Mutual Funds and Hedge Funds

Mutual Funds and Hedge Funds
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P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford CHAPTER 4 Mutual Funds and Hedge Funds utual funds and hedge funds invest cash on behalf of individuals and companies. The funds from different investors are pooled and investments are chosen by the M fund manager in an attempt to meet specified objectives. Mutual funds, which are called “unit trusts” in some countries, serve the needs of relatively small investors, while hedge funds seek to attract funds from wealthy individuals and large investors such as pension funds. Hedge funds are subject to much less regulation than mutual funds. They are free to use a wider range of trading strategies than mutual funds and are usually more secretive about what they do. This chapter describes the types of mutual fund and hedge fund that exist. It examines how they are regulated and the fees they charge. It also looks at how successful they have been at producing good returns for investors. 4.1 MUTUAL FUNDS One of the attractions of mutual funds for the small investor is the diversification op- portunities they offer. As we saw in Chapter 1, diversification improves an investor’s risk-return trade-off. 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. A mutual fund provides a way in which the resources of many small investors are pooled so that the benefits of diversification are realized at a relatively low cost. Mutual funds have grown very fast since the Second World War. Table 4.1 shows estimates of the assets managed by mutual funds in the United States since 1940. These assets were over 12 trillion by 2011. About 50% of U.S. households own mutual funds. Some mutual funds are offered by firms that specialize in asset management, such as Fidelity. Others are offered by banks such as JPMorgan Chase. Some insurance companies also offer mutual funds. For example, in 2001 the large U.S. insurance company, State Farm, began offering 10 mutual funds throughout the United States. They can be purchased on the Internet or over the phone or through State Farm agents. Mutual funds are regulated by the SEC in the U.S. They are required to state their objectives in a prospectus that is available to potential investors. A number of different types of funds have been created, such as: 1. Bond funds that invest in fixed income securities with a life of more than one year. 67P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 68 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS TABLE 4.1 Growth of Assets of Mutual Funds in United States Year Assets ( billions) 1940 0.5 1960 17.0 1980 134.8 2000 6,964.6 2011 12,224.3 Source: Investment Company Institute. 2. Equity funds that invest in common and preferred stock. 3. Hybrid funds that invest in stocks, bonds, and other securities. 4. Money market funds that invest in interest-bearing instruments with a life of less than one year. 5. Index funds that are passively managed and designed to match the performance of a market index such as the S&P 500. An investor in a mutual fund owns a certain number of shares in the fund. The most common type of mutual fund is an open-end fund. This means that the total number of shares outstanding goes up as investors buy more shares and down as shares are redeemed. Mutual funds are valued at 4 P.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. This total value is divided by the number of shares outstanding to obtain the value of each share. The latter is referred to as the net asset value (NAV) of the fund. Shares in the fund can be bought from the fund or sold back to the fund at any time. When an investor issues instructions to buy or sell shares, it is the next-calculated NAV that applies to the transaction. For example, if an investor decides to buy at 2 P.M. on a particular business day, the NAV at 4 P.M. on that day determines the amount paid by the investor. The investor usually pays tax as though he or she owned the securities in which the fund has invested. Thus, when the fund receives a dividend, an investor in the fund has to pay tax on the investor’s share of the dividend, even if the dividend is reinvested in the fund for the investor. When the fund sells securities, the investor is deemed to have realized an immediate capital gain or loss, even if the investor has not sold any of his or her shares in the fund. Suppose the investor buys shares at 100 and the trading by the fund leads to a capital gain of 20 per share in the first year and a capital loss of 25 per share in the second year. The investor has to declare a capital gain of 20 in the first year and a loss of 25 in the second year. When the investor sells the shares, there is also a capital gain or loss. To avoid double counting, the purchase price of the shares is adjusted to reflect the capital gains and losses that have already accrued to the investor. Thus, if in our example the investor sold shares in the fund after the end of the first year, the purchase price would be assumed to be 120 for the purpose of calculating capital gains or losses on the transaction; if the investor sold the shares in the fund after the end of the second year, the purchase price would be assumed to be 95 for the purpose of calculating capital gains or losses on the transaction.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 69 Index Funds Some funds are designed 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. For example, if IBM has 1% weight in a particular index, 1% of the tracking portfolio for the index would be invested in IBM stock. Another way of achieving tracking is to choose a smaller portfolio of representative shares that has been shown by research to track the chosen portfolio closely. Yet another way is to use index futures. 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 in November 1999. How accurately do index funds track the index? Two relevant measures are the tracking error and the expense ratio. The tracking error of a fund is usually defined as the standard deviation of the difference between the fund’s return per year and the index return per year. The expense ratio is the fee charged per year, as a percentage of assets, for administering the fund. A survey in 2010 by the organization Morningstar, which monitors mutual funds, found that index funds had tracking errors that averaged 0.29% and expense ratios than averaged 0.38%. 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 these costs, and to make a profit, fees are charged to investors. A front-end load is a fee charged when an investor first buys shares in a mutual fund. Not all funds charge this type of fee. Those that do are referred to as front-end loaded. In the United States, front-end loads are restricted to being less than 8.5% of the investment. Some funds charge fees when an investor sells shares. These are referred to as a back-end load. Typically the back-end load declines with the length of time the shares in the fund have been held. All funds charge an annual fee. There may be separate fees to cover management expenses, distribution costs, and so on. The total expense ratio is the total of the annual fees charged per share divided by the value of the share. Khorana et al. (2009) compared the mutual fund fees in 18 different coun- 1 tries. They assumed in their analysis that a fund is kept for five years. The “total shareholder cost” per year is calculated as Front-end load Back-end load Total expense ratio + + 5 5 Their results are summarized in Table 4.2. The average fees for equity funds vary from 1.41% in Australia to 3.00% in Canada. Fees for equity funds are on average 1 See A. Khorana, H. Servaes, and P. Tufano, “Mutual Fund Fees Around the World,” Review of Financial Studies 22 (March 2009): 1279–1310.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 70 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS TABLE 4.2 Average Total Cost per Year When Mutual Fund is Held for Five Years (% of Assets) Country Bond Funds Equity Funds Australia 0.75 1.41 Austria 1.55 2.37 Belgium 1.60 2.27 Canada 1.84 3.00 Denmark 1.91 2.62 Finland 1.76 2.77 France 1.57 2.31 Germany 1.48 2.29 Italy 1.56 2.58 Luxembourg 1.62 2.43 Netherlands 1.73 2.46 Norway 1.77 2.67 Spain 1.58 2.70 Sweden 1.67 2.47 Switzerland 1.61 2.40 United Kingdom 1.73 2.48 United States 1.05 1.53 Average 1.39 2.09 Source: Khorana, Servaes, and Tufano, “Mutual Fund Fees Around the World,” Review of Financial Studies 22 (March 2009): 1279–1310. about 50% higher than for bond funds. Index funds tend to have lower fees than regular funds because no highly paid stock pickers or analysts are required. For some index funds in the United States, fees are as low as 0.15% per year. Closed-End Funds The funds we have talked about so far are open-end funds. These are by far the most common type of fund. The number of shares outstanding varies from day to day as individuals choose to invest in the fund or redeem their shares. 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. One is the price at which the shares of the fund are trading. The other is the market value of the fund’s portfolio divided by the number of shares outstanding. The latter can be referred to as the fair market value. Usually a closed- end fund’s share price is less than its fair market value. A number of researchers have investigated the reason for this. Research by Ross (2002) suggests that the fees paid 2 to fund managers provide the explanation. 2 See S. Ross, “Neoclassical Finance, Alternative Finance, and the Closed End Fund Puzzle,”European Financial Management 8 (2002): 129–137.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 71 ETFs Exchange-traded funds (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 mutual fund for investors who are comfortable earning a return that is designed to mirror the index. One of the most widely known ETFs, called the Spider, tracks the S&P 500 and trades under the symbol SPY. In a survey of investment professionals conducted in March 2008, 67% called ETFs the most innovative investment vehicle of the last two decades and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios. In 2008, the SEC in the United States authorized the creation of actively managed ETFs. ETFs came under scrutiny in 2011 because of their role in the trading activities of Kweku Adoboli, who lost 2.3 billion for UBS. 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 traded on a stock exchange. This gives ETFs the characteristics of a closed-end fund rather than an open-end fund. However, a key feature of ETFs is that institutional investors can exchange large blocks of shares in the ETF for the assets underlying the shares at that time. They can give up shares they hold in the ETF and receive the assets or they can deposit new assets and receive new shares. This ensures that there is never any appreciable difference between the price at which shares in the ETF are trading on the stock exchange and their fair market value. This is a key difference between ETFs and closed-end funds and makes ETFs more attractive to investors than closed-end funds. ETFs have a number of advantages over open-end mutual funds. ETFs can be bought or sold at any time of the day. They can be shorted in the same way that shares in any stock are shorted. (See Chapter 5 for a discussion of short selling.) 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. When shares in a mutual fund are sold, managers often have to sell the stocks in which the fund has invested to raise the cash that is paid to the investor. When shares in the ETF are sold, this is not necessary as another investor is providing the cash. This means that transactions costs are saved and there are less unplanned capital gains and losses passed on to shareholders. Finally, the expense ratios of ETFs tend to be less than those of mutual funds. Mutual Fund Returns 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 result of good luck rather than good investment management. Two key questions for researchers are: 1. Do actively managed funds outperform stock indices on average? 2. Do funds that outperform the market in one year continue to do so? The answer to both questions appears to be no. In a classic study, Jensen (1969) 3 performed tests on mutual fund performance using 10 years of data on 115 funds. 3 See M. C. Jensen, “Risk, the Pricing of Capital Assets and the Evaluation of Investment Portfolios,” Journal of Business 42 (April 1969): 167–247.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 72 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS TABLE 4.3 Consistency of Good Performance By Mutual Funds Number of Percentage of Consecutive Years Number of Observations When of Positive Alpha Observations Next Alpha Is Positive 1 574 50.4 2 312 52.0 3 161 53.4 4 79 55.8 5 41 46.4 6 17 35.3 He calculated the alpha for each fund in each year. (As explained in Section 1.3, alpha is the return earned in excess of that predicted by the capital asset pricing model.) The average alpha of all funds was slightly negative, even before management costs were taken into account. Jensen tested whether funds with positive alphas tended to continue to earn positive alphas. His results are summarized in Table 4.3. The first row shows that 574 positive alphas were observed from the 1,150 observations (close to 50%). Of these positive alphas, 50.4% were followed by another year of positive alpha. Row two shows that, when two years of positive alphas have been observed, there is a 52% chance that the next year will have a positive alpha, and so on. The results show that, when a manager has achieved above average returns for one year (or several years in a row), there is still only a probability of about 50% of achieving above average returns the next year. The results suggest that managers who obtain positive alphas do so because of luck rather than skill. It is possible that there are some managers who are able to perform consistently above average, but they are a very small percentage of the total. More recent studies have confirmed Jensen’s conclusions. On average, mutual fund managers do not beat the market and past performance is not a good guide to future performance. The success of index funds shows that this research has influenced the views of many investors. Mutual funds frequently advertise impressive returns. However, the fund being featured might be one fund out of many offered by the same organization that hap- pens to have produced returns well above the average for the market. Distinguishing between good luck and good performance is always tricky. Suppose an asset man- agement company has 32 funds following different trading strategies and assume that the fund managers have no particular skills, so that the return of each fund has a 50% chance of being greater than the market each year. The probability of a 5 particular fund beating the market every year for the next five years is (1/2) or 1/32. This means that by chance one out of the 32 funds will show a great performance over the five-year period One point should be made about the way returns over several years are expressed. One mutual fund might advertise “The average of the returns per year that we have achieved over the last five years is 15%.” Another might say “If you had invested your money in our mutual fund for the last five years your money would have grown at 15% per year.” These statements sound the same, but are actually different, as illustrated by Business Snapshot 4.1. In many countries, regulators have strict rules to ensure that mutual fund returns are not reported in a misleading way.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 73 BUSINESS SNAPSHOT 4.1 Mutual Fund Returns Can Be Misleading Suppose that the following is a sequence of returns per annum reported by a mutual fund manager over the last five years (measured using annual com- pounding): 15%, 20%, 30%, −20%, 25% The arithmetic mean of the returns, calculated by taking the sum of the returns and dividing by 5, is 14%. However, an investor would actually earn less than 14% per annum by leaving the money invested in the fund for five years. The dollar value of 100 at the end of the five years would be 100 × 1.15 × 1.20 × 1.30 × 0.80 × 1.25 = 179.40 By contrast, a 14% return (with annual compounding) would give 5 100 × 1.14 = 192.54 The return that gives 179.40 at the end of five years is 12.4%. This is because 5 100 × (1.124) = 179.40 What average return should the fund manager report? It is tempting for the manager to make a statement such as: “The average of the returns per year that we have realized in the last five years is 14%.” Although true, this is misleading. It is much less misleading to say: “The average return realized by someone who invested with us for the last five years is 12.4% per year.” In some jurisdictions, regulations require fund managers to report returns the second way. This phenomenon is an example of a result that is well known by mathe- maticians. The geometric mean of a set of numbers (not all the same) is always less than the arithmetic mean. In our example, the return multipliers each year are 1.15, 1.20, 1.30, 0.80, and 1.25. The arithmetic mean of these numbers is 1.140, but the geometric mean is only 1.124. An investor who keeps an invest- ment for several years earns the geometric mean of the returns per year, not the arithmetic mean. Regulation and Mutual Fund Scandals Because they solicit funds from small retail customers, many of whom are unso- phisticated, mutual funds are heavily regulated. The SEC is the primary regulator of mutual funds in the United States. Mutual funds must file a registration docu- ment with the SEC. Full and accurate financial information must be provided toP1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 74 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS prospective fund purchasers in a prospectus. There are rules to prevent conflicts of interest, fraud, and excessive fees. Despite the regulations, there have been a number of scandals involving mutual funds. One of these involves late trading. As mentioned earlier in this chapter, if a request to buy or sell mutual fund shares is placed by an investor with a broker by 4 P.M. on any given business day, it is the NAV of the fund at 4 P.M. that determines the price that is paid or received by the investor. In practice, for various reasons, an order to buy or sell is sometimes not passed from a broker to a mutual fund until later than 4 P.M. This allows brokers to collude with investors and submit new orders or change existing orders after 4 P.M. The NAV of the fund at 4 P.M. still applies to the investors—even though they may be using information on market movements (particularly movements in overseas markets) after 4 P.M. Late trading is not permitted under SEC regulations and there were a number of prosecutions in the early 2000s that led to multi-million-dollar payments and employees being fired. Another scandal is known as market timing. This is a practice where favored clients are allowed to buy and sell mutual funds shares frequently (e.g., every few days) without penalty. One reason why they might want to do this is because they are indulging in the illegal practice of late trading. Another reason is that they are analyzing the impact of stocks whose prices have not been updated recently on the fund’s NAV. Suppose that the price of a stock has not been updated for several hours. (This could be because it does not trade frequently or because it trades on an exchange in a country in a different time zone.) If the U.S. market has gone up (down) in the last few hours, the calculated NAV is likely to understate (overstate) the value of the underlying portfolio and there is a short-term trading opportunity. 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. Other scandals have involved front running and directed brokerage. Front run- ning occurs when a 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 for their own account first. Directed brokerage involves an improper arrangement between a mutual fund and a brokerage house where the brokerage house recommends the mutual fund to clients in return for receiving orders from the mutual fund for stock and bond purchases. 4.2 HEDGE FUNDS Hedge funds are different from mutual funds in that they are subject to very little regulation. This is because they only accept funds from financially sophisticated individuals and organizations. Examples of the regulations that affect mutual funds are the requirements that: 1. Shares be redeemable at any time 2. NAV be calculated daily 3. Investment policies be disclosed 4. The use of leverage be limitedP1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 75 Hedge funds are largely free from these regulations. This gives them a great deal of freedom to develop sophisticated, unconventional, and proprietary investment strategies. Hedge funds are sometimes referred to as alternative investments. The first hedge fund, A. W. Jones & Co., was created by Alfred Winslow Jones in the United States in 1949. It was structured as a general partnership to avoid SEC regulations. Jones combined long positions in stocks considered to be undervalued with short positions in stocks considered to be overvalued. He used leverage to magnify returns. A performance fee equal to 20% of profits was charged to investors. 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 fund’s performance after allowing for fees was better than the most successful mutual funds. Not surprisingly, the article led to a great deal of interest in hedge funds and their investment approach. Other hedge fund pioneers were George 4 Soros, Walter J. Schloss, and Julian Robertson. The term “hedge fund” implies that risks are being hedged. The trading strategy of Jones did involve hedging. He had little exposure to the overall direction of the market because his long position (in stocks considered to be undervalued) at any given time was about the same size as his short position (in stocks considered to be overvalued). However, for some hedge funds, the word “hedge” is inappropriate because they take aggressive bets on the future direction of the market with no particular hedging policy. Hedge funds have grown in popularity over the years. The year 2008 was not a good year for hedge fund returns, but it is estimated that at the end of the year over 1 trillion was still invested with hedge fund managers throughout the world. Many hedge funds are registered in tax-favorable jurisdictions. For example, over 30% of hedge funds are domiciled in the Cayman Islands. Funds of funds have been set up to allocate funds to different hedge funds. Hedge funds are difficult to ignore. It has been estimated that they account for 40% to 50% of the daily turnover on the New York and London stock exchanges, 70% of the volume of convertible bond trading, 20% to 30% of the volume of credit default swap trading, 82% of the volume of trading in U.S. distressed debt, 33% of the trading in non-investment grade bonds. They are also very active participants in the ETF market, often taking short positions. Fees One characteristic of hedge funds that distinguishes them from mutual funds is that fees are higher and dependent on performance. An annual management fee that is usually between 1% and 3% of assets under management is charged. This is designed to meet operating costs—but there may be an additional fee for such things as audits, account administration, and trader bonuses. Moreover, an incentive fee that 4 The famous Warren Buffett of Omaha can also be considered to be a hedge fund pioneer. In 1956, he started Buffett partnership LP with seven limited partners and 100,100. Buffett charged his partners 25% of profits above a hurdle rate of 25%. He specialized in special situations, merger arbitrage, spin offs, and distressed debt opportunities and earned an average of 29.5% per year. The partnership was disbanded 1969 and Berkshire Hathaway (a holding company, not a hedge fund) was formed.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 76 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS is usually between 15% and 30% of realized profits (if any) after management fees are charged. This fee structure is designed to attract the most talented and sophisticated investment managers. Thus, a typical hedge fund fee schedule might be expressed as “2 plus 20%” indicating that the fund charges 2% per year of assets under management and 20% of profit. On top of high fees there is usually a lock up period of at least one year during which invested funds cannot be withdrawn. Some hedge funds with good track records have sometimes charged much more than the average. Steve Cohen’s SAC Capital Partners has charged as much as “3 plus 35%” and Jim Simons’ Renaissance Technologies Corp. has charged as much as “5 plus 44%.” The agreements offered by hedge funds may include clauses that make the in- centive fees more palatable. For example: 1. There is sometimes a hurdle rate. This is the minimum return necessary for the incentive fee to be applicable. 2. There is sometimes a high-water mark clause. This states that any previous losses must be recouped by new profits before an incentive fee applies. Because different investors place money with the fund at different times, the high-water mark is not necessarily the same for all investors. There may be a proportional adjustment clause stating that, if funds are withdrawn by investors, the amount of previous losses that has to be recouped is adjusted proportionally. Suppose a fund worth 200 million loses 40 million and 80 million of funds are withdrawn. The high-water mark clause on its own would require 40 million of profits on the remaining 80 million to be achieved before the incentive fee applied. The proportional adjustment clause would reduce this to 20 million because the fund is only half as big as it was when the loss was incurred. 3. There is sometimes a clawback clause that allows investors to apply part or all of previous incentive fees to current losses. A portion of the incentive fees paid by the investor each year is then retained in a recovery account. This account is used to compensate investors for a percentage of any future losses. Some hedge fund managers have become very rich from the generous fee sched- ules. In 2010, hedge fund managers reported as earning over 1 billion were John Paulson of Paulson and Co., Ray Dalio of Bridgewater Associates, Jim Simons of Renaissance Technologies (a former math professor), David Tepper of Appaloosa Management, Steve Cohen of SAC Capital, and Eddie Lampert of ESL Investments. If an investor has a portfolio of investments in hedge funds, the fees paid can be quite high. As a simple example, suppose that an investment is divided equally between two funds, A and B. Both funds charge 2 plus 20%. In the first year, Fund A earns 20% while Fund B earns –10%. The investor’s average return on investment before fees is 0.5 × 20% + 0.5 × (−10%) or 5%. The fees paid to fund Aare2% + 0.2 × (20 − 2)% or 5.6%. The fees paid to Fund B are 2%. The average fee paid on the investment in the hedge funds is therefore 3.8%. The investor is left with a 1.2% return. This is half what the investor would get if 2 plus 20% were applied to the overall 5% return. When a fund of funds is involved, there is an extra layer of fees and the investor’s return after fees is even worse. A typical fee charged by a fund of hedge funds used to be 1% of assets under management plus 10% of the net (after incentive fees and management fees) profits of the hedge funds they invest in. Suppose a fund of hedgeP1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 77 funds divides its money equally between 10 hedge funds. All charge 2 plus 20% and the fund of hedge funds charges 1 plus 10%. It sounds as though the investor pays 3 plus 30%—but it can be much more than this. Suppose that five of the hedge funds lose 40% and the other five make 40%. An incentive fee of 20% of 38% or 7.6% has to be paid to each of the profitable hedge funds. The total incentive fee paid to all hedge funds is therefore 3.8% of the funds invested. In addition there is a 2% annual fee paid to the hedge funds and 1% annual fee paid to the fund of funds. The investor’s net return is –6.8% of the amount invested. (This is 6.8% less than the return on the underlying assets before fees.) The fees charged by funds of hedge funds have declined sharply as a result of poor performance in 2008 and 2011. Incentives of Hedge Fund Managers The fee structure gives hedge fund managers an incentive to make a profit. But it also encourages them to take risks. The hedge fund manager has a call option on the assets of the fund. As is well known, the value of a call option increases as the volatility of the underlying assets increases. This means that the hedge fund manager can increase the value of the option by taking risks that increase the volatility of the fund’s assets. Suppose that a hedge fund manager is presented with an opportunity where there is a 0.4 probability of a 60% profit and a 0.6 probability of a 60% loss with the fees earned by the hedge fund manager being 2 plus 20%. The expected return of the investment is 0.4 × 60 + 0.6 × (−60) or –12%. Even though this is a terrible expected return, the hedge fund manager might be tempted to accept the investment. If the investment produces a 60% profit, the hedge fund’s fee is 2 + 0.2 × 58 or 13.6%. If the investment produces a 60% loss, the hedge fund’s fee is 2%. The expected fee to the hedge fund is therefore 0.4 × 13.6 + 0.6 × 2 = 6.64 or 6.64% of the funds under administration. The expected management fee is 2% and the expected incentive fee is 4.64%. To the investors in the hedge fund, the expected return is 0.4 × (0.8 × 58) + 0.6 × (−60 − 2)=−18.64 or –18.64%. The example is summarized in Table 4.4. It shows that the fee structure of a hedge fund gives its managers an incentive to take high risks even when expected returns are negative. The incentives may be reduced by hurdle rates, high-water mark clauses, and clawback clauses. However, these clauses are not always as useful to investors as they sound. One reason is that investors have to continue to invest with the fund to take advantage of them. Another is that, as losses mount up for a hedge fund, the managers have an incentive to wind up the hedge fund and start a new one.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 78 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS TABLE 4.4 Return from a High Risk Investment where Returns of +60% and –60% Have Probabilities of 0.4 and 0.6, Respectively Expected return to hedge fund 6.64% Expected return to investors −18.64% Overall expected return −12.00% The Hedge Fund Charges 2 plus 20%. The incentives we are talking about here are real. Imagine how you would feel as an investor in the hedge fund, Amaranth. One of its traders, Brian Hunter, liked to make huge bets on the price of natural gas. Until 2006, his bets were largely right and as a result he was regarded as a star trader. His remuneration including bonuses is reputed to have been close to 100 million in 2005. During 2006, his bets proved wrong and Amaranth, which had about 9 billion of assets under administration, lost a massive 6.5 billion. (This was even more than the loss of Long-Term Capital Management in 1998.) Brian Hunter did not have to return the bonuses he had previously earned. Instead, he left Amaranth and tried to start his own hedge fund. It is interesting to note that, in theory, two individuals can create a money machine as follows. One starts a hedge fund with a certain high risk (and secret) investment strategy. The other starts a hedge fund with an investment strategy that is the opposite of that followed by the first hedge fund. For example, if the first hedge fund decides to buy 1 million of silver, the second hedge fund shorts this amount of silver. At the time they start the funds, the two individuals enter into an agreement to share the incentive fees. One hedge fund (we do not know which one) will do well and earn good incentive fees. The other will do badly and earn no incentive fees. Provided that they can find investors for their funds, they have a money machine Prime Brokers Prime brokers are the banks that offer services to hedge funds. Typically a hedge fund, when it is first started, will choose a particular bank as its prime broker. This bank handles the hedge fund’s trades (which may be with itself or with other financial institutions), carries out calculations each day to determine the collateral the hedge fund has to provide, borrows securities for the hedge fund when it wants to take short positions, provides cash management and portfolio reporting services, and makes loans to the hedge fund. In some cases, the prime broker provides risk management and consulting services and introduces the hedge fund to potential investors. The prime broker has a good understanding of the hedge fund’s portfolio and will typically carry out stress tests on the portfolio to decide how much leverage it is prepared to offer the fund. As a hedge fund gets larger, it is likely to use more than one prime broker. This means that no one bank sees all its trades and has a complete understanding of its portfolio. The opportunity of transacting business with more than one prime broker gives a hedge fund more negotiating clout to reduce the fees it pays. Goldman Sachs,P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 79 Morgan Stanley, and many other large banks offer prime broker services to hedge 5 funds and find them to be an important contributor to their profits. Although hedge funds are not heavily regulated, they do have to answer to their prime brokers. A hedge fund is often highly leveraged and has to post collateral with its prime brokers. When it loses money, more collateral has to be posted. If it cannot post more collateral, it has no choice but to close out its trades. One thing the hedge fund has to think about is the possibility that it will enter into a trade that is correct in the long term, but loses money in the short term. Consider a hedge fund that in early 2008 thinks credit spreads are too high. It might be tempted to take a highly leveraged position where BBB-rated bonds are bought and Treasury bonds are shorted. However, there is the danger that credit spreads will increase before they decrease. In this case, the hedge fund might run out of collateral and be forced to close out its position at a huge loss. 4.3 HEDGE FUND STRATEGIES In this section we will discuss some of the strategies followed by hedge funds. Our classification is similar to the one used by Dow Jones Credit Suisse, which provides indices tracking hedge fund performance. Not all hedge funds can be classified in the way indicated. Some follow more than one of the strategies mentioned and some follow strategies that are not listed. (For example, there are funds specializing in weather derivatives.) Long/Short Equity As described earlier, long/short equity strategies were used by hedge fund pioneer Alfred Winslow Jones. They continue to be among the most popular of hedge fund strategies. The hedge fund manager identifies a set of stocks that are considered to be undervalued by the market and a set that are considered to be overvalued. The man- ager takes a long position in the first set and a short position in the second set. Typi- cally, the hedge fund has to pay the prime broker 1% per year to rent the shares that are borrowed for the short position. (See Chapter 5 for a discussion of short selling.) Long/short equity strategies are all about stock picking. If the overvalued and undervalued stocks have been picked well, the strategies should give good returns in both bull and bear markets. Hedge fund managers often concentrate on smaller stocks that are not well covered by analysts and research the stocks extensively using fundamental analysis, as pioneered by Benjamin Graham. The hedge fund manager may choose to maintain a net long bias where the shorts are of smaller magnitude than the longs or a net short bias where the reverse is true. Alfred Winslow Jones maintained a net long bias in his successful use of long/short equity strategies. 5 Although a bank is taking some risks when it lends to a hedge fund, it is also true that a hedge fund is taking some risks when it chooses a prime broker. Many hedge funds that chose Lehman Brothers as their prime broker found that they could not access their assets when Lehman Brothers went bankrupt in 2008.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 80 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS An equity-market-neutral fund uses a long/short strategy, but has no net long or net short bias. A dollar-neutral fund is an equity-market-neutral fund where the dollar amount of the long position equals the dollar amount of the short position. A beta-neutral fund is a more sophisticated equity-market-neutral fund where the weighted average beta of the shares in the long portfolio equals the weighted average beta of the shares in the short portfolio so that the overall beta of the portfolio is zero. If the capital asset pricing model is true, the beta-neutral fund should be totally insensitive to market movements. Long and short positions in index futures are sometimes used to maintain a beta-neutral position. Sometimes equity market neutral funds go one step further. They maintain sector neutrality where long and short positions are balanced by industry sectors or factor neutrality where the exposure to factors such as the price of oil, the level of interest rates, or the rate of inflation is neutralized. Dedicated Short Managers of dedicated short funds look exclusively for overvalued companies and sell them short. They are attempting to take advantage of the fact that brokers and analysts are reluctant to issue sell recommendations—even though one might reasonably expect the number of companies overvalued by the stock market to be approximately the same as the number of companies undervalued at any given time. Typically, the companies chosen are those with weak financials, those that change their auditors regularly, those that delay filing reports with the SEC, companies in industries with overcapacity, companies suing or attempting to silence their short sellers, and so on. Distressed Securities Bonds with credit ratings of BB or lower are known as “non-investment-grade” or “junk” bonds. Those with a credit rating of CCC are referred to as “distressed” and those with a credit rating of D are in default. Typically, distressed bonds sell at a big discount to their par value and provide a yield that is over 1,000 basis points (10%) more than the yield on Treasury bonds. Of course, an investor only earns this yield if the required interest and principal payments are actually made. The managers of funds specializing in distressed securities calculate carefully a fair value for distressed securities by considering possible future scenarios and their probabilities. Distressed debt cannot usually be shorted and so they are searching for debt that is undervalued by the market. Bankruptcy proceedings usually lead to a reorganization or liquidation of a company. The fund managers understand the legal system, know priorities in the event of liquidation, estimate recovery rates, consider actions likely to be taken by management, and so on. Some funds are passive investors. They buy distressed debt when the price is below its fair value and wait. Other hedge funds adopt an active approach. They might purchase a sufficiently large position in outstanding debt claims so that they have the right to influence a reorganization proposal. In Chapter 11 reorganizations in the United States, each class of claims must approve a reorganization proposal with a two-thirds majority. This means that one-third of an outstanding issue can be sufficent to stop a reorganization proposed by management or other stakeholders.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 81 In a reorganization of a company, the equity is often worthless and the outstanding debt is converted into new equity. Sometimes, the goal of an active manager is to buy more than one-third of the debt, obtain control of a target company, and then find a way to extract wealth from it. Merger Arbitrage Merger arbitrage involves trading after a merger or acquisition is announced in the hope that the announced deal will take place. There are two main types of deals: cash deals and share-for-share exchanges. Consider first cash deals. Suppose that Company A announces that it is prepared to acquire all the shares of Company B for 30 per share. Suppose the shares of Company B were trading at 20 prior to the announcement. Immediately after the announcement its share price might jump to 28. It does not jump immediately to 30 because (a) there is some chance that the deal will not go through and (b) it may take some time for the full impact of the deal to be reflected in market prices. Merger-arbitrage hedge funds buy the shares in company B for 28 and wait. If the acquisition goes through at 30, the fund makes a profit of 2 per share. If it goes through at a higher price, the profit is bigger. However, if for any reason the deal does not go through, the hedge fund will take a loss. Consider next a share-for-share exchange. Suppose that Company A announces that it is willing to exchange one of its shares for four of Company B’s shares. Assume that Company B’s shares were trading at 15% of the price of Company A’s shares prior to the announcement. After the announcement, Company B’s share price might rise to 22% of Company A’s share price. A merger-arbitrage hedge fund would buy a certain amount of Company B’s stock and at the same time short a quarter as much of Company A’s stock. This strategy generates a profit if the deal goes ahead at the an- nounced share-for-share exchange ratio or one that is more favorable to Company B. Merger-arbitrage hedge funds can generate steady, but not stellar, returns. It is important to distinguish merger arbitrage from the activities of Ivan Boesky and oth- 6 ers who used inside information to trade before mergers became public knowledge. Trading on inside information is illegal. Ivan Boesky was sentenced to three years in prison and fined 100 million. Convertible Arbitrage Convertible bonds are bonds that can be converted into the equity of the bond issuer at certain specified future times with the number of shares received in exchange for a bond possibly depending on the time of the conversion. The issuer usually has the right to call the bond (i.e., buy it back a prespecified price) in certain circumstances. Usually, the issuer announces its intention to call the bond as a way of forcing the holder to convert the bond into equity immediately. (If the bond is not called, the holder is likely to postpone the decision to convert it into equity for as long as possible.) 6 The Michael Douglas character of Gordon Gekko in the award winning movie Wall Street was based on Ivan Boesky.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 82 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS A convertible arbitrage hedge fund has typically developed a sophisticated model for valuing convertible bonds. The convertible bond price depends in a complex way on the price of the underlying equity, its volatility, the level of interest rates, and the chance of the issuer defaulting. Many convertible bonds trade at prices below their fair value. Hedge fund managers buy the bond and then hedge their risks by shorting the stock. (This is an application of delta hedging that will be discussed in Chapter 7.) Interest rate risk and credit risk can be hedged by shorting nonconvertible bonds that are issued by the company that issued the convertible bond. Alternatively, the managers can take positions in interest rate futures contracts, asset swaps, and credit default swaps to accomplish this hedging. Fixed Income Arbitrage The basic tool of fixed income trading is the zero-coupon yield curve, the construction of which is discussed in Appendix B. One strategy followed by hedge funds that engage in fixed income arbitrage is a relative value strategy, where they buy bonds that the zero-coupon yield curve indicates are undervalued by the market and sell bonds that it indicates are overvalued. Market-neutral strategies are similar to relative value strategies except that the hedge fund manager tries to ensure that the fund has no exposure to interest rate movements. Some fixed-income hedge fund managers follow directional strategies where they take a position based on a belief that a certain spread between interest rates, or interest rates themselves, will move in a certain direction. Usually they have a lot of leverage and have to post collateral. They are therefore taking the risk that they are right in the long term, but that the market moves against them in the short term so that they cannot post collateral and are forced to close out their positions at a loss. This is what happened to Long-Term Capital Management (see Business Snapshot 19.1). Emerging Markets Emerging market hedge funds specialize in investments associated with developing countries. Some of these funds focus on equity investments. They screen emerg- ing market companies looking for shares that are overvalued or undervalued. They gather information by traveling, attending conferences, meeting with analysts, talking to management, and employing consultants. Usually they invest in securi- ties trading on the local exchange, but sometimes they use American Depository Receipts (ADRs). ADRs are certificates issued in the United States and traded on a U.S. exchange. They are backed by shares of a foreign company. ADRs may have better liquidity and lower transactions costs than the underlying foreign shares. Sometimes there are price discrepancies between ADRs and the underlying shares giving rise to arbitrage opportunities. Another type of investment is debt issued by an emerging market country. Eurobonds are bonds issued by the country and denominated in a hard currency such as the U.S. dollar or the euro. Brady bonds are dollar-denominated bonds backed by the U.S. Treasury. Local currency bonds are bonds denominated in the local currency. Hedge funds invest in all three types of bond. Both Eurobonds and local currency bonds are risky. Countries such as Russia, Argentina, Brazil, and Venezuela have defaulted many times on their debt.P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 83 Global Macro Global macro is the hedge fund strategy use by star managers such as George Soros and Julian Robertson. Global macro hedge fund managers carry out trades that reflect global macroeconomic trends. They look for situations where markets have, for whatever reason, moved away from equilibrium and place large bets that they will move back into equilibrium. Often the bets are on exchange rates and interest rates. A global macro strategy was used in 1992 when George Soros’s Quantum Fund gained 1 billion by betting that the British pound would decrease in value. More recently, hedge funds have (with mixed results) placed bets that the huge U.S. balance of payments would cause the value of the U.S. dollar to decline. The main problem for global macro funds is that they do not know when equilibrium will be restored. World markets can for various reasons be in disequilibrium for long periods of time. Managed Futures Hedge fund managers that use managed futures strategies attempt to predict future movements in commodity prices. Some rely on the manager’s judgment; others use computer programs to generate trades. Some managers base their trading on tech- nical analysis, which analyzes past price patterns to predict the future. Others use fundamental analysis, which involves calculating a fair value for the commodity from economic, political, and other relevant factors. When technical analysis is used, trading rules are usually first tested on historical data. This is known as back-testing. If (as is often the case) a trading rule has come from an analysis of past data, trading rules should be tested out of sample (that is, on data that are different from the data used to generate the rules). Analysts should be aware of the perils of data mining. Analysts have been known to generate thousands of different trading rules and then test them on historical data. Just by chance a few of the trading rules will perform very well—but this does not mean that they will perform well in the future. 4.4 HEDGE FUND PERFORMANCE It is not as easy to assess hedge fund performance as it is to assess mutual fund perfor- mance. There is no data set that records the returns of all hedge funds. For the Tass hedge funds database, which is available to researchers, participation by hedge funds is voluntary. 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 fund’s previous returns. This creates a bias in the returns that are in the data 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, some researchers have argued, hedge fund returns are no better than mutual fund returns, particularly when fees are taken into account. Arguably, hedge funds can improve the risk-return trade-offs available to pension plans. This is because pension plans cannot (or choose not to) take short positions, obtain leverage, invest in derivatives, and engage in many of the complex trades thatP1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 84 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS TABLE 4.5 Hedge Fund Performance 2010 2004–2010 Standard Deviation Return Return of Monthly Returns Sharpe Category per Annum per Annum (Annualized) Ratio Convertible arbitrage 10.95% 7.87% 7.08% 0.63 Dedicated short bias −22.47% −3.81% 17.05% −0.42 Emerging markets 11.34% 8.22% 15.22% 0.32 Equity market neutral −0.85% 5.09% 10.64% 0.16 Event driven 12.63% 10.38% 6.11% 1.15 Fixed income arbitrage 12.51% 5.26% 5.93% 0.32 Global macro 13.47% 12.47% 10.03% 0.91 Long/short equity 9.28% 10.24% 9.97% 0.69 Managed futures 12.22% 6.63% 11.80% 0.28 Multi-strategy 9.29% 8.22% 5.45% 0.89 Hedge fund index 10.95% 9.42% 7.70% 0.78 Source: Dow Jones Credit Suisse. The Sharpe ratio is the ratio of the mean of r − r to its standard deviation where r is the f realized return and r is the risk-free rate. f are favored by hedge 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. This may improve its efficient frontier. (See Section 1.2 for a discussion of efficient frontiers.) 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 have 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. This may be unfair. Advocates of hedge funds would argue that hedge fund managers search for profitable opportunities that other investors do not have the resources or expertise to find. They would point out that the top hedge fund managers have been very successful at finding these opportunities. The performance of different types of hedge funds, as given by Dow Jones Credit Suisse, is shown in Table 4.5. Over the seven-year period, 2004 to 2010, the average annual return was 9.42%. This compares with about 1.8% for the S&P 500 index during this period. However, the statistics do not include results for the year 2011 during which the hedge fund index lost 7.40% while the S&P 500 was flat. Also, the statistics do not take account of dividends on the S&P 500 and as already explained there may be biases in the hedge fund data. SUMMARY Mutual funds offer a way small investors can capture the benefits of diversification. Overall, the evidence is that actively managed funds do not outperform the marketP1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford Mutual Funds and Hedge Funds 85 and this has led many investors to choose funds that are designed to track a market index such as the S&P 500. Mutual funds are highly regulated. They cannot take short positions or use leverage and must allow investors to redeem their shares in the mutual fund at any time. Most mutual funds are open-end funds, so that the number of shares in the fund increases (decreases) as investors contribute (withdraw) funds. An open-end mutual fund calculates the net asset value of shares in the fund at 4 P.M. each business day and this is the price used for all buy and sell orders placed in the previous 24 hours. A closed-end fund has a fixed number of shares that trade in the same way as the shares of any other corporation. Exchange-traded funds (ETFs) are proving to be popular alternatives to open- and closed-ended funds. The shares held by the fund are known at any given time. Large institutional investors can exchange shares in the fund at any time for the assets underlying the shares, and vice versa. This ensures that the shares in the ETF (unlike shares in a closed-end fund) trade at a price very close to the funds’s net asset value. Shares in an ETF can be traded at any time (not just at 4 P.M.) and shares in an ETF (unlike shares in an open-end mutual fund) can be shorted. Hedge funds cater to the needs of large investors. Compared to mutual funds, they are subject to very few regulations and restrictions. Hedge funds charge investors much higher fees than mutual funds. The fee for a typical fund is “2 plus 20%.” This means that the fund charges a management fee of 2% per year and receives 20% of the profits (if any) generated by the fund. Hedge fund managers have a call option on the assets of the fund and, as a result, may have an incentive to take high risks. Among the strategies followed by hedge funds are long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures. The jury is still out on whether hedge funds on average provide superior risk-return trade-offs to index funds after fees. There is a tendency for hedge funds to provide excellent returns for a number of years and then report a disastrous loss. FURTHER READING Khorana, A., H. Servaes, and P. Tufano. “Mutual Fund Fees Around the World.” Review of Financial Studies 22 (March 2009): 1279–1310. Jensen, M. C. “Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfo- lios.” Journal of Business 42, no. 2 (April 1969): 167–247. Lhabitant, F.-S. Handbook of Hedge Funds. Chichester: John Wiley & Sons, 2006. Ross, S. “Neoclassical Finance, Alternative Finance, and the Closed End Fund Puzzle.” Euro- pean Financial Management 8 (2002): 1291–1237. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK) 4.1 What is the difference between an open-end and closed-end mutual fund? 4.2 How is the NAV of an open-end mutual fund calculated? When is it calculated?P1: TIX/b P2:c/d QC:e/f T1:g JWBT668-c04 JWBT668-Hull February 24, 2012 17:25 Printer: Courier Westford 86 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS 4.3 An investor buys 100 shares in a mutual fund on January 1, 2012, for 30 each. The fund makes capital gains in 2012 and 2013 of 3 per share and 1 per share, respectively, and earns no dividends. The investor sells the shares in the fund during 2014 for 32 per share. What capital gains or losses is the investor deemed to have made in 2012, 2013, and 2014? 4.4 What is an index fund? How is it created? 4.5 What is a mutual fund’s (a) front-end load and (b) back-end load? 4.6 Explain how an exchange-traded fund that tracks an index works. What is the advantage of an exchange-traded fund (a) over an open-end mutual fund and (b) a closed-end mutual fund? 4.7 What is the difference between the geometric mean and the arithmetic mean of a set of numbers? Why is the difference relevant to the reporting of mutual fund returns? 4.8 Explain the meaning of (a) late trading, (b) market timing, (c) front running, and (d) directed brokerage. 4.9 Give three examples of the rules that apply to mutual funds, but not to hedge funds. 4.10 “If 70% of convertible bond trading is by hedge funds, I would expect the profitability of that strategy to decline.” Discuss this viewpoint. 4.11 Explain the meanings of the terms hurdle rate, high-water mark clause, and clawback clause when used in connection with the incentive fees of hedge funds. 4.12 A hedge fund charges 2 plus 20%. Investors want a return after fees of 20%. How much does the hedge fund have to earn, before fees, to provide investors with this return? Assume that the incentive fee is paid on the net return after management fees have been subtracted. 4.13 “It is important for a hedge fund to be right in the long term. Short-term gains and losses do not matter.” Discuss this statement. 4.14 “The risks that hedge funds take are regulated by their prime brokers.” Discuss this statement. FURTHER QUESTIONS 4.15 An investor buys 100 shares in a mutual fund on January 1, 2012, for 50 each. The fund earns dividends of 2 and 3 per share during 2012 and 2013. These are reinvested in the fund. Its realized capital gains in 2012 and 2013 are 5 per share and 3 per share, respectively. The investor sells the shares in the fund during 2014 for 59 per share. Explain how the investor is taxed. 4.16 Good years are followed by equally bad years for a mutual fund. It earns +8%, –8%, +12%, –12% in successive years. What is the investor’s overall return for the four years? 4.17 A fund of funds divides its money between five hedge funds that earn –5%, 1%, 10%, 15%, and 20% before fees in a particular year. The fund of funds charges 1 plus 10% and the hedge funds charge 2 plus 20%. The hedge funds’ incentive fees are calculated on the return after management fees. The fund of funds incentive fee is calculated on the net (after management fees and

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