Completing Portfolio Management Project - Final Steps - Reserved for Prof Scofield
anglia85
final_paper_example.docxPortfolio Management Project 1
Portfolio Management Project
Your Name
FINC 340
My Name
Abstract
This project deals with many aspects of portfolio management. The investment policy helps the client and the manager to have a clear understanding what type of portfolio will be set up to accomplish specific goals. Changes that should be corrected from the initial investment policy are thoroughly explained. Then the actual investments of 10 common stocks, 3 mutual funds, 2 ETFs, 5 bonds, 5 option contracts and 5 futures contracts are chosen based on the investment policy. These investments each have certain purpose to achieve the goal mentioned in the investment policy. The portfolio overall had made profit at the end of week 6, but when looking at the risk and beta of the portfolio, there was too much risk involved. It might be due to the small sample size of just few weeks but it’s still a concern. Some of the ways that this problem could be fixed in other portfolios is to have a very clear and detailed investment policy and for manager to follow strictly based on that agreement. It’s vital for manager to understand what the client want exactly and what they are trying achieve.
Introduction
Given the situation where the client wants a diversified portfolio with $100,000 invested in each of the following types of securities: Stocks, Bonds, Options and Futures. In this project, the client will be <Client>. With $400,000 worth of assets allocated in different mix of investments, the goal is to protect and enhance the values of the portfolio. The reason why his money is separated into stocks, bonds, options and futures are for diversification. Given the goals of the client and economic conditions, this project will discuss risk and return objectives, what changes should be made to investment policy statement, why specific securities were selected, investment performance, portfolio risk and what was learned from this project.
Investment Policy
The purpose of this investment Policy Statement is to establish a clear understanding between the investor <Client> and the investment advisor <You> as to the investment objectives and policies applicable to the investor’s investment portfolio. This statement will:
· Establish reasonable expectations, objectives, and guidelines in the investment of the Portfolio’s assets
· Set forth an investment structure detailing permitted asset classes, normal allocations and permissible ranges of exposure for the portfolio
· Encourage effective communication between the Investor and the Advisor
· Create the Framework for a well diversified asset mix that can be expected to generate acceptable long term returns at a level of risk suitable to the investor
The statement has been developed from an evaluation of many key factors which impact the investor’s specific situation and investment objectives. This statement is not a contract but intended to be a summary of an investment philosophy that provides guidance for the investor and the advisor.
Scope and Purpose
<You>, as financial adviser to <Client>, is responsible to develop a diversified portfolio with $100,000 invested in each of the following types of securities: Stocks, Bonds, Options and Futures.
Governance
<Your Name> is responsible for monitoring the investing requirements of <Client> as well as monitoring investment and economic issues, and <Client> is responsible for suggesting changes to the IPS as necessary. <You> will also suggest revisions annually after reviewing the asset allocation. <You> also has responsibility of evaluating all the risk and make sure the investments do not exceed tolerable limits.
Goal and Objective
<Client> has two kids who are in elementary school. They will be attending college in little more than 10 years. <Client>’s goal is to invest $100,000 on different types of securities to have enough to pay for the two kids’ college and also to have enough financially when he plans to retire in 20 years.
Types of Investments
Thorough research will be done on companies when choosing the common stocks. How the company deals with their products and development of future products will be looked at. Company’s research & development, profit margin, and future outlook will be looked at when selecting common stocks. Also, well-known companies will be mixed with lesser-known companies in order to balance the risk from lesser-known companies.
The mutual funds that will be selected will be for a long-term need, for college fund and retirement fund. There will be good amount of risk and volatility, however, there is potential for a large reward. Two will be selected from a long-term capital appreciation fund while one will be selected from balanced fund, which will balance out the risk with riskier mutual funds.
The factors for choosing the ETFs will include level of assets, trading activity and index that has wide industry. These factors will be considered to make sure that the ETF has a good liquidity. Another factor to consider will be when the ETF was constructed. Any newfangled ETFs will be avoided.
One of the first things that will be considered when choosing the bonds will be the rating for risk management. The goal is to lower the risk because the fund from bonds are mainly for college fund and retirement fund as well. The maturity dates will be picked so that there are ones for college fund and ones that expire around retirement time. When looking at yield, diversification will be used so that there is a balance between risk and yield.
Option contracts that will be selected will be for short-term, as to this option is usually cheaper and provides short-term asset. The risk and reward will be balanced by mixing call options and put options.
Lastly, the future contracts will be mainly based on what goes on in each sectors of the economy. That is going to tell whether to pick the future contracts or not. The maturity dates were diversified in order to balance out the risk and reward.
Expected return
Common stocks, mutual funds, ETFs and bonds will be mainly used for long-term investment, mostly return for college fund and retirement fund. The option contracts and future contracts will give you return for the short-term liquidity.
Changes to Investment Policy
Based on the experience gained managing the portfolio, there are some aspects that I would like to add or describe more in detail in the initial investment policy statement. First thing is including investment constraints. Although the client is willing to spend $400,000 in different investments, discussing the liquidity constraints on whether he needs a certain amount of liquidity back at certain point would have helped with choosing what types of investment. If not liquidity constraints, discussing more time constraint would have set a clear and direct guideline on what types of investments to choose and what the maturity for those investments would be. After I was looking at all the data from portfolio, I also realized that tax concerns were not discussed. Since different investments have different tax laws, discussing with the client about tax concerns in investment policy would have also helped choosing the types of investment. Special circumstances where client does not want to invest in certain companies due to not sharing the same vision would’ve been also helpful in investment policy. Secondly, discussing risk tolerance more in depth would be useful. I did choose investments with diversification so that there would be balance of risk and return but putting exactly what the risk tolerance of the client and presenting with the worst-case returns for different asset classes historically would be helpful for the client. If the client did not have stable sources of funds available, the client might have wanted a low risk portfolio, but for this project, it’s assumed that the client has stable sources of funds. Third, discussing the benchmark would’ve been helpful for the client to be able to compare different investments’ performance. This will also help the client to let the manager know what he wants to achieve based on the benchmark. Lastly, it would have been better to discuss expected return more in depth. This helps the client how much he should be expected whenever the portfolio comes to maturity.
Construction of Portfolio
As discussed in investment policy, many factors were considered when choosing the common stocks. I will go over few of them as examples. Domino’s Pizza Inc. is one of the most well known companies in the world. When looking at their SEC 10-K, you realize that they put a huge emphasis on research and development. They mention that they “do not consider the amounts spend on research and development to be material.” (EDGAR) Another article discusses a way to order pizza even easier and faster. For those who own an apple watch, “the company has launched a one tap easy order app.” (Anderson, 2016) These future outlooks led me to choose Domino’s Pizza Inc. I have also added two gold companies IBX and SMNF that are lesser-known companies. The price per share for those two companies is less than $8.00 per share. However recent article mentions that “as over a billion Chinese people deal with the realities of currency Depreciation, the long term prospects for gold look better than they have for several years.” (Tillier, 2016) However, because the price of gold fluctuates, those two stocks are high-risk & high-reward stocks. I paired them up with the likes of stable well-known companies with the likes of Domino’s Pizza Inc. and AT&T, Inc. in order to create a diversification. The three mutual funds will be comprised of long-term capital appreciation fund and balanced fund. Pioneer Value A (PIOTX) fund and Janus Global Research T (JAWWX) fund both have holdings in stocks that are over 95%. This is going to increase the risk, but these are used for long-term mutual fund. ProFunds Telecom UltraSector Inc (TCPIX) have holding of 57% in stocks and 43% in cash. This is considered a balanced fund and although this is also going to be used for long-term, there is lower risk involved creating another diversification. The two ETFs chosen are Global X SuperDivident ETF (SDIV) and SPDR S&P International Dividend ETF (DWX). They both have trade volume of 344,848 and 173,382, which symbolize good liquidity for both. Also, since they both have net assets of upwards $700 million, there is no worry for liquidity. The fund inception dates are 2011 and 2008 respectively, so there is no worry of newfangled ETFs. When choosing the bonds, they were diversified as well. There are three corporate bonds and three municipal bonds. The two municipal bonds will be used for retirement fund because of the maturity date and the other three will be for the college fund. The Morgan Stanley has a high coupon rate of 10%, but the rest of the bonds including Goldman Sachs, Quebecor Inc. Royal Oak Mich and California Statewide who have a coupon rate of around 5% balances that yield out. When checking the ratings on Moody’s, all five bonds had acceptable rating level. When dealing with option contracts, I tried to balance out the call and put options. Because the maximum loss for put options is unlimited, there are three call options to two put options to balance them out. The maturity of the option contracts are short as they are mainly used for short-term assets. Once they mature, then could be used for other investments. When deciding the future contracts, I looked mainly at the news and how different sectors are doing. I came across an article regarding copper that “there is a growing chance of a short-term bound from oversold conditions.” (Colombo, 2016) Another article mentions crude oil stating, “Energy companies soared as the price of American benchmark crude jumped 9 percent.” (The AP, 2016). Like the two example mentioned above, all five future contracts including natural gas, Euro FX and Coffee were all chosen based on what was happening in their respective sectors.
Investment Performance
All asset categories of portfolio were able to make profit during the holding period except for the future contracts. For stocks, the beginning value of total investment was $99,993.50 and the ending value of total investment at the end of week 6 was $112,882.38. In order to calculate the holding period return (HPR), we need to subtract the initial value of total investment from the ending value of total investment then divide by the initial investment. The holding period return is $12,888.88 and the return rate is 12.89%. If you compare that to S&P 500 during that time period, the HPR for the benchmark is 1.94%. During week two through week six, stocks made much more profit than the S&P 500. The stock that made the major increase were CoreSite Realty Corporation (COR), Domino’s Pizza Inc. (DPZ), and Barrick Gold Corporation (ABX). COR and DPZ’s price per share increased by six and 8 dollars respectively. ABX’s price per share almost doubled from $7.58 to $12.54. This is due to investing on different underground mine in Nevada and Peru’s Lagunas Norte mine (Gomez, 2016). There weren’t any stocks whose per share value decreased. The initial expectation was that the overall stock value will increase and I believe they will only increase over time because of the research that many of the companies are doing to improve their products and services while markets suggest other products to be more in demand as well.
For bonds, we are going to use government bonds as a benchmark bonds. When calculating the HRP for the five bonds that are selected, the beginning value is $99,943.15 and the ending value of investment is $100,252.70. The holding period return is $309.55 and the return rate is 3.1%. The index for the U.S. Treasury bond is $414.80 for initial value of investment and $419.04 for ending value of investment. The HPR for U.S. Treasury bond is at 2.44%. The portfolio performed slightly better than the benchmark index. The price per bond price actually decreased for all five bonds but the estimated interest earned is the only reason why the ending value of total investment was higher than the initial investment. However, these bonds have at least seven to almost 26 more years until they mature so there is no reason to worry about the decrease. I did not think to make any major profits during the first 4 weeks of investing in these five bonds and the results were expected based on initial expectation. However, as time passes and the interest on the bond increase while the bond price also increase, will only increase the profit of the bonds.
For option contracts, the beginning value of total investments was $97,100.00 while the ending value of total investments was $106,000.00. There was HPR of $8,900 with the return rate being 9.17%. The benchmark for option contracts will be CBOE Holdings, Inc. The beginning price per option is $66.29 and the ending value per option is $61.68. Without an actual calculation, the HPR for the portfolio is way higher than that of the benchmark because benchmark has a negative HPR during this period of time. However, the option contracts in the portfolio didn’t all improve. The only ones that had a higher per option premium were RRD1618C14 and DIN1618O90. DIN1618O90 issued by DineEquity, Inc. is what brought the ending value of total investments. It has the higher increase of per option premium of ninety cents. Combined with 200 contracts compared to the others with 100 contracts were able to increase the end value by a little. The results were very different from what was initially expected. Since the maturity month is only a month away, I chose these five option contracts to make quick profit but that didn’t happen except for the one issued by DIN which saved option contracts as whole. The option contracts part of the portfolio will need active management so they could be sold at the right time.
Lastly, future contract was the only with lower total ending value. The total beginning face value of contracts was $25,750,525.00 while the total ending face value of contracts was $25,314,025.00. There was a loss of $436,500 in the face value of contracts with the holding period return rate being -1.84%. Because the five future contracts were from different sectors in the economy, there was no benchmark to compare it with the five future contracts combined. The one future contract that hurt my portfolio the most was natural gas. This was a result of gas pricing plummeting “dropping to below $32 a barrel, the cheapest oil has been in the last 12 years according to CNBC.” (Jones, 2016) The price of crude oil increased by 60 cents per 1,000 barrel, which help portfolio balance out the loss from natural gas. The results for the future contracts were also different from the initial expectation. The three are very short-term future contracts so they will require active management as well. Euro FX and coffee contracts would be checked occasionally for reevaluation.
Portfolio Risk
The portfolio risk will be determined by calculating the beta for different parts of portfolio. Usually beta is calculated by covariance of the return of an asset and the return of the benchmark divided by the variance of the return of the benchmark. However, due to limited data, we are going to use the simple formula of (stock’s rate of return – risk-free rate) / (market’s rate of return – risk-free rate). The risk-free rate in this scenario is going to be substituted with the three month U.S. Treasury bill which is at .30% currently. If you plug the data in, the beta for the stocks is at 7.67. What this symbolizes is that the stock is more volatile than the market as a whole. Since there was a huge increase in a short amount of time, there is a possibility of dramatic price change in another short time period in either direction. This symbolizes high risk and high reward. Using the Security Market Line (SML), the expected return based on the capital asset pricing model is 12.88%. This also represents the unsystematic risk involved with the stocks. This has higher beta than I expected originally. I expected the beta to be somewhere between 0 and 1 so that the stock is less volatile than the market with less likely for dramatic price change but due for a steady increase.
For bonds, the market rate of return was 2.44% while the bonds rate of return was 3.1%. Once calculated, the beta for the set of bonds comes out to be 1.31. The beta is still higher than 1 meaning there is a possibility of dramatic price change in short amount of time causing high risk and high reward situation. The beta was not as high as stocks so I am not worried about it as much. For stocks and bonds, this could be caused by a small sample size of just few weeks when they are both supposed to be long-term investments. Using the SML, we could find the expected return of the bonds to be 3.1%. The value is lower than the stocks once again, showing lower risk. The bonds portfolio risk was a lot closer to the initial expectation than that of stocks.
Option contracts in the portfolio has rate of return of 9.17% compared to -6.95% market rate of return during week four through week six. The beta for option contracts calculates to be in the negatives. When there is a negative beta, it usually means that the contracts have inverse relation to the market. This is usually very unlikely but possible. Some examples of a negative beta are gold because they usually do better when the stock market declines. This is also very different from the initial expectation, as portfolio was not expecting a negative beta. However, this could also be caused by a small sample size. When using the SML, the expected return of the optional contracts is negative 13.9%. However, the actual data shows that we had increase in final value of total investment. The small sample size shows that these set of optional contracts are very risky.
As mentioned above, regarding the future contracts, because all five are in different sectors of the economy, it’s hard to put them as one and try to find the beta of the portfolio. However, comparing the future contracts separately shows that the future contracts are as risky as the optional contracts. However, we were only able to obtain the data for two weeks from the future contracts.
What Was Learned
While I was conducting this project, I realized that it is very important to understand and maintain the investment policy. Greed stopped me from making selections based on investment policy and more so on how to obtain more profit. That was not the main goal of the client. The main goal of the client was to invest for long-term and be able to use that asset for college fund and retirement fund. Although the sample size was too small to really show how the portfolio would’ve behaved, when calculating the risk, betas were consistently high. Investment policy needs to be strong and very detailed so that the client and the manager could follow the guideline agreed on the policy. This would get rid of all the confusions that lead for manager to pick the wrong investments for the client. After completing the project, I realize that my initial expectation and future outlook could have been strengthened. This could allow the client to be able to evaluate and compare the current results with the initial expectation and also be able to know what to expect in the future. Overall, I learned that portfolio management requires a lot more planning than I thought with attention to details being the very important part. You also have to be able to invest from the client’s point of view instead of what you think would be best in general.
References
Anderson, E. (2016, January 1). Domino's launches 'ultimate hangover angel' that makes ordering pizza even easier. Retrieved February 24, 2016, from http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/leisure/12077384/Dominos-launches-ultimate-hangover-angel-that-makes-ordering-pizza-even-easier.html
Ahlback, J. D. (2003). INVESTMENT POLICY STATEMENT. Retrieved January 25, 2016, from http://www.ewp.rpi.edu/hartford/~youneh/INVII/Week 2/Investment Policy Statement/JD Powers/Investment Policy Statement.pdf
Colombo, J. (2016, January 25). Is The Worst Over For Copper? Retrieved February 24, 2016, from http://www.forbes.com/sites/jessecolombo/2016/01/25/is-the-worst-over-for-copper/#1201a0967593
DPZ 10-K. (2016, February 25). Retrieved February 26, 2016, from http://yahoo.brand.edgar-online.com/DisplayFiling.aspx?TabIndex=2
Gomez, A. (2016, February 22). Here’s Why Barrick Gold (ABX) Stock is Higher Today. Retrieved February 25, 2016, from http://www.thestreet.com/story/13466705/1/here-rsquo-s-why-barrick-gold-abx-stock-is-higher-today.html
Elements of an Investment Policy Statement for Individual Investors. (2010, May). Retrieved January 25, 2016, from http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2010.n12.1
Fu, L. (2016, January 12). Low gas prices result of struggling world economy. Retrieved February 25, 2016, from http://www.redandblack.com/athensnews/low-gas-prices-result-of-struggling-world-economy/article_e862461c-b8ee-11e5-8861-eb53fb64d5eb.html
Moody's - credit ratings, research, tools and analysis for the global capital markets. (n.d.). Retrieved February 26, 2016, from https://www.moodys.com/
