Mutual Funds andHedgeFundsChapter 4RiskManagementandFinanciallnstitutions3e,Chapter4,CopyrightJohnC.Hull2012
Mutual Funds and Hedge Funds Chapter 4 Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 1
Open-End MutualFundsInvestments in mutual funds have grown from$0.5 billion in 1940 to over $12 trillion in 2011Most common type of fund is an open-end fundThis means that the number of shares in thefund goes up as investors buy more shares anddown as they redeem sharesAll purchases and sales of shares are atthe4pm net asset value (NAV) of the fund2RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull 2012
Open-End Mutual Funds ⚫ Investments in mutual funds have grown from $0.5 billion in 1940 to over $12 trillion in 2011 ⚫ Most common type of fund is an open-end fund ⚫ This means that the number of shares in the fund goes up as investors buy more shares and down as they redeem shares ⚫ All purchases and sales of shares are at the 4pm net asset value (NAV) of the fund Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 2
TaxTax is paid as though the investor owned themutual fund investmentsIf the mutual fund realizes capital gains ordividends during a year, the investor has topay taxes on the amount realizedThe investor's basis (i.e., the amount theinvestor is assumed to have paid for themutual fund shares) is adjusted to avoiddouble taxation when the shares are sold3RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull 2012
Tax ⚫ Tax is paid as though the investor owned the mutual fund investments ⚫ If the mutual fund realizes capital gains or dividends during a year, the investor has to pay taxes on the amount realized ⚫ The investor’s basis (i.e., the amount the investor is assumed to have paid for the mutual fund shares) is adjusted to avoid double taxation when the shares are sold Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 3
Types of FundEquityBondHybridMoney MarketIndexRiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull20124
Types of Fund ⚫ Equity ⚫ Bond ⚫ Hybrid ⚫ Money Market ⚫ Index Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 4
Costs (Table 4.2)Annual feeFront-end loadBack-end loadRelatively low in USRelatively high in Canada, DenmarkFinland, Italy, Norway, and Spain5RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull2012
Costs (Table 4.2) ⚫ Annual fee ⚫ Front-end load ⚫ Back-end load ⚫ Relatively low in US ⚫ Relatively high in Canada, Denmark, Finland, Italy, Norway, and Spain Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 5
Closed-End Fund Consists of a fixed number of shares thatare traded in the same way as the sharesof any other companyThe share price tends to be less than theNAV calculated from the market value ofthe investments6RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull2012
Closed-End Fund ⚫ Consists of a fixed number of shares that are traded in the same way as the shares of any other company ⚫ The share price tends to be less than the NAV calculated from the market value of the investments Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 6
Exchange-Traded Funds (ETFspage 71) Often designed to track an indexStarted by an institutional investor that deposits ablock of securities and obtains shares in the fund Shares are traded on an exchangeLarge institutional investors can exchange shares inthe fund for the underlying assets, and vice versaThis keeps the share price close to the NAV of thefund's investments7RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull 2012
Exchange-Traded Funds (ETFs, page 71) ⚫ Often designed to track an index ⚫ Started by an institutional investor that deposits a block of securities and obtains shares in the fund ⚫ Shares are traded on an exchange ⚫ Large institutional investors can exchange shares in the fund for the underlying assets, and vice versa ⚫ This keeps the share price close to the NAV of the fund’s investments Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 7
AdvantagesofETFsoverOpen-andClosed-End Mutual Funds Can be bought or sold (or shorted) atany time of the dayHoldings are disclosed twice a dayInvestments do not have to be sold tocover redemptionsShare price close to NAV of underlyinginvestments8RiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull2012
Advantages of ETFs over Open- and Closed-End Mutual Funds ⚫ Can be bought or sold (or shorted) at any time of the day ⚫ Holdings are disclosed twice a day ⚫ Investments do not have to be sold to cover redemptions ⚫ Share price close to NAV of underlying investments Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 8
Performance of Mutual FundsThe classic study is by Jensen in 1969.His results have been confirmed in laterstudies The average alpha of all funds is slightlynegative. Good performance by a mutual fundmanager in the past is not a good guide tofuture performanceRiskManagementandFinancialInstitutions3e,Chapter4,CopyrightJohnC.Hull20129
Performance of Mutual Funds ⚫ The classic study is by Jensen in 1969. His results have been confirmed in later studies ⚫ The average alpha of all funds is slightly negative. ⚫ Good performance by a mutual fund manager in the past is not a good guide to future performance Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 9
Jensen's Results on the Persistence ofGood Performance (Table 4.3)NumberofConsecutiveNumberofObservationsObservationsforwhichtheYearsofPositiveAlphaNextAlphaisPositive(%)157450.4231252.0316153.447955.854146.461735.310RiskManagementandFinanciallnstitutions3e,Chapter4,CopyrightJohnC.Hull2012
Jensen’s Results on the Persistence of Good Performance (Table 4.3) Risk Management and Financial Institutions 3e, Chapter 4, Copyright © John C. Hull 2012 10 Number of Consecutive Years of Positive Alpha Number of Observations Observations for which the Next Alpha is Positive (%) 1 574 50.4 2 312 52.0 3 161 53.4 4 79 55.8 5 41 46.4 6 17 35.3