module 1 investment policy and modern portfolio theory

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  • Module 1 Investment Policy and Modern Portfolio Theory
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  • Portfolio construction Purpose: maximization of wealth by reaching a heuristic Reward-to- risk How? Allocate, Select and Protect Illustration: realized and expected wealth? Realized wealth = Expected wealth + Error Heuristic Reward to risk = Allocation + Selection + protection It always starts with the Policy: Ask the right question! what risk? Thus, what allocation? Set the right allocation target in terms of objectives, constraints and weight range monitoring
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  • Choose a Portfolio strategy: Passive or Active No matter what, an investment strategy is based on four decisions What asset classes to consider for investment What normal or policy weights to assign to each eligible class The allowable allocation ranges based on policy weights What specific securities to purchase for the portfolio Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments Asset allocationSecurity Selection Active (for pros) Market timing Stock/Bond picking Passive (for ind.) Fixed weights Indexing
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  • First, set the rules: the policy statement TOTAL RETURN= INCOME YIELD + CAPITAL GAIN YIELD Objectives Think in terms of risk and return to find the best weightsi.e., Capital preservation (high income, low capital gain) Low to moderate risk Balanced return (Balanced capital gains and income reinvestment) moderate to high risk Pure Capital appreciation (high capital gains, low to no income) High risk Constraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences Management - Define an allowable allocation ranges based on policy weights Selection - Define guideline to pick securities to purchase for the portfolio (optional)
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  • Examples of Investment Styles
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  • Objectives Age/Risk Matrix Risk tolerance/ Time Horizon 0-5years (C/B/S) 6-10 (C/B/S) 11+ (C/B/S) Higher10/30/600/20/800/0/100 Moderate20/40/4010/40/5010/30/60 Lower50/40/1030/40/3010/50/40 C stands for CASHi.e. money market securities B stands for Bondsi.e. corporate, municipal or treasury securities S stands for Stocksi.e. value, growth, international equity securities Color code: Capital preservation Balanced return Capital appreciation
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  • YOUR TURN! Mr. Bob is 70 years of age, is in excellent health pursues a simple but active lifestyle, and has no children. He has interest in a private company for $90 million and has decided that a medical research foundation will receive half the proceeds now; it will also be the primary beneficiary of his estate upon his death. Mr. Bob is committed to the foundation s well-being because he believes strongly that, through it, a cure will be found for the disease that killed his wife. He now realizes that an appropriate investment policy and asset allocation are required if his goals are to be met through investment of his considerable assets. Currently the following assets are available for building an appropriate portfolio: $45 million Cash (from the sale of the private company interest, net of $45 million gift to the foundation) $10 million stocks and bonds ($5 million each) $9 million warehouse property not fully leased) $1 Million Bob residence Build a policy statement for Mr. Bob!
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  • Objectives (return) Large liquid wealth from selling interest in the private company Income from leasing warehouse Not burdened by large or specific needs for current income nor liquidity. He has enough spendable income. He will leave his estate to a Tax-exempted foundation He has already offered a large gift to the foundation Thus, an inflation-adjusted enhancement of the capital base for the benefit of the foundation will the primary minimum return goal. He is in the highest tax bracket (not mentioned but apparent) Tax minimization should be a collateral goal.
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  • Objectives (risk) Unmarried, Childless, 70 years old but in good health Still a long actuarial life (10+), thus long term return goal. Likely free of debt (not mentioned, but neither the opposite) Not skilled in the management of a large portfolio Yet, not a complete novice since he owned stocks and bonds prior to his wifes death. His heirthe foundationhas already received a large asset base. Long term return goal with a portfolio bearing above average risk.
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  • Constraints Time--Two things: (1) long actuarial life and (2) beneficiary of his estatethe foundation has a virtually perpetual life Taxes: highest tax brackets, investment should take this into consideration: tax- sheltered investments. Unique circumstances: Large asset base, a foundation as a unique recipient some freedom in the building of the portfolio
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  • Adapted Strategy Majority in stocks (shield against inflation, above average risk tolerance, and no real income or liquidity needs) He already has 15% in real estate (house + warehouse) no more needed, diversification effect achieved. Additional freedom: Non-US stocks additional diversification Target 75% equity (including Real Estate) Fixed Income used to minimize income taxesi.e., municipal and treasury securities. No need to look for YIELD nor downgrade the quality of the issues used. Additional freedom: Non-US fixed-income additional diversification effect. Target 25% in fixed income
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  • Proposed Allocation CurrentProposed Range Cash / Money Market70%0%0-5 US Stocks--LC30%30-40 US StocksSC15%15-25 Non US Stocks15%15-25 Total7.5%?60%60-80 Real Estate15% 10-15 US Fixed Income15%10-20 Non-US Fixed Income10%5-15 Total Fixed Income7.5%?25%15-35
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  • In sum, the Importance of Asset Allocation An investment strategy is based on four decisions What asset classes to consider for investment What normal or policy weights to assign to each eligible class The allowable allocation ranges based on policy weights What specific securities to purchase for the portfolio Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments Summary: Policy statement determines types of assets to include in portfolio Asset allocation determines portfolio return more than stock selection Over long time periods sizable allocation to equity will improve results Risk of a strategy depends on the investors goals and time horizon
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  • What is Investments? Purpose: maximization of portfolio wealth through adequate Portfolio management Fair Reward-to-risk Ask the right question! Optimal portfolio management = Allocation + Selection + Risk protection
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  • Investment Vehicles Investments divided by asset class. 1. Fixed-income investments (MM 27 & Bonds 49) 2. Equity investments (stocks 140, COM.) 3. Derivatives (Options and futures) 4. Investment companies (MF 106, HF) 5. Real estate 6. Low-liquidity investments
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  • Build a general culture on investments (Risk, Returns, Correlations) US asset classes Security markets size Government bond return Global equity returns Correlations Global Asset classes performance/correlation Investment companies performance
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  • Alternative Investments Risk and Return Characteristics
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  • Computing Returns The additional cents on the dollar invested R=(profit+additional cash flows)/initial investment Over a period of timeaverage return Average return=(all returns)/nb of observations Why do returns matter? $ does not mean muchalone Cross-comparison between markets Are normally distributed
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  • Example 1: Market Order You buy a round lot (multiple of 100) of ABC stock at $20. Brokerage fees are 3% on each transaction (3% for purchase and 3% for sale). You receive a year later $0.5 per share in dividends and sell the stock at $27. What is the rate of return on investment? Market Orders - buy or sell the stock at the best price at that time.
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  • Solution 1 R=Profit/investment Return= Profit/initial investment = (Ending value - Beginning Value + Dividends - Transaction costs on purchasing and selling) / (initial investment + transaction costs on purchasing) Beginning Value of Investment= $20n Ending Value of Investment = $27n Dividends = $0.5n Transaction Costs for purchase=3% x 20n=0.6n Transaction Costs for sale=3% x 27n=0.81n Profit = $27n - $20n + 0.5n-0.6n-0.81n = 6.09n Initial investment = 20n+0.6n = 20.6n R= $6.09n/$20.6n = $6.09/$20.6= 29.56%
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  • Example 2: Stop loss orders Suppose you have 500 shares of ABC stock, bought at $50 and priced at $60. You put a stop loss order at $55. Why would you do that? If the the price goes to $52, what would be your rate of return with and without the stop loss order? Special orders Stop loss order: Implies that if the market price falls to or below a specified price, the order becomes a market order and the stock will be sold at the prevailing price. Stop buy order: Used by short sellers to minimize losses if market price rises. Solution 2: You are obviously satisfy with a profit of $5 per share. With stop loss; R= (55-50)/50=10% Without stop loss; R= (52-50)/50=4%
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  • Example 3: Limit orders Xyz stock is selling for $40.


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