Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 24

Chapter 24Professional Asset Management

Questions to be answered:• What are the different ways that professional

asset management firms can be organized?• How has the structure of the asset management

industry changed over time?• How are managers at investment advisory firms

compensated?

Chapter 24Professional Asset Management

• Who manages the investment company portfolio and how are its managers compensated?

• How do you compute the net asset value (NAV) for an investment company?

• What is the difference between closed-end and open-end investment companies?

• What is the difference between the NAV and market price for a closed-end fund?

Chapter 24Professional Asset Management

• What are load fees, 12b-1 fees, and management fees and how do they influence investment company performance?

• What are the two major means of fund distribution and what has been the trend for each approach?

• Given the breakdown of all funds by investment objectives, which groups have experienced relative growth or decline?

Chapter 24Professional Asset Management

• What are hedge funds and how do they differ from traditional professionally managed investment products?

• What investment strategies do hedge funds follow and what has been the performance of those fund types over time?

• What legal and ethical standards exist to protect investors who employ professional asset managers?

Chapter 24Professional Asset Management• What are the ethical dilemmas involved in the

professional asset management industry?• What functions should investors expect

professional asset managers to perform for them?

The Asset Management Industry: Structure and 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

– A Investment company offers a general solution

The Asset Management Industry: Structure and Evolution

• Contract directly with a management and advisory firm

– relationship with client– assets under management (AUM)– separate accounts– customized

The Asset Management Industry: Structure and Evolution

• 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 and Advisory Firms

• Much Smaller• Focus on a particular niche of the market• Investment Strategy

– Each client’s assets are held in a separate account.

– The security portfolio are likely to be guided by the firm’s overall investment philosophy.

Organization and Management of Investment Companies

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

• Issue securities• Handle redemptions and dividends

• Start funds with different characteristics to achieve economics of scale

Valuating Investment Company Shares

• The NAV for an investment company is analogous to the share price of a corporation’s common stock.

• The 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

• Differ in the way each operates after the initial public offering• Closed-end investment company

– Stock trades on secondary market– Net asset value (NAV) is computed twice daily, but market price

determined by supply and demand– Many Funds sell at discounts to NAV

• Open-end investment companies– Mutual funds– Sell and redeem shares at NAV

Load versus No-Load Open-End Fund

• The offering price for a share of a load fund equals the NAV of the share plus a sale charge.

• A no-load fund imposes no initial sales charge so it sells shares at the NAV.

• Several variations exist between the full-load fund and the pure no-load fund– Low-load fund– 12b-1 plan– Funds have contingent, deferred sales loads

Fund Management Fees• Charge annual management fees to compensate

professional managers of the fund• Management fees are a major factor driving the

creation of new funds.

Investment Company Portfolio Objectives

• Four broad fund objective categories– Common stock funds– Hybrid funds– Bond funds– Money market fund

Hedge Funds

• Form a portfolio that combines both long and short position in the equity market with the use of financial leverage to enhance return

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

Hedge Fund Strategies• Equity-based strategies

– Long-short equity– Equity market neutral

• Arbitrage-based Strategies– Fixed-income arbitrage– Convertible arbitrage– Merger (risk) arbitrage

• Opportunistic Strategies– High yield and distressed– Global macro– Managed futures– Special situations

• Multiple strategies– Fund of funds

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 prospective deal

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

• The manager might short sell the 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

• The returns to these strategies show a high degree of variability on a year-to year basis, in both an absolute and a relative sense.

Ethics and Regulation in the Professional Asset Management Industry

• Agency problem• Regulation in the asset management industry

– Principal securities laws that govern investment companies• The Investment Company Act of 1940• The Securities Act of 1933• The Securities Exchange Act of 1934• The Investment Advisers Act of 1940

– Regulatory agencies• U.S. Department of Labor• NASDR• U.S. Commodity and Futures Trading Commission• U.S. Internal Revenue Service

Ethics and Regulation in the Professional Asset Management Industry

• Standards for Ethical Behavior– The CFA Institute Code of Ethics– The CFA Institute Standards of Professional

Conduct• The CFA Institute’ Centre for Financial

Market Integrity– Asset Manager Code of Professional Conduct

Ethics and Regulation in the Professional Asset Management Industry

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

What Do You Want from a Professional Asset Manger?

1. Help determine your investment objectives and develop a portfolio that is consistent with them.

2. Diversify your portfolio to eliminate unsystematic risk.3. Maintain your portfolio diversification and your desired risk class

while allowing flexibility so you could shift between alternative investment instruments as desired.

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

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

6. Maintain ethical standards of behavior at all times.

The InternetInvestments Online

http://www.morningstar.comhttp://www.lipperweb.comhttp://www.lipperleader.comhttp://www.brill.comhttp://www.mfea.comhttp://www.investorguide.com/funds.htmlhttp://www.ici.org

End of Chapter 24–Professional Asset Management

Future topicsChapter 25

• Evaluation of Portfolio Performance