27. Key Concepts

LO 27.a - Types of Commingled Pools of Investments:

1. Open-end mutual funds: Transact at the next available Net Asset Value (NAV) after the market closes. Shares can be redeemed directly from the fund company.

2. Closed-end mutual funds: Transact throughout the trading day, but shares cannot be redeemed directly from the fund company. Their price may differ substantially from their NAV, as they are bought or sold by other investors.

3. Exchange-Traded Funds (ETFs): Trade throughout the day, and their shares trade at the NAV. ETFs usually have lower internal fees compared to other funds, impacting investment returns positively.

LO 27.b - Undesirable Trading Behaviors:

1. Late trading: Trading mutual fund shares after the market closes, based on the day's NAV, but at a stale price.

2. Market timing: Rapid buying and selling of mutual fund shares to exploit short-term market movements.

3. Front running: Fund managers trading on their personal accounts before executing large trades for the fund, benefiting from the price impact.

4. Directed brokerage: Fund managers favoring certain brokers in exchange for other benefits.

LO 27.c - Calculation and Use of NAV:

1. NAV calculation: Easily calculated as (Total invested assets - Liabilities) / Total shares outstanding.

2. NAV for open-end funds: Set after the trading day ends.

3. NAV for closed-end funds and ETFs: Calculated continuously throughout the trading day.

4. NAV's purpose: Used to determine the number of shares purchased or sold in a fund.

LO 27.d - Differences Between Mutual Funds and Hedge Funds:

1. Marketing and regulatory oversight: Hedge funds are marketed to wealthy and sophisticated investors, allowing them to avoid certain regulatory oversight applicable to mutual funds.

2. Share redemption: Hedge funds can limit investors' ability to redeem shares at any time, unlike mutual funds.

3. Leverage and short selling: Hedge funds can use leverage and engage in short selling, while these may be restricted for mutual funds.

4. Investment disclosure: Hedge funds have more flexibility in disclosing investment policies and strategies compared to mutual funds.

5. Lock-up periods: Hedge funds may use lock-up periods to restrict investor withdrawals at certain times.

LO 27.e - Hedge Fund Fee Structure and Investor Protection:

1. Fee structure: Hedge funds commonly use a 2% management fee and a 20% incentive fee based on investment performance relative to a hurdle rate.

2. Investor protection: High-water marks and clawback clauses are used to protect investors from paying incentive fees for losses or previous gains.

LO 27.f - Types of Hedge Fund Strategies:

1. Long/short equity funds: Take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations.

2. Dedicated short funds: Take net short positions in equities, with returns negatively correlated to equities.

3. Distressed hedge funds: Invest across the capital structure of financially distressed firms, aiming to profit from improvements or successful bankruptcy outcomes.

4. Merger arbitrage funds: Bet on spreads related to proposed merger and acquisition transactions.

5. Convertible arbitrage funds: Profit from purchasing convertible securities and shorting corresponding stock.

6. Fixed-income arbitrage funds: Obtain profits by exploiting inefficiencies and price anomalies between related fixed-income securities.

7. Emerging market funds: Invest in currencies, debt, equities, and other instruments in emerging or developing markets.

8. Global macro managers: Make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices, performing well during extreme currency market moves.

9. Managed futures funds: Attempt to predict future movements in commodity prices based on technical or fundamental analysis.

LO 27.g - Mutual Fund and Hedge Fund Performance:

1. Mutual fund performance: Generally easy and objective to measure. Actively managed funds have often underperformed the market, leading to the popularity of passive funds like index funds with lower fees.

2. Hedge fund benchmarks: Problematic due to measurement bias and backfill bias, making it challenging to assess their performance accurately.