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Traditional Investments Covers

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Security Analysis and Portfolio Management

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Security Analysis

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Involves estimating the merits of individual investments. A three-step process - 1. The analyst considers prospects for the economy, given the stage of the business cycle, 2. The analyst determines which industries are likely to fare well in the forecasted economic conditions, 3. The analyst chooses particular companies within the favored industries. This is an EIC Analysis, top down approach, Economic, Industry, Company.

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Portfolio Management

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Deals with the construction and maintenance of a collection of investments.

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Portfolio management literature supports the efficient markets paradigm

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On a well-developed securities exchange, asset prices accurately reflect the tradeoff between relative risk and potential returns of a security. Efforts to identify undervalued securities are fruitless. Free lunches are difficult to find.

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Market efficiency and Portfolio management

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A properly constructed portfolio achieves a given level of expected return with the least possible risk

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Six Steps of Portfolio Management

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1. Learn the basic principles of finance, 2. Set portfolio objectives, 3. Formulate an investment strategy, 4. Have a game plan for portfolio revision. Steps 1-4 deal with Evaluate performance, Steps 2-4 deal with protect the portfolio when appropriate.

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1. Background, basic principles, and investment policy

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A person cannot be an effective portfolio manager without a solid grounding in the basic principles of finance. The two key concepts in finance are: 1. a dollar today is worth more than a dollar tomorrow, 2. a safe dollar is worth more than a risky dollar. These two ideas form the basis of all aspects of financial management. There is no distinction between "good companies" and "good investments". The stock of a well-management company may be too expensive, and the stock of a poorly-run company can be a great investment if it is cheap enough. Other important concepts, the economic concept of utility and return maximization (given a level of risk). Setting objectives: investment policy - it is difficult to accomplish your objectives until you know what they are, terms like growth or income may mean different things to different people. Investment policy - the separation of institutional money managers. A board of directions or investment policy committees established policy. An investment manager implements the policy.

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2. Portfolio Construction

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Formulate an investment strategy based on the investment policy statement. Portfolio managers must understand the basic elements of capital markets theory - informed diversification, naive diversification, and beta. International investment - emerging markets carry special risk, emerging markets may not be informationally efficient.

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Stock categories and security analysis

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Preferred stock, blue chips, defensive stocks, cyclical stocks, and valuation of stocks.

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Security Screening

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A screen is a logical protocol to reduce the security universe to a workable number for closer investigation.

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Debt Securities

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Pricing, duration - enables the portfolio manager to alter the risk of the fixed-income portfolio component, and bond diversification.

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Pension funds

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Significant holdings in gold and timberland (real assets) and in many respects, timberland is an ideal investment for long-term investors with no liquidity problems

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3. Portfolio management

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Subsequent to portfolio construction - conditions change, portfolios need maintenance. Passive management has the following characteristics - follow a predetermined investment strategy that is invariant to market conditions, or do nothing, let the chips fall where they may. Active management requires the periodic changing of the portfolio components as the manager's outlook for the market changes. Options and option pricing - Black-Scholes option pricing model. Option overwriting - a popular activity designed to increase the yield on a portfolio and to improve performance in a flat market. Use of stock options under various scenarios. Performance evaluation - did the portfolio manager do what he or she was hired to do? Someone needs to verify that the firm followed directions. Interpreting the numbers? How much did the portfolio earn? How much risk did the portfolio bear? Must consider risk in conjunction with return. More complicated when there are cash deposits and/or withdrawals from the portfolio. More complicated when the manager uses options to enhance the portfolio yield.

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4. Portfolio Protection and Contemporary Issues

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Portfolio protection - called portfolio insurance prior to 1987, a managerial tool to reduce the likelihood that a portfolio will fall in value below a predetermined minimum level. Futures - related to options, use of derivative assets to generate additional income and manage risk. Interest rate risk - duration, Contemporary issues - exchange-traded funds, security analyst or objectivity, stock lending (short sales), regulatory concerns, islamic finance margins, structured products, CFA program.

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Valuation

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Valuation may be the most important part of the study of investments. Security analysts make a career of estimating "what you get" for "what you pay". The time value of money is one of the two key concepts in finance and is very useful in valuation.

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Growing Income Streams

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A growing stream is one in which each successive cash flow is larger than the previous one. A common problem is one in which the cash flows grow by some fixed percentage.

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Growing Annuity

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A growing annuity is an annuity in which the cash flows grow at a constant rate g.

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Growing Perpetuity

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A growing perpetuity is an annuity where the cash flows continue indefinitely.

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Safe Dollars and Risky Dollars

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A safe dollar is worth more than a risky dollar. Most investors are risk averse - people will take a risk only if they expect to be adequately rewarded for taking it. People have different degrees of risk aversion - some people are more willing to take a chance than others.

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Covered Call

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Strike = 50, Price = 250, Own stock, we gain as price goes up. We collect premium from option, but payout money to the owner as the price goes up, negating our gain from owning the stock.

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Naked Call

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Strike = 50, Price = 250, Do not own stock, as price goes up we have unlimited amount to payout, even though we keep premium, unlimited losses because the price could go up to inifinity.

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Risk

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Involves the chance of loss. If a particular horse will win at the track if you made a bet.

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Uncertainty

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Involves a doubtful outcome, what birthday gift you will receive, if a particular horse will win at the track.

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Dispersion and Chance of Loss

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There are two material factors we use in judging risk: the average outcome, and the scattering of the other possibilities around the average. Two securities have the same arithmetic mean, A has less dispersion, B has more, investment B is riskier than investment A

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Total risk

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Refers to the overall variability of the returns of financial assets.

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Non-diversifiable risk

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The risk that must be borne by virtue of being in the market. Arises from systematic factors that affect all securities of a particular type.

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Diversifiable risk

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Can be removed by proper portfolio diversification (unsystematic risk). The ups and downs of individual securities due to company-specific events will cancel each other out. The only return variability that remains will be due to economic events affecting all stocks.

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Relationship between Risk and Return

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Direct Relationship, Role of Utility, Diminishing Marginal Utility of Money, The Consumption Decision, Other Considerations

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Direct Relationship

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The more systematic risk someone bears, the higher the expected return, the more appropriate discount rate depends on the risk level of the investment, the risk-free rate of interest can be earned without bearing any risk.

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Diminishing Marginal Utility of Money

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Rational people prefer more money to less, money provides utility. Diminishing marginal utility of money, the relationship between money and added utility is not linear. "I hate to lose more than I like to win".

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The Consumption Decision

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The consumption decision is the choice to save or to borrow. If interest rates are high, we are inclined to save. e.g., open a new savings account. If interest rates are low, borrowing looks attractive. e.g., a bigger home mortgage.

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The Concept of Return

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"Return" can mean various things, and it is important to be clear when discussing an investment. In most cases, return is measurable.

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Holding Period Return

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The calculation of a holding period return is independent of the passage of time.

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Arithmetic Mean Return

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The arithmetic mean return is the arithmetic average of several holding period returns measure over the same holding period. Arithmetic mean = sum Ri/n. Arithmetic means are a useful proxy for expected returns. Arithmetic means are not especially useful for describing historical return data. It is unclear what the number means once it is determined.

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Geometric Mean

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The geometric mean return is the nth root of the product of n values.

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Comparison of Arithmetic and Geometric Mean Returns

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The geometric mean reduces the likelihood of nonsense answers. The geometric mean must be used to determine the rate of return that equates a present value with a series of future values. The greater the dispersion in a series of numbers, the wider the gap between the arithmetic mean and geometric mean.

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Expected Return

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Expected return refers to the future. In finance, what happened in the past is not as important as what happens in the future. We can use past information to make estimates about the future.

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Return on Investment

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Return on Investment (ROI) is a term that must be clearly defined. Return on Assets (ROA) = Return/Total Assets. Return on Equity (ROE) = Return/Total Stockholders' Equity. ROE is a leveraged version of ROA>

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Standard Deviation and Variance

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Standard deviation and variance are the most common measures of total risk. They measure the dispersion of a set of observations around the mean observation.

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Semi-Variance

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Semi-variance considers the dispersion only on the adverse side. Ignore all observations greater than the mean. Calculates variance using only "bad" returns that are less than average. Since risk means "chance of loss", positive dispersion can distort the variance or standard deviation statistic as a measure of risk.

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Statistics Review

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One has to understand key terms: "Constants", "Variables", "Populations", "Samples", and "Sample Statistics". Properties of Random variables, linear regression, R squared and standard errors.

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Constants

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A constant is a value that does not change. e.g., the number of sides of a cube. e.g., the sum of the interior angles of a triangle. A constant can be represented by a numeral or by a symbol.

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Variable

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A variable has no fixed value. It is useful only when it is considered in the context of other possible values it might assume.

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Discrete random variables

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Are countable, e.g., the number of bonds you buy.

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Continuous random variables

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Are measurable, e.g., realized return on these bonds.

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Quantitative variables

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Are measured by real numbers, e.g., numerical measurement: coupon rate on a bond.

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Qualitative variables

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Are categorical, e.g., bond rating, convertible, callable

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Independent variables

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Are measured directly, e.g., price, dividend on a stock.

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Dependent variables

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Can only be measured once other independent variables are measured. e.g., the total return (requires price paid and received and dividend amounts)

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Populations

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A population is the entire collection of a particular set of random variables. The nature of a population is described by its distribution. The median of a distribution is the point where half the observations lie on either side. The mode is the value in a distribution that occurs most frequently.

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Binomial distribution

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Contains only two random variables, e.g., the toss of a coin (heads or tails).

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Finite population

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One in which each possible outcome is known. e.g., a card drawn from a deck of cards

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Infinite population

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Population where not all observations can be counted. e.g., the microorganisms in a cubic mile of ocean water.

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Univariate population

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Has one variable of interest.

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Bivariate population

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Has two variables of interest. e.g., weight and size.

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Multivariate population

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More than two variables of interest. e.g., weight, size, and color.

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Samples

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A sample is any subset of a population. e.g., a sample of past monthly stock returns of a particular stock.

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Sample statistics

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Sample statistics are characteristics of samples. A true population statistics is usually unobservable and must be estimated with a simple statistic. Expensive , statistically unnecessary.

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Properties of Random Variables

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Example, Central Tendency, Dispersion, Logarithms, Expectations, Correlation and Covariance.

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Central Tendency

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Central tendency is what a random variable looks like, on average. The usual measure of central tendency is the population's expected value (the mean).

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Dispersion

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Investors are interested in the variations of actual values around the average. A common measure of dispersion is the variance or standard deviation.

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Logarithms

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Logarithms reduce the impact of extreme values. e.g., takeover rumors may cause huge price swings. A logreturn is the logarithm of a return relative. Logarithms make other statistical tools more appropriate, e.g., linear regression. Using logreturns on stock distributions: take the raw returns, convert the raw returns to return relatives, take the natural logarithm of the return relatives

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Expectations

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The expected value of a constant is a constant. The expected value of a constant times a random variable is the constant times the expected value of the random variable. The expected value of random variables is equal to the sum of the expected value of each element of the combination.

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Correlations

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The degree of association between two variables. Correlation and covariance are related and generally measure the same phenomenon. Correlation ranges from -1.0 to +1.0. Two random variables that are perfectly positively correlated have a correlation coefficient of +1.0. Two random variables that are perfectly negatively correlated have a correlation coefficient of -1.0.

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Covariance

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The product moment of two random variables about their mean. Correlation and covariance are related and generally measure the same phenomenon.

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Linear Regression

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Linear regression is a mathematical technique used to predict the value of one variable from a series of values of other variables. e.g., predict the return of an individual stock using a stock market index. Linear regression finds the equation of a line through the points that gives the best possible fit.

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R Squared

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R squared and standard error are used to assess the accuracy of calculated securities. R squared is a measure of how good a fit we get with the regression line. If every data point lies exactly on the line, R squared is 100%. R squared is the square of the correlation coefficient between the security returns and the market returns. It measures the portion of a security's variability that is due to the market variability.

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Standard Error

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The standard error is equal to the standard deviation divided by the square root of the number of observations. The standard error enables us to determine the likelihood that the coefficient is statistically different from zero. About 68 percent of the elements of the distribution lie within one standard error of the mean. About 95 percent lie within 1.96 standard errors. About 99 percent lie within 3.00 standard errors.

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Setting objectives is important

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For every person and institution that uses the financial market. Too many investors have a casual attitude. It is easy to be imprecise in communicating with the portfolio manager. Gallup Survey finds 39% believe stocks will return 15% annually for next ten years.

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Why setting objectives can be difficult

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Semantics, Indecision, Subjectivity, Multiple Beneficiaries

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Semantics

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Growth, income, return on investment, and risk mean different things to different people. e.g., a savings account provides income only; it has no growth potential. There must be a clear understanding of the terms when entrusting money to a fund manager. Which stocks are considered "growth" and which are considered "income"? Interpretation of principal and income. One interpretation is that principal is the original amount (accumulated interest is not included). Another interpretation is that accumulated interest is included in principal following the initial year.

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Indecision

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The client's inability to make a decision, e.g., a bank customer wants to have interest compounded but have the interest sent home each month.

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Multiple Beneficiaries

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Investment portfolios often have more than one beneficiary, e.g., an endowment fund has a perpetual life. It is possible to increase current income from the portfolio. Benefits today's beneficiaries, may be at the expense of future beneficiaries.

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Investment Policy

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Deals with decisions that have been made about long-term investment activities, eligible investment categories, and the allocation of funds among the eligible investment categories. e.g., a pension fund decides never to place more than 30 percent in common stock.

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Investment Strategy

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Deals with short-term activities that are consistent with established policy and that will contribute positively toward obtaining the objective of the portfolio. e.g., a manager may be required to maintain at least 30 percent equity by policy but decides to put 50 percent in the stock market because of a belief that the market will advance in the near future.

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Portfolio Objectives

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Preconditions, Traditional portfolio objectives, special situation of tax-free income.

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Preconditions

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Assess the existing situation. What are the current needs of the beneficiary? What is the investment horizon? Are there special liquidity needs? Are there ethical investing concerns established by the fund's owner or overseer?

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Traditional Portfolio Objectives

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Stability of Principal, income, growth of income, capital appreciation

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Stability of principal

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Emphasis is on preserving the "original" value of the fund. The most conservative portfolio objective, will generate the most modest return over the long run, e.g., bank certificates of deposit, other money market instruments.

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Income

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No specific proscription against periodic declines in principal value. e.g., a Treasury note may experience a decline in value if interest rates rise, but the investor will not experience a loss if he holds the note to maturity (the same applies to other fixed income securities).

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Growth of Income

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Differs from income objective. Sacrifices some current return for some purchasing power protection. Income lower in earlier years, income higher in later years. *requires some investment in equity securities.

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Capital Appreciation

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The goal is for the portfolio to grow in value rather than generate income. Appropriate for investors who have no income needs. A major benefit is tax savings. Unrealized capital gains are not taxed, dividend and interest income is taxed.

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Situation of Tax-Free Income

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Accomplished by investing in municipal securities. Free from federal tax and may be free from state and local taxes. Invest directly in municipal bonds for an income strategy. Invest in a mix of municipal bonds and common stock for a growth-of-income strategy.

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The importance of Primary and Secondary Objectives

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The secondary objectives indicates what is next in importance after specification of the primary objective. e.g., an investor chose income as the primary objective, but: does not want to take a lot of risk with the invested money (stability of principal) and wants to keep up with inflation (growth of income)

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Other Factors to Consider in Established Objectives

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Inconsistent objectives, portfolio splitting, liquidity, the role of cash

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Inconsistent Objectives

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Certain primary/secondary combinations are incompatible. Primary: stability of principal, secondary: capital appreciation. "I want no chance of a loss, but I do want capital gains"

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Portfolio Splitting

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A fund manager receives instructions that require that the portfolio be managed in more than one part. e.g., endowment funds. Components will have different objectives. A more convenient way of administering the fund that trying to establish a single, overall objective.

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Liquidity

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Clients may desire some liquidity. Options: invest a portion of the portfolio in money market mutual funds or cash management accounts at brokerage firms with check-writing privileges

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The Role of Cash

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Investment management firms routinely prescribe portfolio proportions for: equity securities, fixed-income securities, cash - arrives in portfolios naturally through the receipt of dividends and interest, includes currency, money market interests, short-term interest-bearing deposit accounts. *Presence of cash creates potential problems of a "cash drag".

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Portfolio Dedication

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Portfolio dedication (liability funding) involves managing an asset portfolio so that it services the requirements of a corresponding liability or portfolio of liabilities. Overlays the primary and secondary investment objectives. The two principal methods are cash matching and duration matching.

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Cash Matching

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The most common form of portfolio dedication. A manager assembles a portfolio of bonds whose cash flows match as nearly as possible the requirements of a particular liability.

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Duration Matching

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In a duration matched portfolio: a rise in interest rates results in a decline in the portfolio's value that is approximately offset by additional income earned from the higher reinvestment rate. A fall in interest rates results in a decline in income from reinvested funds that is approximately offset by the increase in the market value of the portfolio. Involves constructing a portfolio of assets that "pays the bills" associated with a liability or stream of liabilities. Duration is a measure of interest rate risk, the higher the duration, the greater the fluctuation in the price of a bond due to interest rate changes. There are two keys to duration matching, the duration of the asset portfolio must match the duration of the liabilities, the present value of the liabilities to be paid must equal the market value of the asset portfolio.

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Mutual Fund

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A mutual fund is an existing portfolio of assets into which someone may invest directly. Facilitates diversification. Mutual funds are extremely popular investment vehicles for both the small and the large investor. Many institutions place a substantial part of their money with mutual funds. By the end of 2006, there were about 8,100 mutual funds in the United States with assets totaling $10.4 trillion.

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Open-end funds

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May grow in size as new investors open accounts, may grow in size as existing investors add to their accounts, have no set number of shares outstanding, buy back their shares from investors (redemption)

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Closed-end funds

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Have a fixed number of shares that trade like shares of common stock. Are unmanaged portfolios of stock with each share representing partial ownership of the portfolio. May trade on an exchange. Can be sold to other investors.

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Net Asset value versus Market Value

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You buy and sell an open-end fund based on its net asset value. Open-end fund: equals the fund's assets minus its liabilities divided by the number of shares currently existing in the fund. Closed-end fund: trades at market-determined portfolio prices that may be more or less than the net asset value.

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Load Funds

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Have a sales charge associated with the purchase of new shares. A commission split between: a mutual fund salesperson, an investment firm, a national distributor, typically ranges between 1.0 percent and 8.5 percent.

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No-load Funds

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Have no sales charge, shares are bought and sold at net asset value

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Management Fees

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Management fees include: postage costs, clerical time, commissions on the underlying assets, redemption fee - a fee to pay redemption expenses, ranging between 1 percent and 2 percent. Management fees are paid to fund manager, taken directly from the fund's assets, and averages about 0.75 percent of fund's total assets.

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Buying Mutual Fund Shares

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Fund prospectus outlines: the fund's purpose, the management team, the mailing address and phone number, the fund's intended investment activity. Funds also provide descriptive brochures and other correspondence to anyone who inquires. new account application asks for: name, address, tax ID, Investor's choice of shareholder options: dividend reinvestment, automatic monthly investment, systematic withdrawal, IRA designation, telephonic fund switching option.

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Mutual Fund Objectives

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The fund objectives is the type of investment anticipated, capital appreciation and growth funds seek appreciation in the value of shares, income funds seek current income from fixed-income securities and from dividends, growth and income funds seek a combination of income and capital appreciation, balanced funds invest in growth and income securities, bond funds invest in debt only, money market funds seek stability of principal through investment in short-term debt instruments, tax-free funds invest in municipal securities that are free from federal, and sometimes state, taxes, special-purpose funds may focus on a particular industry or region.

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Investment policy

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A statement about the objectives, risk tolerance, and constraints the portfolio faces.

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Investment management

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The practice of attempting to achieve the objectives while staying within the established constraints.

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The Purpose of Investment Policy

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Outline Expectations and Responsibilities, Identify Objectives and Constraints, Outline Eligible Asset classes and their permissible use, and provide a mechanism for evaluation

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Outline Expectations and Constraints

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Investment policy is the responsibility of the client. e.g., an individual, an endowment fund's board. Investment management is the responsibility of the money manager, e.g., a bank trust department, a brokerage firm

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The investment manager's responsibilities

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Educate the client about infeasible objectives, develop an appropriate asset allocation and investment strategy, communicate the essential characteristics of the portfolio to the client, monitor and revise the portfolio as necessary, clients are entitled to progress reports from the investment manager, it is periodically necessary to revise the portfolio because of changes in market conditions. Ensure there is a mechanism for learning when a client's needs change. e.g., marriage, children, health expenditures. A material change in an investor's situation may require substantial changes in the portfolio asset allocation, the time horizon, the risk tolerance, or the return requirements.

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Identify Objectives and Constraints

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Objective setting should include, a target return, an appropriate level of risk

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Individual Investors

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Guardians take forever to make a decision and then worry constantly about it, stability of principal or income are appropriate objectives. Celebrities make decisions quickly, like investment fads and worry about being left out. Adventurers make decisions quickly and feel good about them, often have substantial stock market experience, seek capital appreciation. Individualists are both careful and confident, will listen to advice, read research reports, and investigate investment alternatives.

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Charitable Portfolios

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An endowment fund is a perpetual portfolio designed to benefit both current citizens and future generations. e.g., churches, the public library, the TWCA, environment groups, etc.. A foundation is an organization designed to aid the arts, education, research, or welfare in general, organized as either a trust or as a nonprofit corporation. Create tension between the needs of current beneficiaries and the future beneficiaries for an endowment fund, avoid short-term thinking when portfolio needs are long term.

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Institutional Portfolios

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Insurance Companies and pension funds have special needs: e.g., defined benefit retirement plans must ensure they will be able to meet payments.

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Real Risk

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The consequences of a loss vary widely, depending on the circumstances, e.g., a professional in his peak earning years versus a retired widow

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Investment Committee's Knowledge

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The investment committee: should be differentiated between fact and opinion, and should be honest in assessing the committee's ability and seek professional assistance when appropriate.

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How important is the particular portfolio to the client's overall financial position?

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There is no requirement that an investor keep all of his money with one brokerage firm, trust department, or money manager. The client may be diversified even if it does not appear so.

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Legal Restrictions

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Some states have a legal list outlining permissible investment. e.g., insurance companies may not buy corporate bonds without an investment-grade rating.

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Unanticipated Consquences of Interims Fluctuations

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Fluctuations may not matter in the short run in theory, but this may not be the best case in practice. e.g., an endowment fund that needs to generate money for annual scholarships.

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Outline Eligible Asset Classes and Their Permissible Uses

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Asset allocation decision is the single most important investment decision investors make. Affects long-term rates of return than security selection, market timing, or taxes.

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An effective performance evaluation should:

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1. Confirm that the manager managed in a way he was hired to manage, e.g., an equity manager should not be 75 percent in cash, e.g., a Treasury bond fund manager should not have corporate bonds in their portfolio. 2. Evaluate how well the manager did it, how well did the portfolio do relative to other portfolios comparable in risk and security composition? e.g., a stock portfolio that loses 2 percent when the market is down 15 percent.

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Determining the benchmark is an integral part of setting investment policy

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A benchmark can be absolute, e.g., a 10% rate of return, a benchmark can be relative, e.g., top quarter

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A good benchmark should:

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Be investable - it should be a viable investment alternative. Be specified in advance, e.g., median manager performance is not known until the end of the evaluation period: this is not a good benchmark. Be unambiguous, the securities that comprise the benchmark and the relative proportion each occupies should be known.

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Examples of feasible return objectives

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A long-term average rate of return of 10 percent. Over a five-year period, achieve a rate of return of at least 80 percent of the S&P 500 index. Generate a cash flow of $25,000 in the following 12 months, with subsequent annual cash flows growing at a 2.5 percent annual rate. Reach a terminal value of $1 million by a certain future time.

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Examples of infeasible return objectives

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Maintain purchasing power with 100 percent probability. Earn at least a 10 percent rate of return each calendar year. Ensure that the value of the fund never falls below the principal and produce an annual yield of 7 percent.

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Constraints

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Time Horizon, Tax situation, liquidity needs, legal considerations, unique needs and special circumstances.

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Time Horizon

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The length of time the investment will be at work is critical to proper asset allocation. In the long run, daily fluctuations in security values do not matter. The growth of earnings is most important in the long run.

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Tax Situation

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Taxes are the largest component of trading costs for many investors. Federal, state, and local taxes can exceed 50 percent combined. Investors may avoid taxable bonds and stocks with a high dividend yield, fund managers should carefully consider the sale of a losing stock to accompany the sale of stock that would result in a realized (taxable) capital gain.

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Liquidity Needs

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Some portfolios must produce a steady stream of income to the owner or to a set of beneficiaries. The manager must ensure the required funds are available in a timely fashion.

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Legal Considerations

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Some types of investment portfolios face a legal list of eligible assets. e.g., restricted to investment-grade bonds or a minimum payout ratio of fund assets to maintain tax-exempt status.

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Unique Needs and Special Circumstances

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Social investing, e.g., clients may not want to invest in tobacco stocks or in electric utilities using nuclear power sources. Empirical evidence on whether or not social investing influences realized investment returns is mixed.

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Institutional Investors

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Mutual Funds, Endowment Funds, Pension Funds, Life Insurance Companies, Property and Casualty Insurance Companies.

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Mutual Funds

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A mutual fund is an existing portfolio of assets into which someone can invest directly. All mutual funds have a stated investment objective. The prospectus is the legal document that describes the fund's purpose and investment policy.

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Endowment Funds

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An endowment fund is a long-term investment portfolio designed to assist the organization in carrying out its charitable purpose. An endowment fund has three purposes: help maintain operating independence, provide operational stability, provide a margin of excellence. Endowment funds frequently have an established payout rate based on the average level of fund assets. Endowments usually have at least 50 percent of their assets in equities. The typical national asset mix is 60 percent equities and 40 percent bonds.

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Pension Funds

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There are two main types of pension funds

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Defined Contribution Plans

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The employer established a set dollar contribution to be made on the employee's behalf. The employee makes the asset allocation decision.

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Defined Benefit Plans

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The employer guarantees a specific level of retirement benefits regardless of the performance of the market. e.g., when the employee reaches age 65, the firm will pay its retirees 75 percent of the average of their three highest earning years annually.

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Life Insurance Companies

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Life insurance companies are regulated by state insurance commissioners. Life insurance companies seldom have more than 10 percent of their assets in equities. Investment policy at a life insurance company is liability driven. The performance of the capital markets is secondary. The principal investment objective is to earn a competitive return on the surplus.

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Property and Casualty Insurance Companies

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Property and casualty companies differ significantly from life insurance companies: Disasters strike without warning and vary in scope. With many policies, there is never a claim. Liquidity is especially important at a property and casualty company.

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Characteristics of a Good Investment Policy statement

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It is realistic - the return objectives are reasonably attainable in ordinary market conditions, the target return and the statements about risk should be logically consistent. It should be unambiguous to an outsider - specify what return and yield mean, scrutinize words like normal, average, or ordinary. It should have been sustainable over the past - a statement should not contain language that everyone fully expects to be ignored periodically.

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Procedures for Modifying the Statement

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Changes should be made when necessary and when legally required. An annual policy review provides a useful mechanism for discussing possible changes. It may be necessary to accelerate the policy review if there are material changes in the client's financial situation. Joint responsibility of the client and the investment managers.

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The reason for portfolio theory mathematics

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Why diversification is a good idea, why diversification makes sense logically

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Harry Markowitz's efficient portfolios

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Those portfolios providing the maximum return for their level of risk, those portfolios providing the minimum risk for a certain level of return.

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Linear Combinations

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A portfolio's performance is the result of the performance of its components. The return realized on a portfolio is a linear combination of the returns on the individual investments. The variance of the portfolio is not a linear combination of component variances.

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Return

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The expected return of a portfolio is a weighted average of the expected returns of the components.

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Minimum Variance Portfolio

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The minimum variance portfolio is the particular combination of securities that will result in the least possible variance. Solving for the minimum variance portfolio requires basic calculus.

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Correlation and Risk Reduction

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Portfolio risk decreases as the correlation coefficient in the returns of two securities decreases. Risk reduction is greatest when the securities are perfectly negatively correlated. If the securities are perfectly positively correlated, there is no risk reduction. The variances equation includes the correlation coefficient (or covariance) between all pairs of securities in the portfolio.

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A Covariance matrix

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Is a tabular presentation of the pairwise combinations of all portfolio components. The required number of covariances to compute a portfolio variance is (n^2 - n) / 2. Any portfolio construction technique using the full covariance matrix is called a Markowitz model.

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Single-Index model

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The single-index model compares all securities to a single benchmark. By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other.

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Multi-Index model

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A multi-index model considers independent variables other than the performance of an overall market index. Of particular interest are industry effects. Factors associated with a particular line of business, e.g., the performance of grocery stores vs. steel companies in a recession.

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The concept of Risk Aversion revisited

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Diversification is logical. If you drop the basket, all eggs break. Volatility of individual firms has increased (investors need more stocks to adequately diversify). Diversification is mathematically sound. Most people are risk averse, people take risks only if they believe they will be rewarded for taking them.

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Variance of a Linear Combination

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most investors want portfolio variance to be as low as possible without having to give up any return.

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Portfolio Programming

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Various portfolio combinations may result in a given return. The investor wants to choose the portfolio combination that provides the least amount of variance.

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Concept of Dominance

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Dominance is a situation in which investors universally prefer one alternative over another. All rational investors will clearly prefer one alternative.

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A portfolio dominates all others it:

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For its level of expected return, there is no other portfolio with less risk. For its level of risk, there is no other portfolio with a higher expected return.

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Harry Markowitz: The Father of Portfolio Theory

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Harry Markowitz's "Portfolio Selection" Journal of Finance article (1952) set the stage for modern portfolio theory. The first major publication indicating the importance of security return correlation in the construction of stock portfolios. Markowitz showed that for a given level of expected return and for a given security universe, knowledge of the covariance and correlation matrices is required. He identified the existence of an efficient frontier where portfolios dominated individual securities within the security universe.

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Security Universe

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The security universe is the collection of all possible investments. For some institutions, only certain investments may be eligible.

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Efficient Frontier

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When a risk-free investment is available, the shape of the efficient frontier changes. The expected return and variance of a risk-free/stock return combination are simply a weighted average of the two expected returns and variances. The efficient frontier with a risk-free rate extends from the risk-free rate to point B (the line is tangent to the risky securities efficient frontier) and follows the curve from point B to point C.

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Capital Market Line and Market Portfolio

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The tangent line passing from the risk-free rate through point B is the capital market line (CML). When a security universe includes all possible investments, point B is the market portfolio. It contains every risky asset in the proportion of its market value to the aggregate market value of all assets. It is the only risky asset risk-averse investors will hold. Implications for investors: regardless of the level of risk-aversion, all investors should hold only two securities: the market portfolio and the risk-free rate. Conservative investors will choose a point near the lower left of the CML. Growth-oriented investors will stay near the market portfolio. Any risk portfolio that is partially invested in the risk-free asset is a lending portfolio. Investors can achieve portfolio returns greater than the market portfolio by constructing a borrowing portfolio.

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Security Market Line

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The graphical relationship between expected return and beta is the security market line (SML). The slope of the SML is the market price of risk. The slope of the SML changes periodically as the risk-free rate and the market's expected return change.

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Expansion of the SML to Four Quadrants

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There are securities with negative betas and negative expected returns. A reason for purchasing these securities is their risk-reduction potential. e.g., buy car insurance without expecting an accident. e.g., buy fire insurance without expecting a fire.

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Quadratic Programming

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The Markowitz algorithm is an application of quadratic programming. The objective function involves portfolio variance. Quadratic programming is very similar to linear programming.

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Lessons from Evans and Archer

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Evan's and Archer 1968 Journal of Finance article. Very consequential research regarding portfolio construction. Shows how naive diversification reduces the dispersion of returns in a stock portfolio.

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Naive diversification

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Refers to the selection of portfolio components randomly without any serious security analysis.

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Evans and Archer Methodology

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Measured the average variances of portfolios of different sizes, up to portfolios with dozens of components. Purpose was to investigate the effects of portfolio size on portfolio risk when securities are randomly selected.

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Strength in Numbers

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Portfolio variance (total risk) declines as the number of securities included in the portfolio increases. On average, a randomly selected ten-security portfolio will have less risk than a randomly selected three-security portfolio. Risk-averse investors should always diversify to eliminate as much unsystematic risk as possible.

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Biggest Benefits come first from diversifying

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Increasing the number of portfolio components provides diminishing benefits as the number of components increases. Adding a security to a one-security portfolio provides substantial risk reduction. Adding a security to a twenty-security portfolio provides only modest additional benefits.

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Implications of Evans and Archer

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Very effective diversification occurs when the investor owns only a small fraction of the total number of available securities. Institutional investors may not be able to avoid superfluous diversification due to the dollar size of their portfolios. Mutual funds are prohibited from holding more than 5 percent of a firm's equity shares.

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Implications for Mutual Funds

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Things to consider for mutual fund managers: owning all possible securities would require high commission costs. It is difficult to follow every stock.

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Words of caution

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Selecting securities at random usually gives good diversification but not always. Industry effects may prevent proper diversification. Although naive diversification reduces risk, it can also reduce return. Unlike Markowitz's efficient diversification.

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Diversification and Beta

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Beta measures systematic risk. Diversification does not mean to reduce beta. Investors differ in the extent to which they will take risk, so they choose securities with different betas. e.g., an aggressive investor could choose a portfolio with a beta of 2.0. e.g., a conservative investor could choose a portfolio with a beta of 0.5.

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Capital Asset Pricing Model

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The capital asset pricing model is a theoretical description of the way in which the market prices investment assets.

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Systematic Risk

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Cannot be diversified and is relevant. Measured by beta. Beta determines the level of expected return on a security or portfolio (SML)

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Unsystematic Risk

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Can be diversified and is irrelevant.

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CAPM

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The more systematic risk you carry, the greater the expected return.

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CAPM Assumptions

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Variance of return and mean return are all investors care about, investors are price takers; they cannot influence the market individually, all investors have equal and costless access to information, there are no taxes or commission costs, investors look only one period ahead, everyone is equally adept at analyzing securities and interpreting the news.

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SML and CAPM

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If you show the security market line with excess returns on the vertical axis, the equation of the SML is the CAPM. The intercept is zero, the slope of the line is the expected market risk premium.

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Note on the CAPM assumptions

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Several assumptions are unrealistic: people pay taxes and commissions, many people look ahead more than one period, not all investors forecast the same distribution of returns for the market. Theory is useful to the extent that it helps us learn more about the way the world acts. Empirical testing shows that the CAPM works reasonably well.

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Stationarity of Beta

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Beta is not stationary. Evidence that weekly betas are less than monthly betas, especially for high-beta stocks. Evidence that the stationarity of beta increases as the estimation period increases. The informed investment managers knows that betas change.

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Equity Risk Premium

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Refers to the difference in the average return between stocks and some measure of the risk-free rate. The equity risk premium in the CAPM is the excess expected return on the market. Some researchers are proposing that the size of the equity risk premium is shrinking.

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Correlations of Returns

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Much of the daily news is of a general economic nature and affects all securities. Stock prices often move as a group. Some stocks routinely move more than the others regardless of whether the market advances or declines. Some stocks are more sensitive to changes in economic conditions.

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Linear Regression and Beta

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To obtain beta with a linear regression: plot a stock's return against the market return. Use Microsoft Excel to run a linear regression and obtain the coefficients. The coefficient for the market return is the beat statistic. The intercept is the trend in the security price returns that is inexplicable by finance theory.

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Statistical Significance

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Published betas are not always useful numbers. Individual securities have substantial unsystematic risk and will behave differently than beta predicts. Portfolio betas are more useful since some unsystematic risk is diversified away.

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International Opportunities

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Institutional investors are well aware of the possibilities international investments offer. U.S. equities represent only about 45 percent of the world's equity capitalization. Over the period 1980-2000, the U.S. was the best performing market only once. William M. Morse, an investment consulting firm reports, target allocation for international equity: 15-20%, actual allocation for international equity: 10-20%.

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Why International Diversification?

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International investments carry additional sources of risk. Managers can reduce total portfolio risk via global investment

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Remembering Evans and Archer

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Portfolio theory works to the investor's benefit even if he selects securities at random. Ideally, the portfolio manager selects securities because of their fit with the rest of the portfolio. By choosing poorly correlated securities, a manager can reduce total portfolio risk.

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Remember Capital Market Theory

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Unsystematic risk reduction is possible with more than 20 securities. For a given level of return, any reduction in risk, no matter how small, is a worthy goal. A rational investor will reduce risk if given the opportunity.

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Relationship of World Exchanges

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For U.S. securities, market risk accounts for about one-fourth of a security's total risk. For less developed countries, market risk tends to be higher because: fewer securities make up the market and the securities are exposed to more extreme economic and political events. International capital markets continue to show independent price behavior. International diversification offers potential advantages. Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk. U.S. Securities: Systematic risk, can reduce portfolio variance to 27% by adding more securities. International Securities: Systematic Risk, can reduce portfolio variance to 11.7% by adding more securities.

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Considerations.

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Optimum portfolio size involves a trade-off between: the benefits of additional diversification, commissions and capital constraints, there also is a limit to an investor's time, foreign exchange risk: modest changes in exchange rates can result in significant dollar differences.

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Forward Rates

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The forward rate is a conceptual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency. Typically quoted on the basis of 1, 2, 3, 6, and 12 months. The forward rate is the best estimate of the future spot rate. If the forward rate indicates the dollar will strengthen, importers should delay payments. If the forward rate indicates the dollar will weaken, importers should lock in a rate now.

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Interest Rate Parity

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Interest rate parity states that differences in national interest rates will be reflected in the currency forward market

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Covered Interest Arbitrage

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Covered interest arbitrage is possible when the conditions of interest rate parity are violated. If the foreign interest rate is too high, convert dollars to the foreign currency and invest in the foreign country. If the U.S. interest rate is too high, borrow the foreign currency and invest in the U.S.

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Purchasing Power Parity (PPP)

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Refers to the situation in which the the exchange rate equals the ratio of domestic and foreign price levels. A relative change in the prevailing inflation rate in one country will be reflected as an equal but opposite change in the value of its currency.

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Absolute Purchasing Power Parity

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Follows from "the law of one price". A basket of goods in one country should cost the same in another country after conversion to a common currency. Not very accurate due to: transportation costs, trade barriers, and cultural differences.

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Relative Purchasing Power Parity

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States that differences in countries' inflation rates determine exchange rates.

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A country with an increase in inflation will experience a depreciation of its currency because:

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Exports decline, imports increase, there is less demands of goods from that country

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Foreign Exchange Exposure

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If the dollar is expected to appreciate dramatically, an investor may reduce or eliminate foreign currency holdings. Hedging involves taking one position in the market that offsets another position. Covering foreign exchange risk means hedging foreign exchange risk.

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Hedging with Future Contracts

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A futures contract is a promise to buy or sell a specified quantity of a particular good at a predetermined price by a specified delivery date. On the delivery date, there will be a gain or loss in the future market that will offset the gain or loss experienced when converting the foreign currency.

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Hedging with Foreign Currency Options

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There are two types of foreign currency options: call options give their owner the right to buy a set quantity of foreign currency. A put options give their owner the right to sell a set quantity of foreign currency. The disadvantage of hedging with currency options is that the hedger must pay a premium to establish the hedge. Options provide more precision that future contracts, and options are more expensive than futures contracts.

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Currency options characteristics

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A call option with an exercise price quoted in dollars for the purchase of euros is the same as a put option on dollars with an exercise price quoted in euros. Put-call parity for foreign currency options is a restatement of interest rate parity.

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Key Issues in Foreign Exchange Risk Management

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The steps in foreign exchange risk management: 1. Define and measure foreign exchange exposure, 2. Organize a system that monitors this exposure and exchange rate changes, 3. Assign a responsibility for hedging, 4. Formulate a strategy for hedging.

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Reducing Risk

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Low correlations are attractive as a means of reducing portfolio variability. Emerging markets show low correlation with developed markets, emerging markets show low correlation with each other.

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Following the Crowd

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Some professional money managers carefully analyze emerging markets for: profit potential, portfolio risk reduction. Some professional money managers "follow the crowd" because they feel they must invest in emerging markets.

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Additional Risks arising from Foreign Investment

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Incomplete accounting information, foreign currency risk, fraud and scandals, weak legal system

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Asymmetric Correlations

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Correlation between emerging and developed markets: increases during bear markets, is low during bull markets, the extent of portfolio managers' diversification depends on whether they are experiencing an up or down market.

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Market Microstructure Considerations

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Liquidity risk, trading costs, market pressure, marketability risk, and country risk

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Liquidity Risk

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Some emerging markets' investors are mostly foreign, increases political risk, sets the stage for a market collapse if everyone pulls out at once. Some emerging markets lack depth, the bid/ask spread tends to be wide with few standing orders to buy and sell.

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Trading Costs

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Foreign market trading costs are more than 1 percent higher than domestic trading costs. e.g., bid/ask spreads is an average of 95.4 basis points for Barings' Securities emerging market index. They reach as high as 171 basis points in Turkey. This indicates an investment must appreciate more to show a given net return.

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Market Pressure

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An order to buy or sell a large number of shares might cause a substantial supply/demand imbalance. Causes the price to move adversely from the investor's perspective. Indicates that emerging market investments should be viewed as long-term investments rather than a source of trading profits.

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Marketability Risk

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An investor may be unable to close out a position at a reasonable price

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Country Risk

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Refers to a country's ability and willingness to meet its foreign exchange obligations, especially important in emerging markets. Country risk has two components: political risk and economic risk.

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Multinational Corporations

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Investing in a multinational corporation may provide a ready-made means of getting the risk-reduction benefits of international diversification. Research is unclear whether MNCs are better investments than purely domestic firms.

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American Depository Receipts

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American depository Receipts (ADRs) are receipts representing shares of stock that are held on the ADR holder's behalf in a bank in the country of origin. An alternative to purchasing shares in a foreign company directly on the foreign exchange. Several American depository receipts have market capitalizations exceeding $100 billion

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International Mutual Funds

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Mutual funds permit diversification to an extent that would not otherwise be possible. Some mutual funds invest only in securities issued outside the U.S.. Buying an international mutual fund is a good way to achieve international diversification. Managers of well-diversified international funds outperform MSCI benchmarks.

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