INVESTMENT & PORTFOLIO MANAGEMENT (BF409): LECTURE NOTES (Incomplete)
COMPILED BY
NJABULO NKOMAZANA
Lecturer, Department of Banking & Finance
Midlands State University
UNIT 1: INVESTMENT PROCESS
INTRODUCTION
The investment process falls into three stages:
1. PLANNING
This involves five elements:
1) Analysis of investor conditions in order to determine the requirements of your clients.
2) Analysis of market conditions
3) Understanding investor’s reasons for investment (to offset obligations or speculation)
4) Statement of investment policy (SIP), which is the constitution of the portfolio to be managed in terms of preferences for managing the portfolio. It contains the objectives of the portfolio, which is the dominant desire of the client. It details dos and don’ts.
5) Strategic asset allocation (SAA) as opposed to tactical asset allocation (TAA). SAA is the break down of asset classes in your asset allocation eg: Equity – 30%, Bonds – 40%, Real estate – 10% and Money – 20%. SAA is an asset allocation determined at the inception of the portfolio. It is a base asset mix determined or established on expected risks and returns. On the other hand, TAA is an attempt to profit from misevaluation. The objective is to move among various asset classes within a risk-controlled framework to seek to create an additional source of return. An attempt is made to take advantage of short and immediate term market inefficiencies as a means of managing investors’ exposure to market risk.
2. IMPLEMENTATION
This is divided into three:
(a) Rebranding the SAA. As the horizon date comes near, the consumer becomes less risk tolerant, moving towards cash
(b) Rebalancing the TAA
(c) Security selection
TAA overweight the asset class that you think is undervalued and underweight the asset class that is overvalued. It is also referred to as market timing or beta trading.
3. MONITORING & EVALUATION
This is divided into two:
(a) Monitor to ensure there is compliance with the constitution (SIP)
(b) Measure the performance of the portfolio and the performance of the fund managers. Measurement is used against a benchmark eg. CAPM
UNIT 2: STATEMENT OF INVESTMENT POLICY (SIP)
INTRODUCTION
Translating the aspirations and circumstances of diverse households into appropriate decisions is difficult. The task is equally difficult for institutions, most of which have many stakeholders and often are regulated by various authorities. While many principles of investments are quite general and apply to virtually all investors, some issues are peculiar to the specific investor. For example, age, tax bracket, risk tolerance, wealth, job prospects and uncertainties make each investor’s circumstances somewhat unique.
The statement of investment policy (SIP) systematically reviews the objectives, constraints and strategies that should guide fund management of clients’ portfolio. It involves specifying objectives, specifying constraints, formulating policy and later monitoring and updating the portfolio as needed.
1. OBJECTIVES
Portfolio objectives centre on the risk-return trade-off between the expected return the investors want and how much risk they are willing to assume (risk tolerance). They should represent the most important requirements of the client.
Can either stated precisely or otherwise. Imprecise objectives can be as follows: maximise portfolio returns for the portfolio risk assumed or for the portfolio beta assumed. They can also be stated precisely as follows:
o Long-term real return of 4%
o Long-run nominal return of 100 basis points above the ZSE industrial index
o Long term real return of 4% in which 8% is invested in a broadly diversified portfolio of equity and 1-8% in broadly diversified portfolio of high grade corporate bonds.
The objectives should:
o Communicate the portfolio owner’s major desire
o Easily be understood by the client
o Easily be understood by others in the portfolio’s management such as the board of trustees, Management Company, auditors and portfolio managers.
Different types of investors have different return requirements and risk tolerance.
Types of investors and their objectives
o Individual investors – factors affecting individual investor return requirements and risk tolerance are life-cycle stage and individual preferences.
o Pension funds – objectives depend on the type of pension plan. They are two basic types of pension schemes, which are: defined contribution plan (tax-defered retirement saving accounts established by the firm in trust for its employees, with the employees bearing all the risk and receiving all the return from the plan) and the defined benefit plans (here the assets of the sponsoring firm serve as collateral for the liabilities that the firm sponsoring the plan owes to plan beneficiaries).
o Endowment funds – they are organisations chartered to use their money for specific non-profit purposes. They are financed through gifts from one or more sponsors and are typically managed by educational, cultural and charitable organisations or by independent foundations established solely to carry out the fund’s purposes. Their investment objectives are usually to produce a steady flow of income subject to only a moderate degree of risk. However, other objectives can be specified as dictated by circumstance of a particular fund.
o Banks – given that most of banks’ investments are loans and that most of their liabilities are depositors’ account, their objective would be to try to match the risk of assets to liabilities whilst earning profitable spread between lending and borrowing rates.
2. CONSTRAINTS
These are restrictions placed on the fund manager by the client or a board representing the trustees. Both individuals and institutional investors restrict their choice of investment assets. Examples include;
Regulations -
Portfolio risk – in theory risk is measured by a number of things eg: standard deviation, beta (CAPM), etc. in practice, aggregate risk is usually defined as the percentage of portfolio allocated to a different security types eg: 60-40 portfolio of equity and debt instrument simply implies you have to put your money 60% in equity and 40% in debt.
Allowed/disallowed securities – securities included in each asset group must be well defined eg: if 40% of all assets is to be invested in fixed income securities, the following variables should be clearly defined:
o Duration – average age generated by the portfolio.
o Default risk required – also known as credit risk eg only AAA bonds should be included.
o Callability – the minimum call risk (the risk that the issuer of a bond decides to call it before it matures). To minimise call risk, only non-callable bonds can be included.
Investment horizon – (planned liquidation date of the investment or part of it). For a university endowment fund, an investment horizon could relate to the time to fund a major campus construction project. They should be considered when investors choose between assets of various maturities such as bonds which payoff at specific future dates.
Diversification – the extent to which clients want it to be classified within and between asset classes. This extent should be stated and can be done in several ways:
o State the minimum number of securities desired eg: 60% in equity, only 70counters etc.
o Maximum number of securities which can be held in a portfolio eg; not more than 10% should be invested in the financial sector
o Stating the market coefficient of determination ().The more diversified a portfolio is reflected by its .
Tax and liquidity – the performance of any investment strategy is measured by how much it yields after taxes. Investors who do not want to pay tax such as pension funds may wish to exclude securities which are priced in large part for tax advantages. Tax sheltering and deferral of tax obligations may be pivotal in their investment strategy. Liquidity (the ease with which an asset can be sold and still fetch a fair price) needs vary considerably with the amount invested. Cash and money market securities are the most liquid assets and real estate is among the least liquid. Both individuals and institutional investors should consider how likely they are to dispose of assets at short notice. From this likelihood, they establish the minimum level of liquid assets they want in the investment portfolio. Liquidity can be achieved by:
o Allocation of a percentage of portfolio to short-term money market securities
o Requiring the fixed income securities to be highly marketable (tradable).
Moral obligations – involves profitability investment on religious morals, political grounds etc.
Unique needs – hedging from the collapse of one’s industry, stage of life cycle
3. ASSET ALLOCATION (STRATEGY)
Consideration of clients’ objectives and constraints leads investors to a set of investment policies. Asset allocation involves deciding how much of the portfolio to invest in each major asset category. The process of asset allocation consists of the following steps:
1. Specify asset classes to be included in the portfolio. The major classes usually considered are: Money market instruments, fixed-income securities, Stocks, Real estate, and precious metals.
2. Specify capital market expectations – do the historical data analysis and economic analysis to determine your expectations of future rates of return.
3. Derive the efficient portfolio frontier – finding portfolios that achieve the maximum expected return for any given degree of risk.
4. Find the optimal asset mix – select the best portfolio that best meets your risk and return objectives while satisfying the constraints you face. The extent to which you are allowed to speculate with client’s money. The SIP should discuss the extent to which market timing and security selection can be used.
Assignments:
UNIT 3: PORTFOLIO THEORY
INTRODUCTION
The basic model was developed by Harry Markowitz (1952, 1959), when he derived the expected rate of return for a portfolio of assets and an expected risk measure. He showed that the variance of the rate of return was a meaningful measure of portfolio risk under reasonable set of assumptions. Before presenting the portfolio theory, we need to clarify some general assumptions of the theory. The Markowitz model is based on several assumptions regarding investor behaviour:
(i) Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period.
(ii) Investors maximise one period expected utility and their utility curves demonstrate diminishing marginal utility of wealth.
(iii) Investors estimates the risk of the portfolio on the basis of the variability of expected returns
(iv) Investors base investment decisions solely on expected return and risk, such that their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.
(v) Investors are risk-averse. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a give level of expected return, investors prefer less risk to more risk.
Under these assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offer higher expected return with the same (or lower) level of risk or lower risk with the same (or higher) expected return.
RISK AND RISK AVERSION
Risk is the uncertainty of future outcomes or the probability of an adverse outcome. The presence of risk means that more than one outcome is possible.
Practise question
Suppose we invest $400 000 with two possible outcomes:
o $600 000 with a probability of 0.6
o $300 000 with a probability of 0.4
We can represent the simple prospects using an event tree as follows:
$600 000
$400 000
$300 000
Suppose you are offered an investment with a payoff in the first year described by such a simple prospect (above), how would you evaluate it?
Solution
(i)
(ii)
(iii)
(iv)
The expected return per each unit of risk is $3.27. If the coefficient of variation is less than 1, then it is a risky asset.
Suppose we have an alternative to buy Treasury Bills which have a guaranteed return of 12.5% per annum, the decision tree would look as follows:
$400K
This illustrates that the expected profit of the risky portfolio over investing in safe TBs (risk premium) is:
RISK AVERSION AND UTILITY VALUES
Investors differ in terms of their risk tolerance levels. Risk-averse investors reject investment portfolios with zero risk-premium. Instead they are willing to consider only risk-free or speculative prospects with positive risk premium.
Investors can rank their portfolios using utility scores, with higher utility values being assigned to portfolios with more attractive risk-return profiles. The scoring system commonly used is as follows:
Where is the utility value, is the expected return of an individual asset or portfolio, is the variance of returns, A is an index of the investor’s risk aversion and 0.005 is the scaling convention that allows us to express the expected return and standard deviation as percentages rather than decimals.
Note:
· The higher the expected return, the higher the utility and vice versa.
· The higher the risk, the lower the utility.
· The extent to which variance affects utility depends on the attitude towards risk. A high A means a higher aversion to risk and a low A means more tolerance of risk.
Example:
A portfolio has an expected rate of return of 20% and a standard deviation of 20%. The TB rate is 7%. Which investment alternative will be chosen by an investor whose ? What if ?
Solution:
(Risky portfolio)
(TB – Risk free portfolio)
Since the utility from a risky portfolio is higher than that of TBs (risk free portfolio), the investors should invest in the portfolio.
However, if :