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Funds Management Industry Today

Author: Dr. Sandeep Gupta Chairman, Quantum Stride Group 05Th November 2009

©Copyright 2009 Quantum Stride

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Quantum Stride Group

Quantum Stride Group comprises of three companies:

1. Quantum Stride Singapore Pte. Ltd 2. Quantum Stride Investment Management Company 3. Quantum Stride Ltd.- World's Very First GUBICTM Fund

1. Quantum Stride Singapore ­ it is an advisory firm based out of Singapore offering advice to corporates and high net worth individuals to meet their financial goals. We focus on corporate finance transactions ­ mainly on capital raising by private equity route. We also handle distressed assets and capital restructuring.

2. Quantum Stride Investment Management Company: A Specialist Investment Manager, monitored by Cayman Islands Monetary Authority It manages alternative instruments, particularly Absolute Return Funds (Hedge Funds) Its target people are- high net worth individuals and institutional investors in Middle East, Asia, Europe and USA

3. Quantum Stride Ltd. ­ World's Very First GUBICTM Fund It's a BVI based International Business Company, recognized as a Professional Mutual Fund by the BVI Financial Services Commission. The distinguishing features of the Fund are: Capital Protection for the Investors: Our philosophy is to extract alpha using more conservative exposure than directional funds do and we focus on 100% hedging of our portfolio so maximum downside will be the cost of derivatives, which is expected to be about 7% of AUM. Specialist Advisor/Manager for each market The fund will invest in diverse asset classes such as equities, bonds and foreign exchange We use Shari'a Compliant Stocks for Better Diversification: As we understand, Shari'a Compliant Stocks by their nature are in conservative businesses and have much lesser risk on their balance sheets (by limiting the debt/equity ratio) as compared to non-shari'a compliant stocks. This is why we believe Shari'a Compliant Stocks can provide an excellent way of further diversifying the portfolio. Notably, we are the first fund to understand this and apply this in practice.

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Table of Contents

A. Executive Summary B. Mutual Funds C. Hedge Funds D. Challenges Faced by the Funds Management Industry E. Plausible Solutions F. Conclusions

Page 4 Page 5 Page 7 Page 10 Page 11 Page 12

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Executive Summary

The paper covers the Funds Management Industry including its two counterparts ­ mutual funds and hedge funds, challenges faced by the industry and the plausible solutions. Funds management industry suffers from fierce competition with more than 69,000 mutual funds and 8,000 hedge funds operating worldwide with an estimated $20.3 trillion under management. The Assets under Management for the funds has seen steep decline of almost 30% from top of about $28.6 trillion in 2007 to $20.3 trillion at the end of 2008, largely attributed to fall in stock markets coupled with redemptions faced by the funds. However, the future for the industry seems bright with most of the global markets led by emerging markets picking up again in 2H-2009. The industry faces challenges of retaining & increasing assets under management and reaping profits on the investments. In addition the hedge funds face additional challenge of changing regulatory landscape. Currently five proposals are being considered; though it's uncertain which of the proposals will pass, it is likely that hedge funds can expect registration and development of a compliance program to be a requirement in their near futures. The plausible solutions to the challenges faced by the industry are- aggressive and tactical marketing of the funds, implementing proper and adequate diversification, holistic approach to risk management, enhancing the returns by improving the stock picking skills, improving the timing of entry to and exit from the stocks and usage of quantitative tools under surveillance of a judicious investment advisor and manager. In addition, the hedge funds managers need to anticipate the changes in regulatory environment and try to adapt accordingly not only to comply with requirements of SEC and the relevant authorities but also to signal to the investors the readiness to adopt good business practices. For a fund, geographical diversification is a necessity coupled with usage of various asset classes such as- Equities, Bonds, Foreign Exchange, Real Estate and Commodities to maximize the risk adjusted returns in a portfolio. In addition, employment of sound infrastructure and compliance are of paramount importance for better risk management. We opine that the application of `emotional stages' and technical analysis are practical tools for timing the entry to and exit from the markets.

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Mutual Funds

History of mutual funds

Mutual funds have been there for longer than most people believe. In fact, the industry traces its existence back to 19th-century in Great Britain. The Foreign and Colonial Government Trust, formed in London in 1868, was pretty much like a mutual fund. It showed a dream of largesse to the "investor holding peanuts", by spreading the investments over various stocks." Most of the early 20Th century investment companies in Britain and USA resembled today's closed-end funds. They sold a fixed number of class shares, the price of which was determined by demand and supply matrix. The very first modern mutual fund was the Massachusetts Investors Trust, which was introduced in early 1924 and began with a small portfolio of less than 50 stocks and US$50,000 in assets. This was the first open-end mutual fund. It introduced concepts that were revolutionary to investment companies and investing: a continuous offering of new shares and redeemable shares that could be sold anytime based on the current value of the fund's net assets. Mutual funds began to grow in popularity in the 1940s and 1950s. In 1940, there were fewer than 80 funds in United States, with total assets of around $500 million. In 1960, there were more than150 funds and $17 billion in assets. However, significant amounts of money started flowing into the funds only after mid-1980s. New products: The first international stock mutual fund was introduced in 1940; today there are many international and global stock and bond funds. Before the 1970s, most mutual funds were stock funds, with a few balanced funds that included securities other than stocks in their portfolios. By 1990s, there were more than 1600 bond and income funds in United States. In 1971, the first money market mutual funds were established. The mutual fund industry also began to introduce even more diverse stock, bond, and money market funds. Today's mutual funds run the products ranging from growth funds, to regular income fund/value funds to global bond funds, to "specialized" funds that may specialize in one segment/sector of the securities market.

Global developments

The number of mutual funds worldwide grew rapidly in the 1990s, and so did the mutual fund assets. At the end of 1996, there were more than 34,000 mutual funds, with more than $6 trillion in assets. In 2008, the figures grew to 69,032 mutual funds and $19 trillion under management. Most of the mutual funds are based in the United States, Japan and France. The distribution of fund assets is even more uneven. More than half of the worldwide total in mutual fund assets belongs to Americas, though only one-sixth of the total number of funds are based out of there. Large size is typical of US funds. Trends: US mutual funds are increasingly investing their assets outside the United States. Three types of mutual funds can invest abroad: international mutual funds, global mutual funds and emerging market mutual funds. Securities in emerging markets are becoming an increasingly popular option for mutual fund investors. The constituents of emerging markets are - all countries in Latin America and the Caribbean; all markets in Asia except Australia, Hong Kong, Japan, New Zealand, and Singapore,

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all countries in Africa and the Middle East except Israel; Russia and the Commonwealth of Independent States; and Greece, Portugal and Turkey. The assets under management for the industry has grown more than 60% during 2001-08 (despite the decline of 30% during 2008) and the number of mutual funds have gone up by more than 20% during the period.

Number of Mutual Funds


Americas Europe Asia and Pacific Africa World 13,449 27,343 12,153 426 53,371


13,884 28,858 10,794 460 53,996


13,921 28,541 11,641 466 54,569


14,064 29,306 11,617 537 55,524


13,764 30,060 12,427 617 56,868


14,474 33,151 13,479 750 61,854


15,457 35,210 14,847 831 66,345


16,459 36,780 14,909 884 69,032

Reasons for the popularity of mutual funds

The growth in mutual fund assets worldwide is part of the overall growth in both the size and maturity of many foreign capital markets. The reasons behind this growth are: 1. The securities markets of several developed countries have benefited from 1990s to 2007 from favorable economic conditions. For example, Canada and Western Europe experienced low interest and inflation rates, which enhanced the attractiveness of their capital markets for investors worldwide. 2. Stock markets in emerging markets have grown because of new investment opportunities arising from reforms, lesser government intervention and red tapes, lowered trade barriers, and lusty economic growth. For example, the emerging markets of India, Brazil, and China, are now among one of the largest equity markets in the world. At the same time, demand for capital in emerging markets has risen. Emerging markets are opportunity for mutual funds to diversify risks and benefit from higher returns. Domestic firms benefit from funds through better access to capital and through management input (strategic and financial planning, marketing, etc.). The infusion of foreign capital into local equities markets has also improved liquidity and has helped in improving price-to-earnings ratios in these markets, which leads to reduction of the cost of capital to firms. Investors are turning to mutual funds for diversification and as a way to participate in growing securities markets. Well managed funds are a suitable alternative for investing directly in stocks.

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Hedge Funds

History of Hedge Funds

Alfred Jones was the founder of the first hedge fund. In 1948/49 he raised $100,000 (with more than 1/3rd of the capital his own) and set forth to try to minimize the risk in holding long positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an endeavor to increase the returns. Three years later, Jones altered the structure of his money pool, converting it from a general partnership to a limited partnership and adding a performance fee (20%) as compensation for the managing partner. Alfred Jones was the first investment manager to combine short selling with the use of leverage, sharing risk through a partnership with other investors and a compensation system based on investment performance, he is regarded as the father of the hedge fund.

The Ascent of the Industry

In 1966 an article in Fortune magazine highlighted an investment scheme that outperformed every mutual fund on the market by more than 10% over the last five years, thus, the hedge fund industry was born. Two years later, there were some 140 hedge funds in operation. In order to maximize returns, quite a few funds chose to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1970, followed by a number of hedge fund closures during the bear market of 1973-74. The industry was dormant for more than two decades, until an article mentioned the double-digit performance of Tiger Fund managed by Julian Robertson. With the Tiger Fund capturing the public's attention with its stellar performance, investors flocked to the hedge fund industry that offered thousands of funds and exotic strategies, including forex trading and derivatives such as futures & options and others. Early 1990s saw quite a few money managers leaving the mutual fund industry in favor of hedge funds. Unfortunately, in the late 1990s and in the early 2000s as a number of high-profile hedge funds failed in dramatic fashion.

The Hedge Funds Today ­ Changing Regulatory Landscape

In 2004, the Securities and Exchange Commission required hedge fund managers and promoters to register as investment advisors under the Investment Advisor's Act of 1940. With media attention still focused on the recent failure of hedge funds in 2008 and major part of 2009, there has been an increasing move towards their regulation. Recently in 2009, following proposals are currently being considered:

· · · · ·

Consumer Financial Protection Agency Act of 2009 Private Fund Transparency Act of 2009 Hedge Fund Advisor's Registration Act Private Fund Investment Advisers Registration Act of 2009 Hedge Fund Transparency Act of 2009

Though it's uncertain which of the proposals will pass, it is likely that hedge funds can expect registration and development of a compliance program to be a requirement in their near futures.

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Private Fund Investment Advisers Registration Act of 2009 ("PFIARA") ­

On October 27, 2009, the House Financial Services Committee passed "PFIARA" by a vote of 671 H.R. 3818. The bill will be considered by the full House later this year along with other financial services reform bills. Registration Requirement and Exemptions: Currently, many advisers to private funds rely upon the private adviser exemption to avoid registering as an investment adviser with the Securities and Exchange Commission ("SEC") under the Investment Advisers Act of 1940 ("Advisers Act"). In general, the exemption provides that an adviser with less than 15 clients that does not hold itself out to the public is exempt from registration. The PFIARA would eliminate the private adviser exemption by amending Section 203(b) of the Advisers Act to exclude from the registration exemption an investment adviser to any "private fund." The PFIARA defines a "private fund" as a fund that is "organized or otherwise created under the laws of the United States or of a state" or "has 10% or more of its outstanding securities by value owned by U.S. persons," and would be deemed an "investment company" under the Investment Company Act of 1940 ("1940 Act"), but for the exceptions in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Investment advisers to private funds would therefore be required to register with the SEC and comply with all applicable provisions of the Advisers Act. The amended bill provides an exemption from Advisers Act registration to a private fund adviser if each of the private funds it manages has assets under management ("AUM") of less than $150 million. It is not yet clear, however, whether the AUM test will be calculated once or periodically, and whether it will be based on committed or invested capital. Advisers to venture capital funds (as defined by the SEC) continue to remain outside the scope of registration, as envisaged by the original proposal. Although they will be exempt from Advisers Act registration, advisers to funds with AUM of less than $150 million or venture capital funds will nevertheless be required to maintain records and provide the SEC with annual reports or other data the SEC deems necessary or appropriate. The bill includes a transition period of one year following enactment before its provisions become effective. This would give advisers who would become subject to registration time to implement the appropriate internal systems and controls. The PFIARA would exempt advisers to "venture capital funds" from the requirement to register, but has tasked the SEC with defining the term "venture capital fund" and crafting the exemption. The PFIARA would NOT exempt "foreign private fund advisers". The original bill provided an exemption for foreign advisors defined as investment advisers that have no place of business in the U.S., do not generally hold themselves out to the public in the U.S., have fewer than 15 clients in the U.S. during the preceding 12 months, and have less than $25 million in assets under management that are attributable to U.S. clients.

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Hedge Funds Messiah or Menace:

Critics of hedge funds opine that the hedge funds ­ · · · · · Are destroyer of the markets (by short-selling) Charge too much fees for what are in reality returns generated by betting on market risk (i.e. beta) instead of applying skills (i.e. alpha) Take too much risk in form of leverage, high risk securities such as debt obligation based on sub-prime mortgage, distressed securities etc. Are illiquid investments, hence even if the manager made mistakes, it could be a few months before the investors got their money back Are mostly unregulated, hence can carry undisclosed structural risks

However, investors can't overlook following market benefits of hedge funds · · · · · It is accepted that hedge funds contribute positively to global financial markets. They can provide portfolio diversification for investors since their returns are often less correlated with those of traditional investment funds. Hedge funds contribute to innovation in financial instruments. Hedge funds also improve liquidity in otherwise low liquid market segments, and therefore enhance the efficiency of financial markets. They assist counterparties to reduce or manage their own risks. They often are activist shareholders who are quick to call for necessary business restructuring, improved shareholder value, and better corporate governance. Last but not the least, they offer investors greater investment choice through introducing a new asset class and are important clients and counterparts for the financial services industry.

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Challenges Faced by the Funds Management Industry

The industry's main challenge is to attract new assets under management and to retain the old ones.

Mutual Fund's Assets under Management


Americas Europe Asia and Pacific Africa World


7,433,106 3,167,965 1,039,236 14,561 $11,654,868


6,776,289 3,462,999 1,063,857 20,983 $11,324,128


7,969,541 4,682,836 1,361,473 34,460 $14,048,311


8,792,450 5,640,452 1,677,887 54,006 $16,164,795


9,763,921 6,002,261 1,939,251 65,594 $17,771,027


11,469,062 7,803,906 2,456,511 78,026 $21,807,505


13,421,149 8,934,864 3,678,330 95,221 $26,129,564


10,579,430 6,288,138 2,037,536 69,417 $18,974,521

Mutual funds worldwide have lost assets under management largely attributed to losses in stock markets and redemptions called upon by the investors. In 2008 AUM for the MF industry dropped by 29.6%. Hedge funds suffered even steeper decline in assets (~50%) to an estimated $1.3 trillion in year 2008.

Hedge Funds - Mean Assets Size ($ mn) 300 250 200 150 100 50 0 2001 2002 2003 2004 2005 2006 2007 2008

In addition the hedge funds face additional challenge of changing regulatory landscape. Currently five proposals are being considered; though it's uncertain which of the proposals will pass, it is likely that hedge funds can expect registration and development of a compliance program to be a requirement in their near futures. Next, the industry needs to reap profits on their investments. Most of the mutual funds and hedge funds lost money in 2008 in sync with the stock markets worldwide losing up to ½ of the assets depending on the markets they were treading in.

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Plausible Solutions

The fund managers need to 1. Employ aggressive and intelligent marketing of the funds that includes understanding and addressing the concerns of the investors. 2. Implement proper and adequate diversification: an investment manager needs to diversify in different asset classes such as equities, forex, commodities, real estates and bonds, besides this, the managers need to employ geographical diversification for instance the portfolio could be spreaded to GCC, USA, Brazil, India and China. Furthermore, most statisticians would agree that the optimal number is twenty; 20 stocks for a portfolio manager, 20 funds for a Fund of Fund Manager. 3. Implement a Holistic Approach to Risk management: We can divide the risk in two types first the external risks, second the internal risks. Points of external risk are Global Market Economic Volatility and Regulatory Climate, while, points of internal risk are Internal Controls, Data Quality, Compliance and Ethical Behavior. The external risks are managed by a sound investment/corporate strategy i.e. which asset classes the investment manager will choose; what ratio of the asset classes she will choose, in which markets the manager is going to play and so forth. While, internal risks are managed by strong corporate culture and corporate governance and a solid infrastructure including people and systems. 4. Enhance the returns by: a. Improving the stock picking skills by application of fundamental analysis b. Improving the timing of entry to and exit from the stocks by application of technical analysis and emotional stages of the investors c. Usage of quantitative tools based on fundamental and technical inputs under judicious surveillance of investment manager/advisor In addition, the hedge funds managers need to anticipate the changes in regulatory environment and try to adapt accordingly not only to comply with SEC and the relevant authorities but also to signal to the investors the readiness to adopt good business practices.

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The funds management industry has grown tremendously since its origin. The mutual funds have come long way, from $50,000 in 1924 to $19 trillion in 2008 and from a few mutual funds to about 69,032 in 2008. Similarly hedge funds too have grown and changed significantly since their origin back in 1949. The industry has rapidly grown, with an estimated peak of $2.5 trillion in 2006-07. However, with severe recession in 2008, recent estimations peg its size conservatively at $1.3 trillion. Modern hedge funds offer a variety of strategies, such as merger arbitrage, convertible arbitrage and multi-strategy funds, combining more than two strategies are quite popular. With a fantastic past that has twice seen media-driven publicity push the hedge funds industry to dizzy highs and tarnish its image when it failed to produce the expected super-normal returns, it seems highly probable that the history will repeat itself at some point in coming years. While it is easy to get attracted by the glitter or repelled by the negative publicity, it's always desirable to conduct thorough due diligence prior to making any decision. Before you put your valuable capital at risk, you have to make sure you are choosing the right investment and it's a well informed decision (keeping in mind your risk profile/appetite and your investment objectives); furthermore, an investor must remember that past performance is not an indicator of future performance.

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