Shadow banking

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Lecture overview

• Development of the shadow banking system

• Mutual funds and Exchange-traded funds (ETFs)
• Hedge funds
• Venture capital & private equity funds
• Investment banks

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 Q’s
Questions at the end of the lecture

• What is the broad definition for shadow banks?

• What is the difference between mutual funds and hedge
funds?
• What do we know about the performance of private
equity funds?
• What do investment bankers do?

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Development of the shadow banking
system

• Shadow banking system is a (very) broad term but it

may consist of
– Mutual funds and Exchange-traded funds (ETFs)
– Hedge funds
– Venture capital & private equity funds
– Investment banks
– Fintech market (Peer-to-peer lending, Crowdfunding,
Cryptocurrencies etc.)*
– Insurance companies**
– Pension funds**

* Will be covered on ”Financial innovation” lecture 4

** Will be covered on ”Insurance companies” lecture
Since 2009, the importance of banks in euro
area financial intermediation has declined

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Recall from Slide set #2

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Mutual funds and Exchange-traded funds
(ETFs)

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Mutual funds
Why do they exist?
• Mutual funds (MF) pool the resources of many small
investors under a professional money manager, and use
the proceedings to invest in securities
• There are several benefits of mutual funds
- Liquidity intermediation: investors can quickly convert
investments to cash while still allowing the MF to invest for the
long term
- Denomination intermediation: investors can participate in
securities offerings that would normally require larger capital
- Diversification
- Cost advantages: MF can negotiate lower transaction fees
- Managerial expertise: investors rely on professional money
managers
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Mutual funds
Structure
• Investment (fund management) companies usually offer
a number of different types of mutual funds
- Investors can often move investments among these funds
without penalty (subscription/redemption fee)
• The shareholder (owners) of the MFs are investors
• Funds typically pay their expenses out of fund assets,
rather than by imposing separate fees and charges
directly on investors (investors are paying them
indirectly)
• Most relevant fees: Subscription (Sales loads) fees,
Redemption fees, Management fees

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Financial Times 13
UCITS
• UCITS or ‘undertakings for the collective investment in transferable
securities’ are investment funds regulated at European Union level. They
account for around 75% of all collective investments in Europe. The
legislative instrument covering these funds is Directive 2014/91/EU.
• Due to the intense regulatory process to have a fund approved as UCITS
compliant by a regulator, the UCITS label serves as a stamp of quality and
reliability for investors.
• From 1 July 2011 all UCITS are required to publish a Key Investor
Information Document ("KIID").
• The AIFMD (Alternative Investment Fund Managers Directive) allows for
qualifying investor and retail investor funds to be established under its
rules. For the latter, the investor protection provisions are similar to those of
UCITS but the investment restrictions are less stringent.

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Assets under management (AUM) in Europe

EFAMA: ”Asset Management in Europe”, December 2022 15

EFAMA: ”Asset Management in Europe”, December 2022 16
EFAMA: ”Asset Management in Europe”, December 2022 17
Aktia Q3 Presentation 18
Exchange-traded funds
Introduction

• Suppose you want to start saving, but you do not seek

managerial expertise of money managers. How would
you develop a diversified portfolio?
• The answer is exchange-traded funds
• Exchange-traded funds (ETF) pool the resources of
investors, and use the proceedings to invest in a basket
of securities so as to track an index (for ex. S&P)
• ETFs are listed on stock exchanges → highly liquid

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Exchange-traded funds
vs. mutual funds

• Index mutual funds in 1970s

• First ETF in US in 1993
• Mutual funds pros (compared to ETFs)
- Active money management (is it value adding or not?)
- Key offerings in retirement (some fund plans do not allow ETFs)
• Mutual funds cons (compared to ETFs)
- Fees
- Not listed in stock exchanges, daily valuation
- Active money management (is it value adding or not?)

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Total net assets and number of ETFs
Billions of dollars, year-end

Investment Company Institute 2022 Fact Book 21

Some of the outflows from US domestic equity
mutual funds have gone to ETFs

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Investment Company Institute 2022 Fact Book
European active mutual funds lose out
on €8bn in revenues

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Financial Times, Dec 20, 2023
Hedge funds

• Suppose you are a wealthy investor, and you are

seeking high yields in exchange of risk. How would you
develop a diversified portfolio?
• The answer is hedge funds
• Hedge funds (HF) pool the resources of large investors
under a professional money manager, and use the
proceedings to invest in securities
• Hedge funds often try to take advantage of unusual
spreads between security prices

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What is a hedge fund?

“Anything that charges 2 and 20”

• “Hedge funds are unregulated pools of money managed by an

investment advisor, the hedge fund manager, who has a great deal
of flexibility” (Stulz, 2006)

• “A multitude of skill-based investment strategies with a broad range

of risk and return objectives. A common element is the use of
investment and risk management skills to seek positive returns
regardless of market direction” (Goldman, Sachs & Co.)

–25
A word from the inside

“Hedge funds are investment pools that are relatively unconstrained in

what they do. They are relatively unregulated (for now), charge very
high fees, will not necessarily give you your money back when you
want it, and will generally not tell you what they do.”

“They are supposed to make money all the time, and when they fail at
this, their investors redeem and go to someone else who has recently
been making money. Every three or four years they deliver a one-in-a-
hundred year flood. They are generally run for rich people in Geneva,
Switzerland, by rich people in Greenwich, Connecticut.”

Cliff Asness, AQR Capital Management 26

Hedge funds vs. mutual funds

Hedge funds Mutual funds

Return target Absolute Relative
Level of active Very high Very low to high
management
Flexibility High Low
Liquidity Monthly to quarterly Daily
Portfolio Concentrated Diversified
Performance fee Usually Very rarely
Transparency Very low Medium
Minimum investment Very high Very low
Investor population Small Everyone

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 2016 Documentary “Betting on Zero”.
It investigates the allegation that Herbalife is a
pyramid scheme, and follows Bill Ackman’s
shorting on Herbalife.

Jan 27, 2022

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Meme stocks
r/WallStreetBets

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Venture capital & private equity funds

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Venture capital & private equity funds
• Often Venture Capital is treated as a separate asset
class
• Private equity investors tend to target fairly mature
companies, which may be under-performing or under-
valued, with the goal of improving their profitability and
selling them for a return on their investment (capital
gain)
• Venture investors target early-stage and expanding
companies (often pre-revenue) with fast-growth
potential, with the objective of nurturing and growing
them quickly, then selling them in M&A deals or taking
them public.
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Risk adjustment in private equity returns*

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* Arthur Korteweg (2019), Annu. Rev. Financ. Econ. 2019. 11:131–52

# of listed firms by year on NYSE,
Nasdaq, Amex and market cap 1975-2015

37
Kahle & Stultz (2017). Is the US public corporation in trouble?
Journal of Economic Perspectives 31/3.
Spa Holdings 3 Oy announces a voluntary
recommended public cash tender offer for all the
shares in Ahlstrom-Munksjö Oyj

Under private ownership, the Company would be ideally positioned to invest

further and faster in initiatives to support organic growth as well as benefiting
from additional expansionary capital expenditures and acquisitions to
strengthen selected areas of the portfolio.
The Consortium believes that Ahlstrom-Munksjö, in a private setting, will more
effectively manage all above mentioned initiatives as well as current market
challenges as management can devote its full attention to business
performance without the constraints imposed by its current balance sheet and
the public market.

Stock Exchange Release 38

September 24, 2020
De-listing

• Why go private?

─ Avoid SEC regulation, such as Sarbanes-Oxley.

─ Provides flexibility and ability to avoid public scrutiny of
earnings. Allows companies to take bigger risks and pursue
longer-term growth without alienating their shareholders.
─ Helps attract top talent no longer interested in the life of a
public-company CEO (the scrutiny of [short term] stock analysts,
investors and the media)
─ Tax advantages, and high compensation for partners.
─ Massive PE funds make it possible
Top 10 U.S. Private Equity Firms Of
January 2024

Forbes, Dec 1, 2023 40

Investment banks
Introduction

• Investment banks perform a variety of crucial functions

in financial markets
– Advice, offer marketing and distribution services and aftermarket
support in the initial sale of stocks and bonds
– Deal maker in M&As and spin-offs
– Middleman in the purchase and sale of companies
– Private broker to the very wealthy

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Why do they exist?

• Asymmetric information
– For example: new security issuances, M&As, renegotiation of
loans to distressed firms
– Investment banks emerged as intermediaries in information
sensitive transactions
– Investment banks bring together
• Investors and analysts who want to sell information
• Investors and corporate security issuers who want to purchase
information
– Firms use a reputable investment bank as an advisor and
intermediary

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Case: IPOs
• Most issuers issue only relatively seldom. Therefore, the
investment bank typically has a substantial informational
advantage about the state of the market. What prevents
the investment bank from underpricing the issue
excessively?
• Firms go public only once. What prevents them from
following a "hit and run" strategy, i.e. overprice
excessively their IPO?
• Answer: Investment banks put their reputation on stake
when pricing the offerings. What happens if an
investment bank underprices or overprices too much?

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Spa Holdings 3 Oy announces a voluntary
recommended public cash tender offer for all the
shares in Ahlstrom-Munksjö Oyj
ADVISERS

The Offeror has appointed PJT Partners (UK) Limited and Goldman Sachs
International as financial advisers, Nordea Bank Abp as financial adviser and
arranger outside of the United States, Pöyry Capital Limited as financial
advisor and Hannes Snellman Attorneys Ltd, Roschier, Attorneys Ltd and
Kirkland & Ellis International LLP as legal advisers in connection with the
Tender Offer.
Ahlstrom-Munksjö has appointed UBS Europe SE as financial adviser and
White & Case LLP and Cleary Gottlieb Steen & Hamilton LLP as legal advisers
in connection with the Tender Offer.

Stock Exchange Release 46

September 24, 2020