Neil A. Chriss, December 1998

Banking and Finance G63.2751

Summary of Lecture

This lecture will define what hedge funds are, discuss some of the key strategies that hedge fund managers employ and will introduce some of the important vocabulary and quantitative tools used by hedge fund managers. The accompanying reading for this lecture is Hedge Funds Demystified: Their Potential Role in Institutional Portfolios. I thank the Pension and Endowment Forum of Goldman Sachs & Co. for kindly granting permission for me to reproduce this document for use by the class. A portion of this lecture is drawn from this document.

Types of Investment Funds

There are many types of investment funds besides hedge funds, and to place hedge funds more precisely in the broader context of different funds, it is a good idea to define several other sorts of funds. In this section we will talk about:

• Mutual funds
• Pension funds
• Hedge funds

Mutual Funds

Mutual funds are actually investment companies, that is, they are firms that collect investments from investors and professionally invest money on behalf of investors. Investment companies collect fees from investors, usually drawn directly out of the investment, as a fee for the service of investment. There are primarily three types of fees an investment company will charge:

• Up-front fees: these are fees charged for the collection of assets. In the world of mutual funds, these are often known as sales loads.
• Management fees: these are fees charged for the on-going service of investing assets.
• Performance fees: these fees are a cut of the profits of investing. Performance fees are assessed on the upside portion of the fund value, that is, on the portion of the value of the fund due to investment return. For example, if an investor invests $100 in a fund and the fund value rises to $120, then a performance fee may be charged on the $20 upside.

Mutual funds come in two varieties: closed end and open end. Open end mutual funds are investment companies that continually offer new shares of the fund to the public for investment and stand ready to redeem outstanding shares at the net-asset value (NAV) of the fund. In this sense, the company is the unique market maker of shares in the company. They will sell or buy the shares every day. Mutual funds sell their shares at the fund net-asset value per share, which may be regarded as the value of the investment in the fund. It is calculated by taking the value of all investments in the fund less any liabilities (such as fees) divided by the total number of outstanding shares.

Mutual funds are regulated investment companies. In particular, they are regulated by the Investment Company Acts of 1940 and 1970. The 1940 Act regulates certain aspect of a fund’s operations including financial statements, investment goals, personnel, debt, and managers. The 1970 Act regulates sales charges (i.e. sales load and in particular the maximum sales load) and fees of mutual funds. The main point that concerns us in this lecture is that mutual funds are tightly regulated entities, a fact which is not the case for hedge funds.

Note that open end mutual funds cannot be traded in a secondary market. Their values are determined by the investment company (mutual fund company) and the company is required (by the Act) to buy and sell the shares of the company at the NAV. Two key pieces of terminology concerning all funds are:

• Inflows: this is the flow of money into a fund
• Outflows: this is the flow of money out of a fund

Closed-end mutual funds unlike open end funds are traded in a secondary market. Such funds are distinct from open end funds and work as follows. The fund issues a limited number of shares and does not redeem the shares. Rather, the company publishes information about its NAV and the shares are traded on a secondary market or through an over-the-counter market. In this sense, investors purchases shares of closed end funds much in the same way they purchase shares of stock and for similar reasons. An important feature of closed end funds is that their market values and net-asset values may differ. This is because the net-asset value, determined by the value of the investments in the fund, may be different than the value (per share) that investors are willing to pay for the fund. A closed-end fund whose market value is less than its NAV is said to be trading at a discount.

Pension Funds

A pension fund is an investment company that manages the assets of employees of a company and disburses the assets to employees upon retirement. Contributions to the fund by both employer and employee finance the pension fund assets. There are two main types of pension funds:

• Defined Benefit: these funds manage their assets and set their investment goals according to a set of guidelines that define the type of payouts they will make to employees after retirement.
• Defined Contribution: these funds manage their assets according to a defined set of rules of how an employer’s contributions to the fund are to be made.

I bring up pension funds in this lecture for two reasons. First, they are a type of investment fund and therefore knowledge of them helps to reduce confusion about what and what not a pension fund is, and second, pension funds are large investors in hedge funds. Moreover, the pension industry has been growing world wide for some time; as a result has an impact on capital markets, as expressed in the following quote:

Institutional investors can influence the demand for capital-market instruments in several ways: by increasing the total supply of saving, by influencing the rest of the personal sector’s portfolio distribution between bank deposits and securities, and via the institutions’ own portfolio choices.

Pension Funds, E. P. Davis, Oxford 1997

Another point concerning the relationship between hedge funds and pension fund investment is the need for financial innovation, as Davis points out:

The process of financial innovation-the invention and marketing of new financial instruments which repackage risk or return streams-has been closely related to the development of pension funds.

Pension Funds, E. P. Davis, Oxford 1997

www.benefitslink.com/erisa.

The act begins with the following statement:

The Congress finds that the growth in size, scope, and numbers of employee benefit plans in recent years has been rapid and substantial; that the operational scope and economic impact of such plans is increasingly interstate; that the continued well-being and security of millions of employees and their dependents are directly affected by these plans; that they are affected with a national public interest; that they have become an important factor affecting the stability of employment and the successful development of industrial relations; that they have become an important factor in commerce because of the interstate character of their activities, and of the activities of their participants, and the employers, employee organizations. that owing to the lack of employee information and adequate safeguards concerning their operation, it is desirable in the interests of employees and their beneficiaries, and to provide for the general welfare and the free flow of commerce, that disclosure be made and safeguards be provided with respect to the establishment, operation and administration of such plans; that they substantially affect the revenues of the United States because they are afforded preferential Federal tax treatment; that despite the enormous growth in such plans many employees with long years of employment are losing anticipated retirement benefits owing to the lack of vesting provisions in such plans; that owing to the inadequacy of current minimum standard, the soundness and stability of plans with respect to adequate funds to pay promised benefits may be endangered.

Summarizing the US governments reasons for regulating the pension plan industry, we see:

• Pension plans are vital to the welfare of the US economy
• Profit on capital gains in pension plans receive preferential tax treatment and therefore affect the tax revenue of the US government

The second point is important for investment funds: ERISA money, that is, monies invested by pension plans, receives different tax treatment vis-a-vis capital gains. Moreover, pension plans have three alternatives with regard to how they manage their assets:

• Manage the pension assets itself
• Distribute the pension assets to external money managers
• Use a combination of the first two

Two important points when comparing pension funds as investors in hedge funds versus individuals as investors in hedge funds are 1) fees and 2) tax treatment. Pension funds typically pay fees for assets under management that are well below standard hedge fund fees. For example, Frank Fabozzi in Investment Management (Prentice Hall, 1995) reports that a study in 1991 found that public pension funds pay an average of .31% (31 bps) to have their external assets managed (that is, they pay .31% of total assets under management as management fee) and private pension funds pay .41% (41 bps).

As such, pension funds have different investment goals relative to individual investors. As many hedge funds draw from pension plans for investment capital, understanding the investment goals and rules of pension plans is an important aspect of hedge fund marketing.

More on Tax Treatment of Pension Funds

The following brief discussion on tax treatment of pension funds is taken from Pension Funds, E. P. Davis, Oxford 1997. Broadly speaking there are three different ways a pension fund can be taxed, depending on which part of the pension monies are taxed. From this point of view, pension money is divided into three pieces: contributions (the money going into the fund) and income (the increase in the funds value due to asset appreciation), and benefits (the money coming out of the fund to pay employees upon retirement, or withdrawal from the plan). Each piece may either be exempt (E) or taxed (T).

• Exemption of contributions and income, but taxation on benefits (EET)
• Taxation of contributions only (TEE)
• Taxation of benefits only (EET)

A contribution to a pension plan is said to be tax free if the income to the individual or employer that goes to the pension fund is not taxed. For example, suppose a US employee makes $50,000 per year and contributes $2,000 to his or her pension fund in a given tax year. If this contribution is tax free, then the employee’s taxable income that year is $48,000.

The US follows what is basically an EET taxation plan for pension funds, though there are limits on the level of tax-free contributions for DC plans. Such contributions are limited to $30,000 per annum. For DB plans, the amount of benefits that may be paid to an individual is limited to an indexed ceiling, that is, the maximum level increases with a pre-defined index level.

Most countries globally follow an EET-like plan. The following table may be of interest: