Chapter Seventeen

Mutual Funds and Hedge

Funds

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Mutual Funds and Hedge Funds

Mutual
MutualFunds
Funds(MFs)
(MFs)and
andHedge
HedgeFunds
Funds(HFs)
(HFs)are
are
financial
financialinstitutions
institutions(FIs)
(FIs)that
thatpool
poolthe
thefinancial
financialresources
resources
of
ofindividuals
individualsand
andcompanies
companiesand
andinvest
investthose
thoseresources
resourcesin
in
portfolios
portfoliosof
ofassets
assets
The
Thefirst
firstMF
MFwas
wasestablished
establishedin
inBoston
Bostonin
in1924
1924
By
By1970
1970360
360MFs
MFsheld
heldabout
about$50
$50billion
billionin
inassets
assets
Money
Moneymarket
marketmutual
mutualfunds
funds(MMMFs)
(MMMFs)were
were
introduced
introducedin
in1970
1970
Tax-exempt
Tax-exemptMMMFs
MMMFswere
wereintroduced
introducedin
in1979
1979
By
By2007
2007more
morethan
than8,000
8,000MFs
MFsheld
heldover
over$12
$12trillion
trillionin
in
assets
assets
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Mutual Funds
Cash
Cashflows
flowsinto
intoMFs
MFsisishighly
highlycorrelated
correlatedwith
withthe
thereturn
return
on
onthe
theNYSE
NYSE
Growth
Growthhas
hasalso
alsoresulted
resultedfrom
fromthe
therise
risein
inretirement
retirementfunds
funds
under
undermanagement
managementby
byMFs
MFs
MFs
MFsmanaged
managed~~25%
25%of
ofretirement
retirementfund
fundassets
assetsinin2007
2007

MFs
MFsare
arethe
thesecond
secondmost
mostimportant
importantgroup
groupof
ofFIs
FIsas
as
measured
measuredby
byasset
assetsize,
size,second
secondonly
onlyto
tocommercial
commercialbanks
banks
Banks
Banksshare
shareof
ofall
allMF
MFassets
assetshas
hasgrown
grownto
to21%
21%in
in2007
2007
Insurance
Insurancecompanies
companiesmanaged
managed10%
10%of
ofMF
MFindustry
industryassets
assets
in
in2007
2007
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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
The
The barriers
barriers to
to entry
entry in
in the
the MF
MF industry
industry are
are low
low
the
thelargest
largestMF
MFsponsors
sponsorshave
havenot
notincreased
increasedtheir
their
market
marketshare
sharerecently
recently

the
thelargest
largest25
25MF
MFcompanies
companiesmanaged
managed76%
76%of
ofindustry
industryassets
assets
inin1990
1990
the
thelargest
largest25
25MF
MFcompanies
companiesmanaged
managed71%
71%of
ofindustry
industryassets
assets
inin2007
2007

the
thecomposition
compositionof
ofthe
thetop
top25
25firms
firmsin
inthe
theindustry
industryhas
has
changed
changed
seven
sevenof
ofthe
thelargest
largest25
25firms
firmsinin2007
2007were
werenot
notamong
amongthe
thetop
top
25
25inin1990
1990

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
The
TheMF
MFindustry
industryhas
hastwo
twosectors
sectors

short-term
short-termfunds
fundsinvest
investin
insecurities
securitieswith
withoriginal
original
maturities
maturitiesof
ofless
lessthan
thanone
oneyear
year
money
moneymarket
marketmutual
mutualfunds
funds
tax-exempt
tax-exemptmoney
moneymarket
marketmutual
mutualfunds
funds

long-term
long-termfunds
fundsinvest
investin
inportfolios
portfoliosof
ofsecurities
securitieswith
with
original
originalmaturities
maturitiesof
ofmore
morethan
thanone
oneyear
year

equity
equityfunds
fundsconsist
consistof
ofcommon
commonand
andpreferred
preferredstock
stock
bond
bondfunds
fundsconsist
consistof
offixed-income
fixed-incomecapital
capitalmarket
marketdebt
debt
securities
securities
hybrid
hybridfunds
fundsconsist
consistof
ofboth
bothstock
stockand
andbond
bondsecurities
securities

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Approximately
Approximately25%
25%of
oflong-term
long-termfunds
fundsare
areindex
indexfunds
funds

index
indexfunds
fundsare
arefunds
fundsininwhich
whichmanagers
managersbuy
buysecurities
securitiesinin
proportions
proportionssimilar
similartotothose
thoseincluded
includedininaaspecified
specifiedmajor
majorindex
index
index
indexfunds
fundsinvolve
involvelittle
littleresearch
researchor
ormanagement,
management,which
whichresults
results
ininlower
lowermanagement
managementfees
feesand
andhigher
higherreturns
returnsthan
thanactively
actively
managed
managedfunds
funds

Exchange
Exchangetraded
tradedfunds
funds(ETFs)
(ETFs)are
arealso
alsodesigned
designedto
to
replicate
replicatemarket
marketindexes
indexes

traded
tradedon
onexchanges
exchangesatatprices
pricesdetermined
determinedby
bythe
themarket
market
management
managementfees
feesare
arelower
lowerthan
thanactively
activelytraded
tradedfunds
funds
unlike
unlikeindex
indexfunds,
funds,ETFs
ETFscan
canbe
betraded
tradedduring
duringthe
theday,
day,sold
soldshort,
short,
and
andpurchased
purchasedon
onmargin
margin

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Money
Money market
market mutual
mutual funds
funds (MMMFs)
(MMMFs)
provide
provide an
an alternative
alternative investment
investment to
to interestinterestbearing
bearing deposits
deposits at
at commercial
commercial banks
banks

bank
bankdeposits
depositsare
arerelatively
relativelyless
lessrisky,
risky,because
becausethey
theyare
are
FDIC
FDICinsured,
insured,and
andgenerally
generallyoffer
offerlower
lowerreturns
returnsthan
than
MMMFs
MMMFs

Households
Households own
own the
the majority
majority of
of MFs
MFs

owned
owned69.6%
69.6%of
oflong-term
long-termfunds
fundsin
in2007
2007
owned
owned46.0%
46.0%of
ofshort-term
short-termfunds
fundsin
in2007
2007
48.0%
48.0%of
ofall
allU.S.
U.S.households
householdsowned
ownedMFs
MFsin
in2006
2006
which
whichrepresents
represents~56.3
~56.3million
millionhouseholds
households

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
MF
MF managers
managers must
must specify
specify their
their funds
funds investment
investment
objectives
objectives in
in aa prospectus,
prospectus, which
which isis made
made
available
available to
to potential
potential investors
investors
holds
holdslists
listsof
ofthe
thesecurities
securitiesinvested
investedin
inby
bythe
thefunds
funds
in
in1998
1998the
theSecurities
Securitiesand
andExchange
ExchangeCommission
Commission
(SEC)
(SEC)mandated
mandatedthat
thatprospectuses
prospectusesmust
mustbe
bewritten
writtenin
in
plain
plainEnglish
Englishinstead
insteadof
ofoverly
overlylegal
legallanguage
language(i.e.,
(i.e.,
legalese)
legalese)

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Equity
Equityfunds
fundsrepresent
represent56.7%
56.7%of
ofMF
MFassets
assetsinin2007
2007(~$5.9
(~$5.9trillion)
trillion)

capital
capitalappreciation
appreciationfunds
funds(25.9%)
(25.9%)
world
equity
(12.6%)
world equity (12.6%)
total
totalreturn
return(18.2%)
(18.2%)

corporate
corporatebonds
bonds(2.6%)
(2.6%)
high-yield
high-yieldbonds
bonds(1.5%)
(1.5%)
world
bonds
(0.6%)
world bonds (0.6%)
government
governmentbonds
bonds(1.9%)
(1.9%)
strategic
strategicincome
incomebonds
bonds(4.3%)
(4.3%)
state
statemunicipal
municipalbonds
bonds(1.5%)
(1.5%)
national
nationalmunicipal
municipalbonds
bonds(2.0%)
(2.0%)

Hybrid
Hybridfunds
fundsrepresent
represent6.3%
6.3%of
ofMF
MFassets
assets(~$0.7
(~$0.7trillion)
trillion)
Bond
Bondfunds
fundsrepresent
represent14.4%
14.4%of
ofMF
MFassets
assets(~$1.5
(~$1.5trillion)
trillion)

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Money
Moneymarket
marketfunds
fundsrepresent
represent22.6%
22.6%of
ofMF
MFassets
assets($2.4
($2.4trillion)
trillion)

taxable
taxablefunds
funds(19.1%)
(19.1%)
tax-exempt
tax-exemptfunds
funds(3.5%)
(3.5%)

Four
Fourof
ofthe
thefive
fivelargest
largestMFs
MFsininthe
theU.S.,
U.S.,as
asof
ofFebruary
February6,6,2008,
2008,were
were
managed
by
the
same
company
managed by the same company
American
AmericanFunds
FundsGrowth;A
Growth;A

aagrowth
growthfund
fundwith
with$91.4
$91.4billion
billionininassets
assets

American
AmericanFunds
FundsCWGI;A
CWGI;A

an
aninternational
internationalfund
fundwith
with$83.0
$83.0billion
billionininassets
assets

American
AmericanFunds
FundsCIB;A
CIB;A

an
anincome
incomefund
fundwith
with$81.6
$81.6billion
billionininassets
assets

Fidelity
FidelityInvest:
Invest:Contra
Contra

aagrowth
growthfund
fundwith
with$80.9
$80.9billion
billionininassets
assets

American
AmericanFunds
FundsInvCoA
InvCoA

aagrowth/income
growth/incomefund
fundwith
with$73.5
$73.5billion
billionininassets
assets

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Investor
Investorreturns
returnsfrom
fromMF
MFownership
ownershipreflect
reflectthree
three
components
components

income
incomeand
anddividends
dividendson
onportfolio
portfolioassets
assets
capital
capitalgains
gainson
onassets
assetsbought
boughtand
andsold
soldatathigher
higherprices
prices
capital
capitalappreciation
appreciationon
onassets
assetsheld
heldininthe
thefund
fund

MF
MFassets
assetsare
areusually
usuallymarked
markedto
tomarket
marketdaily
daily

prices
pricesare
areadjusted
adjusteddaily
dailytotoreflect
reflectchanges
changesininthe
thecurrent
currentmarket
market
prices
pricesof
ofthe
theportfolios
portfoliosassets
assets

Then
Thennet
netasset
assetvalue
value(NAV)
(NAV)of
ofaaMF
MFshare
shareisisequal
equalto
tothe
the
market
marketvalue
valueof
ofthe
theassets
assetsin
inthe
theMF
MFportfolio
portfoliodivided
dividedby
by
the
thenumber
numberof
ofshares
sharesoutstanding
outstanding
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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
An
An open-end
open-end MF
MFisis aa fund
fund for
for which
which the
the supply
supply
of
of shares
shares isis not
not fixed
fixed but
but can
can increase
increase or
or decrease
decrease
daily
daily with
with purchases
purchases and
and redemptions
redemptions of
of shares
shares
A
Aclosed-end
closed-end investment
investment company
company isis aa
specialized
specialized investment
investment company
company that
that has
has aa fixed
fixed
supply
supply of
of outstanding
outstanding shares,
shares, but
but invests
invests in
in the
the
securities
securities and
and assets
assets of
of other
other firms
firms
A
Areal
real estate
estate investment
investment trust
trust isis aa closed-end
closed-end
investment
investment company
company that
that specializes
specializes in
in investing
investing
in
in mortgages,
mortgages, property,
property,or
or real
real estate
estate company
company
shares
shares
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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
MFs
MFscharge
chargeinvestors
investorsfees
feesfor
forthe
theservices
servicesthey
theyprovide
provide

sales
salesloads
loads
12b-1
12b-1fees
feesare
arefees
feesrelated
relatedtotothe
thedistribution
distributioncosts
costsof
ofMF
MFshares
shares
cannot
cannotexceed
exceed1%
1%of
ofaverage
averageannual
annualnet
netassets
assetsfor
forload
loadfunds
funds
cannot
cannotexceed
exceed0.25%
0.25%of
ofaverage
averageannual
annualnet
netassets
assetsfor
forno-load
no-load
funds
funds

MFs
MFsmay
mayoffer
offerdifferent
differentshare
shareclasses
classeswith
withdifferent
differentcombinations
combinations
of
ofloads
loads

AAload
loadfund
fundisisan
anMF
MFwith
withan
anup-front
up-frontsales
salesor
or
commission
commissioncharge
chargethat
thatthe
theinvestor
investormust
mustpay
pay
AAno-load
no-loadfund
fundisisan
anMF
MFthat
thatdoes
doesnot
notcharge
chargeup-front
up-front
sales
salesor
orcommission
commissioncharges
chargeson
onthe
thesale
saleof
ofmutual
mutualfund
fund
shares
sharesto
toinvestors
investors
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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
MFs
MFsare
areheavily
heavilyregulated
regulatedbecause
becausethey
theymanage
manageand
and
invest
investsmall
smallinvestor
investorsavings
savings

The
TheSEC
SECisisthe
theprimary
primaryregulator
regulator
The
TheSecurities
SecuritiesAct
Actof
of1933
1933
The
TheSecurities
SecuritiesExchange
ExchangeAct
Actof
of1934
1934
The
TheInvestment
InvestmentAdvisers
AdvisersAct
Actand
andInvestment
InvestmentCompany
CompanyAct
Actof
of
1940
1940
The
TheInsider
InsiderTrading
Tradingand
andSecurities
SecuritiesFraud
FraudEnforcement
EnforcementAct
Actof
of
1988
1988
The
TheMarket
MarketReform
ReformAct
Actof
of1990
1990
The
TheNational
NationalSecurities
SecuritiesMarket
MarketImprovement
ImprovementAct
Act(NSMIA)
(NSMIA)of
of
1996
1996

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2009, The McGraw-Hill Companies, All Rights

Mutual Funds
Even
Even with
with heavy
heavy regulation,
regulation, investor
investor abuses
abuses still
still
occur
occur

market
markettiming
timingisisshort-term
short-termtrading
tradingthat
thatprofits
profitsfrom
from
out-of-date
out-of-datevalues
valueson
onthe
thesecurities
securitiesin
inthe
thefunds
funds
portfolio
portfolio
late
latetrading
tradinginvolves
involvesbuys
buysand
andsells
sellslong
longafter
afterprices
prices
have
havebeen
beenset
setatat4:00
4:00pm
pmE.T.
E.T.
directed
directedbrokerage
brokerageoccurs
occurswhen
whenbrokers
brokersimproperly
improperly
influence
influenceinvestors
investorson
ontheir
theirfund
fundrecommendations
recommendations
improperly
improperlyassessed
assessedfees
feesoccur
occurwhen
whenbrokers
brokerstrick
trick
customers
customersinto
intothinking
thinkingthey
theyare
arebuying
buyingno-load
no-loadfunds
funds
or
orfail
failto
toprovide
providediscounts
discountsproperly
properly

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2009, The McGraw-Hill Companies, All Rights

Hedge Funds
Hedge
Hedgefunds
funds(HFs)
(HFs)are
areinvestment
investmentpools
poolsthat
thatsolicit
solicit
funds
fundsfrom
fromwealthy
wealthyindividuals
individualsand
andother
otherinvestors
investors(e.g.,
(e.g.,
commercial
commercialbanks)
banks)and
andinvest
investthese
thesefunds
fundson
ontheir
theirbehalf
behalf

similar
similartotoMFs,
MFs,but
butnot
notrequired
requiredtotoregister
registerwith
withthe
theSEC
SEC
subject
subjecttotovirtually
virtuallyno
noregulatory
regulatoryoversight
oversightand
andthus
thusgenerally
generallycan
can
(and
do)
take
significant
risk
(and do) take significant risk
do
donot
nothave
havetotodisclose
disclosetheir
theiractivities
activitiestotothird
thirdparties
partiesand
andthus
thus
offer
a
high
degree
of
privacy
offer a high degree of privacy

HFs
HFsavoid
avoidregulation
regulationby
bylimiting
limitingthe
thenumber
numberof
of
investors
investorsto
toless
lessthan
than100
100and
andby
byrequiring
requiringinvestors
investorsto
to
be
beaccredited
accredited
accredited
accreditedinvestors
investorshave
havenet
networth
worthover
over$1
$1million
millionor
orannual
annual
income
over
$200,000
if
single
(or
$300,000
if
married)
income over $200,000 if single (or $300,000 if married)

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2009, The McGraw-Hill Companies, All Rights

Hedge Funds
HFs
HFs use
use more
more aggressive
aggressive trading
trading strategies
strategies than
than
MFs
MFs such
such as
as short
short selling,
selling, leverage,
leverage, program
program
trading,
trading, arbitrage,
arbitrage, and
and the
the use
use of
of derivatives
derivatives
Because
Because HFs
HFs are
are not
not registered,
registered, they
they cannot
cannot be
be
accurately
accurately tracked
tracked

~~9,000
9,000HFs
HFsin
inthe
theU.S.
U.S.in
in2008
2008
~~$2.8
$2.8trillion
trillionin
inassets
assetsin
in2008
2008
~~new
newassets
assetsflow
flowin
inatataarate
rateof
ofabout
about$300
$300billion
billion
annually
annually
~~the
the100
100largest
largestHFs
HFscontrol
controlabout
about70%
70%of
ofthe
theindustry
industry
in
in2008
2008

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2009, The McGraw-Hill Companies, All Rights

Hedge Funds
There
There are
are three
three basic
basic types
types of
ofHFs
HFs
the
themost
mostrisky
riskyHFs
HFsuse
usemarket
marketdirectional
directionaltrading
trading
strategies,
strategies,seek
seekhigh
highreturns
returnsusing
usingleverage,
leverage,and
andinvest
invest
based
basedon
onanticipating
anticipatingevents
events
moderate
moderaterisk
riskHFs
HFshave
haveaamarket
marketneutral
neutral(or
(orvalue)
value)
orientation
orientationthat
thatfavors
favorslonger-term
longer-terminvestment
investment
strategies
strategies
risk
riskavoidance
avoidanceHFs
HFstake
takeaamarket
marketneutral
neutralapproach
approach
and
andstrive
strivefor
forconsistent
consistentreturns
returnswith
withlow
lowrisk
risk

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2009, The McGraw-Hill Companies, All Rights

Hedge Funds
Management
Managementfees
feeson
onHFs
HFsare
arecomputed
computedas
asaapercent
percentof
of
assets
assetsunder
undermanagement
managementand
andrun
runbetween
between1.5%
1.5%and
and2%
2%
Performance
Performancefees
feesgive
givefund
fundmanagers
managersaashare
shareof
ofany
any
positive
positivereturns
returnsearned
earned

the
theaverage
averageisis20%,
20%,but
butperformance
performancefees
feesvary
varysubstantially
substantially
depending
on
the
HF
depending on the HF
aahurdle
hurdlerate
rateisisaabenchmark
benchmarkthat
thatmust
mustbe
berealized
realizedbefore
beforeaa
performance
performancefee
feecan
canbe
beassessed
assessed
aahigh-water
high-watermark
markisiswhen
whenaamanager
managerdoes
doesnot
notreceive
receiveaa
performance
performancefee
feeunless
unlessthe
thevalue
valueof
ofthe
thefund
fundexceeds
exceedsthe
thehighest
highest
NAV
it
has
previously
achieved
NAV it has previously achieved

Offshore
OffshoreHFs
HFsare
areattractive
attractiveto
toinvestors
investorsbecause
becausethey
they
provide
provideanonymity
anonymityand
andare
arenot
notsubject
subjectto
toU.S.
U.S.taxes
taxes
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2009, The McGraw-Hill Companies, All Rights

Hedge Funds
HFs
HFsare
areexempt
exemptfrom
fromregistration
registrationrequirements
requirementsset
setforth
forth
by
bythe
theInvestment
InvestmentCompany
CompanyAct
Actof
of1940
1940

HFs
HFshave
haveless
lessthan
than100
100investors
investorseach,
each,accredited
accreditedinvestors,
investors,and
and
are
sold
only
as
private
placements
are sold only as private placements

HFs
HFsare
areprohibited
prohibitedfrom
fromabusive
abusive(i.e.,
(i.e.,illegal)
illegal)trading
trading
practices
practices
In
In2003
2003the
theSEC
SECrecommended
recommendedthat
thatlarge
largeHFs
HFsregister
register
with
withthe
theSEC
SECas
asinvestment
investmentadvisors
advisors
approximately
approximately25%
25%of
ofHFs
HFswere
werealready
alreadyregistered
registered

In
In2007
2007the
theU.S.
U.S.Treasury,
Treasury,the
theFederal
FederalReserve,
Reserve,the
theSEC,
SEC,
and
andthe
theCFTC
CFTCconcluded
concludedthat
thatcurrent
currentHF
HFregulation
regulationwas
was
sufficient
sufficient
McGraw-Hill/Irwin

17-20

2009, The McGraw-Hill Companies, All Rights