Mutual Funds

and Hedge Funds

4.1 MUTUAL FUNDS
What is Mutual Funds?

· Mutual funds, which are called unit trusts in

some countries, serve the needs of relatively
small investors.
· It is a type of investment vehicle that pools
money from many investors to purchase
securities. These securities can include stocks,
bonds and other income-generated assets.
· The funds is managed by a professional
investment team who makes investment
decision on behalf of the investors.
• One of the attractions of mutual funds for the
small investor is the diversification opportunities
they offer. However, it can be difficult for a
small investor to hold enough stocks to be well
diversified. In addition, maintaining a well-
diversified portfolio can lead to high transaction
costs.

• Mutual funds are regulated by the SEC. They

are required to state their objectives in a
prospects that is available to potential investors.
 A number of different types of funds have been created such as:

[Link] Funds: The most popular funds that invest in common and preferred
stock .
[Link] Funds: That invest in fixed income securities with a life of more than
one year.
[Link] Funds: That invest in stocks, bonds and other securities.
[Link] Market Funds: That invest in interest-bearing instruments with a life
of less than one year.
An investor in a mutual funds owns a certain number of shares in the fund. The
most common type of mutual funds is open-ended.
OPEN-ENDED FUNDS
· This means that the total number of shares outstanding goes up as
investors buy more shares and down as shares are redeemed.
· In open-ended funds, mutual funds are valued at 4p.m. each day. This
involves the mutual fund manager calculating the market value of each asset in
the portfolio so that the total value of the fund is determined.
· Net Asset Value (NAV) the total value is divided by the number of shares
outstanding to obtain the value of each share. Shares in the fund can be bought
from the fund or sold back to the fund at any time.
 Index Funds
Some funds are design to track a particular equity index such as the S&P 500 and the
FTSE 100. The tracking can most simply be achieved by buying all the shares in the
index in amounts that reflect their weight. Another way of achieving tracking is to
choose a smaller portfolio of representatives shares that has been shown by research
to track the chosen portfolio closely.

One of the first index funds was launched in the United States on December 31, 1975,
by John Bogle to track the S&P 500. It started with only $11 million of assets and was
initially ridiculed as being “un-American” and “Bogle’s folly”. However, it was later
renamed the Vanguard 500 Index Fund and the assets under administration reached
$100 billion on November 1999.
 Costs
Mutual funds incur a number of different costs. These include
management expenses, sales commissions, accounting and
other administrative costs, transactions costs on trades and so
on. To recoup those costs, and to make a profit, fees are
charged to investors. Front-end load is a fee charged when an
investor first buys share in a mutual funds. Not all funds
charge this type of fee. Those that do are referred to as front-
end loaded. While, back-end load is when some funds charge
fees when an investor sell shares. Total Expense Ratio is the
total of the annual fees charged per share divided by the value
of the share.
 Khorana et al. compare the mutual fund fees in 18 different countries. They
assume in their analysis that a fund is kept for five years. The Total shareholder
cost per year is calculated as ;

Total Expense Cost +

front-end load/5 +
back-end load/5
Closed-end Funds
· Closed-end funds are like regular corporations and
have a fixed number of shares outstanding. The shares
of the fund are traded on a stock exchange.
· For closed-end funds, two NAVs can be calculated:
(1)One is the price at which the shares of the fund are
trading
(2)Fair market value is the market value of the funds
portfolio divided by the number of shares outstanding.
· Usually a closed-end funds share price is less than its
fair market value.
Exchange-traded Funds (ETFs)
· ETFs have existed in the United States since 1993 and in Europe since
1999. They usually track an index and so are an alternative to an index fund
for investors who are comfortable earning a return that mirrors the index.
· ETFs are created by institutional investors. Typically an institutional
investor deposits a block of securities with the ETF and obtains shares in the
ETF (known as creation units) in return.
· Some or all of the shares in the ETF are then sold or a stock exchange.
· ETF’s can be sold or bought at anytime of the day.
· ETF holdings are disclosed twice a day, giving investors full knowledge
of the assets underlying the fund. Mutual funds by contrast only have to
disclose their holdings relatively infrequently.
Mutual Funds Return
Mutual funds returns represent the earnings or losses an investor receives from
investing in a mutual fund. These includes return from capital gains, dividend or
interest income and Net asset value (NAV) Appreciation.

Do actively managed mutual funds outperform stock indices

such as the S&P 500? Some funds in some years do very well,
but this could be the results of good luck rather good investment
management. Mutual funds frequently advertise impressive
returns. However, the funds being featured might be one fund,
out of many offered by the same organization, that happens to
have produced returns well above the average for the market.
Regulations and Mutual Fund
Scandals
The SEC is the primary regulator of mutual funds in the United States. Mutual
funds must file a registration document with the SEC. There are rules to present
conflicts of interest, fraud, and excessive fees. Despite the regulations, there have
been a number of scandals involving mutual funds.
1. LATE TRADING: refers to a practice in the mutual fund industry
where certain investors were allowed to buy or sell mutual fund shares after
the market had closed for the day, but at that day’s closing price. This gave
those investors an unfair advantage, as they could exploit information that
became available after the market closed but before their trade was
executed, something that regular investors couldn’t do.
2. MARKET TIMING: This is a practice where favored clients are allowed to
buy and sell mutual fund shares frequently (every few days) without penalty.
Taking advantage of this is not necessarily illegal. However, it may be illegal for
the mutual fund to offer special trading privileges to favored customers because
the costs (such as those associated with providing the liquidity necessary to
accommodate frequent redemptions) are borne by all customers.
3. FRONT RUNNING: occurs when mutual fund is planning a big trade that is
expected to move the market. It informs favored customers or partners before
executing the trade allowing them to trade from their own account first.
4. DIRECTED BROKERAGE: Involves improper arrangement between a
mutual fund and a brokerage house where the brokerage house recommend the
mutual fund to clients in return for receiving orders from the mutual fund for
stock and bond purchases.
 4.2 HEDGE FUNDS

Hedge fund are different from mutual fund

in that they are subject to vary little
regulations. This is because they accept
funds only from financially sophisticated
individual and organization. hedge fund are
sometimes referred to as alternative
investment.
The first hedge fund, A.W Jones & Co. was created by Alfred Winslow Jones in
the United States in 1949. It was structure as general partnership to avoid SEC
regulations. Jones combined long position in stock considered to be
undervalued with short position in stock considered to be overvalued. He use
leverage to magnify returns. A performance fee equal 20% of profit was charge
to investor. The fund performed well and the term " hedge fund" was coined in a
newspaper article written about A.W. Jones & Co. by carol Loomis in 1966. The
article showed that the funds performance after allowing for fess was better than
the most successful mutual funds. Not surprisingly, the article led to great deal
of interest in hedge fund and their investment approach. Other hedge fund
pioneer were George Soros , Walter J. Schloss and Julian Robertson.
The term hedge fund implies that the risk are being hedged. The
trading strategy of Jones did not involve hedging. He had little
exposure to the overall direction of the market because his long
position at any given time was about the same size as his short
position. Hedge fund have growth in popularity over the years.
The year 2008 was not a good year for hedge fund return, but it
is estimated that at the end of the year over $1 trillion was still
invested with Hedge fund manager throughout the world.
 FEES
one characteristic of hedge funds that distinguish them from mutual fund is
that fees are higher and dependent in performance. And annual
management fee that is usually between 1 and 3% of asset under
management is charge. This is designed to meet operating costs by this may
be an additional fee for such thing as audit account amid administration
and trade bonuses.
INCENTIVES OF HEDGE FUND MANAGERS

The fee structures give hedge fund manager an incentive to

make a profit, but it also encourage them to take risk. The
hedge fund manager has a call option on the asset of the fund
as well as known the value of a call option increase as the
volatility of the underlying asset increase. This means that the
head funds, fund manager can increase the value of an option
by taking risk that increase the volatility of the fund assets.
 PRIME BROKERS
Prime broker are the banks that offer services to hedge funds. Typically, a hedge
fund when it is first started will choose a single prime broker. This broker
handles the hedge fund trade(which may be with the prime broker or with other
broker dealers), Nets trade off against each other to determine the collateral the
hedge fund has to post, borrow securities for the hedge funds when it wants to
take short position, provides cash management and the portfolio reporting
services and make loans to the hedge fund. The prime broker has a good
understanding of the hedge funds portfolio and will typically carry out stress test
on the portfolio to decide how much leverage it is prepared to offer the fund. A
hedge fund is often highly leveraged and post minimum amount of collateral
with its prime broker. When it loses money, more collateral has to be posted. If it
cannot post more collateral, it has no choice but to close out his trades.
 4.3. HEDGE FUNDS
STRATEGIES
This section explores hedge fund strategies, similar to
Credit Suisse/Tremont's classification, but not all funds
follow the same strategies, such as weather derivatives-
specializing funds.
 LONG/SHORT EQUITY
Alfred Winslow Jones pioneered long/short equity strategies, which
remain popular today. The manager identifies undervalued and
overvalued stocks, taking a long position in the first set and a short
position in the second. Hedge funds also face risks when choosing a
prime broker, as many faced difficulties accessing assets after
Lehman Brothers' 2008 bankruptcy.
 MUTUAL FUNDS AND HEDGE FUNDS
Long/short equity strategies involve stock picking and can yield
good returns in both bull and bear markets. Hedge fund managers
often focus on smaller stocks and use financial analysis. They may
maintain a net long bias or a net short bias. Equity-market-neutral
funds use a long/short strategy but have no net long or short bias.
They can be dollar-neutral, beta-neutral, or sector neutral. Some
funds also maintain factor neutrality, balancing long and short
positions by industry sectors or avoiding exposure to factors like
oil prices or inflation rates.
DEDICATED SHORT
Dedicated short funds managers exploit brokers'
reluctance to issue sell recommendations by
targeting overvalued companies. These companies
are often weak financials, frequent auditor
changes, delayed SEC filings, industries with
overcapacity, and companies seeking to silence
their short sellers.
DISTRESSED SECURITIES
Which have credit ratings of BB or lower, are often sold at significant
discounts and offer a higher yield than Treasury bonds. Fund managers
specializing in distressed securities carefully calculate their fair value,
considering future scenarios and their potential for liquidation. Some funds
are passive investors, buying distressed debt when it's below its fair value,
while others adopt an active approach, purchasing large positions in
outstanding debt claims to influence reorganization proposals. In Chapter
11 reorganizations, one-third of an outstanding issue can stop a
reorganization proposal, converting outstanding debt into new equity.
 MERGER ARBITRAGE
involves trading after a merger or acquisition is announced, with two main
types: cash deals and share-for-share exchanges. Cash deals involve buying
shares in a company for a higher price, potentially generating a profit if the deal
goes through. Share-for-share exchanges involve buying a certain amount of
company B's stock and shorting a quarter of company A's stock. Merger
arbitrage hedge funds can generate steady returns, but they should distinguish it
from inside information trading, which is illegal. Convertible bonds are bonds
that can be converted into the issuer's equity at specific future times, with the
number of shares received depending on the time of the conversion. Ivan Boesky,
the character of Gordon Gekko in Wall Street, was based on him.
 CONVERTIBLE ARBITRAGE
Convertible bonds can be converted into the issuer's equity at
specific future times, with the number of shares received depending
on the conversion. Hedge funds and mutual funds use a
sophisticated model to value these bonds, which depend on the
underlying equity price, volatility, interest rates, and the issuer's
default risk. Hedge fund managers buy the bond and hedge risks
by shorting the stock, shorting nonconvertible bonds, or taking
positions in interest rate futures contracts, asset swaps, and credit
default swaps.
FIXED INCOME ARBITRAGE
involves using the zero-coupon yield curve as a tool for hedge funds to
buy or sell bonds that are undervalued or overvalued. Market-neutral
strategies ensure no exposure to interest rate movements, while
directional strategies take positions based on the belief that a certain
spread between interest rates will move in a certain direction. Emerging
market hedge funds specialize in investments associated with developing
countries, focusing on equity investments and debt issued by the country.
They gather information through travel, conferences, and consulting,
often using American Depository Receipts (ADRs) or Brady bonds.
Hedge funds invest in all three types of bond types, taking the risk of
short-term market movements and potential loss.
 EMERGING MARKET
hedge funds focus on investments in developing countries, focusing on
equity investments and debt issued by these countries. They screen
companies for overvalued or undervalued shares, gathering information
through travel, conferences, and consulting. They invest in securities trading
on local exchanges or American Depository Receipts (ADRs), which may
have better liquidity and lower transaction costs. However, these
investments are risky, as countries like Russia, Argentina, Brazil, and
Venezuela have defaulted on their debt.
 GLOBAL MACRO
Global macro is a hedge fund strategy used by top managers like
George Soros and Julian Robertson to predict global macroeconomic
trends. They place large bets on exchange rates and interest rates to
restore equilibrium. This strategy gained $1 billion in 1992, and has
been used in recent years, but the main challenge is predicting when
equilibrium will be restored.
 MANAGED FUTURE
Managed futures strategies involve hedge fund managers
predicting commodity price movements using various methods,
including judgment, computer programs, technical analysis, and
financial analysis. Trading rules are tested on historical data,
known as back-testing, and out of sample, using data different
from the original data. However, analysts should be aware of the
risks of data mining, as some trading rules may perform well in the
past but not in the future.
 4.4. HEDGE FUNDS
RETURNS
Hedge fund returns refer to the profits or losses
generated by hedge funds over a specific period of
time. it is not easy to assess hedge fund returns as
it is to assess mutual fund returns. There is no
data set that records the returns of all hedge
funds.
 Small hedge funds and those with poor track records
often do not report their returns and are therefore not
included in the data set. when returns are reported by a
hedge fund, the database is usually backfilled with the
funds previous returns. This also creates a bias in the
returns. That is in the set because, as just mentioned, the
hedge funds that decide to start providing data are likely
to be the ones doing well. When this bias is removed,
Someresearchers have argued that hedge fund returns are
no better than mutual fund return.
 Hedge funds can improve the risk- return trade-offs
available to pension plans. This is because pension plans
cannot (or choose not to) take a short position. Obtain
leverage, investment in derivatives, and engage in many
of the complex trades that are favored by the funds.
Investing in a hedge fund is a simple way in which a
pension fund can (for a fee) expand the scope of its
investing.
 It is not uncommon for hedge funds to report good returns
for a few years and then "blow up" long term capital
management reported returns (before fees) of 28%, 59%, 57%,
and 17%, in 1994, 1995, 1996, and 1997, respectively. in 1998 it
lost virtually all its capital. Some people argued that hedge
fund returns are like the returns from writing out-of-the-
money options. Most of the time, the options cost nothing,
but every so often they are very expensive.
 The year 2008 was a very bad one for hedge funds and for the
stock market generally. The credit Suisse/Tremont hedge fund
index was down 19.07% for the year. Although it produced a
return of 8.73% per annum on average over the five-year period
leading up to December 31, 2008. The S&P 500 index performed
worse than the credit Suisse/Tremont hedge fund index. It
declined by 38.5% during 2008 and lost 4.1%per year on average
over the five-year period leading up to December 31, 2008.
However these statistics may be misleading Because they do not
take into account dividends on the S&P 500, and there may be
biases in the hedge funds data, as mentioned above.
 🙂
Thank you for listening!
Your reporters: Group 4

Jessielyn Tuazon Wella Mae Besana

Peter John Gamao Fudel Joy Diosaban