Wealth Management - Week 3

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

Outline
I. Hedge Funds & Private Equity
• What are Hedge Funds?
• Risk and Return
• Top 10 Takeaways
• Manager Selection and Allocation Ideas
• Discussion Questions
II. Individual Investor Implementation
III. 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
Event
Driven
Tactical
Trading
Global Macro /
Long Short
Relative
Value

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 Funds
Have 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.
Seed
Financing
Growth Financing
Pre-IPO
Financing
Growth Capital
LBO
RECAP
Late – Stage
Growth Fin.
Turnaround Investment
MatureGrowth / DevelopmentStart - Up Distressed

Alpha in Private Equity
Chance
Skill
Company selection
Ability to influence strategy
Financial engineering
Informational 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 Return
Equals Index
Average Return
Target Return
Estimated 10 - 20% of
Private Equity
Managers
For illustrative purposes only.

Private Equity
Opportunities 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

•Source: 2010 Yale University Endowment Report
Historical Investment Returns

Asset Allocation
Yale University Endowment

Yale University Endowment

Harvard University Endowment
Harvard
Policy
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 Securities
Investors purchase individual stocks and fixed income securities.
Funds & ETFs
A pooled investment where holders own a share of the pool
proportionate to their environment.
Separate Account Managers
Rather 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 Investments
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity

Five 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
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 Portfolios
Building 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 Portfolios
Building 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 Portfolios
How 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).

Five 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

Expense 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,

1. 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 Funds
1. 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

Fee 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
Average of
All Funds
Weighted Average,
Average of
All Funds
Weighted Average,
Active Passive
Average of
All Funds
Weighted Average,
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.

Pros 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 ETFs
Exchange 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.

ETF 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.

ETF 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%

Exchange 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
25.68 106.39
26.16 106.4
1.85% 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

1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Liquid
Three day settlement of trades
Portfolio not affected directly by redemption

Review
Which Alternative is Best for you?
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
INDIVIDUAL
SECURITIES
MUTUAL
FUNDS
SEPARATE
ACCOUNT
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 Selection
Two 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 Management
Length of Track Record
Stability of Personnel
Compliance Record
•Step 1:
Database Screening
Returns-Based Style Analysis
Style/Cycle Analysis
Risk-Adjusted Performance
Fundamental Analysis
•Step 2:
Quantitative Analysis
People, Philosophy, Process
Investment Research
Evaluation of Firm
Performance Composite
•Step 3:
Qualitative Evaluation

Morningstar 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.

Morningstar Mutual
Fund Research
Example: Fidelity Contra
Fund (FCNTX)
Detailed information
about the fund’s
holdings are available.
Source: Morningstar Inc., 2013

Example: Fidelity Contra Fund (FCNTX)
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 Management
Manager 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

Luck 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

Beta
Beta 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%
BETA
IN UP
MARKET
IN DOWN
MARKET

Example: Portfolio B vs. Market
Portfolio B 0.8 8% -4%
Market 1.0 10% -5%
BETA
IN UP
MARKET
IN DOWN
MARKET

Beta 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

Luck vs. Skill
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.

Luck vs. Skill
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

Capital Asset Pricing Model (CAPM)
Sharpe Ratio
Measures 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 Ratio
Sharpe 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 Managers
Satellite 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 Selection
When 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

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