Portfolio Theory and Investment Analysis - Assignment Example

Portfolio Theory and Investment Analysis This paper acts as a briefing paper on three issues related to the portfolio investments of a UK charity, details of which are contained in the assignment brief: (1) diversification and the stock composition of the investment portfolio; (2) international investments; and (3) derivatives. Diversification The first issue concerns the impact of an investment strategy where 40% of the charity's funds are invested in the stock of a FTSE 100 company and 10% each in six other FTSE 100 companies, regardless of what these companies may be. It is also known that the beta of the portfolio against the FTSE All Share Index is 1.03 and the average monthly correlation between the stocks is 0.65. A good investment strategy is one that earns the investor an expected return that is at least equal to or higher than what comparable investments would earn (Sharpe, 1991). The goal of any investment strategy is to maximise the value of the investment by getting the highest possible expected return for a given level of risk. Every investment involves risk, which is the possibility of losing money if the investment decision turns out to be a wrong one. According to normal human behaviour, the higher the risk, the higher should be the expected return. Different investments have different levels of risk. For the UK charity, the safest investment, which also gives the lowest return, is to buy UK government bonds because the government always pays its debt obligations. Other investments, such as metals, a start-up business, or equities have higher levels of risk, and according to studies such as one by Barclays (2007), equities have consistently given higher returns compared to bonds or metals. Thus, investing in equities is a good first step in the investment strategy. The next question is to choose which stocks to buy and how much of the fund would be spent for each stock. Answering these questions requires knowing how risk is measured and is affected by portfolio diversification. The risk level of investments in equities is measured by beta (Black, 1993), which shows how the value of the investment moves compared to the FTSE All Share Index, a composite number that represents the investment return of the UK equities market. The Index measures the daily values of all shares traded in the London Stock Exchange. If this index went up from 6,131.50 to 6,554.90 in the last 52 weeks, then the return on an investment, also called the market return, in all the shares included in the index would be 6.91% and a 10,000 investment 52 weeks ago would now be worth 10,691 excluding fees and commissions (Economist, 2007). A beta of 1.03 means that the value of the investment portfolio moves very close to the market but is slightly riskier than the market and therefore gives a slightly higher return compared to the market. Thus, if the market returned 6.91% in the last 52 weeks, the portfolio returned 1.3 x 6.91% = 7.12%. A 10,000 investment would be 10,712 or better than the market. However, higher risk also means higher loss than the market if the Index dropped. The correlation coefficient measures how the prices of the stocks in the portfolio move against each other. The figure is always between +1 (perfect correlation) and -1 (negative correlation) or zero (independent correlation). Perfect correlation means all stocks go up or down together; negative correlation means that some stocks go down when others go down; and zero or independent correlation means that the stock prices move independently of each other. A good portfolio is one where the correlation is as close as possible to -1 because this totally eliminates risk, but this does not happen in real life. The correlation coefficient of the stocks in the portfolio is 0.64, which is close to 1, therefore adding a risk factor to the portfolio. If the board decides to do so, the financial manager must find a way to reduce the correlation coefficient, and this would affect beta since coefficients are used in computing for beta (Campbell, 2000). Lastly, what about company size; does it matter FTSE 100 companies are stable, share earnings with investors by way of dividends, grow more slowly and give lower returns because they are less risky. Besides, many of these large companies are multinationals, which means that their international operations somehow insulate them from the risk of the domestic UK market. Having a portfolio of FTSE 100 companies is therefore a wise conservative decision that shows company size and deciding to invest in more than one of them does not really matter. However, since each stock has its own beta, investors must select stocks that have low correlation coefficients with each other in order to come up with lower portfolio beta values. Minimising risk and maximising returns is the goal of every ideal investment strategy, and this can be achieved by building a portfolio with values of beta and correlation coefficients depending on forecasted market price movements. This also means that the trust fund should regularly adjust the portfolio depending on its appetite for risk and its funding needs to take better advantage of the different features of the equities market, not only in the UK but in foreign markets. There are several software programmes that would allow the charity to minimise risk and maximise returns whilst diversifying its investments (Shapiro, 2003, p. 377-390). This practice of putting the investments in several baskets or stocks is called diversification. According to several studies made over the last forty years, diversification reduces the over-all risk of the portfolio whilst increasing the assurance of above market returns (Campbell, 2000; Shleifer, 2000; Sharpe, 1991). Thus, a good portfolio should have more than one stock, and because studies have also shown that having too many stocks does not necessarily mean better returns, the funds have to be placed in those companies where the charity's trustees feel confidence in owning and that best suit their own organisational goals. International Investments Investing some of the funds in overseas markets is an option that is open to the charity's investment managers. Aside from the possibility that the strength of the sterling gives it added advantage in view of foreign currency exchange differences, allowing the fund to buy more for its money, international equities markets also move differently than the UK equities market. This means that the correlation coefficients and betas of these markets can help adjust the values of these variables in the portfolio to maximise returns whilst minimising risks (Black, 1993). There are so-called emerging markets like China and India where several listed companies are growing at a vary fast pace that mirrors their countries' economic growth, and the returns from these markets are way above what had been achieved in the UK. For example, whilst the FTSE 100 went up by only 6.9% in the last 52 weeks, the Shanghai (China) market went up 145.5%, India was up by 52.7%, and Brazil was up by 64.8% (Economist, 2007). Of course, higher returns also mean higher risk, and in hindsight one would not have been able to predict one year ago that these markets would have moved in these proportions, but with improved portfolio management, the charity would be better off by diversifying to international equities, buying stocks in large companies in these countries and allowing it to benefit from the explosive growth of other economies (Orr & Hume, 2007; Barrell et al, 2006). Remember that the stock price merely reflects the business performance of the company whose ownership the stock represents. There are many good, well-managed, and profitable companies all over the world, and owning a part of these companies is what the global capital markets allow investors to do. A possible strategy is to buy stocks in those companies that give generous dividends, because this is how the charity raises the funds for its projects, and have the best potentials for capital gains so the charity could readily sell these stocks should it decide, use the profits for its projects, and then invest the proceeds of the sale in other similar international stocks. As already mentioned, the strength of the sterling currency allows the charity to buy more shares of stock, but the same strength also means that should it decide to sell the shares in the future, it would get less sterling if the currency strengthened during the period. This is why it is good to know how currencies move (and how derivatives are used) when investing in international markets so the fund does not suffer currency losses on the gains it made from its equities investments (Giles & Goff, 2007; Barrell et al., 2006; Shleifer, 2000). Derivatives Derivatives are financial instruments or contracts that get their value from some underlying asset such as a stock, bond, currency, index, or reference rates. There are four types of derivatives contracts - futures, forwards, swaps, and options - that are commonly used to manage risks from changes in the price of any of the underlying assets. Derivatives are an effective way of hedging, or protecting against, financial risks. Thus, with the use of derivatives, the risk can be better managed and the returns of the portfolio can be enhanced. Derivatives accomplish this by cutting losses from the risky components of a portfolio. Minimising losses result in higher returns, and this could be done with the use of derivatives. In effect, therefore, derivatives bring down the level of portfolio risk by protecting the investment against downward movements in the price of the underlying asset. Since a derivative contract is not free and has to be paid for, the portfolio would lose only the amount that was paid to purchase the derivative. Otherwise, the portfolio loses the full value of the decrease in price of the underlying asset. Of course, if the asset went the other way, the cost of the derivative would decrease the amount earned with the increase in the asset price, but derivatives are like insurance policies, and these also cost money. Before considering a brief example to clarify how they work, it would be good to know the four different types of derivatives. A futures contract is an order placed in advance to buy or sell an asset or commodity. This derivative, which refers to any contract where you agree today on the price of a future delivery, has been used in business for centuries. The price is fixed when you place the order, but you do not pay for the asset until it is delivered. This protects the buyer from inflation risk because the amount of the payment has already been fixed. It may also protect the seller in case the price of the goods goes down for some reason, say over-supply. This, however, does not protect either party from currency risk. A forward contract is similar to a futures contract, except that forwards are traded whilst futures are not. A forward contract may be based on a futures contract, but whereas a futures contract is priced according to the selling price of the goods, a forward contract is priced much lower depending on the projected cost advantage of buying the futures contract. Forward contracts for currencies, bonds, and commodities are bought and sold in exchanges. A swap is a back-to-back financial transaction where two counterparties agree to exchange financial obligations. Swaps are effective against interest rate, currency, and inflation risks. Just like forwards, swap counterparties promise to pay the price for a future agreement, but unlike forwards, both parties assume an underlying obligation. Swaps are used to exchange interest rates (floating to fixed), exchange both currencies and interest rates (fixed dollar loans to floating Euro loans), or exchange commodities prices. An option is like an insurance policy and gives one party the right to buy (using a call option) or sell (put option) an asset on a given date at a strike price, or to decide not to do so if not financially attractive. Options can be either European (cashed or exercised only when they expire) or American (exercised any time during the option's life) (Hull, 2000; Shapiro, 2000). Several derivative strategies minimise risks and enhance returns. If an investor thinks the price of a stock would go up, she could buy a call option that allows her to buy the stock at a price lower than the actual price. When the call option is exercised, she gets the shares and saves on the difference between the higher price and the cost of the option. Call options are bought from another investor who wrote the option thinking that the actual price would be lower after a month. If the seller owned stocks, then she just transfers the stocks to the buyer. This is called a covered call position. Otherwise, she is in a naked position, buying the stock at the higher market price and selling them at the lower price, resulting in a loss. Puts are the mirror-image of calls and involve the right to sell a stock at a future date. If the writer of the put takes a short position on the stock, then the position is called a protective put. Otherwise, it would be a naked position that exposes the seller of the put option to catastrophic losses. Reference List Barclays (2007). Capital equity and gilt study 2006. London: Barclays. Barrell, R., Riley, R., & Kirby, S. (2006) UK Economy Forecast. National Institute Economic Review, 196, p. 40-62. Black, F. (1993). Beta and return. Journal of Portfolio Management, 20 (Fall), p. 8-18. Campbell, J. Y. (2000). Asset pricing in the millennium. Journal of Finance, 55, p. 1515-67. Economist (2007). Economic and financial indicators. London: The Economist, December 1, p. 106. Giles, C. & Goff, S. (2007, December 6). Bank cuts UK rates to 5.5% Financial Times. Retrieved 7 December 2007 from http://www.ft.com Hull, J. (2000). Options, futures, and other derivatives, 4th ed. New York: Prentice Hall. Orr, R. & Hume, N. (2007, December 7). FTSE up on rate cut expectations. Financial Times. Retrieved 7 December 2007 from http://www.ft.com Shapiro, A. (2003). Multinational financial management, 7th ed. New York: Prentice Hall. Sharpe, W.F. (1991). The arithmetic of active management. Financial Analysts' Journal, 47 (1), p. 7-9. Shleifer, A. (2000). Inefficient markets: An introduction to behavioural finance. Oxford: Oxford University Press. 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