Chapter 5
Asset Management Companies
• Large institutional clients will utilize firms to manage part or all of their assets
• The size of these asset management firms are ranked by assets under management
(AUM)
• There are various types of management fees charged by these asset management
firms
Types of Investment Companies
• Open-End Funds (Mutual Funds)
• Portfolio composed of securities
• Ready to sell new shares and redeem outstanding shares on demand
at net asset value (NAV)
The NAV is computed daily at the close of the market
Net Asset Value (NAV)
• [(Market value of portfolio) (Liabilities)] (Number of shares outstanding)
• Mutual fund has 10 million shares
• Market value of portfolio is $215 million
• Liabilities are $15 million
• NAV = $20
Disadvantages
• Investors must buy/sell based on the closing price or NAV and cannot trade
on an intra-day basis
• Some funds create taxable events even though the investor maintains their
positions
Closed-End Funds
• Portfolio composed of securities
• Number of shares fixed and trades like common stock
• Investors pay a broker commission
• Value may differ significantly from the NAV
Unit Trust
• Portfolio typically composed of bonds
• There is no active trading of the assets
• Have a fixed termination date
• Trustee will not alter the composition of the portfolio
Charges
• Sales Charges
– Salesforce (wholesale) distribution occurs via agent or stockbroker
• Front-end load at time of investment
• Back-end load at time of sale or redemption
• contingent deferred sales charge based on time invested in mutual
fund
• Sales Charges
• Level load constant charge as opposed to one time charge
• No-load no sales charge
– Direct Distribution
• From the fund to the investor
• Annual Operating Expenses
– The fund annual expense ratio
• Management (investment advisory) fee
• 12b-1 fee (marketing, advertising, distribution and agent
compensation)
• Custody fee (holding cash and securities)
• Annual Operating Expenses
• Transfer agent fee (among buyers and sellers and distribution)
• Independent Public Accountant fee
• Director’s fee
Economic Motivation for Funds
• Financial intermediaries provide value to investors
• Mutual funds provide
– Risk reduction through diversification
– Lower overall transaction costs
• Mutual funds also provide
– Professional portfolio management
– Liquidity
– Variety
– Payments mechanism
Types of Funds
• Broad range of funds exist to meet a multitude of investor needs and desires
• Passive (Index) Funds
– Seek to mimic market indexes
• Active Funds
– Seek to outperform the market by professional management
• Funds may also differ in the size of companies chosen, type of stocks, sectors,
financial instruments, etc
• Fund characteristics may also differ in investment style
– Aggressive
– Growth
– income
• Family of Funds
– Variety of funds available under the umbrella of a larger group of funds
– Many fund management firms offer different investment objectives in the
same fund family
– Usually at little or no cost to investor to switch between funds within the family
Regulation
• Securities Act of 1933
– Requires furnishing information to investors regarding the issuer
• Securities Act of 1934
– Trading after issuance and regulation of broker/dealers and exchanges
• Investment Company Act 1940
– Must register if 100 or more shareholders and this is to prevent selling abuses
and that shareholder receive accurate and timely information
• Investment Advisors Act 1940
– Registration requirements and practices of companies and advisory
individuals
ETF’s
– Funds that trade like stocks
– Like closed-end mutual funds in that their price is determined by
supply/demand
– may be traded on an intra-day basis
– Dividends are taxable
– Capital Gains are taxable on sale
• Can be formulated to mimic
– Various indices
– U. S. Stocks
– International Stocks
– Sectors
– Customized stock market benchmarks
– Indexes for other asset classes
Separately Managed Account
Individually Managed Account
– Investors and institutions may utilize an asset manager to customize a fund to
their unique objectives
– Investors with mid-sized portfolios less than $1 million are now eligible to
participate in IMA’s
– Management fees are higher
Hedge Funds
• Characteristics
– Can assume great risk
– Use a wide range of trading strategies and techniques to achieve superior
returns
– Operates among all markets and asset classes
– Management fees are based on fixed fees plus a portion of returns
Types
• Market Directional Hedge Funds
– Retain some exposure to “systemic risk”
– equity long/short strategies, equity market timing, and short selling.
• Corporate Restructuring Hedge Funds
– Anticipate impact of corporate events
– Distressed securities, merger arbitrage, general corporate restructuring
• Convergence Trading Hedge Funds
– misalignments or alignments of historical relationships among various
financial measures
– Riskless arbitrage strategy
• Trading strategy (no risk) of misalignment
– Risk arbitrage strategy
• Trading strategy (some risk) of misalignment
• Opportunistic Hedge Funds
– These funds have the broadest mandate
– Make specific ‘bets’ on various asset classes
– Diversified portfolios
Concerns
• Hedge funds provide liquidity and stabilization to certain markets
• Hedge funds can also destabilize markets
• Leverage ratios can be excessive
• Example was the 1998 collapse of Long Term Capital Management (LTCM)
Pension Funds
• Fund established for payment of retirement benefits
• Pension sponsors establish pension plans
• Financed by employee/employer contributions
• Qualified plans are granted certain tax exemptions
Types
• Defined Benefit Plans
– Makes specified payments at retirement based on formula of length of service
and earnings of employee
– Insured plans are guaranteed by insurance companies
– Pension Benefit Guaranty Corporation (PBGC) insures benefits of vested
individuals
• Defined Contribution Plans
– Plan sponsor only responsible for allocating participant contributions into the
plan
– Plan sponsor does not guarantee any amount at retirement
– Payments are made according to growth of portfolio
• Defined Contribution Plans
– Legal forms
• Money purchase pension plans
• 401(k) plans
• Employee stock ownership plans (ESOP)
• Hybrid Pension Plans
– Seek to offset the disadvantages of defined contribution and benefit plans
– Pre-set minimum benefit level is specified
– If plan does not meet this goal, the employee must make up the deficit
• Cash Balance Pension Plan
– Defined benefit plan with some features of defined contribution plan
– Defines future benefits exclusive of employer contributions
– Retirement benefits based on fixed amount annual employer contribution and
guaranteed minimum investment return
Regulation
• Employee Retirement Income Security Act of 1974 (ERISA)
– Establishes minimum funding standards
– Sets fiduciary standards of “prudent man” for trustees, managers or advisors
of plan
– Establishes minimum standards for vesting horizons
– Created the PBGC under Dept. of Labor and IRS
Managers
• Assets may be managed by in-house staff and/or outside money managers
• Plan Sponsor Consultants
– Development of plan investment policy
– Actuarial advice
– Design benchmarks
• Plan Sponsor Consultants
– Measurement and monitoring of performance
– Conduct search for asset managers
– Specialized research
Defined Benefit Pension Crises
• Funding ratio
– Ratio of assets to liabilities
• Failure to analyze liabilities caused underfunding of pensions
• Declining interest rates diminished asset values and increased liabilities
• Led to the Pension Funding Equity Act 2004
– Gave corporate sponsors some relief from burdensome pension contributions
• Led to the Pension Protection Act 2006
– Modified and extended provision of the 2004 Act
• Causes of pension crisis were poor regulatory supervision and oversight
• Poor liability-asset management
• Poor accounting by accounting firms
• Poor actuarial treatment by the actuarial profession