital market
Growth high invest primarily in stocks; for capital appreciation
Aggressive growth very high speculative equity investment
Balanced medium a portfolio with a fixed proportion of stocks and bonds
International high diversify asset holdings internationally
SRI - investments with social and environmental considerations
◦ Or speciality funds that are managed to achieve specialised objectives: index
funds, investment style (e.g. large-cap, mid-cap, small-cap, growth, value,
blend), sector (e.g. tech, mining), and others.

Investment Strategies: Active vs Passive Strategy

Active: funds attempt to outperform an index by actively selecting
stocks and trading.
Passive: funds designed to buy a portfolio of assets that mimic an
index.
◦ e.g. mimicing the All Ordinaries Index or ASX 200 Index.
◦ Index funds generate a return, before fees, that is almost the
same as the index it is tracking.

Exchange Traded Funds (ETFs)

ETFs = “investment funds, traded on an exchange, that invest in a basket of
securities or other assets and that generally seek to track the performance of a
specified index or benchmark.” - ASX definition.
ETFs are structured as trust vehicles.
Most ETFs are passive investments that track assets or a market index.
ETFs are also available for assets such as international shares, fixed
income products, foreign currencies, precious metals and commodities.
ETFs are open-ended investments that offers the flexibility to enter and
exit at any time.
Primary market
◦ Players: the fund and authorised participants (APs) who are ASX
registered stock brokers.
◦ APs create fund units by assembling the underling securities of the fund in
their appropriate weighting and then delivering those securities to the
fund.
◦ ETF’s portfolio manager typically does not have to buy/sell securities
except for rebalancing purposes.
◦ The APs receives fund units then introduced to the secondary market.
Advantages of ETFs
Secondary market
◦ Players: APs and investors.
◦ The market price tracks the NAV very closely - since creating/destroying
units is very cheap.
Advantages of ETFs
Portfolio diversification.
Continuous price and trading.
Greater transparency.
Tax benefits over unit trusts as ETFs can fund redemptions with in-kind
transfers without selling holdings.
Lower fees (but brokerage).
Unlike most mutual funds, ETF’s are easily shorted.

Measuring Fund Performance

How to measure a fund’s return?
We can measure a fund’s absolute return.
◦ Holding period return (HPR) = (E − B + I )/B
- E = unit price at end of period.
- B = unit price at start of period
- I = income over the period.
Or, measuring its performance relative to a ‘benchmark’.

◦ This is a passive fund against which other funds’ performance can be
measures.
- Cash trusts - UBS Bank Bill Index
- Fixed interest - UBS Composite Bond Index
- Equity trusts - S&P/ASX 200 Accumulation Index
- Overseas shares - MSCI World Index


How to measure a fund’s risk?
The Beta (β) for each fund can be calculated from past data on the
fund’s unit price.
ri,t − rf ,t = α + βi (rm,t − rf ,t ) + i,t

◦ A high-beta fund (β > 1) is more volatile (risky) than the market as
a whole: it will outperform the market in upswings but underperform
in downswings.
◦ A low-beta fund (β < 1) is the reverse: safer than the market and
less cyclical.
We can then use β to judge the earning performance of different fund

managers in the context of the risk they have taken.


Measures that take both return and risk into consideration:
Sharpe Ratio / Sharpe Index

◦ The SR measures the amount of excess return earned per unit of risk.
ri − rf
SRi =
si
- ri = return on the fund.
- rf = risk-free return.
- si = the standard deviation of fund returns.
Jensen’s Alpha
◦ one risk-adjusted performance index.
α = ri − rf − βi (rm − rf )
- βi = beta of the fund.

- rm = market return.

Active vs Passive Performance

Can fund advisors, as a group, beat the indexes?
Many, many studies confirm the answer is no.

For instance, in a comprehensive study of fund performance over 15 years,
Shoven and Dickson find that Vanguard Index 500 fund beat 92% of all
equity funds on an after-tax basis.
Are there good managers?
Anecdotally, yes! - e.g., Peter Lynch (Fidelity Magallan fund)? Warren
Bufffet (value investing)? John Paulson (event-driven hedge fund)?
- “Buffett’s Alpha” by Frazzini, Kabiller and Pedersen
http://www.nber.org/papers/w19681
Smart money is hedging its bets, though, as more and more new money
gets invested in passive index funds rather than actively managed mutual
funds.

Growth in Passive Assets

Passive investment has become very popular!
Source: “Indexers and Comovement” by Vincent Gregoire.

Superannuation Funds
What are superannuation funds?
A government-supported investment strategy aimed at providing resources
that can be used upon retirement.
In different countries, different names are given to retirement savings

scheme, for example:
◦ the USA uses pension funds
◦ Singapore uses provident funds
◦ Australia uses superannuation funds
Why do we need superannuation funds?

The ageing population can place a significant burden on public
expenditure.
Consequently the government introduced a compulsory superannuation
scheme to support the social security system in the future.
Different regulations, taxes etc apply, but the purpose of these funds is
the same.
Superannuation in Australia
Superannuation Guarantee Charge (SGC) Act 1992 require employers to
provide a specified level of superannuation support for employees:
◦ was at 3% in 1992.
◦ Currently at 9.5%.
◦ increasing to 12% by 2025.
Incentives to encourage contribution beyond the required minimum:
◦ Contributions and earnings of super funds are taxed at a concessional
rate of 15% (but there are limits on what you can contribute).
◦ Withdrawals from super after a member turns 60 are free of tax
payments.
◦ Considerable uncertainty about potential changes.
Superannuation has $1.76 trillion in pooled funds, as of June 2018,
contributing to Australia having the fourth largest pool of investment fund
assets in the world.

Types of Superannuation Funds

There are two types of superannuation funds in terms of the benefits that they
pay:
Defined benefit, where the employer states the benefit that the employee
will receive at retirement.
Defined Contribution / Accumulation Fund: where the amount

received at retirement depends upon contributions made by the employee
and earnings on those funds.

Defined Benefit Plan

A defined benefit plan pays the employee a fixed benefit based on their
salary and years of service.
The benefits may be a flat dollar amount, a percentage of average salary
over a specified period or a unit benefit formula based on period of
employment and salary.
An example of a unit benefit plan:
◦ an employer that awards 2.5 per cent per year of service, with the
total multiplied by average salary during the three highest
consecutive years.
◦ An employee who worked for the company for 20 years would receive
50 per cent (20 × 2.5 per cent) of the average salary for his or her
superannuation benefit.
◦ These arrangements worked well when workers stayed with the same
company for 25 or 30 year...

Defined Benefit Plan (Cont.)

Is the plan funded?
As long as enough cash is coming in to pay current benefits, the fund may
look solvent.
If assets do not cover the present value of future benefits, then the plan is
underfunded.
There is no assurance that future retirees will receive the pensions they
were promised or that current retirees will continue to get their previously
established distribution amount.
Of course, a plan can also be overfunded.
Investment Choices
The sponsor chooses the investments.
If investments perform poorly, the plan will become underfunded - the
sponsor bears the investment risk.

DBP Underfunding
Huge underfunding of government and corporate pension plans in the
US
◦ In 2003, official underfunding for corporate plans was close to $250
billion, unofficial estimates as high as $500 billion.
◦ Official deficit for state pension plans estimated at $94 billion, with
unofficial estimates as high as $1 trillion!
Underfunding in Australia
◦ Defined benefit super schemes $7b in the red (April 2012)
https://www.smh.com.au/business/
defined-benefit-super-schemes-7b-in-the-red-20120423-1xhck.
html

Defined Contribution Fund / Accumulation Funds

With a DC plan, or Accumulation plan, contributions are known.
◦ Amount contributed is usually a % of employees salary.
The future benefits are uncertain.

◦ The retiree gets only whatever has accumulated.
Is the plan funded ?

◦ By definition, yes.
Investment Choices
◦ Often the employee gets some discretion over how the money is
invested.
◦ Therefore, this is similar to an investment managed fund, for which
the balance can be regularly checked, different types of funds can be
selected and the investment returns are subject to the performance
of the assets that the fund invests in.

Super Funds Classification by Function

APRA classifies superannuation funds, by functionality, as:
Corporate funds
◦ Provides benefit to employees of a specific corporation.
◦ The large majority of corporate funds are non-public offer.
Industry funds
◦ Provides benefits to employees in a specific industry.
◦ In recent years, many industry funds have become public offer,
meaning members from the general public can now join.
Public sector funds

◦ Provides benefits to employees of government and state-owned
enterprises.

Super Funds Classification by Function (Cont.)

Retail super funds
◦ Offers products to public on a commercial for profit basis.
◦ Usually run by large financial institutions which provide a range of
wealth management products.
◦ Also includes roll-over funds: if you change jobs or retire early, you
need to retain accumulated super entitlements. This ensure
individual maintains super savings and continues to receive
concession tax arrangements.
Small APRA fund

◦ Fund regulated by APRA with fewer than 5 members with a
professional trustee.
Self-managed super fund (SMSF)

◦ Fund with less than 4 member, all of whom are trustees.
◦ Regulated by the Australian Taxation Office

Super Funds Classification by Function (Cont.)
Source: APRA Statistics Quarterly Superannuation performance, December 2018.

https://www.apra.gov.au/sites/default/files/quarterly_superannuation_
performance_statistics_december_2018.pdf

In the News...
Australians are not saving enough for retirement
http://theconversation.com/
the-majority-of-australians-are-not-saving-enough-for-retirement-24957
Government expected to increase retirement age to 70 by 2035

http://www.smh.com.au/federal-politics/political-news/
retirement-age-rise-to-70-by-2035-joe-hockey-announces-20140502-zr318.
html

Hedge Funds
Birth of Industry: Alfred Winslow Jones, 1966
Traditionally, a HF was a manager investing in both long and short
positions.
Since then, the definition of a hedge fund has become increasingly unclear.
Common factors include:
◦ absolute return
◦ leveraged
◦ invest long and short
◦ performance fees
◦ high water mark
◦ lock-up/liquidity
Almost any fund manager charging an incentive-based fee is considered a
hedge fund.

Hedge Funds (Cont.)

Hedge funds target absolute, not relative, rates of return.
The performance of a hedge fund depends more on the investment skills
of the manager than the movements of the stock market.
Hedge funds have historically had a very low correlation to traditional
investments. Therefore, hedge funds can help to lower the total risk of a
portfolio of investments.
Investors of hedge funds: Swiss banks for European high net worth, funds
of funds, US endowments, pension plans, sovereign wealth funds, retail,
etc.

Hedge Funds Strategies

Market-neutral strategies
◦ A market-neutral strategy seeks to eliminate market risk by equally
balancing long and short positions.
◦ If the longs selected are undervalued and the shorts are overvalued, a
profit will result when the market recognises the mispricing.
Fixed Income Arbitrage

◦ This strategy involves taking long and short positions in bonds with
the expectation that the yield spreads between them will return to
historical levels.
Index Arbitrage Index

◦ This strategy involves buying and selling a basket of stocks or other
securities and taking a counter position in index futures.
◦ There is risk-free arbitrage if the borrowing cost (aka cost of carry) is
lower than the price difference.


Closed-end Fund Arbitrage
◦ In closed-end fund arbitrage, as with stock index arbitrage, the fund
manager buys or sells a basket of stocks.
◦ In this case, the basket replicates the holding of a closed-end mutual
fund.
Convertible Arbitrage
◦ The fund manager simultaneously goes long in the convertible
securities and short in the underlying equities of the same issuers.
◦ This may be a cheap way to buy the equity option embedded in the
bond.
Short Selling
◦ This strategy is based on the sale of securities that are overvalued.
◦ The investor does not own the shares sold, but instead borrows them
from a broker in the expectation that the share price will fall and the
shares may be bought later at a lower price to replace those
borrowed from the broker earlier.

Risk arbitrage.
◦ Fund managers take a long position in the stock of a company being
acquired in a merger, leveraged buyout or takeover and a
simultaneous short position in the stock of the acquiring firm.
◦ Until the acquisition is completed, the stock of the target typically
trades below the purchase price.
◦ The strategy makes a gain if the acquirer ultimately buys the target.
◦ If the takeover fails, this strategy may result in large losses because
the target companys stock price likely will return.
Distressed securities
◦ Fund managers, sometimes referred to as vulture capitalists, typically
invest in the securities of companies undergoing bankruptcy or
reorganisation.
◦ Managers tend to focus on companies that are undergoing financial
rather than operational distress.

The case of LTCM

Long-Term Capital Management (LTCM): a very successful hedge fund,
with Myron Scholes and Robert Merton, who shared the 1997 Nobel Prize in
Economics, on its board.
One of its strategies was fixed income arbitrage:

◦ It sold U.S. Treasury securities and bought European and Japanese
government bonds/futures.
◦ Rationale: non-US bonds were underpriced relative to US bonds;
expect to profit in the long run when price converges.
Following the 1998 Russian financial crisis, panicked investors began
selling non-U.S. treasury debt and buying U.S. treasuries.
◦ This drove prices that should have converged further apart.
◦ Caused LTCM to face margin calls, and forced it to liquidate its
positions at huge losses.
Shleifer and Vishny (1997) show that markets can never be fully efficient,
because arbitrageurs avoid taking some positions as they may be forced to
liquidate prematurely.

Hedge Fund Industry: Global

Industry metrics
◦ AUM: around $1.8 - 2.375 trillion
◦ Number of firms: around 10,000
◦ Firm birth/death rate: 800-1,000 p.a.
◦ Geographic dispersion: about 2/3 in the US, 20% in Europe
(London)
◦ Concentration: 3.9% of funds = 60% industry AUM
Funds of funds
◦ Has a lower minimum (while hedge fund minimums start at $1
million) and diversifies across many hedge funds.
◦ Had accounted for as much as 50% of funds invested in hedge funds,
now down to < 30%.
Source: Guest Lecture by Mark Nicholson, FNCE90047 S1, 2013

Hedge Fund Industry in Australia

According to ASIC Report 439 (July 2015)
Single strategy hedge funds manage $83.7b and funds of funds manage
$12.2b representing 3.5% and 0.5% of the total of $2407b managed funds
in Australia
Australian hedge fund sector characterised by small-sized funds, with more
than half of the 473 funds managing less than $50m.
Only 48 funds manage more than $500b.
Nearly 80% of the operating hedge funds were domiciled in Australia.
17% of all investors were retail direct and 49% were retail indirect.
The Largest net exposure was to listed equities and then cash.
Most common strategy used by hedge funds is ‘equity long/short’.
The median gross leverage ratio was 2 times NAV.
Source: ASIC report: Snapshot of the Australian Hedge funds Sector

http://asic.gov.au/regulatory-resources/find-a-document/reports/
rep-439-snapshot-of-the-australian-hedge-funds-sector/
Hedge Funds Performance in Australia

In the 12 months to 30 Sept 2014, average annual return for single
strategy hedge funds was 4.2%
Since 2006, average annual return has twice been negative, -13.1% in
2008 and -3.6% in 2011
Average and median return of all hedge funds since 2006 strongly
correlated with S&P200 returns.
In general, hedge fund performance measures may be unreliable due to
survivorship, non-reporting.
Source: ASIC report: Snapshot of the Australian Hedge funds Sector

http://asic.gov.au/regulatory-resources/find-a-document/reports/
rep-439-snapshot-of-the-australian-hedge-funds-sector/

Regulation in Australia
All managed funds in Australia are regulated under the scope of the
Corporation Act 2001.
◦ For trusts, must registered with ASIC if it is marketed to retail
investors - subject to certain operational and disclosure requirements
designed to protect investor’s interests; for funds that do not accept
funds from retail investors are subject to fewer requirement.
◦ For companies, must comply with provisions covering capital raising,
corporate governance and disclosure requirements.
Any provider of a Financial Produce or Service in Australia is required to
hold an Australian Financial Services Licence.
Any products marketed to retail investors need to have a Product
Disclosure Statement.
◦ contain such information that might reasonably be expected to have
a material influence on the decision of a reasonable person, as a
retail client, whether to acquire the product
◦ Listed products: must lodge its PDS with ASIC.
◦ Unlisted products: no obligation to lodge with ASIC; but must notify
ASIC.
Next Week
Next week’s topics
Banking
Assignment workshop
Readings
Lecture slides
Kidwell Chapter 13, 14 and 15.

Investment Funds: Dr. Andrea Lu

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Investment Funds: Dr. Andrea Lu

Uploaded by

Copyright:

Available Formats

Overview Managed Funds ETFs Super funds Hedge funds Next week

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 1 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 2 / 39

The main categories of investment funds in Australia:

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 3 / 39

A closed-end fund is a fund that initially sells its shares to the

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 4 / 39

Shares may be traded on the secondary market (exchange traded or

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 5 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 6 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 7 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 8 / 39

Investment Strategies: Investment Style

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 9 / 39

Investment Strategies: Active vs Passive Strategy

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 10 / 39

Exchange Traded Funds (ETFs)

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 12 / 39

Measuring Fund Performance

Or, measuring its performance relative to a ‘benchmark’.

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 13 / 39

Measuring Fund Performance

ri,t − rf ,t = α + βi (rm,t − rf ,t ) + i,t

We can then use β to judge the earning performance of different fund

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 14 / 39

Measuring Fund Performance

Sharpe Ratio / Sharpe Index

- βi = beta of the fund.

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 15 / 39

Active vs Passive Performance

Many, many studies confirm the answer is no.

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 16 / 39

Growth in Passive Assets

Source: “Indexers and Comovement” by Vincent Gregoire.

In different countries, different names are given to retirement savings

Why do we need superannuation funds?

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 19 / 39

Types of Superannuation Funds

Defined Contribution / Accumulation Fund: where the amount

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 20 / 39

Defined Benefit Plan

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 21 / 39

Defined Benefit Plan (Cont.)

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 22 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 23 / 39

Defined Contribution Fund / Accumulation Funds

The future benefits are uncertain.

Is the plan funded ?

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 24 / 39

Super Funds Classification by Function

Public sector funds

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 25 / 39

Super Funds Classification by Function (Cont.)

Small APRA fund

Self-managed super fund (SMSF)

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 26 / 39

Super Funds Classification by Function (Cont.)

Source: APRA Statistics Quarterly Superannuation performance, December 2018.

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 27 / 39

Government expected to increase retirement age to 70 by 2035

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 28 / 39

Dr Andrea Lu Lecture 5: Investment Funds FNCE90047 2019S1 29 / 39

Hedge Funds (Cont.)

ri,t − rf ,t = α + βi (rm,t − rf ,t ) + i,t