TYPES OF MUTUAL FUND #
Mutual funds are pooled investment vehicles that offers instant diversification for their investors. There are three types of mutual funds.
- Open-end Mutual Funds: These are simply called the mutual funds and are the most common type of investment pools vehicle. Investors commingle their funds to be better diversified, to save on transaction fees, and to hire a professional management team. The professional management team will conduct research and ultimately invest commingled assets on behalf of their investors. Investors can redeem their funds anytime they want. Open end mutual funds trade at NAV.
- Money market: Invests in short term interest bearing instruments. Ex– treasury bills
- Equity fund: Invests solely in stocks like S & P 500 index.
- Bond fund: Invests solely in fixed income securities. Ex– corporate bonds.
- Hybrid fund: Blend stock & bond ownership into the same fund.
- Close-end Mutual Funds: These are similar to open-end mutual fund except closed-end funds tend to invest in niche areas like specific emerging markets and investors cannot simply redeem their shares from the fund company. They must find another investor to buy their shares. A closed-end fund can transact at a price other than NAV.
- Exchange traded funds: ETFs enable instant diversification like an open-end fund, but they are exchange-traded, which means they trade throughout the day on the open market just like a closed-end fund does. Exchange-traded funds must disclose their holdings twice each day, which enables investors to have tremendous visibility into their underlying investments.All these funds are subject to significant regulatory oversight.These are all regulated by the Securities and Exchange Commission (SEC) and must register with the SEC and provide a very detailed disclosure document, called a prospectus, to all investors prior to investing. The SEC also enforces the prevention of conflicts of interest, fraud, and excessive fees. Regulatory oversight theoretically helps protect investors and causes increased costs for the funds as they hire compliance specialists to ensure that all regulations are being followed.
NET ASSET VALUE (NAV) #
The fund needs to know the current value of all investment holdings (including cash positions), any liabilities like management fees payable, and the total number of shares outstanding.
MUTUAL FUNDS VS. HEDGE FUNDS #
- Marked to any or all investors.
- Need to provide the redemption of shares at any time the investors demand, calculation of daily NAV & full disclosure of policies & strategies.
- Not permitted to use leverage.
- Long & short term investment are considered as separate classes.
- Restricted to wealthy & sophisticated investors.
- Escape certain regulations.
- Need not provide the redemption of shares at any time the investors demand, calculation of daily NAV & full disclosure of policies & strategies
- Permitted to use leverage.
- Permitted to use both long & short term investment strategies.
HEDGE FUND EXPECTED RETURNS AND FEE STRUCTURES #
Hedge funds charges incentive fees that are engineered to give hedge fund managers significant pay-outs based on their performance. The typical hedge fund fee structure is known as “2 plus 20%,” which means that they charge a flat 2% of all assets that they manage plus an additional 20% of all profits above a specified benchmark. Hedge funds do soften the incentive fee structure with a few safeguards for investors.
Hurdle rate: It is the benchmark that must be beaten before incentive fees can be charged.
High-water mark clause: It essentially states that previous losses must first be recouped and hurdle rates surpassed before incentive fees once again apply.
Clawback clause: It enables investors to retain a portion of previously paid incentive fees in an escrow account that is used to offset.
HEDGE FUND PERFORMANCE & MANAGEMENT BIAS #
- Participation in hedge fund indices is voluntary. If the fund had good performance, then they will report their results to the index vendor. If they did not have good results, then they simply do not report their results to the index. This is known as the measurement bias of hedge fund index reporting.
- When returns are reported by a hedge fund, the database is then backfilled with the fund’s previous returns. This is known as backfill bias and it creates an issue with reliability for hedge fund benchmarks.
- Undesirable Trading Behaviours
UNDESIRABLE TRADING BEHAVIOURS #
Late trading—when orders are accepted after the 4:00 pm cut off trading time. Significant events can occur after 4:00 and trades might be reversed. Hence late trading is illegal and subject to prosecution.
Market Timing—some funds assets are not actively traded, thereby resulting in stale pricing when calculating NAV. If markets are fluctuating before 4:00 pm cut off, it may be profitable to trade at NAV at 4.00pm since the stale pricing means that the value of the shares is likely higher or lower than NAV. Market trades may result in sudden fluctuations in the fund’s size that will require fund to maintain greater liquidity. Although, if trading exceptions are made by regulators, the act of market timing is not illegal.
Front running involves trading ahead of a likely price movement due to a known upcoming trade to be made by the fund, say by traders own account or favoured clients or employees. It is illegal and subject to prosecution.
Directed brokerage involves a quid pro quo whereby a mutual fund will direct trades to a broker in exchange for the broker investing its clients in the mutual fund. Not illegal, it is a strongly discouraged practice.
HEDGE FUND STRATEGIES #
- Long/short equity : Long/short equity hedge funds endeavour to find mispriced securities.
Market neutral funds are where long and short positions make the fund ambivalent to market direction, and factor neutral funds are where positions are isolated from a specific factor like oil or interest rate policy.
- Dedicated short : Dedicated short hedge funds are focused exclusively on finding a company that they think is overvalued and then short selling the stock.
- Distressed securities : Bonds with a credit rating of CCC are considered to be “distressed.” Distressed bonds usually trade at deep discounts to par value and often offer yields upwards of 10% greater than a comparable Treasury. Distressed securities hedge funds are searching for distressed bonds with the potential to turn things around.
- Merger Arbitrage: Merger arbitrage hedge funds try to find arbitrage opportunities after mergers are announced. These are primarily positive deals where the managers are planning on the deal going through.
There are two different types of mergers:
- cash deals : Merger deal is settled by paying cash to the merger company.
- Stock deals: Merger deal is settled by paying in stock to the seller company.
- Convertible arbitrage: Some hedge funds invest using convertible bonds, which are fixed-income instruments that can be converted into shares of stock if the stock price rises above a pre-specified value. If convertible bonds are not converted into shares of stock, then they simply retain their bond status and continue to offer interest payments and a certain principal repayment at maturity.
- Fixed income arbitrage : Fixed income arbitrage hedge funds attempt to exploit perceived mispricing in the realm of fixed-income securities.
- Emerging market : Emerging market hedge funds focus on investments in developing countries. Some hedge funds choose to invest in developing country securities in their local market while others invest using American depository receipts (ADRs).
- Global Macro : In this strategy, hedge fund managers attempt to profit from a global macroeconomic trend that they feel is not in equilibrium (priced correctly and rationally).
- Managed Futures: These hedge funds attempt to predict future movements in commodity prices based on either technical analysis or fundamental analysis. Technical analysis attempts to infer patterns from past price movements and use those patterns as a basis for predictions. When technical analysis is used, fund managers will back test their trading rules using.