Perspectives on Global Asset Management: Beyond mutual funds?

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

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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. - PowerPoint PPT Presentation

Transcript of Perspectives on Global Asset Management: Beyond mutual funds?

Page 1: Perspectives on Global Asset Management: Beyond mutual funds?

Perspectives on Global Asset Management:

Beyond mutual funds?

Professor Massimo Massa

BNP-PARIBAS

Page 2: Perspectives on Global Asset Management: Beyond mutual funds?

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.

Page 3: Perspectives on Global Asset Management: Beyond mutual funds?

The Vanguard ApproachMain Features

• Does it depend on star/dog strategies?

No

• Does it depend on load/fee based strategies?

• Is there a scope for tunneling?

• Is there a scope for incubation?

No

No

Scarce

How is demand related to performance and fees?

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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?

- Well, more as a symbol of frugality. - What about Bogle?

- Relies on Free Press- Little paid advertising or promotion.- Focus on candor

• Is there a branding role of managers?

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The Vanguard ApproachVulnerability

• It has corned itself: the only way to improve is by offering lower and lower fee products. How much can they be lowered?

• Management succession? Why are the top employees so young? Will the organization be able to keep the same focus when he leaves?

• Difficult to get in sophisticated niche.

• 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”?

• It brings price competition and alters (ruin?) the industry’s price structure

Page 6: Perspectives on Global Asset Management: Beyond mutual funds?

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.

Page 7: Perspectives on Global Asset Management: Beyond mutual funds?

Exchange Traded Funds Assets($ Billions)

$1$20

$34

$66$83

$102

$151

$226$252

1993 1998 1999 2000 2001 2002 2003 2004 2005

The Vanguard ApproachResponse from Competition

Page 8: Perspectives on Global Asset Management: Beyond mutual funds?

The Vanguard Approach is therefore:

the Henry Ford of the Industry: everybody can choose the color of the car…provided it is black

20 years later another approach get prominence:

the A+J+O Approach

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What is long/short investing?

• “Leverage” = ($10 + $10)/$10 = 2• What is required return on the whole portfolio?

Cash $10: required return = TBill Initial investment = $10

Long positions: $10 alpha Short positions: $10 alpha

“Identical” systematic risk on both sides.

Assets Liabilities

Page 10: Perspectives on Global Asset Management: Beyond mutual funds?

Sector Weights A+J+O Dollar-Neutral Long/Short

Long Short

Russell 3000 (equal

weighted)

S&P 500

Capital goods 7.8% 8.8% 6.3% 7.5% Consumer discretionary

18.1 18.6 14.3 13.1

Consumer durables

2.6 2.6 2.3 0.9

Consumer staples

7.6 7.8 4.1 9.2

Energy 4.9 4.7 4.0 6.2 Financial 22.0 22.2 20.8 19.8 Healthcare 8.1 7.8 13.1 15.6 Materials 7.7 7.7 4.3 2.7 Services 5.7 5.6 5.0 1.7 Technology 6.5 5.4 18.9 15.0 Telecom 0.4 0.0 1.7 3.7 Transportation 2.2 2.2 1.8 1.7 Utilities 6.4 6.6 3.4 2.9 Note: P/E excludes negatives.

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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.

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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!!!

Page 13: Perspectives on Global Asset Management: Beyond mutual funds?

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/Sinvests in.

• What type of service?

Stock-picking services– Value– Management (e.g., insider trading)– Earnings momentum

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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

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The A+J+O ApproachMain Features

• Does it depend on star/dog strategies?

No

• Does it depend on load/fee based strategies?

• Is there a scope for tunneling?

• Is there a scope for incubation?

No

No

Scarce

How is demand related to performance and fees?

Page 16: Perspectives on Global Asset Management: Beyond mutual funds?

The A+J+O ApproachMain Features

• Is there a conglomerate strategy?

Maybe.

• What is the role of advertising?

- Yes! Huge. It is mostly a name-based business.

- Based on Absolute Performance.

• Is there a branding role of managers?

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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 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

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Panel B: Aggregate package statistics

Number of stocks 30 Total number of shares 843,000 Average closing price $37.13

Total value of package ($Mil) $24.73

% of stocks that are Nasdaq 13.3 % of stocks that are buys 50 Median market capitalization ($ billions) of stocks in Package $3.878

Mean price inverse for stocks in package (%) 3.75

Mean shares traded per stock 28117 Mean (VolRatio) for stocks in package (%) 10.68 Skewness (VolRatio) for stocks in package (%) 4.55

Packaged trading

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Exhibit 5: Example Transaction Cost Report to a Client (transaction costs for fourth quarter 2002)

Broker One-Way Costs (%)

Average Share Price

One-Way Costs (cents/share)

Market Value ($)

% of Total Commission

Total nontraditional (1.15) 27.54 (31.7) 36,847,222 46.1 26,257 Total traditional (2.58) 21.76 (56.2) 43,058,004 53.9 66,014 Total trades executed (1.92) 24.09 (46.3) 79,905,226 100.0 92,271

Nontraditional Crossing Instinet Crossing (2.68) 23.42 (62.8) 1,117,009 3.0 477 ITG POSIT (3.54) 33.42 (118.4) 818,910 2.2 490 Jefferies Crossing (0.02) 40.86 (1.0) 792,721 2.2 194

(2.17) 29.79 (64.6) 2,728,640 7.4 1,161 Package

Goldman package (0.78) 29.17 (22.8) 12,856,366 34.9 8,816 Deutsche package (1.02) 30.27 (30.9) 9,853,384 26.7 6,510 Weeden package (0.76) 31.81 (24.3) 6,012,667 16.3 3,780 Salomon package (4.45) 1.91 (8.5) 148.098 0.4 1,550 Merrill package (0.72) 35.93 (25.8) 1,354,519 3.7 754

(0.87) 28.23 (24.6) 30,225,035 82.0 21,410 Other Archipelago (3.44) 20.93 (72.1) 3,165,248 8.6 3,024 Bloomberg Trdbk 3.06 33.14 101.5 563,38 1.5 510 Liquidnet (5.84) 21.70 (126.6) 164,919 0.4 152

(2.60) 22.15 (57.7) 3,893,547 10.6 3,686

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

Page 21: Perspectives on Global Asset Management: Beyond mutual funds?

Polarization of Investments Process

Polarization

Market-Linked Products

Alternative Investments

Index FundsExchange

Traded FundsInverse Index

FundsLeveraged

Index FundsHedge Funds

Other Alternative

InvestmentsReal Estate

Venture Capital &

Private Equity

…the industry gets polarized.

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Alternative Investments MarketsAssets Under Management ($ Billions)

$750

$350

$225 $200

Hedge Funds Private Equity &Venture Capital

Real Estate Structure Debt

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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.

Page 24: Perspectives on Global Asset Management: Beyond mutual funds?

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

Page 25: Perspectives on Global Asset Management: Beyond mutual funds?

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

Long/ short equity40%

Managed futures14%

Event-driven15%

Global Macro14%

Fixed income arb.7%

Convertible arb4%

Other6%

Page 27: Perspectives on Global Asset Management: Beyond mutual funds?

The Strategy Universe

Income

Opportunistic

Convertible Arbitrage

MSCI World Equity

Market Timing Aggressive Growth

Event Driven

Distressed Securities

Fund of Funds

Market Neutral

Average Bond Mutual Fund

Short Selling

S&P 500

Emerging Markets

Equity Arbitrage

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

0% 5% 10% 15% 20% 25% 30%