Investment Strategies and Portfolio Management - Nelly Capital - Case Study Example

Introduction Traditionally, the investment climate in a country or in the world refers to the prevailing financial and economic conditions that affect the investors in a place. In this case, an investor is an individual or institution that is willing to lend money to an operating business in order to get a stake there. Notably, Johnson (2013) implies that, the rate of investment depends on the investment environment in a country. Further, the investment environment of any country is also linked to that of the whole world. As such, a favourable investment leads to an increase in investment while an unfavourable investment environment discourages investment. This report presents an analysis of the investment environment of UK with regard to the Nelly Capital business. It also presents alternatives for asset allocations for the business, and the necessary investment approaches that may be applicable to the business. Investment Environment Report The investment environment for the UK may be defined under various subheadings that can be of used to relate it to the business opportunities for the Nelly Capital group. First, the United Kingdom does not discriminate between foreign investors depending on nationalities except in a few cases. Conversely, the UK investors do not encounter many impediments when they attempt to invest in foreign countries save for some few countries. Further, the UK has stable economic and political climates that make it attractive to many foreign investors (Great Britain2011). As a result, UK remains the main investment hub for FDI (Foreign Direct Investment) in Europe and also emerging markets are beginning to invest in it. Chart showing FDI projects in Europe for the top countries receiving FDIs Source: EY Attractiveness Survey, June 2014. Other macroeconomic factors that add to the UK’s attractiveness as a venue for foreign investment are the low rates of taxation and inflation. The UK has also subscribed to the Organization for Economic Cooperation and Development’s (OECD) Liberalization Codes that allow the free flow of Capital and other current operations that are invisible. This environment is allows for free flow of investments and hence it implies that Nelly has not only increased external opportunities for investing in foreign countries but also is subjected to a potential competition for home investment opportunities from foreigners especially from the United States. Secondly, the UKs sterling pound has no restrictions regarding its transfer and conversion and hence may be regarded as a free-floating currency. Moreover, the same principle of free-floating currency applies to investments so that those willing to invest in or out of the UK hence requiring the transfer of the currency are free to do so at the prevailing rate (Batra, Kaufmann & Stone2003). For Nelly Capital, it implies that the transfers of assets from or to foreign countries for investment are subject, to an extent, to the rate of exchange. Therefore, it is necessary for Nelly Capital to watch keenly the period for making some international transactions so that they are not made in periods that may cause the group unnecessary capital loss. In specific, transactions involving capital outflows should be timed when the exchange rate is deemed highest while inflows are best done in periods the exchange rate is deemed lowest. According to Clark and Monk (2014)the UKs portfolio and capital markets remain one of the most efficient in the world. In this regard, the investment market of the UK is highly rated by investors due to the efficient regulatory system, favourable taxation for investment, and the supportive infrastructure of the London capital market. Notably, the UKs stock and equity market serves an important function of bridging the trading of the day between the markets in Asia with the opening of the markets in the US. Also, foreign investors have the freedom of borrowing in the UKs local markets at the same rate as the UK investors (Clark & Monk 2014). The chart below shows the growth in returns of UK capital markets. With regard to the above current issues, various arising issues in the environment may also be identified. First, UK has remained as the top recipient FDI Europe and also was a top priority investment for the US as at 2014. In specific, UK has maintained a strong investment partnership with the US and actually US remains the favourable foreign investment avenue for the UK investors while on the other hand US is the main source of FDI into the UK (Clark & Monk 2014). Further, in 2014 the UK government strengthened the position of the country as an investment destination through taxation incentives, support for small and medium enterprises, and other trading missions. In this regard, UK has been indicated by recent studies as making improvements in terms of the regime for start-ups, development of an entrepreneur culture and the flexibility of finance operations. Asset Allocation With this environment, Nelly Capital has various choices in which it may allocate its assets. Importantly, the process of asset allocation involves balancing the risks and the reward of investments based on the investors tolerance for risk, time frame of the investment and the objectives they have. The process of asset allocation involves the assets invested in a given portfolio with the aim of balancing the total risks and rewards (Abbink2010). Further, Abbink finds out that the return of an investment portfolio is dependent on the asset allocation. Asset allocation, therefore, is based on the fact that the performance of different assets is different in different markets and also in different investment environments. Nelly Capital, therefore, due to the improved investment environment of the UK and its allies, as well as due to the efficient financial markets, has a wide range of assets upon which to balance its allocation. The diagram below illustrates the process of investment for Nelly Capital, beginning from the analysis of investment environment, the asset allocation to the investment strategy for the selected portfolio. Diagram of constructing investment strategy Currently, the Nelly Capital group allocates its assets worth 50 million pounds to three portfolios namely equities both in UK and in the overseas, bonds of the UK and European governments, corporations, and then the short term instruments. Based on the goals for investment, tolerances to risks, and the frame of time two strategies may be pursued to assist in the asset allocation process. The basic portfolio managements include the strategic asset allocation and the tactical asset allocation. The strategic asset allocation method requires that the investor sets target allocations and as they are skewed by asset allocation percentages the investor rebalances them periodically. According to Abbink (2010), this method is associated with the strategy of buying and holding rather than keeping an active trading. Generally, the targets remain flexible over time so that they may adapt to changes in investor’s needs and goals. On the other hand, tactical asset allocation permits percentage ranges in each class of assets. Basically, the ranges include the maximum and minimum percentages that the investor allows trade and uses to take advantage of changing market conditions within the ranges. This strategy allows trading at short time intervals and is more speculative in nature. Recommendations for Asset Allocation One of the important goals for the most pressing goals for Nelly Capital is to meet the current deficit between withdrawals and deposits or outflows as compared to inflows. At one hand, the conversion of the short-term security instruments may be able to generate some inflows but that is not repetitive over the long-term. As such, asset allocation would be necessary given the current investment environment that would rebalance the portfolio in a manner that generates inflows periodically (Abbink2010). Apparently, many of the assets the Nelly Capital has invested in are long term in nature and generate income after a longer period of time. At one hand, Lee (2000) asserts that an application of the tactical asset allocation strategy would be welcome to rebalance the equities so that they may generate the deficit inflows. Another necessary rebalancing would involve the conversion of some bonds into various short-term instruments that generate inflows of cash after a short period of time. Tactical allocation strategy would be necessary for the allocation of assets within the short-term instruments as well as in balancing the allocations between the short-term instruments and the equities. The main goal of this allocation of assets to equity and short-term instruments would be to meet the deficit. After meeting this deficit, the strategic asset allocation may be applied in the bonds portfolio that may have its objectives altered depending on the goals of the investors. For instance, in the current situation the bonds are changed to meet the operations of meeting a current time deficit. Moreover, there is a need to consider alternative investment portfolios in the home or foreign markets that may be able to generate more income either in the short or in the long term (Reilly & Brown2012). The above reallocation process is recommended based on certain theoretical and practical. Foremost, the recommendation assumes an effective capital market. This is true in the UK as the Londons stock and capital market is one of the largest in the world. It is also one of the most efficient meaning that the sale and purchase of securities in assets may be done immediately. Secondly, the recommendations assume that the bonds earn their incomes at an annual rate or at least semi-annual rate (Roncalli2014). This is in most cases the typical characteristic of a bond that distinguishes it from the other equities. Moreover, the equities and short-term instruments are expected to yield higher incomes than bonds in the short run and hence the reallocation of funds the short term portfolio will increase the chance of meeting the potential deficit. The theory behind this assumption is that the short term security instruments are riskier as investments and hence they earn more to compensate for the riskiness. Also, practically no rational investor would invest in the short term securities if they expected that the bonds that earn certain income would on average generate more returns than the short-term securities in the short run. Strategies for Investment and Portfolio Management When it comes to investing, investors have two dominant approaches they can choose to follow. Of the two, one is a passive investment or indexing and the second is active investing strategy. After the assets have been allocated to different portfolio that suits the investor’s goals and risk averseness among other factors, the two strategies may be applied to pursue the investments in a given class of assets, for example bonds or equities. Notably, the indexing approach is commonly applied by institutional investors and is less popular among individual investors (Swedroe, Grogan & Lim2010). Nevertheless, there is no rule of thumb for choosing the two that suggests that the passive strategy be followed by the institutional investors while the active strategy is for individual investors. In contrast, both strategies may be used in any scenario of investment and the investor has to decide for themselves the strategy that is appropriate. It follows that investors should be aware of the two strategies, their characteristics, weaknesses and merits that may enable make informed decisions. The rationale of active investment strategy is to beat the market and, therefore, active management of portfolio strives to beat a specific benchmark. In attempt to outperform the market using this strategy, investors gather wide insights and information that relate to market trends, specific factors of a particular company and analyze them critically before making an investment decision. In addition, many investors have developed complex systems that guide them in predicting the movement of the capital markets and the stocks. These systems take into account of the several factors that relate to a specific market and try to predict the movement of prices and hence rates of return for purposes of positioning themselves. Some of the typical methods of analysis applied by typical managers include macroeconomic analysis, technical analysis, quantitative analysis, and the fundamental analysis. Consequently, it seems that the active investment strategy relies on inefficiencies of the market. As such, active managers suppose that the anomalies and irregularities in the financial markets may be exploited for the benefit of the investor. Another assumption the active managers make is that prices react slowly to information and hence experienced and skilful investors can use this factor to beat the market. Generally, Swedroe, Grogan and Lim (2010) claim that active management has a higher investment fees as compared to the passive investment. Also, the strategy depends on the skills of the investor and hence its tax efficiency is dependent on the investment manager. As it concerns returns, the strategy has the risk of achieving returns that are either above or below the market and allows for protection against a down market. Apparently, the method seeks to capitalize on the conditions in the market. On the other hand, indexing or what is passive investment strategy suggests that the investor invests in same securities and in proportions that are the same with some index like S&P 500 or the Dow Jones Industrial Average. In this regard, the managers, in this case, do not have the freedom to make decisions about choosing between securities to buy and the ones to sell. Contrary, the investment managers, in this case, follow the specified methodology of portfolio construction that is guided by the index. In specific, the manager seeks to copy the performance of the index as closest as they can afford to. Consequently, passive managers prefer investing in asset classes or broad sectors of the market, and, therefore, achieve average rates of return from various markets. Therefore, passive investment is based on the assumption of an efficient market and hence prices are deemed to reflect changes in information immediately. Also, they assume that there are anomalies in the market and hence the prices are always fair. This implies that, unlike their counterpart active investors who try to beat the market, the investors in the passive market try to match the market. Catalogue for Investment Strategies and Portfolio Management Nelly Capital can, therefore, consider making investments following either of the two strategies and managements. In the consideration of how the two strategies are likely to perform in the market, it depends on the degree of market efficiency. In this case, market efficiency refers to the absence of irregularities and the ability of prices to reflect the available information in the market. In this regard, active management may outperform the market and beat the passive management. However, Reilly and Brown (2012) suggest that, if the market is more efficient the average returns associated with the passive market are likely to be higher than the returns for active management. For the purposes of this report, Biard’s examination of the efficient asset classes that may be suitable for active or passive managements, were presented as in the catalogue below. Further, Biard measured the average of the frequency that mutual fund in a specific class was excess in return compared to its benchmark. The catalogue is presented below (Roncalli2014). Asset Class % of periods Average Return produces Excess Returns Efficient or Inefficient Asset Class Market Assets %Active/%Passive High Yield Bond 16 Efficient 91/9 Emerging Markets 32 Efficient 77/23 Tax Exempt Income 37 Efficient 97/3 Real Estate 40 Mixed 63/37 International Core 57 Mixed 65/35 Small Cap Growth 59 Mixed 88/12 International Growth 88 Inefficient 99/1 International Value 62 Inefficient 85/15 Small Cap Value 65 Inefficient 69/31 (Roncalli2014) Catalogue for active and passive investment strategies From the two analyses, Nelly Capital may apply each at different asset classes allocated. Generally, the UKs markets are half efficient and both methods may generate returns depending on the allocations. In specific, the active management would be effective for Nelly when applied to short-term instruments and equities while the passive management would be necessary for the long-term bonds. Reference List Abbink, J. B. (2010). Alternative assets and strategic allocation rethinking the institutional approach. Hoboken, N.J., Bloomberg Press.  Batra, G., Kaufmann, D., & Stone, A. H. W. (2003). Investment Climate Around the World Voices of the Firms from the World Business Environment Survey. Washington, D.C., World Bank. Clark, G. L., & Monk, A. H. (2014). The geography of investment management contracts: the UK, Europe, and the global financial services industry.Environment and Planning A, 46(3), 531-549http://www.smithschool.ox.ac.uk/events/Geography%20of%20Investment%20Contracts_GordonClark.pdf Ferri, R. A. (2011). The power of passive investing more wealth with less work. Hoboken, N.J., Wiley. Great Britain. (2011). The impact of UK overseas aid on environmental protection and climate change adaptation and mitigation: fifth report of session 2010-12. Vol. 1, Vol. 1. London, Stationery Office. Johnson, R. S. (2013). Debt markets and analysis. Hoboken, N.J., John Wiley & Sons Lee, W. (2000). Theory and methodology of tactical asset allocation. New Hope (Pa.), Frank J. Fabozzi Associates. Reilly, F. K., & Brown, K. C. (2012). Investment analysis and portfolio management.Mason, Ohio, South-Western Cengage Learning. Roncalli, T. (2014). Introducing Expected Returns into Risk Parity Portfolios: A New Framework for Asset Allocation. Available at SSRN 2321309.http://www.thierry-roncalli.com/download/active-risk-parity.pdf Swedroe, L. E., Grogan, K., & Lim, T. (2010). Active versus Passive Management. Hoboken, John Wiley & Sons Read More