L6 non-Banking FIs

Question 1

Mutual Funds/unit trust

Answer 1

Summary:
Mutual funds (US) or unit trusts (UK) are investment vehicles that pool funds from the public to invest in a variety of financial assets, including domestic and overseas equities, as well as money and capital market instruments.

Key points:

1. Purpose: Mutual funds and unit trusts allow individuals to invest their money more efficiently by aggregating small individual savings into larger investment funds.
2. Investment Scope: These funds typically invest in a diversified portfolio of assets, including money market instruments, equities, and bonds, providing investors with exposure to a range of asset classes.
3. Fee Structure: Investors pay a fee for the management and administration of the fund, known as the expense ratio. This fee covers the costs associated with managing the fund’s portfolio, marketing, and administrative expenses.
4. Types of Funds:
   • Open-ended Funds: These funds continuously issue and redeem shares based on investor demand. They invest in a wide range of securities and adjust their portfolios regularly.
   • Closed-ended Funds: These funds operate as shareholding companies and issue a fixed number of shares through an initial public offering (IPO). Once the shares are issued, they trade on secondary markets like stocks, and the fund does not issue or redeem shares based on investor demand.

Overall, mutual funds and unit trusts offer investors the opportunity to access diversified investment portfolios managed by professional fund managers, albeit at the cost of management fees. The choice between open-ended and closed-ended funds depends on investor preferences and investment objectives.

Question 2

Mutual Funds/unit trust benefits and risks

Answer 2

Benefits of Mutual Funds:

1. Professional Investment Management: Mutual funds are managed by experienced professionals who make investment decisions on behalf of investors, leveraging their expertise and market knowledge.
2. Potential Diversification: Mutual funds invest in a diversified portfolio of securities, spreading risk across various asset classes, industries, and regions, which can help reduce overall investment risk.
3. Economies of Scale: By pooling funds from multiple investors, mutual funds can achieve economies of scale, allowing them to access investment opportunities and services that may not be available to individual investors.
4. Variety of Ways to Earn Money:
   • Capital Gains Distributions: Profits earned from selling securities within the fund’s portfolio are distributed to investors in the form of capital gains distributions.
   • Increased Net Asset Value (NAV): As the value of the fund’s underlying investments increases, the NAV per share of the mutual fund also rises, potentially leading to capital appreciation for investors.
   • Dividend Payments: Mutual funds may invest in dividend-paying stocks or bonds, providing investors with regular income in the form of dividend payments.

Risks Carried by Mutual Funds:

1. Past Performance Does Not Predict Future Returns: While past performance can provide insights into a fund’s historical performance, it does not guarantee future returns. It primarily indicates the volatility or stability of the fund over a specific period.
2. Loss of Investment Capital: Investors may lose some or all of their invested capital due to fluctuations in the value of the fund’s investments or adverse market conditions.
3. Changes in Dividends or Interest Payments: Dividend payments or interest payments from the underlying securities held by the mutual fund may change over time, impacting the income received by investors.

Overall, while mutual funds offer potential benefits such as professional management, diversification, and various ways to earn money, investors should be aware of the risks involved, including the possibility of loss of capital and fluctuations in dividend or interest payments.

Question 3

Mutual funds invest in different securities

Answer 3

Mutual funds invest in a variety of securities, offering different risk profiles and potential returns:

1. Money Market Funds: These funds invest in high-quality, short-term investments issued by U.S. corporations and government entities. They typically have low risks and provide stable returns.
2. Bond Funds: Bond funds invest in a range of bonds, which can vary in risk and return potential. They aim to produce higher returns compared to money market funds but carry higher risks. Different types of bonds, such as government, corporate, and municipal bonds, offer varying risk/reward profiles.
3. Equity Funds: These funds invest in corporate stocks or shares, offering exposure to the equity market. Types of equity funds include:
   
   • Growth Funds: Focus on companies with high growth potential, aiming for capital appreciation.
   • Income Funds: Seek to generate regular income through dividend payments and interest income.
   • Index Funds: Track a specific stock market index, offering broad market exposure at lower costs.
   • Sector Funds: Concentrate investments in specific sectors of the economy, such as technology, healthcare, or energy.
4. Target Date Funds: Also known as lifecycle funds, these funds hold a mix of stocks, bonds, and other investments. The asset allocation gradually shifts over time according to the fund’s target retirement date. They are designed for individuals planning for retirement and offer a diversified investment strategy.

Overall, mutual funds provide investors with access to a wide range of investment opportunities across different asset classes, allowing them to construct diversified portfolios tailored to their risk tolerance and investment objectives.

Question 4

How to buy and sell Mutual Funds

Answer 4

To buy and sell mutual funds, investors typically follow these steps:

1. Purchase Process:
   
   • Investors can buy mutual fund shares directly from the fund itself or through a broker.
   • The price paid for mutual fund shares is the net asset value (NAV) per share plus any applicable fees, such as sales loads.
   • Investors can place buy orders based on the current NAV, which is calculated at the end of each trading day.
2. Redemption Process:
   
   • Mutual fund shares are redeemable, meaning investors can sell them back to the fund at any time.
   • When selling mutual fund shares, investors typically request redemption through the fund management company.
   • The fund is usually required to process the redemption and provide payment to the investor within seven days.
3. Market Price:
   
   • Investors can only sell their mutual fund shares back to the fund management company at the current market price, which is based on the NAV and any applicable fees at the time of redemption.
4. Prospectus Review:
   
   • Before buying shares in a mutual fund, investors should carefully review the fund’s prospectus.
   • The prospectus contains essential information about the mutual fund’s investment objectives, risks, performance history, expenses, and other relevant details.
   • It is essential to read and understand the prospectus to make informed investment decisions.

By following these steps and conducting thorough research, investors can effectively buy and sell mutual funds while understanding the associated costs, risks, and investment objectives.

Question 5

Hedge funds and private equity

Answer 5

Hedge funds and private equity are significant players in the financial industry, but they operate with a level of opacity and limited regulation:

1. Hedge Funds:
   
   • The number of hedge funds increased from approximately 4,000 with $324 billion of assets in 1999 to a peak of 10,700 with $2,150 billion in 2007. However, by the start of 2013, the number declined to 10,100 with $2,054 billion in assets.
   • Hedge funds are largely unregulated, and their activities can be secretive, making it challenging to determine their exact size.
2. Private Equity:
   
   • Global private equity investment experienced significant fluctuations over the years. Investments amounted to $176.6 billion in 2000, fell to $82.2 billion by 2002, then surged to $317.6 billion by 2007. However, the sector was impacted by the credit crisis, with investments decreasing to $246 billion.
   • Private equity firms often follow stock market trends, and their activities can be influenced by market conditions.
3. Interconnection:
   
   • Hedge funds and private equity are increasingly interconnected. Many private equity firms have established hedge funds, particularly in the US.
   • This convergence raises concerns about conflicts of interest and potential insider trading, as the lines between these types of investment vehicles blur.

Overall, while hedge funds and private equity play significant roles in the financial markets, their lack of regulation and opacity raise concerns about market integrity and investor protection, particularly regarding conflicts of interest and insider trading.

Question 6

Hedge funds at the end of 2016

Answer 6

At the end of 2016, hedge funds were a significant force in the financial industry:

1. Total Assets Under Management (AUM):
   
   • The total AUM of 500 hedge fund managers amounted to US$81.2 trillion.
   • The top three managers were BlackRock, Vanguard Group, and State Street Global.
2. Geographical Distribution:
   
   • US-based firms accounted for 53.5% of total AUM, followed by European managers at 31.8%.
   • UK-based firms represented 7.8% of the total AUM and 24.4% of Europe’s AUM.
3. Concentration of Assets:
   
   • The top 20 managers held a significant share of total AUM, amounting to 42.3%.
   • Among these, 13 were US-based managers, accounting for 72.8% of the top 20’s AUM, with the remainder being European.
4. Composition of Assets:
   
   • The majority of total assets (78.4%) were actively managed.
   • Traditional asset classes dominated the allocation, with 78.7% of assets invested in equity (44.3%) and fixed income (34.4%).

Overall, hedge funds were major players in the financial markets, with a substantial concentration of assets among top managers, primarily invested in traditional asset classes and actively managed strategies.

Question 7

Hedge funds

Answer 7

Hedge funds are actively managed investment funds known for employing various strategies to achieve attractive absolute returns, irrespective of market direction. Here are some key features:

1. Secrecy and Ownership:
   
   • Hedge funds tend to operate with a high level of secrecy and are often privately owned.
   • They cannot raise funds from the public and typically cater to a small base of sophisticated investors.
2. Liquidity:
   
   • Hedge funds can be illiquid, operating on monthly or quarterly redemption cycles. Investors may face restrictions on withdrawing their investments.
3. Regulation:
   
   • Compared to traditional investment funds, hedge funds are largely unregulated. This gives them flexibility in their investment strategies but also poses risks to investors.
4. Investment Strategies:
   
   • Hedge funds have the freedom to employ a wide range of investment strategies, including leverage, short selling, and derivatives trading.
   • These strategies allow hedge fund managers to capitalize on market inefficiencies and generate returns in both rising and falling markets.
5. Manager’s Personal Investment:
   
   • Fund managers typically have a significant personal investment in the hedge fund, aligning their interests with those of investors.
6. Investor Base:
   
   • Hedge funds attract a small base of much more sophisticated investors, including high-net-worth individuals, institutional investors, and funds of funds.

Overall, hedge funds offer investors the potential for attractive absolute returns through active management and a diverse set of investment strategies. However, they also come with risks related to their illiquidity, lack of regulation, and complexity.