FMP3 - Fund Management

Question 1

Differentiate among open-end mutual funds, closed-end mutual funds, and exchange traded funds (ETFs)

Answer 1

• Open-ended mutual fund’s number of shares expand and contract as investors buy and sell, orders executed at 4pm every day
• Closed-ended funds keep same amount of shares over time
• ETF created when institutional investor deposits block of shares with ETF and in exchange receives shares of the ETF (diversifying?)

Question 2

Identify and describe potential undesirable trading behaviours at mutual funds

Answer 2

1. Late trading
2. Market timing
3. Front running (if trader knows mutual will make a big trade that will move market, tempting to capitalise)
4. Directed brokerage

Question 3

Explain the concept of net asset value (NAV) of an open-ended mutual fund and how it relates to share price

Answer 3

NAV is the value of assets of the fund divided by the number of shares in the fund

Question 4

Explain key differences between hedge funds and mutual funds

Answer 4

Hedge funds subject to less regulation, lock up periods common, incentive fees common, and no requirement to report NAV

Question 5

Calculate the return on a hedge fund investment and explain the incentive fee structure including the terms hurdle rate, high-water mark, and clawback

Answer 5

• Incentive fees quoted as 2 plus 20, meaning 2% management fee plus 20% of profits
• Incentive fee = hedge fund retained profit percentage * max(return on assets * assets under management - management retention * assets under management)
• Hurdle rate is when incentive fees are only payable on returns above a certain level (hurdle rate is the level)
• High-water mark is where incentive fees are only applicable when cumulative profits for an investor are positive
• Clawback is where incentive fees paid by investor can be used to offset future losses

Question 6

Describe various hedge fund strategies including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and identify risks faced by hedge funds

Answer 6

• Long/short equity: long underpriced, short overpriced
• Dedicated short: short only, look for companies struggling not recognised by the market
• Distressed debt: look for companies near bankruptcy and benefit from reorganisation proposals
• Merger arbitrage: look at likelihood of mergers going through
• Convertible arbitrage: value convertible bonds
• Fixed income arbitrage: long cheap bonds, short expensive
• Emerging markets: specialise in little known securities in developing markets
• Global macro: macroeconomic analysis to look for markets not in equilibrium
• Managed futures: predict future commodity prices

Question 7

Describe characteristics of mutual fund and hedge fund performance and explain the effect of measurement biases on performance management

Answer 7

Actively managed mutual funds do not beat the market on average, index funds tend to be better for an investor

Hedge funds did better than market until 2008, have been worse off since - measuring difficult as hedge funds do not have to report performance