PROFESSIONAL ASSET MANAGEMENT

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Basic Categories

Private Management

: Clients each have a separate account {popular with institutions} Investor 1 Investor 2 $ Asset manager $$ $ Account 1 Account 2 2

Basic Categories

Investment Companies

: Sell shares of the fund and invest the proceeds in a portfolio of stocks, bonds, or other assets Investor 1 Investor 2 $ $ Fund Shares Asset manager $$ Fund Shares Fund Portfolio 3

Professional Asset Management vs. Individuals

1. Diversification 2. Record Keeping 3. Professional Management 4. Lower Transaction Costs 4

Net Asset Value

NAV

  Total Market Value of Portfolio   Fund Total Fund Shares Outstandin g Expenses  Example Market Value = $100 mil Number of Shares = 10 mil NAV = $100 / 10 = $10 / share Suppose Market Value goes up to $112.5 mil, and the management fees during that period were $0.1 mil. What is the ending NAV?

NAV = (112.5 – 0.1) / 10 = $11.24 / share 5

Closed End Funds

 Stock of the fund trades on the regular secondary market  Fund does not usually offer additional shares or repurchase shares  Fund is actively managed  NAV computed twice daily  Market price is NOT NECESSARILY EQUAL to NAV  Premium or discount reflects investors’ opinions of manager’s ability to select good investments in future  Poor history of long-run returns 6

Open-End (Mutual Fund)

 Always willing to buy back (redeem) shares or sell additional shares at the NAV.  May be a sales charge (load) when the fund sells the shares to customers.

 May charge a redemption fee when the customers sell their shares back to the fund. 7

Mutual Funds

 Prospectus will state fund objective  Name of fund will often describe objective as well  Generally must hold some money market instruments to provide liquidity regarding redemptions no matter what the fund objective is 8

Loads: Sales Charge

• Front End: Paid when shares are purchased.

• 3% of NAV is typical • Back End: Paid when shares are redeemed • 5-10% fee on sale. Typically drops by 1% every year.

 No-Load: No sales charge. 9

12b-1 Fees

An alternative to a load to cover advertising & marketing expenses. Can be found in both loaded and no-load funds  Can deduct as much as .75% of assets annually to cover fund advertising & marketing.

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Sales & Marketing Fee Choice

 Some funds give you a choice as to how you want to pay your share of the expenses.  Offer alternatives called choices “A”, “B” or “C” for example.

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Sales & Marketing Fee Choice

A: front-end load B: 12b-1 & rear-end load that decrease the longer you hold shares.

C: Perpetual 12b-1 fees 12

Records Fees

 Funds can charge as much as .25% of assets annually for records fees.

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Management Fees

 Range is typically .20% to 1.00%.

 Does not include trading commissions 14

Expense Ratio

Expense Ratio = Annual Expenses/$ Amt of Fund Assets Annual Expenses are: Management fees, 12b-1 fees, records fees (NOT front or back-end loads and not trading commissions) 15

Expense Ratio

 Studies find that funds with lower expense ratios earn higher returns than those with higher expense ratios.

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Recent Examples

Vanguard 500

: Expense Ratio = .18%, no-load, Mgmt fee is .16%.

Janus 20

: Expense Ratio = .87%, no-load, Mgmt fee is .65%.

Fidelity Magellan:

Mgmt fee = .57%.

Expense Ratio = .74%, 3% front load, 17

Turnover & Taxes

 Turnover: Fraction of portfolio replaced each year.

 Studies indicate that funds with a lower turnover achieve higher returns  Mutual funds have pass-through-status which means that taxes are paid only by the investor, not the mutual fund.

 Investors can be taxed on gains they never received  Don’t buy at end of the year  Not an issue if in a tax-deferred retirement account 18

Performance

 Many Studies find active managers underperform benchmarks after costs and fees by about 1% per year.

 Less than half outperform a broad market index after costs and fees.

 Good performance is associated with low expense ratio.

 Very low correlation between top funds one year and top funds the next year.

 Some positive correlation between bottom funds one year and bottom funds the next year.

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Performance

    Investors tend to put more money in funds that have recently done well Some evidence that these funds continue to do well for a few weeks/months – probably due to momentum effect The stocks in the funds that receive more money tend to do poorly over the subsequent few years Investors in mutual funds tend to overweight growth stocks 20

ETFs

 Exchange Traded Funds  Close-end index funds  Indexes for every sector, region and style  Most trade on AMEX  SPDR – S&P 500  QQQQ – Nasdaq 100  Low expense ratios  Trade like stocks  More transparent than mutual funds  Trade very close to NAV 21

Hedge Funds

 Similar to Mutual Funds  Lightly Regulated  Only open to “Sophisticated” Investors  Not allowed to advertise  No secondary market  Not regularly marked-to-market due to illiquid investments  Can be highly leveraged  Often require a lockup period for investors 22

Investment Strategies

 Long/Short – Market Neutral  Convertible Arbitrage  Merger Arbitrage  Statistical Arbitrage  Distressed Companies 23

Compensation Structure

 Management Fee similar to mutual funds  Performance Fee – typically 20% of profits 24

Results

 Often difficult to know for sure  Some appear to be very high  Some studies say the industry averages no better than mutual funds  Additional fees can cut into positive results – Especially funds of funds 25