### Fund Management

After completing this reading, you should be able to:

• Understand who a fund manager is and the benefits of using fund managers
• Differentiate among open-end mutual funds, closed-end mutual funds, and exchange-traded funds (ETFs).
• Describe the various categories of open end mutual funds
• Calculate the net asset value (NAV) of an open-end mutual fund.
• Understand the various undesirable behaviors in trading
• Explain the key differences between hedge funds and mutual funds.
• Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund including the terms hurdle rate, high-water mark, and clawback.
• Understand who a prime broker is
• Describe various hedge fund strategies, including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and identify the risks faced by hedge funds.
• Describe hedge fund performance and explain the effect of measurement biases on performance measurement.
• Explain the findings of the research carried out on returns of mutual and hedge funds.

## Fund Managers

Fund managers are responsible for investing funds on behalf of their clients. The benefits of using fund managers include:

1. Fund managers have the necessary expertise needed to invest funds;
2. Large funds make it easier for diversification as opposed to smaller funds or when investors invest on their own;
3. Transacting larger trades is relatively cheaper to transacting smaller ones.

## Differences among Open-end Mutual Funds, Closed-end Mutual funds, and Exchange-traded Funds

A mutual fund is made up of a pool of money collected from many investors. The money is then used to invest in securities such as stocks and bonds. The funds are operated by a fund manager whose mandate is to generate income or capital gains for the investors. However, mutual funds lack tax benefits, meaning that any profits made by an investor are subject to being taxed. A mutual fund can be open-end or closed-end.

### Open end mutual fund

In an open-end mutual fund, shares are traded at their net asset value (NAV). The net asset value is the market value of all assets the fund owns at the end of each trading day minus liabilities divided by the number of shares outstanding., i.e.,

$$NAV=\frac{\text{Market value of assets at the close of the day}- \text{Liabilities}}{\text{Number of outstanding shares}}$$

The net asset value (NAV) changes on a daily basis, usually at 4 pm every day, to reflect changes in the underlying investments, which are usually stocks and bonds. All shares are also purchased or redeemed at the NAV. In an open-end fund, one deals with the fund itself when buying shares.

Open end mutual fund consists of equity funds, bond funds, and money market funds. They can be further divided into the following types of funds:

#### Money Market Funds

Fund manager invests in fixed income securities with a maturity period of less than a year. These act as an alternative to a savings account in a bank since they usually offer higher interest rates as compared to a bank savings account.

#### Bond Funds

These funds invest in fixed-income securities with a maturity period greater than a year.

Equity funds

These funds can either be actively managed funds (where investors apply their expertise to achieve the objectives of the fund) or index funds (where the equities track a specific fund, for example, the FTSE 100). Tracking can be achieved by:

• Buying all the shares in the index in amounts that reflect their weight in the index;
• Choosing a smaller portfolio of representative stocks that have been proven to follow the index; or
• Using index futures.

To determine how well a fund has tracked its intended index, tracking error is applied. The most popular tracking area involves obtaining the mean square error, i.e., the squared root of the mean squared difference between the return of the funds and the index.

Funds that invest in more than one security are known as hybrid/multi-asset funds.

## Closed End Mutual Funds

In a closed-end mutual fund, shares are traded at a discount/premium to their net asset value (NAV). This is due to the presence of a management fee of 1% of the funds’ value each year. Instead of a fund growing at say 5%, the fund will grow at (5%-1%=4%).

The number of shares in a closed end fund does not change on a daily basis. Shares are publicly traded on an exchange, and therefore the price is a function of supply and demand. Shares are bought and sold through brokers. After the initial share sale, no more shares are issued.

Other differences:

$$\begin{array}{|l|l|l|} \hline Basis \quad for \quad comparison & Open-end \quad funds & Closed-end \quad funds \\ \hline Subscription & Available \quad for \quad subscription & Available \quad for \quad subscription \quad only \\ {} & throughout \quad the \quad year & during \quad a \quad few \quad specified \quad days \\ \hline Listing & Not \quad listed \quad on \quad a \quad stock \quad exchange. & Listed \quad on \quad an \quad exchange \quad for \\ {} & Transactions \quad occur \quad directly & trading \\ {} & through \quad the \quad fund & {} \\ \hline Transactions & Executed \quad at \quad the \quad end \quad of \quad the \quad day & Executed \quad in \quad real \quad time \\ \hline Maturity & No \quad fixed \quad maturity & Fixed \quad maturity \quad period, \quad say, \quad 3-5 \\ {} & {} & years \\ \hline Selling \quad price & NAV & Premium/discount \quad to \quad NAV \\ \hline Corpus & Variable & Fixed \\ \hline \end{array}$$

Exchange traded funds combine the features of both open and closed ended mutual funds. To create an ETF, an investor deposits money in exchange for shares in the ETF. The shares are then traded like shares of any other company.

Investors are allowed to give up their shares in exchange for the underlying assets. Investors can also obtain additional shares by adding assets with the same components as those already in the ETF.

Some undesirable trading behavior in mutual funds include:

• Late trading: This involves using market developments that occur after 4 pm to cancel or to carry out trade. An offense that is punishable by the law.
• Market timing: Market timing is brought about by the existence of stale prices (prices that do not reflect recent information or those that differ as a result of time zone differences). Market timing is not illegal; however, it requires large funds in order for it to be worthwhile.
• Front running/Tailgating: This is where traders use acquired information to trade for themselves before trading for their firm/clients. Front running is illegal in fund management.
• Directed brokerage: This Involves a contract between a mutual fund and a brokerage house. The mutual fund agrees to carry its trades through the brokerage house which agrees to recommend the fund to its clients. It is legal but frowned upon by regulators.

## Mutual funds vs. Hedge Funds

Hedge funds have fewer regulations as compared to mutual funds, can follow a diverse approach of trading strategies, and are not required to disclose their holdings on a daily basis. They, however, have additional restrictions on how to solicit funds from investors.

Other differences:

$$\begin{array}{|l|l|l|} \hline Basis \quad for \quad comparison & Mutual \quad funds & Hedge \quad funds \\ \hline Flexibility & Manager \quad has \quad lots \quad of \quad constraints & Manager \quad has \quad fewer \quad constraints. \\ {} & to \quad deal \quad with, \quad e.g., \quad limited \quad use \quad of & Can \quad use \quad leverage, \quad sell \quad short, \quad or \\ {} & leverage & even \quad use \quad derivatives \\ \hline Paperwork & Offered \quad via \quad a \quad prospectus & Offered \quad via \quad a \quad private \quad placement \\ {} & {} & memorandum \\ \hline Liquidity & Investors \quad can \quad withdraw \quad their & Investors \quad can \quad only \quad get \quad their \\ {} & money \quad any \quad day & money \quad periodically \\ \hline Self-investment & Manager \quad does \quad not \quad have \quad to \quad put & As \quad a \quad sign \quad of \quad good \quad faith, \quad the \\ {} & some \quad of \quad their \quad capital \quad in \quad the \quad fund & manager \quad is \quad expected \quad to \quad put \\ {} & {} & some \quad of \quad their \quad money \quad in \quad the \quad fund \\ \hline Advertisement & May \quad advertise \quad freely & Not \quad free \quad to \quad advertise \quad in \quad the \\ {} & {} & public \\ \hline Listing & Maybe \quad listed, \quad i.e., \quad closed-end & Cannot \quad be \quad listed \quad on \quad an \quad exchange \\ {} & funds & {} \\ \hline \end{array}$$

## Hedge Fund Fees, Hurdle Rate, High-Water Mark clause, and Clawback

Compared to mutual funds, hedge funds charge investors higher management/operational fees. These include:

• An annual management fee of 1%-3% of assets
• An incentive fee of 15%-30% of realized net profits

A typical hedge schedule that reads “2% + 30%” for example indicates that the fund charges 2% per year of assets under management and 30% of net profit. These high charges are designed to attract the best hedge managers.

As a precondition for imposing high incentive fees, investors may be offered several guarantees. These include:

• Hurdle rate: This is the minimum return that should be earned before the incentive fees are imposed.
• High-water mark clause: This requires the fund to recoup any prior losses before the investment manager is allowed to impose an incentive fee. Prior losses may be comprised of performance losses, management fees, and administrative fees. A proportional adjustment clause may apply so that if the investor suffers a loss and simultaneously withdraws part of their capital, the amount of previous loss to be recouped is adjusted proportionally.
• Claw back: A claw back is an action where hedge investors take back the incentive fees previously awarded to the hedge fund manager so as to offset current losses. A portion of the incentive fees is held in a recovery account so that when the investor makes a loss, they receive some compensation from that account.

## Prime Brokers

The transactions of a hedge fund are handled by a prime broker. These transactions include: lending them money, providing risk management services, providing hedging services, and carrying out stress tests on their portfolio.

## Common Hedge Fund Strategies

1. Long/short equity: As the name suggests, the long/short equity strategy involves maintaining long and short positions in equity and equity derivative securities. The fund manager buys the stocks they feel are undervalued while simultaneously selling those they feel are overvalued.
2. Dedicated short bias: The aim is to earn a return by maintaining a net short position in the market through a combination of long and short positions. This means that short positions take the lion’s share of the fund’s overall positions.
3. Distressed securities: This is an event-driven strategy that tends to focus on companies in distress (financial trouble). Positions in bonds or stocks can be both long and short. Funds that employ this strategy impose more stringent lock-up and withdrawal terms.
4. Fixed income arbitrage: This strategy seeks to profit from discrepancies in related fixed income instruments. The manager might buy long a bond that they feel is undervalued and simultaneously sell short a similar bond they think is overvalued.
5. Convertible arbitrage: This strategy seeks to profit from discrepancies in a company’s convertible securities relative to the company’s stock. It might involve taking a long position in a company’s convertible securities and simultaneously taking a short position in that company’s stock.
6. Merger arbitrage: The strategy entails taking opposing positions in two firms that are about to merge. The goal is to exploit price inefficiencies that may occur before and after a merger. In most cases, a merger announcement is followed by a spike in the stock of the acquiring company and a dip in the stock of the target. The latter is especially associated with failed bids. For a cash bid, the price paid for each stock is usually at a premium to the market price. Offers can take the form of cash or stock of the bidding firm. For a cash bid, the risk arbitrage position consists of buying the target’s stock and then waiting for it to move to the take over price. For a stock exchange deal, the acquirer offers to exchange each target share for Δ shares of the acquirer. The arbitrage position, therefore, consists of a long position in the target offset by a short position of Δ in the acquirer’s stock.
7. Emerging markets: This involves debt/equity investing in emerging markets. It’s a strategy that aims to identify emerging market shares that are overvalued or undervalued.
8. Global macro: This is a general investment strategy that involves making investment decisions guided by the economic/political outlook of a country. In other words, the strategy reflects global macroeconomic trends. They look for countries where the market seems not to be in equilibrium and place bets that the market will adjust and attain equilibrium once again.
9. Managed Futures: The manager invests in financial and commodities futures markets. They make directional bets with long/short positions.

## Research on Returns

### Mutual Fund Research

Actively managed mutual funds have been unable to beat the market after expenses for the past decades. This has been attributed to the fact that the market return is the return to all investors before expenses.

It has also been established, through a test called the persistence test, that only half of mutual funds had the capability to outperform a market in subsequent years after beating the market in the previous year. These findings have made investors prefer index funds to actively managed funds because index funds charge a lower fee and they equally perform better.

### Hedge Fund Research

Some hedge funds have been seen to report a good performance for a few years and then lose a large percentage of the funds under management.

The Barclay Hedge offers an index tracking of all hedge funds. Generally, Hedge funds perform better in bear markets and underperform in bull markets.

### Risks Faced by Hedge Funds

• Liquidity risk: occurs when the fund invests in illiquid assets
Liquidity is a function of (I) the size of the position, and (II) intrinsic liquidity of the instrument
• Pricing risk: some of the assets can be quite difficult to price, e.g., derivatives
• Counterparty risk: The manager gets into contracts with dealers, brokers, and clearing agents. There’s always a risk that these parties will renege on their obligations, putting the fund on the path of unprecedented losses.
• Short squeeze risk: The fund manager may be forced to purchase a security they had sold short sooner than anticipated when the investor from whom the security was borrowed comes calling early.
• Settlement risk: One or more parties in a transaction may fail to deliver securities as per the contract.

### Risks Face by Hedge Funds

• Liquidity risk: occurs when the fund invests in illiquid assets
Liquidity is a function of (I) the size of the position, and (II) intrinsic liquidity of the instrument
• Pricing risk: some of the assets can be quite difficult to price, e.g., derivatives
• Counterparty risk: The manager gets into contracts with dealers, brokers, and clearing agents. There’s always a risk that these parties will renege on their obligations, putting the fund on the path of unprecedented losses.
• Short squeeze risk: The fund manager may be forced to purchase a security they had sold short sooner than anticipated when the investor from whom the security was borrowed comes calling early.
• Settlement risk: One or more parties in a transaction may fail to deliver securities as per the contract.

## Hedge Fund Performance

There are no reliable data records that can help us to assess hedge fund performance over the years. Part of that has much to do with the discretion with which some hedge funds are managed.

Studies have shown that a majority of investors in hedge funds are drawn to the industry largely because of a number of biases. These include:

• Hedge funds tend to have a higher net return than bonds and stocks
• Hedge funds exhibit lower volatility of returns compared to equities
• Hedge fund Sharpe ratios tend to be higher than those of equities and bonds

### Survivorship Bias

The Tass hedge fund database on which most market analysts rely excludes small hedge funds and also those that have had a poor track record over the years. In other words, poor performers tend to drop out while strong performers march on. Thus, only the good funds are included in the database. The resulting performance analysis is therefore inherently biased. This type of bias is known as survivorship bias.

## Questions

### Question 1

A few months ago ABC Corp announced an ambitious takeover bid targeting Company $$X$$, one of its fiercest industrial competitors. ABC tabled an exchange offer with a ratio of 2. Just after the announcement, ABC and $$X$$ were trading at $30 and$50, respectively. Kelvin Lincon, a hedge fund manager, took a long position in $$X$$ and hedged it with ABC stock. The acquisition was successfully concluded a few weeks ago, and the prices have since moved to $40 and$80 for ABC and $$X$$, respectively. Determine the gain for each share of $$X$$.

1. $0, because the bid was successful 2.$10
3. -$10 4.$30

The position is long one share of Company $$X$$ offset by a position in 2 shares of ABC Corp.

Thus, the payoff per share is equal to:

$$\left( 80-50 \right) -2\left( 40-30 \right) =10$$

### Question 2

In which of the following positions would asset liquidity risk be most pronounced for a hedge fund?

1. A $50 million position in T-bonds 2. A$500 million position in T-bonds
3. A $50 million position in distressed securities 4. A$500 million position in distressed securities

Asset liquidity risk depends on two main aspects: (I) the size of the position, and (II) the intrinsic liquidity of the instrument. Distressed securities would attract fewer investors compared to T-bonds, so the former has more liquidity risk. A $500 million position would be less liquid compared to a$50 million position in the same instrument.