Investing in Managed Funds - Example

Running Header: Investing in managed funds Your name: Course name: Professors’ name: Date Table of Contents Table of Contents 2 Question 1 3 Question 2 8 Essential feature of managed funds 8 Advantages of managed funds 8 Disadvantages of managed funds 9 Question 3 10 Definition of asset class 10 Features and important characteristics of major asset classes 10 Question 4 12 Meaning of expected returns 12 Question 5 13 Risk in managed funds 13 Question 6 14 Meaning of diversification in finance and how it impacts the risk and the return 14 Question 7 14 Choosing managed funds options. 15 Word count 2508 17 References 18 Appendix 19 Question 1 1. (a) The historical return for each of the above managed funds for the years 1988 to 2012 Year to dec Shares Property Bonds Cash Conservative fund Balanced fund Growth fund 1988 17.90% 16.10% 12.20% 12.90% 17.15 14.55 17.15 1989 17.40% 2.30% 14.20% 18.40% 13.08 15.9 15.57 1990 -17.50% 8.70% 19.00% 16.10% 16.07 4.11 -11.23 1991 34.20% 20.10% 24.80% 11.20% 19.78 27.2 31.85 1992 -2.30% 7.00% 10.50% 6.90% 8.72 5.02 -0.09 1993 45.40% 30.10% 16.30% 5.40% 15.79 26.85 40.96 1994 -8.70% -5.60% -4.70% 5.30% -1.88 -5.3 -7.99 1995 20.20% 12.70% 18.60% 8.00% 14.24 18.18 19.29 1996 14.60% 14.50% 11.90% 7.60% 11.13 12.55 14.32 1997 12.20% 20.30% 12.20% 5.60% 11.84 11.54 13.01 1998 11.60% 18.00% 9.50% 5.10% 9.88 9.9 12.03 1999 16.10% -5.00% -1.20% 5.00% -0.1 6.34 12.26 2000 3.60% 17.80% 12.00% 6.20% 11.42 8.06 5.86 2001 10.10% 14.60% 5.50% 5.30% 7.26 7.32 10.09 2002 -8.10% 11.80% 8.80% 4.80% 8.2 1.64 -4.42 2003 15.90% 8.80% 3.00% 4.90% 4.73 8.35 13.9 2004 27.60% 32.00% 7.00% 5.60% 11.58 15.1 25.98 2005 21.10% 12.50% 5.80% 5.70% 7.11 11.91 18.71 2006 25.00% 34.00% 3.10% 6.00% 10.15 12.15 23.71 2007 18.00% -8.40% 3.50% 6.80% 2.11 9.63 13.91 2008 -40.40% -54.00% 14.90% 7.60% -1.07 -7.95 -36.23 2009 39.60% 7.90% 1.70% 3.50% 3.48 17.04 32.64 2010 3.20% -1.10% 6.00% 4.40% 4.1 4.72 3.05 2011 -10.50% -1.50% 11.40% 5.00% 6.9 2 -7.41 2012 18.80% 33.00% 7.70% 5.00% 11.95 11.87 19.11 The work is computed using excel file, the formula used in this case is CONSERVATIVE FUND: 50% bonds; 30% cash; 20% property= (0.5) x 12.2% + (0.3) x 12.9% + (0.2) x 16.1% BALANCED FUND: 40% shares; 50% bonds; 10% cash= (0.4) x 17.9% + (0.5) x 12.2% + (0.1) x 12.9% GROWTH FUND: 80% shares; 10% property; 10% bonds= (0.8) x 17.9% + (0.1) x 16.1% + (0.1) x 12.2%. (b) Calculation of the expected (average) return, denoted by E(R), and risk (standard deviation) Year to dec Shares Property Bonds Cash Conservative fund Balanced fund Growth fund 1988 17.90% 16.10% 12.20% 12.90% 17.15 14.55 17.15 1989 17.40% 2.30% 14.20% 18.40% 13.08 15.9 15.57 1990 -17.50% 8.70% 19.00% 16.10% 16.07 4.11 -11.23 1991 34.20% 20.10% 24.80% 11.20% 19.78 27.2 31.85 1992 -2.30% 7.00% 10.50% 6.90% 8.72 5.02 -0.09 1993 45.40% 30.10% 16.30% 5.40% 15.79 26.85 40.96 1994 -8.70% -5.60% -4.70% 5.30% -1.88 -5.3 -7.99 1995 20.20% 12.70% 18.60% 8.00% 14.24 18.18 19.29 1996 14.60% 14.50% 11.90% 7.60% 11.13 12.55 14.32 1997 12.20% 20.30% 12.20% 5.60% 11.84 11.54 13.01 1998 11.60% 18.00% 9.50% 5.10% 9.88 9.9 12.03 1999 16.10% -5.00% -1.20% 5.00% -0.1 6.34 12.26 2000 3.60% 17.80% 12.00% 6.20% 11.42 8.06 5.86 2001 10.10% 14.60% 5.50% 5.30% 7.26 7.32 10.09 2002 -8.10% 11.80% 8.80% 4.80% 8.2 1.64 -4.42 2003 15.90% 8.80% 3.00% 4.90% 4.73 8.35 13.9 2004 27.60% 32.00% 7.00% 5.60% 11.58 15.1 25.98 2005 21.10% 12.50% 5.80% 5.70% 7.11 11.91 18.71 2006 25.00% 34.00% 3.10% 6.00% 10.15 12.15 23.71 2007 18.00% -8.40% 3.50% 6.80% 2.11 9.63 13.91 2008 -40.40% -54.00% 14.90% 7.60% -1.07 -7.95 -36.23 2009 39.60% 7.90% 1.70% 3.50% 3.48 17.04 32.64 2010 3.20% -1.10% 6.00% 4.40% 4.1 4.72 3.05 2011 -10.50% -1.50% 11.40% 5.00% 6.9 2 -7.41 2012 18.80% 33.00% 7.70% 5.00% 11.95 11.87 19.11 Expected average return 11.40% 9.86% 9.35% 7.13% 8.94% 9.95% 11.04% Risk standard deviation 0.19 0.18 0.07 0.04 5.75 8.17 16.27 Expected average return E(R) =   Risk standard deviation δ = Question 2 Essential feature of managed funds Managed funds are basically finds invested by many people with similar investment objectives. A professional manager thus invests funds on behalf of its investors according to their objectives. Managed funds can be in form of ordinary or non-super funds, this is where the money is invested from other financial resources and superannuation funds where the managed funds invested are super contributions. Advantages of managed funds Managed funds provide access to a wide range of investment options; this is because managed funds enables pooling of money together and investing on investments that could not be possible or affordable for an individual to invest, examples of such investments are international shares and commercial property(Lee & Lee 2009,p.113). Diversification, managed funds allow investment in a large number of options across a wide range of asset classes. This basically results in a wide range of asset classes. This diverse investment option is difficult to achieve as an individual. Funds that best suit the investor-This is possible with managed funds, generally there are a number of superannuation and ordinary managed funds which are in the market. Each of these managed funds has a unique investment strategy. This allows an individual to select the most preferred form of investment option. Expert management-managed funds are managed by experts who use their skills, resources as well as experience to protect investor’s money. Regular investment options- In most cases, managed funds offer a regular investment options, this flexibility adds value to this option of investment as it brings more profit and achievement of goals within a short period of time. Investor’s protection- non-super or ordinary managed funds are mainly operated by a responsible entity. This basically means that the interests of the investors are protected. More so. Responsible entities are regulated under the Corporations Act which is also under the control of the Australian Securities and investments Commission (ASIC). On the other hand, superannuation funds are basically regulated by trustees who mainly protect the retirement savings of the investor; this is also under the Superannuation Industry Service Act as well as the Corporation Act. Disadvantages of managed funds Market risks- the asset classes within the managed funds are cyclical meaning that the asset classes’ performance is different hence leading to uncertainty in terms of gains and losses. Depending on the investment option, the managed funds may experience liquidity risk hence meaning that the rate of selling or purchasing the assert portfolio may be a challenge. Increase of risk, this mostly occurs when managed fund borrow funds in order to invest, this may be potentially risky as the technique could lead to more losses rather than the intended gains (Parrino, Moles & Kidwell 2011, p.89). Question 3 Definition of asset class This is a group of securities which have same features and have same market behaviour. They are also under similar regulations and laws in the market that they operate in. Features and important characteristics of major asset classes Shares Shares basically represent claims on an asset, mainly on a company’s asset reflecting the ownership percentage of the company or an asset for that matter. Shares can be risky and hence leading to their high expected return of investment over a long period of time. In this case, the expected rate of returns in 11.40 %, this is the highest expected average return on investments in this case, the standard deviation risk is also relatively small, 0.19. The main features of a share includes decision rights based on the percentage shares, limited liability to shareholder, risk of share loss in the event of company liquidation and uncertain returns of investments because it depends on the company’s performance. Property Based on the average return on investment, property has an average return rate is 9.86% while the standard deviation risk is 0.18. This information reveals that property return rate is medium. The time required for good investment returns in this case is a period of 3 years. More so, property’s main features mainly entails a high inflation hedge, it is also income focused form of asset, it is hardly affected negatively by inflation and it is considered low in liquidity because of the processes needed to complete the asset transaction. Notably, this class of asset is normally considered a good investment for clients targeting moderate returns over a long period of time, it can also be used to achieve capital growth or income or even the two of them at the same time (Leibowitz, Bova & Hammond 2010,p.234). Bonds Bonds are essentially income investments because of the interest paid as a result of using the money, the bond issuer must thus agree to pay a given interest rate at a regular period of time set for the bond to mature. Bonds in this case have average return rate of cash is 9.35% and its standard deviation risk is 0.18. The key features of bonds includes: set maturity dates this is the date in which the principal payment will be paid back, it ranges from one to thirty years. There are interest rates payments in bonds, this can be in form of bond structures such as fixed rate, floating rate bonds and even zero coupon bonds (Lee & Lee 2009, p.113). Cash Cash is basically the liquid amount of money available for spending. Cash is generally not attached to an asset or anything that can limit its liquidity. In this case, the average return rate of cash is 7.13% and its standard deviation risk is 0.04 which is relatively low, as compared to the property, the rate of returns in cash is relatively low, however it has the highest liquidity ratio, it is also highly affected inflation as compared to other asset classes. Cash is also considered short term as its liquidity means that it can be converted into an asset. Question 4 Meaning of expected returns The expected return means the expected amount of gains from a particular investment asset or portfolio; this mainly considers the value of the asset, the growth rate and the risk involved in the investment platform. There are basically ways of calculating the potential returns based on the available information, mainly referred to as historical data about the given asset class. In some cases, historical data is not present, in such cases predictive models can be adopted, if historical data is available, then the data can be used to calculate the future expected returns based on the past performance, normally a period not less than 10 years(Mankiw 2008, p.34). In this case, the expected returns of different classes of assets are calculated based on the available data from 1988 to 2012, the expected returns for the four classes of assets are shares 11.4%, property 9.86%, bonds 9.35% and cash 7.13%. As noted by Mankiw (2008) a risk is regarded as the probability of variation in the expected returns from the actual returns in a negative way. More so, it can be regarded as uncertainty of the possible outcome. In the real world, the lower the risk the lower the potential returns and vice versa. This may however not be true in all case, sometimes a lower risk venture may result in high returns while a higher risk may result in lower returns increases (Besley & Brigham 2011, p.45). Investors always seek low risk and high returns through investment portfolio or managed funds in this case. In this case, the standard deviation reveals how the returns compare to the risk as follows shares 0.19 %, property 0.18%, bonds 0.07% and cash 0.04%. Question 5 Risk in managed funds There are a number of risks in managed funds as identified and discussed below. Market risk- this is mainly based on the asset classes within the managed funds. The performance of some assets may not be correlated over a period of time, the asset value may actually depreciate over time. Gearing risk-this is a risk of managed funds borrowing money in order to invest, this may generate more losses. Currency risk-international currencies values fluctuation may impact on the value of the assets specifically international assets (Lasher 2010,p.36). Security risk-within the asset class securities may differ in performing and hence potentially impacting on the risk levels of the managed funds. Diversification risk-this is the risk of investing in one asset class, this may lead to overall performance if that particular asset class underperforms. Structural risks- these are risks associated with features such as operational and structural variation of managed funds. Liquidity risk- this risk mainly focuses on the portfolio manager’s ability to dispose or purchase the investment portfolio (Ehrhardt & Brigham 2010, p.123). Question 6 Meaning of diversification in finance and how it impacts the risk and the return Diversification in finance is the process to mitigating risk by investing in an asset portfolio with different asset classes in it. Essentially the purpose of diversification is reducing the potential risk; a diverse asset portfolio is more likely to have less risk as compared to a weighted risk from a single class of asset (Brigham&  Houston 2009, p.242). A risk-averse investor is thus more likely to diversify assets in order to limit the risk in the investment process. In Australia, there are options of portfolio assets that can be utilised to reduce risk, such portfolio of asset classes included, bond, property, cash and shares. Diversification can be achieved in this case by considering question 1 section a and b. The portfolio is as follows: CONSERVATIVE FUND: 50% bonds; 30% cash; 20% property= (0.5) x 12.2% + (0.3) x 12.9% + (0.2) x 16.1% BALANCED FUND: 40% shares; 50% bonds; 10% cash= (0.4) x 17.9% + (0.5) x 12.2% + (0.1) x 12.9% GROWTH FUND: 80% shares; 10% property; 10% bonds= (0.8) x 17.9% + (0.1) x 16.1% + (0.1) x 12.2%. The expected return on investments in Conservative funds is 8.94% and the risk is 5.75, the expected return of investment in balanced funds is 9.95% and the risk is 8.17 while the expected returns for growth fund is 11.04 and the risk is 16.27. From this consideration it is true that the higher the risk, the higher the returns Question 7 If your group had $50,000 to invest in a managed fund, which specific managed fund would you choose from those offered in Table One? Justify your choice which should include reference to the characteristics of financial assets, your groups’ financial objectives and the information in the completed Table One. You should use a graph here to show the historical return performance of each of the managed funds to assist with your justification (Besley & Brigham 2011, p.45). Choosing managed funds options. The considerations that I will make which also puts into consideration our financial objectives will be based on the following factors. First, we are still young and hence in a position to take more risks. The managed funds with the potential of high returns with consideration of the risk Characteristics of the asset classes of the managed funds Based on the identified factors, the best portfolio will be Growth funds; the reason for the decision is mainly because despite the high risk, the potential expected returns are higher, more so, it considers property (which is good for young people) and bonds, which have minimal risks. As evident from the charts below, the growth funds are the most stable (not on the decline as compared to the other two options). The gradient is not sloppy. Historical performance of each of the managed funds since 1988 to 2012 Conservative funds Balanced funds Growth funds Word count 2508 References Besley, S & Brigham, EF 2011, Principles of Finance, Cengage Learning, Sydney.p.45-67. Brigham, EF &  Houston, JF2009, Fundamentals of Financial Management, Cengage Learning, Sydeny.  pp. 240-243. Ehrhardt, MC & Brigham, EF 2010, Corporate Finance: A Focused Approach, Cengage Learning, Thausand Oaks. PP.123-143. Lasher, W 2010, Practical Financial Management, Cengage Learning, Sydney.PP.36-56. Lee, AC & Lee, JC 2009, Financial Analysis, Planning & Forecasting: Theory and Application, World Scientific, Sydney. PP. 113-117. Leibowitz, ML , Bova,AP, & Hammond, B 2010, The Endowment Model of Investing: Return, Risk, and Diversification, John Wiley & Sons, Melbourne. PP. 234-245. Mankiw, NG 2008, Principles of Macroeconomics, Cengage Learning, New York.PP.34-45. Parrino, R,  Moles, P & Kidwell, DS 2011, Fundamentals of Corporate Finance, John Wiley & Sons, Sydney.PP.89-102. Appendix Question 1 a Year to dec Shares Property Bonds Cash Conservative fund Balanced fund Growth fund 1988 17.90% 16.10% 12.20% 12.90% 17.15 14.55 17.15 1989 17.40% 2.30% 14.20% 18.40% 13.08 15.9 15.57 1990 -17.50% 8.70% 19.00% 16.10% 16.07 4.11 -11.23 1991 34.20% 20.10% 24.80% 11.20% 19.78 27.2 31.85 1992 -2.30% 7.00% 10.50% 6.90% 8.72 5.02 -0.09 1993 45.40% 30.10% 16.30% 5.40% 15.79 26.85 40.96 1994 -8.70% -5.60% -4.70% 5.30% -1.88 -5.3 -7.99 1995 20.20% 12.70% 18.60% 8.00% 14.24 18.18 19.29 1996 14.60% 14.50% 11.90% 7.60% 11.13 12.55 14.32 1997 12.20% 20.30% 12.20% 5.60% 11.84 11.54 13.01 1998 11.60% 18.00% 9.50% 5.10% 9.88 9.9 12.03 1999 16.10% -5.00% -1.20% 5.00% -0.1 6.34 12.26 2000 3.60% 17.80% 12.00% 6.20% 11.42 8.06 5.86 2001 10.10% 14.60% 5.50% 5.30% 7.26 7.32 10.09 2002 -8.10% 11.80% 8.80% 4.80% 8.2 1.64 -4.42 2003 15.90% 8.80% 3.00% 4.90% 4.73 8.35 13.9 2004 27.60% 32.00% 7.00% 5.60% 11.58 15.1 25.98 2005 21.10% 12.50% 5.80% 5.70% 7.11 11.91 18.71 2006 25.00% 34.00% 3.10% 6.00% 10.15 12.15 23.71 2007 18.00% -8.40% 3.50% 6.80% 2.11 9.63 13.91 2008 -40.40% -54.00% 14.90% 7.60% -1.07 -7.95 -36.23 2009 39.60% 7.90% 1.70% 3.50% 3.48 17.04 32.64 2010 3.20% -1.10% 6.00% 4.40% 4.1 4.72 3.05 2011 -10.50% -1.50% 11.40% 5.00% 6.9 2 -7.41 2012 18.80% 33.00% 7.70% 5.00% 11.95 11.87 19.11 The work is computed using excel file, the formula used in this case is CONSERVATIVE FUND: 50% bonds; 30% cash; 20% property= (0.5) x 12.2% + (0.3) x 12.9% + (0.2) x 16.1% BALANCED FUND: 40% shares; 50% bonds; 10% cash= (0.4) x 17.9% + (0.5) x 12.2% + (0.1) x 12.9% GROWTH FUND: 80% shares; 10% property; 10% bonds= (0.8) x 17.9% + (0.1) x 16.1% + (0.1) x 12.2%. Question 1 b Year to dec Shares Property Bonds Cash Conservative fund Balanced fund Growth fund 1988 17.90% 16.10% 12.20% 12.90% 17.15 14.55 17.15 1989 17.40% 2.30% 14.20% 18.40% 13.08 15.9 15.57 1990 -17.50% 8.70% 19.00% 16.10% 16.07 4.11 -11.23 1991 34.20% 20.10% 24.80% 11.20% 19.78 27.2 31.85 1992 -2.30% 7.00% 10.50% 6.90% 8.72 5.02 -0.09 1993 45.40% 30.10% 16.30% 5.40% 15.79 26.85 40.96 1994 -8.70% -5.60% -4.70% 5.30% -1.88 -5.3 -7.99 1995 20.20% 12.70% 18.60% 8.00% 14.24 18.18 19.29 1996 14.60% 14.50% 11.90% 7.60% 11.13 12.55 14.32 1997 12.20% 20.30% 12.20% 5.60% 11.84 11.54 13.01 1998 11.60% 18.00% 9.50% 5.10% 9.88 9.9 12.03 1999 16.10% -5.00% -1.20% 5.00% -0.1 6.34 12.26 2000 3.60% 17.80% 12.00% 6.20% 11.42 8.06 5.86 2001 10.10% 14.60% 5.50% 5.30% 7.26 7.32 10.09 2002 -8.10% 11.80% 8.80% 4.80% 8.2 1.64 -4.42 2003 15.90% 8.80% 3.00% 4.90% 4.73 8.35 13.9 2004 27.60% 32.00% 7.00% 5.60% 11.58 15.1 25.98 2005 21.10% 12.50% 5.80% 5.70% 7.11 11.91 18.71 2006 25.00% 34.00% 3.10% 6.00% 10.15 12.15 23.71 2007 18.00% -8.40% 3.50% 6.80% 2.11 9.63 13.91 2008 -40.40% -54.00% 14.90% 7.60% -1.07 -7.95 -36.23 2009 39.60% 7.90% 1.70% 3.50% 3.48 17.04 32.64 2010 3.20% -1.10% 6.00% 4.40% 4.1 4.72 3.05 2011 -10.50% -1.50% 11.40% 5.00% 6.9 2 -7.41 2012 18.80% 33.00% 7.70% 5.00% 11.95 11.87 19.11 Expected average return 11.40% 9.86% 9.35% 7.13% 8.94% 9.95% 11.04% Risk standard deviation 0.19 0.18 0.07 0.04 5.75 8.17 16.27 Expected average return E(R) =   Risk standard deviation δ = Read More