REading 41 LOS's

Question 1

LOS 41a: Describe the portfolio approach to investing

Answer 1

Instead of evaluating each invesment in isolation, you should consider how it will complement your whole portfolio.

Reasons for Taking the Portfolio Perspective

taking the portfolio perspective offers diversification benefits.

• Portfolios of securities may offer equivalent expected returns with lower volatility of returns compared to individual securities
• A simple measure of the value of diversification is the diversification ratio. It is the ratio of the standard deviation of equal-weighted portfolio to the standard deviation of a randomly selected component of the portfolio. The lower the ratio, the greater the risk reduction benefits of diversification, and the greater the portfolio effect
• The composition of the portfolio is an important determinant of overall level of risk inherent in the portfolio. By varying the weights of the individual securities, investors can arrive at a portfolio that offers the same return as an equally weighted portfolio, but with a lower standard deviation

Question 2

LOS 41b: Describe types of investors and distinctive characteristics and needs of each

LOS 41c: Describe defined contribution and defined benefit pension plans

Answer 2

Individual Investors

Most individuals accumulate wealth to provide for their needs during retirement through defined-contribution pension plans, where they contribute a part of their wages to the plan while working

Younger investors look for large capital gains, while older investors look to generate a stable income stream.

Institutional Investors

Defined-Benefit Pension Plans In a DB plan, the employer has an obligation to pay a certain amount to its employees every year once they retire. DB plans are long-term investors and aim to match cash flows from plan assets with the timing of future pension payments (liabilities)

Endowments and Foundations ( College funds, charities) They aim to maintain the inflation-adjusted capital value of their funds while generating the necessary income to meet their objectives. They are generally established with the intent of having a perpetual useful life and must balance short-term spending needs with long-term capital preservation requirements

Banks- A bank typically aims to earn a return on its reserves that is greater than the interest that it pays its depositors. Their investments must be very low risk and very liquid

Insurance Companies Insurance companies are also relatively conservative with their investments as they need to satisfy claims when due. Life insurance companies typically have a longer time horizon than nonlife insurance companies, as they are expected to have to make payments after a longer period

Investment companies

Sovereign Wealth Funds A SWF is a government-owned investment fund. SFWS are usually established to invest revenues from finite revenue sources to benefit future generations of citizens or to manage a country’s foreign exchange reserves

Question 3

LOS 41d: Describe The steps in the portfolio management process

Answer 3

The portfolio management process involves the following steps:

• Planning
  
  • Understanding the clients needs
  • Preparing the investment policy statement (IPS)
• Execution
  
  • Determining the asset allocation
  • Analyzing securities
  • Constructing the portfolio
• Feedback
  
  • Monitoring and rebalancing the portfolio
  • Measuring and reporting performance

Planning

The IPS is a written document that describes the objectives and constraints of the investor. It may also include a benchmark against which the portfolio manager’s performance can be evaluated. An IPS should be reviewed and updated regularly, especially if there has been a drastic change in the client’s circumstances

Execution

Asset Allocation: The asset allocation of a portfolio refers to the distribution of investable funds between various asset classes.

Security Analysis- Analysts use their knowledge of various companies and the industry to identify investments that offer the most attractice risk return characteristics from within each asset class

Portfolio Construction- After determining the target asset allocation and conducting security analysis, the portfolio manager will construct the portfolio in line with the objectives outline in the IPS

Feedback

Portfolio Monitoring and rebalancing- Portfolio’s must be regularly monitored for chnages in the composition and then rebalanced when changes cause a significant change in weights of securities

Performance measurement and reporting- this step involves measuring the performance of the portfolio relative to the benchmark stated in the IPS

Question 4

LOS 41e: Describe mututal funds and compare them with other investment products

Answer 4

Pooled Investments are investments in securities issued by entities that represent ownership in the underlying assets held by those entities. They include:

1) Mutual Funds

Mutuals funds pool money from several investors and invest these funds in a portfolio of securities. The value of a mutual fund is referred to as “net asset value”(NAV), which is calculated on a daily basis based on the closing price of the underlying securities. There are 2 types of mutual funds:

1. Open End Funds accept new investment funds and issue new shares at a value equal to the fund’s NAV per share at the time of the investment. Investors can also redeem at the NAV
2. Closed-End funds accept no new investment money into fund. Shares in the fund are traded in the secondary market so no new investors invest in the fund by purchasing shares in the market. These can trade at a premium or discount to NAV, all depends on supply and demand of market shares

The structure of an open end fund makes it easy for them to grow in size but that does pose the following problems:

• the portfolio manager needs to manage cash inflows and outflows
• an inflow of new investment requires the manager to find new investments
• funds need to keep cash for redemptions

Mutual funds can also be classified as:

• Load funds that charge a percentage fee for investing in the fund and/or for redemptions from the fund on top of an annual fee
• No-load funds that only charge an annual fee based on a percentage of the funds NAV

Types of Mututal Funds

• Money-market funds- These invest in high quality, short-term debt instruments. They can be tax-free or taxable
• Bond Funds- these invest in individual bonds and sometimes preference shares as well. Unlike money-market funds, they usually invest in longer term instruments
• Stock funds- These invest in equities and equity indicies. Stock mututal funds can be actively or passively managed. Active aims to outperform a benchmark, while passive looks to follow the benchmark. Activie management entails higher fees and results in higher turnover of portfolio securities
• Hybrid or balanced funds- These invest in both equities and bonds

Other investment products

Exchange Traded Funds (ETFs) issue shares in a portfolio of securities and are desgined to track the performance of a specified index. An ETF purchases a large number of shares in the same proportion as the index it tracks and issues shares in the ETF to investors who want to track the same index.

ETFS combine the features of closed-end and open-end mutual funds. They trade in secondary markets like closed-end, and their prices stay close to NAV like open end

They differ from mutual funds in the following way:

• Investors in index mutual funds purchase shares directly from the fund, while investors in an ETF purchase shares from other investors
• ETFs have lower costs, but unlike mutual funds, investors do not incur brokerage costs
• ETFs are constantly traded throughout the business day. Each trade occurs at the prevailing market price at the time
• ETFs pay out dividends, while index mutual funds usually reinvest dividends
• The minimum required investment is usually smaller for an ETF
• ETFs are generally considered to have a tax advantage over index mutual funds

Separately Managed Accounts (SMAs) is a fund management service for wealthy investors. These accounts are exclusively for the benefit of the client, and cater to their own unique personal needs. They differ from mutual funds in the following ways:

• Unlike investors in mutual funds, investors in SMAs directly own the shares and therefore have control over which assets are bought and sol over the timing of transactions
• Unlike Mutual Funds, in which no consideration is given to the tax position of the investor, transactions in SMAs take into account the specific tax needs of the investor
• The required minimum investment for an SMA is usually much higher than for a mutual fund

Hedge Funds

were originally meant to offer plays against the market and hedge against a downside. Today, the term hedge funds has evolved to encompass a host of funds that simple look to generate absolute returns for investors

• Hedge funds differ from mutual funds in that most hedge funds are exempt from many of the reporting requirements for a typical publice investment company
• They require a minimum investment that is typically $250,000 to start and $1million for more well established
• They usually place restrictions on investors ability to make withdrawals from the fund

Some hedge strategies are listed below:

• Convertible Arbitrage Funds purchase securities such as convertible bonds and simultaneously take short positions in related equity securities
• Dedicated short bias fudns take more short than long positions
• _Emerging Market Funds -_invest in companies in emergin markets by purchasing corporate of sovereign securities
• Equity market neutral funds eliminate exposure to overall market movements by taking short positions in overvalued securities and long positions in undervalued
• Event Driven Funds attempt to take advantage of specific company events, such as mergers and acquisitions
• Fixed-Income arbitrage funds take opposing positions in debt securities to proft from arbitrage opportunities and to limit interest rate risk

Buyout and Venture Capital Funds

Leveraged buyout funds (LBO) raise money specifically for the purpose of buying public companies, taking them private, and retructuring them to make them more efficient and profitable. The idea is to service the debt from acquiring with the company’s cash flow and then exit the investment through an IPO or sale to another company

A ventur capital (VC) provides financing to startups

Buyout and Venture Capital funds have the following characterisitics:

• they take equity positions in companies and play a very active role in managing those companies
• The eventual exit strategy is an important consideration when funds evaluate potential invesments