Fin Quiz - Curriculum Note, Study Session 12, Reading 38 PDF

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Portfolio Management: An Overview

2.

A PORTFOLIO PERSPECTIVE ON INVESTING

Under a Portfolio approach, each individual security is evaluated in relation to its contribution to the investment characteristics of the whole portfolio. 2.2

Portfolios: Reduce Risk

When future is expected to replicate the past, then investors may choose investment, which provides the highest return per unit of risk. When future is not expected to replicate the past, then investors may invest in an equally weighted portfolio i.e. investing equal dollar amount in each security for each quarter. The return of an equally weighted portfolio is equivalent to the return on the randomly selected security. The S.D of an equally weighted portfolio is not simply equal to the average of the S.D. of the individual shares (i.e. S.D of an equally weighted portfolio < average of the S.D. of the individual shares). Portfolios reduce risk more than they increase returns. This implies that they have more effect on risk relative to returns.

 S. D. oftheequallyweightedportfolio = S. D. oftherandomlyselectedsecurity

Individual Investors

Motives of individual investors for investing and constructing portfolios include: Financing children’s education Saving for a major purchase (i.e. car or house) Starting a business Meeting Retirement needs

Portfolios: Composition Matters for the Risk-Return Trade-off

Diversification benefits of a portfolio composed of companies from completely different industries are greater than that of equally weighted portfolio. 2.4

Portfolios: Not Necessarily Downside Protection

Portfolio approach does not necessarily provide downside protection or eliminate all risk; rather, it only provides risk reduction benefits to investors. Portfolio provides diversification benefits when securities have low or negative correlation i.e. returns of securities do not move together. Correlation is not fixed; it may change in an unfavorable manner. This implies that portfolio diversification may provide less risk reduction benefits during times of severe market turmoil relative to normal market conditions. Diversification may become ineffective in case of worldwide contagion. 2.5

Value of Diversification refers to the risk reduction benefits of a simple portfolio. It is measured by diversification ratio.

3.1

Annualized mean returns = Mean quarterly returns × 4 Annualized S.D. = Quarterly S.D × 2 2.3

The portfolio approach provides diversification benefits to investors i.e. reduces risk associated with the investment without necessarily decreasing the expected rate of return.

3.

NOTE:

Portfolios: The Emergence of Modern Portfolio Theory

Modern Portfolio Theory (MPT) by Harry Markowitz: The basic idea behind MPT is that investors should hold portfolios as well as should focus on how individual securities in the portfolios are related to one another. Capital market theory: According to capital market theory, the decision to hold an individual security in a well-diversified portfolio is based on the priced risk of an individual security i.e. systematic or non-diversifiable risk.

INVESTMENT CLIENTS

The choice of various assets depends on the investment needs of individual e.g. For growth purpose, investors may prefer assets with the potential for capital gains. For income purpose (i.e. retirees), investors may prefer to invest in fixed-income and dividend-paying shares.

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FinQuiz Notes – 2 0 1 9

Reading 38

Reading 38

Portfolio Management: An Overview

Defined contribution (DC) pension plan: Under DC plans, Only the contributions (not benefits) are specified by the employer. Investment risk is borne by the employee only. Example: 401 (k) plans in U.S. 3.2

Institutional Investors

Institutional investors are major participants in the investment markets.

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or a foundation i.e. i. To generate sufficient income to fund the objectives of the institution. ii. To maintain the real (inflation-adjusted) capital value of the fund. Time horizon: Foundations and endowments are long-term investors because they are mostly established with the intent of having perpetual lives. Spending rule: It is used by endowment or a foundation to maintain balance between conflicting goals of providing substantial support for current operations and preserving purchasing power of the fund’s assets. In order to be effective, spending rule must be clearly defined and consistently applied.

Types of institutional investors: 3.2.3) Banks 1) 2) 3) 4) 5) 6) 7)

Defined benefit pension plans University endowments Charitable foundations Banks Insurance companies Investment companies Sovereign wealth funds (SWFs) 3.2.1) Defined Benefit Pension Plans

In a defined benefit (DB) pension plan: An employer is obligated to pay a certain annual amount to its employees on their retirement. Investment risk is borne by the employer rather than an employee. Assets are invested in a way to generate cash flows that match the timing of future pension payments (i.e. liabilities). Thus, it requires that sufficient assets are available to pay pension benefits when they come due. Pension plans have long time horizon. When the plan is opened to new plan members, the plan may have long and indefinite time horizon. When the plan is closed to new members, the plan has a long but finite time horizon. 3.2.2) Endowments and Foundations

Banks typically accept deposits from customers and use those deposits to extend loans. When deposits > loans, banks need to invest those excess reserves. To avoid risk and to meet liquidity needs, banks need to invest those excess reserves using conservative investments e.g. fixed-income and money market instruments rather than equities and other riskier assets. In some countries (e.g. in U.S.), banks are legally restricted with regard to investment in equities. Return objective: The bank’s primary objective is to earn a return on its reserves greater than the rate of interest it pays on its deposits. 3.2.4) Insurance Companies Insurance companies write insurance policies and receive premiums in return. These premiums are invested in order to meet liabilities (i.e. to pay claims). Like banks, insurance companies are conservative investors. Life insurance companies have longer time horizons than non-life insurance companies (e.g. auto and home insurance).

University endowments are established to provide financial assistance to a university and its students (e.g. scholarships) on a continuous basis. Endowments of different sizes exist, where size is determined by assets under management.

These include mutual funds. Further discussed in section 5.1.

Charitable foundations are established to meet different objectives. They receive their funding through donations made to them.

Sovereign wealth funds (SWFs) are (large) investment funds that are owned by the government.

Objectives of Endowments & Foundations: Typically, there are two primary objectives of any endowment

3.2.5) Investment Companies

3.2.6) Sovereign Wealth Funds

Reading 38

Portfolio Management: An Overview

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Summary of Investment Needs by Client Type Client

Time Horizon

Risk Tolerance

Income Needs

Liquidity Needs

Individual investors

Varies by individual

Varies by individual

Varies by individual

Varies by individual

Defined benefit pension plans

Typically long term

Typically quite high

High for mature funds; low for growing funds

Typically quite low

Endowments and foundations

Very long term

Typically high

To meet spending commitments

Typically quite low

Banks

Short term

Quite low

To pay interest on deposits and operational expenses

High to meet payment of deposits

Insurance companies

Short term for property and casualty; long term for life insurance companies

Typically quite low

Typically low

High to meet claims

Investment companies

Varies by fund

Varies by fund

Varies by fund

High to meet redemptions

Source: Volume 4, Reading 38, Exhibit 14.

4.

STEPS IN THE PORTFOLIO MANAGEMENT PROCESS

1. The planning Step: Understanding the client’s needs. Preparation of an investment policy statement (IPS) 2. The Execution Step: Asset allocation Security analysis Portfolio construction

4.2

Step Two: The Execution Step

This step involves: a) Target Asset allocation: Selecting an appropriate target asset allocation i.e. weights of different asset classes to be included in the portfolio (e.g. equities, fixed-income securities, and cash, sub-asset classes i.e. corporate and government bonds and alternative assets i.e. real estate, commodities, hedge funds and private equity etc.)

3. The Feedback step: Portfolio monitoring and rebalancing Performance measurement and reporting 4.1

Step One: The Planning Step

This step involves: a) Understanding the needs (i.e. objectives and constraints) of clients. b) Developing an investment policy statement (IPS). IPS is a written document that describes: Investment objectives (i.e. return objectives and risk tolerance of a client) and constraints of a client. Benchmark used to assess portfolio’s performance. The IPS should be reviewed and updated regularly.

These weights are determined based on economic and capital market expectations. The economic and capital market expectations are used by analysts to assess the risk and return characteristics of the available investments. For example, Equities perform well when there is strong economic growth. Bonds perform well when there is recession or when inflation decreases. Asset allocation decision has the greatest impact on the portfolio performance. b) Security analysis: Analyzing, selecting and purchasing individual investment securities: It involves identifying attractive investments in particular market sectors based on detailed analysis of companies and industries i.e. expected level and risk of the company’s cash flows.

Reading 38

Portfolio Management: An Overview

NOTE: First of all, weights of classes are determined  then, sector weightings within an asset class are determined  finally, weights of individual securities or assets are determined. Trading: Trading is also an important part of portfolio construction process. Generally, Trades are passed to a buy-side trader then buy-side trader contacts a stockbroker or dealer to execute those trades.

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Sell-side firm: A sell-side firm refers to a broker or dealer that sells securities to and provides independent investment research and recommendations to investment management companies. Buy-side firm: Buy-side firm refers to investment management companies and other investors that use the services of sell-side firms. 4.3

Step Three: The Feedback Step

Feedback step involves: Approaches of forming economic and capital market expectations: 1) Top-down Approach: Under top-down approach, i. The analyst first considers the prospects for the economy as a whole. ii. Then based on current and forecasted economic environment, the analyst determines those industries and markets that are expected to perform well. iii.Finally, the analyst chooses particular companies within the favored industries that are expected to perform well. 2) Bottom-up Approach: Bottom-up approach focuses on security selection based on company specific circumstances (i.e. management quality and business prospects) rather than macroeconomic forecasts. 5.

As little as US$50

Mutual funds Exchange traded funds Separately managed accounts

US$ 100,000

Mutual funds Exchange traded funds Separately managed accounts Hedge funds Private equity funds US$1,000,000+

Source: Volume 4, Reading 38, Exhibit 17.

5.1

b) Performance Measurement and Reporting: This step involves assessing portfolio’s performance in relation to the client’s objectives i.e. to evaluate Whether the return requirement has been achieved or not. Portfolio’s performance relative to the pre-specified benchmark.

POOLED INVESTMENTS

Investment Products by Minimum Investment Mutual funds Exchange traded funds

a) Portfolio Monitoring and Rebalancing: Once the portfolio has been constructed, it needs to be monitored and reviewed and consequently rebalanced in response to changes in security prices, changes in target asset weightings, changes in fundamental factors and changes in the need or circumstances of the client.

Mutual Funds

Mutual funds: Mutual fund is a comingled investment fund in which capital is pooled in by various individual investors and each investor has a pro-rata claim on the income and value of the fund. It is managed by a professional manager. Investors own shares (called units ) in the mutual fund.

The value of a mutual fund is called the “net asset value or NAV”. NAV is computed on a daily basis, based on the closing price of the securities in the portfolio. NAV depends on the value of the assets in the portfolio. Mutual funds typically invest in a particular category of investments. Mutual funds are subject to various limits and restrictions with regard to their investments. Advantages: Mutual funds provide portfolio diversification benefits to individual investors in an efficient manner. Mutual funds facilitate individual investors to avail the expertise of a professional manager at low costs. Types of Mutual Fund: 1) Opened-end: As the name suggests, an opened-end fund is opened to new investors i.e. it can accept new investment money. Additional shares can be issued and are sold at the current NAV per share.

Reading 38

Portfolio Management: An Overview

Example: Suppose,

depending on the demand for the shares.

NAV (or total value) of a mutual fund = US$10 million Total number of shares = 100,000 NAV per share = Initial value per share = US $10 million/100,000 = US$100

Opened-end v/s Closed-end Funds: Advantage of Opened-end funds: Unlike closed-end funds, the structure of opened-end funds makes it easy to increase the size of the fund. Disadvantages: Unlike closed-end funds,

Now suppose, NAV increases to US$12 million. NAV per share = US $12 million/100,000 = US$120 A new investor (F) is willing to invest US$0.96 million in the fund.

To accommodate the new investment, New shares need to be created = US$ 0.96 million / US $120 = 8,000. New NAV of the fund = US $12 million + US$ 0.96 million = US$12.96 million New total number of shares of the fund = 100,000 + 8,000 = 108,000. Investors can withdraw their investments from the fund at NAV per share. Suppose an investor “E” wants to withdraw all her shares worth US$0.6 million in the mutual fund. Thus, to accommodate this withdrawal,

Number of shares need to be retired = US$0.6 million/ US$120 = 5,000 shares. Type

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Investment (US$)

Shares

Inflow (investor F buys)

960,000

8,000

Outflow (Investor E sells)

–600,000

–5,000

Net

$360,000

3,000

It is important to note that the number of shares held and the value of the shares of all remaining investors, except Investor E would remain the same. Source: Volume 4, Reading 38.

2) Closed-end: As the name suggests, a closed-end fund is not opened to new investors i.e. it does not accept new investment money. New investors can invest into the fund by buying existing shares of the closed-end fund. Investors can liquidate their investments into the fund by selling their shares to other investors. Hence, the number of shares outstanding remains unchanged. Unlike open-end funds, shares in the closed-end funds can be sold for a premium or discount to NAV

Under opened-end funds, it is difficult for the portfolio manager to manage the cash inflows and outflows due to the need to find new assets for making investment and to liquidate assets to meet redemptions. Open-end funds cannot be fully invested because some cash needs to be kept to meet redemptions. Mutual funds can be classified as: Load Funds: Load funds involve following fees. 1) An annual fee based a % of the fund’s NAV. 2) Percentage of fee charged for investing in the fund or for redemptions from the fund. 3) An upfront fee charged by retail brokers (Since load funds are generally sold through retail brokers). No-load Funds: Under no-load funds, only an annual fee based on a % of the fund’s NAV is charged. 5.2

Types of Mutual Funds

The major types of mutual funds based on broad asset type that they invest in include 1) Money market funds (taxable and non-taxable): They can be viewed as a substitute for bank savings accounts. However, they are invested in a different manner from that of bank savings accounts. Basically, these funds are equivalent to cash holdings. As a result, NAV of money market fund is always equal to US$1.00 per share. Money market funds have short-term maturity i.e. overnight and ≤ 90 days. Types of money market funds: a) Taxable money market funds: They invest in highquality, short-term corporate debt and federal government debt. b) Non-taxable: They invest in short-term state and local government debt. 2) Bond mutual funds (taxable and non-taxable): These funds consist of portfolio of individual bonds and preferred shares (occasionally). NAV of bond mutual fund =  

Reading 38

Portfolio Management: An Overview

In a bond fund, an investor can invest for as little as US$100. Bond mutual funds have long-term maturity i.e. 1year, 30-years etc. Type of Bond Mutual Fund

Securities Held

5.3

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Other Investment Products

Exchange traded funds (section 5.3.1): Exchange traded funds (ETFs) are created by fund sponsors. A fund sponsor is responsible to select securities to be included in the basket of securities.

Global

Domestic and nondomestic government, corporate, and securitized debt

Government

Government bonds and other governmentaffiliated bonds

Corporate

Corporate debt

High yield

Below investment-grade corporate debt

An institutional investor deposits the securities with the fund sponsor and receives shares (called units) in return.

Inflation protected

Inflation-protected government debt

National tax-free bonds

National tax-free bonds (e.g., U.S. municipal bonds)

One unit typically represent between 50,000 and 100,000 ETF shares. An institutional investor can sell these shares to the public. The securities held in the ETF can be redeemed by investors by returning the number of shares in the original creation unit. Due to this in-kind redemption, shares are not traded at significant premiums or disc...