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Perspectives on Global Asset Management: Beyond mutual funds?

Perspectives on Global Asset Management: Beyond mutual funds?. Professor Massimo Massa BNP-PARIBAS. The Vanguard Approach Main Features. What type of approach? Main Characteristic?. “Mutualistic”. Customer focus, not product or performance. The goal is to serve shareholders.

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Perspectives on Global Asset Management: Beyond mutual funds?

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  1. Perspectives on Global Asset Management:Beyond mutual funds? Professor Massimo Massa BNP-PARIBAS

  2. The Vanguard ApproachMain Features • What type of approach? Main Characteristic? “Mutualistic”. Customer focus, not product or performance. The goal is to serve shareholders. • What is the market? Wholesale. • What type of service? • Low cost, no load, low fee pricing. • Plain vanilla products, which attempt to offer “dependable return”. • They have cornered the market on the low fee game – huge barriers to entry before someone else could try to compete with them. • Economies of scales means lower average fees in future.

  3. The Vanguard ApproachMain Features How is demand related to performance and fees? • Does it depend on star/dog strategies? No • Does it depend on load/fee based strategies? No • Is there a scope for tunneling? Scarce • Is there a scope for incubation? No

  4. The Vanguard ApproachMain Features • Is there a conglomerate strategy? Well it depends on size. But then liquidity effects. • What is the role of advertising? • Relies on Free Press • Little paid advertising or promotion. • Focus on candor • Is there a branding role of managers? • Well, more as a symbol of frugality. • What about Bogle?

  5. The Vanguard ApproachVulnerability • It brings price competition and alters (ruin?) the industry’s price structure • It has corned itself: the only way to improve is by offering lower and lower fee products. How much can they be lowered? • Difficult to get in sophisticated niche. • Management succession? Why are the top employees so young? Will the organization be able to keep the same focus when he leaves? • Given that they do not pay Fidelity’s scale wages, how will they be able to attract top quality personnel? • What is the money market fund has a default on one of its payment and the net asset value falls below $1? Vanguard has no capital reserves to cover the fund as others have. • Does the fact that they are a technology follower doom them to poorer service ad a reputation for being “behind the times”?

  6. The Vanguard ApproachResponse from Competition • Fidelity: • Introduce Spartan Index Line • Open retail stores around the country • Leading edge technology • Distribution • Continue to focus on the “star system” • More specialization. • Merril Lynch: • Specialize even more in sellers of convenience. • Emphasize customer service staff. • Lower fees. • ETFs and TRACKERs • Even lower costs.

  7. The Vanguard ApproachResponse from Competition Exchange Traded Funds Assets ($ Billions)

  8. The Vanguard Approach is therefore:the Henry Ford of the Industry: everybody can choose the color of the car…provided it is black20 years later another approach get prominence: the A+J+O Approach

  9. What is long/short investing? Assets Liabilities • “Leverage” = ($10 + $10)/$10 = 2 • What is required return on the whole portfolio?

  10. The A+J+O ApproachMain Features • What type of approach? Main Characteristic? A client’s base portfolio: • variable fraction of customer money: • % in riskless (or interest sensitive assets) • % in market index (or equity sensitive assets) • Or all in riskless + index futures • To match the customer consumption profile Enhancement • Use fraction (possibly >100%) of what is invested in riskless to put into L/S hedge funds, to enhance returns • It does not matter how (using what instrument) alpha is generated: alpha is portable • Or use futures to enhance.

  11. The A+J+O ApproachMain Features • What is the main benefit of the Long/Short? “Long/Short”. Focus on performance. • For Standard Mutual Funds portfolio selection is based in benchmarks • long portfolio will be evaluated against (style) benchmark (witness the use of tracking errors as a measure of active risk) => become “closet indexers” • Benchmark used and alpha constructed to measure the performance of a manager that is supposed to maximize utility of return. • But the measure is not “incentive compatible”. It changes the behavior of the manager • L/S will be free from any benchmark!!!

  12. The A+J+O ApproachMain Features • What type of approach? Main Characteristic? “Long/Short”. Focus on performance. • What is the market? Not clear yet. Presumably still niche market. Benchmark are used to describe to the clientele the kind of assets the L/S invests in. • What type of service? Stock-picking services • Value • Management (e.g., insider trading) • Earnings momentum

  13. The A+J+O ApproachMain Features • What are the main drivers of performance? Purely in-house, quantitative screening of firms • What approach to costs? • Since they don’t use outside research, no soft dollars needed to purchase this research  Forces brokers to compete on order execution   Get better execution. • Usage of package trading. • Communicate to clients on execution costs

  14. The A+J+O ApproachMain Features How is demand related to performance and fees? • Does it depend on star/dog strategies? No • Does it depend on load/fee based strategies? No • Is there a scope for tunneling? Scarce • Is there a scope for incubation? No

  15. The A+J+O ApproachMain Features • Is there a conglomerate strategy? Maybe. • What is the role of advertising? • Based on Absolute Performance. • Is there a branding role of managers? • Yes! Huge. It is mostly a name-based business.

  16. Packaged trading • What is packaged trading? • Why does it work/exist? • Double-blind auction idea • If package composition were disclosed, every bidder, including losing bidders, would be able to front-run the trades of either the asset manager or the winning bidder • If the broker’s book were known, the manager would know actual cost of execution and could bring bid down • By their measure, packaged trading one-way average cost is $.246 a share whereas traditional brokerage costs $.562

  17. Packaged trading

  18. Packaged trading

  19. The future • How can we envision future division of labor between types of funds? • Polarization into “beta” and “alpha” strategies: • Only two extremes should exist: • index funds or ETFs • hedge funds doing L/S • Everything else is a combination of these two, which is less transparent than the two extremes • No benchmarks • No soft dollars

  20. …the industry gets polarized. Polarization of Investments Process Polarization Market-Linked Products Alternative Investments Exchange Traded Funds Venture Capital & Private Equity Other Alternative Investments Leveraged Index Funds Inverse Index Funds Index Funds Hedge Funds Real Estate

  21. Alternative Investments Markets Assets Under Management ($ Billions)

  22. What is a Hedge Fund? • US • Hedge funds are private unregistered investment pools for wealthy individuals or institutional investors. • Hedge funds invest in a variety of securities and use return enhancing tools such as leverage, derivatives and arbitrage • Legally structured as a private investment limited partnership (LP) or a limited liability corporation (LLC) • Typically charges a management fee (1-3%) and an incentive fee (15-25%) • Europe • A fund management firm that charges an incentive fee. • Looks to create absolute returns, I.e. returns in excess of those predicted by CAPM or other asset pricing models.

  23. Key Differences Between Hedge Funds and Mutual Funds • Absolute return objective (10% to 25% per year) versus relative returns (out-performance of an index). • Often clearly stated risk objective, e.g. 20% p.a. • Market volatility presents opportunities since hedge funds can trade from both the long and short of the market. • Managers compensation is primarily based on performance, not based on the size of the assets under management (better aligning interests of managers with investors). • Many funds are closed or give an explicit size at which they will close • Limited capacity for most strategies, managers try to grow by steps, e.g. 100 MUSD, 400 MUSD, 1000 MUSD in order to avoid failure • Moore returned 3bn to investors in 2001

  24. Hedge Fund Fees • The fee structure is homogenous: • A management fee of a 1-3% p.a. and, • An incentive fee of 10%-30% of profits • Often a reference rate must be met before incentive fees are paid, e.g. 3 month T-bill + 200 bp. • Incentive fee gives incentive and protects from ``earnings dilution'' due to size constraints of a particular strategy. • High watermark • The manager only receives the incentive fee on new ``high-highs'‘, typically calculated monthly or quarterly. • Reduces risk taking incentives of managers • Locks in investors when the fund is in ``drawdown’’ (100% participation in first profits) • Gives managers a downside

  25. Hedge Fund Styles by Assets

  26. The Strategy Universe 40% Aggressive Growth Market Timing 35% Opportunistic 30% S&P 500 25% Event Driven Market Neutral 20% Fund of Funds MSCI World Equity Distressed 15% Equity Arbitrage Securities Income Convertible Arbitrage Emerging Markets 10% Average Bond Mutual Fund 5% Short Selling 0% -5% -10% 0% 5% 10% 15% 20% 25% 30%

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