Investment Analysis and Portfolio Management

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Investment Analysis and Portfolio
Management

First Canadian Edition

By Reilly, Brown, Hedges, Chang

17

Copyright © 2010 by Nelson Education Ltd.


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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

Copyright © 2010 by Nelson Education Ltd.


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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

Copyright © 2010 by Nelson Education Ltd.


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The Asset Management Industry:

Structure & Evolution

Copyright © 2010 by Nelson Education Ltd.


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The Asset Management Industry:

Structure & Evolution


Contract directly with a management
and advisory firm


Relationship with client


Assets under management (AUM)


Separate accounts


Customized


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The Asset Management Industry:

Structure & 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


Copyright © 2010 by Nelson Education Ltd.


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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


Copyright © 2010 by Nelson Education Ltd.


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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

Copyright © 2010 by Nelson Education Ltd.


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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

Copyright © 2010 by Nelson Education Ltd.


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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


Expenses

Fund NAV=

Total Fund Shares Outstanding

-

Copyright © 2010 by Nelson Education Ltd.


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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


Copyright © 2010 by Nelson Education Ltd.


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Investment Companies:

Closed
-
End Mutual Funds

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Closed
-
End Versus Open
-
End
Investment Companies


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


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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

Closed
-
End Versus Open
-
End
Investment Companies

Copyright © 2010 by Nelson Education Ltd.


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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

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Investment Companies


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

Copyright © 2010 by Nelson Education Ltd.


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Investment Companies


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

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Investment Companies


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

Copyright © 2010 by Nelson Education Ltd.


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Basic Concepts


Alternative Assets


Limited Partnership

Investment Companies

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Investing in Alternative Asset Classes

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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

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Hedge Funds & Private Equity


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

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Hedge Funds & Private Equity

Copyright © 2010 by Nelson Education Ltd.


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Hedge Funds & Private Equity


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

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Hedge Funds & Private Equity

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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

Copyright © 2010 by Nelson Education Ltd.


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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


Copyright © 2010 by Nelson Education Ltd.


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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


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Hedge Funds & Private Equity


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


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Hedge Funds & Private Equity


Multiple strategies


Fund of funds:


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


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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


Copyright © 2010 by Nelson Education Ltd.


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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


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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

Copyright © 2010 by Nelson Education Ltd.


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Hedge Fund Performance

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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

Copyright © 2010 by Nelson Education Ltd.


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Private Equity

Copyright © 2010 by Nelson Education Ltd.


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Private Equity

Copyright © 2010 by Nelson Education Ltd.


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Private Equity


Organization


Three Subcategories


Venture Capital


Seed


Early stage


Later stage


Buyouts


Special Situations


Distressed Debt


Mezzanine Financing

Copyright © 2010 by Nelson Education Ltd.


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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

Copyright © 2010 by Nelson Education Ltd.


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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)

Copyright © 2010 by Nelson Education Ltd.


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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


Copyright © 2010 by Nelson Education Ltd.


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Ethics & Regulation in the Professional
Asset Management Industry


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


Copyright © 2010 by Nelson Education Ltd.


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Ethics & Regulation in the Professional
Asset Management Industry


Examples of Ethical Conflicts


Incentive Compensation Schemes


Soft Dollar Arrangements


Marketing Investment Management


Copyright © 2010 by Nelson Education Ltd.


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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


Copyright © 2010 by Nelson Education Ltd.


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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