Investment Management
Investment
Management UNIT 2 – GLOBAL INVESTMENT AND DIRECT ALLOCATION DECISIONS
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Source Material
Reilly, F. K. & Brown, K.C. (2003). Investment Analysis, Portfolio
Management. 7th Ed. South Western Publishing
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Why Global Investment?
Large Foreign Market - The foreign market for stocks and bonds is huge.
U. S. markets comprise less than half of the total available securities
More opportunities allows for the broadening of the range of risk-return choices
The ROI Argument
The rates of return on non-U.S. securities often have substantially exceeded those for U.S.-only securities
Higher returns on equities are explained by higher growth rates in some countries
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Why Global Investment?
Diversification
Diversification with foreign securities can help reduce portfolio risk.
Since foreign investments are impacted by somewhat different forces than domestic investments, risks can be reduced.
The low correlation between U.S. stock markets and many foreign markets can help to substantially reduce portfolio risk
Barriers to global investing, both for companies and for individual investors, are getting smaller.
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Why Global Investment?
According to Surz (2018), the U.S. stock market is the largest in the world with the stock market valuing $34 trillion, compared to the rest of the world’s $44 trillion capitalization.
This represents 43% of world market value, a decrease from 50% in 2000
But the U.S. houses only 17% of the world’s stocks
Over the same period, emerging markets and Asia, namely China, have garnered increasing market shares.
Thus, ignoring foreign markets can substantially reduce the investment choices for investors.
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Rates of Return on US and Foreign Securities
The S&P 500 index is a benchmark of American stock
market performance, dating back to the 1920s.
The average annual return since adopting 500 stocks
into the index in 1957 through 2019 is roughly 8%.
A foreign security’s return in its domestic market is not the
“bottom line. ”
Exchange rates have a major impact on the
equivalent U. S. return on a foreign investment.
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Rates of Return on US and Foreign Securities
The key factor is the changing strength of the U. S. dollar
vis-à-vis the foreign currency.
Stronger dollar: Income from foreign investments get
exchanged for fewer dollars over time, reducing net
return for the U. S. investor.
Weaker dollar: Income from foreign investments get
exchanged for more dollars over time, increasing net
return for the U. S. investor.
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Risk Diversification
Recall that diversification involves risk reduction.
Correlations range from +1 (perfect positive correlation) to – 1 (perfect negative correlation)
By combining securities whose returns are not perfectly positively correlated with each other in a portfolio, the portfolio standard deviation characteristically falls.
The lower the correlation coefficient between investments, the greater the benefit of diversification.
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Risk Diversification
Correlations between U. S. markets and major foreign markets are relatively low.
In bond markets, the correlations, while positive, are all below +. 50
In equity markets, the correlations are a bit higher, but still relatively low with an average of about +. 54
The bottom line is that there is considerable benefit to international diversification.
Portfolios that are diversified internationally tend to have substantially lower standard deviations.
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Risk Diversification
Correlations also vary greatly between pairs of counties.
Macroeconomic differences cause the correlation of bond returns between the United States and foreign countries to differ
The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time
There is a higher correlation between U. S. and Canadian returns than between U. S. and various European returns.
As global competition and various regulatory barriers have fallen, correlations have increased.
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Global Investment Choices
Investments are divided by asset classes and are called
financial assets because their payoffs are in money
Fixed-Income Investments
Bonds, Preferred Stock
Capital market securities (at least one year to original
maturity)
Equity Instruments
Derivatives
Futures, Options
Managed Investments
Mutual Funds, Hedge Funds
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Fixed Income Investments
Except for preferred stock, fixed income securities are debts of the issuer. For e.g., bonds.
They promise specified cash flows at predetermined times.
The legal force behind the agreement varies by the type of security and issuer, and this affects the risks and required returns borne by the investor.
At one extreme, if the issuing firm does not make its payment at the
appointed time, creditors can declare the issuing firm bankrupt.
In other cases (for example, income bonds), the issuing firm must make
payments only if it earns profits.
Yet, in other instances (for example, preferred stock), the issuing firm
does not have to make payments unless its board of directors votes to
do so.
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Fixed Income Investments
Most fixed income instruments specify a number of features
including the following:
The maturity date – the date that the obligation is to be
fully repaid, according to its provisions.
The coupon rate – the income that the investor will
receive each year.
The par value – the principal value of the obligation;
usually the original value and also the amount to be
returned to the investor on the maturity date.
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Capital Market Instruments
Capital market instruments are fixed-income obligations
that trade in the secondary market,
These are securities which you can buy and sell to other individuals or institutions.
Capital market instruments fall into four categories:
Treasury securities
Government agency securities
Municipal bonds
Corporate bonds
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Treasury Securities
All government securities issued by the Treasury are fixed
income instruments.
They may be bills, notes, or bonds depending on their times
to maturity. Specifically,
T-bills mature in one year or less
T-notes in over one to 10 years
T-bonds in more than 10 years from time of issue
Government obligations are essentially free of credit risk
because there is little chance of default and they are highly
liquid.
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Government Agency Securities
Government Agency securities are sold by various agencies of the
government to support specific programs,
but they are not direct obligations of the Treasury.
Examples of agencies that issue these bonds include:
The Federal National Mortgage Association (FNMA or Fannie Mae)
which sells bonds and uses the proceeds to purchase mortgages from insurance companies or savings and loans
The Federal Home Loan Bank (FHLB)
which sells bonds and loans the money to its 12 banks, which in turn provide credit to sav ings and loans and other mortgage-granting institutions.
Other agencies are the Government National Mortgage Association (GNMA), Banks for Cooperatives, Federal Land Banks (FLBs), and the Federal Housing Administration (FHA).
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Municipal Bonds
Municipal bonds are issued by local government entities as either general
obligation or revenue bonds.
General obligation bonds (GOs) are backed by the full taxing power of the municipality
Revenue bonds pay the interest from revenue generated by specific projects
(e.g., the rev enue to pay the interest on sewer bonds comes from water taxes).
Municipal bonds differ from other fixed-income securities because they
are tax-exempt.
The interest earned from them is exempt from taxation by the federal gov ernment and by the state that issued the bond,
prov ided the inv estor is a resident of that state.
For this reason, municipal bonds are popular with investors in high tax
brackets.
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Corporate Bonds
Corporate bonds are fixed-income securities issued by industrial
corporations, public utility corporations, or railroads
to raise funds to invest in plant, equipment, or working capital.
They can be broken down by issuer, in terms of
credit quality (measured by the ratings assigned by an agency
on the basis of probability of default), eg. of bond rating
agencies S & P, Moody’s, & Fitch. Most designations range from
high (or AAA to AA), medium (or A to BBB), and low (or BB, B,
CCC, CC to C)
maturity (short term, intermediate term, or long term),
based on some component of the indenture (sinking fund or call
feature).
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Corporate Bonds
All bonds include an indenture,
the legal agreement that lists the obligations of the issuer
to the bondholder, including the payment schedule and
features such as call provisions and sinking funds.
Call provisions specify when a firm can issue a call for
the bonds prior to their maturity, at which time current
bondholders must submit the bonds to the issuing firm,
which redeems them (that is, pays back the principal
and a small premium).
A sinking fund provision specifies payments the issuer
must make to redeem a given percentage of the
outstanding issue prior to maturity.
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Types of Corporate Bonds
• Mortgage bonds are
backed by liens on specific assets, such as
land and buildings.
• In the case of bankruptcy, the
proceeds from the sale of these assets are
used to pay off the mortgage
bondholders.
Collateral Trust Bonds
Collateral trust bonds
are a form of
mortgage bond
except that the assets
backing the bonds
are financial assets,
such as stocks, notes,
and other high-quality
bonds.
Equipment Trust Certificates
Equipment trust certificates
are mortgage bonds that
are secured by specific
pieces of transportation
equipment, such as
locomotives and boxcars
for a railroad and airplanes
for an airline.
Secured bonds are the most senior bonds in a firm’s capital structure and have the lowest risk of distress or default. They include various secured issues that differ based on the assets that are pledged.
Mortgage Bonds
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Types of Corporate Bonds
Unsecured bonds or debentures are backed only by the firm’s promise to
pay.
Debentures promises to pay interest and principal, but they pledge no
specific assets (collateral) in case the firm does not fulfill its promise.
This means that the bondholder depends on the success of the
borrower to make the promised payment.
Debenture owners usually have first call on the firm’s earnings and any
assets that are not already pledged by the firm as backing for senior
secured bonds.
If the issuer does not make an interest payment, the debenture owners
can declare the firm bankrupt and claim any unpledged assets to pay
off the bonds.
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Types of Corporate Bonds
• Subordinated bonds are similar to debentures, but, in the case of default, subordinated bondholders have claim to the assets of the firm
• only after the firm has
satisfied the claims of all
senior secured and
debenture bondholders.
• Within this general category of subordinated issues, you can find senior subordinated, subordinated, and junior subordinated bonds. Junior subordinated bonds have the weakest claim of all bondholders.
Income Bonds
• Income bonds st ipulat e int erest payment schedules, but t he int erest is due and payable only if t he issuers earn t he income t o make t he payment by st ipulat ed dat es.
• I f t he company does not earn t he required amount , it does not have t o make t he int erest payment and it cannot be declared bankrupt .
• Instead, the interest payment is considered in arrears and, if subsequently earned, it must be paid off.
• Because of this feature, income bonds offer higher returns to compensate investors for the added risk.
• I ncome bonds are fairly popular wit h municipalit ies.
Convertible Bonds
• Convertible bonds have t he int erest and principal charact erist ics of ot her bonds, wit h t he added feat ure t hat t he bondholder has t he opt ion t o t urn t hem back t o t he firm in exchange for it s common st ock.
• For example, a firm could issue a $1,000 face-value bond and stipulate that owners of the bond could turn the bond in to the issuing corporation and convert it into 40 shares of the firm’s common stock.
• These bonds appeal t o invest ors because t hey combine t he feat ures of a fixed-income securit y wit h t he opt ion of conversion int o t he common st ock of t he firm, should t he firm prosper.
• Because of t heir desirable conversion opt ion, convert ible bonds generally pay lower int erest rat es t han nonconvert ible debent ures of comparable risk.
Subordinated Bonds
Zero coupon bond promises no interest payments during the life of the bond but only the payment.
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International Bond Investing A Eurobond is an international bond denominated in a currency not native to
the country where it is issued. Eurobonds are typically issued in Europe, with the major concentration in London.
Specific kinds of Eurobonds include
Eurodollar bonds
Euro-yen bonds
Euro-deutschemark bonds
Euro-sterling bonds
A Euro-dollar bond is denominated in U.S. dollars and sold outside the United States to non-U.S. investors.
A specific example would be a U.S. dollar bond issued by General Motors and sold in London.
Eurobonds can also be denominated in yen.
For example, Nippon Steel can issue Euro-yen bonds for sale in London.
Also, if it appears that investors are looking for foreign currency bonds, a U.S. corporation can issue a Euroyen bond in London.
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Yankee Bonds and International Domestic Bonds
Yankee bonds are sold in the United States, denominated in U.S. dollars, but issued by foreign corporations or governments.
This allows a U.S. citizen to buy the bond of a foreign firm or government but receive all payments in U.S. dollars, eliminating exchange rate risk.
An example would be a U.S. dollar–denominated bond issued by British Airways.
Similar bonds are issued in other countries, including the Bulldog Market, which involves British sterling–denominated bonds issued in the United Kingdom by non-British firms, or the Samurai Market, which involves yen-denominated bonds issued in Japan by non- Japanese firms.
International domestic bonds are sold by an issuer within its own country in that country’s currency.
An example would be a bond sold by Nippon Steel in Japan denominated in yen. A U.S. investor acquiring such a bond would receive maximum diversification but would incur exchange rate risk.
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Bond Ratings
Most bonds are rated for default, or credit risk by one or more rating
agency.
Duff and Phelps
Fitch Investors Service
Moody’s
Standard & Poors (S & P)
Ratings are from AAA to D, some agencies give slightly different
modifiers or letters
Top four ratings (AAA down to BBB): Investment Grade Securities
Below the top four ratings: Speculative Grade Securities (High-yield
or junk bonds)
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Preferred Stock
Preferred stock is classified as a fixed-income security because its
yearly payment is stipulated as either
a coupon (for example, 5 percent of the face v alue) or
a stated dollar amount (for example, $5 preferred).
Preferred stock differs from bonds because its payment is a dividend
and therefore not legally binding.
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Equities
Returns are not contractual; rather, returns vary according to performance, and can be much better or much worse than fixed income investments.
Equity represents an ownership interest.
The owner gets as much or as little as is left over after all fixed and higher priority claims have been met.
The most common equity investment is in common Stocks.
Relatively risky investment compared to fixed income securities
When considering an investment in common stock, people tend to divide the vast universe of stocks into categories based on general business lines and by industry within these business lines.
The division includes broad classifications for industrial firms: utilities, transportation firms, and financial institutions.
Within each of these broad classes are industries with the most div erse industrial groupings include: industries as automobiles, industrial machinery, chemicals, and bev erages.
Ut ilit ies include elect rical power companies, gas suppliers, and t he wat er indust ry.
Transport ation includes airlines, t rucking firms, and railroads. Financial inst it utions include banks, savings and loans, insurance companies, and invest ment firms.
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Foreign Equity Investments
There are several means of obtaining an equity interest
in foreign investments. This can be facilitated through:
American Depository Receipts (ADRs)
Direct investment in foreign shares
listed on a U. S. or foreign stock exchange
Indirect investment in international or global mutual
funds
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American Depository Receipts (ADRs)
This is the easiest way to acquire foreign shares
Certificates are issued by a U. S. bank
Represent indirect ownership of shares of a foreign firm on deposit in a bank in the firm’s home country
Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.
Buy and sell in U. S. dollars
Dividends in U. S. dollars
May represent multiple shares
Very popular - over 2000 ADR programs in over 70 countries available in 2012
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Direct Investment in Foreign Shares
The most difficult approach, especially when purchasing
stock in the foreign country (in the foreign currency) and
transferring back to the investor’s home country.
A growing number of foreign firms do list their stock
directly on the NYSE.
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International and Global Mutual Funds
Allows investment in both U. S. and foreign stocks
International funds: invest mostly outside the U. S.
Funds can specialize and allow for:
Diversification across many countries
Concentrate in a segment of the world
Concentrate in a specific country
Concentrate in types of markets
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Derivative Securities
A derivative is a security whose price is dependent upon or derived from
one or more underlying assets.
The derivative itself is merely a contract between two or more parties.
Its value is determined by fluctuations in the underlying asset.
The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
There are many types of derivative investments, including financial
derivative securities whose payoffs are tied to various financial assets.
Options
Warrants
Puts and calls
Futures contracts
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Options
An options is a financial derivative that represents a
contract sold by one party (option writer) to another party
(option holder).
Warrants - give the owner the right to purchase a
company’s common stock from the company at a
specified price within a designated period of time.
Puts and calls - give the owner the right to sell (put) or buy
(call) a company’s stock within a specified period of time
at a specified price (called the striking price).
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Futures Contract
These are standardized contracts to make or take
delivery of some financial (or other) asset in exchange
for a specified payment at a future date.
Payment is not due until the future date, but a margin (a good faith deposit) is required.
Futures contracts are often used to manage risk,
especially the risk of changing interest rates and
exchange rates.
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Managed Investments
Managed Investments enable you to invest while leaving
the burden of management in the hands of specialists.
Hedge Funds: typically act as a partnership where one partner manages funds for all other partners according to some investment strategy.
Venture capital pools: Similar to hedge funds, these partnerships obtain an equity interest in a promising start- up or privately held firms.
Real Estate Investment Trusts (REITs): provides investors with an indirect means of investing in real estate.
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Asset Allocation Decisions
Asset Allocation is the process of deciding how to
distribute an investor’s wealth among different
countries and asset classes for investment purposes
An Asset Class is a group of securities that have
similar characteristics, attributes, and risk/return
relationships
A broad asset class, such as “bonds,” can be divided into smaller asset classes, such as Treasury bonds, corporate bonds, and high-yield bonds.
Much of an asset allocation strategy depends on the investor’s policy
statement, which includes the investor’s goals or objectives, constraints,
and investment guidelines.
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Managing Risks 37
Managing Risks Risk management involves:
Identification- for this to be effectively the types and categories of risk
must be known.
Measurement- after risks are identified the potential impact must be
quantified in order to effectively determine the strategies for minimizing
the impact.
Controls- determine the level of risk the firm can take, and take actions
that bring the actual level to desired level.
This can include policies, limits, hedges, futures, etc.
Reporting and Review- risk exposure and controls strategies are reported
to senior management and board of directors.
Review and assessment of controls are periodically conducted.
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Managing Risks 39
Individual Investor Lifecycle: Preliminaries
Life Insurance: Providing death benefits and, possibly, additional cash
values
Term life and whole life insurance
Universal and variable life insurance
Non-life Insurance
Health insurance & disability insurance
Automobile insurance & Home/rental insurance
Cash Reserve
To meet emergency needs
Equal to six months living expenses
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Phases of the Lifecycle
Accumulation phase
Early to middle years of working career
Consolidation phase
Past midpoint of careers. Earnings greater
than expenses
Spending/Gifting phase
Begins after retirement
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Phases of the Lifecycle 42
Phases of the Lifecycle
Accumulation Phase Indiv iduals in the early-to-middle years of
their working careers and are attempting to accumulate assets to satisfy fairly immediate needs
For example, a down payment for a house or longer-term goals such as children’s college education, retirement
Typically, their net worth is small, and debt from car loans or their own past college loans may be heav y.
As a result of their typically long inv estment time horizon and their future earning ability, indiv iduals in the accumulation phase are willing to make relativ ely high-risk inv estments in the hopes of making abov e av erage nominal returns ov er time.
Consolidation Phase Indiv iduals are typically past the midpoint
of their careers, hav e paid off much or all of their outstanding debts, and perhaps hav e paid, or have the assets to pay, their children’s college bills.
Earnings exceed expenses, so the excess can be inv ested to prov ide for future retirement or estate planning needs.
The typical inv estment horizon for this phase is still long (20 to 30 years), so moderately high-risk inv estments are attractive.
At the same time, because indiv iduals in this phase are concerned about capital preserv ation, they do not want to take v ery large risks that may put their current nest egg in jeopardy.
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Phases of the Lifecycle
Spending Phase This phase typically begins when indiv iduals retire.
Living expenses are covered by social security income and income from prior investments, including employer pension plans.
Because their earning years have concluded (although some retirees take part-time positions or do consulting work), they seek greater protection of their capital.
A t the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation.
The av erage 65- year-old person in the United States has a life expectancy of about 20 years. Thus, although their ov erall portfolio may be less risky than in the consolidation phase, they still need some risky growth inv estments, such as common stocks, for inflation (purchasing power) protection.
Gifting Phase
The gifting phase is similar to, and may be concurrent with, the spending phase.
In this stage, individuals believe they hav e sufficient income and assets to cover their expenses while maintaining a reserve for uncertainties.
Excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.
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Lifecycle Investment Goals
Near-Term, High- Priority Goals
• These are short er-t erm financial object ives t hat individuals set t o fund purchases t hat are personally import ant t o t hem, such as accumulat ing funds t o make a house down payment , buy a new car, or t ake a t rip.
• Parent s wit h t eenage children may have a near-t erm, high priorit y goal t o accumulat e funds t o help pay college expenses.
• Because of t he emot ional import ance of t hese goals and t heir short t ime horizon, high-risk invest ment s are not usually considered suit able for achieving t hem.
Long-Term, High- Priority Goals
• This typically include some form of financial independence, such as the ability to retire at a certain age.
• Because of their long-term nature, higher-risk investments can be used to help meet these objectives.
Lower-Priority Goals
• It might be nice to meet these objectives, but it is not critical.
• Examples include the ability to purchase a new car every few years, redecorate the home with expensive furnishings, or take a long, luxurious vacation.
• A well-developed policy statement considers these diverse goals over an investor’s lifetime.
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Investing Early and Often 46
The Portfolio Management Process
The process of managing an investment portfolio never
stops.
Once the funds are initially invested according to the plan, the real work begins in monitoring and updating the status of the portfolio and the investor’s needs.
The Portfolio Management Process:
Specifies investment goals and acceptable risk levels
Should be reviewed periodically
Guides all investment decisions
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The Portfolio Management Process 48
The Portfolio Management Process
Step 1 – Construct a Policy Statement
The investor, either alone or with the assistance of an investment advisor, must construct a policy statement.
The policy statement is a road map. In it, investors specify the types of risks they are willing to take and their investment goals and constraints.
All investment decisions are based on the policy statement to ensure they are appropriate for the investor.
Because investor needs change ov er time, the policy statement must be periodically reviewed and updated.
Step 2 – Determine Investment Strategy
The investor or the manager should study current financial and economic conditions and forecast future trends.
The investor’s needs, as reflected in the policy statement and financial market expectations will jointly determine investment strategy.
Economies are dynamic; they are affected by numerous industry struggles, politics, and changing demographics and social attitudes.
Thus, the portfolio will require constant monitoring and updating to reflect changes in financial market expectations.
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The Portfolio Management Process
Step 3 - Construct the Portfolio
With the investor’s policy statement and financial market forecasts as input, the investor or the advisors implement the investment strategy
and determine how to allocate av ailable funds across different countries, asset classes, and securities.
This involves constructing a portfolio that will minimize the investor’s risks while meeting the needs specified in the policy statement.
Step 4 - Continual Monitoring
Continuous monitoring of the investor’s needs and capital market conditions and, when necessary, updating the policy statement is critical.
Based upon all of this, the inv estment strategy is modified accordingly.
A component of the monitoring process is to ev aluate a portfolio’s performance and compare the relative results to the expectations and the requirements listed in the policy statement.
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The Need for Policy Decision
While it does not guarantee investment success, a policy
statement will provide discipline for the investment process and
reduce the possibility of making hasty, inappropriate decisions.
There are two important reasons for constructing a policy
statement:
First, it helps the investor decide on realistic investment goals
after learning about the financial markets and the risks of
investing; so when asked about their investment goals,
people won’t just say, “to make a lot of money,” or some
similar response.
Second, it creates a standard by which to judge the
performance of the portfolio manager.
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The Need for Policy Decision
Another important purpose of writing a policy statement is to help investors understand their own needs, objectives, and investment constraints.
As a part of this, investors need to learn about financial markets and the risks of investing.
This background will help prevent them from making inappropriate investment decisions in the future and will increase the possibility that they will satisfy their specific and measurable financial goals.
The policy statement helps the investor to specify realistic goals and become more informed about the risks and costs of investing.
Constructing a policy statement is mainly the investor’s responsibility.
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The Need for Policy Decision
The policy decision also sets the standards for
evaluating portfolio performance.
Provides a comparison standard in judging the performance of
the portfolio manager.
Benchmark portfolio or comparison standard is used to reflect
the risk an return objectives specified in the policy statement
Should act as a starting point for periodic portfolio review and
client communication with the manager
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Constructing the Policy Statement
Constructing the policy statement begins with a profile analysis of the
investor’s current and future financial situations and a discussion on
investment objectives and constraints.
Objectives
Risk
Return
Constraints
Liquidity
Time horizon
Tax factors
Legal and regulatory constraints
Unique needs and preferences
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Investment Objective
The investor’s objectives are his or her investment goals expressed in terms of both risk and returns.
The relationship between risk and returns requires that goals not be expressed only in terms of returns.
Expressing goals only in terms of returns can lead to inappropriate investment practices by the portfolio managers,
such as the use of high-risk investment strategies or account “churning,”
which involves moving quickly in and out of investments in an attempt to buy low and sell high.
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Investment Objective
Risk objectives should be based on investor’s ability to
take risk and willingness to take risk.
Risk tolerance depends on an investor’s current net
worth and income expectations and age
More net worth allows more risk taking
Younger people can take more risk
Careful analysis of client’s risk tolerance should
precede any discussion of return objectives
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Investment Objective
The return objective may be stated in terms of an
absolute or a relative percentage return,
but it may also be stated in terms of a general goal
such as:
capital preservation
current income
capital appreciation
total return
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Investment Objective
Capital Preservation
Capital preservation means that investors want to minimize their risk of loss, usually in real terms.
As such, they seek to maintain the purchasing power of their investment.
That is, the return needs to be no less than the rate of inflation.
Generally, this is a strategy for strongly risk-averse investors or for funds needed in the short-run, such as for next year’s tuition payment or a down payment on a house.
Capital Appreciation
Capital appreciation is an appropriate objective when investors want the portfolio to grow in real terms over time to meet some future need.
Under this strategy, growth mainly occurs through capital gains.
This is an aggressiv e strategy for inv estors willing to take on risk to meet their objectiv e.
Generally, longer-term investors seeking to build a retirement or college education fund may have this goal.
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Investment Objective
Current Income
When current income is the return objective, the investors want the portfolio to concentrate on generating income rather than capital gains.
This strategy sometimes suits investors who want to supplement their earnings with income generated by their portfolio to meet their living expenses.
Retirees may favor this objective for part of their portfolio to help generate spendable funds.
Total Return
The objective for the total return strategy is similar to that of capital appreciation; namely, the investors want the portfolio to grow over time to meet a future need.
Whereas the capital appreciation strategy seeks to do this primarily through capital gains, the total return strategy seeks to increase portfolio value by both capital gains and reinvesting current income.
Because the total return strategy has both income and capital gains components, its risk exposure lies between that of the current income and capital appreciation strategies.
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Investment Objective: 25-Year-Old
Assume he holds a steady job, is a v alued employee, has adequate insurance cov erage, and has enough money in the bank to prov ide a cash reserv e.
Let’s also assume that his current long- term, high-priority inv estment goal is to build a retirement fund.
Depending on his risk preferences, he can select a strategy carrying moderate to high amounts of risk because the income stream from his job will probably grow ov er time.
Further, giv en his young age and income growth potential, a low-risk strategy, such as capital preserv ation or current income, is inappropriate for his retirement fund goal;
a total return or capital appreciation objective would be most appropriate.
Here’s a possible objective
statement:
“Invest funds in a variety of m oderate- to higher-risk investments.
The average risk of the equity portfolio should exceed that of a broad stock market index, such as the NYSE stock index.
Foreign and domestic equity exposure should range from 80 percent to 95 percent of the total portfolio.
Remaining funds should be invested in short- and intermediate-term notes and bonds”.
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Investment Objective: 65-Year-Old Assume our typical 65-year-old inv estor
likewise has adequate insurance cov erage and a cash reserv e.
Let’s also assume she is retiring this year.
This individual will want less risk exposure than the 25-year-old investor, because her earning power from employment will soon be ending;
she w ill not be able to recov er any inv estment losses by sav ing more out of her paycheck.
Depending on her income from social security and a pension plan, she may need some current income from her retirement portfolio to meet liv ing expenses.
Giv en that she can be expected to liv e an av erage of another 20 years, she will need protection against inflation.
A risk-av erse inv estor will choose a combination of current income and capital preserv ation strategy;
a more risk-tolerant investor will choose a combination of current income and total return in an attempt to have principal growth outpace inflation.
Here’s a possible objective
statement:
“Invest in stock and bond investments to meet income needs (from bond income and stock dividends) and to provide for real growth (from equities).
Fixed-income securities should comprise 55–65 percent of the total portfolio;
Of this, 5–15 percent should be invested in short-term securities for extra liquidity and safety.
The remaining 35–45 percent of the portfolio should be invested in high- quality stocks whose risk is similar to the S&P 500 index”.
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Investment Constraints Liquidity Needs An asset is liquid if it can be quickly converted
to cash at a price close to fair market value.
Generally, assets are more liquid if many traders are interested in a fairly standardized product.
Treasury bills are a highly liquid security; real estate and v enture capital are not.
Investors may have liquidity needs that the investment plan must consider.
For example, although an inv estor may hav e a primary long-term goal, sev eral near-term goals may require av ailable funds.
Wealthy indiv iduals with sizable tax obligations need adequate liquidity to pay their taxes without upsetting their inv estment plan.
Some retirement plans may need funds for shorter-term purposes, such as buying a car or a house or making college tuition payments.
Our typical 25-year-old investor probably has little need for liquidity as he focuses on his long- term retirement fund goal.
This constraint may change, however, should he face a period of unemployment or should near-term goals, such as honeymoon expenses or a house down payment, enter the picture.
Should any changes occur, the investor needs to revise his policy statement and financial plans accordingly?
Our soon-to-be-retired 65-year-old investor has a greater need for liquidity.
A lthough she may receive regular checks from her pension plan and social security, it is not likely that they will equal her working paycheck.
She will want some of her portfolio in liquid securities to meet unexpected expenses or bills.
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Investment Constraints
Time Horizon Time Horizon: A close (but not perfect)
relationship exists between an investor’s time horizon, liquidity needs, and ability to handle risk.
Investors with long investment horizons generally require less liquidity and can tolerate greater portfolio risk:
less liquidity because the funds are not usually needed for many years;
greater risk tolerance because any shortfalls or losses can be overcome by returns earned in subsequent years.
Investors with shorter time horizons generally favor more liquid and less risky investments because losses are harder to overcome during a short time frame.
• Because of life expectancies, our 25-year-
old inv estor has a longer inv estment time
horizon than our 65-year-old inv estor.
• But, as discussed earlier, this does not mean
the 65-year-old should put all her money in
short-term CDs;
• she needs the inflation protection that
long-term inv estments, such as
common stock, can prov ide.
Because of the differing time horizons,
the 25-year-old will probably have a greater proportion of his portfolio in
equities, including stocks in growth companies, small firms, or international
firms, than the 65-year-old.
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Investment Constraints
Our typical 25-year-old inv estor probably is in a fairly low tax bracket, so detailed tax planning will not be a major concern, and tax- exempt income, such as that av ailable from municipals, will also not be a concern.
Nonetheless, he should still invest as much as possible into tax deferred plans, such as an IRA or a 401(k).
The drawback to such inv estments, howev er, is that early withdrawals (before age 591⁄2) are taxable and subject to an additional 10 percent early withdrawal tax. Should the liquidity constraint of these plans be too restrictiv e, the young inv estor should probably consider total-return- or capital-appreciation- oriented mutual funds.
If the 65-year-old retiree was in a high tax bracket prior to retiring—and has sought tax- exempt income and tax-deferred inv estments— her situation may change shortly after retirement.
Without large, regular paychecks, the need for tax deferred inv estments or tax-exempt income becomes less. Taxable income may now offer higher after-tax yields than tax-exempt municipals due to the inv estor’s lower tax bracket.
Should her employer’s stock be a large component of her retirement account, careful decisions must be made regarding the need to div ersify v ersus the cost of realizing large capital gains (in her lower tax bracket).
Tax Concerns: Investment planning is complicated by the tax code. Taxes complicate the situation even more if international investments are part of the portfolio. Taxable income from interest, dividends, or rents is taxable at the investor’s marginal tax rate. The marginal tax rate is the proportion of the next one dollar in income paid as taxes.
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Taxes and Interest Income Assuming a marginal tax rate of 26%, an investor that receives
$2,000 in interest income will have a $520 tax liability ($2,000 X 26%)
So as an investor if you received $2,000 interest income on a
$100,000 investment that would be a 2% ROI on a pre-tax basis,
what would be your after-tax ROI?
After Tax Return on Investment (AT -ROI)
AT - ROI = Pre-tax ROI X ( 1 – Marginal Tax Rate)
After Tax Return on Investment (AT -ROI)
AT – ROI = Pre-Tax ROI X ( 1 – Marginal Tax Rate)
AT - ROI = 2% X ( 1 – .26 ) = 1.48%
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Investment Constraints
Tax-free Income
income that is NOT subject to income taxes
Tax Free Savings Accounts (TSFA)
tax-free investments
Tax deferred investments
compound tax free but when withdrawn are subject to taxes
Registered Retirement Savings Accounts (RRSP)
individuals can deposit money into and earned tax deferred income
At withdrawal, all funds are subject to tax
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Legal and Regulatory Factors
The investment process and financial markets are highly regulated.
At times, these legal and regulatory factors constrain the
investment strategies of individuals and institutions.
Funds removed from a regular IRA account or 401(k) plan before
age 591⁄2 are taxable and subject to an additional10 percent
withdrawal penalty.
You may also be familiar with the tag line in many bank CD
advertisements— “substantial interest penalty upon early
withdrawal.”
Such regulations may make such investments unattractive for
investors with substantial liquidity needs in their portfolios
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Legal and Regulatory Factors
Regulations can also constrain the investment choices available
to someone in a fiduciary role.
A fiduciary, or trustee, supervises an investment portfolio of a third party, such as a trust account or discretionary account and must make investment decisions in accordance with the owner’s wishes.
A properly written policy statement assists this process.
In addition, trustees of a trust account must meet the
“prudent-man” standard, which means that they must invest
and manage the funds as a prudent person would manage
his or her own affairs.
Notably, the prudent-man standard is based on the composition of the entire portfolio, not each individual asset in the portfolio.
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Legal and Regulatory Factors
For our typical 25-year-old investor, legal and regulatory matters will be of little concern,
with the possible exception of
insider trading laws; and
penalties associated with early
withdrawal of funds from tax-
deferred retirement accounts.
Should he seek a financial advisor to assist him in constructing a financial plan, the financial advisor would have to obey the regulations pertinent to a client- advisor relationship.
Similar concerns confront our 65-year- old investor.
In addition, as a retiree, if she wants to do some estate planning and set up trust accounts, she should seek legal and tax advice to ensure her plans are properly specified and implemented.
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Unique Needs and Preferences
This category covers the individual concerns of each investor.
Some investors may want to exclude certain investments from their portfolio
solely on the basis of personal preferences.
For example, they may request that no firms that manufacture or sell tobacco, alcohol, pornography, or env ironmentally harmful products be included in their portfolio.
As of 2001, ov er 200 mutual funds include at least one social-responsibility criterion.
Because each investor is unique, the implications of this final constraint differ
for each person;
there is no “typical” 25-year-old or 65-year-old investor.
Each individual will have to communicate specific goals in a well-
constructed policy statement.
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Importance of Asset Allocation
Asset Allocation is the process of dividing funds among different asset classes.
A major reason why investors develop policy statements is to determine an overall investment strategy.
Though a policy statement does not indicate which specific securities to purchase and when they should be sold, it should prov ide guidelines as to the asset classes to include and the relativ e proportions of the inv estor’s funds to inv est in each class.
Rather than present strict percentages, asset allocation is usually expressed in ranges.
This allows the inv estment manager some freedom, based on his or her reading of capital market trends, to inv est toward the upper or lower end of the ranges.
For example, suppose a policy statement requires that common stocks be 60 percent to 80 percent of the value of the portfolio and that bonds should be 20 percent to 40 percent of the portfolio’s value.
If a manager is particularly bullish about stocks, she will increase the allocation of stocks toward the 80 percent upper end of the equity range and decrease bonds toward the 20 percent lower end of the bond range.
Should she be more optimistic about bonds, that manager may shift the allocation closer to 40 percent of the funds inv ested in bonds with the remainder in equities.
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Importance of Asset Allocation
A review of historical data and empirical studies provides strong support for
the contention that the asset allocation decision is a critical component of
the portfolio management process.
In general, four decisions are made when constructing an investment
strategy:
What asset classes should be considered for investment?
What normal or policy weights should be assigned to each eligible asset class?
What is the allowable allocation ranges based on policy weights?
What specific securities should be purchased for the portfolio?
The asset allocation decision comprises the first two points.
How important is the asset allocation decision to an investor?
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Financial Markets
A financial market is a broad term describing any
marketplace where buyers and sellers participate in the trade
of assets
such as equities, bonds, currencies and derivatives.
Financial markets are typically defined by having
transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices of securities that trade.
Some financial markets only allow participants that meet
certain criteria,
w hich can be based on factors like the amount of money held, the investor’s geographical location, know ledge of the markets or the
profession of the participant.
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Financial Markets
Most financial markets have periods of heavy trading
and demand for securities.
In these periods, prices may rise above historical norms.
The opposite is also true – downturns may cause prices to
fall past levels of intrinsic value,
based on low levels of demand or other macroeconomic forces like tax rates, national production or employment levels.
Information transparency is important to increase the confidence of participants and therefore foster an
efficient financial marketplace.
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Functions of a Financial Market
Intermediary Functions – these include:
Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers
Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income
Productive usage: Financial markets allow for the productive use of the funds borrowed thereby enhancing the income and the gross national production
Capital formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country
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Functions of a Financial Market
Price determination: Financial markets allow for the determination of
price of the traded financial assets through the interaction of buyers
and sellers. They provide a sign for the allocation of funds in the
economy based on demand and supply through the mechanism
called price discovery process;
Sale mechanism: Financial markets provide a mechanism for selling
of a financial asset by an investor so as to offer the benefit of
marketability and liquidity of such assets;
Information: The activities of participants in the financial market
result in the generation and subsequent dissemination of information
to various segments of the market so as to reduce the cost of
transaction of financial assets.
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Functions of a Financial Market
Financial Functions of financial markets include the following:
Providing the borrower with funds so as to enable them to carry out
their investment plans.
Providing the lenders with earning assets so as to enable them to
earn wealth by deploying the assets in production debentures;
Providing liquidity in the market so as to facilitate trading of funds.
Providing liquidity to commercial banks;
Facilitating credit creation;
Promoting savings;
Promoting investment;
Facilitating balanced economic growth; and
Improving trading floors.
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