Perspectives on Global Asset Management: Beyond mutual funds

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Perspectives on Global Asset ManagementBeyond
mutual funds?

• Professor Massimo Massa
• BNP-PARIBAS

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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.

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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
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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?

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The Vanguard ApproachVulnerability

• It brings price competition and alters (ruin?)
  the industrys 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 Fidelitys 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?

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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.

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The Vanguard ApproachResponse from Competition
Exchange Traded Funds Assets ( Billions)
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The Vanguard Approach is thereforethe Henry
Ford of the Industry everybody can choose the
color of the carprovided it is black20 years
later another approach get prominence the
AJO Approach
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What is long/short investing?
Assets
Liabilities

• Leverage (10 10)/10 2
• What is required return on the whole portfolio?

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(No Transcript)
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The AJO ApproachMain Features

• What type of approach? Main Characteristic?

• A clients 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 gt100) 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.

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The AJO 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) gt 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!!!

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The AJO 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

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The AJO ApproachMain Features

• What are the main drivers of performance?

Purely in-house, quantitative screening of firms

• What approach to costs?

• Since they dont 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

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The AJO 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
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The AJO 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.

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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 brokers 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

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Packaged trading
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Packaged trading
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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

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the industry gets polarized.
Polarization of Investments Process
Polarization
Market-Linked Products
Alternative Investments
Exchange Traded Funds
Other Alternative Investments
Venture Capital Private Equity
Inverse Index Funds
Leveraged Index Funds
Index Funds
Hedge Funds
Real Estate
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Alternative Investments Markets Assets Under
Management ( Billions)
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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.

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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

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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

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Hedge Fund Styles by Assets
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The Strategy Universe
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Aggressive Growth
Market Timing
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Opportunistic
30
SP 500
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Event Driven
Market Neutral
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Fund of Funds
MSCI World Equity
Distressed
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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