Investment Proposal for a High Net Worth Individual - Coursework Example

Introduction

Diversification is a risk management technique that inculcates a wide a variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will on average yield high returns. However, the returns are part of the growth engine. Thus, the returns will pose a lower risk than any investment in the portfolio. Diversification also enhances promotion to new developments. This translates to access to more assets and investments opportunities. Moreover, diversification solidifies the owner’s wealth in equity. This implies that his capital base will be large as a result of multiple investments in a number of portfolios (Julia Butler, n.d.) Ultimately, the growth in the asset allocations increases the risk exposure that an investor can experience. This, in the long run, enables a clear understanding of the fluctuating inflation rates in different countries across the globe. This particularly plays a crucial role in risk assessment mechanisms. Risk tolerance is dictated by the amount an investor is willing to sacrifice. The risk tolerance level will also be fundamental in deciding whether to convert the asset into stocks, bonds or cash. A high risk investor is more likely to risk more finances in order to get better rewards. Thus, it is prudent to state that diversification, based on the choices available for asset allocation, will limit the losses and reduce the fluctuations of investments returns (Andreu, & Sarto, 2015).

In addition, diversification helps in improving the returns for the particular risk undertaken by an investor. Poor performance by the portfolio of choice is eliminated potentially (Shauna, 2013). A business that has incorporated diversification in its capital strategy will yield a lot of benefits. Investing in foreign securities is not likened to the trend exhibited by the domestic securities. This is to say that a severe economic condition in another foreign country might not have adverse impacts in the domestic country the same way and vice versa. This way, an investor would be cushioned against the adverse effects of economic downturns. With the advent of diversification, mutual funds have necessitated the buying of shares in mutual which have proved to be an inexpensive source of diversification (Doroghazi, 2009).

Another aspect of diversification is the need for rebalancing as suggested by Andreu and Sarto (2015). This warrants that the assets relate to the original asset allocation mix. This move is necessary to prevent the realignment of goals and overemphasis of the assets’ portions. Hence, the levels of risks will reduce to great manageable levels that will be vital in ensuring that an investor is buying low and selling high. Thus, no favors portrayed at all in the various classes of assets. An investor on the path of investing will need to be knowledgeable and certain about the target investment mix either based on stock, bonds, or short term investments. This means taking into account the current financial situation, the time the money will be available and the tolerance for volatility. On the other hand, a constant review of the portfolio will regularly be maintained to ensure that it stays within the limits of the business strategy; in matters of finances and the scope of operations (Julia Butler, n.d.).

Manager structure

Since the future outlook of investments in equities and fixed income is uncertain, due to the unpredictable market conditions and uncertain monetary policies by Central Banks. Diversifying into hedge funds will be a better alternative for the HNWI investor. From a broader and vague perspective, hedge funds draws capital from a variety of recognized depositors and invest in selected assets after undertaking a complex analysis of the returns and risks associated with the assets (Bruce & Institutional Investor, 2002).

Investing in hedge funds is majorly focused on comparatively liquid assets. As such, regulators do not cap its use of leverage leaving it to be less regulated. While the U.S SEC may soon start regulating the funds, the investor can still take advantage of the unregulated funds. However, he must be careful to avoid being taken advantage of by malevolent hedge fund companies. In choosing the manager of the funds, the investor should exercise extreme selectivity to avoid being a victim of the limited transparency that is predominant in this form of investment (Bruce & Institutional Investor, 2002). A vital benefit of investing in hedge funds is that the HNWI investor will be less exposed to drawdowns. He will also earn portfolio returns that are less volatile regardless of the existing market (systematic) risks.

The Credit Suisse Hedge Fund Index can be used to determine or decide the hedge funds that the investor should invest in (Davies & Servigny, 2012). Compiled by Suisse Tremont, the index includes funds and their weight in a hedge strategy. With over 9000 funds, the Credit Suisse Database provides data on the performance of various funds and their returns as calculated and rebalanced every month. The strategies for various hedge funds is summarized in the below diagram (Boven, 2016).

Considering the promising future of hedge funds, the HNWI investor should allocate 80% of his total value to hedge funds. Out of this, the investment mix should be as shown below:

Hedge fund

Allocation

Cash

42%

Convertible Arbitrage (Bonds)

18%

Stock

25%

Emerging markets

15%

According to Capocci (2013), hedge funds will have high returns in the coming years. However, high returns can only be realized from highly risky investments (Boven, 2016). Computing the standard deviation of the returns of a portfolio (σp) gives its risk level (Boven, 2016). To ascertain the exact value of an investment and the risk-return trade-off, it is important to consider the risk free percentage (Rf), the returns of the portfolio (Rp), and the σp. Thus, the suggested mix was arrived at after an analysis of the potential hedge funds that the investor can consider. This is done by determining those that are likely to outperform the market after computing their Sharpe measure.

The risk of each fund was obtained by finding the standard deviation using the formula;

(Boven, 2016)

If we take the expected returns from the hedge funds to be 6, 4, 3, and 2% for cash, bonds, stock, and emerging markets respectively, the expected returns from investing in hedge funds can be determined.

Returns expected from hedge funds = sum of the returns of individual assets

= (6% x 42%) + (4% x 18%) + (3% x 25%) + (2% x 15%)

= 4.29%.

Another factor that is important to consider when determining the portfolio mix is the status of the asset as compared to the market (Rittereiser & Kochard, 2010). The assets included in the portfolio mix are those that were found to be undervalued or misplaced. As such, such assets are expected to have greater returns in future. Their market status will change when other investors realize how valuable and profiting they are (Bruce & Institutional Investor, 2002). Apparently, it was tranquil to select the assets due to information asymmetry. Despite the coming in of technology, most investors have insufficient information regarding the movement of prices of assets. This makes it easy to take advantage of mispriced assets before other investors start investing in them (Lofthouse, 2001).

While the expectation that the market value of the selected hedge funds will increase in future is a predominant reason for the selection of the funds, several other factors were considered. For instance, if the HNWI investor invests in the selected funds, they will gain access to specialised strategies that may not be accessible by undertaking other investments. One such strategy is short-selling. If during the 5-year period the price of bonds or stock worsens, the HNWI investor might sell the securities to other investors. This will help in averting the loss associated with the decline in prices of the stock and bonds as proclaimed by Davies and Servigny (2012).

Additionally, emerging market is an economic source of return. Its inclusion in the hedge funds mix reduces the total volatility of the HNWI investor’ portfolio since it is highly diversified (Boven, 2016). The investment in emerging market involves investing in currencies. Particularly, the USD since it is expected that its value in India, Eastern Europe, and developing countries such as those in Africa will increase. The investor can, thus, venture into the market and reduce probability of loss by shorting futures (Longo, 2009). This will hedge market exposure, and, therefore, hedges the entire portfolio and increases the HNWI investor’s chances of reaping maximally from their investment in the selected hedge funds (Boven, 2016). The HNWI investor currently has 60% of his investment in equities and 40%in fixed income. Apparently, hedge funds have a low connection to such kind of investments suggesting that hedge funds are better than the HNWI investor’s previous undertakings. According to Capocci (2013), connection and expansion or diversification benefits have an indirectly proportional association. Thus, since the selected hedge funds have a low correlation, the benefits that the HNWI investor will derive from diversification are high.

What’s more, the number of large investors in emerging markets and cash is limited. Instead of focusing on fixed income and equity only, the HNWI investor should venture into more attractive investments. A good example is dollar buying in emerging markets. Most countries in emerging markets are experiencing tough economic times. They are increasing the amount of good that they import from U.S while their exports to the U.S are decreasing (Longo, 2009). The long-term implication of this trend is that the dollar will appreciate against the local currencies. Investors in emerging markets will, thus, earn from such favourable currency movements (Black, 2004). The snowballing demand of the U.S dollar is yet to be taken advantage of by huge investment companies. Hence, the investor should allocate 15% of his investment in hedge funds to emerging markets where futures are also unremittingly being appreciated (Capocci, 2013).

The investments to ponder in would involve the time horizon within which the investment would take. In our case, 3-5 years would be appropriate since private equity which is composed of buyouts and venture capitals can be allocated periodically. For instance, a period of six months over five years with a given market interest rate and the yield returns that the sources of finance will accrue upon maturity. A 30% private equity shall be obtained by means of venture capitalists and angels investments. These schemes will add greater efficiency by providing greater risk-adjusted returns in the long-run. The Internal Rate of Return (IRR) would be of great benefit in assessing the performance development over time. If the IRR is higher than the market rates, then it would be prudent to make an investment. However, if the IRR is lower than the interest rate, for instance IRR is 10% and the interest rate is 12%, then the investment should not be attempted. This is because the present value of the benefits to be obtained should be more than the present value of the costs that the business is supposed to incur (Davies, Servigny, & A. 2012).

The various type of private equity that the firm can embrace includes private equity/ buyouts which inculcate, acquisition of existing firms or merging with an existing one. This means that the business would incur moderate risks hence, high returns. Another potential ground would be the venture capital which takes root immediately from the on-set of the new business that has the potential of generating high returns in the future (Braga, 2016). Although the risks associated with this kind of equity are high, it would be gross to underestimate the grounds for success that the business would amount to given its innovativeness and technology parameters that would fast-track the growth and progress bar. An optimal mix of the two buyout and venture firms can help propagate the growth of the business to a great extent. This is in terms of soliciting for more funds from other sources and in so doing generate high returns for the cash invested. Although the risk to be expected would be high, the best alternative is to employ appropriate policies and mechanisms. This will lessen the chances of the firm coming to an insolvency position that can be prevented by a well-established proposal and making an informed decision on the strategy to adopt (Doroghazi, 2009).

Debt financing is crucial to the performance of any business. Another dimension of private equity is the angel deals which have slowly been absorbed into the convertible debt when the firm stabilizes and begins to make a fortune Business angels come in handy and provide the best in terms required finance and uplift the business through harsh economic conditions characterized by high risks with minimal rate of returns. Before a business can attain stability, and reap high returns that would eventually share with the sole investor, the liquidity position of the business would have stabilized. The firm is now abled with wings to survive through any harsh economic times regardless of the weather (Andreu, & Sarto, 2015).The matter of financial projections is a key aspect when valuing a company or a firm. It entails, apart from finances, the validity and quality of an idea, the assets valuation and measurement, the market size and the structure of the managing team. This can be closely backed by the J-curve phenomenon. This is the idea that the funds channeled into a business by an investor would at first be low but in the long run generates high returns (Shauna, 2013).

The investor perhaps would be highly considerate of the investment returns and the level of risks that pertains to the business venture. The anticipated levels of inflation and the general exposure to new and emerging trends in the finance sector such as taxation issues, the need to compete with other players in the industry as well enjoy the benefits of economies of scale that accrue to the firm. All these factors coupled would make the environment challenging to the investor given that losses are inevitable and the degree of risk and returns are highly related if one is to springboard to the next level in terms of exposure and taking ground financially. The advantages of private investments cannot be overestimated. This is to say that the fact that they possess a low correlation with other assets is proving to be quite essential in terms of the diversification that it entails. The investor would perhaps need to consider also the investment spectrum which is a depiction of the various levels of funds and sources that are faster and liquid in nature. Also, consider the speculations and the due diligence concerning the source of funds (Lofthouse, 2001).

Diversification – deciding the right level

While the target mix looks appropriate for the investor, there is need to constantly rebalance and carry out constant check-ups. This is to ensure the investors’ strategy and tolerable risk level is attained (Fidelity, 2015).

Regular check-ups will ensure that the diversified portfolio has a risk level that will not jeopardize the returns the investor presumes to gain from the investment. For instance, for the hedge funds, the current allocation to cash is 42%, 18% for bonds, stock is 25% and emerging markets is 15%. In 4 years’ time, taking a hypothetical scenario, the weight of stock might increase to 70%, while bonds, cash, and emerging markets reduce to 10%, 12%, and 8% respectively. The additional cash implies that the portfolio will have surplus impending risks (Bruce & Institutional Investor, 2002). This is because, traditionally, larger price fluctuations have been experienced in stock than for cash, emerging markets, or bonds (Rittereiser & Kochard, 2010). It can, therefore, be said that while rebalancing is often considered to be an exercise targeted at risk reduction, it helps in resetting an investor’s investment collection/mix to the initial expected returns and an apposite level of risk (Fidelity, 2015).

According to Black (2004), since investing is basically a continuous process, it will be important to keep track of the investment mix. With this, the portion of investment allocated to alternatives that might overtime prove to be conservative can be increased. Also, more risks can be taken to increase the returns from the portfolio. While rebalancing hardly guarantee profit realization, it helps in ensuring that the investor’s resources are used appositely. It also ensures that the holistic view adopted in the portfolio construction prevails throughout the existence of the investment as asserted by Fidelity (2015).

Implementation - what are the risks to successful execution of your recommendations?

Fraud is among the inhibiting factors that will impede correlation especially if an investor is dependent on an external source of information. Likewise, interest rates which can be said to be a key player in determining how the investor will execute successfully the operations of the business is also another impediment (Braga, 2016). This is so because it affects the level of certainty about the business yielding high returns. In addition, the expectations of future changes of cash inflows will affect the current levels of investments.

Another crucial factor, as hypothesized by Shauna (2013), is the instability of currencies. That is due to inflation levels that keep shifting. This will affect the level of execution and success rates due to the variations in the returns. Which are affected when the economy is at boom, peak, or the negative aspects: regression and depression. The liquidity of the assets that the investor has undertaken will influence the degree of certainty. Since a high level of liquidity translates to more risky investments which could be healthy for an investor who aims to reap maximally. Another cause for alarm is the taxation strategy by the authorities that should hinder the successful execution of the projects identified. High taxation rates discourage any form of investments. Especially the budding ones while lower rates significantly improve the levels of performance. Moreover, the failure of an invention and innovation especially emerging firms poses a threat to the anticipated success levels. This can be attributed to poor technology that proves inefficient in the operations of a firm (Braga, 2016). 

Time taken to build the program to the suggested allocation levels

Timing is of essence in the success of this project. A minimum of three years and a maximum of five years would prove sufficient to the success rate of the project. Given that the levels of expectancy are based on different seasons of the economic times that keep adjusting based on the prevailing market conditions. For a bond or stock to mature and yield high returns for instance, time is a key factor which will determine the output that the bondholder anticipates to be rewarded with. Consequently, the timing of the project is dependent on the seasons that are exhibited by different economic times. This will be decisive to the investor on what are the opportune times to cash in on the project and reap the best out of it (Andolfatto, Berentsen, & Waller, 2015). 

Market timing

Market timing is a strategy that aims at locking out the existence of hedge funds by selling the stock in short supply such that an investor is able to sell at a very high rate yet he purchased at low prices. In addition, the investor must be in a position to identify undervalued securities that concern bankruptcy. This, apparently, will potentially be a benefit to the profits that will be generated. (Fidelity, 2015). Buying before the reorganization plan has been announced will also serve as an important element. Research can also be an important consideration on how the market performs. Similarly, the competitive mechanisms being geared towards the survival and ultimate success mechanisms must be considered.

Conclusion

The above elucidation candidly and comprehensively reveals that the HNWI needs to undertake the investment decisions with hedge fund and private equity derivatives. Each should be in proportion according to the ultimate investment mix. This way, the investor would be in a position to enjoy ostensibly the prevailing market rates without having to incur unplanned uncertainties. This would result to losses and low returns in the long run. For the period stipulated of five years the investor will be in a position to fully familiarize with the current emerging trends in the investments options available: whether to seek correlations or merge in a bid to increase the competitiveness within the business industry. Taking into account the liquidity positions of the stocks, and the bonds that are on offer as alternative sources of finance will prove beneficial since it will guarantee high returns even though the level of risk associations is high (Longo, 2009). Diversification of asset allocation consequently should not be neglected since it will be fundamental in fast-tracking the immediate financial needs that the investor will be in need of.