investment analysis and portfolio management first canadian edition

Investment Analysis and Portfolio Investment Analysis and Portfolio ManagementManagement

First Canadian EditionFirst Canadian EditionBy Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang1717

Copyright © 2010 by Nelson Education Ltd. 17-2

•Structure and Evolution•Private Management and Advisory

Firms•Organization and Management of

Investment Companies•Hedge Funds and Private Equity•Ethics and Regulation•Professional Asset Manager

Chapter 17 Professional Money Management,

Alternative Assets, and Industry Ethics


The Asset Management Industry: Structure & Evolution

• Two Organization Forms• Contract directly with a management and

advisory firm• Commingling of investment capital of several

clients in an investment company• Differences between These Two Forms

• Private management and advisory firms develop a personal relationship with clients

• Investment company offers a general solution



•Contract directly with a management and advisory firm

• Relationship with client• Assets under management (AUM)• Separate accounts• Customized



•Commingling of investment capital of several clients in an investment company

• Invest a pool of funds belonging to many individuals in a single portfolio of securities

• Issue new shares representing the proportional ownership of the fund


Private Management & Advisory Firms

•Majority of private management and advisory firms are still much smaller

•More narrowly focused on a particular niche of the market


Private Management & Advisory Firms

• Investment Strategy• Each client’s assets are held in separate account• Security portfolio guided by the firm’s overall

investment philosophy• While the specific stock allocations might vary,

the same fundamental orientation toward stock selection will be applied to all accounts


Organization & Management of Investment Companies

• Investment Companies• Financial intermediaries that pool the assets of

individual investors and invest the fund in securities or other assets

• Major Duties• Investment research• Management of the portfolio• Administrative duties

• Management fee is percentage of total value of the fund

• Family of funds achieve economies of scale


Organization & Management of Investment Companies

• Valuating Investment Company Shares• Net Asset Value (NAV) for an investment

company is analogous to the share price of a corporation’s common stock.

• NAV of the fund shares will increase as the value of the underlying assets (the fund security portfolio) increases

Total Market Value of Fund Portfolio Fund ExpensesFund NAV=

Total Fund Shares Outstanding


Closed-End Versus Open-End Investment Companies

• Closed-End Investment Company• Functions like any other public firm and its stock

trades on the regular secondary market• Fund generally doesn’t issue or redeem shares

once it is established• Price of fund is different from its NAV• Puzzle for modern finance why closed-end funds

often sell at a discount from NAV • Often a means of investing in a pool of assets

from a foreign country


Investment Companies: Closed-End Mutual Funds



• Open-End Investment Companies• Company continues to sell and repurchase

shares after their initial public offerings• Fund stands ready to issue or redeem shares

at the net asset value (NAV)• Investors who buy or sell the shares may have

to pay sales charges (the load)• Normally called mutual funds


• Load versus No-Load Open-End Fund• Offering price for a share of a load fund equals the NAV

of the share plus a sale charge• No-load fund imposes no initial sales charge so it sells

shares at the NAV• Several variations exist between full-load and pure no-

load fund• Low-load fund• 12b-1 plan• Funds have contingent, deferred sales loads



Investment Companies

• Fund Management Fees• Charge annual management fees to compensate

professional managers of the fund• Fee typically is a percentage of the average net

assets of fund varying from about 0.25 to 1.00%• Management fees are a major factor driving the

creation of new funds• Mutual fund fees have been declining due to the

industry consolidation



• Investment Company Portfolio Objectives• Equity funds: Invest almost exclusively in common

stocks• Bond funds: Concentrate on various types of bonds to

generate high current income with minimal risk• Balanced funds: Diversify outside a single market by

combining common stock with fixed income securities• Money market funds: Invest in diversified portfolios of

short-term securities



• Breakdown by Fund Characteristics• By major Means of Distribution

• Sales force • Direct purchase from the fund • Direct institutional marketing

• By Investment Objective• Equity funds• Equity funds• Hybrid funds• Money market funds



• Global Investment Companies• Funds that invest in foreign securities are either

international funds or global funds• International funds often hold only foreign stocks from

U.S., Germany, Japan, Singapore, and Korea• Global funds contain both Canadian and foreign securities• Increasing large number of foreign investment companies

that offer both domestic and global products in their local markets


• Basic Concepts• Alternative Assets• Limited Partnership



Investing in Alternative Asset Classes


Hedge Funds & Private Equity

• The Development• Significant development in professional asset

management industry over the past 20 years was emergence of global market for hedge fund investing

• Hedge fund investing traces back to 1949• Structured as a partnership structure with an

incentive fee for superior performance



• Portfolio that combines both long and short position in equity market with use of financial leverage to enhance return

• Better able to produce superior returns than traditional investment structures, such as mutual funds



• Hedge Fund Characteristics• Far less liquid than mutual fund (or even closed-

end fund) shares• Severe limitations on when and how often

investment capital can be contributed to or removed from a partnership

• Performance allocation and high-watermark


Hedge Fund Strategies

• Equity-Based Strategies• Long-short equity:

• Managers attempt to identify misvalued stocks and take long positions in undervalued ones and short positions in the overvalued ones

• Equity market neutral: • limit the overall volatility exposure of the fund by taking offsetting

risk positions on the long and short side• might also involve adopting derivative positions


Hedge Funds Strategies

• Arbitrage-Based Strategies• Fixed-income arbitrage:

• Returns are generated by taking advantage of bond pricing disparities caused by changing market events, investor preferences, or fluctuations in fixed-income market

• Convertible arbitrage: • Seeks to profit from disparities in relationship between prices for convertible

bonds and underlying common stock


Hedge Funds Strategies

• Arbitrage-Based Strategies• Merger (risk) arbitrage:

• Returns are dependent upon magnitude of spread on merger transactions, which are directly related to the likelihood of the deal



• Opportunistic Strategies• High yield and distressed:

• Invest in risky bonds• Global macro

• Broad class seeks to profit from changes in global economies• Managed futures

• Using long and short positions in variety of futures contracts• Special situations

• Events like bankruptcies, spinoffs



• Multiple strategies• Fund of funds:

• Invest in a number of funds so as to achieve well-diversified allocation to the hedge fund investment space


Risk Arbitrage Investing

• Take equity positions in companies that are the target of a merger or takeover attempt

• Require managers to compare their own subjective judgment about the success of the proposed takeover with the success probability implied by the market price of the target firm’s stock following the announcement of the deal


Risk Arbitrage Investing

• If manager thinks takeover is more likely to occur than market does, he or she will buy target firm shares.

• Manager might short sell target firm shares if he or she thinks the proposed deal is less likely to be completed


Hedge Fund Performance

• Not all hedge funds are the same when it comes to their risk and return profiles

• Returns to these strategies show a high degree of variability on a year-to year basis, in both an absolute and a relative sense• There are only 2 (of 14) years in which every strategy class

earned positive returns• Emerging markets was the worst performing strategy in

1995 (-16.9%). However, it was the best performing strategy in 1996 ( +34.5%)

• The long/short equity strategy performed well in 2003 and 2004, but lost money in 2002


Hedge Fund Performance


Private Equity

• Basic Concepts• Any ownership interest in an asset (or assets) that

is not tradable in a public market• Typically fund either new companies or established firms

that are seeking to change their organizational structure or are experiencing financial distress

• Far less liquid than public stock holdings and considered long-term positions within an investor’s overall portfolio

• Characteristics• Higher return and low liquidity• Good sources of diversification


Private Equity


Private Equity

• Organization• Three Subcategories

•Venture Capital• Seed• Early stage• Later stage

•Buyouts•Special Situations

• Distressed Debt• Mezzanine Financing


Private Equity

• The Investment Process• Zero-stage capital: Using personal savings and bank

loans• Venture capital: Seek to obtain additional seed and

early-stage funding they need to advance their idea to the next level; in exchange, the venture capital firm receives an equity stake in the company

• Venture capital firm will ultimately want to liquidate equity holdings in order to create a return on investment

• Buyout• IPO


Private Equity

• Returns to Private Equity Funds• Long-term, highly illiquid investments• Return pattern known as “J-curve effect”

• Average annual returns for these investments tend to be quite high over time

• Initial years of new private equity commitment usually produce negative returns

• In addition to its higher overall risk level, huge dispersion in fund returns (good performance vs. bad performance managers)


Ethics & Regulation in the Professional Asset Management Industry

• Agency Conflict• Regulation in the Asset Management

Industry• Complex interaction between provincial and

federal laws• Goal is to ensure portfolio managers act in best

interests of their investors



• Standards for Ethical Behaviour• Chartered Financial Analysts Institute

(CFA)• Code of Ethics• Standards of Professional Conduct• Centre for Financial Market Integrity• Asset Manager Code of Professional Conduct



• Examples of Ethical Conflicts• Incentive Compensation Schemes• Soft Dollar Arrangements• Marketing Investment Management


What Do You Want From A Professional Asset Manager?

• Help determine you investment objectives and develop a portfolio that is consistent with them

• Diversify your portfolio to eliminate unsystematic risk

• Maintain portfolio diversification and desired risk class while allowing flexibility to shift between alternative investment instruments as desired


What Do You Want From A Professional Asset Manager?

• Attempt to achieve a risk-adjusted performance level that is superior to that of your relevant benchmark

• Administer the account, keep records of costs and transactions, provide timely information for tax purposes, and reinvest dividends if desired

• Maintain ethical standards of behaviour at all times

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