Investment Strategy for Morris Capital - Case Study Example

INVESTMENT STRATEGY Introduction: Summary of Case Facts Morris Capital, a UK fund established in June 2005 for educational purposes, enjoys a charitable fund status. Members who contribute to the fund are allowed to withdraw their funds after a minimum period of five years, if they wish. The portfolio carried by the fund, with assets amounting to £13.5 million as of 1st January 2010, is allocated as follows: UK equities 35% Overseas equities 20 UK government bonds 20 UK corporate bonds 15 Commercial property 5 Cash and short-term instruments 5 ------- Total 100% Beginning June 2010, members will be eligible to withdraw their invested funds that have matured within 5 years. It is estimated that funds outflows will exceed funds inflows by 3% per annum for the next 5 years. Advice is now sought by the investments committee of the fund, as to the future strategic allocation and tactical asset allocation ranges. This report is required to present the following matters: 1. Current issues affecting the investment environment 2. Alternatives for plausible strategic asset allocations 3. Recommendations for the actions the fund should take 4. To what extent the fund should use “active” versus “passive” investment approaches in the different asset classes. Preliminary considerations Before any recommendations can be made, the nature of the investing fund should be discussed so that certain limitations as to what may or may not be done could be determined. Firstly, the Morris capital possesses a charitable fund status, which enjoys certain advantages but at the same time imposes specific restrictions as to its financial activities. Among the advantages, is that it is tax exempt for several kinds of taxes, and is also eligible for business rate relief and allows its contributors tax relief on their donation. Among the restrictions, however, is that all money raised and surpluses realized may only be distributed according to the purpose of the fund. This usually precludes the distribution of dividends to the contributors, since the charitable nature of the fund does not allow it to serve the pecuniary interests of its contributors (Business Link, 2010). For this reason, therefore, the fund could not be truly considered a competitor with other funds such as mutual funds and depositary institutions for investment purposes. Mutual funds and deposit accounts with interest payments are managed for the purpose of financial gain for the investor. It is thus important to realize that in creating an investment strategy for Morris capital, there is no need per se of matching or exceeding the gains made by mutual funds and other investment instruments. Returns should aim at the fund’s sustainability to meet its purpose (providing education) and to recover its investment base (compensate for withdrawals). 1. Current issues affecting the investment environment During the period 2007-2009, the country, as well as the world, witnessed the meltdown in capital and wealth in what is now known as the financial crisis. Originally triggered by the cascading default in sub-prime mortgages, falling property values eroded the collateral base of the mountain of debt that had piled up as a result of the aggressive lending policy of the US financial institutions. The now-famed credit crisis resulted, followed by a slowdown in business activity and economic recession. In 2010, a gradual levelling off and recovery of economic indicators has been seen, the earliest of which is the stock market index which is taken as the leading indicator of the directions taken by the economy. At this point in time, housing prices are at low levels, stock prices are undervalued, unemployment rates have peaked, inflation rate is under control, and commercial activity is starting to pick up. There are still some issues that concern economic planners and investors alike, namely: 1.1 Regulatory reforms in the financial industry Changes already made in the Basel Accord to address the crisis may continue to undergo adjustments, with the expectation that measures will tend to increase control and tighten regulatory standards. There are several of the opinion that tighter regulatory measures should be adopted, particularly among investors seriously hit by the recent crisis. There is currently a recommendation by the Group of Thirty which is under consideration about global financial regulation, seeing as how the recent crisis began in one country (the US) and spread to others (the UK) (Crowley, et al. 2009). 1.2 Role of UK government in the businesses that had been bailed out There is still existing concern about government intervention in private business due to massive infusion of government funds in distressed industries. It is believed that the government’s loans to these banks will eventually turn into equity, or that even in its role as creditor the government will have the right to interfere in the way the company runs its business. Businessmen have began to complain that government has begun to overstep its bounds from intervention to meddling, and lacking in the expertise of running a business, will tend to run it inefficiently (Francis, 2009). Investors in such businesses will naturally be concerned that there would be a risk that they would not be able to recover their investment. 1.3 High level of public debt According to BBC News (21 May 2009), the UK was downgraded by ratings agency Standard and Poor’s from “negative” to “stable” for the first time ever since the agency began analysing public finances in 1978. The reason was that according to S&P’s view, the UK’s finances were rapidly deteriorating. This assessment appears to be based on the report by the Office for National Statistics that public sector net borrowing increased to £8.46 billion in April 2010, from only £1.84 billion only 12 months prior. This could be disadvantageous for the economy because a credit downgrade will increase costs for UK borrowings abroad. Higher costs of borrowing will further increase government spending, and will create pressure to raise taxes. Furthermore, bringing down the debt level entails painful measures such as tax increases in a situation of rising unemployment, and spending curbs that may dampen growth. 1.4 Government’s deficit spending The following graph shows the upward adjustments in forecasted budget deficits after factoring in the effects of the economic crisis. According to the BBC report, government funds have been depleted by higher social benefits payments, as well as lower tax receipts due to increased unemployment and reduced business outputs and business closures. Another consideration is the cost of the massive bailout package which taxpayer’s money had been made to defray. 1.5 Clash between FSA regulation and the EU legislation It should also be taken into consideration that The UK, as all member countries within the European Union, is presently struggling with the practical issues of financial and legislative integration. The UK through the FSA is abiding by a principles-based, outcomes-based approach in regulation, while the EU rules require more detailed, strict, and tighter oversight. 2. Alternatives for plausible strategic asset allocations Presently, the asset allocations are as presented in the stated facts of this case. The heaviest investment is in UK equities at more than one-third, followed by overseas equities, UK government bonds, UK commercial bonds, commercial property, and cash and near-cash assets. From Bloomberg and Watson Wyatt information services, it is determined that as of December 2009, the average equity dividends on UK equities is -10.9%; that the average yield on UK corporate bonds is 5.8%; and the coupon rate on one-year government bonds is 4.25%. Since the country of origin of the overseas equities have not been divulged and the cash and near-cash placements have been aggregated, the returns for these shall be assumed at the average rates of 3% for overseas equities, and 1% for cash bank deposits. From these proxy values for returns, the weighted average return of this portfolio may be computed at 6.4%. Adopting the conservative view and assuming further that new contributions amount to an additional 3% of the fund’s value, then the cash inflow amounts to an annual rate of 9.4%, and the expected cash outflow is 3-percentage points higher than this, or 12.4%, an estimate bordering on the worst-case scenario. Thus, an adjustment to the allocations should gain a total weighted average return of at least 12.4% in order to maintain the fund’s value. From the foregoing considerations, it is recommended that a reduction in the allocation to equity be made, down from 35% to 20%, Investment to UK corporate bonds should be increased from 15% to 20%, and that of UK government bonds increased from 20% to 30%. This should bring the weighted average return to about 12.5%. The table that follows shows the computation. From the final figure, the proposed new asset allocation for the fund portfolio should yield somewhere in the region of 12.53%, which should surpass the theoretically derived 12.4% attrition rate of the fund due to withdrawals. 3. Recommendations for the actions the fund should take The fund should concentrate on investing in cash-yielding investments. Its purpose is to build up its capital base that will be gradually eroded by the withdrawal of seed money by the sponsors involved. The recommended action is thus for it to gradually shift its funds from the equities to the government securities and bonds, which it should overweigh at this time because of their lower risk and their consistent cash yield. It is recommended that the investment of the fund here be raised by 50% of the current investment, since the fund is in dire need of cash to shore up the coming years. The fund should also increase its investment in corporate bonds. The number of company closures has gradually reduced and it is now visible which of the companies appear to be safe from failure, so choice as to which companies should be invested in will be easier to gauge. 4. To what extent the fund should use “active” versus “passive” investment approaches in the different asset classes. There are various implications between active and passive investment approaches. An active investment approach requires the deliberate decision-making of a fund manager, who analyzes the market, forecasts where each asset appears to be going, and making custom decisions about which to buy, hold or sell and at what prices. Sometimes, active investment is described by its selectivity because of the action of picking-and-choosing assets. Passive investing, on the other hand, is done automatically, usually based on the basket of stocks or assets that are linked to a certain index, and the adjustments or placements are made mechanically. For instance, with regard to the Standard and Poor’s 500 Index, a passive fund will own all 500 stocks that are listed in the index. An actively managed capital fund, however, will only pick the best 100 to 200 stocks on the list. By “best” is meant the most advantageous, according to the enlightened discretion of the fund manager, arrived at after careful analysis and comparison (Anspach, 2009). For the Morris Capital fund, a charitable fund, safety is the primary issue, followed only by earnings capacity. So far, it has been the bone of contention among market observers as to whether custom-managed funds outperform the index in terms of realized gains (Regnier, 2009). There are certain instances that a fund may outperform the market, but analysis of individual trades shows that this may be occasioned by insider information, and there is seemingly no consistency because of the time element. A fund that outperforms the index during the boom years may fail during the bust. Since the interest of Morris Capital is not to realize windfall gains, so much as to ensure a regular and consistent flow of cash, passive investment will serve it better since it is easier to track the index. Furthermore, Morris Capital will benefit from the lower costs of passive investment, as actively invested funds can be much more expensive than passive funds (Cobley, 2009). Conclusion The foregoing recommendations are given as one of several possibilities, which it is expected the fund management agent shall weigh carefully against others. In summary, this representation urges emphasis on safety, liquidity and capital preservation. REFERENCES Anspach, D 2009 What is the Difference Between Active and Passive Investing? Accessed 15 February 2010 from http://moneyover55.about.com/od/howtoinvest/a/activevspassive.htm BBC News/Business. 21 May 2009. Rating agency warning on UK debt. Accessed 15 February 2010 from http://news.bbc.co.uk/2/low/business/8061019.stm Bloomberg financial services. 2010. Accessed 15 February 2010 from http://www.bloomberg.com/markets/rates/uk.html Business Link. 2010 The charity model and social enterprise; How to get charitable status. Accessed 15 February 2010 from http://www.businesslink.gov.uk/bdotg/action/detail?type= RESOURCES&site=210&itemId=5000789540 Cobley, M & Cowan, L 2009 In Europe, Are Active Managers Worth It? Wall Street Journal - Eastern Edition, 6/3/2009, Vol. 253 Issue 128, pC2 Crowley, D F C; Heiman, B J; Miller, R C; Morgan, P J; Perlow, M D; Tang, D K Y; Page, K S. Group of Thirty issues road-map for financial reforms. Journal of Investment Compliance (Emerald Group), 2009, Vol. 10 Issue 2, p50-53, 4p; DOI: 10.1108/15285810910971292 Francis, T 2009 Has Government Crossed the Line? BusinessWeek Online, 6/15/2009. Sourced from Academic Source Complete. Luxenberg, L 2009 Why Doesnt Everyone Use Passive Investing? Accounting Today, 4/20/2009 Supplement, p4-6 Regnier, P 2009 Can You Outsmart the Market? Fortune International (Europe), 12/21/2009, Vol. 160 Issue 11, p34-38 Watson Wyatt financial figures. 2010 Accessed 15 February 2010 from http://www.watsonwyatt.com/europe/pubs/statistics/render2.asp?ID=19 Read More