Risk Management and Investment of Investment Trust Fund - Case Study Example

Risk Management and Investment Risk Management and Investment Executive summary This report seeks to transform an old portfolio with the establishment of new means for achieving a fund’s aims. The report begins by analyzing an existing portfolio and the past performance of the old fund. It determines the specific risks that would prevent the achievement of the fund’s aims, upon which; some recommendations will be put forward to help in curbing the existing problems in the portfolio. This report finds out that there are many risks that exist in the portfolio, despite that it is a good portfolio.in the modification of the old portfolio, the report will give some specific recommendations that comprises excluding and the addition of some assets to the structure of the new portfolio. This would improve the fund’s performance. Table of Contents Background of the Fund 4 Purpose of the Fund 4 Assumptions 5 3. Past Performance of the Fund 5 Annual Return of the Fund 5 The Divided Yield and the Total Interest 5 Capital Asset Pricing Model (CAPM) and the Return of the Fund 6 Comparing Funds 7 4. Risk Analysis 7 Standard Deviation 7 Value at Risk 8 Shape Ration 9 Stock Specific Risks 10 Portfolio Risks 11 Asset Allocation 11 Eliminating Assets from the New Fund 12 Adding New Assets to the New Fund 13 Outline of the New Portfolio 13 INVESTMENT THEORY 14 References 16 Introduction Background of the Fund Located in the UK, this investment trust fund is aimed at maximizing the long-term returns and at minimizing the risk of capital loss. The particular fund is comprised of ten assets, namely, I Shares FTSE Bric 50 Fund, BP PLc, TUI Travel, Barclays PLC, LIoyds Banking Group PLC,ETFS Gold, I Shares FTSE/Xinhua China 25, BT 5.75% 2028 Bond and the Standard Chartered 7.75% 2018 Bond. All securities are comprised of stocks listed in London Stock Exchange while none of them is a bond. In this report, we shall analyze the past performance of fund and the associated risks of the fund that could prevent the achievement of the fund’s aims. The report shall also outline some recommendations for the portfolio that shall ensure that the fund achieves its aims (Alexander, 2009, pg.55). Purpose of the Fund The investment trust analyzed is in the type of a hedge fund whose aim is to maximize income and maintain low risks of capital loss. In this case, the fund should invest in securities with the minimum possible risks and with a stable income. Structure of the report This report is presented with explanations to events that lead to the other. A series of explanations begins with the old, the transformational process and lastly, the establishment of the transformed strategy. It begins with explanation on the past performance of the old fund. It will also analyze the associated risks of the fund, which may hinder the achievement of the fund’s aims. On identifying the risks, the report will finally outline some recommendations for cubing the risk problem and introduce a transformed portfolio that shall ensure the achievement of the fund’s aims. Assumptions The commencement date is assumed April 21, 2014 while the cut-off date is 21st July 2015. The presentation of this report also ignores any effects caused by taxes, commissions, price rises and all other possible charges. The report assumes all inter-banking rates as risk free rates while the market return rate is assumed for the available shares. The report assumes a slight difference in the fund’s return and the real returns of the fund (Joseph, 2013, pg.44). 3. Past Performance of the Fund Much information regarding the fund’s past performance is extracted from its available data. This can well be discussed with consideration to different aspects of performance. Annual Return of the Fund There has been quite a vast performance on returns. The total annual return of the fund is recorded as 15%. LLOY gives the highest return amounting to 30 % while FXC gives the lowest return of about 2 %. A large number of securities records an annual return of above 20% while, only two of the securities records an annual return of less than 10%. There are no negative annual returns from any security. With majority of the assets recording high performances, the funds performance can thereby be described a good one (Amenc and Le Sourd, 2003, pg. 26). The Divided Yield and the Total Interest The distribution yield of the fund is calculated by annualizing the recent distribution of fund and dividing by the available fund. The yield stands for a single distribution from the fund while it does not stand for the total returns of the fund. On the other side, the fund’s dividend flat yield is 3% and 0.46% higher than the dividend yield of FTSE all shares. This is demonstrated in Table 3: in the appendices. In this case, the Hedge Fund paid a quarterly divided distribution on July 30 2012, of $0.4.112 per share (Walker and Walker, 1992, pg. 35). The distribution yield on the same date was 3 %. The Hedge Fund does not seek to stabilize the distribution rate artificially neither does it seek to return capital for crating an illusion for higher yields. On the other hand, the portfolio divided yield, which is the cumulative weighted yield on the portfolio securities held by the fund on a specific date, is calculated on a daily bases and creates a snapshot every day of the yield of every portfolio holding based on the annual trailing divided per share. For the investments in UK securities, the net yield and the gross yield have been identical. Shares have been bought and sold at market price while they have not been individually redeemed from the fund (Bogle, 2010, pg.7). Capital Asset Pricing Model (CAPM) and the Return of the Fund The expected rate of return on a risky investment is equivalent to the rate of return on a risk-free investment. In this model, β (beta) is used to represent the specific sensitivity of an asset to the market risk. This is calculated with bases of the available data. According to the given data on the fund, β is given as 0.8 while this means that the volatility of the portfolio’s price is less than the market price. In this connection, if the market price increases by 1%, the portfolio’s price will increase by 0.8% (Gadsden, 1998, pg.21). Funds performance is not only assessed through the annual ration and the divided yield. Other rations that can be used to assess the performance may include; the shape ration, Treynor ration, and Jensen’s alpha. The shape ration is used to measures the excess return per unit of deviation in a portfolio. This ration examines risks; both the idiosyncratic and the systematic risks. For instance, in our case, the fund’s ration is estimated to be 13.5. This is found to be a high ration and thus the high performance of the fund. If the distribution of the annual return is invalid, the shape ratio also comes out invalid. The Treynor ration in our case is 0.2. Consequently, if the ration is high, the fund performance is also high. Therefore, the portfolio can afford 0.2 returns per unit of the market ratio. On the other hand, the Jensen’s alpha calculates the excess return of the portfolio over the theoretical return. In a case of 75 of Jensen’s alpha, the fund return is also calculated as 7% higher than the theoretical return. In this ration, the unsystematic risk is neglected (Richelson and Richelson, 2011, pg. 54). Comparing Funds In this section, we shall compare this fund, with other funds, whereby, we shall determine the strengths and weaknesses of this fund. It has been found out that the annual return of the fund discussed in this report can be ranked the last in a group of six funds and ranked the second from last position in a comparison with other four income funds. The top rank is taken by a fund that is twice the size of this fund. In comparison with other funds, this particular fund is therefore unsatisfying (Aufmann, 2010, pg.22). Name of stock type annual return This fund income 10% Small beads income DT Income 9.4% Hiderin FT Growth 12.6% Jostem IT Growth 31.1% I&M it income 18.8% 4. Risk Analysis This portfolio is faced with many risks that need to be addressed. The portfolio cannot be assumed a risk-free one since it has a good look on its performance. This section seeks to analyze the fund’s risks. Standard Deviation The advantage of using standard deviation in measuring risk is that it is easy to calculate and uses a simple concept of normal distribution of the returns. In this fund, just as common with most hedge funds, no symmetric returns and therefore, the standard deviation metric masks the higher probability of large loses. In the same way, a large standard deviation means that the fund has a high volatility and thus has the highest risk. For instance, if in one fund, the largest standard deviation is found to be 154.50 and the smallest is 1.02, the fund that has the larger standard deviation is said to be more risky than the others are. This bond therefore brings few risks to the portfolio. Generally, the assets that have large deviations may prevent the achievement of the funds’ aims (Fevurly, 2013, pg. 32). Value at Risk This metric is based on a combination of standard deviation and mean. Value at risk does not describe risk in terms of volatility. Unlike standard deviation, VAR describes risk as the highest amount that is likely to be lost with a probability of 5%. In the distribution of our fund, Value at Risk is represented by the leftmost results with a 5% probability (Mirabile, 2013, pg.8). Both the probability and the amount can be underestimated after the assumption of the distributed returns. Given a confidence level of 90%, it means that the minimum and the maximum value at risk of two assets are 400.5 and 4.4067. In such a case, it means that there is 10% chance each day that the two assets face loss of over 400.5 and 4.4067 respectively (Alexander, 2008, pg.27). The Value at Risk of the current portfolio is 69165434.45. This means that there is a 90 % possibility that the fund will not incur loses more than 69165434.45 in a single day. If the confidence level goes to 95%, it would mean that the assets are faced with 5% chance of incurring a loss each day. Generally, assets that have a high Value at Risk increases the risk of the fund (Nguyen, 2012, pg.33). Technical analysis The efficiency of the market greatly influences the effectiveness of the technical analysis that provides investors with some reference. However, the technical analysis may not be applicable in analyzing risks associated with the fund. This is because of the fund’s strategy of buy and hold. Shape Ration This measure of the risk-adjusted returns indicates the amount of additional return obtained at every level of risk taken. The fund has a shape ration greater than one and is therefore a great measure. The fund experiences a period of low interest and this makes the shape ration more attractive in determining the risk (Indian Commerce Association, 1948, pg.12). However, there are other non-numerical risks, which are difficult to measure, and can have huge impact on the return of the portfolio. These risks may be brought about by factors such as the loss of brand reputation or by poor management. Negative news about a company can affect its reputation that may in turn cut down its market value. Some assets in the portfolio may face this kind of risk. An example is in the Rhino cement manufacturing company whereby, a ten storey house collapsed (Malkiel and Malkiel, 1999, pg.35). This knocked down a large number of the company’s stock value since the company’s cement was mentioned as low quality. This event brought bad reputation and much criticism to the company. Customer and other investor’s confidence were greatly affected. This left the investors with much doubt of whether a similar event may reoccur in future. In that case, the investment of the Rhino cement company may increase the portfolio’s risk (Singapore Securities Research Institute, 1975, pg.75). In a similar incidence, the Australian Company Red Bull GmbH, which produces the Red Bull Energy drink, was hit with the same saga. The drink was once announced to contain a lager capacity of caffeine. A larger number of people seized from purchasing the commodity and found other alternatives. This incidence brought a 2% slump in a single day. The Australian company Red Bull GmbH suffered a great loss of their market value with the reduced customer trust for the company. The bad reputation has hit the GmbH performance for a long time. Therefore, holding this stock would increase the risk of the fund. Generally, there is a strong relationship between the risk of the fund and the reputation of assets (Neoh, 1986, pg.44) In addition to that, there is also a relationship between the risk of the fund and managers. Good management protects the company from affections while the company prospects would not face more certainity. Good management would protect the stock price from fluctuating. In a place of poor management, the stock price varies intensely and thus the portfolio containing this security becomes more risky. If a company loses its good manager, the security of the company is more likely to become uncertain. Holding the stock in the same company would therefore prevent the fund from achieving its aims (Smithers, 2013, pg.88). Stock Specific Risks Numerous stocks exist in this fund and all the stocks account for large portion of its market value and are faced with various risks. Among the main risks is the large price volatility that is measured by standard deviation. Among the numerous stocks are the paper stocks that encounter many risks. Technological advancements introduced the digital era (Connor, et al., 2010, pg. 77). This brought in a reduced demand of the analogues materials. People putting down their writings on paper are much weaker than before. In the recent days, many people would prefer to save their texts on computers while a limited number would store texts in written documents. Before the use of the written texts is completely kicked off, it would be wise to hold this kind of security. Additionally, the stacks may also face some political risks. Thus, if the paper industry opens more branches in countries, which has poor security, The Company is at the risk of incurring loses once crises arise in the countries. These risks may have serious impacts on the fund’s aim and may prevent it from achieving the aims (Esposito, 2011, pg. 90). Portfolio Risks The portfolio risk is measured by standard deviation. Risk measurements are determined by the correlation between assets. If the correlation coefficients between assets are positive, it means that the portfolio’s risk measurement is larger. On observing the current portfolio, the correlation coefficient between assets is positive. This shows that it has some risks that are because of the positive correlation. On the other hand, a portfolio whose beta is less than one is faced with fewer risks. However, it offers lower returns (Alexander, 2010, pg. 20). On analyzing the current portfolio, its weighted beta is found to be less than one and thus a less risk. However, the portfolio offers lower returns (Ilmanen, 2011, pg. 67). Asset Allocation If assets are allocated in an inappropriate way, a high risk may be encountered. This means that there is a great connection between the portfolio’s risk and asset allocation. Considering the available stocks in this fund, there is uneven allocation of the financial stocks. Representing the portfolio on a table shows that there are problems with the allocation of the portfolio’s assets (Vasavada, 2010, pg.22) Industry number weight of number weight of market value Financial 4 40.12% 41.07% Paper 3 31.13% 31.35% Total 7 71.25% 72.42% This fund has numerous stocks and with one bond. On the other side, the portfolio may also encounter risks originating from this type of classification. The single type of asset class may inaugurate risks to the fund. With the occurrence of the large volatility within the stock market, the fund’s income would greatly change. This therefore may prevent the fund from achieving its aims (Haslem, 2003, pg. 80). 5. Recommendations for the fund The past performances and the potential risks of the fund have been discussed. In this section, there would be the provision of relevant recommendations for the fund (Belmont, 2011, pg. 5). Features of the New Portfolio The new portfolio should possess new feature that would guarantee increased annual return. The fund aims are maximization of the long-term capital returns and the minimization of risk of capital loss. The return basis of the new portfolio is an absolute benchmark of 25% per year. In order to achieve a lower risk, the portfolio should have the least correlations between assets and a lower standard deviation. It should also maintain a beta level of between zero and one (Ridley, 2004, pg. 9). Additionally, the new portfolio should kick out the assets that have serious financial problems. Eliminating Assets from the New Fund The new fund should exclude some assets. The assets to be excluded include the paper industry among other assets with the lowest returns (Travers, 2012, pg. 34). Other companies that are at high chance of facing great risks should also be excluded from the current fund. This would ensure the absence of any asset that would prevent the new fund from achieving its aims. Exclusion of assets that faces some specific risks discussed above would make the new portfolio less risky. Another asset to be excluded would take such assets like the Australian Red Bull company that has lost its brand reputation since this would reduce the portfolio’s annual return. All assets that have a large correlation with other assets should also be excluded in the new portfolio. The BP asset should also be eliminated from the new fund. This is because BP as a very low percentage of its annual return. It has also a decreasing pre-tax profit that is a bad signal. Excluding the asset would therefore reduce the risks incurred by the new fund. Adding New Assets to the New Fund In order to achieve its aims, some new assets should be added to the current fund. However, this should follow much consideration of the assets to be added. Assets to be added must first show a high percentage in its annual returns and have the lowest standard deviation of return (Darbyshire and Hampton, 2012, pg. 90). Assets should also show an increasing pre-tax profit in the years and portray a record of high trust among customers and investors as well as being in a sec tor that increases the sector number. Assets of these type guarantees a good profitability in the new portfolio. Assets included in the current fund should have a large number of bonds, for example, the BT 5.75% 2028 Bond. More funds would be required in the fund so that it can gain a stable income with low risks. The bods annual return should be selected with respect to their amount of their annual return compare to the market return. Good bonds should have a high annual return than its market return and should be from a healthy issuer to avoid any credit risk. Lloyds Banking Group PLC and Barclays PLC should also be accepted in the new fund (Gregoriou, 2006, pg. 97). Outline of the New Portfolio The establishment of the new portfolio should consider optimization of the portfolios’ structure. There is a large Value at Risk with a low annual return in the existing portfolio. In order to curb this problem, the new fund should reduce the proportion to around five percent. These modifications will bring up a new portfolio. This would demonstrate an increased annual return that shall go beyond the achievements of the old portfolio. This would make the new fund a better portfolio than the existing one in the area of returns. The standard deviation of the new portfolio shall be much lower than for the old one. This shall be established to ensure that the aims of the fund are absolutely met (Gregoriou et al. 2003, pg. 7). The addition or elimination of some assets should consider the value of the new fund. Assets added should improve the fund while all negativity inaugurating assets should be kept aside from the new fund. INVESTMENT THEORY This report has much relied on the fundamental approach. This was based on the belief that the price of a stock is influenced by its own value. This depends heavily on the potential earnings of the company in its future. The price of the stock is determined by looking at company’s earnings per share, its trends and the economic news. These considerations are useful in determining whether the stock’s price is below or above its intrinsic value. This is also useful in predicting the future directions of the prices of the stock. The report also had much emphasis on the Efficient Market Hypothesis investment theory. According to this theory, it is very difficult to beat the market since the efficiency of the stock market causes existing share prices to incorporate and reflect all relevant information. Stocks would just trade at their value on stock exchanges. This makes it impossible for investors to buy undervalued goods or make inflated sales on stocks. It is not possible to outperform the overall market through careful stock selection or by market timing. The only way an investor can obtain higher returns is through the purchase of more risk investments (Haslem, 2003, pg. 78). 6. Conclusion In conclusion, the report has analysed the issue of fund performance, whereby several factors were found to be hindrances to the achievement of the fund’s aims. However, the report provided some recommendations for overcoming these risks. It was found out that the funds performed better than the markets. It derived some of the numerical and non-numerical risks that may bring much uncertainity to the fund. Such risks included; the large price volatility, positive correlation coefficients between assets, and an inappropriate way of allocating assets. The report outlined some recommendations that were believed to curb the risk problem and improve the fund’s performance of the returns. Such recommendations suggested the addition or elimination of some assets depending with their core effect to the new fund. References ALEXANDER, C. (2008). Market risk analysis Volume 2, Volume 2. Chichester, England, Wiley. ALEXANDER, C. (2008). Market Risk Analysis, 1 Quantitative Methods in Finance. Chichester, John Wiley & Sons. ALEXANDER, C. (2008). Market Risk Analysis: Pricing, Hedging and Trading Financial Instruments. Great Britain, John Wiley & Sons. AMENC, N., & LE SOURD, V. (2003). Portfolio theory and performance analysis. Chichester, England, Wiley. AUFMANN, R. N. (2010). Mathematical excursions. Boston, MA, Brooks/Cole, Cengage Learning. BELMONT, D. P. (2011). Managing hedge fund risk and financing: adapting to a new era. Singapore, J. Wiley & Sons (Asia) Pte. BOGLE, J. C. (2010). Common sense on mutual funds. Hoboken, N.J., Wiley. CONNOR, G., GOLDBERG, L. R., & KORAJCZYK, R. A. (2010). Portfolio risk analysis. Princeton, Princeton University Press. DARBYSHIRE, P., & HAMPTON, D. (2012). Hedge Fund Modeling and Analysis Using Excel and VBA. Hoboken, John Wiley & Sons. ESPOSITO, E. (2011). The future of futures the time of money in financing society. Cheltenham, Edward Elgar. FEVURLY, K. R. (2013). The Handbook of Professionally Managed Assets A Definitive Guide to Profiting from Pooled Investments. Berkeley, CA, Apress. GADSDEN, S. (1998). The Canadian mutual funds handbook. Toronto, McGraw-Hill Ryerson. GREGORIOU, G. N. (2006). Funds of hedge funds performance, assessment, diversification, and statistical properties. Amsterdam, Butterworth/Heinemann/Elsevier. GREGORIOU, G. N., KARAVAS, V. N., & ROUAH, F. (2003). Hedge funds: strategies, risk assessment, and returns. Washington, DC, Beard Books. HASLEM, J. A. (2003). Mutual Funds Risk and Performance Analysis for Decision Making. Oxford, Blackwell Pub. HASLEM, J. A. (2003). Mutual Funds Risk and Performance Analysis for Decision Making. Oxford, Blackwell Pub. ILMANEN, A. (2011). Expected returns an investors guide to harvesting market rewards. Chichester, West Sussex, United Kingdom, Wiley. INDIAN COMMERCE ASSOCIATION. (1948). The Indian journal of commerce: a quarterly of the Indian Commerce Association. Patna, Dept. of Applied Economics & Commerce, Patna University. JOSEPH, C. (2013). Advanced credit risk analysis and management. MALKIEL, B. G., & MALKIEL, B. G. (1999). The new random walk down Wall Street: including a life-cycle guide to personal investing. New York, Norton. MIRABILE, K. (2013). Hedge fund investing: a practical approach to evaluating the risk and rewards. NEOH, S. K. (1986). Stock market investment in Malaysia and Singapore. Kuala Lumpur, Berita Pub. NGUYEN, T. (2012). Investing in the high yield municipal market how to profit from the current municipal credit crisis and earn attractive tax-exempt interest income. Hoboken, N.J., Wiley. RICHELSON, H., & RICHELSON, S. (2011). Bonds the unbeaten path to secure investment growth. Hoboken, N.J., Bloomberg Press. RIDLEY, M. (2004). How to invest in hedge funds: an investment professionals guide. London [u.a.], Kogan Page. SINGAPORE SECURITIES RESEARCH INSTITUTE. (1975). Securities industry review. [Singapore], Singapore Securities Research Institute. SMITHERS, A. (2013). Wall street revalued imperfect markets and inept central bankers. Hoboken, N.J., Wiley. TRAVERS, F. J. (2012). Hedge fund analysis an in-depth guide to evaluating return potential and assessing risks. Hoboken, N.J., Wiley. VASAVADA, N. P. (2010). Taxation of U.S. investment partnerships and hedge funds: accounting policies, tax allocations, and performance presentation. Hoboken, N.J., Wiley. WALKER, K. L., & WALKER, K. L. (1992). Guaranteed investment contracts: risk analysis and portfolio strategies. Homewood, Ill, Business One Irwin. Appendices Table 1.Existing Portfolio Investment Name EPIC CODE Size of holding Notes I Shares FTSE Bric 50 Fund BRIC 100,000 shares BP Plc BP. 800,000 shares TUI Travel TT 80,000 shares Barclays PLC BARC 150,000 shares Lloyds Banking Group PLC LLOY 2,500,000 shares ETFS Gold BULP 250,000 shares I Shares MSCI Brazil USD ETF IBZL 50,000 shares I Shares FTSE/Xinhua China 25 FXC 25,000 shares BT 5.75% 2028 Bond - £500,000 Nominal BRITEL 53/4 12/07/28 Standard Chartered 7.75% 2018 Bond - £500,000 Nominal STANLN 73/4 04/03/18 Cash £ £0 BRIC BP. TT BARC LLOY BULP IBZL FXC price 345 765 543 467 334 3344 5336 2257 MA(5) 346.87 766.43 544.67 466.89 335.21 3345.5 5338.2 2259 Signal Sell sell buy sell buy sell sell sell Table 3: Dividend Yield of Stocks BRIC BP TT BARC LLOY BULP IBZL FXC Divided yield 3.67% 4.70% 2.56% 3.89% 4.24% 2.32% 2.55% Flat yield 3% Fund’s divided yield 3% Fund’s interest return 2.54% Read More