Analysis of the Issues Related to an Investor - Research Paper Example

INVESTMENT MANAGEMENT Executive Summary Investment strategies adopted for the individual investors is dependent on several factors to ensure balancing optimum returns to them, taking into considerations their background, uncertainties prevailing in the market, risk appetite of the investor and tolerance to risks in line with his short term and long term needs/objectives. Therefore, the strategies to be adopted vary from customer to customer and their life cycle. Apart from capital growth, protection of the interests of the investors from the vagaries of the market conditions is important. The paper seeks to analyze the issues related to an investor, Purpose of the investment policy statement  There are uncertainties in human life, and the people have to plan for the future and provide for the contingencies. The concept of ‘Insurance’ in the minds of the individuals as alienated from the meaning of the word used in commercial parlance by the insurance industry is a very pertinent in the discussion, apart from the growth of capital, insulation from inflation and savings point of view, because uncertainty is ingrained in the human life. On the other hand, uncertainties in the capital markets, money markets and commodity markets are legendary. The portfolio management is wrought with uncertainties on both the counts. It is a balancing act conditioned by several external factors which are not in the control of the investors. The purpose of the Investment Policy Statement is to ensure that the investor and the portfolio manger understand the risks and responsibilities respectively, involved in the process as these are crystallized in a document. Investment policy statement is a document stating the agreement between the portfolio manager and his client outlining the frame work within which the portfolio manager is expected to use his discretion in discharging his responsibilities as a portfolio manager with regard to the funds earmarked by the investor for this purpose. The statement consists of the investment objectives of the client, the strategies to be adopted by the portfolio manager to meet these objectives, broad guidelines for asset allocation, risk parameters, liquidity requirements of the investor apart from any specific directive given in managing the funds. Client profile The client is in his late forties with a small family consisting of his wife and a daughter. The client owns a retail stores. The business is running well and the income from the business amply covers his family expenses. He is planning to renovate his house, after ten years at a cost of $ 400,000 at the time of marriage of his daughter who is 12 years’ old now. Investment Amount: S$ 1,000,000/= Questionnaire: Many a times, the investors in general have no specific objective in relation to the investments they make, but for a vague idea of growth. A questionnaire properly designed could elicit their financial background as a whole, their commitments related to their retirement, their children and business. A pro-forma questionnaire in the Appendix I, which we have given to the client during the preliminary discussions to firm up our strategy, depicts the salient points which are generally relevant to the investor, covering important points related to all the clients, though it is not exhaustive as it will vary from client to client. Investment Horizon The investment horizon means the length of time for which the amount remains to be invested. Investment horizon depends upon the need for money by the investor and the extent of the investor’s requirement and the time frames. The investment decisions, allocation and reallocation hinges on investment horizon for an optimum investment strategy. Though there are no hard and fast rules for defining the short term, medium term and long term investment with reference to specific time frame, when the investment horizon is shorter, say less than three years, equities could be considered riskier asset class on account of volatility involved. Investments for a period longer than 10 years could be considered as long term as in the present case. Anything in between could be considered as medium term. Considering the age profile of the investor and the information given the investment horizon is long term in nature, a portfolio mix of 40% fixed income securities and 60% equity could be ideal to start with. However, it is also suggested that the portfolio should be reoriented towards debt over the period of time to reach a level of 80:20 ratio between fixed income securities and equity on periodical review/reallocation. Return Objectives  The client’s investment philosophy mostly hinges on long term appreciation of capital, and his instructions clearly stipulate that there should not be any demand for additional investment, especially liabilities on account of derivatives such as Futures and Options, though he has not specifically told not to invest in derivatives. His propensity to take risk is moderate, but, insists on preservation of capital as a prudent investor, though he has not specified any limits for losses. The investor has a rather long term view on capital appreciation and discourages speculation at all costs. Due to fear of recession in the economy, consequently in his business he is interested in regular income from investments in the long run, especially, at the time of retirement from the business in about 15 years. However, on an overall basis, the rate of return expected by him is comfortably more than the bank interest to take care of inflation without attaching too much risk to the investments, and the discussion revealed that he is satisfied with a return of about 8 to 9% on his investments. Risk Tolerance  The risk tolerance of the client is not altogether very low considering his expectations and his level of understanding about the riskover the investment horizon. The expected rate of return by the investors increases with the increase in their risk perception. Uncertain market conditions increases the risk and therefore, equity shares are considered to be riskier compared to government securities or bank fixed deposits where the rate of return is constant. Elimination of risk is not the idea in risk management of the portfolio, but taking calculated risks completely understanding the implications to avoid unnecessary risks. The returns should be commensurate with the risk and the risk attached to them are at the acceptable level and compatible with the objectives. Risk premium or the pattern of risk level in the benchmark portfolios necessitates shifts in asset allocation. Norton (2006, p. 2) states that investment risk could be boiled down to two elements: the overall risk for the entire market, and the specific risk of a specific security — the degree to which its price movements are uncorrelated with the general market’s fluctuations. Ability to assume risk and the willingness on the part of the investor to take risk are two very crucial factors to be considered. If the expected return of the investor is very high, the investor has to accept more risk. According to Kevin, S. (2006, p.2) there are 5 phases in portfolio management, Security analysis, Portfolio Analysis, Portfolio selection, Portfolio revision and Portfolio evaluation. Depending upon the nature and level of individual’s risk perception, the evaluation process differs. Lancaster, B. P., Schultz, G. M., and Fabozzi, F. J. (2008, p. 52) state that Lower credit grade borrowers exhibit higher risk multipliers relative to the baseline (risk grade AA) This is due to the “credit curing effect.” Careful analysts compare various alternatives with different risk-return profiles and evaluate whether the level of risk assumed is compatible with the investment objectives. Asset Allocation Asset allocation is the process of distributing the investible funds of the investor among different asset classes. An asset class consists of securities with common character with minor differences in risk-return relationship. Bertocchi, M., Ziemba, W. T. and Schwartz, S. L. (2010, p. 307) state that the “pools of capital and their asset allocation can significantly shape domestic capital markets, changing the incentives of investors”. Current economic status in the backdrop of impact of the crisis in banking sector and subsequent economic meltdown in US and Europe yet show visible signs of recovery in spite of huge stimulus packages announced by various governments. According to Swenson (2008, p.594) the business cycle is the economy’s recurring pattern of expansions and recessions. Leading economic indicators can be used to anticipate the evolution of the business cycle because their values tend to change before those of other key economic variables. Swenson (2008, p.586) states “Once the analyst forecasts the state of the macro economy, it is necessary to determine the implications of that forecast for specific industries. Not all industries are equally sensitive to the business cycle”. Current status of the economy and the fortunes of various industries in such a scenario are very important in evaluation of the investment decisions in proper perspective. The current crisis according to Gushusrl, de Souza and Wallace (2008, p. 1) “is rooted in the risk management of particular financial-services institutions. In the U.S. and western European banking systems in particular…” The portfolio management at this juncture calls for timely and decisive actions on the part of the investment managers to overcome the difficulties. Inflation and volatility in commodity markets affects different industries differently in the economy. According to Hill (2010) “Inflation should also be good news for investors in companies that have been able to export throughout the recession and also for gold, traditionally seen as a store of value, though some analysts think the gold price has risen too far too fast”. The intricate relationship of the companies/industries with the various developments in the economy should be carefully watched to make tactical shifts in the asset allocation. In the process of asset allocation we have considered different types of securities with different risk-return profile and the proper mix depending upon the ability and willingness to take risk on the part of the client, his life cycle and expected rate of return and the securities could be categorized broadly as under: Stocks After dematerialization of shares, stocks as an asset class have been widely accepted by the investors. Ziemba, R. and Ziemba, W. T. (2007, p. 4) states that for success in stocks, one has two crucial elements: general uncertainty about the economy and the product’s acceptance and the effect of competition. There are advantages in this type of investment such as capital growth, dividends, diversified opportunities, encouragement to investors through governments’ taxation policies and ease in making transactions. Equities generally outperform government bonds and Treasury bills in most of the stock markets, over the long term. But, “The Dow Jones stock market average rate of return over the last 10 years has been on the downturn. With the stock market fluctuating as the Fed continues to toy with interest rates has left the US economy in shambles leaving speculators to determine which way the market goes’. (Dow Jones, 2007) Bonds Investment in low-risk asset class is preferred at the time of uncertainties, recession and bad economic outlook with rising unemployment. The fall in the yields on gilts only mean that the yields stated in terms of the increased market value of the gilts have fallen, but not the specified return on this asset class, if one holds the gilts to maturity. But the gilts can be sold in the market at profit. Portfolio mix The constituents of the portfolio of the client are given below: Fixed Income Securities – Bonds (40%) Singapore Airlines (SIA) Corporate Bonds 10% SGS Bond NY05100N 15% PineBridge Singapore Bond 15% -------- 40% Equity (60%) Keppel Corporation Limited 10% DBS Group Holdings Limited 15% Fraser and Neave Limited 10% Jardine Cycle & Carriage Limited 10% Singapore Telecommunications Limited (SingTel) 15% -------- 60% Total 100% Singapore Airlines (SIA) SIA launched the first-ever corporate bonds for retail investors in Singapore. Corporate bonds had never been available to retail investors before. SIA is offering five-year bonds to retail investors - with a yield of 2.15 per cent. Though the rate is not attractive, in the current low interest rate environment it is better than the savings bank rates. The bonds have not been given a rating, but analysts said the risks should be muted since SIA has sound fundamentals. The airline posted a net profit of S$253 million for its second quarter ended June. SGS Bond NY05100N SGS Bonds are issued by the Singapore government. They pay interest every half a year in the form of a coupon payment. SGS Bonds are better alternatives to fixed deposits and can be used to enhance guaranteed long term returns. Coupon of the bonds NY05100N is 3.250%, and the maturity is at 01/09/2020. Indicative yield works out to 2.61%. PineBridge Singapore Bond The objective of the fund is to invest as a direct investment portfolio, to provide stable income with capital preservation by investing primarily in high credit quality SGD fixed income instruments issued by Singapore and non Singapore entities. Cumulative performance of the fund is 5.08%, 8.15% and 18.61% for one, three and five years respectively. Keppel Corporation Ltd. The company engages in offshore and marine, property, infrastructure, and investment activities worldwide with a return on equity at 21.93% is a good long term bet considering the diversified nature of the operations with a good growth potential. DBS Group Holdings Ltd. The company operates as the holding company for DBS Bank Ltd. the company offers investment management solutions and stock broking services. It has branches in China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Myanmar, Singapore, Taiwan, Thailand, the Philippines, the United Arab Emirates, the United Kingdom, the United States, and Vietnam. But for the recent economic meltdown in US, financial services sector is growing at a faster rate especially in the new economies such as India and Philippines. The profit margin for the trailing 12 months works out to 24.97% Fraser and Neave Limited Fraser and Neave Limited operates in the food and beverage, property, and publishing and printing industries. It operates in the Asia Pacific, Europe, and the United States. Fraser and Neave, Limited was founded in 1883 and is based in Singapore. The profit margin of the company for the trailing twelve months works out to 14.39%. Diversified nature of the business gives stability and balances the risk profile of the company. Jardine Cycle & Carriage Limited It is an investment holding company, engages in the manufacture, assembly, distribution, and retailing of motor vehicles and motorcycles in Singapore, Malaysia, Indonesia, and Vietnam.  The company has diversified operations, which includes financial services, agriculture, IT and infrastructure with employee strength of 137,000. Return on equity on twelve month trailing basis works out to 23.66%. Risk is minimized through diversification in the operations. Singapore Telecommunications Limited (SingTel) Sing Tel is engaged in operation and provision of telecommunication systems and services in Singapore and Australia, and investment holding. Its investments in associated and joint venture companies include Advanced Info Service Public Company Limited (AIS) in Thailand, Bharti in India, Globe Telecom, Inc. (Globe) in the Philippines, and PT Telekomunikasi Selular (Telkomsel) in Indonesia. Its overall return on investment works out to 12.17%. Telecom sector is growing with an array of services, and the companies investments in the growing economies in this sector is expected to yield good returns in the long run. Review and reallocation: In line with our strategy to progressively reduce the equity component of the portfolio, reallocation of the portfolio is planned by making review of the accumulated profits, if any, on quarterly basis. It is proposed to allocate the accretions during the period towards investment in the fixed income securities to increase its proportion to the desired level as planned on an overall basis, after taking into account the need for funds by the investor. Careful analysis and continuous monitoring of the trends in various industries, economy and the markets is very important for making proper investments. Company specific analysis with reference to earning prospects, leverage, growth indicators and financial ratios should take into account the economic conditions prevailing. With reference to leverage, Antczak, S. J., Lucas, D. J. and Fabozzi, F. J. (2009, p. 277) states that “it is important to consider what variables may cause them to change for better or worse. The economy? The cost of inputs such as fuel for airlines or steel for automakers?...” The efficiency in the price discovery process is dependent upon liquidity of the stock. According to Koubi (2008, p. 70) the “indicator of equity market development is the size and the liquidity of the stock market”. ‘Value investing’ calls for understanding and application of fundamental analysis in stock selection after taking into account various aspects such as sales, growth, leverage, competition, management, Earning Per Share (EPS) and Price Earnings Ratio (P/E Ratio). Technical analysis is followed in monitoring the performance and firming up the exit strategy, because timing is very crucial in decisions. Projected returns The investment policy with capital protection orientation envisages capital gains through a mix of equity and debt in the portfolio, in tune with the investor’s long term objectives. Considering the recent correction in the stock markets, and the long term nature of the investment, the returns expected in the region of 8 to 9% by the client is reasonable, and two third of the investment has been made in the stocks.  The investment in fixed income securities would be progressively increased to make the Stock-Bond ratio 20:80 to coincide with the retirement of the investor. The projected returns would comfortably be in tune with the expectation of the client due to the fact that the equity investments are made when the markets have bottomed out and stabilized at the current levels after the recent melt down, with the scope for growth in future. However, if tactical shift is considered due to economic conditions at a later stage, by moving funds from equity to fixed income asset class, the ROI in the worst case scenario would be around 6to 7%, due to diversified nature of the investments. With the estimated profits in future from the business and capital growth in the investments, renovation of the house should be comfortably possible in the third/fourth year. Summary The investment objectives of the client as given in the Investment Policy Statement form the basis for the portfolio management. The same guidelines for investing are adopted for reallocation consequent upon review on a constant basis. In the final analysis, the success of the Portfolio Manager lies in his ability not only to give better returns compared to the benchmark indices, but also in convincing the client to understand the situation during the down turn and appreciate the good performance on comparative basis, and not on the basis of positive returns always. This is possible through interaction with the clients on a regular basis for apprising him of the market conditions. Appendix I Questionnaire I PERSONAL DETAILS 1. Name of the investor: 2. Age: 3. Number of dependants: 4. Income Salary/Profession: Business: House Property: Other Income: 5. Investments: Stocks Bonds Deposits with banks Life Insurance Pension Fund 6. Loans & Advances given: 7. Tax dues: 8. Undivided share value of ancestral properties: 9. Liabilities Loans & Advances taken: 10. Properties under dispute 11. Liabilities on litigations (if unfavorable) II FINANCIAL PLANS 1. Future Investment Plans: i. ii. III INVESTMENT OBJECTIVES 1. Investment objectives 2. Opinion about speculation 3. Rate of return expected 4. Ability to withstand loss of capital (in %) 5. Other Future Plans contingent on investments Plan Period Outlay Priority 1. 2. 3. IV RETIREMENT 1. Right now are you prepared for retirement, if forced? 2. When do you want to retire? 3. What is your retirement plan? 4. Have you factored inflation into account? 5. Will your children depend on you at that time? 6. Do you plan for donations to charities? V RETIREMENT PLAN 1. Capital Expenditure plan: 2. Average income needed per annum: 3. Periodicity: Monthly/Quarterly/Annually 4. Other remarks VI REPORTING 1. Fortnightly/Monthly/Quarterly Note: Please give personal details such as Address, Phone No(s), Email address, Social Security ID, details of the nominee, bank name and address, etc. References Antczak,S. J., Lucas, D. J. and Fabozzi, F. J., 2009, Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives, John Wiley and Sons, Hoboken. Bertocchi, M., Ziemba, W. T. and Schwartz, S. L., 2010, Optimizing the Aging, Retirement, and Pensions Dilemma, John Wiley and Sons, Hobeken. Dow Jones, 2007, Stock Market Average Rate Of Return, November 12, 2007, [online] Available at:http://www.dowjonesstockmarket.info/stock-market-average-rate-of-return/ [Accessed 19 November 2010]. Fabozzi, F. J., 2007, Fixed income analysis workbook, 2nd ed., John Wiley and Sons, Hobeken. Gushusrl, K., de Souza, I. and Wallace, V., 2008, Taking a calmer view, Strategy+Business, October 14, 2008, [online] Available at: http://www.strategy-business.com/article/rr00063 [Accessed 23 November 2010]. Hill, J., 2010, Capital Hill on... Inflation, The Investment Trust Magazine, 19 November 2010, Edinburgh, Scotland, [online] Available at: [Accessed 19 November 2010]. Kevin, S., 2006, Portfolio Management, 2nd ed., Prentice-Hall, New Delhi. Koubi, V., 2008, On the Determinants of Financial Development and Stock Returns, Journal of Money, Investment and Banking ISSN 1450-288X Issue 1 (2008). EuroJournals Publishing, Inc., [online] Available at:http://www.eurojournals.com/jmib1%20vally.pdf [Accessed 19 November 2010]. Norton, R., 2006, Derivative Wisdom, Strategy+Business, February 28, 2006, Issue 42, [online] Available at: http://www.strategy-business.com/article/06111?pg=1 [Accessed 22 November 2010]. Ziemba, R. and Ziemba, W. T., 2007, Scenarios for Risk Management and Global Investment Strategies, John Wiley & Sons Ltd., Chichester. Read More