Wealth Management - Week 3

Wealth ManagementAn Unbiased Approach to Managing Your Investments Designed for the Affluent Investor

OutlineI. Hedge Funds & Private Equity

• What are Hedge Funds?• Risk and Return• Top 10 Takeaways• Manager Selection and Allocation Ideas• Discussion Questions

II. Individual Investor ImplementationIII. Endowment Models

What is a Hedge Fund?

A managed portfolio of investments that uses a variety of strategies in hopes of achieving outsized, or attractive, risk adjusted returns

Hedge Fund Characteristics•Usually Open to Limited Number of Investors•Typically Require a Large Minimum Investment (i.e. reserved for the wealthy)•Lack Liquidity•High Fees & Manager Compensation•Often Include Derivatives to Either Hedge Risk or Magnify Returns•Low Regulation and Easy to Establish

What Are Hedge Funds?-Asset management organization dedicated to the pursuit of absolute returns - implementation vehicles for active risk

Relaxed constraints on benchmark, short selling, leverage and traded instruments

Seeks to access to some of the best talent in money managementSkill based

A large portion of manager compensation is performance based, usually with a high water mark – managers also usually have a high percentage of their personal net worth invested

Manager/investor incentives aligned

Hedge funds comprise a large and growing set of strategies. Diversification benefits across managers can be similar to those of individual stocks

Diverse strategies

Can give exposure to return drivers that are different to the drivers of traditional asset class returns

Low correlation to traditional assets

Lightly regulated Careful consideration of business risks is key

Terms include lock-ups, notice periods and typically monthly redemptions at best

Illiquid

Loose constraints

Source: Goldman Sachs

Hedge Fund Strategies

Fixed Income Relative Value

Equity Market Neutral

Convertible Trading

Emerging Market Debt Relative Value

Credit Relative Value

Take advantage of mispricing in a company’s stock due to an event.

Mergers, Corporate Reorganizations, Restructurings, Acquisitions, or other major events can cause price movement; managers make bets on how the price of a company will react to these movements

Long and Short positions in equity, fixed income, futures, and currency markets.

Primarily on economic and political views.

Managed Futures

Global Macro

Quantitative Macro

Macro Relative Value

EventDriven

Tactical Trading

Global Macro / Long Short

RelativeValue


Manager Incentive Structure•Frequently use “2 and 20” compensation

•Charges 2% of AUM and 20% of any profits earned.•Managers often tell investors that they will forgo a bonus until they “make the client whole again”, thus they can still collect the 2% AUM fee until the investor is out of the red.

•Given the difficult-to-predict markets of the last several years, many managers have considered the “hole” they are in to be too deep and have resolved to close their hedge funds and relaunch; therefore avoiding the “make whole again” promise to their investors.

Hedge FundsHave historically provided steady returns with low volatility

Source: Dow Jones Credit Suisse Core Hedge Fund Index, www.hedgeindex.com/

% Return (12/31/2005 – 2/28/13)

“Disappointing Returns?”Annual Returns from 2000-2012

Source: Goldman Sachs, Bloomberg

Do these Dow Jones Hedge Fund Index returns for the last 13 years look disappointing? Probably not too much, except in 2008 and 2011. But look what happens when we move to the next slide……

“Disappointing Returns?”

Source: Goldman Sachs, Bloomberg

Annual Returns from 2000-2012

When you compare the performance of hedge funds to the performance of the MSCI World Index, you can see that there is significantly less volatility and steadier returns.

Implementation of Hedge Funds

This is not a complete list of pros and cons associated with hedge funds. Please contact your financial advisor for more information.


What is Private Equity?• Generally, investments in non-publicly traded entities• Long history - much of the world’s economy is in

private hands • An illiquid asset class that requires a long term

perspective

All companies on the S&P 500 at some point were private companies. Thus, much of the world’s economy is privately held.

Types of Private Equity Investments

Company Life Cycle

Angel Investor

General Venture Capital

Late / Cross-over VC

Mezzanine / Buyout

Distressed / Restructuring

Private Inv. In Public Co.Going Private Transaction

Private Investment in Public Co.

SeedFinancing

Growth Financing

Pre-IPO FinancingGrowth Capital

LBO

RECAP

Late – StageGrowth Fin.

Turnaround Investment

MatureGrowth / DevelopmentStart - Up Distressed


Alpha in Private Equity

Chance Skill Company selectionAbility to influence strategyFinancial engineeringInformational advantages Ability to drive operational improvement

•Alpha is the non-market expected return – the value added by a manager through skill and insight.

Private MarketsSources of Value Creation Public Markets


Manager Selection is Critical

Source: Goldman Sachs Private Equity Group.Past performance is not indicative of future returns, which may vary. This illustration does not represent the performance of any fund or product managed by GSAM or GS & Co.

Distribution of returns from private equity suggests that:• Returns are asymmetrically distributed• Manager selection is rewarded, not asset allocation• Investing in a private equity index is neither possible, nor desirable

Public Equity Markets Private Equity Markets

Average ReturnEquals Index

Average Return

Target Return

Estimated 10 - 20% of Private EquityManagers

For illustrative purposes only.

Private EquityOpportunities for greater outperformance

Private equity fund returns are compared with 4-year annualized average returns of public funds, realized over a period starting three years after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 1990 and 1996. The public data for public fund returns over the years 1993 through 2002. Past performance is not indicative of future results, which will vary. Sources: Venture Economics (private data) and MorningStar Principia (public data).

Implementation in Your Portfolio• Look for 1940 Act Mutual Funds that provide liquid exposure to the strategies you

deem suitable for your portfolio. • Strategies that have been historically reserved for the wealthy are now available to

individual investors. • “2 and 20” rule will not apply; instead, the net expense ratio will likely range from 1-

4%, depending on a variety of factors (turnover, carrying costs, etc.)• Funds have transparency.• Choose either benchmark or benchmark-free strategies.

• http://quotes.morningstar.com/fund/wabix/f?t=WABIX

Top 10 Hedge Fund Takeaways

• Hedge Fund does not necessarily equal another Hedge Fund • A diversified hedge fund portfolio can dramatically decrease risk• Small doesn’t necessarily mean Good• Monitoring for style drift is important• A diversified hedge fund portfolio may be suitable for a significant

allocation• Historical returns are not the best predictors of future returns• Manager selection matters• Most hedge funds are not market neutral• Diversification adds significant value• But just hiring a number of managers isn’t enough

Ivy League Endowment Funds

•Source: 2010 Yale University Endowment Report

Historical Investment Returns

Asset Allocation Yale University Endowment


Historical Investment Returns Yale University Endowment


Historical Investment Returns Yale University Endowment


Historical Investment Returns Harvard University Endowment

HarvardPolicy

Portfolio Benchmark*

60/40 Stock/Bond Portfolio*

1 Year -0.05% -1.03% 6.71%

3 Years 10.42 9.17 12.82

10 Years 9.49 7.09 5.86

20 Years 12.29 9.23 7.94

•S&P 500 Index / Citi US BIG•Source: www.hmc.harvard.edu/images/historicalIR_lg11.jpg

Different Methods of Investing

Individual SecuritiesInvestors purchase individual stocks and fixed income securities.

Funds & ETFsA pooled investment where holders own a share of the pool proportionate to their environment.

Separate Account ManagersRather than being a portion of a pooled investment, the investors own the actual securities that comprise the portfolio.

Mutual Funds are sold by prospectus which contains more complete information including investment objective, fees and expenses. Contact you financial advisor to obtain a prospectus and read it carefully before investing or sending money.

Considerations for Investing

Five Considerations when Selecting Types of Investments1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Considerations for InvestingFive Considerations when Selecting Individual Securities

Investor must select and manage each transaction Investor is responsible for all decisions

1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity


Short-Term/Long-Term Capital Gains, Dividend Income, Interest Income

1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Five Considerations when Selecting Individual Securities

Commissions or fees


Investor makes all investment decisions

Portfolio not directly affected by decisions of other investors

1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity Three day settlement of trades

Transactions can be made at the will of the investor

Stock PortfoliosBuilding your own portfolio

Pros of building your own portfolio

- Flexibility to pick specific investments that fit your goals and risk tolerance

- Ability to manage taxes

- No management fees

- Transparency

- Liquidity

Stock PortfoliosBuilding your own portfolio

Cons of building your own portfolio

- Lack of investor sophistication

- Many investors lack discipline to diversify or stick to goals

- Trading costs

- Market timing is difficult to impossible

- Can be time consuming to do the necessary fundamental research and stay up-to-date on relevant news and pricing

- Example: Many experts recommend at least 1 hour of research per investment per month. If you own 20 stocks/bonds, that is potentially 20 hours a month of research.

Stock PortfoliosHow to do Fundamental Analysis

- Develop your own model

Commercial Research Reports

- Morningstar has charts, detailed analysis, valuation projects, rankings, performance history, financial statements, and more

- Value Line covers 1700 stocks and provides analysis on safety, timeliness, technical ranks, and earnings forecasts. Stocks are ranked from 1 to 5 with 1 being the best. Since 1965, purchase stocks ranked 1 have outperformed the Dow 19 to 1.

- Investors Business Daily provides stock screeners, charts, analysis, and information on institutional purchases.

- Other sites include TheStreet.com, Seeking Alpha, Forbes, The Motley Fool, Yahoo! Finance, etc.


Characteristics of Open-End Mutual Funds

A mutual fund that contracts and expands in share size based on purchases and sales.

By continuously selling and buying back fund shares, these funds provide investors with a very useful and convenient investing vehicle.

For Open-End Funds, the value of the fund will always equal the Net-Asset Value (NAV).

Considerations for InvestingFive Considerations when Selecting Mutual Funds

1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Purchase a basket of securities in one transaction

Purchased and sold in amounts as low as $250

Easy to Track

Can be set up for periodic distributions such as monthly income


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Mutual funds must distribute their gains and losses each year

Most funds are not managed for after tax returns


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Fund Pricing

Internal Costs

Confusing Fee Structure A,B,C,D,E,F,Y

Economies of Scale

Considerations for InvestingExpense Ratio Example

Fee charged by fund’s manager to manage 0.55% the fund’s portfolio

Marketing and advertising and broker 0.20%compensation comes out of 12b-1 fees

All other fees are accounted for in this total 0.29%

This is all of the fund’s annual operating costs 1.04%

MANAGEMENT FEE

DISTRIBUTION (12B-1)

OTHER EXPENSES

TOTAL ANNUAL FUND OPERATING EXPENSE

This example assumes a non-guaranteed rate of return of 10% per year and disregards tax implications. This does not represent the performance of any particular mutual fund.

Share Classes

• A Shares typically have a front-end load that is taken off your investment, but typically have lower 12b-1 fees. A Shares may also have ‘breakpoints’ in the fees at certain investment levels.

• B Shares typically have a back-end load that is taken off when you sell the fund. The back-end load typically decreases the longer you hold the fund. B Shares typically will convert to A Shares after specified period of time.

• C Shares typically have no front-end load or back-end load if held for more than 1 year. C Shares typically do have higher expense ratios and 12b-1 fees.

A vs. B vs. C Shares

Share Classes

• Over the long run, A Shares have lower expenses and higher relative performance

• For Years 1- 4, B & C Shares had the best performance

• B Shares beat A Shares after Year 9

• This example demonstrates the need to consider investment horizon before selecting share class

A vs. B vs. C Shares Example

Source: Comparing Mutual Fund Classes,


Five Considerations when Selecting Mutual Funds1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Professional management

Style Drift

Management Changes

Owner has no control over purchases or sales

Shares have to be sold to meet redemption


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

All purchases and sales are made at NAV

Mutual Fund transactions occur once per day

Mutual Fund companies are the purchaser and seller of every mutual fund transaction

Typically three day settlement of trades

Characteristics of Mutual Funds1. Mutual funds are essentially an investable portfolio of stocks and/or bonds.

2. Mutual funds are categorized by their style (e.g.- Large Cap Value Fund, Small Cap Growth, etc)

3. Mutual Funds are not managed to minimize taxes. Excessive trading can decrease fund performance through increased taxes and broker fees.

4. Expenses can cut into fund performance. Expenses are categorized as:- Initial Fees also known as ‘front load’ fees. These are paid upon initial purchase of a fund. Typically, only ‘A’ shares have a front load- Deferred Fees also known as ‘back end’ fees. These are paid when you sell shares in the fund. These fees are typically associated with ‘B’ shares.- 12b-1 Fees are associated with marketing and distributions.- Management Fees are paid to the manager for the management of the fund.- Net Expense Ratio = Total dollar amount of fees / Net Asset Value

Characteristics of Mutual FundsFee example of the Growth Fund of America A shares (AGTHX)

Fees are typically quoted as a percentage, rather than dollar amount

Front load fee

Total Fees / NAV

Management Fees

Marketing

Sources: Morningstar

Mutual Fund Expenses“After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.”

—William F. Sharpe, 1990 Nobel Laureate

Average of All Funds

Weighted Average, Based on Fund Assets

Active Passive

Domestic Mutual Fund Expense Ratios





Active Passive



International Mutual Fund Expense Ratios

1.46%

0.95% 0.91%

0.18%

1.64%

1.08%1.01%

0.33%

William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.Mutual fund expense ratios as of April 9, 2010. Asset weighting based on net assets as of December 31, 2008. Data provided by Morningstar, Inc.Passive funds are those coded by Morningstar as Index Funds.

Characteristics of Mutual FundsPros and Cons of Mutual Funds

Pros:

- Professional Management

- Diversification

- Economies of Scale (lower transaction costs)

- Liquidity

- Simplicity

Cons:

- Expenses

- Dilution (larger funds have a disadvantage in placing trades)

- Taxes

Characteristics of ETFsExchange Traded Funds (ETFs)

ETFs track indices, commodities or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Pros of ETFs

By owning an ETF, you get the diversification of an index fund. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund.

ETFs also have better potential tax benefits due to the fact that they are not actively managed.

ETFs have better transparency than mutual funds as an investor can check the fund holdings at any time.

ETFs are an easy way to target specific equity sectors or commodities.

Characteristics of ETFsETF fees vs. Mutual Fund Fees

SPDR S&P 500 ETF Vanguard Large Cap Index

Both funds track the S&P 500 index, but the Vanguard Mutual Fund has nearly triple the expense ratio of the ETF.

This is not an endorsement and is purely for informational purposes only.

Characteristics of ETFsETF taxable distributions vs. Mutual Fund taxable distributions

The more an active fund will force investors to pay the IRS. Investors who sell out before the day of record for that distribution will not receive the tax bill, while loyal investors who stay in will pay it for the entire amount!

ETFs are allowed to make ‘in kind’ trades that are not considered a taxable event by the IRS.

Mutual Fund

1.46%

11.53%

0.97%

6.51%

1.7%

6.7%

0.62%

4.21%

Characteristics of ETFsExchange Traded Funds (ETFs)

Cons of ETFs

Payment of dividends goes into your brokerage account and are not directly invested back into the fund.

Rebalancing to target asset allocation can be difficult as attempting to get exact asset weightings is nearly impossible.

Dollar cost averaging can be difficult and expensive to implement.

Some ETFs lack liquidity, which can result in higher Bid-Ask spreads and transaction costs.

Example- ELR (SPDR Dow Jones Large Blend) has an average 3 month volume of 3100 shares, whereas SPY (SPDR S&P 500) has an average 3 month volume of 181,672,000 shares. The result is ELR having a spread that is 5 times larger than SPY on a price basis.

A large component of buying and selling costs for ETFs is the difference between the bid and the ask

Larger ETFs typically have tighter bid/ask spreads

25.68 106.3926.16 106.41.85% 0.01%

< $5 Million Assets < $5 Million Assets

Bid

Spread

Ask

Bid/Ask Spreads

• Use limit orders rather than market orders– Does not rely on a deep order book– Allows you to set a fair price for the purchase or sale– Market makers can see your order on the exchange and fill it

• Stop-loss orders tend to cause the biggest problems– Drops a market order on the exchange when the prices are going

down– Tends to place a sell order precisely when liquidity is lowest– Led to major losses in the May 6 “Flash Crash” in the US– Circuit breakers on European exchanges will keep losses smaller, but

not prevent them entirely

Rules of Thumb for Trading


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Five Considerations when Selecting Separate Account Managers


1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Investor owns a basket of securities

Professional management

All securities held in a separate account

Performance reports



1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

No imbedded capital gains

Managers will generally hold low cost basis stock

Managers can be instructed to take gains or losses



1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Fees and/or commissions that may vary according to account size

Negotiated



1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

Custom Portfolio

Management Changes

Managers can be directed to make specific transactions


Considerations for InvestingFive Considerations when Selecting Separate Account Managers

1. Management

2. Taxation

3. Costs

4. Control

5. LiquidityLiquid

Three day settlement of trades

Portfolio not affected directly by redemption

ReviewWhich Alternative is Best for you?

1. Management

2. Taxation

3. Costs

4. Control

5. Liquidity

INDIVIDUALSECURITIES

MUTUALFUNDS

SEPARATEACCOUNT

MANAGERS

Remember, Goals drive investments, investments do not goals

Manager Selection

The following are two distinct discussions:

Investment Managers

Investment Advisors

If Asset Allocation is the key, should we even try active management?

Manager SelectionTwo Levels of Manager Evaluation

QUANTITATIVE QUALITATIVE

EVALUATION

Quantitative:

How have managers performed compared to their respective benchmark?

What are the costs and fees?

Minimum investment amounts?

Qualitative:

What is the investment strategy and is it in line with my goals?

Does the manager invest in securities that are aligned with my values?

Manager Search and Selection

Assets Under ManagementLength of Track RecordStability of PersonnelCompliance Record

•Step 1:Database Screening

Returns-Based Style AnalysisStyle/Cycle AnalysisRisk-Adjusted PerformanceFundamental Analysis

•Step 2:Quantitative Analysis

People, Philosophy, ProcessInvestment ResearchEvaluation of FirmPerformance Composite

•Step 3:Qualitative Evaluation

Characteristics of Mutual FundsMorningstar Mutual Fund Research

Example: Fidelity Contra Fund (FCNTX)

If you research this fund on the Morningstar website, the first you will notice is the rating:

Source: Morningstar Inc.


Example: Fidelity Contrafund (FCNTX)

Manager information is also readily available:


Does your manager drink his own Kool-Aid?All fund managers must disclose the amount of personal funds they have in their managed fund.

Would you invest in a fund where the manager didn’t have any of his own money in the fund? Note: 46% of US Funds report zero manager ownership.

In this example the manager has over $1 million of personal money in the fund.

Source: Fund Spy, Russel Kinnel,

Morningstar Inc.

Does your manager follow the fund strategy?

Good managers stick to primary fund strategy

Example- If you purchase a value fund, and you notice the manager has recently purchased a growth stock, it may be time to cash out.

Also important to monitor fund strategy with benchmark performance.

Example- If you own a growth fund, and it fails to perform when growth stocks are rallying, it may be time to cash out.



Detailed information about the fund’s holdings are available.

Source: Morningstar Inc., 2013



Performance comparison


Sub-Styles

•Value Sub-Styles– Deep Value– Yield– Traditional Value– Value of Growth– Multifactor Approaches

•Growth Sub-Styles– Momentum-Based Growth– Pure Growth– Conservative Growth

Active vs. Passive Management

Beliefs Required to Use Active ManagementManager can add value AFTER FEES and AFTER TAXES through Performance, Tax Efficiency, and Risk Control.

The ability to identify managers who will add value in the future.


Luck vs. Skill

Beta

R Squared

Alpha

Active vs. Passive ManagementLuck vs. Skill

Beta (β)

R Squared

Alpha (α)

A measure of explainable/expected risk

Represents a market, or systematic, risk associated with the portfolio that cannot be diversified away

Relies upon how the “market” is defined-- what is the benchmark?

Benchmark will always be assigned a beta measurement of 1.00

BetaBeta Considerations

Beta (β) is based on historical price data and can change over time.

Beta is calculated from price changes, not fundamental or balance sheet items.

Portfolio or fund Beta can change if asset allocation changes.

Beta is a ‘rear-view mirror’ and doesn’t necessarily predict what lies ahead.

Beta tells nothing about the price paid for an asset (value investing).

Beta treats up and down price movements equally.


Example: Portfolio A vs. Market

Portfolio A 1.2 12% -6%

Market 1.0 10% -5%

BETAIN UP

MARKETIN DOWNMARKET


Example: Portfolio B vs. Market

Portfolio B 0.8 8% -4%

Market 1.0 10% -5%

BETAIN UP

MARKETIN DOWNMARKET

Active vs. Passive ManagementBeta Rules

Should not stand alone

Validity of beta depends upon the relevance of the Market/Index being issued

Must be combined with R Squared to insure that the Market/Index is an “apples to apples” comparison


Capital Asset Pricing Model (CAPM)

Beta (β)

R Squared

Alpha (α)

It defines the systematic/market risk imbedded within a portfolio; bulls desire high beta, bears desire low beta

It does not define a guaranteed future return and, like all quantitative information, does not stand alone


Beta (β)

R Squared

Alpha (α)

Measures the correlation between the portfolio and the benchmark/market

Determines whether or not statistical information in Modern Portfolio Theory is meaningful

Generally 80% correlation or greater is considered statistically significant

R- Squared

• Example- A fund with an R-Squared value of 85, means that 85% of the fund’s movements can be explained by the benchmark index. The remaining 15% of the fund’s movements are attributed to other factors, such as specific stock selection.

• For index tracking funds, a higher R-Squared value is preferred.

• Typically, for actively managed funds, a lower R-Squared value is preferred.


Beta (β)

R Squared

Alpha (α)

STOCKS

Measures the non-systematic return associated with the portfolio-- i.e., the manager’s positive or negative value through their security selection and timing instead of the market’s movements

A positive alpha indicates the manager has added value

A negative alpha indicates the manager has not added value

Alpha (α)

• A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. A similar negative alpha would indicate an underperformance of 1%.

• For investors, a higher alpha is more desirable • Alpha is risk-adjusted • Alpha is independent of index returns

Sources: fi360.com, Fiduciary Analytics

Active vs. Passive ManagementCapital Asset Pricing Model (CAPM)

Sharpe RatioMeasures risk-adjusted returns, and tells us if the portfolio returns are due to smart investment decisions, or as a result of excess risk. Higher Sharpe Ratios are better.

Sharpe RatioSharpe Ratio Example

If you are deciding whether to purchase one of 2 different mutual funds, using the Sharpe Ratio will help comparability.

Fund 1- 1 Yr Return 20% Fund 2- 1 Yr Return 25%

By just examining returns, you may be tempted to pick Fund 2. Assume Fund 1 has a standard deviation of 12% and Fund 2 has a standard deviation of 20%, and the risk free rate is 4%;

Fund 1 Sharpe Ratio = 2

Fund 2 Sharpe Ratio = 1.25

Because Fund 1 has a larger Sharpe ratio, it has a greater risk adjusted return than Fund 2.

Sources: fi360.com, Fiduciary Analytics

Adding Satellite ManagersSatellite Managers

• Any Manager that can add Alpha to a portfolio

• Enhanced Return

• Enhanced Diversification

• “Tax-Alpha”

• Sources of Alpha

• Manager Skill

• An Inefficient Asset Class

• Non-Correlation to Traditional Asset Classes

• Tax-Efficiency

• Illiquidity

• Non-Transparency

• The Use of Satellite Managers Means Accepting:

• Active Management Fees (sometimes quite high)

• Potential Deviation Away from Strategic Asset Allocation

Manager SelectionWhen to Fire a Manager

Consistent under-performance of the portfolio vs. benchmark and peers

Significant style drift

Dramatic management change

Change in buy/sell discipline

How do I follow progress in each of the above categories?

QUESTION?

Buy High And Sell Low

2 Year returns AFTER hiring/ firing

2 Year returns BEFORE hiring/ firing

Fired

Fired

Hired

Hired

Peter Lynch

“All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage.”

Warren E. Buffet

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”

Passive vs. Active Management

Passive vs. Active Investment Management

• Many asset classes are considered very efficient.

• ie LargeCap Equities

• Most active managers underperform most of the time

• Especially due to fees and taxes

• Many active managers are “closet indexers”, penalized for tracking error and “style drift”.

• Also:

• No Shorting

• No Leverage

• Net of fees and taxes, it is very difficult to add value over time.

Efficient Markets Hypothesis

The Hypothesis States:

• Current prices incorporate all available information and expectations.

• Current prices are the best approximation of intrinsic value.

• Price changes are due to unforeseen events.

• “Mispricings” do occur but not in predictable patterns that can lead to consistent outperformance.

Implications

• Active management strategies cannot consistently add value through security selection and market timing.

• Passive investment strategies reward investors with capital market returns.

Eugene F. Fama, University of Chicago

The Failure of Active Management

Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2012. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400 Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P Developed ex. US SmallCap Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database.

Percentage of Active Public Equity Funds That Failed to Beat the Index

January 2006-December 2011

The Failure of Active Management

Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Index used for comparison: Government Long—Barclays Capital US Long Government Index; Government Intermediate—Barclays Capital US Intermediate Government Index; Government Short—Barclays Capital US 1-3 Year Government Index; Investment Grade Long—Barclays Capital US Long Government/Credit; Investment Grade Intermediate—Barclays Capital US Intermediate Government/Credit; Investment Grade Short—Barclays Capital US 1-3 Year Government/Credit; National Muni—S&P National Municipal Bond Index; CA Muni—S&P California Municipal Bond Index. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Barclays Capital data, formerly Lehman Brothers, provided by Barclays Bank PLC.

Fixed Income Category

Percentage of Active Fixed Income That Failed to Beat the Index

January 2006-December 2011

Wealth Management - Week 3

Education

hedge funds private

hedge risk

performance of hedge

implementation of hedge

goldman sachs private

hedge fund characteristics

disappointing returns

private companies