1. FIN 422: Student Managed Investment Fund
Topic 9: Professional Portfolio Management, Alternative Assets, and Industry Ethics
Larry Schrenk, Instructor

2. Overview 17.1 The Asset Management Industry
17.2 Private Management and Advisory Firms
17.3 Organization and Management of Investment Companies
17.4 Investing in Alternative Asset Classes
17.5 Ethics and Regulation in the Professional Asset Management Industry

3. Learning Objectives @

4. Readings
Reilley, et al., Investment Analysis and Portfolio Management, Chap. 17

5. 17.1 The Asset Management Industry

6. 17.1 The Asset Management Industry: Structure and Evolution
Two structures:
Contract directly with a management and advisory firm
Commingling of investment capital of several clients in an investment company
Differences:
Private management and advisory firms develop a personal relationship with clients
A Investment company offers a general solution

7. 17.1 The Asset Management Industry: Structure and Evolution

8. 17.1 The Asset Management Industry: Structure and Evolution
Contract directly with a management and advisory firm
Relationship with client
Assets under management (AUM)
Separate accounts
Customized
Commingling of investment capital of several clients in an investment company
Invest a pool of funds belonging to many individuals in a single portfolio of securities
Issue new shares representing the proportional ownership of the fund

9. 17.1 The Asset Management Industry: Structure and Evolution

10. 17.2 Private Management and Advisory Firms

11. 17.2 Private Management and Advisory Firms
The majority of private management and advisory firms are still much smaller
More narrowly focused on a particular niche of the market
Investment Strategy
Each client’s assets are held in a separate account
The security portfolio is likely to be guided by the firm’s overall investment philosophy
While the specific stock allocations might vary, the same fundamental orientation toward stock selection will be applied to all accounts

12. 17.2 Private Management and Advisory Firms (slide 2 of 3)

13. 17.2 Private Management and Advisory Firms

14. 17.2.1 Investment Strategy at a Private Money Management Firm
Client’s assets are held in a separate account
Security portfolios formed for each client are guided by the firm’s overall investment philosophy
PCM:
Investment strategy and major holdings for two of PCM’s model portfolios: one in equities and one in fixed-income securities
Investment approach makes it clear that PCM’s large-cap growth stock product will invest client money primarily in technology companies
Specific stock allocations might vary from one client to another, but the same fundamental orientation toward stock selection will be applied to all accounts
A client choosing to invest in PCM’s core fixed-income product will end up holding a portfolio of bonds split between government and investment-grade corporate names

15. 17.2.1 Investment Strategy at a Private Money Management Firm

16. 17.3 Organization and Management of Investment Companies

17. 17.3 Organization and Management of Investment Companies
Financial intermediaries that pool the assets of individual investors and invest the fund in securities or other assets
Major duties
Investment research
Management of the portfolio
Administrative duties
Management fee is generally stated as a percentage of the total value of the fund
Family of funds helps achieve economies of scale

18. 17.3.1 Valuing Investment Company Shares
The NAV for an investment company is analogous to the share price of a corporation’s common stock.
The NAV of the fund shares will increase as the value of the underlying assets (the fund security portfolio) increases

19. 17.3.2 Closed-End versus Open-End Investment Companies
Closed-end investment company:
Functions like any other public firm and its stock trades on the regular secondary market
Fund generally does not issue or redeem shares once it is established
Price of the fund is different from its NAV
It is a puzzle for modern finance why close-end funds often sell at a discount from NAV
Often a means of investing in a pool of assets from a foreign country

20. 17.3.2 Closed-End versus Open-End Investment Companies

21. 17.3.2 Closed-End versus Open-End Investment Companies
Open-end investment company:
Open-end investment companies, or mutual funds, continue to sell and repurchase shares after their initial public offerings
They stand ready to sell additional shares of the fund at the NAV, with or without sales charge, or to buy back (redeem) shares of the fund at the NAV, with or without redemption fees
Have enjoyed substantial growth (in both number of funds and AUM) since World War II

22. 17.3.2 Closed-End versus Open-End Investment Companies

23. 17.3.2 Closed-End versus Open-End Investment Companies
Load versus No-Load Open-End Funds
The offering price for a share of a load fund equals the NAV of the share plus a sale charge.
A no-load fund imposes no initial sales charge, so it sells shares at the NAV.
Several variations exist between the full-load fund and the pure no-load fund
Low-load fund
12b-1 plan
Funds have contingent, deferred sales loads

24. Fund Management Fees
All investment firms charge annual management fees to compensate professional managers of the fund
The fee typically is a percentage of the average net assets of the fund varying from about 0.25 to 1.00 percent
Management fees are a major factor driving the creation of new funds
Mutual fund fees have been declining due to the industry consolidation

25. 17.3.4 Investment Company Portfolio Objectives
A mutual fund can be created around any portfolio of assets
However, mutual funds tend to exist for only the more liquid asset classes, such as stocks and bonds
There are four broad (Level 2) fund objective categories recognized by the Investment Company Institute:
Common stock funds
Bond funds
Hybrid funds
Money market funds

26. 17.3.4 Investment Company Portfolio Objectives

27. 17.3.4 Investment Company Portfolio Objectives

28. 17.3.4 Investment Company Portfolio Objectives

29. 17.3.4 Investment Company Portfolio Objectives
Equity funds
Invest almost exclusively in common stocks
Bond funds
Concentrate on various types of bonds to generate high current income with minimal risk
Balanced funds
Diversify outside a single market by combining common stock with fixed income securities
Money market funds
Invest in diversified portfolios of short-term securities

30. 17.3.4 Investment Company Portfolio Objectives

31. 17.3.5 Breakdown by Fund Characteristics
Major means of distribution
Sales force or investment professional
By direct purchase from the fund or direct marketing
By investment objective
Equity funds
Hybrid funds
Money market funds

32. 17.3.5 Breakdown by Fund Characteristics

33. 17.3.6 Global Investment Companies
Funds that invest in non-U.S. securities are generally called either international funds or global funds
Both international and global funds fall into familiar categories: money funds, government and corporate bond funds, and equity funds
Most global or international funds are open-end funds, but a significant number are closed-end funds to minimize trading of illiquid foreign securities
A large number of non-U.S. investment companies that offer both domestic and global products in their local markets

34. 17.3.7 Mutual Fund Organization and Strategy: An Example
The Dreyfus Corporation, established in 1951 and headquartered in New York City, is a leading mutual fund company in the United States
The Dreyfus Appreciation Fund (DGAGX) is a one of several equity-oriented portfolios that the company offers to its institutional and retail investors
The Appreciation Fund is different from other funds in the Dreyfus family in that it is not managed directly by in-house portfolio managers
DGAGX is managed by Fayez Sarofim, a Houston-based professional who has run his own private management firm since 1958 and serves Dreyfus as a subinvestment advisor

35. 17.3.7 Mutual Fund Organization and Strategy: An Example

36. 17.4 Investing in Alternative Asset Classes

37. 17.4 Investing in Alternative Asset Classes
Alternative asset classes can include a wide variety of investment opportunities, including:
Hedge funds
Private equity
Real estate
Natural resources and commodities
Management Structure
Usually structured as a limited partnership rather than as a mutual fund to manage the commingled assets
The Fund “alpha”
Excess returns generated by the fund, implying the superior performance by the fund management

38. 17.4 Investing in Alternative Asset Classes

39. Hedge Funds
One of the most significant developments in the professional asset management industry over the past 20 years has been the hedge fund investing
Hedge fund investing is not new and can be traced back to 1949, structured as a partnership structure with an incentive fee for superior performance
With both long and short and financial leverage, it is able to produce superior returns than traditional investment structures, such as mutual funds

40. Hedge Funds

41. 17.4.2 Characteristics of a Hedge Fund
Hedge funds:
Less restricted in how and where they can make investments
Less correlated with traditional asset class investments, providing diversification benefits
Investments are far less liquid than mutual fund (or even closed-end fund) shares
Severe limitations on when and how often investment capital can be contributed to or removed from a partnership
In calculating this performance fee, investors usually require that any past losses be recouped before managers receive the additional payout; this arrangement is known as a high-water mark

42. 17.4.2 Characteristics of a Hedge Fund

43. 17.4.3 Hedge Fund Strategies Equity-Based Strategies
Long-short equity: Managers attempt to identify misvalued stocks and take long positions in the undervalued ones and short positions in the overvalued ones
Equity market neutral: attempt to limit the overall volatility exposure of the fund by taking offsetting risk positions on the long and short side, an effort that might also involve adopting derivative positions

44. 17.4.3 Hedge Fund Strategies Arbitrage-Based Strategies
Fixed-income arbitrage: Returns are generated by taking advantage of bond pricing disparities caused by changing market events, investor preferences, or fluctuations in the fixed-income market
Convertible arbitrage: Seeks to profit from disparities in the relationship between prices for convertible bonds and the underlying common stock
Merger (risk) arbitrage: Returns are dependent upon the magnitude of the spread on merger transactions, which are directly related to the likelihood of the deal

45. 17.4.3 Hedge Fund Strategies Opportunistic Strategies
High yield and distressed: Invest in risky bonds
Global macro: This broad class of strategies seeks to profit from changes in global economies
Managed futures: This strategy entails using long and short positions in a variety of futures contracts
Special situations: Events like bankruptcies, spinoffs
Multiple strategies
Fund of funds: Invest in a number of funds so as to achieve a well-diversified allocation to the hedge fund investment space

46. 17.4.4 Risk Arbitrage Investing: A Closer Look
Take equity positions in companies that are the target of a merger or takeover attempt
Require managers to compare their own subjective judgment about the success of the proposed takeover with the success probability implied by the market price of the target firm’s stock following the announcement of the deal
If the manager thinks the takeover is more likely to occur than the market does, then he or she will buy target firm shares.
The manager might short sell the target firm shares if he or she thinks the proposed deal is less likely to be completed

47. 17.4.4 Risk Arbitrage Investing: A Closer Look

48. 17.4.4 Risk Arbitrage Investing: A Closer Look

49. 17.4.5 Hedge Fund Performance
Not all hedge funds are the same when it comes to their risk and return profiles
The returns to these strategies show a high degree of variability on a year-to year basis, in both an absolute and a relative sense
Over 1990 to 2010, hedge funds overall produced positive “Alpha”
Emerging markets was the worst performing strategy in 1995 (-16.9%). However, it was the best performing strategy in 1996 ( +34.5%)
The long/short equity strategy performed well in 2003 through 2007, but lost money in 2002 & 2008

50. 17.4.5 Hedge Fund Performance

51. Private Equity
Refers to any ownership interest in an asset (or assets) that is not tradable in a public market
Typically fund either new companies or established firms that are seeking to change their organizational structure or are experiencing financial distress
Generally far less liquid than public stock holdings and are therefore considered to be long-term positions within an investor’s overall portfolio
Characteristics
Higher return and low liquidity
Good sources of diversification

52. Private Equity

53. Private Equity
Development and Organization of the Private Equity Market
Organized private equity investing began in the United States back in 1946
Subcategories:
Venture Capital
Seed
Early stage
Later stage
Buyouts
Special Situations
Distressed Debt
Mezzanine Financing

54. Private Equity

55. 17.4.6 Private Equity The Private Equity Investment Process
The zero-stage capital: Using their personal savings and bank loans
The venture capital: Seek to obtain the additional seed and early-stage funding they need to advance their idea to the next level; in exchange, the venture capital firm receives an equity stake in the company
The venture capital firm will ultimately want to liquidate their equity holdings in order to create a return on their investment
Buyout
IPO

56. Private Equity

57. 17.4.6 Private Equity Returns to Private Equity Funds
Private equity commitments should be viewed as long-term, highly illiquid investments
The return pattern known as the “J-curve effect”
Average annual returns for these investments tend to be quite high over time
The initial years of a new private equity commitment usually produce negative returns
In addition to its higher overall risk level, there exists a huge dispersion in fund returns, that is, good performance vs. bad performance managers

58. Private Equity

59. Private Equity

60. 17.5 Ethics and Regulation in the Professional Asset Management Industry

61. This agency conflict occurs frequently in financial relationships
17.5 Ethics and Regulation in the Professional Asset Management Industry
The issue of ethical behavior arises any time one person is hired to look after the interests of another
Economists often refer to this potential conflict as the principal–agent problem
This agency conflict occurs frequently in financial relationships

62. 17.5.1 Regulation in the Asset Management Industry
Principal securities laws that govern investment companies
The Securities Act of 1933
The Securities Exchange Act of 1934
The Investment Company Act of 1940
The Investment Advisers Act of 1940
The Employee Retirement Income Security Act of 1974
The Pension Protection Act of 2006
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

63. 17.5.1 Regulation in the Asset Management Industry

64. 17.5.1 Regulation in the Asset Management Industry
Regulatory agencies
The U.S. Securities and Exchange Commission (SEC) is the main federal agency responsible for regulating professional asset management activities in the United States
U.S. Department of Labor: For protection of pension plans, including 401(k) plans
The Financial Industry Regulatory Authority (FINRA): the largest independent regulator for all securities firms
The Commodity and Futures Trading Commission: monitors futures and commodities trading activities
U.S. Internal Revenue Service: setting and enforcing of tax policies

65. 17.5.2 Standards for Ethical Behavior
Avera (1994) outlines four general principles for conduct in the profession:
Managers conduct themselves with integrity and act in an ethical manner
They perform financial analysis in a professional and ethical manner
They act with competence and strive to improve
They always use proper care and exercise independent professional judgment
The CFA (Chartered Financial Analysts) Institute has developed a rigorous Code of Ethics and Standards of Professional Conduct
The Code of Ethics expands on the four themes

66. 17.5.2 Standards for Ethical Behavior
A recent initiative of the CFA Institute has been the creation of a comprehensive Asset Manager Code
This code sets forth minimum standards for providing asset management services to clients, based on the following general principles:
Managers must:
Act in a professional and ethical manner at all times
Act for the benefit of clients.
Act with independence and objectivity
Act with skill, competence, and diligence
Communicate with clients in a timely and accurate manner
Uphold the applicable rules governing capital markets

67. 17.5.3 Examples of Ethical Conflicts
Incentive Compensation Schemes
Brown, Harlow, and Starks (1996) documented that mutual fund managers with the worst relative performance midway through a compensation period were more likely to increase the risk of the portfolio in an effort to increase their final standing
Soft Dollar Arrangements
Soft dollars are generated when a manager commits the investor to paying a brokerage commission that is higher than the simple cost of executing a security trade in exchange for the manager receiving additional bundled services from the broker

68. 17.5.3 Examples of Ethical Conflicts
Marketing Investment Management Services
Conventional wisdom holds that it is in the investors’ best interests for managers to build a steady awareness over time of their relative merits
Capon, Fitzsimons, and Prince (1996) documented that the main factor determining which fund to invest in was the immediate past return of the portfolio
Zweig (2000) observed that this tendency causes mutual funds to time their advertisements around relative peaks in their performance