Asset Management and Portfolio

Formation:
Syndicate assignment, Q2 and Q4

August 2014
Hugh Napier (9601398N)
Motlodi Charles Ntjana
(303921)

Similo ###
Priya Garg (956738)

Question 2:

a) Ferreira, Keswani et al. (2013) examine what factors influence openend managed mutual fund performance. Historic research on
understanding fund performance has focused on fund
characteristics such as size, age, fees and expenses, loads,
turnovers (liquidity), flows and historic returns, management
structure and domestic vs international diversification. The rationale
being that older and larger funds should have purchasing power
(bulk orders) and scale (management overheads and expertise),
which should reduce total expense ratios and allow for better
returns to end consumers. The overall trading and legal
environment allow for trading efficiencies and ensure high liquidity
and investor protection. Interesting current literature provides both
supportive and contradictory findings to the above logic to
predicting mutual fund performance. For example (Chen, Hong et al.
2004) suggest that fund performance in fact worsens as fund size
increases. Several arguments have been made relating to large
funds not being able to invest as actively in small market cap stocks
as larger funds and also that their purchasing activities are easily
tracked in the market based on the large trade volumes. Thus
smaller funds are potentially more agile than larger funds and may
outperform them for this reason.
This paper examines all of the above factors as well as country
specific factors and examines whether they influence or predict
mutual fund performance better than the classic fund specific
characteristics listed above. The non country specific factors are
listed below, with Table 1 below describing in more detail the
country specific factors and the associated findings.
Non-country specific factors (Findings of Ferreira, Keswani et al.
(2013)):

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Fund size: Performance has a negative correlation with fund

size
Fund family size: Performance has a positive correlation with

fund family size

Age: No relation found in US markets, but newer funds

perform better than older funds outside the USA

Expenses: No consistent correlation with fund performance
Loads: No relation between loads and performance
Flows: Smart money effects are not correlated with flows
Past performance: Positive correlation between past
performance and future performance, but country specific

actors could explain this better

Management structure: Team managed funds perform worse

than individually managed funds

Number of countries where fund is sold: Weak evidence for
funds selling in multiple countries performing better

TABLE 1: Country specific factors influencing mutual fund

performance (Ferreira, Keswani et al. 2013)
Element
Economic
development

Financial
development

Investor protection
and legal

Description

Finding

More developed
economies will include
investors with greater
financial education and
awareness. This should
exert pressure on mutual
fund managers to
perform better for the
fees that they charge
More developed financial
economies should have
higher liquidity
(turnover), lower
transaction costs and
greater information flow
and transparency.

Broad economic
development is not a
statistically significant
factor in predicting
mutual fund performance

Investor protection is a
fundamental starting

Trading costs are

negatively correlated
with fund performance
and increased share
turnover improves fund
performance (1 std dev
improvement in turnover
equates to a 38 basis
point improvement in
performance)
Common law countries
demonstrate positive
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point for any investment

decision and activity. This
is best captured by the
legal frameworks and
infrastructure

infrastructure

Mutual fund industry More mature mutual fund

markets should have
development and
greater experience and
concentration
thus generate better
returns

correlations to fund
performance relative to
civil law countries.
Indicators for shareholder
rights and the securities
market regulations also
show positive
correlations to fund
performance.
No correlation between
the age and maturity of
mutual markets, with
their performance was
found

b)
I.

Ferreira, Keswani et al. (2013) employed a four factor CAPM

model in order to understand and model mutual fund
performance. They combined the three factor Fama and
French (1992) model with that of Jegadeesh and Titman (1993)
(Fama and French 1992, Jegadeesh and Titman 1993). The
additional factors include factors that track the impact of
market capitalisation, market to book value and the impact of
historic performance (momentum) on fund performance. They
thus ended up with a CAPM model as below:

Where:
0
1
2
0

Market beta from standard CAPM

Small market cap to large market cap beta
High book to market vs low book to market beta
Market momentum beta

This model has greater explanitory power than the classic

CAPM model used by Malkiel (1995). This is best shown in
Table II, where the coefficients for these additional factors are
shown to be sttaistically significant and non zero, particulatrly
in the USA market. Of interest is the focus of Malkiel (1995),
was in the USA market.

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II.

A time lag is necessary to allow the fund managers time to

respond to the information presented in the various indicators.
Mutual fund managers will also adjust portfolios on the basis
of trends emerging and this will take time to establish. The
quarterly interval is used based on the reporting intervals of
indicators such as GDP and various confidence indices.

III.

Most data sets that are used to evaluate mutual fund

performance only track the performance of current funds
(Malkiel 1995). Thus in evaluating fund performance, all non
performing funds that are closed would be excluded from
analysis. This introduces a survivorship bias / phenomenon, in
which mutual fund returns are over stated. This is most likely
to be the reason behind the independent variables having
limited (5%) predictive power in explaining fund excess
returns in Ferreira, Keswani et al. (2013). Not only are non
performing funds dropped from reporting records, but fund
managers often create incubator funds, where only the best
performing funds are ultimately reported on and marketed
(Malkiel 1995).
Thus in order to account for this the four factor CAPM model
created by Ferreira, Keswani et al. (2013), could be extended
to include a fifth factor which would be a dummy variable to
track any changes to a fund. For example a value of zero
could be ascribed to funds, which have no investment strategy
changes, no merges with other funds and have been in
existence throughout the data review period (time interval of
analysis); whereas a value of 1 could be ascribed to funds
which undergo any change relating to investment strategy,
merging with other funds or those that are newly created in
the period under review. This approach could determine the

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survivorship impact on fund performance anmd determine if it

is a major factor in explaining mutual fund excess returns.
c) According to chen et al.( 2004), evidence has been found that small
funds perform better than large ones in the USA. The findings
revealed that liquidity constraints play an important role in
explaining why fund size erodes fund returns. This association was
most prominent among funds that invest in small and illiquid stocks
(small Caps), suggesting that these adverse scale effects are related
to liquidity.
The negative Size effect in the USA is economically significant as a
one standard deviation increase in fund size yields a 0.15% decline
in the next quarters fund return. This striking difference on
diseconomies of scale is unique to the USA, as fund size does not
seem to hurt the performance of funds that invest overseas.
d) Empirical researchers do not know the true model. Neither theory
nor intuition, neither the scientific tests nor data mining can give
empirical researchers sufficient guidance to specify a
Scientific/econometric model which exactly mirrors the true datagenerating process. If the model differs from the true datagenerating process, estimates are biased and standard errors do not
reveal the true level of uncertainty, as a consequence inferences
maybe unreliable. A test is claimed as robust if it still provides
insight to a problem despite having its assumptions altered or
violated. In general, being robust means a system can handle
variability and remain effective.

Importance

Robustness tests were introduced to avoid problems in

interlaboratory studies and to identify the potentially responsible
factors
The robustness test examines the potential sources of variability in
one or a number of responses of the method being studied.
Help Identify the system suitability test (SST) limits can be defined
(e.g. resolution, tailing factors, capacity factors, column efficiency in
a chromatographic method) can be evaluated
Another Aim of a robustness test may be to predict reproducibility or
intermediate precision estimates

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Question 4:

Text

d) The Investment Committee of Actis (China) is involved with

accepting the investment opportunities that are presented to them
from the Investment Principals, such as Joseph Li in this case. The main
aim of IC is to approve the projects that conform to the investment
policy of the company.
This being said, Actis is a private equity firm and not a venture capital
company. The clear distinction between the two lies on many factors
such as the return on investment criteria, target industry, investment
size, investment horizon, the use of leverage and different options for
financing etc. However, the most important differentiation factor is the
type of target companies they aim to invest in: venture capital
companies aim to provide funding to companies that are either in their
infancy stage or still in the process of developing their idea/product. In
line with that, these start-ups are have either no revenues or are
operating at losses due to the initial cost of setting up operations or
researches carried out and hence carry high risk and low liquidity.
Venture capital companies base their decisions on the growth
potentials of the company itself, and hence require a high rate of return
to offset the high risk (Fenn, 1995).
On the other hand, private equity firms focus on companies that are
relatively mature. These firms perform on their proven technology or
strategy, in the case of 7 Days Inn. They are generally earning
accounting profit, which makes them less risky investments and with a
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slightly higher liquidity than start-ups. Private equity firms also base
their decisions on the growth potential of the company.
In line with the above, 7 Days Inn falls between the categories of earlystage ventures that venture capitals fund and the later-stage ventures
that private equity firms fund. At the time of consideration, the Inn was
incurring losses at the time of consideration, even though the EBITDA is
generally improving over the years, suggesting both growth potential
and validation of the companys business plan. However, it is relatively
less mature than later-stage ventures and still faces losses: though this
can be explained by costs incurred due to the rapid expansion of the
franchises, it still raises a red flag for the IC.
e)

There are three general valuation approaches that can be adopted:

discounted cash flows, comparable transactions and opportunity cost

method. The discounted cash flow method involves the adjusted
present value method and weighted average cost of capital method.
The comparable transactions method involves comparing key
accounting ratios of the venture being considered to that of similar
companies in its industry. Lastly, the opportunity cost method involves
evaluation of different methods available to the investor.
As 7 Days Inn is in the service sector and hence comparable transactions
would apply more aptly as the valuation method. Lins pitch to the IC is
that the budget hotels sector in the lodging industry has high growth
potential and hence comparing 7 Days Inn to other budget hotels will
provide a good view of where it stands versus other budget hotels and
how its customer acquisition and retention strategies fare.
Due to the nature of the sector, the European Private Equity & Venture
Capital Association (EVCA) suggests various comparative criteria:

Price/ Earnings Ratio

Price/ EBITDA Ratio
Price/ turnover Ratio

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Other criteria that are specific to the lodging industry should also be
applied, such as:

Room yield
Rental costs
Maintenance costs
Agent fees
Occupancy rate

f) There are several factors that impact the lodging industry: the
macroeconomic standing of the economy, technological
advancements that allow better advertisement and customer
acquisition as well as for service delivery, competition from similar
lodging facilities, changing demographics of travellers, the presence
of well-known hotels versus new domestic start-ups and finally the
changing travelling trends.
The Lehman Bankruptcy will have a direct impact on Chinas
macroeconomic standing and the travelling trends of 7 Day Inn
customers.
Firstly, the Bankruptcy impacts the flow of international travellers to
the country, both those that travel for leisure and those that travel for
business purposes. Due to the Bankruptcy, forecasts of recession imply
that the foreign traveller, especially those that travel for leisure, will
face two options: downgrading from their current lodgings to cheaper
ones, if they wish to continue their vacations, or in the adverse
situation, cancelling trips altogether. Leisure foreign travellers also may
then choose to plan their vacations domestically rather than
internationally.
In the case of 7 Days Inn, since it is a budget hotel chain that attracts
mainly domestic business and leisure travellers, this can lead to higher
sales forecasts: international travellers from high-end hotels will seek
more affordable, standardized service for a lower cost than those that
they incur at four- and five-star hotels.

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In contrast to that, there will be an economy-wide impact on the

Bankruptcy: the recession in the United States of America will impact
Chinas economy as well. Some industries in China will be directly
impacted, e.g. the exported goods sector: closing down of firms in
these sectors or even slashing of wages results has a two-fold
implication: depending on the impact of business activity, the budget
hotels will see a drop in business travellers and lower wages implies
immediate termination of luxury expenditure, e.g. travelling for leisure.
There are two opposing impacts of the Bankruptcy: downgrading of
travellers from expensive, higher-end hotels to budget hotels and the
loss of the existing customer base. The decision to invest in 7 Day Inn
will then be derived from whether the incoming new customers will
offset the loss of the already acquired customers. From the information
given, since the business already has a very lean business model, e.g.
low variable costs, smaller rooms leading to low maintenance costs,
low staff to room ratio, low rental costs, etc., and a high level of
adaptability, e.g. introducing the IT and eCommerce platform for
bookings Actis should invest to 7 Days Inn.
However, due to the macroeconomic impact of Lehman Bankruptcy,
the strategy for 7 Days Inn will need to be changed from rapid
expansion through franchises in new locations to sustainability. The
focus should then be on the smooth running of existing hotels to not
incur any new fixed costs from leasing new locations that may,
eventually, lead to losses on current hotels and their ultimate closedown.

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References

Chen, J., H. Hong, M. Huang and J. D. Kubik (2004). "Does Fund Size Erode
Mutual Fund Performance? The Role of Liquidity and Organization."
American Economic Review 94(5): 1276-1302.
Fama, E. F. and K. R. French (1992). "The Cross-Section of Expected Stock
Returns." The Journal of Finance 47(2): 427-465.
Ferreira, M. A., A. Keswani, A. F. Miguel and S. B. Ramos (2013). "The
Determinants of Mutual Fund Performance: A Cross-Country Study."
Review of Finance 17(2): 483-525.
Jegadeesh, N. and S. Titman (1993). "Returns to Buying Winners and
Selling Losers: Implications for Stock Market Efficiency." The Journal of
Finance 48(1): 65-91.
Malkiel, B. G. (1995). "Returns from Investing in Equity Mutual Funds 1971
to 1991." The Journal of Finance 50(2): 549-572.
European Private Equity & Venture Capital Association. (2007). Guide on
Private Equity and Venture Capital for Entrepreneurs. Brussels: EVCA.
Fenn, G. W., Liang, N., & Prowse, S. (1995, December). The Economics of
the Private Equity Market. Washington DC.

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