Lecture 7

• Lecture 7 covers shadow banking, mutual funds, ETFs, hedge funds, VC, PE, investment banks, Fintech, and insurance/pension companies.

Shadow Banking

• Financial intermediaries take investments (excluding deposits) and invest in capital markets.
• They operate outside regular banking regulations and oversight.

Mutual Funds

• Pool resources from many small investors.

• A professional money manager (institutional investor) invests the proceeds in securities.

• Benefits:

  • Liquidity intermediation: Investors can convert investments into cash whenever needed while still invested in longer term funds.
  • Denomination intermediation: Investors can participate in securities offerings that typically require larger capital, pooling funds to afford investments costing hundreds of thousands.
  • Diversification achieved through pooled funds.
  • Cost advantages: Mutual funds negotiate lower transaction fees.
  • Managerial expertise can generate better returns, although not guaranteed to beat the benchmark.

• US households hold more wealth in regulated funds, while bank-centric countries have a lower share.

• Deposits in the EU and Japan are higher than in the US, where most of the money is in regulated funds.

• In 2022, rising interest rates negatively impacted those with loans.

• However investors benefitted from falling prices with rising money market rates

• Banks use deposits to fund operations and lending, and might not inform about money markets.

Structure of Mutual Funds

• Investment companies offer various types of mutual funds.

• Investors can move funds without penalty fees like subscription or redemption fees.

• Investors pay management fees indirectly, taken directly out of funds' assets.

• Main fees include subscription, redemption, and management fees.

• Administrator: Manages dividends, taxes, and net present value.

• Custodian: Holds assets in a separate bank to ensure shareholder interests protection.

• Investment Manager: Manages the fund's portfolio according to its investment objectives.

• Broker-dealer: Sells fund shares to the public, varying by country.

• Open-end funds: Can be exchanged daily.

• The mutual funds market is large and growing.

• UCITS are investment funds regulated at the EU level.

• Compliance is a certification of quality and reliability.

• AIFMD is similar but less stringent, at 20% in the same equity versus UCITS at 10%.

• Discretionary mandates, once more common than investment funds, have now reversed.

• Investment fund: Pools savings of investors with similar investment goals and objectives (e.g., ESG fund).

• Discretionary mandate: Opt-out fund from investors' private bank accounts, where an investment mandate is delegated to an asset manager. For example, avoiding certain companies or sectors.

• Solutions are tailored to investors’ needs.

ESG in Discretionary Mandates

• ESG integration: Asset manager applies all three factors in investment decisions (DM or MF).

• Best-in-class: Invests in a defined percentage of leading companies in sustainability performance (DM or MF).

• Exclusion: Asset managers exclude certain sectors or firms (e.g., nuclear power) (Applies to DM or MF).

• Aktia has experienced growth in asset management, partly due to acquiring Taaleri, which mainly offered DM.

Exchange-Traded Funds (ETFs)

• Pools resources and invests in a basket of securities to track an index, traded throughout the day. For example, tracks S&P.
• Passive management by funds following an index, removes need for expertise.
• ETFs listed on the stock exchange, providing higher liquidity and flexibility.

Mutual Funds vs. ETFs

• MFs are actively, while ETFs are passively managed.

• Active management arguments:

  • If a fund manager consistently makes wrong choices, it is unfavorable.
  • Professional expertise leads to providing higher returns.

• MFs are key offerings in retirement plans, while some do not allow ETFs.

• MFs have fees and are not listed in stock exchange.

• Fund sizes in the US are larger than in the EU.

• There has been significant growth in ETF markets over the last 10 years

• There has been a shift from active to passive ETFs.

• The EU was late to the trend, it is now growing growth in ETF markets.

• This shift has reduced revenues and consequences of active mutual funds.

• ETF Market is highly competitive, fees are 0% by employing stock lending profits.

Hedge Funds

• Offshore investment funds that employ a multitude of skill-based investment strategies with a broad range of risk and return objectives.

• They target abnormal positive return, by using an effective benchmark is zero.

• The are only only available to wealthier investors as they require large amounts invested.

• They charge a management and success fee.

• Due to illiquidity, value was lost during the GFC.

• Markets turn sour and investors are blocked from withdrawing making them even more illiquid.

• MFs follow strict regulations, allowing for less flexibility.

• Hedge funds: Registered in offshore accounts, avoid strict regulations, report as they like.

• Hedge fund management relies on “trust me principle".

Venture Capital (VC) Funds

• Pooled funds that manage investments from investors who seek private equity in start-ups.
• Nurture small- to medium-sized enterprises with potential growth, and make them public or trade in M&A deals.

Private Equity (PE) Funds

• Pooled investment funds which target mature companies.

• Goal of improving profitability, selling them for returns on their investment.

• Private equity markets are smaller than mutual funds but still significant.

PE and VC Compared

• Private Equity:

  • low to medium risk
  • later stage company maturity
  • typically low to medium investor control
  • all industries
  • deal size is mostly $25M+
  • proportion of deal: mostly 100%

• Venture Capital:

  • high risk
  • early stage company maturity
  • typically high investor control
  • typically technology industries
  • deal size is mostly $10m
  • proportion of deal: mostly less than 20%

• VCs fail, focus is on the selection bias of news. VC compared to similar risk investment in stock markets.

• It earns a positive risk-adjusted return before 2000, since the last 25 years it has received the same return.

• PEs have had positive risk-adjusted returns consistently.

• The number of listed companies has nearly halved since the 90s due to companies delisting by buying out shareholders.

• Case: Spa Holdings Oy offer for Ahlstom-Munksjö, investors disagreeing to a small premium being offered.

• Why companies delist:

  • Avoid SEC regulations.
  • Greater flexibility and limits public scrutiny.
  • Attract CEO talent.
  • Tax advantages and partner compensation.

• PE firms are massive, able to finance billions.

Investment Banks

• Advisory-based financial service that performs a variety of functions within financial markets.
• Underwriting fee: finds correct price for shares, distribution, aftermarket support, roadshows.
• Deal maker in M&As.
• Acts a middleman in purchases and sales of companies.
• Private broker for wealthy individuals.
• Main activities: IPOs, M&As, debt issuance.
• Customers readily pay for investment banks.
• Investment banks provide intermediaries in information-sensitive transactions for the true value of a company.
• They connect sellers and those wanting information, and support those corporate security issuers.
• An investment banks reputation is at stake, they must perform and sell access to clients well.

Case: IPOs

• Investment banks have state of market awareness, they’re able to help determine correct price.
• IPO underpricing: price slightly under true value to attract investors. If investment banks underprice too greatly, companies will avoid working with them (reputation).
• The same goes for excessive IPO pricing.
• Investment banks typically earn the most money from M&As which varies depending on expertise: debt issuance, M&As, IPOs.

Feature Comparison

• Investment Bank: Advisory, Market-based liquidity, Strict regulation, Transaction and advisory fee.
• ETFs: Passive investing, stock exchange-based liquidity, regulated reporting, low fees.
• Mutual Funds: Diversified active investing, medium daily NAV liquidity, regulated, management, subscription, redemption fees.
• Hedge Funds: Abnormal positive return strategies, HNWI investor type, low lock-up period liquidity, Light regulation, management, success fees.
• VC & PE: Private-company investing, Institutions and HNWI investor type, very low long-term investment liquidity, Light regulation, high fees.
• Discretionary Mandate: Portfolio management, Institutions investor type liquidity depending on assets invested in, varies regulation, and management fee.

Explore mutual fund benefits, operational costs, and denomination intermediation. Understand money market dynamics during rising interest rates and investment strategies. Compare investment outcomes in the US and Finland during 2022.