Mutual Funds February 3rd, 2010 Mutual Fund Explosion Initially higher interest rates caused by regulatory ceilings placed on FI’s attracted investors to money market mutual funds starting in the early 70’s. However, it is really only in the 1990’s that mutual funds in their broadest scope exploded. A major part of the explosion was due to equity funds, which were driven by two factors a bullish stock market and a better educated investor. The two of course fed on each other: the more satisfied investors were with their returns, the more they invested in mutual funds which in turn drove equity markets higher, which in turn spurred more investors to invest, which drove equity markets higher…. Bond and money market fund were also helped by investors understanding the concept of diversification, risk, fees and efficiency and that fixed income funds could earn a higher return than most bank deposits with about the same level of risk. Mutual funds had grown from $135 billion in 1980 to $7.4 trillion by 2003. Investor Education Investors in the US began to understand the risk return equation and that for higher equity returns they needed to (1) diversify by buying into funds and (2) be patient since equity markets are notorious for their ups and downs. Therefore, US investors have shown remarkable tolerance with respect to volatility. Does supply and demand suggest that equity returns are being compressed as more and more investors accept this volatility? What implication does that have for future investment now that markets have proved to be “quite risky”? Types of Funds Money Market Funds – short term highly liquid investments which in effect allow almost daily deposits and withdrawals while earning competitive “market” rates as opposed to lower bank rates. Underlying principal in most funds is usually stable. Bond Funds – fixed income i.e. they try to achieve a target yield e.g. 300 b.p. over Treasuries or LIBOR. Hence the investor can count on receiving interest payments usually monthly while having a principal that won’t change dramatically in value in the case of low to average risk funds. Equity Funds – stock funds that pay little in the way of dividends where the underlying value in the portfolio of the stocks determines whether the investor wins or loses. Principal is thus highly volatile. Hybrid Funds – combination of 2 or all 3 of the above. Hedge Funds – unregulated and limited to a select group of qualified investors. Why Mutual Funds? The power of diversification and the efficiency of modern financial markets. For the risk averse, funds can focus on a highly rated securities – US government and Local Municipalities; AAA corporations and FI’s. For the more risk prone, high return seeker, funds offer a whole host of investment options which can yield huge returns and on occasion huge losses for investors. Mutual Fund Objectives Beat the Market! Mutual funds try to outperform indices that are comparable to the instruments in which they invest. For example, the performance of a a broad based stock fund that invests in mostly NYSE stocks might be compared to the performance of S&P 500. Hence an investor should go in search of a fund that suits his/her risk appetite and compare its historical performance to the relevant index. Building a Mutual Fund Let’s build a mutual fund. We need to find experienced fund managers who have good track records picking winners. We need to find investors which might involve sales people and/or advertising. We need to write up a prospectus stating what our objectives are: e.g. fixed income with no more than 30% invested in fixed rate instruments, average maturity of no more than 5 years; minimum 80% vested; no more than 10% non investment grade securities with target of BBB+ to A- rating or equivalent as determined by our analysts. Limits on leverage i.e. “no borrowed”* funds to exceed 10%. Permission (prohibition) to hedge. We need to determine in advance what our reward is going to be e.g. 0.3% of Net Asset Value plus 5% of any positive return (e.g. if the fund earns 10% then the manager would get 5% of 10% or 0.5% more as a reward for the performance); maximum 20% borrowed funds to Total Assets. Interest rate and currency derivatives limited to hedging purposes only. * Remember how repos work? Such a clause would define what was meant by leverage to include repos, derivatives (or possibly prohibit). Some terminology Net Asset Value = Total Assets minus liabilities or simply the owners’ equity in the fund. Liabilities might include (1) redemptions payable – i.e. a person has indicated that he wants to sell his/her interest in the fund but he/she needs to wait 5 days before getting the actual cash. (2) borrowed funds to leverage the investors money possibly including repos. Mark-to-market – refers to the valuation of the funds. Typically funds will go out at the end of the day and price whatever assets they have in the fund based on what the bid rate is in the market for these securities. Therefore, the end of day values are marked to market or in other words valued per what the market price is at that time for the different securities in the fund. What happens when there is no quotable price? Could be a “black box model” that calculates (probably not in a public fund) or Could be marked to zero if there is no available quote. Most probably they would ask some third party to give a conservative net realizable value – still theoretical, but better than zero. Closed End Funds Closed end fund is much like a bond. The fund manager goes out and raises e.g. $100 MM to invest in high tech stocks. In this case, he/she accumulates the cash and sells a million shares for $100 a piece. Therefore, at the end of the subscription period, there is only cash in the fund and the value is presumably $100 per share. The manager then starts to buy stock and depending on whether these stocks go up or down will generally push the share price of the fund up and down. However, the NAV of the Fund may go up 5% in value while the share price may only go up 3% in value thus creating a discount i.e. The sum of all the shares in the fund is 2% (5%-3%) less than the NAV. If the NAV goes up 5% while the share price goes up 7% then there would be a premium. Discounts and Premiums in closed end funds are generally caused by the investors’ perception of the competence of fund managers. i.e. if there are two closed end funds that invest in the same industry and start with the same NAV. The superior performing fund will attract more investor demand. Hence supply and demand will dictate that the poorer performing fund’s price will go down while the superior performing fund’s price will go up. Open End Funds Open End funds are the most common. They take in money from investors and purchase stocks. There isn’t an initial subscription period. As the fund gets cash it will invest some or all of it according to its objectives. The investor gets credit with its percentage of the fund’s ownership when he/she enters: new money divided by new money plus existing NAV. As a result there are no premiums or discounts. Liquidity When investing in a closed end fund an investor needs to see how liquid the shares are. When investing in a open end fund, the investor needs to be aware of how liquid the actual instruments in the fund are. In the Closed End case, the investor may have a hard time selling his/her share. In the Open End case, if all the investors rush to get out, those investors who are last may get the illiquid assets which are difficult to sell at what seems to be their fair economic value. Fees! Load funds (sales commission) vs. No Load Funds Admin fees (bookkeeping, share administration, fund evaluation such as rating agency fee or third party mark-to-market, etc..) Performance Fees (manager and analyst fees) – sometimes fixed sometimes a percentage of return. At times highly complex formulas. Calculating the return Subtract load e.g. if you pay 4% up front on a $100 purchase, you only get $96 worth of fund hence you have a 4% negative return from inception. If you get a 10% return on this fund, it is 10% on $96 or $9.60 at the end of year one. Total return on your investment is ($96+$9.60)/$100 If you pay a 1% admin and management fee on NAV then your return will be ($96+9.60-0.96*). *it is probably calculated on average NAV for the year so the number would be a bit more than 0.96). Hedge Funds For qualified investors i.e. “wealthy” people and financially sophisticated institutions. They are not required to register with the SEC and therefore are usually unregulated. Interestingly wealthy is defined as $200K ($300K if married) annual income or $1,000,000 net worth – just low enough to get some people in serious trouble! This was probably done to allow some people to make a living as a “day trader”. Typically, hedge funds use aggressive high risk strategies that might not be available or marketable to public funds. These strategies can be highly complex. Hedge Fund Strategies On the high risk side hedge funds may take on billions of dollars worth of notional exposure and take offsetting positions by hedging. These strategies are usually used to take advantage of anomalies in the market place – i.e. arbitrage. An example would be buying billions of dollars worth of one type of US government bond and simultaneously selling a similar type of US government bond. There may be an unhedged risk portion i.e. the bonds might have slightly different maturities – but the fund managers view the mismatch as likely inconsequential. The managers may have stop loss provisions which will force them to sell if their “wager” is wrong. In other cases, they may simply borrow lots of money to fund purchases of medium risk securities with the bet that they will see a major change in risk profile well ahead of time and “jump out the way of the speeding locomotive”. Others are experts in distressed assets where they can identify value that the original owners fail to see. Debt of companies in bankruptcy or countries in economic downturns can be candidates for this type of investing. In other cases, hedge funds can create better than average returns with very low risk. Hedge fund managers use their expertise in hedging and identifying counter cyclical securities so as to create very even returns for investors even in economic downturns. Others will invest in volatility of different financial and commodity markets to make money regardless of whether markets are going up or down. Many hedge funds are in somewhat illiquid assets or take positions that may take years to realize their true value. Hence investors in Hedge Funds can be locked in for years. Hedge Fund Fees Fees in hedge funds are typically high. There is a base fee of around 2% of NAV regardless of performance. There is then typically a reward fee which is triggered once a benchmark is reached e.g. all returns beyond 8% will result in a 30% of that return. This means that if the $100,000 investment yields 20% after the initial management fee of 2%. The Fund manager’s compensation will be $2,000 management fee plus $20,000 minus $8,000 or $12,000 x 30% which is equal to $3,600. Therefore, total compensation for the fund manager is $5,600 ($2,000 plus $3,600). The investor of course gets $16,400. Hedge funds managers however need to work off losses before they can receive the gains so if there was prior period where they did not meet the 8% hurdle that would be subtracted from the current return.