Chapter 17 - Mutual Funds and Hedge Funds

Chapter Seventeen
Mutual Funds and Hedge Funds
I. Chapter Outline
1. Mutual Funds and Hedge Funds: Chapter Overview
2. Size, Structure, and C!psitin " the Mutual Fund #ndustr$
a. Histrical %rends
&. 'i""erent %$pes " Mutual Funds
(. Mutual Fund )eturns and Csts
a. Mutual Fund *rspectuses and O&+ectives
&. #nvestr )eturns "r! Mutual Fund Ownership
c. Mutual Fund Csts
,. Mutual Fund -alance Sheets and )ecent %rends
a. .ng-%er! Mutual Funds
&. Mne$ Mar/et Mutual Funds
0. Mutual Fund )egulatin
1. Mutual Fund 2l&al #ssues
7. Hedge Funds
a. %$pes " Hedge Funds
&. Fees n Hedge Funds
c. O""shre Hedge Funds
d. )egulatin " Hedge Funds
II. Learning Goals
1. 34a!ine hw and wh$ the !utual "und industr$ has grwn thrugh ti!e.
2. 'istinguish &etween lng-ter! !utual "unds and !ne$ !ar/et !utual "unds.
(. 5nderstand what is cntained in a !utual "und prspectus.
,. Calculate the net asset value " and the return n a !utual "und invest!ent.
0. #denti"$ the !ain regulatrs " !utual "unds.
1. 34a!ine trends in the dllar value " !utual "unds utstanding gl&all$.
7. 6nw what a hedge "und is.
III. Chapter in Perspective
Mutual "unds pl investrs7 "unds and invest in !ne$ r capital !ar/et instru!ents,
and s!eti!es derivatives. %he$ allw investrs t gain diversi"icatin and pr"essinal
!anage!ent accrding t speci"ic pu&lished &+ectives at lw cst. Mne$ !ar/et
!utual "unds prvide den!inatin inter!ediatin t investrs as !st !ne$ !ar/et
securities have den!inatins that are t large "r individual savers t a""rd. %he$ als
""er higher rates " return than &an/ accunts. )ecall "r! Chapter 1 that investrs
desire t place s!e " their "unds in less li8uid, higher earning accunts t "und lng
ter! gals. .ng ter! !utual "unds prvide investrs a lw cst !eans t gain e4psure
t high return !ar/ets while eli!inating !st diversi"ia&le ris/. %he strng stc/ !ar/et
" the 199:s &rught recrd increases in &th the level " !utual "und assets and the
nu!&ers " "unds. %he prer stc/ !ar/et per"r!ance " the earl$ 2:::s hwever,
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Chapter 17 - Mutual Funds and Hedge Funds
slwed and even reversed the trend " !utual "und grwth. Fr! the end " 2::1 t ;une
2::2, industr$ assets declined a&ut <(,: &illin due t "und withdrawals and declining
e8uit$ values. 2rwth returned t the industr$ in 2::( and 2::, with &etter stc/ !ar/et
returns. #n 2::0 and 2::1 net new cash "lws in e8uit$ "unds were <1(0.1 and <109.,
&illin respectivel$ &e"re drpping "" t <92., &illin in 2::7. Hedge "unds grew
rapidl$ a"ter generating ver$ high returns in the 199:s and earl$ 2:::s. Hwever, the
"inancial crisis in the late 2:::s led t the largest decline in !utual "und industr$ assets
ever. =ssets "ell <2., trillin t <9,1:2.1 &illin, a 2:> drp in 2::?. #ndustr$ assets in
2:1: recvered t <11,217.: &illin. Si!ilarl$ net new cash "lws in 2::? were -<2((.9
&illin, the wrst in recent ti!es. 38uit$ "unds had the wrst ut"lws verall while
in"lws t the !uch sa"er gvern!ent &nd "unds actuall$ increased during the crisis.
IV. Key Concepts and e!initions to Co""unicate to Students
38uit$ "unds Open-end !utual "und
-nd "unds Clsed-end invest!ent c!pan$
H$&rid "unds )eal 3state #nvest!ent %rust @)3#%A
Mne$ !ar/et !utual "unds .ad "und
Mar/ed t !ar/et B-lad "und
Bet asset value @B=CA 12&-1 "ee
Hedge "unds %a4 e4e!pt "unds
Capital gains distri&utins 'ividend distri&utins
Mutual "und share classes *er"r!ance "ees
)is/$ ar&itrage 'irectinal trading
V. #eaching $otes
%. Mutual Funds and Hedge Funds& Chapter Overvie'
Open end !utual "unds sell shares t the pu&lic and redee! the! "r! the pu&lic. %hus,
li8uidit$ is never a cncern t "und sharehlders.
1
%he !utual "und pls the cash
received and invests in securities in line with the "und7s stated &+ective. -ecause the
"unds invest in large a!unts, the$ are a&le t negtiate ver$ lw transactin csts. %hus,
s!all investrs @and even !an$ institutinal investrsA are a&le t &tain diversi"ied
prt"lis n !re "avra&le ter!s than the$ culd achieve n their wn. Mutual "unds
1
%his ris/ is &rne &$ the "und and re8uires the "und t hld larger cash &alances than the$ wuld
therwise.
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Chapter 17 - Mutual Funds and Hedge Funds
prvide ther services t investrs as well including:
Free e4change " invest!ent &etween a !utual "und c!pan$7s "unds
=ut!atic peridic invest!ent and reinvest!ent " "und distri&utins
Chec/ writing privileges n certain "unds t$pe @MMMF and &nd "undsA
=ut!atic withdrawals
)ecrd /eeping "r ta4 purpses
(. Si)e* Structure* and Co"position o! the Mutual Fund Industry
a. Historical #rends
=lthugh !utual "unds have &een arund since the 192:s, as recentl$ as 197: there were
nl$ (1: "unds with <0: &illin in ttal industr$ assets. #n 2:1: there were 7,017 !utual
"unds with ttal net assets " <11,217.: &illin. %here has &een a huge increase in the
nu!&er " accunts since 199:, althugh all nu!&ers "ell during the crisis. *art " the
grwth in !utual "unds has &een driven &$ the grwth in retire!ent "unds under
!anage!ent &$ the !utual "und industr$. )etire!ent "unds grew "r <,.: trillin in
assets in 199: t ver <10.7 trillin in 2:1:. Mutual "unds !anage a&ut 20> " this
ttal. Much " the grwth in this !ar/et has c!e "r! s called institutional !unds,
which are "unds that !anage retire!ent plans "r a c!pan$7s e!pl$ees. =&ut ?:> "
all retire!ent plan invest!ents are in institutinal "unds. Fr! the 197:s nward !utual
"unds en+$ed rapid grwth. Money "ar+et "utual !unds @MMMFsA grew in the 197:s
due t )egulatin D. )egulatin D li!ited the rate " interest &an/s culd pa$ n their
depsits and rising pen !ar/et rates induced investrs t see/ higher returns in !ne$
!ar/et !utual "unds. #a, e,e"pt !unds grew rapidl$ in the 19?:s as ta4es wed
cli!&ed, and -ond and e.uity !unds grew tre!endusl$ rapidl$ with the &ull !ar/ets "
the 19?:s and 9:s. Mutual "unds are nw the secnd largest "inancial inter!ediar$, and i"
their rate " grwth cntinues, the$ will sn verta/e &an/s as the cuntr$7s largest
inter!ediar$. =s a result " the rapid grwth, c!!ercial &an/s, insurers and ther
institutins have als &egun perating invest!ent !anage!ent "unds. %here are
generall$ lw entr$ &arriers int the "und industr$. %he twent$ "ive largest "unds
hwever !anage 70> " industr$ assets indicating that there are large ecn!ies " scale
in "und e4penses that pr!te large size.
-. i!!erent #ypes o! Mutual Funds
Ma+r t$pes " "unds include:
.ng ter! "unds @7:.2> " !utual "und assets 2:1:A
/.uity !unds: *ri!aril$ hld c!!n and pre"erred stc/ @,,.1>A
0ond !unds: *ri!aril$ hld "i4ed inc!e securities with !aturities ver 1 $ear
@19.?>A
Hy-rid !unds: -lends " e8uit$ and &nd "unds. @0.?>A
#a, e,e"pt !unds: Funds that specialize in investing in ta4 e4e!pt securities
Inde, !undsE Funds that atte!pt t !i!ic the per"r!ance " a given inde4,
&ecause the$ d nt activel$ engage in ti!ing and stc/ selectin the$ generall$
have lwer e4pense ratis than ther "unds.
2
%hese have nw grwn t a&ut 20>
2
%he average e4pense rati "r Canguard "unds in 2::7 was :.19>, cnsidera&l$ &elw e4pense ratis "r
!anaged prt"lis.
17-(
Chapter 17 - Mutual Funds and Hedge Funds
" lng ter! "unds. #n 2:1: there were (09 inde4 "unds !anaging a&ut <?(7
&illin in assets.
/,change traded !unds 1/#F2: = variant " inde4 "unds that are traded n an
e4change. #n 2:1: there were a&ut <92, &illin invested in 3%Fs. %he
advantage " an 3%F is that it can &e traded thrughut the da$ at cntinuusl$
updated prices. 3%Fs can &e purchased n !argin and sld shrt, unli/e inde4
"unds. %here are n capital gains distri&utins t add t ta4 lia&ilit$ in a given
$ear either. %hese "eatures allw "r &etter hedging and ar&itrage strategies.
34a!ples include S*')s n the =M3F and Canguard7s .arge-Cap C#*3)S
"unds.
(

Shrt ter! "unds @29.?> " !utual "und assets in 2:1:A
Money "ar+et "utual !unds: Funds that invest in securities with 1 $ear
!aturit$ r less.
#a, e,e"pt "oney "ar+et "utual !unds
#n 2:1: lng ter! "unds c!prised a&ut 7:> " ttal "unds, a"ter "alling t as lw as
09.1> in prir $ears due t the crisis in the ecn!$. %he !ne$ !ar/et "und share
actuall$ grew t a&ut ,:> during the crisis, in part &ecause the Fed te!praril$ insured
all !ne$ "und accunts. Over the lnger ter!, the split &etween lng ter! and shrt
ter! "unds used t &e a&ut 1::,:, &ut strnger e8uit$ &ull !ar/ets and increased
educatin a&ut e8uit$ invest!ents increased hldings in lng ter! "unds, particularl$
e8uities.
%he !a+r hlders " &th t$pes " "unds are individual investrs. #ndividual investrs
held a&ut 09.?> " lng ter! "unds in 2:1: and ,:.2> " shrt ter! "unds. #nvestrs in
MMMFs give up depsit insurance, &ut usuall$ gain higher rates " return. %his is
pr&a&l$ a sa"e &et t gain a slightl$ higher rate " return as nl$ ne MMMF has ever
"ailed. #n 2::2 and 2::( &an/ depsit rates " return were actuall$ greater than MMMF
returns and !ne$ "lws t MMMFs were reduced as !re peple chse &an/ depsits.
#ndividual participatin in !utual "unds is &ec!ing !re widespread as "inancial
educatin increases and interest in the stc/ !ar/et cntinues. %he pri!ar$ reasn !st
peple hld !utual "unds is t prvide supple!ental retire!ent inc!e. %he &ull
!ar/ets " the 199:s, the lw transactins csts " purchasing shares, the diversi"icatin
achieved, and the ther services prvided &$ "unds are !a+r reasns &ehind their rapid
grwth. Fund grwth slwed with the prer stc/ !ar/ets " the earl$ part " the
centur$, &ut grwth in !ar/et value " lng ter! "unds "r! 2::2 t 2::, was 22> per
$ear. Mne$ !ar/et "und grwth was -?> per $ear ver the sa!e ti!e perid. .ng
ter! "unds grew t 70.,> in 2::1 as the stc/ !ar/et per"r!ed well &e"re "alling &ac/
in 2::7 as the !rtgage !ar/et e""ects spilled ver int stc/s and ther lng ter!
invest!ents. #n 2::7 and 2::? "lws t these "unds increased &e"re declining as the
ecn!$ recvered and !re investrs &egan see/ing higher $ields. See %e4t Figure 17-
2 "r "lws per $ear.
(
S*')s !i!ic the SG*0::, and C#*3)S trac/ an inde4 " large capitalizatin stc/s.
17-,
Chapter 17 - Mutual Funds and Hedge Funds
3. Mutual Fund 4eturns and Costs
a. Mutual Fund Prospectuses and O-5ectives
Mutual "unds are re8uired t pu&lish the speci"ic &+ectives " the "und in the prospectus
@a "r!al su!!ar$ " a prpsed invest!entA. B investr shuld invest in a "und
withut care"ull$ reading the prspectus. %he prspectus will cntain histrical return
in"r!atin, usuall$ "r 1 $ear, ( $ear and 0 $ear perids and perhaps lnger. %he
prspectus !ust als shw histrical "ees and the e""ect " thse "ees n a given
invest!ent ver ti!e.
%eaching %ip: %he reader shuld &e aware that a prspectus, while cntaining necessar$
in"r!atin "r the investr, is &asicall$ a !ar/eting tl. Fr instance, ne rarel$ "inds
!uch a&ut ris+ in a prspectus and the "unds will "ten tut the perid that !a/es the
returns appear the &est.
%eaching %ip: Fund &+ectives and apprpriate gals @!a+r categries nl$A: See
www.!rningstar.c!, www.ici.rg, and Mal/eil, -., A Random Walk Down Wall Street,
H.H. Brtn *ress 199:. Much " the "llwing !aterial is drawn "r! Mal/eil7s &/.
Fund %$pe
6ggressive Gro'th
Fund O&+ective
C!!n stc/ "und, stressing pic/ing stc/s with unrecgnized grwth, usuall$ s!all
"ir!s r sectr "unds, high turnver, higher &eta r stc/s, little r n dividend inc!e.
%hese "unds have su&stantial ptential "r capital lss. Sectr "unds, s!all and !id cap
grwth "unds !a$ "it int this categr$. %here are als s!e &ear !ar/et "unds that
invest cunter-c$clicall$.
C!pati&le #nvestr 2al@sA
.ng ti!e hrizn, willing and a&le t ta/e su&stantial ris/ in hpe " high returns, high
a&ilit$ t re!ain in the !ar/ets regardless " ecn!ic cnditins.
Gro'th
Fund O&+ective
C!!n stc/ "und, stressing pic/ing s!e stc/s with unrecgnized grwth, and s!e
stc/s that pa$ !derate t su&stantial dividends, !derate t high turnver, higher &eta
stc/s, nl$ !derate dividend inc!e. %hese "unds als have su&stantial ptential "r
capital lss. .arge cap grwth "unds are an e4a!ple in this categr$
C!pati&le #nvestr 2al@sA
.ng ti!e hrizn, willing and a&le t ta/e su&stantial ris/ in hpe " high returns, high
a&ilit$ t re!ain in the !ar/ets regardless " ecn!ic cnditins.

Gro'th 7 Inco"e
Fund O&+ective
-asicall$ a c!!n stc/ "und, pr&a&l$ with s!e &nds, stressing pic/ing s!e
stc/s with unrecgnized grwth, and s!e sta&le stc/s that pa$ su&stantial dividends
as well as cupn &earing &nds, !derate turnver, "und &eta at r near the I!ar/etI,
17-0
Chapter 17 - Mutual Funds and Hedge Funds
generall$ higher dividend inc!e. %here is a su&stantial ptential "r capital lss in
adverse ecn!ic cnditins. =ll size &lend and value "unds !a$ "it int this categr$.
C!pati&le #nvestr 2al@sA
%hse with a !derate t lng ti!e hrizn, willing and a&le t ta/e ris/ in hpe "
higher returns, !derate a&ilit$ t re!ain in the !ar/ets regardless " ecn!ic
cnditins.

Inde,
Fund O&+ective
'uplicate per"r!ance " s!e inde4 such as the SG*0::. .i/e all stc/ "unds there is
su&stantial chance " capital lss during adverse ecn!ic cnditins. %hese "unds have
ver$ lw turnver and lw e4penses. %here are inde4 "unds that !i!ic per"r!ance "
the entire !ar/et while s!e "unds are designed t give returns si!ilar t an industr$ r
!ar/et sectr, including di""erent size sectrs such as s!all caps, !id caps, etc. %here
are als varius internatinal inde4 "unds availa&le nw.
C!pati&le #nvestr 2al@sA
#nvestrs with a !derate t lng ti!e hrizn that are willing and a&le t ta/e ris/s in
return "r $ields c!para&le t the I!ar/etI. #nvestrs are "ten thse wh &elieve in
e""icient !ar/ets with sta$ing pwer t ride ut tugh ecn!ic ti!es.

0alanced
Fund O&+ective
=ppr4i!atel$ e8ual prprtins " stc/s and &nds althugh this varies with !ar/et
cnditinsE the$ are usuall$ ver$ well diversi"ied. %he stc/s are usuall$ J&lue-chipJ t$pe
with esta&lished dividend recrds. -nds are usuall$ high grade with su&stantial
cupns, the "und "cus is t$picall$ @&ut nt alwa$sA n current inc!e. S!e !a$ have
su&stantial internatinal invest!ents "r diversi"icatin purpses. %he "und7s &eta is
usuall$ &elw the I!ar/etI, with generall$ high dividend and interest inc!e. #nvestrs
"ace !derate ptential "r capital lss in adverse ecn!ic cnditins. = special t$pe "
&alanced "unds called %arget 'ate "unds have nw develped that are designed "r
investrs wh will retire within the given target date. =s investrs age the$ nr!all$
want t reduce the ris/ " their invest!ents. %hese "unds d this aut!aticall$ as the
target date appraches. %here are currentl$ Bear %er! "unds with a 2:1, target date,
#nter!ediate %er! "unds with a range " target dates " 2:10-2:29 and .ng %er! with
target dates " 2:(: and lnger.
C!pati&le #nvestr 2al@sA
%hse with a !derate ti!e hrizn, willing and a&le t ta/e !derate ris/ in return "r
higher current inc!e, and have s!e a&ilit$ t re!ain in the !ar/ets regardless "
ecn!ic cnditins.
Inco"e
Fund O&+ective
*ri!aril$ higher current $ield, "i4ed inc!e securities, !stl$ &nds. -nds are usuall$
high grade with su&stantial cupnsE the &+ective is usuall$ t generate !a4i!u!
current inc!e. %he "und &eta is nr!all$ su&stantiall$ &elw the I!ar/etI, and the "und
nr!all$ generates high interest inc!e. %here is s!e ptential "r capital lss in
17-1
Chapter 17 - Mutual Funds and Hedge Funds
adverse ecn!ic cnditins. #n"latin ris/ can &e severe and ta4es can signi"icantl$
erde returns.
C!pati&le #nvestr 2al@sA
%hse with a !derate ti!e hrizn, willing and a&le t ta/e !derate ris/ in return "r
higher current inc!e, investrs are "ten thse wh need the invest!ent inc!e "r
living e4penses.

Money Mar+et
Fund O&+ective
.wer $ielding "i4ed inc!e securities. Mst "und invest!ents will have a !aturit$ less
than r e8ual t 1 $ear. %he "und &+ective is t prvide a rate " return superir t &an/
invest!ents while !ini!izing chance " capital lss. %here is little ris/ " capital lss.
C!pati&le #nvestr 2al@sA
#nvestrs with a shrt t !derate ti!e hrizn, wh are unwilling r una&le t ta/e
!uch ris/ in return "r !derate t lw $ields. #nvestrs are "ten thse wh need the
invest!ent inc!e "r living e4penses and cannt a""rd t ris/ capital lsses, r the
"unds !a$ &e used as a Kpar/ing space7 "r a shrt ti!e. %here are ptentiall$ large
pprtunit$ lsses n these invest!ents i" held "r a lng ti!e perid.
%hese state!ents are generalities and !an$ variatins e4ist within a "und categr$. Fr
instance, it is entirel$ pssi&le t "ind a grwth "und with greater ris/ than an aggressive
grwth "und. See Mrningstar "r !re speci"ic "und &+ective de"initins. 2rwth
"unds have &een a!ng the !st ppular in recent $ears.
=&ut 01.1 !illin husehlds @,(.9>A wned !utual "unds in 2:1:. %he !edian age
investr is 0: althugh tw-thirds are &etween ages (0 and 1,. %he$ are e!pl$ed,
!arried and have a wr/ing spuse. =&ut ?:> " "und hlders invest in s!e e8uities.
%he !edian invest!ent is <?:,::: and the !edian nu!&er " "unds held is "ur.
=lthugh !an$ peple nw chec/ their "und7s per"r!ance ver the #nternet, the
!a+rit$ d nt cnduct &u$Lsell transactins n-line.
-. Investor 4eturns !ro" Mutual Fund O'nership
)eturns c!e "r! three surces:
1. =ppreciatin in the value " the !utual "und7s shares due t unrecgnized gains in the
"und7s underl$ing assets. %hese are usuall$ "ar+ed to "ar+et daily. %he value " a
!utual "und share is its net asset value 1$6V2. %he B=C is e8ual t the ttal value
" the "und7s hldings less an$ lia&ilities divided &$ the nu!&er " !utual "und shares
utstanding. Mutual "unds are pen ended, !eaning that investrs &u$ shares directl$
"r! the "und and the "und redee!s their shares upn de!and. $O#/: #t is
i!prtant t understand that B=C is set as " ,::: *M 3S% each &usiness da$.
%eaching %ip: Mst !utual "unds are li!ited in the a!unt " de&t @lia&ilitiesA the$ can
use. Man$ unit trusts are nt hwever. .everaged "unds have generall$ ris/ier rates "
return and have &an/ruptc$ ris/. = !utual "und shuld nt technicall$ g &an/rupt
@a&sent su&stantial derivatives psitinsA &ecause the$ we nl$ the !ar/et value " their
hldings. Hwever in Septe!&er 2::?, *ri!ar$ )eserve Fund- a !ne$ !ar/et !utual
17-7
Chapter 17 - Mutual Funds and Hedge Funds
"und K&r/e the &uc/7 and had its share value "all &elw the standard <1 due t lsses n
<7?0 !illin " c!!ercial paper issued &$ .eh!an &rthers. %his led t cntagin and
a run n !ne$ "unds with ver <2:: &illin ut"lws ver the ne4t "ew da$s. %he
%reasur$ guaranteed pa$!ents n !ne$ "unds "r ne $ear t stp the runs. %he
insurance ran ut Septe!&er 19, 2::9. Mu can trac/ the resulting change in "lws in
%e4t Figure 17-2.
%eaching %ip: = disadvantage " the pen end nature " !utual "unds is the need t hld a
cash reserve t handle rede!ptins "r! "und sharehlders. Hithut cash reserves a
!utual "und can &e "rced t sell "und hldings t redee! shares. = dra!atic case " this
ccurred in the crash " Oct&er 19?7. =t the ti!e "unds held lw cash reserves and were
"rced t sell t !eet the ver$ large nu!&er " rede!ptin rders. $O#/: #n a !re
general sense, newer evidence n "unds7 a&ilit$ t pr"ita&l$ engage in stc/ selectin
indicates that "und !anagers !a$ have s!e real stc/ selectin a&ilit$ nce we separate
ut li8uidit$ trades "r! in"r!atin trades " "und !anagers. %his i!plies a higher cst
t the pen end structure than we previusl$ thught.
2. 'ividend distri&utins: 'istri&utins &$ the "und " dividend and interest inc!e
earned n the "und7s underl$ing hldings. Funds are nr!all$ re8uired t distri&ute
at least 9:> " dividend and interest inc!e earned.
(. Capital gains distri&utins: )ecgnized capital gain increases due t the "und7s selling
" shares result in capital gains distri&utins. Funds are nr!all$ re8uired t
distri&ute at least 9:> " realized capital gains.
'istri&utins are nr!all$ paid 8uarterl$ r annuall$.
%eaching %ip: #nvestrs will nt nr!all$ wish t &u$ int a "und right &e"re a
distri&utin date. 'ing s will create ta4a&le inc!e "r! the distri&utins in the
current ta4 $ear. %he ta4a&le inc!e will &e ""set &$ a capital lss n the !utual "und
shares, &ut the lss will &e unrecgnized until the individual sells the !utual "und shares.
%eaching %ip: #nvestrs shuld chse a "und with a turnver rate that !eets their gals,
particularl$ i" the "und is nt held in a ta4 sheltered vehicle. High turnver "unds
generate !re ta4 lia&ilities each $ear. %a/ing 0.5 (1 / annual turnover ratio) will give
the average hlding perid " securities within the "und. %urnver ratis are reprted &$
Mrningstar and in the "und prspectus.
Closed end invest"ent co"panies have a "i4ed nu!&er " shares utstanding and d
nt issue new shares r redee! shares "r! investrs. %hese shares are traded li/e stc/s
and !a$ &e e4change listed. Clsed end "unds are either created as a clsed end
c!pan$, as !st unit invest!ent trusts are, r the$ are "r!er !utual "unds that have
decided t clse t new investrs, such as Fidelit$7s Magellan Fund. 5nit trusts, such as
the ppular real estate invest"ent trusts 14/I#s2, !a$ &e levered and can have e4tre!e
rates " return. 5nli/e !utual "und shares, clsed end "und shares !a$ trade at a
pre!iu! r a discunt t the B=C " the "und. 3!pirical evidence has presented n
17-?
Chapter 17 - Mutual Funds and Hedge Funds
cnvincing reasn wh$ "und discunts and pre!iu!s e4ist.
c. Mutual Fund Costs
Csts t a !utual "und investr @nt all "unds charge each t$pe " "eeA.
Load charge: %he lad is usuall$ a "rnt end lad, !eaning that this "ee is paid up
"rnt when the investr &u$s shares in the "und. #t is cnceptuall$ e8uivalent t a
&r/er7s c!!issin. %he !a4i!u! size lad allwed is ?.0>, althugh ver$ "ew
"unds @!stl$ sectr r internatinal "undsA charge lads ver 0> tda$ &ecause "
the c!petitiveness " the !utual "und industr$. #n "act, the !a+rit$ " "unds nw
charge n lad at all and the a!unt " dllars invested in lad "unds is lees than
invested in s called Kn lad7 "unds. $o load !unds are directl$ !ar/eted,
cnse8uentl$, the investr !ust g l/ing "r the!. -r/ers sell lad "unds.
Statistical per"r!ance " lad "unds is n &etter than the per"r!ance " n lad
"undsE thus, investrs wh use lad "unds are pa$ing "r the advice " a &r/er as t
what t$pe " "und is apprpriate "r the!, &ut there is n ther return "r pa$ing the
lad charge. S!e "unds charge &ac/ end lads instead " r in additin t "rnt end
lads. #n a &ac/ end lad the investr pa$s the lad when the shares are sld. %his is
&etter than a "rnt end lad &ecause in a "rnt end lad $u earn nthing n the
a!unt that ges t the &r/er whereas that !ne$ culd &e invested "r the hlding
perid n a &ac/ end lad. #" a "und has !ultiple class shares @and ver hal" nw dA,
the di""erent classes usuall$ represent di""erent !ethds " assessing the lad charge.
S!e "unds charge hlding perid cntingent &ac/ end lads such that the lad is
reduced i" the investr leaves their !ne$ with the "und "r lnger perids. 5suall$
a"ter "ive $ears the lad is zer.
Fr e4a!ple
Class 6 shares pa$ a "rnt end lad, and usuall$ incur a s!all 12&-1 "ee @see &elwA
Class 0 shares have n "rnt lad, &ut incur a &ac/ end lad and a larger 12&-1 "eeE
a"ter a set perid " ti!e such as 1-? $ears, the Class - shares cnvert t Class = and
thus incur the s!aller 12&-1 "ee.
Class C shares have n "rnt lad, and a &ac/ end lad is incurred nl$ i" shares are
sld within a set nu!&er " $ears. %hese shares d nt nr!all$ cnvert t Class =
and carr$ the "ull 12&-1 "ee "r the entire ti!e the$ are held.
%eaching %ip: %his !eans investrs "ace trade""s in deter!ining which class " "und
share t purchase. %he &est chice will depend n the ter"s o! the !und, the e,pected
ti"e the investor 'ill stay in the !und and in s!e cases the a"ount o! "oney
invested. Br!all$, Class = shares entail the highest cst &ecause less !ne$ is
invested with the "rnt lad deductin. %he real cst " a "rnt end lad is actuall$ wrse
than the stated lad. #" $u have <1,::: t invest and $u place $ur !ne$ in a "und
with a 0> "rnt end lad $u get an invest!ent wrth <90:. S $u pa$ a c!!issin "
<0: which gives a c!!issin rate " <0: L <90: r 0.21>. Fr lnger e4pected hlding
perids the investr !a$ &e &etter "" with Class - shares rather than Class C shares
&ecause " the reduced 12&-1 "ee a"ter the cnversin.
%he de!and "r n lad "unds has &een increasing and discunt @and therA &r/ers ""er
investrs services where the investr can &u$ and sell !utual "unds shares ""ered &$
17-9
Chapter 17 - Mutual Funds and Hedge Funds
di""erent !utual "unds spnsrs withut incurring an$ lad charges. -r/ers are
c!pensated &$ a prtin " the 12&-1 "ees.
%eaching %ip: %he =!erican =ssciatin " #ndividual #nvestrs @==##A pu&lishes a lw
cst &/ annuall$ titled, N%he #ndividual #nvestr7s 2uide t .w .ad Mutual Funds.O
.w lad is ,> r less. = searcha&le data&ase is als availa&le. %he &est surce "
!utual "und data is pr&a&l$ Mrningstar, which prvides its *rincipia prduct at a
reasna&le cst.
%(-8% !ees: %he hidden lad. Fr s!e reasn the S3C allws "unds t assess what is
called a 12&-1 "ee in lieu " @r in additin tA a "rnt end lad. Hith a "rnt end lad the
investr purchasing the "und shares pa$s all " the c!!issin. #n a 12&-1 plan the lad
is assessed n all the "und7s sharehlders. %his !a/es the lad a!unt @>A appear
s!aller. Mar/eting and servicing csts can &e n !re than :.20> per $ear and
!anage!ent "ees are li!ited t :.70> per $earE thus the !a4i!u! 12&-1 charge is 1>
per $ear. = n-lad "und can charge a 12&-1 "ee " n !re than :.20> and still advertise
as a n lad "und. =s nted the !a4i!u! "r lad "unds is 1>. %he assessed "ee !a$
var$ with the class " shares chsen as discussed a&ve.
Operating /,penses: Fund !anagers7 e4penses and pr"its are generated &$ the
perating e4penses that are assessed t the "und.
%eaching %ip: = Jwell !anagedJ "und pr&a&l$ shuld have an expense ratio " less than
2.
%tal csts " investing in !utual "unds declined in the 199:s and csts are li/el$ t
cntinue t drp. Since 19?: "und csts had drpped "r! 2.21> t 1.(0> in 199?.
%eaching %ip: %he e""ect " lads and "ees n returns
%his $ear $u invested <1:,::: in a !utual "und with a 1> lad @ne ti!e "eeA and
esti!ated annual e4penses " 1.(0>. Fees are charged against average assets "r the
$ear. %he grss return is 11.0>. Hhat is $ur return net " lads and e4pensesP
=!unt initiall$ invested Q <1:,::: R @:.:1 <1:,:::A Q <9,,::
=!unt a"ter grss return Q <9,,:: 1.110 Q <1:,,?1
=verage asset value "r $ear Q @<1:,,?1 S <9,,::A L 2 Q <9,9,:.0:
Fees Q <9,9,:.0: T :.:1(0 Q <1(,.2:
3nding a!unt a"ter "ees Q <1:,,?1 - <1(,.2: Q <1:,(,1.?:
Bet rate " return @"irst $earA Q @<1:,(,1.?: L <1:,:::A R 1 Q (.,7>
%eaching %ip: Fees are assessed n average assets, &ut "r si!plicit$ # "ten have students
use $ear end assets. #n the !utual "und prspectus and annual reprts the "und returns
presented are net " perating e4penses, 12&-1 "ees and c!!issins, &ut the reprted
returns d nt include lads.
#n 2:1: average !ees and e,penses paid &$ !utual "und investrs were :.99> n stc/
"unds and :.70> n &nd "unds. %hese e4penses have cntinued t "all ver the last
17-1:
Chapter 17 - Mutual Funds and Hedge Funds
decade.
Mutual "und 8utes are si!ilar t stc/ 8utes. %he Wall Street !ournal "r instance
prvides B=C, invest!ent &+ective, e4pense rati, and lad charges i" an$. Fund returns
are als ran/ed within the invest!ent &+ective. )e"er t the WS! 8ute sheet in the te4t.
Bte that the HS; ran/ings d nt include an$ !easure " ris/. Mrningstar ran/ings
include an ad+ust!ent "r "und ris/ and thus are pr&a&l$ &etter ran/ings t use.
Bevertheless, !st studies shw that ran/ings are nt predictive " "uture per"r!ance s
care !ust &e used in interpreting an$ ran/ing sche!e.
9. Mutual Fund 0alance Sheets and 4ecent #rends
a. Long8#er" Funds
#n 2:1: e8uit$ invest!ents were 01.2> " ttal "unds invested in lng ter! "unds.
#nvest!ents in crprate and "reign &nds c!prised 17.,>, and 5.S. gvern!ent and
agenc$ securities !ade up 1,.7>., while !unicipal invest!ents were 7.1>. %he
percentages " de&t and e8uit$ hwever can var$ widel$ ver di""erent !ar/et cnditins.
Mar/et ti!ing "unds @als called asset allcatin "undsA are designed t var$ the a!unt
" !ne$ in the di""erent asset classes accrding t "recasts " per"r!ance. 'uring the
"inancial crisis assets "ell "r! <7,?29 &illin in 2::7 t <0,,(0.( &illin in 2::?, a drp
" al!st (1>. -$ 2:1: assets recvered t <1,7?(.1 &illin, althugh the "unds pared
&ac/ e8uit$ hlding during the crisis and had nt $et returned t pre-crisis levels "
invest!ents in e8uities.
#n 2:1: the S3C prpsed changes t 12&-1 charges. %he ter! 12&-1 wuld n lnger &e
used and the "ees wuld &e ter!ed K!ar/eting and service "ees.7 %he annual !anage!ent
"ee @capped at :.70>A wuld &e ter!ed Knging sales "ees,7 and wuld have t &e
ter!inated nce an investr had paid the e8uivalent t the lad charged n classes "
!utual "und shares that pa$ a "rnt end lad. #" "r e4a!ple the shares with a "rnt end
lad paid a0> lad charge, the !anage!ent "ee prtin " the 12&-1 assessed n ther
"und classes !ust &e ter!inated when the investr7s ttal pa$!ent is e8uivalent t a 0>
"rnt end lad. =s " this writing, this is nl$ a prpsal.
-. Money Mar+et Funds
#n 2:1: MMMFs held 1,.:> in pen !ar/et paper, 29.:> in %reasuries and agencies,
12.7> in !unicipals and 11.?> in reps. Mne$ !ar/et "unds !aintain a cnstant B=C
" <1.::. =s interest is earned an investr is credited with !re shares. Mne$ "unds
increased sa"et$ " their invest!ents during the "inancial crisis, increasing hldings "
5.S. gvern!ent securities "r! 1(.1> in 2::7 t (0.0> in 2::?.
:. Mutual Fund 4egulation
%he S3C is the pri!ar$ regulatr " !utual "unds. %he !a+r acts regulating !utual
"unds include the &an/ing and securities acts " 19(( and 19(, and the Invest"ent
Co"pany 6ct o! %;9<. %hese laws re8uire !utual "unds t !eet disclsure re8uire!ents
si!ilar t pu&lic issues " de&t and e8uit$, and intrduced !an$ anti-"raud prcedures
and li!its n "ees. Bewer laws such as the Insider #rading and Securities Fraud
/n!orce"ent 6ct o! %;== re8uired "unds t develp !echanis!s t avid insider
17-11
Chapter 17 - Mutual Funds and Hedge Funds
trading a&uses and the Mar+et 4e!or" 6ct o! %;;< allwed the S3C t intrduce circuit
&rea/ers. Mre recentl$, the $ational Securities Mar+ets I"prove"ents 6ct 1$SMI62
" 1991 e4e!pts !utual "und sellers "r! !st state versight.
/thical pro-le"s in the "utual !und industry
Fur !ain categries " trading a&uses have &een identi"ied:
1. Mar/et ti!ing: =llwing selected traders, t$picall$ "und !anagers, t &u$ !utual
"und shares and then sell the! in a shrt ti!e perid, usuall$ the ne4t da$ t
e4plit prices changes in hldings in verseas !ar/ets.
2. .ate trading: %his is the &ig news ite!. #t cnsists " allwing certain investrs t
&e a&le t &u$ r sell !utual "und shares a"ter clse " trading at ,::: *M 3S%.
)ecall the B=C is set "r the da$ at that ti!e. =s new in"r!atin c!es ut,
investrs can pr"ita&l$ set up trades &ased n the new in" that is nt $et
incrprated int the "und B=C. .ate trading and !ar/et ti!ing allw certain
classes " investr t un"airl$ pr"it at the e4pense " lnger ter! investrs.
(. 'iluted &r/erage arrange!ents: = "r! " Kdirected rder "lw.7 #n this practice
!utual "und !anagers used certain &r/ers when the$ decide t &u$ and sell
shares held in the !utual "und. #n e4change "r this, the &r/ers agree t advise
their wn clients t purchase that !utual "und, regardless " whether that was the
&est "und "r that particular client. %his is a "r! " s"t dllar /ic/&ac/.
,. S!e &r/ers have allegedl$ duped investrs int purchasing shares with 12&-1
plans, a "r! " lad charge, &$ telling the investrs the "und had n lad. S!e
"unds and "und "a!ilies als prvide discunts t 8uali"ied cust!ers. #n s!e
cases, the &r/ers did nt realize @r +ust did nt tellA the cust!ers the$ 8uali"ied
"r a discunt and vercharged the cust!ers.
Bew rules resulting "r! the a&uses:
#n general the rules are designed t increase disclsure a&ut ptential cn"licts "
interest, clse legal lphles a&used &$ !anagers and increase versight and
independence " the &ard. %he !ini!u! percentage " independent &ard !e!&ers
was increased "r! 0:> t 70>. )ecall that under Sar&anes-O4le$ at least ne &ard
!e!&er !ust have accunting e4pertise and /nwledge " 2==*. %he S3C als nw
re8uires senir e4ecutives " "unds t reprt all trading in "unds, nt +ust trading in
individual stc/s. Client trades and hldings !ust als &e held cn"idential @the$ had
&een revealed t ther "und !anagersA.
1. )ules n !ar/et ti!ing: Fir!s !ust pr!ulgate and disclse !ethds t li!it
"re8uent trading. Fir!s !ust disclse whether the$ are using K"air value pricing7
@FC*A. FC* is a !ethd t update securities prices where the last price 8ute is
Kstale7 r ut " date &$ several hurs r !re. %his is i!prtant "r "unds hlding
stc/s that trade in verseas !ar/ets.
2. % li!it i!prper directed rder "lw, &r/ers are re8uired t disclse t
cust!ers an$ tie in arrange!ents with speci"ic "unds. %hese are de"act cn"licts
" interest and shuld &e disclsed.
(. =s " Oct&er 2::, all "unds !ust have a chie" c!pliance ""icer @CCOA that
answers t the &ard. %he CCO7s duties include plicing persnal trading &$ "und
!anagers, !nitring allcatins " trades and c!!issin, ensuring accurate
17-12
Chapter 17 - Mutual Funds and Hedge Funds
in"r!atin disclsure and reprting wrngding t the &ard.
,. Sharehlder reprts !ust disclser all "ees sharehlders paid as well as
!anage!ent7s discussin " "und per"r!ance ver the perid. #nvestrs nw get
a reprt shwing hw !uch the$ paid, hw !uch the &r/er @i" an$A was paid,
and hw the "und c!pares with industr$ averages "r "ees, lads and &r/erage
c!!issins.
0. *)O*OS3' &$ S3C, &ut nt apprved: NHard clsingO n &u$Lsell rder
prcessing as " ,::: *M 3S% dail$. %he industr$ is "ighting this ne &ecause
the$ clai! &r/ers wuld have t have the rders &$ as earl$ as 1:::: a! in the
da$. @%his is a pr&le! that culd easil$ &e slved &$ technlg$ hwever.A
#n March 2::9 the S3C increased disclsure re8uire!ents "r !utual "unds. %he "unds
!ust nw ""er a straight"rward e4planatin " /e$ "und in"r!atin at the &eginning "
a prspectus prvided t investrs as a result " a ptential invest!ent rder. %he "ull
prspectus will still &e availa&le n the we&.
%eaching %ip: Mrningstar is !aintaining a "und watch list "r "unds under investigatin
with prescriptins "r investrs, such as N*rceed with cautin,O N'n7t send new
!ne$,O and NCnsider selling.O %his in"r!atin is availa&le at www.!rningstar.c!.
%he scandals dn7t see! t have had a lasting deleterius e""ect n the industr$. Surve$s
&$ the #nvest!ent C!pan$ #nstitute @#C#A indicate that 70> " peple have a "avra&le
perceptin " the industr$, althugh this perceptin is driven heavil$ &$ current !utual
"und per"r!ance.
>. Mutual Fund Glo-al Issues
'uring the 199:s !utual "unds were the "asting grwing "inancial institutin in the
5nited States. 2rwth slwed r declined in !st !a+r cuntries " the wrld in 2::1,
reversing a decade lng trend, &ut pic/ed up again as the ecn!ic grwth i!prved in
the !id-2:::s nl$ t decline again during the crisis. Hwever, in the late 2:::s grwth
in nn-5.S. invest!ents utpaced grwth in 5.S. "unds. %tal assets " nn-5.S. !utual
"unds were <112.1 &illin in 1992. =s " 2:1: there were <1,.1( trillin invested in
!utual "unds utside the 5.S. -arriers t entr$ are t$picall$ higher in ther cuntries, &ut
lcal "inancial pr&le!s, as in ;apan, have recentl$ encuraged "reign regulatrs t
allw 5.S. entr$ int their !ar/ets.

?. Hedge Funds
Introduction
Hedge "unds are invest!ent pls that slicit !ne$ "r! wealth$ individuals and
institutins. #n 2:1:, ttal invest!ent in hedge "unds was <1.77 trillin. %he !re than
1:,::: hedge "unds are !uch less regulated than t$pical !utual "unds &ecause the$ are
nt pen t the general pu&lic. Bt all hedge "unds are re8uired t register with the S3C.
5nli/e !utual "unds, hedge "unds are e4e!pt "r! pu&lic li8uidit$, disclsure, leverage
and distri&utin re8uire!ents. % 8uali"$ "r these e4e!ptins hedge "unds are nt pen
t the general pu&lic. %he$ !a$ nl$ &e issued via a private place!ent and an individual
hedge "und !a$ have n !re than 1:: wners that are dee!ed Kaccredited investrs.7
17-1(
Chapter 17 - Mutual Funds and Hedge Funds
% &e accredited the investrs !ust have a net wrth " ver <1 !illin r have annual
inc!e " at least <2::,::: @<(::,::: i" !arriedA. Man$ hedge "unds re8uire a
!ini!u! invest!ent " &etween <1::,::: and <2: !illin. Hedge "unds need nt reprt
hldings t the S3C, the$ are allwed t participate in illi8uid !ar/ets and the$ are nt
re8uired t adhere t a particular invest!ent st$le. #n 2::( the S3C rec!!ended that
large hedge "unds @ver <20 !illinA register as invest!ent advisers. %his wuld su&+ect
the! t audits and increase S3C versight. #n 2::( nl$ a&ut 20> " hedge "unds were
registered. %he "ailures " the -ear Stearns High 2rade Structured Credit Strategies "und,
the -ear Stearns High-2rade Structured Credit 3nhanced .everage Fund and the -ernard
Mad"" #nvest!ent Securities led t increased scrutin$ " hedge "unds. %he 'dd Fran/
&ill re8uires that hedge "unds with !re than <1:: !illin register with the S3C under
the #nvest!ent =dvisrs =ct. Fund advisrs !ust nw reprt "inancial in"r!atin n the
"unds the$ !anage t the FSOC t help li!it s$ste!ic ris/ in the ecn!$. %he Federal
)eserve can als e4ercise versight " "unds dee!ed large enugh r intercnnected
enugh t present a s$ste!ic ris/.
,
-an/s and ther "ir!s li/e t &e the KPri"e 0ro+er7 "r hedge "unds &ecause hedge
"unds are high dllar vlu!e active traders. =tte!pting t get and /eep this &usiness can
lead t cn"licts " interest.
%hereticall$, hedge "unds are designed t engage in ris/ ar&itrage strategies, "ten
invlving spreads in !ultiple !ar/ets. #n practice, these "unds "ten &et that prices will
return t histrical patterns, and the$ !a$ use !athe!atical !dels t identi"$ alleged
!ispricings that can &e pr"ita&l$ e4plited at lw ris/. #" prices d nt cn"r! t the
e4pected patterns hwever, a hedge "und can "ind lsses !unting rapidl$. #n rder t
!a/e enugh return n !ispricings, !an$ " these "unds are highl$ leveraged, s s!all
lsses can 8uic/l$ endanger a "und. %he !st well /nwn "und, .ng %er! Capital
Manage!ent @.%CMA, is a classic e4a!ple " hu&ris and ver-reliance n !athe!atical
!dels t !easure and cntrl ris/. =n e4cellent vide n hedge "unds and the -lac/-
Schles !del titled, N%rillin 'llar -et,O is availa&le "r! *-S %elevisin.
B ne hedge "und culd generate the s$ste!ic ris/ caused &$ .%CM &ecause "
increased !nitring &$ "und creditrs, &ut hedge "unds use si!ilar !dels and invest in
si!ilar situatins. #n thin !ar/ets such as e!erging cuntr$ de&t r e8uities,
si!ultaneus transactins &$ !ultiple hedge "unds @NherdO e""ectsA culd create r
e4acer&ate crises.
a. #ypes o! Hedge Funds
Hedge "unds are nt all the sa!e and !a$ &e classi"ied int three &rad t$pes althugh
verlapping strategies are certainl$ pssi&le, particularl$ acrss di""erent !ar/et
cnditins.
Mar+et directional !unds ta/e psitins in securities r !ar/ets ahead "
in"r!atinal annunce!ents r e4pected !ar/et !ves. %hus the$ engage in ris+y
ar-itrage strategies. Mar/et ti!ers wuld "it int this categr$. %hese "ten use
,
Much tugher regulatins " the hedge "und industr$ were prpsed &ut "ailed t pass Cngress.
'etails are in the te4t.
17-1,
Chapter 17 - Mutual Funds and Hedge Funds
leverage and are e4psed t signi"icant levels " !ar/et ris/. S!e !a$ use a
cntrarian strateg$ and unli/e !utual "unds, !a$ engage in e4tensive shrt selling.
Mar+et neutral or value oriented !unds !a$ tr$ t "und securities that are
te!praril$ !ispriced such as a stc/ r &nd " a "ir! in an ut " "avr industr$ r
in "inancial distress. Funds " "unds, !ulti-strateg$ "unds and specialt$ "unds l/ing
"r hstile ta/evers, .-Os etc, !a$ "it int this categr$ and the$ usuall$ have less
ris/ e4psure than directinal "unds.
4is+ avoidance !unds "it the traditinal interpretatin " the ter! Khedge "und.7
%hese "unds ta/e levered &ets n lwer ris/ r even pure ar&itrage situatins rather
than engaging in ris/$ ar&itrage. %he$ !a$ &u$ stc/ and ""set the ris/ &$ shrting a
cnverti&le &nd n the sa!e "ir!.
-. Fess on Hedge Funds
Hedge "unds charge !anage!ent "ees that are si!ilar t standard annual !utual "und
e4penses. %hese "ees t$picall$ run &etween 1.0> and 2.:>. Hwever, hedge "unds
charge a per"r!ance "ee as well i" certain cnditins are !et. *er"r!ance "ees average
2:> " the gain in the "und assets. #n rder t assess the per"r!ance "ee the "und will
have t !eet a hurdle rate @!ini!u! rate " returnA and "ten !ust pass a Khigh-water
!ar/7 test. %he high-water !ar/ !eans the per"r!ance "ee cannt &e assessed unless
the "und7s B=C is at an all ti!e high at the ti!e " assess!ent.
c. O!!shore Hedge Funds
%he Ca$!an #slands are the lcatin " a&ut 70> " hedge "unds. %his is &ecause
""shre "unds are nt ta4ed n distri&utins " pr"its and are nt su&+ect t 5.S. estate
ta4es n "und shares. O""shre "unds trade !re perhaps &ecause the$ dn7t "ace capital
gains ta4es, the$ engage in less windw dressing and dn7t engage in as !uch Kherd
&ehavir7 as nshre "unds.
Hedge Fund Per!or"ance
Hedge "unds did ver$ well in the 199:s and did well thrughut !uch " the 2:::s until
the su&pri!e crisis hit in 2::7 when tw -ear Stearns hedge "unds invlved in !rtgage
&ac/ed securities 8uic/l$ "ailed. 5-SL'illn )ead Capital clsed hedge "unds in 2::7,
and in earl$ 2::? Citigrup &arred investr withdrawals "r! ne " its hedge "unds.
%he "inancial crisis reduced the a!unt " assets in hedge "unds, althugh a "ew "unds
did well during the crisis. %he t$pical hedge "und had negative returns " 10.7> in 2::?,
with a&ut 70> " "unds lsing !ne$ that $ear. 3ven s !an$ "unds utper"r!ed the
inde4es in the sa!e ti!e perid. =lthugh returns were "ar &etter in 2::9 @in the 2:>
rangeAE the "unds underper"r!ed the SG* 0:: ver that ti!e perid. Fund rede!ptins
"llwed a si!ilar pattern as "r !utual "unds.
%he cllapse " the tw -ear Stearns hedge "unds led t investr lsses " <1.1 &illin
and led t the &an/ruptc$ " the c!pan$. %he "unds &ught C'Os with &rrwed "unds
and initiall$ en+$ed a psitive spread. %he "und !anagers insured s!e, &ut nt all, "
the ris/s &$ purchasing credit de"ault swaps. =s the su&pri!e crisis un"lded and the
value " the C'O hldings drpped "ar !re than anticipated, -ear7s creditrs as/ed "r
additinal cllateral n lans and the "unds did nt have the cash needed. %his led t "ire
17-10
Chapter 17 - Mutual Funds and Hedge Funds
sales " assets and wrd 8uic/l$ gt ut that -ear was in tru&le. %his in turn led t
additinal sales " su&pri!e securities which e4acer&ated the pr&le!s at -ear eventuall$
leading t the assisted &u$ut as -ear 8uic/l$ ran ut " capital.
-ernard Mad"" #nvest!ent Securities was the "und run &$ "r!er B=S'=D chair!an
-ernie Mad"".
0
Mad"" ran an ld "ashined *nzi sche!e, clai!ing t have <10 &illin
in stc/ hldings that were "ictitius.
1
He apparentl$ had nt purchased stc/s since the
!id-199:s. Mad"" was arrested in late 2::? and the "ir! was li8uidated a"ter his sns
turned hi! in t authrities. Mad"" pled guilt$ t 11 "elnies and was sentenced t 10:
$ears in +ail with restitutin charges " <17: &illin.
Mre recentl$ a large hedge "und, 2allen 2rup ..C, was clsed in Oct&er 2::9 due
t an insider trading scandal. %he "under, )a+ )a+aratna!, and 2: thers were charged
with cri!inal vilatins " insider trading laws. %he "ir! had allegedl$ used inside
in"r!atin "r! cnsulting grups t invest. =s " this writing ther "unds are als
under investigatin "r si!ilar accusatins.
VI. @e- Lin+s
http:LLwww."ederalreserve.gvL He&site " the -ard " 2vernrs " the Federal
)eserve
http:LLwww.ws+.c!L He&site " the Hall Street ;urnal #nteractive
editin. %he we& versin " the well /nwn
"inancial newspaper can &e persnalized t !eet
$ur wn needs. #nstructrs can als receive via e-
!ail current events cases /e$ed t "inancial !ar/et
news c!plete with discussin 8uestins.
http:LLwww.ici.rg #nvest!ent C!pan$ #nstitute we&site. See the
Mutual Fund Fact&/ "r industr$ statistics.
http:LLwww.lipperwe&.c!L .ipper =nal$tical Services is an e4cellent site "r
!utual "und in"r!atin.
https:LLpersnal.vanguard.c!LusLh!eP"r!*ageQprtal
Canguard 2rup7s we&site.
http:LLwww.sec.gvL %he S3C7s we&site.
http:LLwww.nasda8.c!L %he B=S'7s we&site.
0
%he Mad"" "und was nt a hedge "und, &ut acted as a "und " hedge "unds.
1
= *nzi sche!e is a cn where high returns are paid t "und investrs with !ne$ paid in &$ new
investrs. %he sche!e can grw as lng as su""icient new "unds are paid int the "und. Hrd " !uth "
the high returns ""ered &$ the Mad"" "und led t large "und in"lws "r a ti!e. #nvestrs !ust &e
s/eptical whenever a "und ""ers higher than nr!al returns.
17-11
Chapter 17 - Mutual Funds and Hedge Funds
http:LLwww.!rningstar.c! )ated &$ -arrn7s as the nu!&er ne we&site "r
in"r!atin a&ut the !utual "und industr$.
VII. Student Learning 6ctivities
1. 2 t http:LLwww.!rningstar.c! and &tain the reprt n a large "und "
$ur chice. Hhat is the "und7s strateg$ and hw has it per"r!ed ver the last ( and
0 $earsP Hhat is the "und7s star ratingP Hhat are the tp "ive hldings " the "undP
2. O&tain the NMutual Funds "r 'u!!iesO &/ &$ 3ric %$sn. Hhat are the
!a+r reasns "r investing in !utual "undsP Hhat is changing in the !utual "und
&usinessP
(. Fr an$ speci"ic !utual "und, where can $u "ind its lowest 8uarterl$ return
@its wrst three-!nth peridA during the past 1: $earsP Hhat are the ta4 cnse8uences
" e4changing shares "r! ne "und t anther within the sa!e "und "a!il$P Mutual
"unds can &e purchased directl$ "r! the "und c!pan$ r indirectl$ thrugh anther
part$ @"r e4a!ple, thrugh a &r/er, "inancial planner, r retire!ent planA. Hhat
prtin " sales " stc/ and &nd "unds is !ade directl$ t the investrP *lease cite
$ur surces.
,. =t the #nvest!ent C!pan$ #nstitute we&site &tain the reprt titled
NFre8uentl$ =s/ed Duestins =&ut %a4atin "r Mutual Funds.O Hw are !utual
"und hldings ta4edP 'es the investr7s hlding perid !atterP Hw des "und
turnver a""ect an investr7s lia&ilit$P
0. 5sing the latest Fact&/ "und at the #nvest!ent C!pan$ #nstitute we&site,
ran/ the "llwing t$pes " "und &$ ttal assets in the !st recent ti!e perid:
=ggressive 2rwth, 2rwth, 2rwth and #nc!e, -alanced, =sset =llcatin, -nd
"unds and Mne$ Mar/et Mutual Funds. 34plain the !a+r di""erences &etween each
t$pe " "und.
17-17