Insurance
One of the oldest and most important intermediary is insurance. The Economist article notes that along with disintermediation, the last three decades have seen insurance companies competing more directly with banks and mutual funds. Perhaps as a result of the roaring bull market of the last 20 years, investors seem unconcerned with investment risk.
Hedge Funds
The recent collapse of Long-Term Capital Management draws our attention to hedge funds.
• What are they? • Why are they popular? • Why did LTCM fail, and what risks does this identify?
Mutual Funds
A mutual fund is a form of investment company. It is distinguished from a closed-end investment company in that its size changes as new money comes in to the fund, or holders withdraw money from the fund.
Hedge Funds - Defined
Hedge Fund managers make money from a management fee—usually 1% of assets (to cover operating expenses) + incentive fees, which are often 20% of the fund’s profits. (Contrast to Mutual Fund managers, whose bonuses depend on performance relative to a benchmark.) If a hedge fund is down, incentive fees don’t kick in until investors are made whole (I.e., assets reach the high-water mark).
Pension Plans
The Economist article shows that since 1975, in the US, the number of participants in defined contribution pension plans has risen from under 10 million to around 50 million, while the number of participants in defined benefit plans has remained around 40 million. It identifies 401(k) plans as retail and defined benefits as wholesale funds.
Hedge Funds- Defined
The earliest hedge funds were so-named because they effected positions that were market-neutral. Today, they often have a specific focus. As noted by Edwards, one of the reasons for the popularity is that their returns have low correlations with most benchmarks. In fact, most have dynamic trading strategies that generate returns that resemble options positions. As an example, David Hsieh of Duke has identified that funds who identify themselves as trend followers have payoffs that resemble long positions in a spread on the US stock market. But the payoffs are higher than the comparable option position in stable periods.
Cons:
– Subordination of individual interests to the fund. (Examples of this include tax-timing, and timing of liquidity costs.)
Mutual Funds3
The relative importance of the costs and benefits can be estimated by the popularity of different types of funds. Question: What does the growing popularity of low-cost index funds say about the relative importance of possible benefits to mutual funds?
Insurance 3
Students often misunderstand the role of financial markets in “insuring” various risks. In general, financial contracts like options and futures cannot hedge individual specific risks, such as fire, etc. This can only be accomplished with insurance. (We have an elective on option pricing and risk management - Yan).
Insurance 2
The article correctly identifies that what we usually think of as insurance differs importantly from other intermediation insurance entails risk sharing - which is accomplished by the law of large numbers (and probability and statistical models). (Although in several weeks we will argue that banks provide “insurance” against liquidity risk.
Equity
In the early days, common stock (equity) enabled a company to separate ownership and control. Professional managers ran a company, while the owners were dispersed. In such an environment, shareholders had virtually no bargaining power. The only disciplining force on management was the market for corporate control. The inability of shareholders to pressure management to do their bidding is referred to as agency problems.
Hedge Funds - Defined
Hedge funds are similar to other investment companies in that they pool individual contributions in a portfolio. However, they restrict the number of investors as well as their expertise to circumvent SEC restrictions on disclosure, etc. So they have virtually no restrictions as compared to other funds.
Shareholders Unite
The most natural solution to the “agency problem’’ is that there be one large shareholder - or an entity that consolidates disparate shareholders’ control rights. Pension funds and investment companies represent such an eny?
The human condition is tied to the search for the phlogiston - or grail. But, even if markets are generally informationally efficient, we would expect a reward to efficient and innovative information processing. For example, in the early days of LTCM, much of their positive abnormal returns was attributed to identifying arbitrage opportunities across the globe.