Investment Analysis and Portfolio

Management
First Canadian Edition

17 By Reilly, Brown, Hedges, Chang

 Chapter 17
Professional Money Management,
Alternative Assets, and Industry Ethics

• Structure and Evolution

• Private Management and Advisory
Firms
• Organization and Management of
Investment Companies
• Hedge Funds and Private Equity
• Ethics and Regulation
• Professional Asset Manager
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 The Asset Management Industry:
Structure & Evolution
• Two Organization Forms
• Contract directly with a management and
advisory firm
• Commingling of investment capital of several
clients in an investment company
• Differences between These Two Forms
• Private management and advisory firms develop
a personal relationship with clients
• Investment company offers a general solution

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The Asset Management Industry:
Structure & Evolution

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 The Asset Management Industry:
Structure & Evolution

• Contract directly with a management

and advisory firm
• Relationship with client
• Assets under management (AUM)
• Separate accounts
• Customized

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 The Asset Management Industry:
Structure & Evolution

• 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

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 Private Management
& Advisory Firms
• Majority of private management and
advisory firms are still much smaller
• More narrowly focused on a particular
niche of the market

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 Private Management
& Advisory Firms
• Investment Strategy
• Each client’s assets are held in separate account
• Security portfolio 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

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 Organization & Management of
Investment Companies
• 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 percentage of total value of
the fund
• Family of funds achieve economies of scale

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 Organization & Management of
Investment Companies
• Valuating Investment Company Shares
• Net Asset Value (NAV) for an investment
company is analogous to the share price of a
corporation’s common stock.
• NAV of the fund shares will increase as the value
of the underlying assets (the fund security
portfolio) increases

(Total Market Value of Fund Portfolio ) - (Fund Expenses )

Fund NAV=
(Total Fund Shares Outstanding )

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 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 doesn’t issue or redeem shares
once it is established
• Price of fund is different from its NAV
• Puzzle for modern finance why closed-end funds
often sell at a discount from NAV
• Often a means of investing in a pool of assets
from a foreign country

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 Investment Companies:
Closed-End Mutual Funds

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 Closed-End Versus Open-End
Investment Companies
• Open-End Investment Companies
• Company continues to sell and repurchase
shares after their initial public offerings
• Fund stands ready to issue or redeem shares
at the net asset value (NAV)
• Investors who buy or sell the shares may
have to pay sales charges (the load)
• Normally called mutual funds

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 Closed-End Versus Open-End
Investment Companies
• Load versus No-Load Open-End Fund
• Offering price for a share of a load fund equals
the NAV of the share plus a sale charge
• No-load fund imposes no initial sales charge so it
sells shares at the NAV
• Several variations exist between full-load and
pure no-load fund
• Low-load fund
• 12b-1 plan
• Funds have contingent, deferred sales loads

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 Investment Companies

• Fund Management Fees

• Charge annual management fees to compensate
professional managers of the fund
• Fee typically is a percentage of the average net
assets of fund varying from about 0.25 to 1.00%
• Management fees are a major factor driving the
creation of new funds
• Mutual fund fees have been declining due to the
industry consolidation

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 Investment Companies

• 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
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 Investment Companies

• Breakdown by Fund Characteristics

• By major Means of Distribution
• Sales force
• Direct purchase from the fund
• Direct institutional marketing
• By Investment Objective
• Equity funds
• Equity funds
• Hybrid funds
• Money market funds

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 Investment Companies
• Global Investment Companies
• Funds that invest in foreign securities are either
international funds or global funds
• International funds often hold only foreign stocks
from U.S., Germany, Japan, Singapore, and
Korea
• Global funds contain both Canadian and foreign
securities
• Increasing large number of foreign investment
companies that offer both domestic and global
products in their local markets

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 Investment Companies

• Basic Concepts
• Alternative Assets
• Limited Partnership

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Investing in Alternative Asset Classes

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 Hedge Funds & Private Equity

• The Development
• Significant development in professional asset
management industry over the past 20 years was
emergence of global market for hedge fund
investing
• Hedge fund investing traces back to 1949
• Structured as a partnership structure with an
incentive fee for superior performance

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 Hedge Funds & Private Equity

• Portfolio that combines both long and short

position in equity market with use of
financial leverage to enhance return
• Better able to produce superior returns than
traditional investment structures, such as
mutual funds

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Hedge Funds & Private Equity

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 Hedge Funds & Private Equity

• Hedge Fund Characteristics

• 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
• Performance allocation and high-watermark

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Hedge Funds & Private Equity

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 Hedge Fund Strategies

• Equity-Based Strategies
• Long-short equity:
• Managers attempt to identify misvalued stocks and take
long positions in undervalued ones and short positions in
the overvalued ones
• Equity market neutral:
• limit the overall volatility exposure of the fund by taking
offsetting risk positions on the long and short side
• might also involve adopting derivative positions

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 Hedge Funds 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 fixed-income
market
• Convertible arbitrage:
• Seeks to profit from disparities in relationship between
prices for convertible bonds and underlying common
stock

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 Hedge Funds Strategies

• Arbitrage-Based Strategies
• Merger (risk) arbitrage:
• Returns are dependent upon magnitude of spread on
merger transactions, which are directly related to the
likelihood of the deal

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 Hedge Funds & Private Equity

• Opportunistic Strategies
• High yield and distressed:
• Invest in risky bonds
• Global macro
• Broad class seeks to profit from changes in global
economies
• Managed futures
• Using long and short positions in variety of futures
contracts
• Special situations
• Events like bankruptcies, spinoffs

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 Hedge Funds & Private Equity

• Multiple strategies
• Fund of funds:
• Invest in a number of funds so as to achieve well-
diversified allocation to the hedge fund investment space

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 Risk Arbitrage Investing

• 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

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 Risk Arbitrage Investing

• If manager thinks takeover is more

likely to occur than market does, he or
she will buy target firm shares.
• Manager might short sell target firm
shares if he or she thinks the proposed
deal is less likely to be completed

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 Hedge Fund Performance

• Not all hedge funds are the same when it comes to

their risk and return profiles
• Returns to these strategies show a high degree of
variability on a year-to year basis, in both an
absolute and a relative sense
• There are only 2 (of 14) years in which every strategy class
earned positive returns
• 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 and
2004, but lost money in 2002

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Hedge Fund Performance

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 Private Equity
• Basic Concepts
• 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
• Far less liquid than public stock holdings and considered
long-term positions within an investor’s overall portfolio
• Characteristics
• Higher return and low liquidity
• Good sources of diversification

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Private Equity

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Private Equity

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 Private Equity

• Organization
• Three Subcategories
•Venture Capital
• Seed
• Early stage
• Later stage
•Buyouts
•Special Situations
• Distressed Debt
• Mezzanine Financing
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 Private Equity
• The Investment Process
• Zero-stage capital: Using personal savings and
bank loans
• Venture capital: Seek to obtain 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
• Venture capital firm will ultimately want to
liquidate equity holdings in order to create a
return on investment
• Buyout
• IPO Copyright © 2010 by Nelson Education Ltd. 17-39
 Private Equity

• Returns to Private Equity Funds

• Long-term, highly illiquid investments
• Return pattern known as “J-curve effect”
• Average annual returns for these investments tend to be
quite high over time
• Initial years of new private equity commitment usually
produce negative returns
• In addition to its higher overall risk level, huge
dispersion in fund returns (good performance vs.
bad performance managers)

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 Ethics & Regulation in the
Professional Asset Management Industry

• Agency Conflict
• Regulation in the Asset Management
Industry
• Complex interaction between provincial and
federal laws
• Goal is to ensure portfolio managers act in best
interests of their investors

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 Ethics & Regulation in the Professional
Asset Management Industry

• Standards for Ethical Behaviour

• Chartered Financial Analysts Institute
(CFA)
• Code of Ethics
• Standards of Professional Conduct
• Centre for Financial Market Integrity
• Asset Manager Code of Professional Conduct

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 Ethics & Regulation in the Professional
Asset Management Industry

• Examples of Ethical Conflicts

• Incentive Compensation Schemes
• Soft Dollar Arrangements
• Marketing Investment Management

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 What Do You Want From
A Professional Asset Manager?
• Help determine you investment objectives
and develop a portfolio that is consistent
with them
• Diversify your portfolio to eliminate
unsystematic risk
• Maintain portfolio diversification and
desired risk class while allowing flexibility
to shift between alternative investment
instruments as desired

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 What Do You Want From
A Professional Asset Manager?

• Attempt to achieve a risk-adjusted

performance level that is superior to that of
your relevant benchmark
• Administer the account, keep records of
costs and transactions, provide timely
information for tax purposes, and reinvest
dividends if desired
• Maintain ethical standards of behaviour at
all times

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