Executive Summary
The world economy has suffered severe financial crisis following a number of economic meltdowns that occurred in early 1990s, the beginning of 2000, as well as late 2000s. Specifically, the 2008 financial crisis was stern and affected economies of various nations in the world intensively.
As result, diverse individual and institutional investors have avoided expanding their portfolios anticipating for bad economic moments that would result to losses in their investments. However, the few investors who continue investing in new assets, as well as expanding their initial investments have remained cautious to evade losses resulting from economic downturns.
Nevertheless, with the existence of mutual funds, it is expected that investors would be able to invest in a portfolio that would assure them high returns with respect to maintenance of a moderate level of risk. Given that emerging markets such as Singapore, South Korea and Malaysia are doing well in the market, one would realize that it would be easy to diversify risks from a variety of market securities available (Elton, Gruber & Brown 2006, p. 80).
Introduction
Selection of market securities that would be included in certain investment portfolio requires scanning of various instruments in diverse financial markets. The markets from which the market instruments are picked are both capital market and money market. The capital market is involved in the sell and purchase of long-term market securities while money market is concerned with the trading of short-term securities.
Selection of best financial instruments is tiresome, as it requires adequate time to asses performance since one has to scan the performance of various industries, as well as individual firms. In addition, one has to compare the performance of debt markets in various countries in order to choose the best performing bonds, which should be in line with the taste and requirements of customers. All this activities are streamlined towards increasing the level of returns while minimizing the level of risks (Reilly &Brown 2007, p. 12).
In this view, we should use a concept put forward by Markowitz who emphasized on determining the level of risks and returns for various market securities before investing in any single market instrument. His concept was based on the expected return and variance where variance measures the level of risk an index is exposed to.
We should use this concept in constructing an investment portfolio consisting of six equities and six bonds for an open-ended fund to be offered to the esteemed institutional investors. The investment portfolio will further be evaluated based on its benchmark. The report will begin by presenting an Investment Policy Statement.
The report will select 12 best performing securities based on evaluation taste from 30 securities. Construction and performance appraisal of financial instruments will follow later. The paper will finalize at the end with a conclusion, which will mostly focus on summarizing the whole paper and suggest other techniques that would be employed to reduce the amount of risks and improve the level of returns for various investors.
Investment Policy Statement
Our investment strategy has always and will always begin with identification of preferences and expectations of our clients. Various investors come to Lucrative Mutual Fund with diverse requirements in relation to risk tolerance level and required rate of returns. According to our management, there are two categories of investors that is, active and passive investors. Active investors focus on obtaining optimal return for their returns while maintaining a certain level of risk.
However, passive investors also aim at achieving a return above that of the market and therefore they will cautiously choose securities that achieve their targets. We as a mutual fund are dedicated towards providing investments to our esteemed customers that are worthwhile both in short-term and long-term (Bodie, Kane & Marcus 2008, p. 26).
We are determined to construct a mixed investment portfolio that will include six equity shares and six bonds, which ensure that the investment is well diversified to the lower risk level, as well as raise the level of return for our customers. Lucrative Mutual Fund is determined to pick shares from world market shares, which include those of U.S., Canada, U.K. and other European nations. The six shares will be picked from the same industry, although the industry should indicate high chances of future growth.
The firms from which the shares will be picked should have large market capitalization and show the likelihood of future growth and expansion. The six bond indices will be chosen from stable nations, which have had sustainable economic growth and consistent political policies. Lucrative Mutual Fund objective is to develop a product for its prospective investors that will assure high return on equity while on the other hand mitigating the high level of risks using less risky sovereign bonds.
Due to strict regulations in the financial markets with regard to short selling, Lucrative Mutual Fund will not use any short selling strategy or any other strategy in an attempt to raise the required rate of return or minimize the level of risk. Derivates will as well not be used and therefore our investment will generally consist of bonds and equities.
The final batch will have securities in different weights to attain optimal returns in addition to minimizing the level of risks. The performance of the final batch will be measured against a portfolio that has similar market securities as those in the final batch. However, the weight of securities in the portfolio used for benchmarking will be equal.
In relation to our objective, which remains to accessing accurate and up-to-date information to make a crucial financial decision, Lucrative chose Bloomberg as its trading platform and its source of financial information pertaining to the market securities.
However, the Financial Times and New York Times will be reliable sources of information with regard to financial performance of various sectors of the economy, as well as full disclosure of financial information of individual firms in the diverse industries. The information will be pertinent in predicting the market trends and making relevant investment adjustments.
With various scanning processes, Lucrative Mutual Fund will choose six equities from companies with large market capitalization in the Standard and Poor 500 Index. Top performing bond indices will be chosen based on Bloomberg evaluation. The bond indices will have different maturity periods but will not exceed 1 year. Lucrative will majorly invest in short-term debt market and therefore, most bond indices will have a maturity of 3 months to 12 months.
The first portfolio, which includes six shares and the second that includes six bond indices, will be scanned through optimization process to find out the most efficient investment among equity shares and bonds for the two portfolios. We shall further compare the performance of the market and our investment portfolio with respect to their level of risks and returns. With consideration of prospective institutional investors’ requirements, we will combine the two portfolios that best suits the target risk/return profile.
Selection Process
The world’s economy still suffers from the consequences of the financial crisis that occurred in 2008. This makes it possible to include imprecise information that would negatively affect our evaluations. Therefore, caution will be taken to exclude such data.
Stock choice
Standard and Poor 500 Index is a capitalization-weighted index, which consists of 500 large-cap common stock. The Standard and Poor 500 Index is a representation of the main industry segments in the U.S. The performance of this Index is highly correlated to the general performance of the U.S. economy.
If the U.S. economy improves, the Standard and Poor 500 indexes will indicate improvement, but will automatically fall if the U.S. economic performance declines. S &P 500 index has over USD 4.83 trillion matched with assets amounting to about $1.1 trillion.
In particular, the U.S. Utility sector has grown considerably to attain a growth of 9% per annum from the time when the financial crisis hit various economies. The U.S government released a bailout package of USD700 billion that was expected to encourage economic growth, as well as mitigate the economy from plunging into more recessions.
There was an average increase of 1.5% in stock prices as at March 21, 2011. In accordance to NAESCO (National Association of Energy Service Companies) report, which was released in June 2010, it is anticipated that industrial annual returns will hit $7.0 billion to 7.5 billion by 2011. This will amount to an annual average growth rate of 25% for the last three years (Das, Markowitz & Scheid 2010, p. 312).
From S&P 500 Index evaluation, one would conclude that the utility sector of the economy have been performing significantly well and therefore highly attractive.
Source: Bloomberg March 20, 2012
The graph above indicates stock prices of diverse companies, having their investments in the utility sector. The stocks of such companies that have their stocks listed in S&P 500 Index showed poor performance between the year 2007 and 2010. This was an indication of difficult financial times for most companies.
This led to stocks plunging to the lowest level in the year 2008, although it started picking up at the beginning of the year 2009, maintaining an upward trend. In addition, the U.S. economy has specifically recovered at a fast pace currently experiencing a GDP growth rate of 2.9%.
Source: Bloomberg March 20, 2012
Data chosen for the first 6-equity portfolio are the weekly equities of the last-prices from March 10, 2009 to Feb 10, 2012, covering a period of three years. Lucrative Mutual Fund remains objective in using its criteria in the selection procedure, which includes concerted endeavor in finding underpriced market securities, purchasing shares with large market capitalization, selecting equities with positive alpha and purchasing shares with price earnings ratio of less than 28, given that the industry’s P/E is averagely 27.
Although we have our own systems of evaluating those stocks that are underpriced in the markets, we have as well crosschecked with other financial analysts to pinpoint shares that are considered underpriced (Liu & Wang 2010, p. 67). Bloomberg will generally help in collecting information regarding security market capitalization and the price earnings ratio.
Through a number of scanning and selection processes, we have identified the following six equities that meet our standards requirements (Oster 1994, p. 12).
Bond choice
Bearing in mind that bonds are considered a market security with comparatively low risk, it is no doubt that most risk-averse investors will choose bonds as their investment. Most investors have used bonds as an instrument of reducing the high level of risks featured in the stocks. Stock investment portfolio is generally volatile and quite unpredictable as compared to bonds. Bonds are characterized by low levels of risks, although owners do not claim ownership in a company that issues the bond.
While considering bonds as part of the batch investment, we need to factor in the interest rate of bonds. Interest rates are very crucial in determining the price of a debt instrument. Moreover, interest rate is inversely related to the price of the bond.
Given the fact that we shall choose stocks from the Standard and Poor 500 Index, basing on the market capitalization and high-required rate of return, we will have to cope with high levels of risks. However, the level of risks will be mitigated by adding bonds in our investment portfolio, which will have the effect of stabilizing earnings of the prospective investors.
Information relating to the first 6-bond index portfolio is the bond index weekly prices from Feb 20, 2010 to Feb 10, 2012, covering a period of two years. Initially, the function of the ranked return on Bloomberg will be used in identifying bond indices that are performing exceptionally in the financial market, given the different maturity periods.
Although it appears that best performers come from the same country, Lucrative Mutual Fund will consider purchasing bonds from other countries in an attempt to reduce sovereign risks associated with one country. This will help to diversify risks existing or that are likely to occur within a certain market segment.
Bonds are to be chosen from nations that have difficulties in the bond market. This major step will help in choosing bond indices that are highly priced. In addition, it would help determine the states that anticipate experiencing an increase in prices in the next three months.
The table below will show sovereign bonds that Lucrative Mutual Fund chose in order to reduce high-level risks featured in the stock portfolio. The bond indices indicate a slight difference in their maturities. The six bond indices, which are chosen from different countries, will be put in the initial bond portfolio.
Conclusion
This paper has discussed the critical selection process of securities to be put in a given investment portfolio. The selection began with 30 securities before narrowing down to 12 securities, which included six stocks and six bonds.
Equities were chosen based on market capitalization while bonds were chosen based on interest rate, credit ratings and the political stability of sovereign state. Efficient frontier has been effectively utilized in determining the best combination of two set of portfolios including equity and bond markets. This was made possible through determination of securities correlation.
List of References
Bodie, Z, Kane A, & Marcus A 2008, Investments, McGraw-Hill Irwin, New York.
Das, S, Markowitz, H & Scheid J 2010, “Portfolio Optimization with Mental Accounts”, Journal of Financial and Quantitative Analysis, Vol. 45, no. 1, pp 311-334.
Elton, E, Gruber, M & Brown S 2006, Modern Portfolio Theory and Investment Analysis, John Wiley, New York.
Liu, Z & Wang J 2010, “Value, Growth, and Style Rotation strategies in the long- run”, Journal of Financial Service Professional, Vol. 4, no. 1, pp 67-90.
Oster, SM 1994, Modern Competitive Analysis, Oxford University Press, Nueva
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