Mutual Funds and Hedge Funds Services of Investment Companies Types of Investment Companies Types of Mutual Funds Cost of Mutual funds Return of Mutual Funds Exchange Traded Funds Hedge Funds and Their strategies

Services of Investment Companies Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs

Net Asset Value Used as a basis for valuation of investment company shares Selling new shares Redeeming existing shares NAV= Market Value of Assets - Liabilities Shares Outstanding

Types of Investment Organizations Unit Trusts Managed Investment Companies Open-End Closed-End Other investment organizations Commingled funds REITs Hedge Funds

Open-End and Closed-End Funds Shares Outstanding Closed-end: no change unless new stock is offered Open-end: changes when new shares are sold or old shares are redeemed Pricing Open-end: Net Asset Value(NAV) Closed-end: Premium or discount to NAV

Investment Policies Money Market Equity Specialized Sector Bond Balance & Income Asset Allocation Indexed International

Costs of Investing in Mutual Funds Fee Structure Front-end load Back-end load Operating expenses 12 b-1 charges distribution costs paid by the fund Alternative to a load Fees and performance

Example An open-end fund has a total asset of $120 million and a liability of $10 million. It has 10 million shares outstanding. What is its NAV? It is sold with a front-end load of 5%. What is its offering price?

Fund Returns Page 106

Table 4.2 Impacts of Costs on Investment Performance

Exchange Traded Funds ETF allow investors to trade index portfolios like shares of stock Examples - SPDRs and Webs Potential advantages Trade continuously Lower taxes Lower costs Potential disadvantages

First Look at Mutual Fund Performance Average mutual fund performance is generally less than broad market performance Over certain horizons there is persistence in positive performance Evidence is not conclusive Some inconsistencies

Figure 4.3 Diversified Equity Funds versus Wilshire 5000 Index

Sources of Information on Mutual Funds Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (biz.yahoo.com / funds) Investment Company Institute (www.ici.org) Popular press Investment services

Hedge Funds vs. Mutual Funds Transparency: Limited Liability Partnerships that provide only minimal disclosure of strategy and portfolio composition No more than 100 “sophisticated”, wealthy investors Transparency: Regulations require public disclosure of strategy and portfolio composition Number of investors is not limited

Hedge Funds vs. Mutual Funds Investment strategy: Very flexible, funds can act opportunistically and make a wide range of investments Often use shorting, leverage, options Liquidity: Often have lock-up periods, require advance redemption notices Investment strategy: Predictable, stable strategies, stated in prospectus Limited use of shorting, leverage, options Liquidity: Can often move more easily into and out of a mutual fund

Hedge Funds vs. Mutual Funds Compensation structure: Typically charge a management fee of 1-2% of assets and an incentive fee of 20% of profits Compensation structure: Fees are usually a fixed percentage of assets, typically 0.5% to 1.5%

Hedge Fund Strategies Directional Bets that one sector or another will outperform other sectors Non-directional Exploit temporary misalignments in relative valuation across sectors Buy one type of security and sell another Strives to be market neutral

Table 26.1 Hedge Fund Styles

Statistical Arbitrage Uses quantitative systems that seek out many temporary and modest misalignments in prices Involves trading in hundreds of securities a day with short holding periods Pairs trading: Pair up similar companies whose returns are highly correlated but where one is priced more aggressively Data mining to uncover systematic pricing patterns

Portable Alpha Invest wherever you can find alpha. Hedge the systematic risk of the investment to isolate its alpha. Establish exposure to desired market sectors by using passive products such as indexed mutual funds or ETFs. Transfer alpha from the sector where you find it to the asset class in which you ultimately establish exposure.