Mutual Funds and Hedge Funds Term Paper

Excerpt from Term Paper :

The first aspect of successful mutual fund performance is to define a benchmark. Most funds have specific benchmarks that they use both internally and externally. Externally, the benchmarks are often used in promotional material, relating the performance of the fund to the performance of the Dow Jones Industrial Index or some other broad-based market indicator. Funds operating in specific sectors will benchmark against a sector index. The idea behind this is that the fund should demonstrate a track record of success - otherwise the investor should simply purchase the Index, many of which are available as exchange-traded funds. Internally, fund benchmarks are more complex. For example, the risk level of the fund relative to the market is factored into the equation.

The next component of mutual fund performance is the ability to analyze securities. Most major fund companies employ experts who can make specific recommendations within a given sector. The success of a fund company depends in part on the strength of these analyses, as they form the basis for the investment decisions made by the fund's manager.

The investment decisions themselves are another key factor in fund performance. Part of successful fund management is knowing what to invest in, and part is knowing when to make the investment and when to divest. Fund managers with consistent track records of outperforming their respective benchmarks become stars within the industry, and savvy investors or investment advisors seek out products associated with those fund managers.

In that regard, retention of top fund management talent is another key success factor in the mutual fund industry. Investors understand that the past performance of a mutual fund is not a guarantee of future success, but they like to improve the odds by investing in funds whose managers have a consistent track record of success. It is imperative that firm's retain successful fund managers to ensure the continued marketability of that particular fund.

Another success factor in the mutual fund industry is marketing. Mutual funds are considered "public" investments in that they are available for sale to all investors. There are thousands of funds available, so competition is intense. There are multiple channels for distribution - either direct to the investor or through an investment advisor. Therefore mutual fund companies spend hundreds of millions of dollars marketing through these two channels.

Fund companies attempt to differentiate their offerings, on the basis investment philosophy, management fee structure (price) or a particularly strong track record of past performance. Some fund companies differentiate on the basis of their distribution channels. Some focus on direct sales to consumers, others deal almost exclusively through investment advisors, to whom they market extensively with dedicated sales representatives. Several fund companies are distributed exclusively through a single financial institution.

The leading mutual fund firm is Fidelity Investments with $1.57 trillion in assets under management in the U.S. And a further $280 billion under management outside the U.S. They offer a comprehensive package including advisory services, discount brokerage, estate management and life insurance.

Fidelity's success has been on the basis of its strong fund performance and its innovative marketing. Its Contrafund is the largest mutual fund in the U.S., and its Magellan fund is the second-largest (and former #1). Fidelity has actively targeted the baby boomer market, placing a strong focus on financial security and lifestyle imagery.

The second-largest fund manager in the U.S. is the Vanguard Group. They are a cost-oriented firm and a pioneer of index funds. Whereas many other funds were benchmarked against an index, Vanguard introduced the idea of buying a fund that mirrored the index itself. These funds are popular amongst conservative investors, who prefer the perceived stability of "doing what the market does" and passive investors, who do not believe it is possible to consistently beat the market on a risk-weighed basis. Founder John Bogle launched the idea when he realized that three-quarters of fund managers did not beat the S&P 500 Index.

Vanguard has a unique ownership structure that it lauds as a competitive advantage, in that it is owned by the funds themselves. This is because Vanguard is not expected to make a profit for itself, or that if it does this will be returned to the unitholders. Vanguard's fund are "no-load" and the company maintains a low cost structure, which means that they are competing on the basis of price.

The number three company is American Funds. American does not advertise to the public, but rests its success on the recommendation of investment advisors and their track record of performance.

The Hedge Fund Industry - Success Factors

The hedge fund industry is characterized by several differences from the mutual fund industry. The first is the target market itself. Because hedge funds are targeted exclusively to accredited investors, they do not engage in public marketing the way conventional funds do. This alters one of the key success factors. Marketing is not as important to hedge funds. Indeed, many hedge funds do not even have websites. Since most hedge funds are closed, marketing is only important during the initial round of capital-building. To that end, the key success factor is that of the fund marketers to build relationships with investment advisors and large individual investors. Much of the recent growth in hedge funds is attributable to the institutional market as pension funds and insurance companies seek to diversify into a greater variety of asset classes and make gains beyond that which the standard equity market offers.

The performance aspect of hedge fund performance is more complex, given the wide range of objectives within the hedge fund universe, but the ultimate goal remains the same - a successful hedge fund must demonstrate strong performance. In the hedge fund industry, most firms will launch a series of funds and the ability to raise capital for one fund will depend on the success of any previous funds from that firm or manager. No matter what tools, sectors or strategies are involved, the manager must be able to consistently meet or exceed the fund's benchmarks in order to ensure continued success.

Performance is so important to the hedge fund industry that most funds are highly secretive, wary of divulging their proprietary investment strategies. In this way, they protect the one competitive advantage that they have - if secrets of their success were known, they would cease to have any such advantage.

Performance is especially critical in light of the fiscal structure of hedge funds, whereby the fund makes its money by taking a percentage of gains. Leading hedge fund manager, SAC, takes 50% of the gains of their funds. In order to continue to attract investors given such a figure, SAC must demonstrate consistent superior performance.

Another leading hedge fund manager is Renaissance Technologies. As with SAC, the appeal of the company is its performance, which is estimated at 35% per year. It is worth noting that the beta of the fund (that is to say its risk relative to the market) is not known. This shows that while the term performance to hedge funds sometimes means, at least externally, raw performance, rather than risk-weighted performance.

To achieve its high level of performance, Renaissance employs some 150 mathematicians and statisticians to study and chart market movements in order to anticipate future shifts in prices. This is an example of how expertise is the specific driver of hedge fund performance. Each fund has very unique characteristics, and the performance of the fund is largely dependent on the fund manager and the research team to develop expertise in the specific area of specialization of the fund. Hedge funds often seek to develop sustainable competitive advantage by specializing in complex investment strategies. In addition to the team of mathematicians, Renaissance employs computer programs to conduct the bulk of its trading, which again lends them a sustainable competitive advantage in terms of delivering consistently superior performance.

ESL, a fund operated in the Berkshire Hathaway mold, is another major player in the hedge fund industry. The key success factor is performance, born of long-term plays driven by in-depth fundamental analysis. ESL holds relatively few positions, and does not engage in sophisticated strategies to the degree that many other hedge funds do.

The European hedge fund industry is dominated by London firms, such as the Man Group, GLG and BlueCrest. London represents some three-quarters of all European hedge fund business, and English funds represent all ten of the top ten European hedge funds. France and Switzerland are secondary players. The industry is small relative to the American industry, but is growing rapidly, at a time when new fund launches in the U.S. are slowing down. The industry worldwide, however, is growing in terms of assets under management.

The hedge fund industry is Asia is nascent, and largely based out of Hong Kong. There are several Asian-focused hedge funds in Europe and North America. Three leading Hong Kong-based hedge fund managers are Ward Ferry Management, Value Partners, and ADM Capital. Singapore is a competitor to Hong…

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