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

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

Learning Objectives @

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

17.1 The Asset Management Industry

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

17.1 The Asset Management Industry: Structure and Evolution

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

17.1 The Asset Management Industry: Structure and Evolution

17.2 Private Management and Advisory Firms

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

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

17.2 Private Management and Advisory Firms

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

17.2.1 Investment Strategy at a Private Money Management Firm

17.3 Organization and Management of Investment Companies

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

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

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

17.3.2 Closed-End versus Open-End Investment Companies

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

17.3.2 Closed-End versus Open-End Investment Companies

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

17.3.3 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

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

17.3.4 Investment Company Portfolio Objectives

17.3.4 Investment Company Portfolio Objectives

17.3.4 Investment Company Portfolio Objectives

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

17.3.4 Investment Company Portfolio Objectives

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

17.3.5 Breakdown by Fund Characteristics

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

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

17.3.7 Mutual Fund Organization and Strategy: An Example

17.4 Investing in Alternative Asset Classes

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

17.4 Investing in Alternative Asset Classes

17.4.1 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

17.4.1 Hedge Funds

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

17.4.2 Characteristics of a Hedge Fund

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

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

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

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

17.4.4 Risk Arbitrage Investing: A Closer Look

17.4.4 Risk Arbitrage Investing: A Closer Look

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

17.4.5 Hedge Fund Performance

17.4.6 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

17.4.6 Private Equity

17.4.6 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

17.4.6 Private Equity

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

17.4.6 Private Equity

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

17.4.6 Private Equity

17.4.6 Private Equity

17.5 Ethics and Regulation in the Professional Asset Management Industry

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

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

17.5.1 Regulation in the Asset Management Industry

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

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

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

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

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