Managed Funds, Meaning of Diversification and How It Affects Risk and Return - Assignment Example

Fund TABLE ONE: HISTORICAL ASSET CLASS RETURNS Source: IRESS, Colonial First State, RIMES YEAR TO 30TH JUNE AUST. SHARES GLOBAL SHARES PROPERTY FIXED INTEREST (BONDS) CASH CONSERVATIVE FUND BALANCED FUND DIVERSIFIED FUND 1997 26.84% 28.46% 28.53% 16.76% 6.77% 16.53% 19.79% 22.97% 1998 0.96% 41.58% 9.97% 10.88% 5.11% 10.40% 15.08% 17.74% 1999 14.14% 8.21% 4.31% 3.28% 5.04% 6.07% 7.18% 8.58% 2000 18.15% 23.69% 11.91% 6.17% 5.58% 9.80% 13.09% 16.09% 2001 9.11% -5.82% 13.91% 7.42% 6.08% 6.21% 4.44% 3.42% 2002 -4.54% -23.26% 14.85% 6.21% 4.66% 1.54% -3.26% -7.13% 2003 -1.61% -18.28% 12.15% 9.78% 4.97% 3.70% -0.60% -4.06% 2004 21.73% 19.38% 17.24% 2.33% 5.30% 8.73% 11.96% 15.31% 2005 26.03% 0.57% 18.10% 7.79% 5.64% 9.57% 9.61% 10.93% 2006 24.02% 19.97% 18.05% 3.41% 5.76% 9.71% 12.99% 16.47% 2007 29.21% 8.23% 25.87% 3.99% 6.42% 10.14% 11.80% 14.50% 2008 -13.67% -21.03% -36.35% 4.42% 7.34% -1.86% -6.87% -11.52% 2009 -20.34% -16.31% -42.27% 10.82% 5.48% -1.09% -6.18% -11.48% 2010 13.10% 5.50% 20.40% 7.90% 3.90% 7.67% 7.97% 8.65% 2011 11.90% 3.00% 5.80% 5.50% 5.00% 6.05% 6.05% 6.49% EXPECTED RETURN 10.34% 4.93% 8.19% 7.11% 5.54% 6.88% 6.87% 7.13% RISK 14.72% 18.80% 19.67% 3.67% 0.83% 4.65% 7.72% 10.67% All final calculations should be correct to two decimal places (ie two places after the dot point) expressed as a percentage. 2. What are managed funds? As the name suggests, managed funds are investment funds which are professionally managed by a professional funds manager who invest in a number of investments. However, the actual mix and type of the investments that compose the fund usually depend on a predetermined mandate which is communicated by the fund manager. The fund is usually comprised of different asset classes such as cash, property, fixed interest, property and shares. When an investor gives his /her money, it used to buy assets in line with the objective of the investment. People who invest in a managed fund are given a certain number of a unit whose value is calculated on a daily basis and changes as the market value of the assets composing the fund rises or falls (James, 2010). There a four types of managed funds which include unit trusts, superannuation funds, group investment funds and insurance bonds. Managed funds are popular forms of investment due to a number of reasons including; a) the ease of diversifying ones investment, b) the fact that the funds are managed by experts c) the ease of reinvesting ones investment earnings d) the ease of setting up a regular investment plan e) The ability to start investing even with very small amounts of money. 3. Meaning of diversification and how it affects risk and return Diversification is a technique for managing investments by way of mixing a big variety of investments within a portfolio with an aim of minimizing the impact which any one given security/asset could have on the overall performance of the portfolio. The effect of diversification is to lower risk associated with ones portfolio and hence increase expected returns (Oleg, 2011). For instance, if one invested all his funds in property in 2009, he/she would have made a loss from the investment. Similarly, if he/she invested his money on Aust and Global shares, he would have made a loss (as can be seen in table1). However, suppose the person split the money into four and invested part of it in property, bonds, cash and shares; half of the investment (property and shares) would have yielded a loss while half of the investment (bonds and cash) would have yielded some interest. These means that by diversifying his /her investment to more asset classes, the person would have reduced the loss made and even make an overall profit. Diversification therefore helps in reducing risk and increasing returns. However, when diversifying, one should try to invest in a combination that minimizes the overall risk or that which has the potential for the greatest returns. 4a) asset class Investments are classified into different groups. These groups are the asset classes. An asset class is a group of investments/securities which have/show similar characteristics and /or behave in a similar manner in the market place and are subjected to the same rules and regulations. Asset classes include the stocks, bonds, cash equivalents as well as property. Characteristics of a) Shares- as can be seen from the table 1 above, shares are one of the most risky asset classes. Both the Ausi Shares and Global shares have some of the highest risks although the Ausi shares also have the highest returns. However, shares are generally regarded as a highly risky class of investment. As it can be seen from the table, their returns are uncertain. The uncertainty is associated with the fact that at times, companies fail to make enough money to pay dividends. At times the board decides not to declare dividends but instead reinvests the money in the organization (Doyen, 2010). Sometimes because of information or structural flaws, the market may not value the shares accurately. At times, the boards have been known to approve mergers which have imposed prices that do not reflect the shares future earnings potential. Sometimes, dissolution may be approved by the board and the assets are liquidated at a price which fails to reflect the value of the organization’s ongoing business. All these are some of the reasons that make stocks highly risky. However, when the economy is performing well, shares can have very good returns which greatly boost the investors’ wealth. b) Property – as can be seen from the diagram, property can be a highly risky form of investment. The returns from a property remain relatively stable as long as the economy is stable. However, if there is an economic depression as was in 2008 and 2009, properties can yield very big losses. This makes them a highly risky form of investment. However, properties have some beneficial features in that they produce returns that are relatively stable as can be seen from the table apart from during the times of economic depression. The returns are a component of both rental income and capital appreciation. As such, real property can be said to have a coupon paying feature like a bond due to its ability to pay regular and steady income stream as well as a share like feature due to the fact that it fluctuates rapidly during times of economic depression. c) Bonds – as can be seen, bonds returns are relatively assured although the returns are relatively low. However, bonds have relatively low risk as compared to other forms of investments. The low level of risk is attributed to its characteristics. The bonds have fixed maturity date which makes them more predictable and hence less risky. Similarly, bonds pay fixed amount of interest per specific period of time (James, 2001). This is the coupon rate of interest and the issuer of the bond is bound to pay the interest at the end of the period. This means that the investor is always assured to receive the fixed rate of interest at the end of the period making the bonds less risky. Similarly, the bond holder is assured to get the face value of the bond once it matures. All these characteristics makes bond highly predictable and hence less risky. However, where the risk is low, the returns are also low as can be seen from the table1. d) Cash – as can be seen from the above table, returns on cash are relatively assured. As such, cash as an asset has a very low risk. However, where the risk is low, the return is also low. The low risk is associated with the fact that when one lends money to a company, he/she earns interest. The investment is usually on call and gives a regular income and hence protecting ones wealth base. The cash being on call implies that one will have access to his/her cash when in need. There are also no fees for entry or exist while there are no penalties for making withdrawals. These are characteristics that make cash investment very attractive and hence less risky than other forms of investments. However, the returns on cash are also low. The four multi sector funds a) Colonial First State Wholesale diversified – this is a multi sector fund aimed at providing medium to long-term growth of capital alongside some income through investment in cash, property, shares and fixed interest or bonds. The distribution of funds among the assets includes 70% investment in growth assets i.e. property and shares while 30% is invested in defensive assets including fixed interest (bond) and cash. b) Colonial wholesale conservative fund –this is a multi sector fund that is aimed at providing a regular stream of income as well as maintaining and increasing ones capital value in the medium term. The distribution of funds among the asset classes is such that 30% is provided for investment in growth assets which include property and shares while 70% of the funds are invested in the defensive assets i.e. cash and bonds. c) Colonial first estate wholesale balanced fund – this is a multi sector fund aimed at providing a balance of capital growth and income from investing in cash, property, fixed interest as well as shares in the medium term. The funds distribution among the asset classes is such that 50% of the funds are invested in growth assets including shares and property while 50% is invested in defensive assets including cash and bonds. d) Colonial first estate high Growth fund –this is a fund aimed at providing long term growth of capital through investment in a diversified portfolio of global and Australian shares. The funds allocation is such that 100% of the funds are invested in growth assets or the shares. c) Growth assets are assets such as stocks and properties that provide investment returns that comprise of income and growth in capital that outperform inflation. On the other hand, defensive assets are investments which are made with the aim of achievement of more stable returns as opposed to the investment assets but with little or no growth in capital. They include cash as well as fixed interest. 5. Risks of choosing to invest in managed funds Just like shares, the prices of managed funds may rise hence giving one a capital gain. However, there is a risk that the price of the managed fund may drop below the price they were bought at implying a loss in capital (David, 2005). There is a risk that the management fees as well as administration fees one pays will reduce the expected returns. Although not as big as in shares, the risk of losing ones investments is still there. 6. If we had $50,000 in a managed fund, we would choose colonial first estate balanced fund. This is in line with our objective of having some source of income where we can get some pocket money as well as having some capital growth for the sake of investment after college. This fund will provide us with a balance of capital growth and income from investing in cash, property, fixed interest as well as shares in the medium term (Jane, 2009). Furthermore, the funds distribution among the asset classes is such that 50% of the funds are invested in growth assets including shares and property while 50% is invested in defensive assets including cash and bonds. As can be seen from the table, the balanced fund has a medium level of risk. This implies that apart from having some income and some growth in capital, we will be able to adequately diversify risk. As such, we can always be assured of some form of income and growth in capital which we can make use of after the end of investment period. Furthermore, the timing is mid term which makes it ideal for us as we would want to withdraw the funds in the medium term for investment in other areas. References James, K2010, Introduction to managed funds international finance journal, Vol.8, No.125, Pp14-26 Oleg, D2011, Investing in actively managed funds Journal of applied Economic sciences, Vol.5, No.15, Pp7-15. Doyen, O2010, The arithmetic active management University press: Cambridge David, S2005, Introduction to finance Light House Publishers ltd, Melbourne. Jane, B2009, Fundamentals of finance Oxford university press, Sydney. James, W2001, Introduction to finance: making wise investment decisions, Prentice Hall, London. Appendix The average returns for the assets are calculated as follows; a) Aust Shares , Total returns over the years is=(26.84%+0.96%+14.14%+18.15%+9.11%+-4.54%+-1.61%+21.73%+26.03%+24.02%+29.21% +-13.67%+-20.34%+13.10%+11.90%) =155.03% Average return =155.03/15 =10.3353 =10.34% Global Shares Total returns = (28.46%+41.58%+8.21%+23.69%+-5.82%+-23.26%+ 18.28%+19.38%+0.57%+19.97%+8.23%+-21.03%+16.31+5.50%+3.0%)=73.53% Average returns =73.89%/15=4.93% Property Total returns =28.53%+9.97%+4.31%+11.91%+13.91%+14.85%+12.51%+17.24%+18.10%+1 8.05%+25.87%+-36.35%+-42.27%+20.40%+5.80%) =122.83% Average return =122.83/15=8.188667 =8.19% Fixed interest bonds Total returns= (10.88%+3.28%+6.17%+7.42%+6.21%+9.78%+2.33%+7.79%+3.41%+3.99%+4.42%+10.82%+7.90%+5.50%) = 106.66% Average returns =106.66/15 = 5.344133 =7.11% Cash Total returns =(6.67%+5.11%+5.04%+5.58%+6.08%+4.66%+4.97%+5.30%+5.64%+5.76%+6.42%+7.34%+5.48%+3.90%+5.0% =83.05% Average returns = 83.05/15 = 5.54% Conservative fund Total returns =16.53%+10.40%+6.07%+9.80%+6.21%+1.54%+3.70%+8.73%+9.57%+9.71%+10.14%+-1.86%+-1.09%+7.67%+6.05%=103.17% Average returns =103.17/15 = 6.878 =6.88% Balanced fund Total returns = (15.08%+7.18%+13.09%+ 4.44%+-3.26%+- 0.60%+11.96%+9.61%+12.99%+11.80%+-6.87%+-6.18%+7.97%+6.05%)=103.05 Average returns = 103.05/15 =6.87% Diversified fund Total returns = (17.74%+8.58%+16.09%+3.42%+-7.13%+4.06%+15.31%+10.93%+16.47%+14.50%+-11.52%+-11.48%+8.65%+6.49%) = 106.96% Average returns =106.96/15 Calculation of risk Aust Shares Year Return (%) Average return (%) Deviation from average return (%) 1997 26.84% 10.34 +16.50 272.25 1998 0.96% 10.34 -9.38 87.9844 1999 14.14% 10.34 +3.8 14.44 2000 18.15% 10.34 +7.81 60.9961 2001 9.11% 10.34 -1.23 1.5126 2002 -4.54% 10.34 -14.88 221.4144 2003 -1.61% 10.34 -11.95 142.8025 2004 21.73% 10.34 +11.39 129.7321 2005 26.03% 10.34 +15.69 246.1761 2006 24.02% 10.34 +13.68 187.1424 2007 29.21% 10.34 +18.87 356.0769 2008 -13.67% 10.34 -24.01 576.4801 2009 -20.34% 10.34 -30.68 941.2624 2010 13.10% 10.34 +2.76 7.6176 2011 11.90% 10.34 +1.56 2.4336 total 3248.322 Total variance =3248.322 Standard deviation = √ 3248.322/15 = 14.72 Global Shares Year Return (%) Average return (%) Deviation from average return (%) 1997 28.46 4.93 23.53 553.6609 1998 41.58 4.93 36.65 1343.223 1999 8.21 4.93 3.28 10.7584 2000 23.69 4.93 18.76 351.9376 2001 -5.82 4.93 -10.75 115.5626 2002 -23.26 4.93 -28.19 794.6761 2003 -18.28 4.93 -23.21 538.7041 2004 19.38 4.93 14.45 208.8025 2005 0.57 4.93 -4.36 19.0096 2006 19.97 4.93 15.04 226.2016 2007 8.23 4.93 3.36 10.89 2008 -21.03 4.93 -25.96 673.9216 2009 -16.31 4.93 -21.24 451.1376 2010 5.50 4.93 0.57 0.3249 2011 3.00 4.93 -1.93 3.7249 TOTAL 5302.535 Total variance= 5302.535 Standard deviation=√5302.535/15 =18.8 Property Year Return (%) Average return (%) Deviation from average return (%) 1997 28.53 8.19 20.34 413.7156 1998 9.97 8.19 1.78 3.1684 1999 4.31 8.19 -3.88 15.1544 2000 11.91 8.19 3.72 13.8384 2001 13.91 8.19 5.72 32.7184 2002 14.85 8.19 6.66 44.3556 2003 12.15 8.19 3.96 15.6816 2004 17.24 8.19 9.05 81.9025 2005 18.10 8.19 9.91 98.2081 2006 18.05 8.19 9.41 88.5481 2007 25.87 8.19 17.68 312.5824 2008 -36.35 8.19 -44.54 1983.812 2009 -42.27 8.19 -50.46 2546.212 2010 20.40 8.19 12.21 149.0841 2011 5.80 8.19 -2.39 5.7121 Total 5804.593 Variance = 5804.593 Standard deviation =√5804.593/15 =19.67 Fixed interest (Bonds) Year Return (%) Average return (%) Deviation from average return (%) 1997 16.76 7.11 9.65 93.1225 1998 10.88 7.11 3.77 14.2129 1999 3.28 7.11 -3.83 14.6689 2000 6.17 7.11 -0.94 0.8836 2001 7.42 7.11 0.31 0.0961 2002 6.21 7.11 -0.9 0.81 2003 9.78 7.11 2.67 7.1289 2004 2.33 7.11 -4.78 22.8484 2005 7.79 7.11 0.68 0.4624 2006 3.41 7.11 -3.7 13.69 2007 3.99 7.11 -3.12 9.7344 2008 4.42 7.11 -2.69 7.2361 2009 10.82 7.11 3.71 13.7641 2010 7.90 7.11 0.79 0.6241 2011 5.50 7.11 -1.61 2.5921 Total 201.8745 Variance =201.8745 Standard Deviation =√201.8745/15 =3.67 Cash Year Return (%) Average return (%) Deviation from average return (%) 1997 6.77 5.54 1.23 1.5129 1998 5.11 5.54 -0.43 0.1849 1999 5.04 5.54 -0.50 0.25 2000 5.58 5.54 0.04 0.0016 2001 6.08 5.54 0.54 0.2916 2002 4.66 5.54 0.88 0.7744 2003 4.97 5.54 0.57 0.3249 2004 5.30 5.54 -0.14 0.0196 2005 5.64 5.54 0.10 0.01 2006 5.76 5.54 0.22 0.0484 2007 6.42 5.54 0.88 0.7744 2008 7.34 5.54 1.8 3.24 2009 5.48 5.54 -0.06 0.0036 2010 3.90 5.54 -1.64 2.6896 2011 5.00 5.54 -0.54 0.2916 Total 10.4175 Variance =10.4175 Standard deviation =√10.4175/15 =0.83 Conservative fund Year Return (%) Average return (%) Deviation from average return (%) 1997 16.53 6.88 9.65 93.1225 1998 10.40 6.88 3.52 12.3904 1999 6.07 6.88 -0.81 0.6561 2000 9.80 6.88 2.92 8.5264 2001 6.21 6.88 -0.67 0.4489 2002 1.54 6.88 -5.34 28.5156 2003 3.70 6.88 -3.18 10.1124 2004 8.73 6.88 1.85 3.4225 2005 9.57 6.88 2.68 7.1824 2006 9.71 6.88 2.83 8.0089 2007 10.14 6.88 3.26 10.6276 2008 -1.86 6.88 -8.74 76.3876 2009 -1.09 6.88 -7.97 63.5209 2010 7.67 6.88 0.79 0.6241 2011 6.05 6.88 0.83 0.6889 Total 324.2352 Variance =324.2352 Standard deviation =√324.2352/15 =4.65 Balanced fund Year Return (%) Average return (%) Deviation from average return (%) 1997 19.79 6.87 12.92 166.9264 1998 15.08 6.87 8.21 67.4041 1999 7.18 6.87 0.31 0.0961 2000 13.09 6.87 6.22 38.6884 2001 4.44 6.87 -2.43 5.9049 2002 -3.26 6.87 -10.13 102.6169 2003 -0.60 6.87 -7.47 55.8009 2004 11.96 6.87 5.09 25.9081 2005 9.61 6.87 2.74 7.5076 2006 12.99 6.87 6.12 37.4544 2007 11.80 6.87 4.93 24.3049 2008 -6.87 6.87 -13.74 188.7876 2009 -6.18 6.87 -13.05 170.3025 2010 7.97 6.87 1.1 1.21 2011 6.05 6.87 -0.82 0.6724 Total 893.5852 Variance =893.5852 Standard deviation =√893.5852/15 =7.72 Diversified Fund Year Return (%) Average return (%) Deviation from average return (%) Deviation squared 1997 22.97 713 15.84 250.9056 1998 17.74 7.13 10.61 112.5721 1999 8.58 7.13 1.45 2.1025 2000 16.09 7.13 8.96 80.2816 2001 3.42 7.13 -3.71 13.7641 2002 -7.13 7.13 -14.26 203.3476 2003 -4.06 7.13 -11.19 125.2161 2004 15.31 7.13 8.18 66.9124 2005 10.93 7.13 3.8 14.44 2006 16.47 7.13 9.34 87.2356 2007 14.50 7.13 7.37 54.3169 2008 -11.52 7.13 -18.65 347.8225 2009 -11.48 7.13 -18.61 346.3321 2010 8.65 7.13 1.52 2.3101 2011 6.49 7.13 0.64 0.4096 Variance =1707.969 Standard deviation =√1707.969/15 =10.67 Read More