CHAPTER 5 Mutual Funds, Hedge Funds, and Pension Funds
FIN701 Financial Institutions Management
CHAPTER 5 Mutual Funds, Hedge Funds, and Pension Funds
Fund – FI whose primary purpose is to acquire and manage financial assets (e.g., bonds, shares, money market securities) or its owners o Mutual fund – FI that pools financial resources of individuals and companies and invests in diversified portfolios of assets, targeting a specific level of risk o Hedge fund – FI that pools financial resources of sophisticated investors and invests in a diversified pool of assets, usually high risk o Pension fund – FI that pools retirement savings of individuals, invests in diversified portfolio of assets, and pays an income to its owners after retirement Funds provide opportunity for small savers to invest in financial securities, diversify risk, and generate greater economies of scale by incurring lower transaction costs and commissions Growth in savings, from employee benefits (pension fund, firm-operated or government operated) or through individual efforts (RRSP and RESP), created FIs whose liability side is all OE Provides wealth management services and are subject to interest rate risk, market risk, foreign exchange risk, and offbalance-sheet risk
MUTUAL FUNDS Open-end mutual fund stands ready to sell new shares to investors and to redeem outstanding shares on demand at their fair market value Legally required to provide investors with prospectus that outlines fund’s investment strategy and its costs 2008: more than 2000 different mutual companies held total assets of $507b Size, Structure, and Composition of the Industry Historical Trends 1998-2008: average of 85% of assets under management with number of mutual funds increased from 1130 to 2015 and accounts increases from 32.8m to over 50m Comparison of net sales over the years may be misleading due changes in the markets (e.g., limits on foreign content in RRSPs) Clone fund – mutual fund that is RRSP-eligible and that creates returns equivalent to a foreign stock portfolio using derivatives Funds of funds – mutual funds that invest in other mutual funds Regulated at provincial/territorial level to protect investors by ensuring disclosure of information and market transparency o Majority of Canadian mutual funds regulated by Ontario Securities Commission (OSC) and harmonizes regulations through the Canadian Securities Administrators (CSA) Top 15 mutual funds represents 93% of the $470b mutual fund assets reported; Big Six banks represent 47% of net mutual fund assets of $237b Different Types of Mutual Funds Long term funds include: o Bond funds – funds that contain fixed income capital market debt securities with maturity over one year o Equity funds – fund that contain primarily common stock securities o Balanced funds – funds that contain bonds and stock (common and preferred) securities Short-term funds include: o Money market mutual funds that are invested in short term paper, usually with maturities of less than six months Long-term funds dominate, with short-term money market funds making up only 14% of total assets Investor Returns from Mutual Fund Ownership Return from investing in mutual fund shares reflects three aspects of the underlying portfolio of mutual fund assets i. Income and dividends are earned on those assets ii. Capital gains occur when assets are sold by mutual fund at prices higher than the purchase price iii. Capital appreciation in underlying values of the assets held in fund’s portfolio add to the value of mutual fund shares Marketed-to-market – adjusting asset and balance sheet value to reflect current market price o Net asset value (NAV) or net asset value per share (NAVPS) - net asset value of mutual fund is equal to the market value of the assets in mutual fund portfolio divided by number of shares outstanding
FIN701 Financial Institutions Management
It is the price investors get when selling back shares to the fund that day or buying any new shares in the fund that day Open-end – supply of shares in fund is not fixed but can increase or decrease daily with purchases and redemptions of shares; has fixed number of outstanding shares at any given time Closed-end investment companies – specialized investment companies that invest in securities and assets of other firms but have a fixed supply of shares outstanding themselves o Income trusts – income fund/trust set up to own assets whose earnings (income) are passed on to the unit holders monthly or quarterly and taxed on hand o Real estate investment trusts (REITs) –specialize in investment in real estate company shares and/or buying mortgages Since number of shares available for purchase is fixed, NAV determined by value of underlying share and demand for investment company share
Mutual Fund Costs Load versus No-Load Funds Load fund – mutual fund with an up-front sales or commission charge that has to be paid by investor o Provides more personal attention and advice No-load fund – mutual fund that does not change up-front fees or commission changes on sale of mutual fund shares to investors Fund Operating Expenses Annual fees charged to cover all fund-level expenses experienced as a percentage of fund assets Management fee – amount paid to an investment manager for operating a mutual fund, such as administration and shareholder services, excluding brokerage fees Mutual funds require small percentage (or fee) of investable funds to meet fund-level marketing and distribution costs Management expense ratio (MER) – ratio of all operating costs expressed as a percentage of its total average assets o MER increases by inclusion of trailer fee (also called trailer commission), which is an amount paid monthly or quarterly to investment advisor (person who sells the fund to the investor) as long as the investor owns the fund o Fees may amount to 0.5% per year of amount of assets owned by investor Regulation Mutual funds are members of self-regulating organizations (SROs) such as Investment Industry Association of Canada and Mutual Fund Dealers Association of Canada (MFDA) Securities and Exchange Commission (SEC) investigates violations of mutual fund o Market timing – excessive buying and selling of securities to take advantage of opportunities between different markets Common in international funds since traders can exploit differences in time zones o Late trading (called backward pricing) – illegally buying or selling securities submitted after closing time at that day`s price o Brokerage fees – fees paid to brokerage firms for promoting a stock or mutual fund GLOBAL ISSUES Worldwide investments in mutual funds have increased over 120% from $11.65t (2001) to $26.1t (2007), but declined to $18.97t (2008) Mutual fund industry has worked to lower barriers that prevent mutual fund firms from marketing their services more widely and to improve competition in the often diverse fund markets around the world HEDGE FUNDS History, Size, Structure, and Composition of the Industry Not subject to regulatory oversight globally because of small number of investors permitted in each fund and the fact that investors are viewed as being sophisticated so they do not need protection o Sold without a prospectus and does not require published financial statements 191 Canadian hedge funds with assets of $26.6b; $14.1b represents Canadian-sponsored assets Global hedge fund peaked $1.93t in mid-2008 and by the end of 2008, reached $525b due to losses and withdrawals Uses aggressive strategy unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading Non-directional strategy – arbitrage position that allows hedge fund to benefit whether market prices go up or down
FIN701 Financial Institutions Management
Event driven strategy – hedge designed to take advantage of potential occurrence in market such as purchase of shares of a merger target or an investment in distressed debt Opportunistic strategy – hedge designed to take advantage of temporary pricing discrepancies in markets
Types of Hedge Funds Hedge fund managers follow variety of investment strategies and are set with specific parameters so that investors can forecast risk-return profile Classifications of hedge funds i. More risky – market directional that seek high returns using leverage, typically investing based on anticipated events Classified by objectives: o Aggressive growth funds invest in equities expected to experience acceleration in growth of earnings per share with high price-to-earnings ratio, low or no dividend o Emerging markets funds invest in equity or debt securities of emerging markets, which tend to have higher inflation and volatile growth o Macro funds aim to profit from changes in global economies by using leverage and derivatives, such as shifts in government policy that impact interest rates o Market timing funds allocate assets among different asset classes depending on manager`s view of economic or market outlooks o Short selling funds sell securities in anticipation of being able to buy them back in future at lower price based on assessment of overvaluation on securities or in anticipation of earnings disappointment ii. Moderate risk – market neutral or value orientation that have moderate exposure to market risk, typically favouring longer-term investment strategy Classified by objectives: o Distressed securities funds buy equity, debt, or trade claims, at deep discounts, of companies in or facing bankruptcy or reorganization o Fund of funds mix hedge funds and other pooled investment vehicles to provide more stable long-term investment returns than any of the individual funds o Opportunistic funds change investment strategy as opportunities arise to profit from events, such as IPOs, sudden changes resulting from disappointing earnings announcement, and hostile takeover bids o Multistrategy funds take diversified investment approach by implementing various strategies simultaneously to realize short- and long-term gains Overweight and underweight different strategies to best capitalize on current investment opportunities o Special situations funds invest in event-driven situations, such as mergers, hostile takeovers, reorganizations, or leverage buyouts iii. Risk-avoidance – market neutral that strive for moderate, consistent returns with low risk Classified by objectives o Income funds invest with primary focus on yield or current income rather than solely on capital gains o Market neutral-arbitrage funds attempt to hedge market risk by taking offsetting positions, often in different securities of the same issuer Obtaining returns with low or no correlation to both equity and bond markets o Market neutral-securities hedging funds invest equally in long and short equity portfolios in particular market sectors o Value funds invest in securities perceived to be selling at deep discounts relative to intrinsic values Fees on Hedge Funds Managers charge two types of fees: i. Management fee computed as a percentage of total assets under management and typically runs between 1.5% and 2.0% ii. Performance fee gives fund managers a share of any positive returns on hedge fund and typically 20% Paid to hedge fund manager before returns are paid to fund investors
FIN701 Financial Institutions Management
Hurdle rate is a minimum annualized performance benchmark that must be realized before a performance fee can be assessed High-water mark where manager does not receive performance fee unless value of fund exceeds highest net asset value it has previously achieved
Offshore Hedge Funds Offshore hedge funds trade more intensely, due to lower or zero capital gains tax for offshore funds Engage less often in positive feedback trading (rushing to buy when market is booking and rushing to sell when market is declining) than domestic hedge funds Offshore hedge funds have been found to herd (mimic each other`s behaviour when trading while ignoring information about the fundamentals of valuation) Regulation Hedge funds not subject to numerous regulations, such as regulations requiring certain degree of liquidity, regulations requiring mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in pricing of funds shares, disclosure regulations, and regulations limiting use of leverage September 2009: hedge funds are required to be registered 2007: committee of U.S. financial system regulators concluded that current regulations on hedge funds were sufficient to prevent hedge funds from threatening financial system`s stability o Conclude that risks can be maintained through combination of market discipline and limiting access to private pools of capital to wealthy investors PENSION FUNDS Size, Structure, and Composition of the Industry Pension funds driven by government regulations regarding retirement savings in Canada Retirement savings comes from: i. Government-funded or sponsored plans (Canadian Pension Plan and Quebec Pension Plan) ii. Employer-sponsored pension plans (trusteed pension funds , profit-sharing plans, group RRSPs) iii. Individual savings (RRSP) 2008: top 100 pension funds total $598.6b Vested assets – contributions to pension plan that are legally owned by employee and may be withdrawn prior to retirement and transferred to another registered plan in which assets are locked until retirement Risk of pension fund is that assets growth, which comes from investment returns and new contributions, will not meet liabilities to their beneficiaries Defined contribution plan – employer contributes certain percentage each year for benefit of employee whose payment on retirement depend on amount in the plan Defined benefit plan – payments to employees on retirement are known and employer contributions are determined by actuarial calculations based on factors such as mortality rates and investment returns Plans assets held on trust for benefit of employees, but vesting, which gives employees legal right to the funds, may occur Balance Sheet and Recent Trends Growth in pension funds and significant contribution to capital of corporations has led to growth of shareholder activism and push for pension funds to have representation on companies’ board of directors Investment in assets exposes funds to interest rate risk, market risk, and foreign exchange risk Disbursement of pensioners expected to increase over the coming years as baby boom retires and starts drawing benefits World Bank recommends compulsory contributions of fully funded plans, where workers save part of their earnings Regulations Private pension plans regulated by and reported to OSFI and subject to Pension Benefits Standards Act; others report to provincial or territorial bodies Regulators concerned with protecting retirement savings of funds that may be in danger in event of insolvency or bankruptcy proceedings GLOBAL ISSUES 2002-2007: Canadian average compound annual growth rate in pension fund 22.06% (second to Australia with 27.34%) 2007: Canadian pension assets represented 5.9% of top 300 pension funds tracked
CHAPTER 5 Mutual Funds, Hedge Funds, and Pension Funds
Fund – FI whose primary purpose is to acquire and manage financial assets (e.g., bonds, shares, money market securities) or its owners o Mutual fund – FI that pools financial resources of individuals and companies and invests in diversified portfolios of assets, targeting a specific level of risk o Hedge fund – FI that pools financial resources of sophisticated investors and invests in a diversified pool of assets, usually high risk o Pension fund – FI that pools retirement savings of individuals, invests in diversified portfolio of assets, and pays an income to its owners after retirement Funds provide opportunity for small savers to invest in financial securities, diversify risk, and generate greater economies of scale by incurring lower transaction costs and commissions Growth in savings, from employee benefits (pension fund, firm-operated or government operated) or through individual efforts (RRSP and RESP), created FIs whose liability side is all OE Provides wealth management services and are subject to interest rate risk, market risk, foreign exchange risk, and offbalance-sheet risk
MUTUAL FUNDS Open-end mutual fund stands ready to sell new shares to investors and to redeem outstanding shares on demand at their fair market value Legally required to provide investors with prospectus that outlines fund’s investment strategy and its costs 2008: more than 2000 different mutual companies held total assets of $507b Size, Structure, and Composition of the Industry Historical Trends 1998-2008: average of 85% of assets under management with number of mutual funds increased from 1130 to 2015 and accounts increases from 32.8m to over 50m Comparison of net sales over the years may be misleading due changes in the markets (e.g., limits on foreign content in RRSPs) Clone fund – mutual fund that is RRSP-eligible and that creates returns equivalent to a foreign stock portfolio using derivatives Funds of funds – mutual funds that invest in other mutual funds Regulated at provincial/territorial level to protect investors by ensuring disclosure of information and market transparency o Majority of Canadian mutual funds regulated by Ontario Securities Commission (OSC) and harmonizes regulations through the Canadian Securities Administrators (CSA) Top 15 mutual funds represents 93% of the $470b mutual fund assets reported; Big Six banks represent 47% of net mutual fund assets of $237b Different Types of Mutual Funds Long term funds include: o Bond funds – funds that contain fixed income capital market debt securities with maturity over one year o Equity funds – fund that contain primarily common stock securities o Balanced funds – funds that contain bonds and stock (common and preferred) securities Short-term funds include: o Money market mutual funds that are invested in short term paper, usually with maturities of less than six months Long-term funds dominate, with short-term money market funds making up only 14% of total assets Investor Returns from Mutual Fund Ownership Return from investing in mutual fund shares reflects three aspects of the underlying portfolio of mutual fund assets i. Income and dividends are earned on those assets ii. Capital gains occur when assets are sold by mutual fund at prices higher than the purchase price iii. Capital appreciation in underlying values of the assets held in fund’s portfolio add to the value of mutual fund shares Marketed-to-market – adjusting asset and balance sheet value to reflect current market price o Net asset value (NAV) or net asset value per share (NAVPS) - net asset value of mutual fund is equal to the market value of the assets in mutual fund portfolio divided by number of shares outstanding
FIN701 Financial Institutions Management
It is the price investors get when selling back shares to the fund that day or buying any new shares in the fund that day Open-end – supply of shares in fund is not fixed but can increase or decrease daily with purchases and redemptions of shares; has fixed number of outstanding shares at any given time Closed-end investment companies – specialized investment companies that invest in securities and assets of other firms but have a fixed supply of shares outstanding themselves o Income trusts – income fund/trust set up to own assets whose earnings (income) are passed on to the unit holders monthly or quarterly and taxed on hand o Real estate investment trusts (REITs) –specialize in investment in real estate company shares and/or buying mortgages Since number of shares available for purchase is fixed, NAV determined by value of underlying share and demand for investment company share
Mutual Fund Costs Load versus No-Load Funds Load fund – mutual fund with an up-front sales or commission charge that has to be paid by investor o Provides more personal attention and advice No-load fund – mutual fund that does not change up-front fees or commission changes on sale of mutual fund shares to investors Fund Operating Expenses Annual fees charged to cover all fund-level expenses experienced as a percentage of fund assets Management fee – amount paid to an investment manager for operating a mutual fund, such as administration and shareholder services, excluding brokerage fees Mutual funds require small percentage (or fee) of investable funds to meet fund-level marketing and distribution costs Management expense ratio (MER) – ratio of all operating costs expressed as a percentage of its total average assets o MER increases by inclusion of trailer fee (also called trailer commission), which is an amount paid monthly or quarterly to investment advisor (person who sells the fund to the investor) as long as the investor owns the fund o Fees may amount to 0.5% per year of amount of assets owned by investor Regulation Mutual funds are members of self-regulating organizations (SROs) such as Investment Industry Association of Canada and Mutual Fund Dealers Association of Canada (MFDA) Securities and Exchange Commission (SEC) investigates violations of mutual fund o Market timing – excessive buying and selling of securities to take advantage of opportunities between different markets Common in international funds since traders can exploit differences in time zones o Late trading (called backward pricing) – illegally buying or selling securities submitted after closing time at that day`s price o Brokerage fees – fees paid to brokerage firms for promoting a stock or mutual fund GLOBAL ISSUES Worldwide investments in mutual funds have increased over 120% from $11.65t (2001) to $26.1t (2007), but declined to $18.97t (2008) Mutual fund industry has worked to lower barriers that prevent mutual fund firms from marketing their services more widely and to improve competition in the often diverse fund markets around the world HEDGE FUNDS History, Size, Structure, and Composition of the Industry Not subject to regulatory oversight globally because of small number of investors permitted in each fund and the fact that investors are viewed as being sophisticated so they do not need protection o Sold without a prospectus and does not require published financial statements 191 Canadian hedge funds with assets of $26.6b; $14.1b represents Canadian-sponsored assets Global hedge fund peaked $1.93t in mid-2008 and by the end of 2008, reached $525b due to losses and withdrawals Uses aggressive strategy unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading Non-directional strategy – arbitrage position that allows hedge fund to benefit whether market prices go up or down
FIN701 Financial Institutions Management
Event driven strategy – hedge designed to take advantage of potential occurrence in market such as purchase of shares of a merger target or an investment in distressed debt Opportunistic strategy – hedge designed to take advantage of temporary pricing discrepancies in markets
Types of Hedge Funds Hedge fund managers follow variety of investment strategies and are set with specific parameters so that investors can forecast risk-return profile Classifications of hedge funds i. More risky – market directional that seek high returns using leverage, typically investing based on anticipated events Classified by objectives: o Aggressive growth funds invest in equities expected to experience acceleration in growth of earnings per share with high price-to-earnings ratio, low or no dividend o Emerging markets funds invest in equity or debt securities of emerging markets, which tend to have higher inflation and volatile growth o Macro funds aim to profit from changes in global economies by using leverage and derivatives, such as shifts in government policy that impact interest rates o Market timing funds allocate assets among different asset classes depending on manager`s view of economic or market outlooks o Short selling funds sell securities in anticipation of being able to buy them back in future at lower price based on assessment of overvaluation on securities or in anticipation of earnings disappointment ii. Moderate risk – market neutral or value orientation that have moderate exposure to market risk, typically favouring longer-term investment strategy Classified by objectives: o Distressed securities funds buy equity, debt, or trade claims, at deep discounts, of companies in or facing bankruptcy or reorganization o Fund of funds mix hedge funds and other pooled investment vehicles to provide more stable long-term investment returns than any of the individual funds o Opportunistic funds change investment strategy as opportunities arise to profit from events, such as IPOs, sudden changes resulting from disappointing earnings announcement, and hostile takeover bids o Multistrategy funds take diversified investment approach by implementing various strategies simultaneously to realize short- and long-term gains Overweight and underweight different strategies to best capitalize on current investment opportunities o Special situations funds invest in event-driven situations, such as mergers, hostile takeovers, reorganizations, or leverage buyouts iii. Risk-avoidance – market neutral that strive for moderate, consistent returns with low risk Classified by objectives o Income funds invest with primary focus on yield or current income rather than solely on capital gains o Market neutral-arbitrage funds attempt to hedge market risk by taking offsetting positions, often in different securities of the same issuer Obtaining returns with low or no correlation to both equity and bond markets o Market neutral-securities hedging funds invest equally in long and short equity portfolios in particular market sectors o Value funds invest in securities perceived to be selling at deep discounts relative to intrinsic values Fees on Hedge Funds Managers charge two types of fees: i. Management fee computed as a percentage of total assets under management and typically runs between 1.5% and 2.0% ii. Performance fee gives fund managers a share of any positive returns on hedge fund and typically 20% Paid to hedge fund manager before returns are paid to fund investors
FIN701 Financial Institutions Management
Hurdle rate is a minimum annualized performance benchmark that must be realized before a performance fee can be assessed High-water mark where manager does not receive performance fee unless value of fund exceeds highest net asset value it has previously achieved
Offshore Hedge Funds Offshore hedge funds trade more intensely, due to lower or zero capital gains tax for offshore funds Engage less often in positive feedback trading (rushing to buy when market is booking and rushing to sell when market is declining) than domestic hedge funds Offshore hedge funds have been found to herd (mimic each other`s behaviour when trading while ignoring information about the fundamentals of valuation) Regulation Hedge funds not subject to numerous regulations, such as regulations requiring certain degree of liquidity, regulations requiring mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in pricing of funds shares, disclosure regulations, and regulations limiting use of leverage September 2009: hedge funds are required to be registered 2007: committee of U.S. financial system regulators concluded that current regulations on hedge funds were sufficient to prevent hedge funds from threatening financial system`s stability o Conclude that risks can be maintained through combination of market discipline and limiting access to private pools of capital to wealthy investors PENSION FUNDS Size, Structure, and Composition of the Industry Pension funds driven by government regulations regarding retirement savings in Canada Retirement savings comes from: i. Government-funded or sponsored plans (Canadian Pension Plan and Quebec Pension Plan) ii. Employer-sponsored pension plans (trusteed pension funds , profit-sharing plans, group RRSPs) iii. Individual savings (RRSP) 2008: top 100 pension funds total $598.6b Vested assets – contributions to pension plan that are legally owned by employee and may be withdrawn prior to retirement and transferred to another registered plan in which assets are locked until retirement Risk of pension fund is that assets growth, which comes from investment returns and new contributions, will not meet liabilities to their beneficiaries Defined contribution plan – employer contributes certain percentage each year for benefit of employee whose payment on retirement depend on amount in the plan Defined benefit plan – payments to employees on retirement are known and employer contributions are determined by actuarial calculations based on factors such as mortality rates and investment returns Plans assets held on trust for benefit of employees, but vesting, which gives employees legal right to the funds, may occur Balance Sheet and Recent Trends Growth in pension funds and significant contribution to capital of corporations has led to growth of shareholder activism and push for pension funds to have representation on companies’ board of directors Investment in assets exposes funds to interest rate risk, market risk, and foreign exchange risk Disbursement of pensioners expected to increase over the coming years as baby boom retires and starts drawing benefits World Bank recommends compulsory contributions of fully funded plans, where workers save part of their earnings Regulations Private pension plans regulated by and reported to OSFI and subject to Pension Benefits Standards Act; others report to provincial or territorial bodies Regulators concerned with protecting retirement savings of funds that may be in danger in event of insolvency or bankruptcy proceedings GLOBAL ISSUES 2002-2007: Canadian average compound annual growth rate in pension fund 22.06% (second to Australia with 27.34%) 2007: Canadian pension assets represented 5.9% of top 300 pension funds tracked
