1. investment setting, asset allocation, money management and ethics(2)
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BAFI045
Investment
The Investment Setting, AssetAllocation, MoneyManagement & Industry Ethics
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RMIT University Slide 2RMIT University Slide 2
Reference
Reilly, Frank K. and Keith C. Brown, Analysis ofInvestmentand Management Portfolios (9thEdition), Thomson South-Western, 2009. Chapters 1 (pp. 3-9); 2 (pp. 35-54); and 24
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RMIT University Slide 3
What Is An Investment?
Defining Investment: A current commitment of $for a period of time in order to derive futurepayments that will compensate for:
The time the funds are committed
The expected rate of inflation
Uncertainty of future flow of funds
Reason for Investing
By investing (saving money now instead of spendingit), individuals can tradeoff present consumption fora larger future consumption.
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RMIT University Slide 4
Historical Rates of Return
Return over A Holding Period Holding Period Return (HPR)
Holding Period Yield (HPY)
HPY = HPR - 1
Annual HPR and HPY
Annual HPR = HPR1/n
Annual HPY= Annual HPR1 = HPR1/n 1
where n = number of years of the investment
InvestmentofValueBeginning
InvestmentofValueEndingHPR=
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RMIT University Slide 5
Historical Rates of Return
Example: Assume that you invest $200 at thebeginning of the year and get back $220 at the end
of the year. What are the HPR and the HPY for your
investment?
HPR =
HPY =
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RMIT University Slide 7
Historical Rates of Return
Computing Mean Historical ReturnsSuppose you have a set of annual rates of return(HPYs or HPRs) for an investment. How do youmeasure the mean annual return?
Arithmetic Mean Return (AM)AM = HPY / n
where HPY = the sum of all the annual HPYs
n = number of years
Geometric Mean Return (GM)
GM = [ HPR]1/n - 1where HPR = the product of all the annual HPRs
n = number of years
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RMIT University Slide 8
Historical Rates of Return
Suppose you invested $100 three years ago and it isworth $110.40 today. The information below showsthe annual ending values and HPR and HPY. Thisexample illustrates the computation of the AM and
the GM over a three-year period for an investment.
Year Beginning Ending HPR HPYValue Value
1 100 115.0 1.15 0.152 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20
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RMIT University Slide 9
Historical Rates of Return
AM = HPY / n=
GM = [ HPR]1/n - 1=
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RMIT University Slide 10
Historical Rates of Return
Comparison of AM and GM
When rates of return are the same for allyears, the AM and the GM will be equal.
When rates of return are not the same for allyears, the AM will always be higher than theGM.
The AM is best used as an expected valuefor an individual year, while the GM is the bestmeasure of an assets long-term performance.
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RMIT University Slide 11
Historical Rates of Return
A Portfolio of Investments
Portfolio HPY: The mean historical rate of return for a
portfolio of investments is measured as
the weighted average of the HPYs for the individual investments inthe portfolio, or
the overall change in the value of the original portfolio.
The weights used in the computation are the relative beginning
market values for each investment, which is often referred to as
dollar-weighted or value-weighted mean rate of return.
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RMIT University Slide 12
Historical Rates of Return
The following exhibit demonstrates how to computethe rate of return for a portfolio of 3 stocks.
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RMIT University Slide 13
The Portfolio Management Process
Policy Statement Specifies investment goals and acceptable risk levels
Should be reviewed periodically
Guides all investment decisions
Study Current Financial and Economic
conditions and forecast future trends
Determine strategies to meet goals Requires monitoring and updating
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RMIT University Slide 14
The Portfolio Management Process
Construct the Portfolio Allocate available funds to minimize investors risks
and meet investment goals
Monitor and Update
Evaluate portfolio performance
Monitor investors needs and market conditions
Revise policy statement as needed Modify investment strategy accordingly
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RMIT University Slide 15
What is Asset Allocation?
Asset Allocation The process of deciding how to distribute an
investors wealth among different countries and asset
classes for investment purposes.
Asset Class Refers to the group of securities that have similar
characteristics, attributes, and risk/return relationships.
Investor: Depending on the type of investors,investment objectives and constraints vary
Individual investors
Institutional investors
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RMIT University Slide 16
The Importance of Asset Allocation
An investment strategy is based on fourdecisions
What asset classes to consider for investment
What policy weights to assign to each eligible class
What allocation ranges are allowed based on policyweights
What specific securities to purchase for the portfolio
According to research studies, most (85% to95%) of the overall investment return is due tothe first two decisions, not the selection ofindividual investments
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RMIT University Slide 17
The Asset Management Industry:
Structure and Evolution Two Organization Forms
Contract directly with a management and advisoryfirm
Commingling of investment capital of several clients
in an investment company Approximately 9500 professionally managed funds in
Australia
Differences between These Two Forms
Private management and advisory firms develop apersonal relationship with clients
A Investment company offers a general solution
See Exhibit 24.1
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RMIT University Slide 18
Exhibit 24.1
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RMIT University Slide 19
Valuing Investment Company
Shares
The NAV for an investment company isanalogous to the share price of acorporations common stock.
The NAV of the fund shares will increaseas the value of the underlying assets (thefund security portfolio) increases.
Total Market Value of Fund Portfolio Fund ExpensesFund NAV=
Total Fund Shares Outstanding
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RMIT University Slide 20
Closed-End Versus Open-EndInvestment Companies
Closed-End Investment Company
Functions like any other public firm and its stock
trades on the regular secondary market
The fund generally doesnt issue or redeem sharesonce it is established
The price of the fund is different from its NAV
It is a puzzle for modern finance why close-end funds
often sell at a discount from NAV
It is often a means of investing in a pool of assets
from a foreign country
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RMIT University Slide 21
Closed-End Versus Open-EndInvestment Companies
Open-End Investment Companies
The company continues to sell and
repurchase shares after their initial public
offerings
The fund stands ready to issue or redeem
shares at the net asset value (NAV)
Investors who buy or sell the shares mayhave to pay sales charges (the load)
These funds are normally called mutual funds
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RMIT University Slide 22
Closed-End Versus Open-EndInvestment Companies
Load versus No-Load Open-End Fund
The offering price for a share of a load fund equals
the NAV of the share plus a sales charge.
A no-load fund imposes no initial sales charge so it
sells shares at the NAV.
Several variations exist between the full-load fund
and the pure no-load fund
Low-load fund
Funds have contingent, deferred sales loads
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RMIT University Slide 23
Closed-End Versus Open-EndInvestment Companies
Fund Management Fees
Charge annual management fees to
compensate professional managers of the
fund
The fee typically is a percentage of theaverage net assets of the fund varying from
about 0.25 to 1.00 percent Management fees are a major factor driving
the creation of new funds
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RMIT University Slide 24
Closed-End Versus Open-EndInvestment Companies
Global Investment Companies
Funds that invest in non-Australian securities (e.g.,Singaporean securities) are generally called eitherinternational funds or global funds
International funds often hold only non-Australian securitiesfrom such countries as US, Germany, Japan, and Korea
Global funds contain both Australian and non-Australiansecurities
A increasing large number of investment companiesoffer both domestic and global products in the localmarkets
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RMIT University Slide 25
Investing in Alternative Assets
Increasing trend towards committing financialcapital in non-traditional asset classes
Hedge funds
Private equity
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RMIT University Slide 26
Investing in Alternative AssetClasses
Management Structure
Structured as a limited partnership rather than asa mutual fund to manage the commingled assets
The Fund alpha Abnormal returns generated by the fund, implying
the superior performance by the fundmanagement
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RMIT University Slide 27
Exhibit 24.14
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RMIT University Slide 28
Hedge Funds
The Characteristics As a private partnership, hedge funds are generally
less restricted in how and where they can makeinvestments
Less correlated with traditional asset classinvestments, providing diversification benefits
Hedge fund investments are far less liquid thanmutual fund (or even closed-end fund) shares
There are severe limitations on when and how often
investment capital can be contributed to or removedfrom a partnership
Performance allocation and high-watermark
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RMIT University Slide 29
Private Equity
Basic Concepts Refers to any ownership interest in an asset (or
assets) that is not tradable in a public market Typically fund either new companies or established firms that
are seeking to change their organizational structure or areexperiencing financial distress
Generally far less liquid than public stock holdings and aretherefore considered to be long-term positions within aninvestors overall portfolio
Characteristics Higher return and low liquidity
Good sources of diversification
See Exhibit 24.21
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RMIT University Slide 30
Exhibit 24.21
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RMIT University Slide 31
Private Equity
Returns to Private Equity Funds Private equity commitments should be
viewed as long-term, highly illiquidinvestments
The return pattern known as the J-curveeffect
Average annual returns for these investmentstend to be quite high over time
The initial years of a new private equitycommitment usually produce negative returns
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RMIT University Slide 32
Ethics and Regulation in the Professional
Asset Management Industry
Agency problem
Regulation in the asset management
industry Principal securities laws that govern
investment companies
Differ across countries Regulatory agencies
Differ across countries
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RMIT U i it Slid 33
Ethics and Regulation in the Professional
Asset Management Industry
Examples of Ethical Conflicts
Incentive Compensation Schemes
Soft Dollar Arrangements Marketing Investment Management Services