1. Beyond Traditional Funds

2. Mutual Funds as Institutional Investors
Because of their extensive stock ownership, mutual funds can have an influence on decision-making at public companies.
They exercise this influence through the proxy voting process.
Mutual funds are required to provide information on their proxy voting policies and procedures and on the votes they cast.
Activist investors attempt to use the proxy voting process to increase shareholder value.
Socially responsible investors seek societal change as well as a financial return. Responsible investing considers environmental, social, and governance factors as part of the investment process.

3. The Importance of Institutional Investors
The largest owners of stock in the United States are now institutional investors who manage money for others.

4. The Importance of Mutual Funds
Mutual funds are the largest holders of stock among institutional investors.
U.S. Holdings of Stocks by Institutional Investor Type
Source: SIFMA, Fact Book 2009

5. Corporate Governance Stockholders are the owners of a company.
They elect a board of directors to represent their interests.
The board appoints a CEO to manage day-to-day operations.
The board oversees the work of the management team and guide the company on strategic initiatives.
Stockholders also vote on other significant matters.
The specifics of corporate governance are determined by:
State law.
Stock exchange rules.
Federal regulations.
The company’s charter and by-laws

6. Indirect Stockholder Control

7. Stockholder Meetings
Most companies are required to hold a stockholder meeting at least once a year.
At these meetings, stockholders elect a board of directors and vote on other proposals.
Companies send detailed information about the proposals to shareholders before the meeting in a proxy statement.
Most proposals are submitted by management, though some may be submitted by stockholders.
Few stockholders physically attend the meeting; most cast their votes in advance.
This process is call proxy voting.

8. Proxy Voting by Mutual Funds
Mutual funds must publicly disclose:
Their proxy voting policies and procedures.
The proxy votes cast throughout the year.
How they manage conflicts of interest with regard to voting proxies.
Mutual fund proxy voting policies:
Generally begin with a statement of principle, which is often to vote in the best, long-term economic interest of fund investors.
Outline how the fund will vote on the most common proposals.
Director elections and executive compensation are usually covered.
State that votes on other proposals will be determined on a case-by-case basis.
They may explain the general principles that will be used to evaluate these proposals.

9. Proxy Voting Decisions
Institutional investors may consult the following when making proxy voting decisions:
Academic research.
Proxy advisory firms.
The leading firms are RiskMetrics and Glass Lewis.
Engagement = information provided by companies.
Fund boards of directors.
Boards approve proxy voting policies and review votes at least annually.
Some boards may determine votes on specific issues.

10. Stockholder Activism
Activist investors seek to earn a return by advocating change at a company. They may:
Nominate an alternative slate of directors.
Express dissatisfaction with management in the media.
Submit shareholder proposals.
Lobby against management’s recommendations.
Some state and union pension funds have become prominent activists.
Many of these funds have a substantial proportion of their assets invested in stock index funds.

13. The Competition from Exchange Traded Funds and Hedge Funds
ETFs and hedge fund have experienced tremendous growth recently.
ETFs use an unusual share creation process, which helps to make ETFs very tax-efficient and to keep the market price close to NAV.
Most ETFs are passively managed, though they use a wide variety of indexes.
Hedge funds are unregulated and use a wide range of investment strategies.
There is dispute about the benefits of hedge funds.

14. The ETFs Markets

15. The Growth of ETFs

16. Advantages of ETFs Exchange-traded No investment minimum
Shares can be bought and sold throughout the day.
Exchange-traded
Can be bought in quantities as small as one share.
No investment minimum
Many are index funds with lower expenses.
No shareholder servicing costs.
Lower expense structure
Some ETFs invest in commodities and currencies.
Broader set of investments
ETFs tend to generate fewer capital gains because they are often index funds and because of the in-kind nature of the share creation process.
Tax efficiency

17. Disadvantages of ETFs Daily redemption at NAV No trading commissions
Investors in traditional mutual funds are guaranteed to receive the NAV when they redeem.
Investors in ETFs receive the market price, which can be higher or lower than the NAV.
Daily redemption at NAV
Investors in ETFs pay brokerage commissions when they buy or sell shares.
No trading commissions
Most ETFs are passively-managed index funds.
Broader array of actively-managed strategies

18. Types of ETFs Investment company ETFs Commodity ETFs
Invest in securities.
Organized as open-end mutual funds or unit trusts.
Regulated under the 1940 Act.
Investment company ETFs
Invest in commodities, real estate or currencies, either directly or through derivatives.
Organized as partnerships, investment trusts or grantor trusts.
Regulated by the SEC, but not subject to the 1940 Act.
Commodity ETFs
Bonds, usually issued by a bank.
Return is linked to the performance of an index or basket of securities, commodities or currencies.
Exchange-traded notes

19. Creating an ETF Establishing a new ETF is a complicated process.
ETFs must file an exemptive application with the SEC, asking for relief from some of the Act regulations.
For example, ETFs don’t redeem shares at NAV every day, though this is a requirement for traditional funds.
ETFs must organize a group of authorized participants who are essential to the creation of ETF shares.
Authorized participants are usually hedge funds, market makers or broker-dealers.

20. Creation Process for ETF Shares
Sale of Creation Unit Shares
The authorized participant breaks down the block of shares and either holds onto them or sells them in the public market.
Exchange for Creation Unit
In exchange for the creation basket, the AP receives a creation unit, which is a large block of ETF shares (usually 25,000 or 250,000).
Assemble Creation Basket
An authorized participant (AP) assembles a creation basket, a portfolio of securities that exactly matches the portfolio of securities held by the ETF, based on a portfolio composition file the fund publishes daily.

21. Creation Process for ETF Shares

22. Advantages of the Creation Process
Tax efficiency.
Because the creation process involves an in-kind exchange of a creation unit for a creation basket, it is not a taxable event.
It allows the ETFs to pass securities with capital gains on to authorized participants.
Market price vs. NAV.
The creation process helps to keep the market price for ETF shares close to the NAV.
Authorized participants can earn a profit by arbitraging any differences.
To ensure that the arbitrage process works smoothly, the exchange where the ETF is traded publishes an intraday indicative value – an estimate of NAV – at 15-minute intervals.
The arbitrage process has worked fairly well at keeping ETF share prices and NAVs in line – but it’s not perfect.

23. ETF Pricing (September 2009)
Percentage Discount or Premium versus NAV
Percent of ETFs
Cumulative Percent
 0.25% discount 5%
0.26% – 0.50% discount 6%
10%
0.11% – 0.25% discount
14%
25%
0.10% discount – 0.10% premium
33%
59%
0.11% – 0.25% premium
11%
70%
0.26% – 0.50% premium
12%
82%
> 0.50% premium
18%
100%
Source: Cerulli Associates, The Cerulli Report: Exchange-Traded Funds: Threat or Threatened? (2009)

24. ETF Investment Strategies
Index ETFs
Most ETFs are passively-managed.
Investment approach (sampling or replication) may be limited by organizational structure of the ETF.
Some ETFs use specialized or custom indexes.
Some index ETFs are very aggressive and replicate a leveraged or short index (or a leveraged, short index!).
These funds generally target their indexes daily.
Investment goal is to minimize tracking error.
Active ETFs
There are only a handful of active ETFs.
Most are fixed-income funds.
Because ETFs publish their portfolios daily, there is concern that active ETFs will be subject to front running.

25. Sources of Tracking Error
The higher the fees and expenses, the higher the tracking error.
Fees and expenses
Narrow indexes can be concentrated in a few holdings; they may be difficult to replicate while still meeting diversification requirements.
Diversification requirements
If replication is not used.
May not track index exactly.
Sampling
If cash is held, it will not generate index returns.
Cash management

26. Volatility ETF
Typically moves inversely to major market indices, such as the S&P 500
When the S&P 500 is rising volatility ETFs will typically decline.
A strong uptrend in the S&P 500 means a downtrend in volatility ETFs, and vice versa.
Day traders can exploit the big moves that occur in volatility ETFs at major market reversal points, as well as when the major indexes are in a strong decline.

27. Household Characterstics

28. Risk Tolerance

29. What is Hedge Funds
Hedge funds are commingled investment vehicles that are not regulated. They may:
Invest in a wide variety of assets.
Require investors to remain in the fund for long periods.
Use leverage to enhance returns.
Sell securities short extensively.
Charge performance fees based on gains.
. . .though they are not required to do any of these things to be a hedge fund.

30. Advantages of Hedge Funds (1)
Investors believe that managers can generate returns with positive alpha.
Alpha (above-market returns)
Hedge funds are intended to provide positive returns in any market environment.
Absolute returns
Hedge funds are intended to provide lower variations in returns.
They take offsetting positions to reduce volatility.
Lower volatility
Returns are intended to have low correlations with traditional investments.
Low correlation

31. Advantages of Hedge Funds (2)
Because they are exempt from regulatory restrictions, hedge funds can invest in many kinds of assets.
Unique strategies and assets
Hedge funds are thought to attract high-caliber investment talent.
Star management talent
Hedge fund managers often invest substantial personal assets in their funds.
Manager co-investment

32. Disadvantages of Hedge Funds
Hedge funds have often failed to deliver on their promises.
Advantages reconsidered
Hedge fund fees are much higher than mutual fund fees.
High fees
Investors have limited ability to redeem from a hedge fund.
Lack of liquidity
Hedge funds generally don’t provide much information about their investments.
Transparency
Studies have shown that average hedge fund returns are substantially overstated.
Overstatement of performance results

33. Hedge Fund Fees Hedge fund fees typically have two components:
Management fee.
Typically 2% of assets.
Carried interest or carry = performance fee.
Typically 20% of realized capital gains.
Usually subject to a high water mark so that the carry is not earned unless the value of the hedge fund has increased.
The typical fee is referred to as “2 and 20”.

34. Hedge Fund Strategies (1)
Buy undervalued stocks and sell overvalued stocks short at the same time.
Equity long-short
Look at the relationship between two securities, and trade when they appear out of line.
Relative value or arbitrage
Buy securities of companies near bankruptcy.
Distressed securities
Buy securities and press for corporate change.
Shareholder activism

35. Hedge Fund Strategies (2)
Invest based on a macroeconomic outlook.
Global macro
Trade futures contracts.
Managed futures
Invest using a range of strategies.
Multistrategy
Borrow money or use derivatives to boost returns.
Used with many of the preceding strategies.
Leverage

36. Hedge Fund Investors Institutional investors. Individual investors.
Account for a growing proportion of industry assets.
Individual investors.
Particularly important for start-up funds.
Fund of funds.
Invest in other hedge funds.
Claim to add value by selecting superior hedge funds, though this has been questioned.
Charge additional fees, usually “1 and 10”.

37. Avoiding Regulation
Hedge funds avoid U.S. regulation by making only a private offering in the United States.
They do not market or advertise.
They limit the type and number of investors.
They accept a maximum of 100 accredited investors
At least $1 million excluding their home
Or income of at least $200,000 (adjusted for inflation)
Alternatively, they can accept 499 investors with at least $5 million in investments.
Many hedge funds require a $5 million investment.

38. Why (Not) Regulate Hedge Funds?
The large investors in hedge funds watch out for themselves.
Because of their small size and the diversity of their strategies, hedge funds do not pose a systemic risk.
Hedge fund investors, creditor and counterparties effectively regulate hedge funds.
Why
Even large investors have sometimes needed protection.
Small hedge funds have caused financial panics in the past.
Some of the supposed regulators pose a risk to the system themselves.