Risk Management and Investment - The Investment Fund and the Investment Trust - Term Paper Example

Investment and Risk Management Investment and Risk Management Executive Summary This paper dwells on the nature and design of the previous portfolio with a description of new approach aimed at helping the investment fund achieve its objectives, missions, and goals. The immediate course of this report reviews the existing portfolio. It is also important to discuss how the fund performed in the past. Specific risks associated with investments are discussed herein, and recommendations constructed in accordance with the need to combat problems drawn from the existing portfolio. The report notes that there are several risks associated with the old portfolio, in as much as individuals may believe that it is a well-constructed investment portfolio. Recommendations-described in detail in this report-comprise additional asset allocation and remodeling the structure of assets. Coupled with other measures indicated, it is highly likely that the investment fund will perform better. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 5 The Fund: Background 5 The Fund: Purpose 5 The Report: Structure 5 Assumptions 6 The Fund: Past Performance 6 The Fund: Annual Return 6 Dividend Yield and Total Interest 7 CAPM (Capital Asset Pricing Model) and the Return of the Fund 7 Other assessment ratios 8 Comparison of this fund among other Funds 8 4. Risk Analysis 9 Standard Deviation 9 VaR 9 Technical Analysis 10 Shape Ration 10 Risk and reputation 11 Management 12 Stock Specific Risks 12 Portfolio Risks 13 Beta of the Portfolio 13 Asset allocation 13 5. Recommendations for the Fund 14 Features of the New Portfolio 14 Eliminating Assets from the New Fund 14 Addition of New assets to the New Fund 15 Overview of the New Portfolio 15 6. Conclusion 16 Bibliography 17 Introduction The Fund: Background The Investment Fund is located in the United Kingdom. The main aim of the fund is to maximize long-term capital returns. Composition of the fund includes; Greggs PLC, Tate & Lyle, Domino Printing Sciences PLC, JD Sports Fashion PLC, Bellway PLC, William Hill PLC, Beazley PLC, RPC Group PLC, Huntsworth PLC and the CER Plc. In this composition, all securities consist of stocks registered in London Stock Exchange. Additionally, no stocks are bonds. Most importantly, the report analyzes previous performances of the fund in relation to risks and risk factors that pose threats to the achievement of main aims of the invested amount. Lindsey and Schachter, (2007, pg. 67) notes that in the process of analyzing an investment portfolio, recommendations should follow so that the aims of the fund are achieved. The Fund: Purpose The Investment Fund analyzed in this report falls under the Investment Trust. The investment funds are aimed at ensuring that the long term capital returns are maximized. Considering this scenario, it is advisable that the fund is invested in securities characterized by stable incomes and minimum risks. The Report: Structure The report structure is presented in a design indicating the problems and the series of events leading to the emergence of the noted issues. The sequence of discussion commences with the past, the shifts in processes, and finally, the development of recommended strategy. This report will also review risks associated with the investment funds that may deter realization of major objectives the fund was designed for. After identifying the risks related to the old portfolio, the discussion will outline a number of recommendations modeled to combat the particular risk issue. Finally, a new portfolio should follow to ensure that the aims of the fund are catered for. Assumptions The main assumption made in this report is that the inauguration (inception) date is January 1, 2012 and December 31, 2015 as the end-date. In the presentation of this discussion, effects occurring because of price increases, commissions, taxes or other normal charges, are ignored. It is also assumed that inter-banking rates are risk free and the normal rate of market return applies for available shares. The University of Michigan (1927, pg44) affirms that there is a small difference between the actual fund returns and fund’s return. The Fund: Past Performance There is sufficient data about the previous performances of the investment fund. Using various aspects for and approaches to fund analysis, the available information will be vital in this analysis. The Fund: Annual Return There is a strong indication of vast performances related to the returns of the investment fund. Records show that the annual return of the fund stands at 15%. Hunts worth PLC has reported highest return amounts of 30% while the least return amounts of around 2% were reported by Beazley PLC. From the securities listed in this fund, the largest portion report annual returns of 20% plus. However, only two securities reported annual returns below 10%. Securities are not characterized by negative returns in annual computations. It is worth noting that when a significant number of assets report high performances, the fund in question is considered good (Bogle, 2010, pg.14). Dividend Yield and Total Interest The distribution yield of the Investment 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. In this case, the investment Fund paid a quarterly divided distribution on June 27 2012, of $0.2261 per share. The distribution yield on the same date was 4 %. The Investment Fund does not seek to artificially stabilize the distribution rate neither does it seek to return capital for the purpose of 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 (Walker, 1992, pg. 44). For the investments in UK securities, the net yield and the gross yield have been identical. There has been much buying and selling of shares at market price while they have not been individually redeemed from the fund (Amenc & Le Sourd, 2003 p57). CAPM (Capital Asset Pricing Model) and the Return of the Fund The securities’ and the annual returns of the fund can be compared with the expect returns calculated by CAPM model. In this model, β (beta) is used to characterize the specific sensitivity of an investment asset to the market risk. The β (beta) of every stock in the fund and the β (beta) of the portfolio can be calculated based on the available data. According to the given data on the fund, beta is given as 0.6 while this means that the volatility of the portfolio’s price is less than the market price. Therefore, if the market price increases by 1%, the portfolio’s price will increase by 0.6% (Gadsden, 1998, pg.28). Other assessment ratios Apart from the annual rate and dividend yield, there are other ratios that can be used to assess the fund’s performance. These may include; the shape ration, which is used to measures the excess return per unit of deviation in a portfolio, Treynor ration, and jensen’s alpha. Additionally the shape ration examines risks; both the idiosyncratic and the systematic risks. For instance, in our case, the investment fund’s ration is estimated to be 12.37. This is a high ration while this translates to 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 0.12. Subsequently, if the ration is high, the fund performance is also high. Therefore, the portfolio can afford 0.12 returns per unit of the market ratio. On the side of Jensen’s alpha, the excess return of the portfolio over the theoretical return is calculated. If there is estimated 8% of Jensen’s alpha, the fund return is also estimated to be 8% higher than the theoretical return. In this ration, the unsystematic risk is neglected (Richelson, 2011, pg. 30). Comparison of this fund among other Funds This section will compare this fund with other funds. We shall also determine the fund’s strengths and weaknesses. In a group of six funds, with this fund included, it has been found out that the annual return of the fund discussed in this report can be ranked the last while it is ranked the second from last position in an association with other four income funds. In addition to that, the fund at the top rank is seen as twice the size of this fund. For this reason, this fund is unsatisfying comparing it with other funds (Aufmann, 2010, pg.24). Stock type annual return This fund income 10% Greggs PLC income 9% Domino Printing Sciences PLC growth 13% Bellway PLC growth 32% JD Sports Fashion PLC income 19% Hunts worth Plc income 13.43% 4. Risk Analysis The fund’s performance looks good; however, there exist many risks in this portfolio that needed to be concerned. This section seeks to analyze and describe the fund’s risks in the following order: Standard Deviation Standard deviation is an indicator to ration the return’s volatility or the price’s fluctuation. The good thing with using standard deviation in measuring risk is that it uses a simple concept of normal distribution of the returns and is also easy to calculate. In this fund, just like it is common with most investment funds, symmetric returns are unavailable and thus, 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, assuming that the largest standard deviation of, for example HNT, price is 152.40 while the smallest is 0.91. Thus, HNT is thus more risky than the others. The bond brings few risks to the portfolio. In another instance, if the standard deviation of return ranges from 0.00115 to 0.0098. That demonstrates that 0.00115-bond has the largest risks and it does few contributions to the risk of the fund. Generally, the assets with large standard deviation may prevent achievement of the fund’s aims (Karp and Schlessinger, 2002, pg. 29). VaR This metric is based on a combination of mean and the standard deviation. Value at risk does not describe risk in terms of volatility. Unlike standard deviation, Value at Risk describes risk as the highest amount that is likely to be lost with a probability of 5%. In the fund distribution, Value at Risk is represented by the leftmost results with a probability of 5% (Nguyen, 2012, pg.40).Both the probability and the amount can be underestimated after the assumption of the distributed returns. In a case of confidence level of 90%, the minimum and the maximum value at risk of two given assets are 397.2 and 3.3067. In such a case, it means that there are 10% daily changes that the two assets experience loses of over 397.2 and 3.3067 respectively (Alexander, 2008, pg.30). The Value at Risk of the current portfolio is 70165400.45. This means that there is a 90 % possibility that the fund will not incur loses more than 70165400.45 in a single day. If the confidence level increases with a certain percentage, lets say 7%, it would mean that the assets are faced with 7% chance of incurring a loss each day. Generally, assets that have a high Value at Risk increases the risk of the fund (Mirabile, 2013, pg.18). Technical Analysis The efficiency of the market greatly influences the effectiveness of the technical analysis which provides investors with some reference. On the other hand, the theory of EMH points out that technical analysis will be invalid in the weak-form market efficiency. However, the technical analysis may not be applicable in analyzing risks associated with the fund. This is as a result of the fund’s strategy of buy and hold. Shape Ration This is a measure of the risk-adjusted returns which 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. Risk and reputation Negative news about a company can affect its reputation which may in turn cut down its market value. This kind of risk may be faced by some assets in the portfolio. An example is in the company whereby, its products Bamburi cement manufacturing company whereby, a tall building collapsed in the middle of the town knocking down a large number of the company’s stock value. Following this incidence, the company lost its reputation while its products were much criticized. 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 Bamburi cement company may increase the portfolio’s risk (Singapore Securities Research Institute, 1975, pg.65). In a similar incidence, TUK, a soft drinks producing company, was hit with the same saga. The compan7y’s product was at one point mentioned to contain a lager capacity of caffeine. A larger number of people seized from purchasing the commodity and found other alternative soft drinks. This incidence brought a 2% slump in a single day. The particular company, TUK, suffered a great loss of their market value with the reduced customer trust for the company. The bad reputation has hit the TUK 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.50) Management If a company loses a good manager, then its business will be affected and its prospect faces more certainty. This means that there is a big 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. If a company has a poor management, the stock price varies intensely and thus the portfolio containing this security becomes more risky. If the company management deteriorates in quality, the security of the company is more likely to become indeterminate. Holding the stock in the same company would therefore prevent the fund from achieving its aims (Alexander, 2009, pg.10). Stock Specific Risks This fund has got ten stocks existing within it, the stocks account for the greatest value of the fund’s market. This section analyses the stock’s specific risks. Among these risks are the share price volatility, the sector problems and the financial problems. If the price volatility is high for a specific stock, the stock is also found to encounter a large risk. Share price volatility is measured by standard deviation. The risk of sector problems is incurred whereby; certain stocks are outdated or are replaced with imitations. The establishment of technology in many regions may also bring about the sector problems. Some existing stocks may be kicked out of the market by the emergence of other efficient stocks which perform similar services. People’s purchasing power on certain commodities becomes weaker than before and thus the falling demands of the specific commodities. On the other side, the company may experience other risks like in a [lace of political crises. The establishment of the company branches in countries that are faced with issues of insecurity, the company may encounter massive loses of property. This therefore affects the functions of the fund and may thus hinder the establishment of its aims. Risk on the financial problems is a common factor for many companies. In an example, if the pre-tax profit of GRG, TATE and DNO experience a downward trend, it means that the companies’ profitability requires to be improved. The portfolio risk is reduced upon the elimination of assets that have a deteriorating ROE. 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. The current portfolio has positive correlation coefficients between assets. As a result of the positive correlation efficient between assets, is quite predictable that the portfolio has some risks. Beta of the Portfolio A portfolio whose beta is less than one is faced with fewer risks and offers lower returns (Alexander, 2010, pg. 22). The current portfolio has a weighted beta of less than one and therefore has a less risk. However, the portfolio offers lower stock returns (Ilmanen, 2011, pg. 101). Asset allocation section describes the risk of the portfolio from the asset allocation aspect. Asset allocation is closely related to the portfolio’s risk and assets should be highly allocated. Inappropriate allocation may lead to a high risk (Vasavada, 2010, pg.22). Considering the available stocks in this fund, there is inappropriate allocation of the financial stocks. Considering this fund, the financial stock can be estimated as being 39.12% of the total number while it has 40.00% of the market value. This can be seen as a problem in its asset allocation. In case of some negative events that hit the financial sector, this fund would thereby suffer a great loss (Belmont, 2011, pg. 5). Representing the portfolio on a table shows that there are problems with the allocation of the portfolio’s assets. Industry number weight of number weight of market value Financial 4 39.12% 41.00% Power 3 30.13% 33.35% Total 7 69.25% 74.35% 5. Recommendations for the Fund After a critical analysis of the past performance and the associated potential risks of the fund, this section gives some recommendations for the fund in detail and assesses the new fund comprehensively (Haslem, 2003, pg. 80). Features of the New Portfolio The new portfolio should have a higher annual return than the current one, of approximately up to 25 per cent. Maximization of long-term capital returns should be their motive to chasing a higher return. Secondly, the correlations between assets should be smaller and negative. Lower standard deviation also forms part of the new portfolio while the beta is always below one. Assets with large financial problems should not exist in the new portfolio. Eliminating Assets from the New Fund In order to achieve the aims of the fund, some assets should be eliminated from the fund. JD Sports Fashion PLC should be removed and the reasons are as follows. Firstly, the JD Sports Fashion PLC’s annual return is among the lowest. Additionally, its financial data has some serious problems. Its pre-tax profit and ROE are going down, which is often not a good signal. Nevertheless, the sector heavy problem can be partly solved since the number of energy stock drops. Finally, JD Sports Fashion PLC faces some specific risks and therefore, excluding this asset will make the portfolio less risky. Assets with large correlations with other assets should also be eliminated in the new portfolio. Addition of New assets to the New Fund In order for the fund to achieve its aims, some new assets should be included. The consideration of new assets should be based on their correlation with other assets as well as their Pre-tax profit and the increment in their ROE. The POE of any asset to be added should show an increment aspect over the years. Their standard deviation should also be as low as possible. JD Sports Fashion PLC Bond, should be added since it is a type of an income fund. This ahs a meaning that bonds should account more in the portfolio. Assets of these type guarantees a good profitability in the new portfolio (Gregoriou, 2006, pg. 97). Assets included in the current fund should have a large number of bonds, for example, the JD Sports Fashion PLC Bond. Additional funds would be required in the fund so that it can gain a stable income with low risks. The bonds annual return should be selected with respect to their amount of their annual return compared 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. William Hill PLC and the Domino Printing Sciences PLC should also be accepted in the new fund. Overview of the New Portfolio Besides adding and eliminating of assets from the new fund. The structure of the portfolio should also be optimized. The existing portfolio demonstrates a large Value at Risk with a low annual return. In order to control this problem, the new fund should consider reducing the proportion to at least five percent. These the modification herein shall bring up a new and an advanced portfolio that shall achieve its aims which includes the demonstration an increased annual return which shall go beyond the achievements of the old portfolio. This would make the new fund a better portfolio than the existing one in the field of returns. The old portfolio had a larger standard deviation. 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. Efficient Market Hypothesis investment theory was greatly emphasized through out the report. 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 Issues regarding fund performance have been analysed in the report. Several factors were found to be the key hindrances to the achievement of the fund’s aims. However, some recommendations for overcoming these risks were provided. The report derived numerical and non-numerical risks that may bring much uncertainity to the fund. Among the risk; the large price volatility, positive correlation coefficients between assets, and an inappropriate way of allocating assets were discovered. Recommendations for change included the addition or elimination of some assets depending with their core effect to the new fund. Bibliography ALEXANDER, C. (2008). Market Risk Analysis, 1 Quantitative Methods in Finance. Chichester, John Wiley & Sons. ALEXANDER, C. 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