Assets That the Investor Has Chosen to Determine Which of Them Provide the Best Combination of Returns - Case Study Example

?Introduction Selecting the right kind of portfolio poses the greatest challenge to nay investor. It is expensive in terms of time, manpower involvedin data collection and analysis. An investor in a portfolio hedge fund seeks to look at the best kind of investment that should bring in the most favourable results in the future. In our case study, we will be looking at the assets that the investor has chosen to determine which of them provide the best combination of returns. This will be done through looking at how to reconstruct the portfolio in order to give him the best value for his money. Different methods of analysis, reconstruction will be used. The process will involve majorly looking at the different kind of risks inherent in the portfolio and determining ways on how to reduce the risk. Executive Summary The investor seeks to come up with a well-structured portfolio that will serve him the purpose of better returns in the future. The investor has identified seven stocks namely: Barclays, BP, Lloyd Banking, European FTS, ISHARES CHINA, EFTS CMOD SECS, MSCI BRAZIL, and TUI TRAVEL. The investor intends on investing in stock shares as his major line of returns. The portfolio seems diverse as it entails stocks from different regions. The shares are all have a fair volatility ranging from a minimum of 4% -13%.This is a major strength in the portfolio as the investor will be least faced by shares that are quite elastic. However, in my view, the investor poses as one who is a traditional investor. He selects only share stocks and avoids investing in other securities such as bonds. There arises a risk in investing shares; one can never tell the exact time to sell them off as predicting when such shares will appreciate becomes a hustle. At the same time, all these companies issue out dividends. For investor companies, investors prefer that they maintain their levels of dividends so that such monies can be used in investing in other opportunities that would profit the company. In reconstructing the portfolio, I t will involve looking at the risk levels associated with the different kind of stocks and look into eliminating the least favourable ones either through statistical analysis or by going by what the market proposes. While analysing the portfolios past performance, it will entail looking at how the individual stocks performed. Our portfolio is composed of equity based investments. This will entail looking at how the individual shares performed in the industry and across other stocks. In our case, our cut-off date will be on January 1 ,2020 for the purpose of buying stocks. Barclays With Barclay’s stock, the return on equity has decreased significantly over the years from 23.41% to 5.65% in year 2009 through to year 2011.This means that the company has been making low returns over the years or has very high operational costs. At the same time, the company could be having very high equity levels. The price per share for the company is quite low at 2.51, meaning that it is not a very favourite stock among investors or alternatively, the investors foresee a likelihood of the prices going up. It’s good to note that the company’s volatility is a bit high at 10%.This means that the stock is likely to affect a large investor upon any change in the market conditions. The earnings per share has also increased over the years from 25.1 to 35.9 from year 2010 to 2012.This is a very positive remark for the investor as over the years they experience value for their money. The stock also pays out dividends to its shareholders at the end of every financial year. This would be a good indication to a normal investor who looks into trading with shares. However, for the investor’s portfolio this would not be a positive move as the investor would view the company as failing in investment decisions. Usually, investors prefer companies that look to invest their funds in the most profitable investments, companies that can manage to increase their asset base too. The company floats only 87% of its shares and has an average correlation of 0.680. BP PLC. The company’s ROE has decreased significantly from 20.93, 16.86 and -3.88 in 2008, 2009 and 2010 respectively. This means that the company has experienced losses for instance in the year 2010 or that its operating costs have become very high over the years. At the same time, its market and book value of assets has a very high ratio of over 1 over the three years. This means that the company is risk-averse and aims at undervaluing its stocks as compared to those of the market. The stock is performing over 100% better than the stocks in the market. Another feature is that on a quarterly basis, the stocks change severally between a range of -3-10 %.However, it’s good to note that the volatility of the stock is quite low at 4%.At the same time, the earnings per share have stabilized at an average of 1% apart from year 2011 when the EPS was at 135.9.The company is also floating all its shares. Its correlation stands at 0.664 and this is fair enough. EFTS CMODSECS (LON) This is a group of shares that has not been floated at the stock exchange market. The company performs much better than all FTSE shares through from 2009, 2010 and most part of 2011 whereby it begins showing dismal performance way below other stocks in the industry. However towards the beginning of 2012, the stock shows a positive indication by rising slightly above the industry’s averages. Throughout the 12 months of the year, the share changes by a very big margin of about 13% and changes in a negative direction when compared to the industry’s averages. This would be a good share to include in the portfolio as it is not mostly determined by the fluctuations that affect the stock exchange. The European EFT The company experiences a volatility of 5% as compared to other stocks in the industry. The company has not listed on the stock exchange but pays out dividends to its members. As compared to other stocks in the industry, it performs slightly above industrial averages with most at times performing at the market average. It changes negatively as compared to other stocks in the industry and would form a good stock for portfolio diversification as its not affected by the market. However, this would be a very risky asset as most at time the change produced by the market is usually to protect the risk averse investor. ISHARES CHINA The company has been experiencing an average volatility of 5%.It has all its shares as free float for investors who are willing to trade. The price of the stock changes negatively in the year basing it on quarterly basis; this means that the share is not so stable. ISHARES MSCI BRAZIL Between the beginning of 2009 and towards the end of 2011, the share has been performing way above the market average. However, the change significantly dropped and has stabilized with the market average. However, that change has been a gradually positive one. Lloyds Bank This is one of the shares in the portfolio that has a very high volatility at 13%.It has 40% of its shares held by strategic shareholders and the investor would only be pen to invest utmost 60% of the total shares. Its asset correlation stands at 0.689.The stock performs quite well as from 2009 and 2010 and this good performance becomes gradually dismal from mid-2010 until late 2011 even below the market average that the change begins to happen in 2012. TUI TRAVEL The company has 60% of free float available to the investor. The average FTSE shares have its price index very high. However, the company has managed to maintain a high price index which seems to be rising at a high rate. Its volatility is also rather high at 8%.At the same time, its EPS has increased significantly from about 8 to 26 from the year 2011-2013.This is a very good stock that is independent of other stocks in the markets. BT 5.75% 2028 Bond This is the only bond that the investor has chosen. The bond has experienced two major downfalls, one in the year 2000 and the other in year 2010.The bond has a return of interest of 5.75% which is very fair for an investor. The bond matures in the year 2028.It is advantageous and not as inflexible as the equities. Possible Risks The company will be incorporating various stocks from different industries. This leaves it in a position of facing risks as result of merging the various weaknesses of different strategies. Large number of Equity or traditional Assets as opposed to hedge funds The company should focus onto investing in other securities such as bonds, bills. The company only has equity shares; it would be advisable to invest in other securities as opposed to investing in only one line. This is because shares tend to experience a common trend especially when they are listed in stock exchange. Uncertainty of new stocks: Most stocks in the investor’s portfolio are new even in the market. New stocks are not stable hence the investor even being risk averse may not be in the best position to get good returns as new stocks are usually unstable. The trading risk associated with new stocks is usually very high. Such stocks include EFTS CMODSECS (LON) and European ETS. The Stocks have not been in the market for so long. The investor will have to do research and get the proper knowledge on such similar stocks. Other research would be on what is the average attitude of the investor, what would be the public interest in such stocks, what is the company’s investment in investing in such new areas of trade, study of the company’s management. Is the company’s new management experienced and has the right skills. What kind of financing options, alliances, collaborations and partnerships that the company has invested in. An analysis of this kind of nature if positive will reduce the investor’s risk in the stocks. If negative, the investor will have to change his portfolio to include other stocks.( The ordinary investor) Other risks that are associated with the investor’s portfolio would be Economic Risks; the investor would face very many fears associated with investing in the market place. Such factors would include political instability in case the country holding any investment goes into political chaos, terrorist attack, inflation or depression. But it’s good to note that the investor has tried to mitigate this risk by diversifying his portfolio into different countries such as Brazil, the US, China and Europe. This helps him reduce the risk of ‘putting all your eggs in one basket’. Inflation: Inflation is a scare to every investor. This is because it reduces the value for your own money. There is no investor who tends to escape this risk, at one point in time; all people get affected by this due to the fluctuation in the economy through depressions and recessions. The inflation may not be felt so much by our investor as all his investments are in the form of stocks. The advantage is that the companies holding such stocks usually adjust the prices of the stocks to accommodate the inflation usually to the advantage of the investor. The Market value Risk: The market usually changes and what is regarded as the ‘hottest’ investment no longer becomes as desirable as it was there before. This is usually the case especially where the markets are really competitive and the economy is very industrious. For our investor, the stock in China would most likely face this kind of risk. China is a market that is very industrious and dynamic with radical changes taking place every day. This means that the stock would be faced out after some time, as there are so many new companies coming up day in day out. Being a top conservative: This refers to an investor being one who is risk averse or such a careful investor. The investor has invested heavily on shares as opposed to other hedge funds such as bonds and bills. This kind of investment may be safe but limits one from reaching their financial goals quickly or ever reaching them considering that at times markets cannot be independent, they move in the same direction as other external factors. The force of sale risk: There is a major advantage in investing in stock shares as one is assured that at a particular time your stock is going to appreciate, the problem is that you are not sure when this will be. This puts the investor in a tight point as he may be forced to sell the stock at a time that he is not prepared. Our investor has most of his stocks in shares and being risk averse he is incapacitated in determining when his shares will appreciate and when to sell them off and as a result he may sell them immaturely. (Investing for Beginners) Very high correlation: Assets in the portfolio have a very high correlation. The correlation ranges from 0.56 -0.69.This is very high correlation of stocks. This means that as the market or industry changes, the stocks change in a similar direction. The investor stands at risk as the assets will not stand a test of time. The most advantageous or fair risk would be one that correlation ranges between -1.0 and 0.1. Recommendations for the Investor The investor should therefore step up to mitigate various risks by doing the following:- Technical strategies Since our investor is new in the market, he should take time and observe how all the seven stocks behave in the market. He will need to come up with daily charts of observing how each individual stock is doing and record. He may need to come up with a list of top performing stocks and least performing stocks. However, when doing this he has to place in mind that stocks behave differently and a stock may be performing too well but in future may not be so productive. An interesting stock to watch would be EFTS CMODSECS, the stock has had a very low past, always performing below the market average. However, the stock has all along registered a positive slope all this while and in the year 201 it should be performing better than the market average. Another stock would be I SHARES FTSE CHINA, this stock begins by being above the average market price index but as time goes by it drops considerably and goes below the market average. This is a stock that the investor should watch much more closely with lots of skepticism. Lloyds Banking comes in as a very unstable stock and its price index being very irregular. The stock moves from being one that is performing way above the market average to being below the market average though it later begins to reclaim itself at the beginning of 2012.It would be interesting to watch how this stock would behave in the coming year 2012 considering that it has the highest volatility of 13%.In my view , this would be a very risky investment for the investor. Fundamental Strategies; this is a bit different approach from the strategic strategy. It looks critically at each individual stock’s relatives in the market. It looks quantitatively and qualitatively at how other stocks are behaving in the market. It entails at looking at how these stocks will affect the security’s value. If the relatives are doing much better and recording positive results than the investors stocks, then it would not be advisable to bring in the stocks. Social Strategies: This involves getting information from crowding sources that give information about the best performing stocks, stocks to buy and other stocks to watch in the long run for the investor. Our investor will have to do this as it would be blind of him to fail to listen to stock experts considering he possesses very little or no knowledge about the stocks history. A stock’s history for about 2-3 years would not be sufficient to help an investor determine the best investments to dig into especially when investing in hedge funds that are critical to a strategic investor. Create an automated portfolio Management. The investor should create an automated portfolio management system. He will then feed the system with the data of the seven stocks. He will select the appropriate assets as generated by the machine and determine the combination that diversifies risk level. The engine will provide him with the most profitable kind of stocks to buy and will get to know the most optimal number of stocks to buy.(Portfolio and risk management) Portfolio reconstruction: The investor will also have to obviously reconstruct the portfolio. Reconstructing your portfolio is evaluating whether all your investments are performing according to your expectations. The process involves removing underperforming assets and replacing them with others that are more productive and promising. The underperforming assets may be due to the changing dynamics of the economy or difference in timeline with other performing assets in the portfolio. We will be looking at the opportunity cost of deploying or holding onto these investments. The investor will use the following techniques to evaluate his data and determine which combination of assets will make the best possible portfolio. Stratification. This is a method that mimics the summation of a very broad fund index. The method is disadvantaged as it will not add value to the construction process and would be least recognized. For the portfolio, the investor would stratify as follows:- In our case, the safest and risk free investment would be Barclays as it has the most stable returns of 4551m in 2009, 6007M in 2010 and 5819M in 2010.Its shows gradual increase in return and for a risk-averse investor, it would be among the first rank strategies. Secondly would be the BP that has its return at 16537, 13605 and 621 through years 2009, 2010 and 2011 respectively. Others stock would rank later in the portfolio as they have a new inception. Modified value at risk Optimization (VaR) This method comes in as one of the more preferable models of evaluating risk. The method to use in our portfolio would be the Variance-Covariance method that will assume a confidence level of 99% in measuring the risk of losses.(J.Tang) Correlation between Hedge Fund Strategies. At the same time, we will need to invest in assets that have little or no correlation to each other. This is called asset diversification. The investor will need to realize that if assets are not diversified there is a very high risk associated as in case of risk accruing, the investor may suffer loss. Assets need to move in different direction such that the correlation of the assets should be negative. In the portfolio, most of the assets have an asset correlation of below 1.Barclays has a correlation of 0.680, BP has one of 0.664, Lloyd Banking a correlation of 0.689 and TUI a correlation of 0.561.These kinds of correlation tend to provide bad diversification of the asset portfolio. A good portfolio would be at -1 and 0.1, otherwise scenario would mean that the portfolio does not provide a good balance. For instance the investor has assets from banking such as Barclays and the Lloyds Banking that will move in the same direction as they are affected similarly by the prevailing market conditions. In choosing the portfolio assets, the investor needs to consider that. The investor has also diversified his portfolio by investing in various foreign stocks. This is in particular to shares in MSCI Brazil and Xinhua China, the FTSE shares particularly play a very major role in diversifying of the portfolio. The investor could also consider looking for more investment that will bring in higher dividend yield and stable balance sheets as they promise increased cash. The investor could also consider investing in solid assets such as gold, diamonds, silver, natural gas and oil .These assets tends to be very stable when it comes to change in the environment. They work best when it comes to portfolio construction. Their volatility is also very low as compared to other stocks. This is because factors that affect them tend to be across the divide and they enjoy some level of monopoly due to their natural availability. Market forces play an almost insignificant role in their case. Tactical Allocation This entirely refers to identifying strategies that will help in making the portfolio mix elastic in accordance with the changes in how return and risk usually behave. This will just be through the introduction of markets that will serve this sole purpose and at the same time bring in returns. Such assets may not be totally geared to investment but to ensuring that the portfolio is elastic to the market. For instance, the total composition of these strategies would be about utmost 40% as it could happen to fail due to a change in marketing strategy or even in wrong timing. The investor will have to look at past performance of different markets and discover the likely economic problems that would arise afterwards, the investor will look into ensuring that he brings in a stock/market that is not affected by such prevailing conditions. For instance, if there were certain conditions of inflation and depression ,the investor should consider assets that are almost inelastic to this change for instance stocks in the oil industry, stocks in the Alcohol Industry among such other strategies. The investor could also embark on Regional Allocation of assets in different regions such as Japan, the US, Europe as different regions experience different economic conditions. Recommended Portfolio In advising the investor, I would consider a combination of the following assets. Barclays in place of Lloyd Banking as they both fall in the same banking industry. Barclays has a lower volatility at 10% as compared to Lloyd’s that falls at 13%.Lloyds also has a higher coefficient as compared to Barclays. Barclays also has a higher percentage of free float. However, upon eliminating Lloyd ,the investor should consider other options available in the industry that have better price index, lower volatility and lower coefficients as compared to Barclays. This stock may not be the best to invest as its risk. EFTS CMOD SECS: This would be an interesting stock to watch. It begins way below average but as time goes by it gradually increases and goes beyond the market average price. It also has a low volatility at 4%. MSCI BRAZIL: The share is rather stable as compared to other market stocks. It maintains above the average of the market though slowly becomes unstable towards the end of 2012 but slowly picks up .It would be a good stock to include for asset diversification in place of the China stock. It has an acceptable volatility maintained at 5%. BP STOCK: This would be included in the investors choice in order to compare other stocks within its industry. It a great asset for asset diversification as it’s a solid asset. However, upon conducting market surveys in the industry, it does not fall under the best performing, meaning the investor has more options. BT 5.75% 2028 Bond: This is the only bond that an investor could use to diversify the portfolio. The investor has only focused on long-term investments in terms of stocks. However, the investor could still consider looking at the market to get other bonds and bills that could be doing much more favorably. CONCLUSION In my conclusion, I would wish to state that the investor has tried to really diversify his assets. His assets for example would be invested across many regions for China, Britain, Brazil and the USA all of whom experience different kinds of economic conditions and would fall in as security for each other in case of certain risks maturing. The investor should always seek to bring in those stocks that can be trusted to maintain returns through the long run. He should also diversify his portfolio into other assets such as bonds; bills that will help him acquire value for money within a very minimum period of time. Being a hedge fund means that the investor has to acquire much more knowledge as compared to other ordinary investments. Hedge funds include very complex security instruments and their investment methods tend to be more opaque and focus to long term characteristics. The investor will have to engage a lot of statistical analysis during the first years of inception. He should also observe this analysis for about an year or so before he puts the investment on.(J.Tang) Reference List Asset Diversification extracted from < http://www.theskilledinvestor.com> viewed on 15/04/2012 at 0930 hrs. Beginners guide to asset allocation extracted from < http://www.sec.gov > viewed on 14/04/2012 at 1015 hrs. 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