Investment Strategy and Portfolio Management - Essay Example

Investment Strategy and Portfolio Management Table of Contents Introduction 3 Prevalent Issues in the Investment Environment 4 Strategic Asset Allocation 4 The Challenge of Strategic Asset Allocation 5 Tactical Asset Allocation 5 Plausible Asset Allocation for Kaplan Capital 6 Recommendation and Conclusion 8 References 11 Introduction The financial managers of majority of the charitable funds prefer to assign their investor’s wealth to conventional asset categories, for example, stocks, bonds, as well as cash. Nevertheless, these managers have progressively started to include more asset categories, such as currencies, derivatives, commodities, corporate bonds, hedge funds and other illiquid funds. The decision pertaining to strategic asset allocation relates to the selection of funds across these extensive ranges of investment categories. Moreover, the strategic asset allocation decision is the principal determining factor of the risk profile of a fund’s investment. It should be noted that the exposure of a fund to market-wide risk aspects is decided by the strategic asset allocation decision of the fund managers. The market-wide risk aspects that a fund is generally exposed to comprise of the business cycle, rate of interests, inflation rates, and the stock market among others (Jong et al 2008). While making strategic asset allocation decisions, the fund managers have certain objectives. First, the managers want to achieve a satisfactory risk-return trade-off. Second, unlike the conventional investment managers, a charitable fund has definite responsibilities in the form of prospective fund benefits, which often take inflation into account. Finally, the charitable funds make investments on behalf of their investors, who have specific investment requirements and expectations. A fund manager has to balance all these aspects so as to attain a best possible strategic asset allocation alternative (Jong et al 2008). This report discusses the contemporary issues that are prevalent in the investment environment in relation to professionally managed funds. It emphasizes on the prospective strategic asset allocation as well as the tactical asset allocation choices available to Kaplan Capital and suggests actions that the fund manager should take in the upcoming period. Prevalent Issues in the Investment Environment Strategic Asset Allocation Strategic asset allocation generally involves allocation of funds in three assets groups, such as bonds, stocks, and cash. However, enlarging the investment horizon beyond these traditional categories of assets enhances the risk-return attributes of a strategic asset allocation. The inclusion of asset groups that bear minimal correlation with the existing assets in the fund endows the fund with the maximum advantage. Strategic asset allocation can be termed as the practice of identifying the target long-term allotments to the existing asset categories. Strategic asset allocation plays an imperative role in the investment process. This is owing to the fact that strategic asset allocation determines the success of diversified portfolios. The process of strategic asset allocation involves allocating funds to the existing assets classes taking into consideration the fulfillment of the long-term investment objectives of the fund. In other words, the objective of strategic asset allocation method is to decide the long-term coverage to the various asset categories (Idzorek, 2006). The Challenge of Strategic Asset Allocation The realistic realization of strategic asset allocation is definitely not simple. In order to structure a long-term portfolio, fund managers are required to think methodically and consider the preferences as well as the constraints confronted by the investors. The financial constraints faced by the investors could be in the form of labor income or fixed operating expense. Furthermore, it is important that the investors should outline investment beliefs in relation to the future. The fund managers should not only account about the associated risk and the average investment returns, but also about the practices that establish the rate of interests and the risk exposure (Lee, 2000). These beliefs are required to be aligned with certain rational outlook about the stability of the economy. Additionally, the fund managers have to find out the optimal investment combination of assets required to earn suitable returns. Finally, the fund managers have to carry out their strategic investment plan without forming any bias for certain assets that form an integral component of benchmark indices. Thus, the process of strategic asset allocation requires a very systematic and forward looking approach in order to attain enhanced returns from the investment (Campbell, 2002). Tactical Asset Allocation Tactical asset allocation process is generally described as the alteration in the percentage of assets comprising a portfolio, so as to attain certain level of expected returns within a small time period of, for instance, three or six months. Characteristically, these expected returns are the consequence of a rapid and often a big alteration in the expected risk premium level of investors. This often results in a huge modification in the market rates. The sudden rise in the requisite risk premium is owing to the overreaction of investors to a definite piece of news reaching the market (Boulier & Hartpense, 2004). The type of asset allocation process employed by a fund manager depends primarily on the information that is utilized in the decision making process. Generally it can be observed that the long-term asset allocation approach depends mainly on two factors. These factors are the constraints faced by the investors and their long-term expectations for investment returns. The optimal trade-off between the risk and return of the portfolio acts as a benchmark for the investors’ long-term plans. The fundamental driven method of asset allocation is dependent on the average expected return in the period of about 5 years. These expected returns in the medium period reflect the standard anticipated premiums of assets, taking into account the global economic cycle and the structural alterations in the economic atmosphere. These expected returns lead to slow variations in the asset allocation of funds across a period of about five years (Maginn et al 2010). Sudden crucial changes amid the equilibrium value and the market value of an asset make it mandatory for fund managers to allocate assets in view of a short period of time. Such a scenario arises during periods of substantial over valuation or under valuation of the markets. Thus, tactical asset allocations are directed to adjust for short-term mispricing in the market, which is transient in nature (Boulier & Hartpense, 2004; Lee, 2000). Plausible Asset Allocation for Kaplan Capital As already discussed, selection of individual assets is not the chief determining aspect of enduring performance of a fund portfolio. It is rather important that a portfolio comprises of appropriate allocations of the diverse asset categories. This kind of strategic asset allocation is essential for Kaplan Capital because all the underlying assets in the portfolio are likely to respond in dissimilar ways to the alterations in the market circumstances. For sustaining the impacts of the global financial proceedings, it is necessary that the asset components a portfolio display diminutive or no association with each other. The returns of the charitable fund of Kaplan Capital can be further augmented by means of tactical asset allocation. The approach which is used in tactical asset allocation comprises of provisionally increasing or diminishing the proportion of investment in certain asset groups to benefit from the interim fluctuations in the market circumstances. Such variations should always be carried out within already agreed upon boundaries in order to remain in line with the fund’s long-term investment policy (Kleinwort Benson, 2011). It is likely that the fund managers of Kaplan Capital would be careful in their investment outlook and choice of investment strategies since they have to preserve the assets of the group they serve. Nevertheless, it is crucial that the approach opted by the fund is in order with the long-term goal of the charity. In future, Kaplan Capital should opt for additionally diversified strategies and have a more extensive selection of asset groups. At present, the asset categories in Kaplan Capital’s portfolio are limited to equities, government and corporate bonds and cash. It is expected that the net cash outflow of Kaplan Capital in the forth coming six months would rise to about 6% of the total assets of the portfolio. Hence, it is necessary that the fund generates higher returns from the asset portfolio in order to be able to meet the prospective expenses in the new future. The inclusion of asset groups that bear considerably less correlation in terms of performance would help the charity fund to produce higher and more stable asset returns (Maginn et al 2010). Thus, Kaplan Capital should include hedge funds, real estate and private equity in addition to their already existing asset categories of cash, bonds and equities. Taken as a whole, it is necessary the asset allocation that the managers of Kaplan Capital decide on is prepared according to the specific requirements and objectives of the charity fund. The approach employed by the fund manager of a charitable fund plays a significant role in producing adequate returns, which help in funding of the firm’s activities. The returns from the investment attribute for a considerable percentage of annual income of the firm over and above the new contributions made by members. Nevertheless, it had been observed that there are major variations in the performance of the various charity funds existing in the UK (Kleinwort Benson, 2011). This implies that the generation of enhanced returns within an established investment approach can help the charity funds to augment their funding activities. This rise in the funding activities in addition to the generation of better investment returns provide the prospective contributors greater assurance to contribute assets (Kleinwort Benson, 2011). Recommendation and Conclusion It is very important for fund managers to obtain an optimal balance between risk as well as return. It has been observed that investors can generally expect to earn a return of around 5% over the treasury or the gild bond by investing in equities (Barings, 2011). Nevertheless, there have been numerous phases of substantial instability and absolute loss in the markets. Thus, it is imperative that the fund managers stress not only on absolute returns of their funds, but also significantly emphasize on the risk taken to accomplish those returns. This would ascertain that the fund returns are distributed to the investors as steadily as possible. It would be advisable for funds to focus on accomplishing targeted returns instead of comparing their performances against conventional benchmarks. This is because it is possible that a particular fund performs better than the chosen benchmark or peer group, even if it had generated negative returns (Schneeweis et al 2010). Thus, it is desirable that a fund sets a targeted return and attempts to accomplish that return on a regular basis. This approach is transparent and simple to comprehend in addition to being forward looking. The approach of targeted return also provides the fund manager the flexibility to invest in various categories of assets depending on their likeliness to attain the fund’s investment objective. Generally, charity funds allocate their funds across equities, bonds and cash. However, it is not an advisable approach, as studies have revealed that charity funds which employ more diversified investment approaches generate higher returns that those which don’t (Breeze, 2008). The appropriate approach to diversification is one that relies on the risk-return attributes of the existing asset groups. Therefore, the fund manager should plot the various asset groups in accordance to their expected returns and the associated risks. This would enable the fund manager to focus on the highest possible rate of return for the least potential risk. Furthermore, the fund manager would be able to estimate how these assets perform in combination, which would assist the formation of long-term investment strategies of the fund (Maginn et al 2010). Such a targeted investment approach would provide the charitable fund with superior risk-return investment profile in its portfolio. This kind of a portfolio would be better equipped for the potential market volatility in the future and would also not be inclined to some assets that are inherent in a benchmark. In order to keep away from negative returns, it is necessary to adjust a portfolio with the help of tactical asset allocation. This requires investment in asset groups that possess low correlations with existing assets, thus enabling the fund manager to augment returns, diversify risk and accomplish the investment goal of the fund. Furthermore, controlled risk management along with planned elementary research helps in identifying expansion prospects at the stock as well as the sector level (Barings, 2011). References Barings. (2011). Targeted Return for Charities. Groups. [Online] Available at: http://www.barings.com/ucm/groups/public/documents/marketingmaterials/019959.pdf [Accessed March 12, 2012]. Boulier, J. F. & Hartpense, M. (2004). Fundamental-Driven And Tactical Asset Allocation: What Really Matters? International Actuarial Association. [Online] Available at: http://www.actuaries.org/AFIR/Colloquia/Boston/Boulier_Hartpence.pdf [Accessed March 12, 2012]. Breeze, B. (2008). Investment Matters: In Search of Better Charity Asset Management. Institute for Philanthropy. Campbell, J. Y. (2002). Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Harvard University. [Online] Available at: http://kuznets.fas.harvard.edu/~campbell/papers/atlantatalk.pdf [Accessed March 12, 2012]. Idzorek, T. M. (2006). Strategic Asset Allocation and Commodities. PIMCO. [Online] Available at: http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/Commodities.pdf [Accessed March 12, 2012]. Jong, F. D. et al (2008). Strategic Asset Allocation. Maastricht University. [Online] Available at: http://www.fdewb.unimaas.nl/finance/faculty/Schotman/saa2.pdf [Accessed March 12, 2012]. Kleinwort, B. (2011). Charity Investment Services. Kleinwort Benson Bank Limited. Lee, W. (2000). Theory and Methodology of Tactical Asset Allocation. John Wiley and Sons. Maginn, J. L. et al (2010). Managing Investment Portfolios: A Dynamic Process. John Wiley and Sons. Schneeweis, T. et al (2010). The New Science of Asset Allocation: Risk Management In A Multi-Asset World. John Wiley and Sons. Read More