FMI - PPT - Seminar (Week) 09 (Aug 2023)

SMU Classification: Restricted
Financial institutions that

manage assets –
Mutual Funds & Hedge Funds
FNCE102: Financial Markets and Investments
(FMI)
WEEk 09
Chapter Four
Mutual Funds and

Other Investment
Companies
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Overview
• Investment companies • Mutual funds
• Mutual funds • Functions
• Unit investment trusts • Investment styles and
(UIT) policies
• Hedge funds • Costs of investing
• Closed-end funds • Performance
• Sources of information

©2021 McGraw-Hill Education 4-3
Investment Companies
• An investment company pools and invests the

funds of individual investors in securities or
other assets
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs

Net Asset Value (NAV)
• Investment companies pool assets of

individual investors, but also need to divide
claims to those assets among investors
• Calculation of NAV
Market Value of Assets - Liabilities
Shares Outstanding

Investment Companies:
Unit Investment Trusts
Unit Investment
Trusts
Managed
Investment
Investment
Companies
Companies
Other
Investment
Organizations
• Unit investment trusts (UIT) are pools of money invested in a portfolio
that is fixed for the life of the fund
• Unmanaged
• Declined from $105 billion (1990) to $85 billion (2017)
Managed Investment Companies
Unit Investment
Trusts
Open-end funds
Managed
Investment
Investment
Companies
Companies Closed-end
Other funds
Investment
• Open-End Organizations
• Stand ready to redeem or issue shares at the NAV

• Priced at Net Asset Value (NAV)
• Closed-End
• Do not redeem or issue shares
• Shares outstanding constant; investors cash out by selling to new investors
• Priced at premium or discount to NAV

Other Investment Organizations
• Commingled funds
Unit Investment
• Partnerships of investors that Trusts
pool funds Managed

Investment Commingled
Investment
• REITs Companies
Companies
Funds
• Similar to a closed-end fund Other

Investment REITs
• Equity versus mortgage trusts Organizations
• Hedge funds Hedge Funds
• Vehicles that allow private

investors to pool assets to be
invested by a fund manager

Mutual Funds
• Common name for open-end investment

companies
• Dominant investment company today
• Accounts for 80% of investment company assets
• Assets under management (early 2021)
• U.S. – $23.9 trillion
• Non-U.S. – $40 trillion

Mutual Funds: Investment Policies

(1 of 2)
• Money market
• Invest in money market securities such as
commercial paper, repurchase agreements, or CDs
• Equity
• Invest primarily in stock
• Sector
• Concentrate on a particular industry or country
• Bond
• Specialize in the fixed-income sector

Mutual Funds: Investment Policies

(2 of 2)
• International
• Global, international, regional, and emerging market
• Balanced
• Designed to be candidates for an individual’s entire
investment portfolio;
• hold both equities and fixed-income securities in relatively
stable proportions;
• many are funds of funds
• Asset allocation and flexible funds
• Hold both stocks and bonds
• Engaged in market timing; not designed to be low-risk
Index
• Tries to match the performance of a broad market index
Table 4.1 U.S. Mutual Funds by Investment

Classification 1
Assets ($ billion) % of Total Number of

Assets Funds
Equity Funds
Capital appreciation focus 3,021 12.6% 1,234
World/international 3,205 13.4% 1,459
Total return 6,603 27.2% 1,763
Total equity funds 12,728 53.3% 4,456
Bond Funds
Investment grade 2,518 10.5% 579
High yield 355 1.5% 250
World 541 2.3% 329
Government 394 1.6% 188
Multi sector 530 2.2% 221
Single-state municipal 191 0.8% 279
National municipal 686 2.9% 271
Total bond funds 5,214 21.8% 2,117

12
Table 4.1 U.S. Mutual Funds by Investment

Classification 2
Assets ($ billion) % of Total Number of

Assets Funds
Hybrid (bond/stock) funds 1,620 6.8% 723
Money market funds
Taxable 4,228 17.7% 265
Tax-exempt 105 0.4% 75
Total money market funds 4,333 18.1% 340
Total 23,896 100.0% 7,636
• Note: Column sums subject to rounding error.

• Source: 2021 Investment Company Fact Book, Investment Company Institute.

13
Mutual Funds: How Funds Are Sold

• How Funds Are Sold
• Directly by the fund underwriter (i.e., direct-marketed
funds)
• Sold through the mail, various offices of the fund, over the
phone, or over the Internet
• Indirectly through brokers acting on behalf of the
underwriter (i.e., sales-force distributed)
• Broker or financial advisers receive a commission for selling
shares
• Potential conflict of interest
• Financial supermarkets
• Sell shares in funds of many complexes
• Broker splits management fees with the mutual fund company

Costs of Investing in Mutual Funds
• Fee structure
1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charges
• Fees must be disclosed in the prospectus

• Share classes with different fee combinations

Example 4.2 Fees for Various Classes

The table below lists fees for different classes of the Dreyfus High Yield
Fund in 2021. Notice the trade-off between the front-end loads versus
12b-1 charges in the choice between Class A and Class C shares. Class I
shares are sold only to institutional investors and carry lower fees.
Class A Class B Class I
Front-end load 0–4.5%a 0 0
Back-end load 0 0–1%b 0%
12b-1 feesc 0.25% 1.0% 0%
Expense ratio 0.7% 0.7% 0.7%
a Dependingon size of investment. Starts at 4.5% for investments less than

$50,000 and tapers to zero for investments more than $1 million.
b Depending on years until holdings are sold. Exit fee is 1% for shares redeemed
within one year of purchase.
c Including annual service fee.
© McGraw Hill 16
Fees and Mutual Fund Returns
• Example
• Initial NAV = $20
• Income distributions of $0.15
• Capital gain distributions of $0.05
• Ending NAV = $20.10

Impacts of Costs on
Investment Performance

Taxation of Mutual Fund Income

• “Pass-through status” under the U.S. tax code
• Taxes are paid only by the investor, not by the
fund itself
• Disadvantage is that fund investors do not control
the timing of the sales of securities from the
portfolio, reducing their ability to engage in tax
management
• High portfolio turnover rate can be
particularly “tax inefficient”
• Average turnover dropped to 32% in 2020
Exchange Traded Funds (ETFs)

• ETFs are offshoots of mutual funds that allow investors
to trade index portfolios just as they do shares of stock
• Examples: “spiders,” “diamonds,” “cubes,” and “WEBS”
• Potential advantages
• Trade continuously like stocks
• Can be sold short or purchased on margin
• Cheaper than mutual funds
• Tax efficient
• Potential disadvantages
• Prices can depart from NAV
• Must be purchased from a broker (for a fee)
Figure 4.2 Growth of U.S. ETFs Over Time
Access the text alternative for these images
© McGraw Hill 21
Figure 4.3 Investment Company Assets

Under Management, 2021 ($ billion) 1

© McGraw Hill 22
Figure 4.3 Investment Company Assets

Under Management, 2021 ($ billion) 2
© McGraw Hill 23
Mutual Fund Investment

Performance
• Performance of actively managed funds
• Wilshire 5000 index used as a benchmark for the
performance of equity fund managers
• Wilshire 5000 average return was 12.49%, which
was 0.96% greater than the average mutual fund
from 19 71 to 2020.

Figure 4.4 Actively Managed Equity Funds

versus Wilshire 5000 Index
© McGraw Hill 25
Information on Mutual Funds

(1 of 2)
• Prospectus
• Statement of Investment Objectives
• Describes investment objectives and policies
• Description of fund’s investment adviser and
portfolio manager
• Presents fees and costs
• Statement of Additional Information (SAI)
• Fund’s annual report

Information on Mutual Funds

(2 of 2)
• “Encyclopedias” of mutual fund information

• www.morningstar.com
• www.finance.yahoo.com/funds
• www.ici.org
• Directory of Mutual Funds

Chapter Twenty-Six
Alternative Assets

©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Overview
While traditional assets (stocks, bonds, bills) and traditional
investment vehicles (mutual funds) still dominate investing,
alternative assets have increased substantially in recent
years.
• Alternative asset characteristics v s. traditional asset ersu
characteristics.
• Hedge Funds.
• Private Equity.
• Alternative Asset performance.
• Unusual fee structure.
© McGraw Hill 29
Traditional v s. Alternative: Transparency

ersu
Traditional Assets. Alternative Assets.

• Subject to the Securities • Hedge funds and private
Act of 1933 and the equity funds set up as
Investment Company Act limited liability parentships
of 1940. (LLPs) or limited liability
• Transparency and companies (LLCs)
predictability of strategy. • Required to provide only
• Periodic public updates on minimal information on
portfolio composition. strategy and portfolio
composition.
© McGraw Hill 30
Traditional v s. Alternative: Investors

ersu
Investors – Traditional Assets. Alternative Assets.

• Individuals. Accredited.
• Institutions. • Net Worth.
• Income Requirement.
• Professional Certification
Requirement.
• Knowledgeable
Employees in Private
Funds.
Sophisticated.
© McGraw Hill 31
Traditional v s. Alternative: Investment

ersu
Strategies
Traditional Assets. Alternative Assets
• Avoid Style Drift. • Hedge Funds – The Wide
• Limited leverage. World of Hedge Funds.
• Limited short sells. • May act opportunistically.
• Restricted derivative use. • Private Equity.
© McGraw Hill 32
Traditional v s. Alternative: Liquidity

ersu

• Higher Liquidity. • Lock-Up Period (hedge
• Liquidity needs. funds and private equity).
• Redemption Notices.
• Structural illiquidity (real
estate, collectibles).
© McGraw Hill 33
Traditional v s. Alternative: Compensation

ersu
Structure
• Management Fees: Fixed • Management Fees: Fixed
percentage of assets percentage of assets
under management. under management,
typically 1 to 2%
• Incentive Fees: A fraction
of profits, typically 20%,
beyond some benchmark.
© McGraw Hill 34
Role of Alternative Assets in Diversified

Portfolios
❑ Low correlation with traditional asset classes →
diversification.
❑ Better reflects the investment universe.
❑ Some private equity and hedge funds can act as “engines”
of capital growth.
❑ Bets that one sector or another will outperform other
sectors of the market.
© McGraw Hill 35
Figure 26.1 The Rise of Alternative Assets,

2000 to 2021
Figure 26.1 The Rise of Alternative Assets, 2000 to 2021.
Source: Credit Source and PreQin.

Access the text alternative for slide images.
© McGraw Hill 36
Hedge Fund Strategies

(1 of 2)
• Directional strategies
• Bets that one sector or another will outperform
other sectors of the market
• Nondirectional strategies
• Exploit temporary misalignments in relative
pricing
• Typically involves a long position in one security
hedge with a short position in a related security
• Strives to be market neutral
Table 26.1 Hedge Fund Styles 1
Style Strategy
Equity market Commonly uses long/short hedges. Typically controls for industry, sector, size, and other
neutral exposures and establishes market-neutral positions designed to exploit some market
inefficiency. Typically deploys leverage to amplify inefficiencies.
Long/short Equity-oriented positions on either side of the market (that is, long or short), depending on
equity hedge outlook. Not meant to be market neutral; low beta may be incidental. May establish a
concentrated focus regionally (example, U.S. or Europe) or on a specific sector (example, tech
or health care stocks). Derivatives may be used to hedge positions.
Dedicated short Net short position, usually in equities, as opposed to pure short exposure. In recent years, the
bias number of true dedicated short bias managers has dwindled.
Event driven Attempts to profit from events such as mergers & acquisitions (risk-arbitrage event driven),
regulatory changes, restructurings, bankrupitcies, and reorganizations (distressed event
driven), or other litigation. Can invest across asset classes and events (multi-strategy event
driven).
Fixed-Income Attempts to profit from price anomalies in related interest rate securities. Includes interest rate
arbitrage swap arbitrage, U.S. versus non-U.S. government bond arbitrage, yield-curve arbitrage, and
mortgage-backed arbitrage.
Convertible Hedged investing in convertible securities, typically long convertible bonds and short
arbitrage corresponding stock, particularly when there is a price discrepancy in the conversion ratio.

38
Table 26.1 Hedge Fund Styles 2
Style Strategy
Global macro Involves long and short positions in capital or derivative markets across the world. Portfolio
positions reflect views on broad market conditions and major economic trends.
Emerging Goal is to exploit market inefficiencies in emerging markets. Typically long only because short-
markets selling is not feasible in many developing markets. Can be invested across asset classes (and
currency).
Managed futures Use financial, currency, or commodity futures. May make use of technical trading rules or a less
structured judgmental approach.
Multistrategy Opportunistic choice of strategy depending on outlook.
Fund of Funds Fund allocates its-cash-to several other-hedge-funds-to be managed.

39
Hedge Fund Strategies

(2 of 2)
• Statistical arbitrage - Use of quantitative systems

to uncover many perceived misalignments in
relative pricing and ensure profit by diversifying
across all of these small bets
• Pairs trading – Stocks are paired based on underlying
similarities and long/short positions are established to
exploit any relative mispricing between each pair
• Data mining – Sorting through large amounts of
historical data to uncover systematic patterns that can
be used as the basis of a trading strategy

High-Frequency Strategies
• While statistical arbitrage is facilitated by

rapid-trading technology, other hedge fund
strategies are dependent on high-frequency
trading
• Electronic news feeds
• Cross-market arbitrage
• Electronic market making
• Electronic “front running”

Portable Alpha
(1 of 5)
• Portable alpha is a strategy that involves the

following steps:
1. Invest in positive alpha positions
2. Hedge the systematic risk of that investment
3. Establish market exposure where you want it by using
passive indexes
• Also called alpha transfer because you transfer
alpha from the sector where you find it to the asset
class in which you ultimately establish exposure
Portable Alpha
(2 of 5)
• An Example of a Pure Play

• $2.5 million portfolio
• You believe alpha > 0 and that the market is about
to fall, rM < 0
• Therefore, you establish a pure play on the
perceived mispricing
• The return on your portfolio is
rportfolio = rf +   ( rM − rf ) + e + 
Portable Alpha
(3 of 5)
• An Example of a Pure Play (continued)

• Assumptions
• Beta = 1.20
• Alpha = 0.02
• Risk-free rate = 0.01
• S&P 500 (S0) = 2,500
• You want to capture the 2% alpha per month,

but you don’t want the positive beta of the
stock because of an expected market decline
Portable Alpha
(4 of 5)

• Hedge your exposure by selling S&P 500 futures
contracts (S&P multiplier = $50)
$2,500,000
Hedge ratio = × 1.2 = 24 contracts
2,500 × $50
• After 1 month, the value of your portfolio will be:
$2,500,000(1 + 𝑟𝑝 ) = $2,500,000 1 + .01 + 1.2 𝑟𝑚 − .01 + .02 + 𝑒
= $2,545,000 + $3,000,000 × 𝑟𝑚 + $2,500,000 × 𝑒

Portable Alpha
(5 of 5)

• The dollar proceeds from your futures position
• Hedged proceeds = $2,575,000 + $2, 500,000 × e

• Beta is zero and your monthly return is 3%
Venture Capital and Angel Investors

Angel Investors: Wealthy individuals or families.
• Invest in earliest stages of business development.
• Often syndicated through angel networks.
Venture Capital (VC): Professionally managed money that

invests in startups.
• Two forms: Independent VC funds or corporate venture
capital.
• Structured as limited liability partnerships.
• General Partners (GPs) control funds under management.
• Limited Partners (LPs) provide capital.
© McGraw Hill 47
Table 26.2 Categories of Private Equity

Table 26-2
Categories of Private Equity*
*PreQin maintains one of the most comprehensive databases on private equity performance.
Private Equity Approach

Angels Wealthy individuals or families who provide funding at the very earliest stages
of start-ups in exchange for equity or convertible debt positions.
Venture capital Professionally managed money that provides funding for start-ups in exchange
for equity. They are organized as independent venture funds or corporate
venture capital to invest in all stages of startup development: seed capital,
early stage, and late stage. Venture capital can specialize in one industry or
invest across industries.
Leveraged buyout Investment firms that use an equity position levered by a large debt position to
purchase mature. financial positions. A management buyout is a one-off
transaction similar to a leveraged buyout but conducted by the management
team of the acquired company.
Growth capital Minority equity investments in companies that need capital to expand
operations.
Mezzanine capital Subordinated debt (often convertible) or preferred stock investments, which
are used to support growth of start-ups and other private equity investments.
© McGraw Hill 48
Figure 26.2A Startup Life Cycle
© McGraw Hill 49
Figure 26.2B Venture Capital Fund Life Cycle
© McGraw Hill 50
Fund Life Cycle

Vintage Year: The first year of the venture fund.
• Typically, when raised capital is first deployed.
• Vintage year will have considerable influence on expected
fund performance.
Term Sheet: The written agreement specifying the deal

structure.
• Details include stock type, dividends, voting rights, capital
invested, ownership, liquidation preferences, and anti-
dilution measures.
© McGraw Hill 51
Figure 26.3 Venture Capital Average Deal Size

($ millions)
© McGraw Hill 52
Private Equity Valuation

Value determines required ownership per dollar invested,
determined by a required capital multiplier
Initial Investment  Capital Multipler

Terminal ownership share =
Forecast Terminal Value
© McGraw Hill 53
Example 26.3 Private Equity Valuation 1
An early-stage venture capitalist contributes $2,000,000 in the first round

of financing with targeted exit multiple of 10x invested capital in an
estimated eight years. The VC expects an additional round of that will
dilute ownership share by 50%. The VC projects the firm can be sold for
$90,000,000 in eight years. What equity position must be required to
justify this investment?
Initial Investment  Capital Multipler

Terminal ownership share =
Forecast Terminal Value
$2,000,000  10
= = 22.22 →
$90,000,000
Terminal ownership share
Initial ownership share =
1 − Dilution
2222
= = 4444, or 44.44%
1 − .50
© McGraw Hill 54
Example 26.3 Private Equity Valuation 2
Given an initial position 44.44% ownership from $2,000,000 invested,

what must be the venture capitalist’s initial valuation of the company
excluding the VC’s investment?
Initial ownership share  Initial company value = $2,000,000

.4444  Initial company value = $2,000,000 →
$2,000,000
Initial company value = = $4,500,000 →
.4444
Pre-money value = $4,500,000 − $2,000,000 = $2,500,000
© McGraw Hill 55
Leveraged Buyouts (LBOs)

• LBO Funds take public companies private through
invested equity (typically 10 to 40%) and massive amounts
of debt (typically 60 to 90%).
• They seek mature companies with reasonably stable cash
flow and lower debt that have recently experienced
underperformance.
• Once acquired, LBOs improve the now private company’s
operations, governance, and capital structure.
• LBOs exit through IPO or acquisition, typically 5 to 7 years
from initial purchase.
© McGraw Hill 56
Example 26.4 Leveraged Buyouts 1
An LBO fund purchases a regional telecom firm, which has recently fallen
on hard times. The telecom firm trades at $42 per share with 20,000,000
shares outstanding. The LBO offers $50 per share to purchase the
company outright, funded by 25% equity and 75% by high-yield debt
securities. The LBO believes it can work with management to grow the
firm at a rate of about 6% while reducing debt by 5% each year, exiting in
year 6. What is the expected IRR of this investment?
Step 1: Calculate expected value of the firm at exit.
Value6 = Value0  (1 + g )6 = $50×20,000,000×1.066 = $1, 418,519,112
Step 2: Estimate capital structure at exit:

Weight of Debt 0 = 75%, reduced 5% per year →
Weight of Debt 6 = 75% − (5%  6 years) = 45% →
Weight of Equity 6 = 1 − Weight of Debt 6 = 55%
© McGraw Hill 57
Example 26.4 Leveraged Buyouts 2
An LBO fund purchases a regional telecom firm, which has recently fallen
on hard times. The telecom firm trades at $42 per share with 20,000,000
shares outstanding. The LBO offers $50 per share to purchase the
company outright, funded by 25% equity and 75% by high-yield debt
securities. The LBO believes it can work with management to grow the
firm at a rate of about 6% while reducing debt by 5% each year, exiting in
year 6. What is the expected IRR of this investment?
Step 3: Solve for LBO’s expected internal rate of return (IRR):

Equity6 Value6  Weight of Equity 6
Equity0 = =
(1 + IRR)6 (1 + IRR)6
$1,418,519,112  55% $780,185,512

= = →
(1 + IRR) 6
(1 + IRR) 6
IRR = .2089, or 20.89%
© McGraw Hill 58
Figure 26.4 Leveraged Buyouts Grow the Pie

and the Slice
Figure 26.4 LBO increases its equity position in its portfolio

company by growth and debt reduction ($ millions)
© McGraw Hill 59
Fee Structure in Hedge Funds

(1 of 2)
• Typical hedge fund fee structure

• Annual management fee of 1% to 2% of assets
• Incentive fee equal to 20% of investment profits
beyond a stipulated benchmark performance
• Incentive fees are effectively call options, where

the manager gets the fee if the portfolio value
rises sufficiently, but loses nothing if it falls
Strike price = current portfolio value * (1 + benchmark return)
Fee Structure in Hedge Funds

(2 of 2)
• High water mark is the previous value of a

portfolio that must be reattained before a
hedge fund can charge incentive fees
• Give managers an incentive to shut down funds
that have performed poorly
• Likely cause of high attrition rate
• Funds of funds are investment funds that
invest in other funds rather than investing
directly in securities such as stocks or bonds
• Also called feeder funds
Incentive Fees in Funds of Funds

• A fund of funds has $1 million invested in three hedge funds
• Hurdle rate for the incentive fee is a zero return
• Each fund charges an incentive fee of 20%
• The aggregate portfolio of the fund of funds is -5%
• Still pays incentive fees of $.12 for every $3 invested


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SMU Classification: Restricted

Financial institutions that

Mutual Funds and

INVESTMENTS | BODIE, KANE, MARCUS

• An investment company pools and invests the

INVESTMENTS | BODIE, KANE, MARCUS

Net Asset Value (NAV)

• Investment companies pool assets of

INVESTMENTS | BODIE, KANE, MARCUS

• Stand ready to redeem or issue shares at the NAV

INVESTMENTS | BODIE, KANE, MARCUS

pool funds Managed

• Similar to a closed-end fund Other

• Hedge funds Hedge Funds

• Vehicles that allow private

INVESTMENTS | BODIE, KANE, MARCUS

• Common name for open-end investment

INVESTMENTS | BODIE, KANE, MARCUS

Mutual Funds: Investment Policies

INVESTMENTS | BODIE, KANE, MARCUS

Mutual Funds: Investment Policies

Table 4.1 U.S. Mutual Funds by Investment

Assets ($ billion) % of Total Number of

INVESTMENTS | BODIE, KANE, MARCUS

Table 4.1 U.S. Mutual Funds by Investment

Assets ($ billion) % of Total Number of

• Note: Column sums subject to rounding error.

INVESTMENTS | BODIE, KANE, MARCUS

Mutual Funds: How Funds Are Sold

INVESTMENTS | BODIE, KANE, MARCUS

Costs of Investing in Mutual Funds

• Fees must be disclosed in the prospectus

INVESTMENTS | BODIE, KANE, MARCUS

Example 4.2 Fees for Various Classes

a Dependingon size of investment. Starts at 4.5% for investments less than

Fees and Mutual Fund Returns

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Taxation of Mutual Fund Income

Exchange Traded Funds (ETFs)

Figure 4.2 Growth of U.S. ETFs Over Time

Access the text alternative for these images

Figure 4.3 Investment Company Assets

Access the text alternative for these images

Figure 4.3 Investment Company Assets

Access the text alternative for these images

Mutual Fund Investment

INVESTMENTS | BODIE, KANE, MARCUS

Figure 4.4 Actively Managed Equity Funds

Access the text alternative for these images

Information on Mutual Funds

INVESTMENTS | BODIE, KANE, MARCUS

Information on Mutual Funds

• “Encyclopedias” of mutual fund information

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Traditional v s. Alternative: Transparency

Traditional Assets. Alternative Assets.

Traditional v s. Alternative: Investors

Investors – Traditional Assets. Alternative Assets.

Traditional v s. Alternative: Investment

• Limited short sells. • May act opportunistically.

• Restricted derivative use. • Private Equity.