Balanced Fund Consultation - Essay Example

Balanced Fund Consultation

Introduction

The allocation of assets and the resultant portfolio makes one of the most fundamental investment strategy as the methodology seeks to balance the rewards and the risks that the assets may be exposed to. The apportionment of the assets follows certain aspects including a person’s investment horizon, risk tolerance, and their goals. Multifarious assets classes such as cash, equities, and fixed-income possess varied degrees of returns and risks, and as such each one of them will changed dissimilarly over time (Fabozzi & Markowitz, 2011). There are various things that can be invested in by an organization, whether small or big. Indeed, these investments are dependent on the needs of the investor’s needs compared to the incessant market tracking that may be involved. Throughout the investment process and decisions that are made therein, it is key that emotions are not involved. The removal of the impact of emotions is fundamental in any investment decisions that an investor is going to make. In the case of the pension fund, the following analysis will either confirm or reject the notion following an extensive analysis of the investments made.

From the data in the excel sheet, it is clear that the company prioritized investing in equities and bonds. Various allocations of the two aspects were conducted based on the prevailing market conditions. The portfolio that the company has chosen demonstrates that the company does not have a high risk tolerance. The total amount that the company has invested is £401mn. Out of that amount, the company has invested £191 mn in equity and £210 mn in bonds. Therefore, the percentage investments in both equity and bonds will be as thus:

Equity = {(Equity investment/Total investment) ×100} %

= {(191/410×100) %

= 46.58%

Bonds Investment = {(Bonds investment/Total investment) ×100} %

= {(210/410×100)} %

= 51.21%

The above calculation is indicative of the fact that the company favored investing in bonds as opposed to equity. In the current situation, the company’s portfolio reads 51.21% investment in bonds and 46.58% investment in equity. That is the current portfolio balance that is characterizing the organization’s portfolio. The allocation of the firm’s funds is indicative of the current market climate. In the present climate, the returns that the firm expects to get from both sets of investment is relatively similar (Brown 2012). However, the returns that they will get from the bonds slightly edges those that will come from equity. For this reason, the nature of the portfolio is very appropriate as it reflects the existing climate in the markets.

Special Drawdowns

The returns in the market that the company has invested in are going to experience certain changes in the next three years. According to forecasts, there are going to be drawdowns of about £20 mn and £45 mn in the next three and five years respectively. The phenomenon compels the company to prepare for these draw-downs in a specific manner. The preparation of the impending market drawdowns are important as it will allow the company to enjoy certain advantages. According to Ayal and Amir (216), the preparation will enable the company to reach certain decisions when they are calm as well as collected. The demeanor is important as it will allow the company to navigate the murky waters of the drawdown in a composed manner. This way, the decisions that they will make will not be considered as knee-jerk reactions since they will have set everything in motion during the preparations. Therefore, discussing the situation in advance permits the company to establish measures that will be undertaken. Inevitably, this will bring forth composure even during the period.

Moreover, preparing for drawdowns enables organizations to maintain the projects and keep them on track. The phenomenon is going to allow the company to prepare itself on how it is going to manage the risks that will be associated with the oncoming market drawdowns. The management of the risks associated with the drawdowns are similarly going to make certain that the company’s portfolio is not adversely affected hence the maintenance of the company’ investments (Yang, Zhou & Ding 2014).

The organization can prepare for these eventualities by using the technical analysis to follow the trends of the market. This one will allow the company to measure the information that is integrated in the price of the security. It allows the company to properly manage risks. Also, the company can use the S&P 500 as its portfolio overlay. Economic experts believe that the usage of this strategy reduces, hedges or increases exposure. The preparation for the medium or long-term trends of the market may be done by considering two technical indicators of the S&P 500. The first tool that the company may consider is the position of the slope that characterizes the 200-day moving average. The second indicator is the relative strength of the investment items. In this strategy, the company should compute the percentage on either side of the 200-day moving average alongside the rate of change (ROC) within 100-150 days. The reduction of certain equity exposure in cases whereby the 200-moving average slopes down on the negative side is necessary for the company to survive. In the second tool, the market internals can be gauged, and this reduces the instances of false moves. Either way, by using the two tools, the company will have cushioned itself against the effects that will be brought about by the expected drawdowns.

Theories and Their Applications

The trading activities such as the ones being captured in this paper may be influenced by certain theoretical frameworks. The discussion of these theories provides a clear understanding regarding the things that people consider or rather use before they make their investment decisions. The first theory is the theory of judgment. Scholars have begun to consider the impact that behavioral corporate finance has on investment decisions. In this theory, it is postulated that corporations have become natural arbitrageurs in various senses. Researchers have also insinuated that the investment decision that is made by a firm is representative of the Chief Executive Officer’s image more than anything else. The theory can be applied herein when the CEO is aggressive. This means that he or she will be able to ensure that they utilizes more leverage while at the same time holding less cash and the vice-versa is also true (Ledenyoy & Ledneyoy 2013, p. 10). In addition, the theory, depending on the behavior of the CEO, can be used to make the company invest more into assets, especially if the CEO is conservative.

The second theory is the prospect theory, developed by Kahneman and Tversky (1979). In their empirical studies, they discovered that individuals underweight consequences which are simply probable in comparison to the results that are acquired with certainty. Also, the two postulated that people by and large abandon components, which are by and large regarded as shared by every prospect under consideration (Ledenyoy & Ledenyoy 2013, p. 15). In this theory, value will be attached to losses and gains and not to final assets. Moreover, decisions weights are used instead of probabilities. The definition of value functions is based on reference point deviations. The definition named above always represents the concave for gains, which implies risk aversion, usually convex for losses, which means risk seeking, and by and large is steeper in losses compared to gains, implying loss aversion. In general, the decision weights are generally lower compared to the corresponding probabilities with the exception of the points possessing low probabilities (Barberis 2013, p. 180). The theory can be used to make investment decisions by considering the risks that are involved in each trading activity.

Lastly, the expected utility theory can be used to make investment decisions. In this theory, the preferences that people display with regard to the choices having uncertain outcomes are covered. The theory is derived from expected hypothesis, which states that “under uncertainty, the weighted average of all possible levels of utility will best represent the utility at any given point in time” (Levy 2016, p. 25). The weighted average that is used in this calculation is taken under the assumption that a particular vent may occur, which leads to them being assigned probabilities. The utility theory can be applied in static conditions, which means that the decision that one is going to make will be dependent on the existing conditions in the global markets and nothing else. Therefore, using the weighted average, an investment decision can easily be reached in circumstances such as the one that has been described above.

Equity Allocations

The European markets, where the company is found, are going to experience some changes in the short-term, medium term, and long-term. According to the information that was provided by the economist of the investment fund that the company has used, the following table will represent those changes.

Time scaleGDPInt. RatesUS$/UK£IR Structure CPI Const.Index

Short term +1.5% +25 bp 1.45 normal +.25% +1.5%

Medium term +2.5% +150 bp 1.55 normal +2.5% +3.5%

Long term +1.0% +250 bp 1.75 inverted +3.0% +5.1%

The information mentioned in the above table plus the impending drawdown means that the portfolio needs rebalancing so as to minimize the risks associated with the assets. It is a necessary step even if the assets’ returns will be affected. The original investment allowed the customer to have a 46.58% as equities. However, with the expected changes in the growth, interest rates and inflations in the market, this is bound to change. The investment is going to be exposed to certain short-term, middle-term, and short-term risks (Blanchet 2014, p. 109). The risks should be contained by balancing the allocation of funds. In order to balance the portfolio, the company needs to auction stocks in the British American Tobacco and buy bonds in the WM Morrison Supermarkets given the returns therein. The portfolio return of the BAT will thus be:

Whereby E [RP] = Expected Returns

N= the number of stocks in the portfolio

Wi = the proportion of the portfolio invested in stock

E [Ri] =expected return on stock i

Given that the present portfolio consists of two assets, then the expression will be given

as:

Therefore, E [Ra]=5.2% and E[Rb]= 6.2%

E [Rp]= .46(5.2%)+(1-0.46)(6.2%)

= 5.74%

The risk of the portfolio after calculating is = 0.5%.

Given the parameters of the above mentioned table and the expected rate of returns for the portfolio, it is clear that there is going to be an exposure of the equity funds in both the short-term, middle-term, and long-term. The expected rate of returns for the equity allocation is expected to be 5.74%. Considering the equity allocations, the company will be best advised to reallocate resources from BAT to WM Morrison Supermarkets. The decision is informed by the fact that the BAT shares have a lot of volatility and they are going to be affected by the impending markets as forecasted by the above table. The long-term future of the BAT shares is going to be absolutely affected given the fact that the interest rates are going to increase by 250 bp while the growth is only going to increase by +1 in the long-term. On the other hand, the WM Morrison Supermarkets shares are going to wither the storm given their rate of growth. The investment in the WM Morrison Supermarkets has already produced the joint highest returns on the equity investment by the company. This is despite the fact that it was allocated the least amount of money when the investment decision was being made.

In other words, the above reallocation means that the entire face of the portfolio is going to change. The investments that were made in the BAT will now be added to the WM Morrison Supermarkets. This is in order to safeguard the WM Morrison Supermarkets investment from the oncoming turmoil in the market even though it is stronger. Indeed, experts believe that the whole business will profit from this move as the removal of the most volatile equity investment will safeguard the whole company from suffering the adverse effects that have been projected (Vermeulen 2013, p. 105).

Bond Allocations

The total amount that the company invested was £401 while the amount that was allocated to bonds was £210. This translates to 51.21% of the investment that was made as indicated by the portfolio. It is clear that at present, the bond stocks are performing better than the equity stocks. Ideally, we should have increased the values of the bond stocks but for the fact that it is forbidden by the instructions. Therefore, in order to overcome the oncoming market storms in the next five years, the company will need to allocate the bonds. The best strategy is to take the worst performing stocks and add them to the best performing stocks (Dichtl, Drobetz, & Wambach 2016, p. 780; Perez, Hodge, & Le 2016, p. 400). Even as the company does this, it has to anticipate that the long-term performance of the bonds remain relatively the same. Any significant change to the volatility of the best performing bonds may lead to unwanted situation whereby they may be exposed to risks.

From the information provided, the US West Communications bonds with the last quoted price being 103, but with current yield rate of 6.999 is the best amongst the catalogued bonds. The interest volatility in the long-term and per the given data is going to increase up to +250 bp, which means that the fixed assets are going to rip big. This is the more reason as to why bonds need to be reallocated so that the ones with the highest yielding rates have a higher amount attached to them compared to the lowest yielding bonds. Consistent with this argument, the company should reallocate the Wells Fargo Co MTN BE, which currently yields 3.592 at 103.74. The decision is supplemented by the fact that the latter bond, even as it is not yielding much, is not redeemable, which does not serve the short-term purposes of the firm. Also, the Wells Fargo Co MTN BE will be very much affected by the expected volatilities in the market.

On the other hand, the company will be looking to secure the same faction of the portfolio according to the instructions. This is very dangerous as the bonds will be exposed to the same market conditions (Karoui 213, p. 69). This means that all of them will be affected in a way. Essentially, the effect of the expected turmoil will be dependent on the degree of cushion that a bond has. For this reason, it was decided that the above two bonds be considered for reallocation.

Conclusion

In conclusion, the current state of the portfolio markets is healthy. The company made its priorities clear by investing more in bonds over equity stocks with 46% and 52% investments respectively. This demonstrates the fact that the bonds are currently doing better given the existing market conditions. The expected utility theory, the prospect theory, and the behavior theory can all be used to make the investment decisions in this case. These theories, in addition to indicating the risks that should be taken by the company, are used to postulate the manner in which the management may make investment decisions. Nonetheless, the allocation of equity and bonds will be influenced by the market forecast that has been provided. The computed risk and return rates of 5.75% and 0.5% respectively are used to make portfolio re-allocations in a manner that will cushion the company against risks. In order to prevent the most volatile equity, the BAT, the company would be wise to reallocate it to the WM Morrison Supermarkets. With regard to the bonds, the company is going to reallocate its Wells Fargo Co MTN BE to US West Communications bonds.