1. Investment Setting, Asset Allocation, Money Management and Ethics(2)

7/28/2019 1. Investment Setting, Asset Allocation, Money Management and Ethics(2)

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BAFI045

Investment

The Investment Setting, AssetAllocation, MoneyManagement & Industry Ethics

RMIT University


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RMIT University Slide 2RMIT University Slide 2

Reference

Reilly, Frank K. and Keith C. Brown, Analysis ofInvestmentand Management Portfolios (9thEdition), Thomson South-Western, 2009. Chapters 1 (pp. 3-9); 2 (pp. 35-54); and 24


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RMIT University Slide 3

What Is An Investment?

Defining Investment: A current commitment of $for a period of time in order to derive futurepayments that will compensate for:

The time the funds are committed

The expected rate of inflation

Uncertainty of future flow of funds

Reason for Investing

By investing (saving money now instead of spendingit), individuals can tradeoff present consumption fora larger future consumption.

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Historical Rates of Return

Return over A Holding Period Holding Period Return (HPR)

Holding Period Yield (HPY)

HPY = HPR - 1

Annual HPR and HPY

Annual HPR = HPR1/n

Annual HPY= Annual HPR1 = HPR1/n 1

where n = number of years of the investment

InvestmentofValueBeginning

InvestmentofValueEndingHPR=

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Example: Assume that you invest $200 at thebeginning of the year and get back $220 at the end

of the year. What are the HPR and the HPY for your

investment?

HPR =

HPY =

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Computing Mean Historical ReturnsSuppose you have a set of annual rates of return(HPYs or HPRs) for an investment. How do youmeasure the mean annual return?

Arithmetic Mean Return (AM)AM = HPY / n

where HPY = the sum of all the annual HPYs

n = number of years

Geometric Mean Return (GM)

GM = [ HPR]1/n - 1where HPR = the product of all the annual HPRs

n = number of years

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Suppose you invested $100 three years ago and it isworth $110.40 today. The information below showsthe annual ending values and HPR and HPY. Thisexample illustrates the computation of the AM and

the GM over a three-year period for an investment.

Year Beginning Ending HPR HPYValue Value

1 100 115.0 1.15 0.152 115 138.0 1.20 0.20

3 138 110.4 0.80 -0.20

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AM = HPY / n=

GM = [ HPR]1/n - 1=

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Comparison of AM and GM

When rates of return are the same for allyears, the AM and the GM will be equal.

When rates of return are not the same for allyears, the AM will always be higher than theGM.

The AM is best used as an expected valuefor an individual year, while the GM is the bestmeasure of an assets long-term performance.

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A Portfolio of Investments

Portfolio HPY: The mean historical rate of return for a

portfolio of investments is measured as

the weighted average of the HPYs for the individual investments inthe portfolio, or

the overall change in the value of the original portfolio.

The weights used in the computation are the relative beginning

market values for each investment, which is often referred to as

dollar-weighted or value-weighted mean rate of return.

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The following exhibit demonstrates how to computethe rate of return for a portfolio of 3 stocks.

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The Portfolio Management Process

Policy Statement Specifies investment goals and acceptable risk levels

Should be reviewed periodically

Guides all investment decisions

Study Current Financial and Economic

conditions and forecast future trends

Determine strategies to meet goals Requires monitoring and updating

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The Portfolio Management Process

Construct the Portfolio Allocate available funds to minimize investors risks

and meet investment goals

Monitor and Update

Evaluate portfolio performance

Monitor investors needs and market conditions

Revise policy statement as needed Modify investment strategy accordingly

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What is Asset Allocation?

Asset Allocation The process of deciding how to distribute an

investors wealth among different countries and asset

classes for investment purposes.

Asset Class Refers to the group of securities that have similar

characteristics, attributes, and risk/return relationships.

Investor: Depending on the type of investors,investment objectives and constraints vary

Individual investors

Institutional investors


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The Importance of Asset Allocation

An investment strategy is based on fourdecisions

What asset classes to consider for investment

What policy weights to assign to each eligible class

What allocation ranges are allowed based on policyweights

What specific securities to purchase for the portfolio

According to research studies, most (85% to95%) of the overall investment return is due tothe first two decisions, not the selection ofindividual investments

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The Asset Management Industry:

Structure and Evolution Two Organization Forms

Contract directly with a management and advisoryfirm

Commingling of investment capital of several clients

in an investment company Approximately 9500 professionally managed funds in

Australia

Differences between These Two Forms

Private management and advisory firms develop apersonal relationship with clients

A Investment company offers a general solution

See Exhibit 24.1


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Exhibit 24.1


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Valuing Investment Company

Shares

The NAV for an investment company isanalogous to the share price of acorporations common stock.

The NAV of the fund shares will increaseas the value of the underlying assets (thefund security portfolio) increases.

Total Market Value of Fund Portfolio Fund ExpensesFund NAV=

Total Fund Shares Outstanding


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Closed-End Versus Open-EndInvestment Companies

Closed-End Investment Company

Functions like any other public firm and its stock

trades on the regular secondary market

The fund generally doesnt issue or redeem sharesonce it is established

The price of the fund is different from its NAV

It is a puzzle for modern finance why close-end funds

often sell at a discount from NAV

It is often a means of investing in a pool of assets

from a foreign country


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Open-End Investment Companies

The company continues to sell and

repurchase shares after their initial public

offerings

The fund stands ready to issue or redeem

shares at the net asset value (NAV)

Investors who buy or sell the shares mayhave to pay sales charges (the load)

These funds are normally called mutual funds


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Load versus No-Load Open-End Fund

The offering price for a share of a load fund equals

the NAV of the share plus a sales charge.

A no-load fund imposes no initial sales charge so it

sells shares at the NAV.

Several variations exist between the full-load fund

and the pure no-load fund

Low-load fund

Funds have contingent, deferred sales loads


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Fund Management Fees

Charge annual management fees to

compensate professional managers of the

fund

The fee typically is a percentage of theaverage net assets of the fund varying from

about 0.25 to 1.00 percent Management fees are a major factor driving

the creation of new funds


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Global Investment Companies

Funds that invest in non-Australian securities (e.g.,Singaporean securities) are generally called eitherinternational funds or global funds

International funds often hold only non-Australian securitiesfrom such countries as US, Germany, Japan, and Korea

Global funds contain both Australian and non-Australiansecurities

A increasing large number of investment companiesoffer both domestic and global products in the localmarkets


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Investing in Alternative Assets

Increasing trend towards committing financialcapital in non-traditional asset classes

Hedge funds

Private equity


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Investing in Alternative AssetClasses

Management Structure

Structured as a limited partnership rather than asa mutual fund to manage the commingled assets

The Fund alpha Abnormal returns generated by the fund, implying

the superior performance by the fundmanagement


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Exhibit 24.14


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Hedge Funds

The Characteristics As a private partnership, hedge funds are generally

less restricted in how and where they can makeinvestments

Less correlated with traditional asset classinvestments, providing diversification benefits

Hedge fund investments are far less liquid thanmutual fund (or even closed-end fund) shares

There are severe limitations on when and how often

investment capital can be contributed to or removedfrom a partnership

Performance allocation and high-watermark


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Private Equity

Basic Concepts Refers to any ownership interest in an asset (or

assets) that is not tradable in a public market Typically fund either new companies or established firms that

are seeking to change their organizational structure or areexperiencing financial distress

Generally far less liquid than public stock holdings and aretherefore considered to be long-term positions within aninvestors overall portfolio

Characteristics Higher return and low liquidity

Good sources of diversification

See Exhibit 24.21


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Exhibit 24.21


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Private Equity

Returns to Private Equity Funds Private equity commitments should be

viewed as long-term, highly illiquidinvestments

The return pattern known as the J-curveeffect

Average annual returns for these investmentstend to be quite high over time

The initial years of a new private equitycommitment usually produce negative returns


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Ethics and Regulation in the Professional

Asset Management Industry

Agency problem

Regulation in the asset management

industry Principal securities laws that govern

investment companies

Differ across countries Regulatory agencies

Differ across countries


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RMIT U i it Slid 33

Ethics and Regulation in the Professional

Asset Management Industry

Examples of Ethical Conflicts

Incentive Compensation Schemes

Soft Dollar Arrangements Marketing Investment Management Services

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1. Investment Setting, Asset Allocation, Money Management and Ethics(2)

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