The Equity Markets Are the Best Investment Avenue from the Long Term Perspective - Coursework Example

Look at the Assignment Criteria Table of Contents Table of Contents 1 Introduction 2 Issues in investment environment 2 Alternatives for asset allocation 4 Recommendations 6 Conclusion 8 Bibliography 11 Introduction The modern financial markets offer a host of investment opportunities. The returns earned on these investments depend on the maturity and risk involved in the financial instrument. A fund with a long term horizon can take the advantage of the higher returns offered by the equity markets. The equity markets are said to perform well in the long term. Therefore this is the best investment avenue from the long term perspective. Other long term investments include long term bonds, insurance, property, etc. For the short term horizon a fund can opt for bonds of short term maturity. Issues in investment environment The investors faith in the equity market was shaken after it plunged in November 2008. Buoyed by the high long term returns the people had invested heavily in the capital markets. It is true that the equity markets still offer good returns from the long term point of view (Credit Suisse, 2009). For this an investor must stay invested in the equities. In the past 109 years the markets worldwide have given variable returns. There are certain events that cannot be predicted in advance and hence the direction of the markets in such situations cannot be forecasted as in the case of the recent global crisis when the worldwide markets bottomed out. This has depressed mood in the equity market thereby making the investors risk averse. As the share prices are low buying equities may provide good returns in the short term. The current annualized equity risk premium of 3.5% shows that the equity returns compound faster and is likely to benefit the investors in the long run (Credit Suisse, 2009). The markets have recovered over the previous levels with an improvement in the market demand. This has improved the revenue of the companies and making a positive impact on their earnings. It has been observed that the share price of a company falls when the markets expect the earnings of the company to decline whereas the markets react positively to improved earnings. From this it can be inferred that the improved corporate earnings is likely to push up the markets making it an important investment avenue. Till the middle of 2007 the companies were able to issue bonds at a spread of less than 100 bp beyond the risk-free rate. With the deterioration in the global market the bond market closed towards the end of 2008. It reopened in 2009 focusing only on the cream companies (Water UK, 2009). To boost the economy the central banks of the various countries have kept the interest rates low. This has been done to stimulate new investment. The high rate of inflation together with the low interest rates has lowered the real interest rate. This is also reflected in the returns earned on the bonds as the low rate of interest has taken the sheen from the bonds. The governor of Bank of England Mervyn King has said that the rise in inflation is temporary. From this it can be interpreted that the interest rates in UK are not expected to rise in the near term (Yahoo Finance, 2010). The fall in the price of long-dated bonds is steeper than the short- dated bonds. In the current market the interest rate is low. Low interest rate has made the long term bonds unattractive for investment. It is not expected to rise in the near term. This may be one of the reasons that the demand for the long term bonds is less as no one wants to block funds at the current interest rate for a long period. The property market in UK is yet to recover from the recessionary phase. Price in the property market has risen in merely 7% of the postcodes. Moreover this is accompanied by a low volume (This is money, 2010). The housing market in UK has declined by nearly 20% from the highest levels in 2007. As the sentiment in the housing market is currently bearish its recovery will take time (Walayat, 2009). Alternatives for asset allocation Morris Capital is a UK based fund house with the primary objective of financing educational requirements of children. The members of the fund house can withdraw their money after a period of 5 years. Asset allocation of the fund comprises of UK equity; overseas equity; commercial property; corporate and government bonds and cash and short term instruments. The allocation of assets is based on the policy of the portfolio. This is governed by the financial objective and risk appetite of the fund. As Morris Capital is a fund set up for meeting the educational needs of children it can be assumed that the fund house has a low risk appetite. This is also evident from its limited equity exposure. The risk bearing capacity of a fund sets the benchmark while allocating funds into different asset classes. As the risk of the fund house is low it can invest the funds in government bonds and other highly rated corporate bonds. The fund house expects that from June 2010 the fund withdrawals will exceed the fund inflows by 3% annually. This means the time horizon of the funds will fall making it necessary for the fund house to maintain sufficient amount of liquidity for meeting the demand of early withdrawal by the members. A fund house with a long time horizon can afford to take more risk. This means that the fund house can invest a significant percentage of its funds in the equities. It has been seen that the equity markets give good returns in the long run thus making it the preferred asset class from the long term perspective. Morris Capital has a five year horizon before a member can withdraw the money. This means that the initial amount deposited by a member remains with the fund house for a fixed period of five years. The fund house can invest a significant portion of this fund in the equities. This will help it in creating value for its members. For the funds that are expected to mature in the near-term the fund house must allocate limited proportion in the equities. This is because excessive equity exposure for these kinds of funds can be risky as this is a mature fund. For the mature funds the fund house can invest the money in the fixed income earning assets. These assets do not have any risk and give quick access to funds. The fixed income earning instruments like the government bonds of short term maturity falls within this class of investment. . The importance of asset allocation particularly increases in times of financial difficulties. Bonds are considered to be the safest and therefore a greater percentage of the funds must be allocated to this asset class. But when the interest rates are low it is recommended to invest in the bonds with short term maturities. This is mainly because when the interest rate in the market finally starts rising, the option of reinvestment in the bonds offering a higher interest rate can be availed (Texas Bank and Trust, 2006). Therefore the fund house must be careful while choosing the bonds. As the market rate of interest is currently low the fund house must invest in the short term bonds. This will give it the opportunity to invest in the higher rate instruments once the market condition improves. The investment in properties is suitable for a long term investment horizon. Property prices appreciate fast but the problem with investing in this type of asset is the lack of liquidity in the property market. For meeting the payment on the funds, Morris Capital must allocate a lesser proportion of its funds to property. Moreover the property market is still passing through a bad phase as the recovery in this asset class will take time. It will take a few more years for the property market to stabilize. Morris Capital already has a 5% allocation to the commercial property. The fund house has forecasted that after June 2010 the cash outflows will exceed the cash inflows. As the property market is currently depressed it may not be profitable for the fund house to liquidate its property investments in the present market scenario. If the forecast of the fund house turns out to be true then it may face problems with regard to meeting the withdrawal demands of the members. Therefore the fund house must invest a limited portion of the financial contributions in properties. This will provide the needed cash for meeting the withdrawals by the fund members. Recommendations The recovery in the markets has already begun. This is evident from the rise in the market indices of the Asian countries. With the rise in the market demand the earnings of the company has improved. This is a positive indicator for the financial markets. It has renewed the interest in the equity markets. The rise in the company earnings has pushed up its share price. In this market environment Morris Capital can opt for stock selection technique. It can identify the undervalued and overvalued stocks. The fund house can enter into a short position on the stocks that are currently overvalued. Similarly it can enter into a long position i.e. buy the stocks that are undervalued. Basically the fund house can adopt an active strategy for the equity markets i.e. it can exit its short position in the overvalued stocks when their prices fall. Similarly it can sell the stocks in which it has a long position when their prices rise. At the time of investing in the bond markets Morris Capital must be careful with regard to the maturity of the bond. In the current low interest rate scenario the fund house must refrain from making investments in the long term bonds. This is because with the rise in the interest rates in the future the price of the low interest bearing bonds will fall (Washington State University, n.d.). Investing in the short term bonds is recommended in this type of market scenario as the amount realized from such bonds can be reinvested in the high interest yielding instruments once the rate of interest moves up. This means that the fund house must keep a careful watch on the interest rates to make use of the favourable interest rate movements. The property market will take time to recover. This means that the fund house has to exercise a passive strategy with respect to this asset class as the property market in UK will take a few more years to give positive returns. Due to the limited liquidity in the property market it is recommended that the fund house does not allocate much of its funds to this asset class. This will unnecessarily block the funds creating problems in making fund payments. With regard to the current 5% investment in this category the fund house must wait before liquidating its investments as this will not yield significant profits. Presently the best strategy for the fund house is to invest in the emerging economies of Asia that have not been impacted much by the global recession. Besides this the fund house must monitor the interest rate movements while investing in the fixed asset instruments. Apart from this the fund must also consider the tax benefits that it can avail from the choice of an investment. This increases the effective rate of return that it is able to earn on its investment. Conclusion As it is not possible to forecast the future the investors must assign strategic weights to the various asset classes. This tactical allocation of the weights is based on the investment objective as well as the maturity of the fund. A pension fund with a higher proportion of the active members over the retired members has a long term investment horizon. Therefore it can safely allocate a higher percentage of its funds to equity. If the investment objective of the fund is to invest in low risk assets then it must assign a minimum weight to equity in the portfolio and invest heavily in the fixed asset instruments like government bonds, deposits, etc. Reference Credit Suisse. 2009. Credit Suisse Global Investment Returns Yearbook 2009. Available at: http://emagazine.credit-suisse.com/app/_customtags/download_tracker.cfm?dom=emagazine.credit-suisse.com&doc=/data/_product_documents/_shop/254094/research_institute_yearbook.pdf&ts=20100217064308 [Accessed on February 17, 2010]. Texas Bank and Trust. 2006. Investment strategies in the current market environment. Available at: http://www.texasbankandtrust.com/trust_pdf/1grow/Investment%20strategies.pdf [Accessed on February 17, 2010]. This is money. 2010. Are house prices rising in your postcode?. Mortgages & Homes. Available at: http://www.thisismoney.co.uk/house-prices-postcodes [Accessed on February 17, 2010]. Walayat, N. 2009. CURRENT UK HOUSING MARKET ANALYSIS AND FORECAST TRENDS. UK Housing Market Crash and Depression Forecast 2007 to 2012. Available at: http://www.marketoracle.co.uk/Article8080.html [Accessed on February 17, 2010]. Washington State University. No Date. Bond Value: Three Important Relationships. Session 3: Bond Valuation. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page24.htm [Accessed on February 17, 2010]. Water UK. 2009. 2009 Investor Survey A report by Indepen for Water UK. Available at: http://www.water.org.uk/home/policy/reports/finance/2009-investor-survey/investor-survey-2009.pdf [Accessed on February 17, 2010]. Yahoo Finance. 2010. Bonds round-up: Stable UK rates expected. Available at: http://uk.finance.yahoo.com/news/bonds-round-up-stable-uk-rates-expected-digilook-f417b276538a.html [Accessed on February 17, 2010]. Bibliography BBC. 2008. The downturn in facts and figures. UK Downturn. Available at: http://news.bbc.co.uk/2/hi/business/7734971.stm Brigham, F.E. Houston, F.J. 2007. Fundamentals of financial management. Thomson. Dimson, E. Marsh, P. Staunton, M. 2002. Global evidence on equity risk premium. Available at: http://faculty.london.edu/edimson/assets/documents/Jacf1.pdf Read More