### Mutual Funds and Hedge Funds

After completing this reading, you should be able to:

• Differentiate among open-end mutual funds, closed-end mutual funds, and exchange-traded funds (ETFs).
• Calculate the net asset value (NAV) of an open-end mutual fund.
• 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.
• 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.

# Active vs. Passive Management

An actively managed mutual fund refers to a fund in which a manager or a management team makes decisions about how to invest the fund’s money. In such a fund, the managers rely on their analytical skills, forecasts, and their own judgment to make buy/sell/hold decisions. Proponents of active management disagree with the efficient market hypothesis which asserts that it’s impossible to beat the market in an efficient market. They argue that it is possible to outperform the market by identifying mispriced securities.

A passively managed mutual fund, on the other hand, is a fund that simply follows a market index such as the S&P 500. It does not have a management team charged with making investment decisions. Instead, the fund invests in the securities included in the index.

Although actively managed funds have higher costs than passively managed funds, they do not always outperform the (market) index. Recent research overwhelmingly suggests that in the long-term, index-tracking funds generally outperform actively managed funds.

The excess return of an investment relative to the return of a benchmark index is referred to as the investment’s alpha. According to research, when a manager has achieved above-average returns for one year (or several years in a row), the probability of achieving above-average returns in the next year is roughly 50%. The results strongly suggest that obtaining positive alphas occurs is a matter of luck, not skill.

## 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 where the funds are used to invest in securities such as stocks and bonds. The portfolio of investments is operated by a manager whose mandate is to generate income or capital gains for the investors. A mutual has strict investment objectives which must be followed by the manager at all times. These objectives are laid down in the fund’s prospectus.

Index funds are mutual funds designed to track a particular stock index such as the S&P 500. 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.
• Using index futures.

It’s important to note that a mutual fund is both an investment and a company. However, it does not produce or sell any tangible product as most companies do. Rather, it’s in the business of making investments. A mutual fund can be open-end or closed-end.

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 and then divided by the number of shares outstanding., i.e.,

$$NAV=\frac { market\quad value\quad of\quad assets\quad of\quad assets\quad at\quad close\quad of\quad business-liabilities }{ no\quad of\quad outstanding\quad shares }$$

NAV changes on a daily basis 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.

In a closed-end mutual fund, shares are traded at a discount/premium to their net asset value(NAV). The reason behind this is that the 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:

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

An exchange-traded fund (ETF) is a relatively recent investment vehicle that tracks an index, a commodity, or even a basket of assets. Just like closed-end funds, an ETF’s shares are traded on an exchange. However, they differ from closed-end funds in several aspects:

• The share price hews more closely to the NAV than closed-end funds. Among large EFTs, discounts and premiums stay within 1% of the NAV
• Institutional investors have the liberty to exchange the EFT’s shares for the underlying assets, or even deposit new assets and receive shares in return.

Unlike open-end funds, ETFs:

• Can be traded at any time of the day, hence are more liquid
• Have lower expense ratios

## Mutual funds vs. Hedge Funds

Hedge funds and mutual funds both involve the pooling of funds, but unlike mutual funds (closed-end), hedge funds are not listed on an exchange. Furthermore, hedge funds involve a limited number of investors, mostly high net worth individuals or organizations.

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.

## 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.

### 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)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.