Mutual funds and hedge funds

Current products and issues

• Mutual Funds are the largest buy side manager type
worldwide, but they face a number of significant challenges.

• ETFs – Problem Number 1

• Hedge funds – Problem Number 1A

• Mutual Fund Issues

• Hot Money – Cash Drag
• Fees
• Timing and day trading
• Late Trading
Exchange Traded Funds
• Diamonds, SPDRs, HOLDRS, VIPRs
• Quasi-closed-end fund tracking an index, country or
sector
• The funds hold a basket of index stocks
• If an index does not exist, the fund sponsor makes one
• Operating expenses paid out of assets
• Low expenses
• Exchange listed
• Gives them 2 huge advantages over mutual funds
Exchange traded products
• Catch all definition for ETFs, Exchange Traded Notes and
other nomenclature associated with index related
materials.

TVIX – Exchange traded note because they mimic the

index (VIX) with derivative securities, not equities

GLD, USO – Mimic commodities with derivative contracts

ETF Success
Hedge Fund Success
Barclay hedge
Active management losing to ETF funds
ETF structure allows its flexibility
ETF structure
• The Fund Sponsor determines the strategy of the fund
and the Index the fund tracks.
• Authorized participant can be a broker-dealer
• Creation Units allow the fund to create new shares or
redeem shares overnight.
• Authorized participant exchanges creation units, which
can be replicated portfolios – cash is permitted
• Received a fixed amount of shares, say 50,000 from the
sponsor.
• Structure allows exchange listing and trading and
shorting.
Some Major ETFs and Their Sponsors
A competitive market for ownership and investor
interest
 Hidden risks of ETFs
• Van Eck considering Mongolia Fund launch
• $6 billion GDP
• $1 billion market cap
• Expenses of recently launched ETFs average higher

• Your ETF can close

• Not too much of a problem unless there is a tax event

• Short interest on ETFs can exceed 100%

• This is interesting, does the structure fully protect investors
Trading characteristics make ETFs a popular
hedging vehicle
Hedge Fund Success
Notes on hedge funds
• Sophisticated Investors
• Over $3 Trillion in assets under management
• AUM hurt in 2007-2008
• Now well over $3T despite mediocre recent performance.

• Shorting is a frequent part of the investment strategy

• Leverage is a crucial part of the investment strategy
• Trading execution is a crucial part of the investment
strategy

• 2 and 20 contract for managers

Top 10 Hedge Fund Pay Packages
Manager Group/Fund 2006 Pay
James Simons Renaissance $1700 million
Kenneth Griffin Citadel Investment $1400 million
Edward Lampert ESL Investments $1300 million
George Soros Soros Fund $950 million
Steven Cohen SAC Capital Advisors $900 million
Bruce Kovner Caxton Associates $715 million
Paul Tudor Jones II Tudor Investment $690 million
Timothy Barakett Atticus Capital $675 million
David Tepper Appaloosa $670 million
Carl Ichan Ichan Partners $600 million
Prof Irvine FINA 4310

Performance and Compensation

• We want to induce managers to
• generate positive alphas
• take risks according to our preferences

• Its been suggested that Hedge Funds are a compensation

contract masquerading as in investment vehicle.
Prof Irvine FINA 4310

Actual Compensation Contracts

• Fixed and variable compensation
• ‘fixed’: percentage of asset base (expense ratio)
• variable:
• ‘fulcrum’ fee’s (mutual funds)
• 20/20 fees (hedge funds)
Prof Irvine

‘Fixed’ Isn’t Constant

• The fixed part of compensation is a fraction of assets
under management
• negative (positive) returns decrease (increase) assets under
management
• bad (good) performance leads to fund withdrawals (inflows)
• Hot money problem
Prof Irvine

Fulcrum Fee
• Based on a benchmark:
• symmetric around benchmark returns
• as a fraction of return difference
• e.g. 10% (rP - rB)
• capped gains and losses

Variable Total
fee fee

0 0
rP - rB rP - rB
Prof Irvine

2/20 Fees
• Typical hedge fund contract
• 200 basis points per year fixed
• 20% of returns exceeding a high-water mark
• note: No benchmark, 20% raw returns

• ‘high-water mark’
• e.g. 10% per year, LIBOR
• If returns negative in one year, high-water mark increases by that amount for
next year
• e.g. –5% this year, next year’s high-water mark: 15%
 Net Assets of Equity Funds
$6,000.00
$5,669.6

$5,500.00
$4,937.3
$5,000.00

$4,500.00 $4,384.1

$4,041.9
$4,000.00
$3,684.8

$3,500.00 $3,418.2

$2,978.2
in billions $3,000.00
$2,666.5
$2,500.00 $2,368.0

$2,000.00
$1,726.1

$1,500.00
$1,249.1

$1,000.00 $852.8

$514.1
$500.00
$161.4 $194.7 $239.5
$45.1 $55.9 $30.9 $39.2 $32.7 $44.4 $53.7 $83.1
$0.00
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Year
Source: Investment Company Fact Book
Equity Funds still dominate
Inflows are not as consistent anymore
Fund Share
US Investment Company Employment
Types of equity mutual funds
• Index

• Growth
• large growth style box
• Growth and Income
• growth, but dividend payers
• Aggressive Growth
• small growth style box
• Sector funds
• Gold
Index funds continue to increase in popularity
Types of equity mutual funds
Style Box

Size

Value - Growth
Types of Equity Mutual Funds: Style Box
Figure 4.4 Morningstar Report

4-31
 Types of Equity Mutual Funds: Style Box

• Categorizes funds into 9 different categories based on

market capitalization (small, medium, large) and valuation
(value, growth, blend).

• Helps investors w/ asset allocation strategy.

• Previous style box categorizes the fund as a large blend,

meaning the fund invests in mostly large cap stocks that
are a mixture of value and growth companies.
Morningstar Report Cont.

4-33
Market-Cap Classifications
 Types of hybrid funds
• Balanced
• a balanced fund generally keeps the exposure to equities relative
to bonds fairly constant
• Flexible portfolio
• allows the manager more flexibility in altering the fund’s bond-stock
mix
• Target Date
• Changes composition based on a specific retirement date
Hybrid funds popularity
The new hybrids include enhanced mutual fund
strategies
401-K Allocations
Alternative Investments are increasingly available to
small investors through ETFs @etf.com
 What are alternative investments?
• Essentially any asset with low correlation to existing asset classes
• Particularly stock market returns
Commodities are a popular alternative ETF
Alternatives have low correlation with the rest of the market
Fund ownership
Average Fund costs are finally falling – a bit
Note that these numbers are asset weighted
Investors are getting savvy about expenses
Index funds charge much lower expenses
Tax Issues

• Returns have ‘pass-through’ status

• Realized capital gains must be distributed to investors
• Tax liability for investors upon distribution
• This can have grave consequences for your tax bill!

• Vanguard Admiral line

• tax savvy for $250K
• control fund turnover
• and other activities to minimize taxes
• such as limiting the openness of the fund
 Tax example

• Fund has realized capital gains of 20% by Dec. 29,

holding it in cash
• You acquire shares at NAV on Dec. 30 for $1000
• On Dec. 31, the fund distributes $200 in capital gains,
NAV drops to $800
• At a tax rate of 35%, you pay $70
• After tax return of –7%, in two days
Cash drag
• Open-ended mutual funds have a problem
• Investors can put cash in or take cash out at will
• fund is holding a cash reserve
• can reduce returns in rising markets
Prof Irvine

Hot Money
Fund flows and performance
Closed-end mutual funds
• Price established in a stock exchange
• No change in shares outstanding
• open end funds shares outstanding will change as new shares are
sold or old shares redeemed
• Price is often below NAV
• trades at a discount
Total closed end fund Assets
Bond closed-end funds most popular
Worldwide Fund Assets
Top 10 Countries with over $1 Trillion in Domestic Mutual Funds:
$46. 7T - 2018
You will fail to guess all:
• 1. United States – $T 21.07
• 2. Country 2 - $T 4.64
• 3. Country 3 – $T 2.77
• 4. Country 4 - $T 2.19
• 5. France - $T 2.07
• 6. Country 6 $T 1.94
• 7. Japan - $T 1.80
• 8. Country 8 - $T 1.76
• 9. UK - $1.68
• 10. Country 10 - $T1.21
Source: Investment Company Fact Book 2019
Emerging market performance
Global Stock Market Capitalization
Credit Suisse 2030 Forecast
Peter Lynch
Fidelity Magellan under Lynch