Mutual Funds

and Hedge Funds

Lecture 3
(Chapter 4 of the textbook)

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Mutual Funds Intro
⚫ What is mutual fund?
⚫ A mutual fund is a financial vehicle that pools assets
from shareholders to invest in securities like stocks,
bonds, and other assets.
⚫ Mutual funds are operated by money managers who
allocate the fund’s assets and attempt to produce
capital gains or income for fund investors.
⚫ Two types of mutual funds:
⚫ Open-end funds (most common): issue and redeem
shares directly for its investors on a daily basis
⚫ Close-end funds: fixed number of shares. The shares
can only be traded on a stock exchange 2
Mutual Funds Intro
⚫ Mutual funds versus firms:
⚫ A mutual fund is similar to a firm: It is financed by
capital from investors. Manager allocates the capital
for investments and creates value for investors.
“Real” Firm Investors
Projects Investment Finance

Stocks, Fund Investors

Bonds… Investment Finance

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Mutual Funds Intro
⚫ Example: Fidelity Select Semiconductors
Portfolio

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Mutual Funds Intro
⚫ Fidelity Select Semiconductors Portfolio
⚫ Total Net Assets (TNA): Assets-minus-liability of the fund
⚫ Net Asset Value (NAV): The share price of the mutual fund for
investors to buy or sell at each day-end.

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Mutual Funds Intro
⚫ Fidelity Select Semiconductors Portfolio
⚫ The fund is managed by a professional money manager

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Mutual Funds Intro
⚫ Fidelity Select Semiconductors Portfolio
⚫ Portfolio holdings

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Mutual Funds Intro
⚫ Fidelity Select Semiconductors Portfolio
⚫ Historical performance

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Mutual Funds Intro
⚫ Mutual funds returns for investors = mutual fund gross
returns – mutual fund fees
⚫ Gross returns: mutual fund’s investment returns over a period
⚫ Fees: the management fees and some other costs charged by
the fund over a period
⚫ E.g., if a fund earns 5% investment returns this year and the
annual fee is 2%, the mutual fund returns for investors = 3%

⚫ Although mutual fund fees seem to be small (usually 1%-

2% per year), it can significantly erode the returns for
long-term mutual fund investors

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Mutual Funds Intro

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Mutual Funds Intro
⚫ Mutual funds returns can be misleading to investors
⚫ Suppose a fund has following annual returns in the past
five years: +15%, +20%, +30%, -20%, +25%
⚫ It is tempting to compute average annual return as the simple
average of the 5 returns: 14%
⚫ If we invest $100 in the fund five years ago, we now should have:
$100*(1+15%)*(1+20%)*(1+30%)*(1-20%)*(1+25%)=$179.4
⚫ If we invest $100 in the fund five years ago, with 14% annual
return, we now should have: $100*(1+14%)^5=$192.54
⚫ Why these two numbers are different? What is the correct way to
compute average annual return of the fund from investor’s
perspective?

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Mutual Funds Intro
⚫ What are the advantages of investing in mutual
funds compared trading by yourself?
⚫ Diversification at a low cost
⚫ Professional money management (in doubt)
⚫ Convenience: automatically reinvest dividends and
capital gains

⚫ Perhaps due to these advantages, the mutual fund

industry has experienced dramatic growth in the past
decades
⚫ Let’s see some statistics from Investment Company Institute (ICI)
2022 factbook 12
Mutual Funds Intro
⚫ Mutual funds experienced dramatic growth

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Mutual Funds Intro
⚫ Suppose a fund has following annual returns in the past
five years: +15%, +20%, +30%, -20%, +25%
⚫ To compute average annual return from investor’s perspective,
we should consider compounding effect (with re-investment)
⚫ [(1+15%)*(1+20%)*(1+30%)*(1-20%)*(1+25%)]^(1/5)-1=12.4%

⚫ The actual average annual return (12.4%) is lower than the

simple average (14%), but mutual funds sometimes report the
simple average annual returns to inflate their performance.

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Statistics on Mutual Funds
⚫ The majority of US
mutual funds are
equity funds
⚫ Equity funds: Invest in
stocks
⚫ Bond funds: Invest in
bonds
⚫ Money market funds: high-
quality, short-term debt
instruments, cash, and
cash equivalents.

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Statistics on Mutual Funds
⚫ Mutual funds hold a large share of financial assets

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Statistics on Mutual Funds
⚫ Mutual funds hold a large share of financial assets

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Statistics on Mutual Funds
⚫ Mutual funds are important assets in households’ asset
allocation

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Statistics on Mutual Funds
⚫ Most mutual fund assets are held by households

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Statistics on Mutual Funds
⚫ Index funds are becoming increasingly important
⚫ Index funds are designed to mimic the performance of a
financial market index (e.g., S&P 500 index)
⚫ They are considered “passive investments”

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Statistics on Mutual Funds
⚫ Index funds are becoming increasingly important
⚫ Five largest mutual funds by 2022

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Mutual Fund Performance
Evaluation
⚫ Reference for mutual fund performance evaluation:
Chapter 3 of Performance Evaluation and Attribution of
Security Portfolios by Fischer and Wemers

⚫ What is mutual fund performance evaluation?

⚫ Investment returns are the ultimate output provided by
asset managers. Performance evaluation is to measure
the quality of the output.
⚫ Performance evaluation is important
⚫ $27 trillions are managed by US mutual fund.
⚫ The mutual fund industry extracts huge amount of 22
management fees.
Mutual Fund Performance
Evaluation
⚫ Performance evaluation is difficult
⚫ The efforts and skills of asset managers are
unobservable.
⚫ The output (fund returns) is random and noisy. It’s hard
to distinguish between luck and skill.

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Mutual Fund Performance
Evaluation
⚫ Luck versus skill in mutual fund performance: An
example from Jensen (1969)

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Mutual Fund Performance
Evaluation
⚫ Jensen (1969) suggests that mutual fund
outperformance in a singe year is due to luck

⚫ What do we see from this example:

⚫ We must use models that help us to better separate the
influence of luck from skill in portfolio returns, else we
run the risk of choosing and rewarding lucky managers
rather than skilled managers.

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Performance Evaluation:
Sharpe Ratio
⚫ Sharpe Ratio is one of the most widely used
measure of fund performance:

⚫ It’s estimated by:

⚫ 𝑅𝑝 is sample mean return, 𝜎

ෞ𝑝 is sample STD of return.
⚫ Usually, it’s annualized (excel example) 26
Performance Evaluation:
Sharpe Ratio
⚫ Interpretation of Sharpe Ratio:
⚫ Skilled manager has better investment opportunity
(efficient frontier)

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Performance Evaluation:
Sharpe Ratio
⚫ Assumptions of Sharpe Ratio:
1. The portfolio is the entire portfolio held by an investor,
not just a portion
⚫ e.g., think about insurance
⚫ A partial solution: only use Sharpe Ratio to compare funds
within a pre-defined benchmark
2. The investor cares only about the mean and standard
deviation of his entire portfolio
3. The investor is myopic, in that he considers only one-
period outcomes
4. Agency problem: fund managers do not have aversion
to take optimal level of risks (avoid being fired) 28
Performance Evaluation:
Jensen Alpha
⚫ The Jensen model (single-factor model) assumes that a
single systematic risk factor affects all securities, and,
thus, all portfolios of these securities.
⚫ We estimate Jensen alpha through a linear regression:

⚫ 𝑅𝑝 is fund portfolio return, 𝑅𝐵 is benchmark portfolio return, t

indicates time
⚫ 𝛽𝑝 measures the tendency to move together with the benchmark.
𝛼𝑝 captures the outperformance or underperformance relative to
benchmark.

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Performance Evaluation:
Jensen Alpha
⚫ The key of applying Jensen model is to choose an
benchmark portfolio
⚫ Jensen Alpha can be manipulated by choosing an
irrelevant benchmark:
⚫ Suppose a S&P 500 index fund has a mean return of 10%
per year
⚫ If you choose S&P 500 index as the benchmark: alpha = 0%
⚫ If you choose US treasury bond as the benchmark:
alpha≈10%
⚫ Solution: choose a benchmark that matches the style
or type of securities that the manager chooses from
⚫ E.g., small-cap fund should be benchmarked against small-
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cap index instead of large-cap index
Performance Evaluation:
Multi-Factor Alpha
⚫ Often, we do not know the style or type of securities from
which a fund manager chooses.
⚫ E.g., Applied Finance Explorer Fund, The Hartford Equity Income
Fund, American Funds American Mutual Fund

⚫ Instead of determining the appropriate benchmark by

ourself, we can put multiple benchmarks into the model
and let data tell us which benchmark is related to this fund

⚫ In reality, we cannot put too many benchmarks into the

model, since we cannot estimate such a large model
⚫ The practice is to select a few powerful benchmarks
into the model 31
Performance Evaluation:
Multi-Factor Alpha
⚫ Equity funds: a popular model among academics is the
four-factor model:

⚫ RMRF: market factor: market excess returns

⚫ SMB: size factor: mimic the strategy of buying small firms and
selling large firms
⚫ HML: value factor: mimic the strategy of buying value firms and
selling growth firms
⚫ UMD: momentum factor: mimic the strategy of buying past winners
and selling past loser firms
⚫ Interpretation: A positive β on a given factor suggests the fund
is mimicking a given investment strategy
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Performance Evaluation:
Multi-Factor Alpha
⚫ Buffett’s Alpha (Frazzini, Kabiller, and Pedersen, 2018):
⚫ Berkshire Hathaway company (managed by Buffett) is required to
disclose its portfolio holding quarterly
⚫ We can construct a similar portfolio to Berkshire and compute the
historical returns of this “Buffett’s portfolio”
⚫ Then, we can apply multi-factor model to evaluate Warren Buffett’s
portfolio performance

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Performance Evaluation:
Multi-Factor Alpha
⚫ Buffett’s Alpha (Frazzini, Kabiller, and Pedersen, 2018):

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Performance Evaluation:
Multi-Factor Alpha
⚫ Fixed-Income Funds:
⚫ Fama-French (1993) Model:

⚫ TERM: bond maturity premium factor (buying 10-year Treasury

bond and selling 30-day T-bill)
⚫ Default: default risk premium factor (Buying Baa corporate
bonds and selling 10-year Treasury bond)

⚫ Elton, Gruber, and Blake (1995) Model:

⚫ FIRF: Bond Market Factor (Barclays Aggregate Bond Index

return) 35
⚫ OPTION: bond optionality factor
Hedge Funds Intro
⚫ Mutual Funds are restricted because
⚫ Shares must be redeemable at any time
⚫ NAV must be calculated daily
⚫ Investment policies must be disclosed
⚫ Use of leverage is limited
⚫ Hedge funds (also called alternative
investments) are not subject to these
restrictions

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Hedge Funds Intro
⚫ The first hedge fund, A.W. Jones &Co., was
created in the US in 1949.
⚫ It was structured as a general partnership to avoid
SEC regulations.
⚫ The fund combined long positions in undervalued
stocks with short positions in overvalued stocks.
⚫ The long position has similar size as the short
position, so the market risk is hedged. That’s the
origin of the term “hedge fund.”
⚫ Nowadays, many hedge funds take aggressive
bets on the future direction of market without
hedging. The word “hedge” is inappropriate. 37
Hedge Funds Intro
⚫ The determining features of a hedge fund
⚫ Suppose you want to set-up a hedge fund
1. Accredited investor: the majority of your investors
must be high income guys
2. Large personal stake: You need to put your own
money into the hedge fund to earn the trust from your
investors
3. First year lock-in: Investors cannot redeem in the first
year of the investment
4. Infrequent redemption: Redemption is only allowed on
a few dates each year

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Hedge Funds Intro
⚫ The determining features of a hedge fund
⚫ Suppose you want to set-up a hedge fund
5. High minimum: You do not want to waste time dealing
with requests from many small investors. You will
impose a minimum investment amount of 1 million
dollars.
6. Alternative investment strategies: Long/Short equity,
Dedicated Short, Merger Arbitrage, Convertible
Arbitrage, Fixed Income Arbitrage, Global Macro…
7. 2/20: Fee structure is 2% of AUM + 20% of profits
8. Leverage: if you can earn 10% alpha per year with $10
million, why not borrow $50 million more from the
bank? 39
Hedge Funds Strategy
⚫ Key difference between HF strategies and
traditional investment strategies
⚫ Lower legal and regulatory constraints
⚫ flexible mandates permitting use of shorting and
derivatives
⚫ A larger investment universe on which to focus
⚫ Aggressive investment styles that allow
concentrated positions in securities offering
exposure to credit, volatility, and liquidity risk
premiums
⚫ Relatively liberal use of leverage
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Incentives of Hedge Fund
Managers
⚫ The incentive component of the hedge fund
manager’s fee gives the hedge fund manager
a call option on the performance of the fund
in each year
⚫ The hedge fund manager has an incentive to
take excessively high risks

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Incentives of Hedge Fund
Managers
⚫ Suppose a hedge fund with 2/20 fee structure can choose
an investment with a 0.4 probability of a 60% profit and a
0.6 probability of a 60% loss
⚫ The expected return of this project:

0.4*60%+0.6*-60%=-12%
⚫ The expected fee for the manager:
⚫ Reject the project: 2%
⚫ Accept the project:
▪ If the project realizes profit:
fee = 2%+20%*(60%-2%)=13.6%
▪ If the project realizes loss: fee = 2%
▪ Expected fee = 0.4*13.6%+0.6*2%=6.64%
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Incentives of Hedge Fund
Managers
⚫ Suppose a hedge fund with 2/20 fee structure can choose
an investment with a 0.4 probability of a 60% profit and a
0.6 probability of a 60% loss
⚫ The expected return of this project:

0.4*60%+0.6*-60%=-12%
⚫ If the project is accepted, the expected return for the
investor:
⚫ If the project realizes profits:
return = 60%-2%-20%*(60%-2%) = 46.4%
⚫ If the project realizes loss: return = -60%-2% = -62%

⚫ The expected returns = 0.4*46.4%+0.6*(-62%)=-18.64%

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Incentives of Hedge Fund
Managers
⚫ By taking high risk-low return project, hedge fund
managers gain a lot at the cost of investors

⚫ What’s worse, two hedge fund manager can coordinate

and game the 2/20 system
⚫ Hedge fund A buys silver and Hedge fund B shorts silver
⚫ Both funds adopt 2/20 fee structure and the managers share the
management fees
⚫ What are the manager’s pay-offs?
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