FINANCE 361 – Topic 2 – Investors, assets and
markets
Paul
Geertsema
1
Content
s
1 Reading (before
class)3
2 What are we doing today7
3 Market participants9
4 Investable assets22
5 Markets24
6 How banks work26
7 The business of fund
management36
8 A list of books...40
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
1
Reading (before class)
• Review BKM Ch 1, 2, 3, 4 (e.g. all of Part 1)
• For funwww.alexcartoon.com
– Daily since 1999... so there are now thousands of
cartoons
– Once you have gone through all of them,
you’ll
have better appreciation of how the City really works
– Note: will not be examined
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Reading (before class) (cont.)
• First one (8 Jun 1999)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Reading (before class) (cont.)
• Another one (2 Feb 2021)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Reading (before class) (cont.)
• You might not get the previous joke if you don’t know about the
GameStop episode –
seeen.wikipedia.org/wiki/GameStop_short_squeeze for
background)
Source: https://www.reddit.com/r/dataisbeautiful/comments/lkz1wm/oc_timeline_of_the_rise_and_fall_of_gme_stock/
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
2
What are we doing today
• Have a chat about what investment management
means
• Talk about
– Who invests (Market participants)
– What they invest in (Investable assets)
– Where they invest (Markets)
• Discuss banks
– How they are structured
– The sort of business they do
– How they make money
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
What are we doing today (cont.)
• Discuss fund managers
– Who gives them money to manage (and, why?)
– How do they make money
◦ For their
◦ clients
For themselves
• So this topic is about making sure you have a fair idea of
the entities that are involved in markets, how they are
incentivisedand how they operate
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
3
Market participants
• In common language, the people and organisations that
buy and sell financial assets as part of their normal
business
• Why do we care?
– If you want to work in finance, you will likely be
employed by one of these participants
– To understand investments, you need to understand the
entities making investments
– Each of these participants have different incentives and
con- straints
9
◦ We’ll see that markets are on the whole pretty efficient
◦ By that I mean it is not all that easy to “beat the
market”
◦ Understanding the incentives and constraints of other
parti- cipants is one of a few ways to get the “edge”
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361 ClassifNotes
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(C) Drmarket
Paul Geertsema,
2022
Market participants (cont.)
• Hopefully it will also help you avoid getting ripped off
– “But the sales guy said all the smart money were
pushing for allocations in the deal ...”
◦ You should be a bit more sceptical about what you
hear from sales...
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• So, let’s get a list
– Mutual funds
– Insurance companies
– Banks
– Hedge funds
– Sovereign wealth funds
– Large corporates
– Central banks
– Governments
– Individuals
– Family offices
– etc.
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• We’ll talk about each of these in a bit more detail
– I’ll give an example of each
– I tell you what (I think) they really want (aka incentives)
– I’ll tell you what some of their constraints are
• Mutual funds
– Tracker funds (eg ETF’s)
◦ Just want lots of AUM (assets under management)
◦ Take a small annual fee (5 to 90 bp)
– Actively managed (eg Fidelity Emerging Markets )
– What they really want
◦ To beat the benchmark (aka bogey), so they can get
lots of AUM, so they can get lots of fees
– Constraints
◦ Regulations about diversification and not using
derivatives
◦ Investors pull money out when the going gets tough
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Insurance companies (eg AIG, Swiss Re)
– Reinvest premiums received so as to be able to pay out
claims in the future
– What they really want
◦ High and predictable returns so they can fund their
highand predictable liabilities
– Constraints
◦ Regulations regarding capital adequacy, solvency and
liquidity
◦ Price risk using actuarial principles, not really
comfortable with “market price of risk” concepts
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Banks
– Commercial banks (eg CBA/ASB)
◦ What they really want
· Loyal depositors that will fund them cheaply
· Careful borrowers that will repay their money in full
and on time
◦ Constraints
· Regulations, public perception (do you love your
bank?), keeping up with technology, hackers
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Investment banks (eg Morgan Stanley)
– What they really want
◦ Lots of P&L and bonuses
· Clients buying complex products that are hard to
price
· “Hot” markets with lots of deals and trading
(bankers are not lazy)
◦ Constraints
· Regulations, public outrage, more regulations,
capital ad- equacy rules, liquidity rules,
compliance, risk, etc
– We’ll have more to say about banks later
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Hedge funds
– Big (D.E. Shaw, Citadel, Renaissance Technologies,
etc.)
– Others
– What they really want
◦ Lots of rich investors that believe it is possible to beat
the market, if only you are smart enough (the second
part is not a problem for your typical HF guy)
◦ Beating the benchmark by miles so they can take the
20 part of their “2 and 20” fee
– Constraints
◦ So hard to borrow money
◦ Investors pulling out money just when it is a good
time to buy
◦ Irrational markets that make no sense
◦ Not really as unregulated as they used to be (SEC,
Madoff scandal)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Sovereign wealth funds
– Government owned investment pools
◦ eg Superannuation Fund (NZ), Qatar Investment
Authority (Oil Money), Norway Oil Fund,
◦ SAFE (State Administration of Foreign Exchange,
China)
– What they really want
◦ Long term returns
◦ Continued government sanction for their existence
◦ Few headlines, low profile
– Constraints
◦ Public perception (ethical investing)
◦ Fairly strict investment criteria, due process (it is the
civil service, after all)
– Are unusual in that they can afford to take the long view
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Large corporates
– Investing surplus cash (Apple)
– Funding their customers (GE Capital)
– Hedging risk (ie FX hedging)
◦ FX = Foreign Exchange
– What they really want
◦ Not to be fleeced
◦ Expertise (investments are usually not their core
business)
– Constraints
◦ Shareholders
◦ Lenders
◦ Understanding markets, products
◦ Not their day job, they have a real business to run
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Central banks
– Manage the currency for sovereign states
– Issue debt on behalf of the state
– Inflation targeting
– Often have some regulatory role as well
– Big beasts with a lot of power
◦ Can make rules
◦ Can print money (aka Quantitative Easing)
◦ Sets the interest rate
◦ “Don’t fight the fed”
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
– What they really want
◦ Economic stability
◦ Manageable inflation
· Low unemployment
· Steady economic growth
◦ Healthy banking sector, moderately profitable, nothing
too exiting
– Constraints
◦ Government directed (nominally independent)
◦ Civil service process
◦ Not naturally market orientated (they have to work at
it)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Market participants (cont.)
• Governments
– Nation states (Australia)
– States (Texas, or Western Australia)
– Local (Auckland City Council)
• Individuals
– “Retail” - current & savings account, credit cards
– “Mass Affluent” - own a house or two, some cars; a bit of
money saved up
– “High Net Worth” if their liquid assets (ie excluding
properties, paintings and pets) is a million or more
• Family office
– If your family has serious money (say $100mn or more)
– Essentially set up your own fund management company
to man- age your assets
– Your employees are often “High Net Worth” themselves
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
4
Investable assets
• In other words, what you can invest in
• Can break it down by
– Source of risk, or
– Structure
• Source of risk
– Equities aka stocks
– Bonds / Fixed Income
– Money / Currencies
– Commodities
– Property aka real estate
– Intellectual property (Film rights,
patents)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Investable assets (cont.)
• Structure
– Cash aka underlying
– Derivatives
– Structured products
– Funds, ETFs
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
5
Markets
• In other words, where you go to buy or sell something
• Exchanges
– Mostly electronic nowadays
– Equities, some bonds, some derivatives, some
commodities
– Liquid, transparent (but not always for all securities)
• Over the counter (OTC)
– Proprietary dealer systems (growing)
– or Phone/Bloomberg (less common these days)
– FX, some bonds, credit derivatives
• Brokers
– For specialised assets, like shipping capacity or
wine
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
Markets (cont.)
• “By appointment”
– You have to go and find buyers (or sellers) yourself
– Property, bespoke structured products
• Dark pools / Block trading / Algorithmic trading / High
frequency trading
• Important dimensions
– Liquidity (the cost of moving in and out of a position)
– Depth (amount you can trade before you move the
price)
– Transparency (availability of price data)
– Access (who can trade)
– Speed (of execution)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
6
How banks work
• Most people have only a hazy idea of what large banking
institutions do and how they are organised
• In this section I aim to give you an “X-ray” view of these
organisa- tions (with an Investment Bank focus)
• It is important to understand how banks work
– If you are planning a career in finance, you will either
work for them or work with them at some point
– They are intimately involved in the creation and trading of
most types of financial assets
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• I’ll show you the different ways in which a bank is
commonly “cut and diced”
– So you can go from:
◦ “I think she works for a bank”
– to:
◦ “She is an IBD Associate in the Financial Institutions
Group for Deutsche Bank in London”
◦ or
◦ “She is a Director in Product Control responsible for
Interest
Rate Exotics at Bank of America in New
York”
• Lets get to work
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Different “dimensions” of position
– Rank
– Office
– Role
– Product
– Client base
– Geography
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Rank
– Like most large organisations (Military, Health Care, Civil
Ser- vice), banks have a fairly well established seniority
structure
– From bottom to top...
– Analyst
– Associate
– Manager
– Vice-President (VP) / Associate Director (AD)
– Director (Can sign on behalf of the firm)
– Managing Director (MD)
– Executive Committee
– CEO
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Office
– Historically, banks have categorised their people into
different “Offices”
– Front Office
◦ Deal directly with clients of the bank
◦ Some direct involvement in making money
◦ Investment banking, capital markets, trading, sales,
research
◦ Most risk, most upside, hard to get in
– Middle Office
◦ Control functions
◦ Check that front office are within risk limits and not
stealing money or breaking rules
◦ Product control, Risk, [Accounting, Tax, Compliance]
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
– Back Office
◦ Narrow definition: Operations [Ops]
· Confirmations
· Clearing / payments
· Regulatory reporting
◦ Wider definition: includes support functions
· Legal
· IT
· Operations
· Facilities
· HR
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Role
– This is what you actually do
– Will obviously have some overlap with Office
– Really applies to front office roles
– Often split into primary and secondary
• Primary (creation of new securities)
– IBD (Investment Banking Division)
◦ Coverage/Origination
◦ Execution
◦ Structuring
◦ Debt Capital Markets (DCM) / Equity Capital Markets
(ECM)
◦ Syndicate
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Secondary (trading of existing securities)
– Sales/Distribution
– Research
– Trading
– Structuring
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Product
– More commonly applied to the Secondary business
◦ Traders need to understand the product they trade
– Equities
– Fixed Income
◦ Credit
◦ Interest Rates
– FX
– Commodities
– Can overlay adjectives like
◦ Derivatives
◦ Structured
◦ Exotic
◦ Flow
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
How banks work (cont.)
• Client base
– More commonly applied to the Primary business
◦ Investment bankers need to understand their clients
– Consumer goods / Retail
– Oil & gas / Energy
– Technology
– Mining & minerals
– Manufacturing
– Defence
– Healthcare / Pharma
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
7
The business of fund management
• Its all about AUM
• Good past returns makes it easier to attract new investors
• Trackers (aka passive fund managers)
– Boring, safe business
– Invest in the benchmark assets to produce the
benchmark return (less fees and tracking error)
36
FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
The business of fund management (cont.)
• Traditional fund managers (aka real money)
– Active fund management
– Sector allocation
– Security selection
– Try to beat the market; on the whole does not succeed.
◦ Does this mean they are not working hard enough, or
they are working very hard?
– Regulated (insurance, pension funds, etc)
– Fee is a percentage of assets managed per year,
sometimes in- clude a loading or exit fee
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
The business of fund management (cont.)
• Alternative fund managers (aka hedge funds aka leveraged
money)
– Supposed to be the smart money
◦ No doubt the typical HF employee is pretty sharp;
however, not sure that it helps
◦ To be more precise, not sure it helps the investor
make more money
– Largely unregulated, often use leverage
– Usually take 2% of assets managed per year, and 20%
of out- performance relative to benchmark (“2 and 20”)
◦ Think carefully about HF manager incentives vs
investor pref- erences
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
The business of fund management (cont.)
– Little evidence of return persistence
◦ There are always 5 funds that outperformed all the
others
◦ Its just that they are not the same funds year to year
◦ Luck vs skill?
– That said... the Medallion Fund at Renaissance
Technologies generated 39% annualized after fees
from 1988-2018 (and 66% before fees!)
◦ Seeen.wikipedia.org/wiki/Renaissance_Technologie
sfor the full story
– Some evidence that smaller funds do better than larger
funds
– Games hedge funds play
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
8
A list of books...
• So you want to be an investment banker/trader/fund
manager/hedgie? Absorb the culture; your holiday reading
list:
– Where are the customer’s yachts? (A personal favourite...)
– Barbarians at the gate
– Monkey business
– Liar’s Poker
– The Big Short
– When Genius Failed
– The Quants
– F.I.A.S.C.O
– Too Big to Fail
– Straight To Hell
• Want a larger list?
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022
A list of books... (cont.)
– https://www.quantnet.com/threads/master-reading-list-forquants- mfe-financial-engineering-students.535/
• Some more serious books
– A random walk down wall street (Malkiel)
– Thinking, slow and fast [behavioural] (Kahneman)
– Thinking strategically [game theory] (Dixit, Nalebuff)
• PhD level stuff
– Asset Pricing (Cochrane)
– Dynamic Asset Pricing (Duffie)
– Econometrics of Financial Markets (Cambell, Lo,
MacKinlay)
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FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema,
2022