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Section D : Case Study (50 Marks) · This section consists of questions with serial number 1 - 5. · Answer all questions. · Marks are indicated against each question. · Do not spend more than 80 - 90 minutes on Section D. Case Study Read the case carefully and answer the following questions: 1. Prepare a comprehensive investment strategy for Mr. Ramchandani clearly stating the investment objectives and constraints. (10 marks) < Answer > 2. a. Using the information provided in Table 2, calculate the annualized tracking error of the equity portfolio of Convergys. b. Is the tracking error of the equity portfolio rather high or low? According to its tracking error, would you classify it as an indexed portfolio? c. Discuss the causes of tracking error. (6 + 4 + 3 = 13 marks) < Answer > 3. a. Using the information provided in the case, calculate the Sharpe ratio and the ratio of excess return over the benchmark to tracking error (Information ratio) of the equity portfolio of Convergys for the year 2003-04. b. Do the Sharpe ratio and the information-ratio of the equity portfolio of Convergys convey the same information? Discuss. (6 + 3 = 9 marks) < Answer > 4. a. Calculate target active return of the equity portfolio of Convergys. b. Assuming normally distributed returns of the equity portfolio of Convergys, what is the probability that the equity portfolio of Convergys displays a negative performance? (2 + 6 = 8 marks) < Answer > 5. a. Is the investment strategy for bonds suggested by Mr. Basu consistent with the view of Mr. Ramchandani about interest rates? Using the modified duration approach check whether Mr. Ramchandani’s portfolio will gain or lose within the five-day period, given that his forecast is realized. (Assume that the duration of the portfolio is equal to the weighted average of individual bond’s durations.) b. When considering the path of 1-year interest rates for the next 10 years, it can generally be assumed that the value expected by the markets and the series of forward 1-year interest rates shown in Table 3 will be different. Briefly explain the reasons for this. (6 + 4 = 10 marks) < Answer > Mr. Haresh Ramchandani (42) is working as Genaral Manager in a Pharmaceutical company. His wife, Surekha is a housewife. They have two children – a son and a daughter. His son, Prakash, is presently in XI standard and wants to go abroad for his higher education. His daughter, Diya is in IX standard and wants to become a doctor. Mr. Ramchandani earns Rs.70,000 per month and receives Rs.1.6 lakh every year as bonus. Total monthly expenses of Mr. Ramchandani are Rs.40,000. The total amount in the saving portfolio of Mr. Ramchandani is Rs.50 lakhs. His total investment needs are expected to be Rs.80 lakhs and he wants at least 50% of this requirement from his saving portfolio. Mr. Ramchandani plans to obtain substantial capital gains from his investment to finance construction of a hospital after 10 years. He wants substantial portion of services of the hospital to be offered to poor people and wants to build an endowment for which he requires an additional Rs.20 lakhs. Mr. Ramchandani is planning to invest his savings to meet his future needs. One of his friends Mr. Mangesh Shenoy advised him to consider investing through Convergys as its track record is quite impressive. Convergys is a financial institution that manages a diversified portfolio of equities and bonds. Until the end of 2003-04, Convergys’s equity portfolio contained mostly Indian shares and only a few foreign shares. Its unofficial benchmark was the Standard Market Index. In April 2004, the Board of Directors of Convergys adopted new and more detailed targets for the fund’s operations. The equity portfolio consisted of Indian Shares, Foreign Shares and Cash equivalents with clearly defined benchmark indices and target active returns. Mr. Ramchandani wants to analyze the last year’s performance of Convergys by estimating its target active return, its tracking error, Sharpe ratio and information ratio. Information ratio can be calculated by estimating the ratio of excess return over the benchmark to tracking error. He contacted one of the portfolio managers of the company, Mr. Anurag Basu who furnished the relevant information provided in Table 1 and Table 2. After discussion, Mr. Basu advised Mr. Ramchandani that in view of his essential requirements for education of his children, he should invest in bonds and for capital appreciation he should also invest in stocks. The ideal proportion suggested by the portfolio manger requires 60% of his savings portfolio should be in fixed income securities and balance should be dedicated to equities. Table 1: Equity Portfolio of Convergys
Table 2: Summary of Monthly Returns on Equity Portfolio
of Convergys and the Standard Market Index
In order to make some quick gains from some expected changes in interest rates, Mr. Ramchandani also wants advise about his investment strategy in bonds. According to the published reports, which use current government bond market prices to calculate the yield curve and forward 1-year rates, the yield curve is expected to be as shown in Table 3. However, Mr. Ramchandani has created a forecast shown in Table 4 for the yield curve expected to occur five days later based on his own view of economic and market conditions. If this forecast is used, five days later the yield curve will shift up and will be flatter than the current yield curve. Mr. Basu advises Mr. Ramchandani to create a 7-year bond long/4-year bond short position that would be duration neutral (i.e. the position would have a Macaulay’s duration of zero) in order to take advantage of the expected changes in the term structure of interest rates. Table 3:
Published Forecast of Yield Curve
Note: The "forward 1-year interest rate" is the 1-year interest rate for forward contracts that start 1 year prior to maturity. Table 4: Yield Forecast by
Mr. Ramchandani
You may assume a
risk free rate of return of 5% p.a. END OF SECTION D Section E : Caselets (50 Marks) · This section consists of questions with serial number 6 - 11. · Answer all questions. · Marks are indicated against each question. · Do not spend more than 80 - 90 minutes on Section E. Caselet 1 Read the caselet carefully and
answer the following questions: 6. According to the caselet, momentum investing often only works for a short period of time, but when it does, it pays off. However, momentum stocks are risky for that very reason, that it's difficult to determine when their window of opportunity will close. Do you agree? Discuss. (8 marks) < Answer > 7. If you have invested in a diversified fund, which has adopted diversification strategy of stocks as suggested in the caselet, what kinds of issues should make you reconsider your ownership of the diversified fund? (10 marks) < Answer > We’ve often heard of "the secret of successful investing is to diversify their risk" - so how does one go about this? And what does diversification really mean - does it only mean that one should spread ones portfolio across various types of assets, in terms of cash, debt, shares, mutual funds, deposits etc? Or can one diversify ones portfolio even further? Looking at the investment instruments available to investors there is plenty to choose from in each category. For example, within deposits, today investors have the choice of fixed, semi fixed, two in one accounts etc. For mutual funds also investors can diversify across liquid, balanced, growth, income etc. Coming to stocks also there is a lot of diversification possible. It's critical to understand the basic types of stock available on the market in order to match your investment style to types of stock. The most basic way to classify stocks is by size, growth potential and returns. When stock market experts talk about size, they're referring to the market capitalization of a stock. "Market cap" refers to the rupee value of a company. It's computed by multiplying the total number of a company's shares by the current price per share. Large-cap stocks are shares of companies with the biggest market capitalization. Stocks of Reliance, ACC, Infosys, Satyam etc, are considered the most stable and successful. Their sheer size provides a cushion during recessions. Large caps are more likely to pay dividends to shareholders. But because they are more established with less room to grow, large caps are less likely than smaller stocks to give those big-time returns. A blue chip is one of an elite group of stocks of corporations that have a history of good dividend returns (in both good financial times and bad), solid management and good growth potential. Blue-chip stocks, like Hindustan Levers, ITC, etc are among the most stalwart and low-risk investments available in the stock market. Small-cap stocks are the babies of the stock market. The upside to these stocks lies in the market perception that these stocks have a major growth potential. Orchid pharmaceuticals, Morepan lab, Aks opticfibre etc. can be classified in this category. Small caps have the potential to do even better than large-caps, in terms of returns at the bourses. Investors interested in long-term growth, hunt out the strongest small-cap prospects. The downside: Many small-cap stocks may not even have any real earnings. In the short term, these stocks can be volatile and are less likely to pay dividends. Penny stocks are so named because their shares can often be had for mere pennies. That sounds good to frugal investors. Obviously, penny stocks have enormous growth potential. But every good shopper knows that cheap is not always a bargain. There may be good reasons that the stock is depressed in the first place. The company may be too new to have gained investor confidence, or perhaps it is in a state of financial turmoil. Journalists and professional analysts at major stock brokerages tend to ignore penny stocks, so there is little information about these companies from third-party sources, increasing the risk of fraud and thus making them less attractive. Since most penny stocks are traded on minor stock exchanges with less-than stellar reputations for overseeing their member firms, the risk of fraud is compounded. All these variables make the purchase of penny stocks risky for novices, no matter what they might hear in an Internet chat room. However, experienced investors should not rule out penny stocks altogether, In terms of growth potential and return growth stocks, Momentum stocks, value stocks, income stocks and cyclical stocks should all form a part of the portfolio. Growth stocks are stocks with rapidly rising profits, such as Global telesystems, Himachal futuristic, Visual Soft, NIIT etc. Technically speaking, growth stocks usually register annual earnings increase of 15-25 percent. Growth investors expect that a company with accelerating profits will also have a rising stock price. As you'd expect, while you can make lots of money in growth stocks, you can also lose a lot. This happens when professional growth investors divest from a growth stock if its growth rate slows, sending the stock price spiraling down. Momentum stocks are like growth stocks-squared. Momentum
investors buy shares in companies whose earnings are growing at increasingly
higher rates. Lately, these have been technology stocks such as Infosys,
Satyam, Wipro etc. Momentum investing often only works for a short period of
time, but when it does, it pays off. However, momentum stocks are risky for
that very reason, that it's difficult to determine when their window of opportunity
will close. Caselet 2 Read the caselet carefully and
answer the following questions: 8. The caselet states that Exchange Traded Funds (ETFs) also score over other open-ended index funds. The tracking error of ETFs is low compared to a normal index fund because of various advantages they enjoy. Briefly outline the difference between an Index fund and ETF. (8 marks) < Answer > 9. There are numerous advantages of Exchange Traded Funds (ETF) as described in the caselet however, they offer certain disadvantages too. Enumerate the disadvantages attached with the ETF. (7 marks) < Answer > Exchange-traded funds (ETFs) represent an exciting
product class that has exploded in asset size and interest in recent years
and are also making their presence felt in India. ETFs are basically
passively managed funds that track a particular index such as S&P CNX
Nifty. Listed and traded on the exchanges like any other stock, ETFs have
several advantages for traders. The product is popular in countries such as
the US where about 60 per cent of trading volume on AMEX is from ETFs. The
first that has been introduced in India has been the Nifty Benchmark Exchange
Traded Scheme (NIFTY BeES), an open-ended ETF, which was listed on the NSE on
January 8, 2002. An ETF as a product brings with it many advantages,
which would not only attract retail investors but also institutions that look
at index or industry, based products for hedging their portfolios. An ETF
tracks the S&P CNX Nifty Index and is invested in all the 50 index-based
scrips in the same weightage as they represent the index. The minimum
investment in the scheme is one unit (around 1/10th of Nifty). Nifty BeES trades on the secondary market (NSE) and
can be bought and sold just like any other share in a dematerialized form and
are settled in the T+5 rolling settlement. Moreover, BeES are created or
redeemed directly in real time, by exchanging the underlying Nifty 50 shares
close to their actual value. This ensures that the Nifty BeES shares trade
close to the fair value of the Nifty at any point of time. It's easier to
keep track of it too - the value of one Nifty BeES equals 1/10th the value of
index. The flexibility to trade in an ETF intra-day that are usually close to
the actual intra-day NAV of the scheme makes it almost real-time trading. Nifty BeES are also considered equivalent to holding
the Nifty 50 shares, allowing investors to take advantage of arbitrage
opportunities between the cash and the index futures and options market. In
the Indian context, this could provide liquidity to not only the cash market
but also the derivatives segment. This is likely to appeal to small
investors, who are deterred to trade in index futures due to requirement of
minimum contract size. ETFs may not offer the leverage of derivatives
products but they are simpler to understand. One can buy minimum one unit of
ETF, can place limit orders and trade intra-day. And there won't be a need to
necessarily rollover a position in case they wish to hold it for a longer
period. Since ETF can be bought and sold like other shares. For ordinary investors, ETFs can be an excellent alternative to index funds. In fact, the Nifty BeES is even more accessible to retail investors. While the minimum investment required for a Nifty futures is Rs 2 lakh (margin money is 8-15 per cent depending on portfolio), it is just Rs 109 (1/10th of the Nifty value) in case of the Nifty BeES. ETFs also score over other open-ended index funds. The
tracking error of ETFs is low compared to a normal index fund because of
various advantages they enjoy. Due to the creation/redemption of units
through the in-kind mechanism the ETFs can keep lesser funds in cash. So,
unlike index funds, which often hold cash to meet redemption requirements,
ETFs do not need to hold much cash. Expenses such as brokerage are eliminated
completely. Besides, there is a minimal or no impact cost since ETFs do not
buy stocks from the market directly. Also, time lag between buying/selling
units and the underlying shares is much lower. The tracking error of existing
Nifty Index Funds ranges from 0.5% to 1.5%. On the other hand, Nifty BeES,
the only ETF in the market today tracking the Nifty, has the lowest tracking
error among all the index funds in the market. For instance, one may not be able to capture premium in
the futures by buying futures and selling spot due to higher impact cost and
cumbersome stock borrowing procedures. But ETFs can be used to arbitrage
effectively between index futures and spot index. Index funds are an alternate for investors with low risk
appetite and who are averse to the volatility of the diversified equity
funds. And those who do not want to risk higher amounts in futures trading;
an ETF is the answer. Caselet 3 Read the caselet carefully and
answer the following questions: 10. The caselet states that a simple strategy of buying into equity and debt funds paid off better than balanced funds. According to you, what are the prime reasons behind the unimpressive performance of the balanced funds? (9 marks) < Answer > 11. The caselet strongly recommends combination of an equity fund and a debt fund as an ideal alternative to a balanced fund. Suggest one more viable alternative of balanced funds and indicate the changes required to be made by an investor if he/she adopts a combination of equity fund and debt fund as an alternative to the balanced fund. (3 + 5 = 8 marks) < Answer > Investors have, of late, been cold-shouldering `balanced' mutual fund schemes, though there is no dearth of support for pure play `equity' and `income' schemes. This may seem paradoxical as a `balanced' fund is nothing but a portfolio of `equity' and `fixed income' investments in a certain proportion. The reason for lukewarm investor support can, however, be traced to the performance of balanced funds, which have not been offering value to investors. An analysis indicates that a simple strategy of buying into equity and debt funds paid off better than balanced funds. The statistics are stacked against such funds: · Absolute returns from a simple strategy of making one's own cocktail of balanced funds is, on an average, higher. For instance, HDFC Balanced Fund's net asset value rose 80 per cent between April 2001 and February 2004, trailing the returns of 104 per cent that would have accrued from the simple strategy of separately buying into HDFC Growth and HDFC Income. · The volatility of returns, a measure of risk, for the simple strategy is lower. For instance, HDFC Balanced Fund's monthly returns vary between negative 3 per cent and positive 6.7 per cent, most of the time. In contrast, the monthly returns for the simple strategy range between negative 2 per cent and positive 6.3 per cent. Thus, the deviation in monthly returns for the simple strategy is lower, suggesting reduced risk. The higher returns make this approach even more attractive. The fund that stood out was HDFC Prudence, which gained 152 per cent during the period and was miles ahead of other balanced funds. The numbers indicate that other than HDFC Prudence, the case for investing in any other balanced fund is tenuous. Even in HDFC Prudence, the risk-adjusted performance for the simple strategy has been only marginally superior. Four funds — Alliance `95, Franklin India Balanced, HDFC Prudence and Tata Balanced Fund — did better than the simple strategy in a bear market. Similarly, four funds — Birla Balance, HDFC Prudence, Principal Balanced and Prudential ICICI Balanced — performed better than the simple strategy in a bull market. Barring HDFC Prudence, no other fund has outperformed such an approach across various phases of the market. Each balanced fund's performance was compared to a combination of an equity fund and a debt fund from the same fund house. The analysis pertains to the period between April 2001 and February 2004. For instance, for Franklin India Balanced fund, a combination of Templeton India Growth and Templeton India Income was considered. The strategy involved investing 60 per cent in the former and 40 per cent in the latter in April 2001. These investments would then be held without any changes made mid-way. The performance of such a simple `buy-and-hold' strategy was compared to the balanced fund. The result: Only two balanced funds delivered better returns than the strategy. The volatility of monthly returns was lower for only three balanced funds.Could the period considered be viewed as biased against `balanced' funds? There is the possibility that the rise in stock prices since March 2003 could make the performance of the simple strategy look better. Again, the numbers rule out such a bias: The strategy has on an average performed better during both during the bear (April 2001-March 2003) and bull (March 2003-February 2004) markets. Balanced funds have also consistently underperformed, even on a month-to-month basis. Even had the investors invested in the 60:40 proportion in any month other than April 2001, it is likely that they would have gained more than the balanced fund. In terms of average monthly out-performance, only Alliance 95, HDFC Prudence and Prudential ICICI Balanced fared better than that of the simple strategy. Average monthly out-performance refers to the excess of the returns generated by a balanced fund over the strategy in each month between April 2001 and February 2004. The performance of Alliance `95 and Prudential ICICI, however, may need to be adjusted. Alliance Equity and Prudential ICICI Growth, the respective equity funds in the simple strategy, were unimpressive during the period under analysis. There is an even more powerful reason to think that balanced funds are struggling to add value. The simple strategy is just that — a hurdle that is easy to overcome. The balanced funds were unable to beat even this hurdle. If a higher standard were considered, then the performance of all balanced funds, except HDFC Prudence, would be even more indifferent. The higher standard is the performance of combinations such as DSP-ML Opportunities and DSP-ML Bond Fund, Templeton India Growth and Templeton India Income, HDFC Growth and HDFC Income, and HDFC Equity and HDFC High Interest Fund. By steering clear of balanced funds and choosing separate equity and debt funds, investors also have the freedom to employ strategies involving a combination of funds from various fund houses to enhance returns. For instance, Templeton India Growth could be combined with HDFC High Interest Fund; or HDFC Equity with Sundaram Bond Saver. Combinations involving equity funds with an impressive
long-term track record would have delivered a vastly better performance than
balanced funds, including HDFC Prudence. Such equity funds include HDFC
Equity, Franklin India Bluechip, Franklin India Prima, HSBC Equity, Templeton
India Growth, Prudential ICICI Power, HDFC Top 200, Alliance Basic Industries
and UTI Petro Fund. Given such choices, investors may be better off steering
clear of balanced funds. Theoretically, balanced funds are positioned as the
best choice for a retail investor. The strategy of constantly shuffling the
composition of investments between debt and equity is supposed to lock in
gains before a downtrend manifests and thereby reduces the risk of loss of
portfolio value. The advantage such funds offer is that the fund manager is
supposed to be better at rebalancing the portfolio than the ordinary
investor. The managers' record, however, leaves a lot to be desired. As one
cannot put all one's money into HDFC Prudence, alternative strategies have to
be considered. END OF SECTION E END OF QUESTION PAPER |
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Section D : Case Study Returns Required: · Mr. Ramchandani’s salary is sufficient to meet regular expenditures of his family and therefore, he does not require any monthly return to meet his household expenditure. He has good surplus earning which he can invest in fixed income securities as well as equity. Investments in debt securities gives more safety to his investment portfolio and equity investment gives chance for capital appreciation. · Very high returns are not required from the equity investment of Rs.20 lakhs. Equity portfolio should at least produce Rs.40 lakh in 10 years i.e. 7.17% yearly return is required. As higher risks are involved with equity, it should provide the entire investment needs of Mr. Ramchandani i.e. 80 lakhs at a return of about 14.87%. · Ideally, equity portfolio should provide his fund need, and also money for establishing an endowment fund. For generating this money also the expected return from equity portfolio goes upto 17.46%. · As there is a substantial monthly surplus, no additional yearly investments are being planned for the post retirement requirement and marriage expenses of his daughter. Risk Tolerance: · The risk tolerance is low for the funds required for the higher education of Mr. Ramchandani’s children. · Risk tolerance level is moderately high for the funds required for the hospital and endowment fund as they are not as important as the education of his children. High level of risk tolerance is required to achieve a return of 17.46% p.a. · Reduction in the risk tolerance level will demand additional investments from Mr. Ramchandani. Constraints: · Liquidity: Liquidity requirements are almost nil. · Investment Horizon: The time period of investment is medium to long term (10 years). · Taxes: Mr. Ramchandani falls into high tax bracket due to his high salary. Investment in tax saving instrument should be made to lower down the tax burden. · Other circumstances: Additional fund of Rs.25 lakhs is required for the establishment of the endowment fund. The additional requirement demands a higher return at of course, higher risk tolerance level. 2. a. Tracking error is the standard deviation of the difference between a fund’s return and the benchmark index. It can be
calculated as follows for Equity Portfolio of Convergys:
From the table, it is clear that the variance of
the difference between the return on Equity Portfolio of Convergys and the
standard market index s2 = \ Tracking error = b. The
tracking error measures the volatility of active returns. Active returns are
defined as the difference between the fund's returns and the benchmark's
returns. Indexed portfolios typically display tracking errors in the 1 to 3 percent range. At 1.93 percent., the equity portfolio has a tracking error that is not too high for an index portfolio. Hence it can be classified as an indexed portfolio. c. Tracking error can be caused by i.
Transaction
costs in construction of the index. ii. Differences in the composition of the indexed portfolio and the index itself. iii. Discrepancies between prices used by the organization in constructing the index and transaction prices paid by the indexer.
Average Rp = 21.62% , Rf = 5% (given)
Sharpe Ratio = Information Ratio = b. The two ratios convey different
information: the portfolio appears good under the Sharpe ratio, but bad under
the information ratio. Note that this is not a problem, because the Sharpe
ratio and the information ratio answer different questions. The Sharpe ratio
considers how the fund rewards the volatility, while the information ratio
considers how the fund performs with respect to its benchmark. 4. a. The target active return = W1T1+W2T2+W3T3, where W1, W2 and W3 are the weights and T1, T2 and T3 are target active returns. = 0.94 ´ 1.5 + 0.03 ´ 0.05 + 0.03 ´ 0.2 = 1.4175% b. Based on historical statistics, the portfolio returns had a mean of 21.62 percent and a standard deviation of 7.51 percent. \Z =
By looking at the Cumulative Normal Distribution table, we find that the probability of observing a negative performance is Prob (R < 0%) = 0.199% @ 0.2%
5. a. Since the yield curve shifts up, will bear losses on the long position in 7 years bonds and will gain on his short position in 4 years bonds. Whether the total portfolio will gain or lose depends on the proportions of the two bonds in the portfolio. On the other hand, the proportions are such that the duration of the portfolio is equal to zero. Using the assumption that portfolio duration is equal to the weighted average of bonds’ durations, we have:
Therefore, the return on the portfolio is equal
since Therefore, the portfolio will gain in value if Mr.Ramchandani’s forecast is realized. b. One reason that forward interest rates differ from expected future short-term interest rates is the existence of risk premium. Even if the market were to assume that future short-term interest rates would on average be flat, investors would still demand a risk premium for long-term bond returns, which have larger price volatility, so the long-term bond yield curve would curve upwards towards the right, as would the forward curve (at least partially). This bias makes the forward curve higher than expected short-term interest rates. The second reason is the "convexity effect." Section E: Caselets Caselet 1 6. Momentum investing is basically the type
of investing that people do when they follow trends. Momentum investors buy
stocks that have been very popular and appreciating rapidly and they hope
that the trend will continue. You've probably heard of the popular saying
"buy low, sell high." Momentum investing has a similar slogan but
it's "buy high, sell higher." momentum
investing, like many other investment strategies, is basically a strategy
that seems to work until it no longer does. In other words, the strategy may
work for some period of time, but by its very nature, it contains the seeds
of its own destruction. As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy, with the promise of high upside and limited downside -- a bet one apparently cannot lose. But the risk of this strategy is that, while momentum investors can all pile in at the same time, they cannot all escape (sell) at the same time unless markets are both highly liquid (large blocks can be sold quickly and at the same price) and continuous (prices do not gap sharply downward with no opportunity to sell). Unfortunately for momentum investors, there is no guarantee of either condition being true all the time. And, unfortunately, markets sometimes seem to become both illiquid and non-continuous at just the wrong time. The door shuts just as everyone is trying to escape. As increasing capital is attracted to the momentum strategy (including investments in many newly formed mutual funds and hedge funds) the market's volatility increases. The result is that, whenever there is a whiff of bad news, numerous previous buyers scramble to get out before the barn door shuts. In this type of environment, stocks become highly illiquid and prices become discontinuous. When the upward momentum ceases, concentrated selling quickly accelerates, as momentum investors attempt to be among the first to get out. This not only drives prices lower but also leads to margin calls, and thus more selling. Prices, particularly those with no fundamental underlying valuation, tend to fall at least as hard and as fast as they had risen and panic can ensue. (As an aside, this also happens on the way up. As many momentum investors jump in at the same time, the price tends to spike up very quickly and discontinuously. Momentum investors perceive this as a very fortunate turn of events, not realizing that the exact same thing will happen on the way down when they tend to try to sell the stock all at the same time.) The bottom line is that momentum investors cannot escape downside risk without actually paying the call premium. By avoiding the premium, they do receive the upside potential, but the downside risk of the strategy cannot be known until the game is over. And the really bad news is that momentum investors who use leverage to increase the size of their bets (attempting to increase their returns) can often ill afford to be wrong even once; they can literally be wiped out by one bad choice. 7. Keep
your investment goals at the forefront The most important thing to consider is what impact selling out of the fund will have on your overall investment strategy. Put another way, how will selling affect what you're investing for? If your goal is saving for long-term retirement income, for example, it may pay to reconsider whether selling your units - and therefore potentially crystallising immediate losses and exit fees/penalties - is the best way to work towards achieving your investment goals. Persistent poor performance A fund's performance will always have short-term ups and downs in the returns and capital growth it achieves, and in the level of volatility it generates. This is the basic nature of investment markets. Of course, over the past three years, in international sharemarkets in particular, we've witnessed levels of turbulence not experienced since the 1930s (certainly more sustained than the two most recent downturns of 1974-5 and 1981-2). Whether or not this should prompt you to sell out of your fund is another matter, however. The important issue is over what period you judge the business cycle to be so that you can fairly judge the true abilities of whether or not your fund manager is able to add value. If your fund manager does not seem to be able to add value regardless of where the investment market is in the business cycle, it may be time to consider change. If the fund no longer suits your risk profile
Another reason to reconsider is if the returns and/or volatility are substantially and persistently higher than levels with which you're comfortable. Given the market conditions of the past three years, this might sound like a bad joke, but there is some logic behind it. If the returns from your fund are abnormally high, the fund manager may be undertaking investment strategies that don't fit with your risk profile - your tolerance for taking risk or absorbing capital loss. Some of the disillusionment we're seeing with share funds, for example, seems to be because their rapid growth in the five years to 2000, followed by their subsequent bumpy ride, may not have fit with the risk profiles of many people who invested in them. If your fund gets too big
Fund size is another important reason to reconsider your fund investment. Very large funds can often become unwieldy. If a fund grows too quickly, it can become hard for the fund to do what it's designed to do. That's why you'll occasionally hear about fund managers closing funds to new investment - to protect the interests of the existing investors in the fund. If a key person leaves, or style changes
If your fund manager suddenly loses its leading investment manager, or changes investment style, you need to consider the impact of this on your investment. The effect of a key person's departure can vary between fund managers. Most claim to have a team-based approach, in which the departure of a single individual can be covered by other team members, while the fund manager attempts to poach a replacement from its rivals. However, there are several 'boutique' fund managers in New Zealand, which depend on the highly-promoted skills of one or two individuals, and therefore raise the prospect of a 'key person risk'. If you're invested with a boutique fund manager which depends heavily on a single 'star' investment manager, you need to pay especially close attention to any changes in personnel. If your fund manager changes ownership
Another issue to consider is when your fund manager is taken over by another organisation. The new owner will usually move to undertake what is known in the jargon as "consolidation" - that is, closing down older, frequently unfashionable or unprofitable funds, and merging them with their own existing funds. This is not necessarily a bad thing for investors. If your existing fund manager has been struggling, the new owner may be able to provide better resources and better-quality people and processes, and therefore be better able to help you achieve your investment goals. If your fund manager is taken over by another organisation, consider carefully all the implications - including potential costs associated with switching out or being transferred over to another product - before coming to any firm decisions. Remember, the important thing is whether any change that occurs fits best with what you're trying to achieve, not with what the fund manager is trying to achieve. If your new fund is quite different in style than your old one, this should prompt you to re-evaluate whether or not it's in your best interests to stay invested. Ultimately, the decision about whether or not to sell out of a fund should come down to how well the fund is continuing to help you work towards your investment goals Caselet 2 8. An ETF is basically created through an initial public offering (IPO) by the Asset management companies in which only authorised participants (Aps), institutions, large investors are allowed to participate. These investors exchange their portfolio of stocks and a cash component for ETFs also known as creation units. These creation units are made of two components namely portfolio deposit and cash component. Portfolio deposit consists of basket of shares that make up an index and the cash component is the difference between the applicable NAV and the market value of the portfolio deposit, which arises mainly due to transaction costs, rounding of shares and incidental expenses involved. These units can be either held as investments or sold in the market to the retail investors. ETFs can be also sold back to the mutual fund company but mutual funds buy it at a heavy discount to encourage their selling on the exchanges. The net asset value (NAV) of an ETF is the value of the underlying components of the benchmark index held by the ETF, plus the accrued dividends, less the accrued management fee. Following points distinguish ETFs from the index funds:
Though ETFs sounds as an interesting option when compared to the index fund one must exercise caution as constant buying and selling of ETFs can add up the trading costs and hence constant churning should be avoided. The ETFs do not necessarily trade at the NAV as they could trade at a premium or at discount. 9. Unfortunately, exchange traded funds do have some negatives points: a. Liquidity
- Some ETF's are thinly traded with low trading volumes, thus settlement
prices can be of concern. b. Bid/ask
spread issues: Can be of concern in volatile and thinly traded issues
because of the way ETFs are structured. Sometimes ETFs are bought
at a premium to the portfolio's value and/or sold at a discount. c. Transaction costs -
treated like stocks with brokerage fees assessed d. Sometimes poor at tracking the underlying
portfolio or markets they are based upon. e. Only institutions and the extremely wealthy can deal directly with the ETF companies (must buy through a broker). f. Unlike mutual funds, ETFs don't necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolios Caselet 3 10. GIVEN the large amounts invested in equities by balanced funds, it can be surmised that the underperformance of their equity portfolios is one of the prime reasons behind their unimpressive showing. Another important reason could be poor timing of entry or exit into the equity market. Other factors could be passive management of the debt portfolio and the costs charged to the balanced funds. Different portfolio: The indifferent performance of the equity portfolio is mystifying considering that equity funds from the same asset management companies have done better. The equity portfolios of the balanced funds, however, are often structured differently from those of the equity funds. For instance, Franklin India Balanced and Templeton India Growth. The equity portfolio of Templeton India Growth had SBI, MICO, HPCL, Grasim and Dr Reddy's as its top picks. The balanced fund, however, did not invest in Grasim and Dr Reddy's Labs. In addition, the top three picks — SBI, MICO and HPCL — accounted for 27 per cent of the net assets of Templeton India Growth. In contrast, these three stocks accounted for 32 per cent of the equity portfolio of the balanced fund. This is the case with most balanced funds. If the portfolios are different, it stands to reason that the performance too will be different. That, however, is no solace for an investor if the balanced fund's equity portfolio consistently underperforms the equity fund. Market timing: Balanced fund managers need to get their timing right. If their entry and exit into the equity market are consistently poorly timed, that could pull down returns too. Returns and risk: In terms of average monthly returns, however, they have been able to generate returns of only about 57 per cent of what was generated by an equity fund. This anomaly between the risks taken and the returns generated may be behind the poor performance of balanced funds. The only fund with a proper risk-return profile is HDFC Prudence. Passive income portion: The passive management of the fund's income portion could be another reason for the under-performance of balanced funds. The income portion of the balanced funds is generally invested in a handful of securities. For instance, HDFC Prudence invests the income proportion in 5 to 7 securities. At the end of January 2004, Franklin India Balanced fund had invested in about 8 securities. In contrast, income funds invest in not less than 30 securities. Balanced funds also invest predominantly only in corporate securities and less or not at all in government securities. This too could have backfired as government securities did well in 2001 and 2002. The lack of proper representation to gilt funds could have led to an opportunity loss of a few percentage points for balanced funds. Costs charged: The costs charged to balanced funds could also be a factor. Balanced funds usually charge about 2.1-2.25 per cent of the net assets each year. The higher costs or the passive management of the debt portfolio however will not show up if equity portfolio does well or the fund manager scores in terms of timing the market. 11. There is another alternative to balanced funds — that of investing in a fund of funds. A fund of funds could emerge a superior alternative to balanced funds. The restriction of investing in funds from just one fund house, however, robs the sheen off a fund of funds. Despite such restriction, funds of funds could emerge superior to both balanced funds and the simple strategy. Until such time, the simple buy-and-hold strategy should be the preferred option. Investor should invest in a combination of equity and debt funds with a good record over a longer period. The advantage of the direct investing approach is that investors can also have 30 or 40 per cent in equity rather than the 60 per cent invested by balanced funds. There is, however, one problem with this approach. When stock prices rise sharply, the proportion of equity funds will increase, exposing the investor to greater degree of risk. To counter this risk, he must balance his portfolio at the right intervals. Balancing refers to resetting the proportion of funds allocated to equity in the portfolio. This would depend on the investor's risk-return preferences. Investors can adopt two approaches to balancing: · Sell a portion of equities at intervals greater than a year. Selling at intervals of less than a year would produce short-term capital gains that attract tax at 30 per cent. If investments are sold after a year, they attract long-term capital gains tax, of only 10 per cent. · Invest fresh money into debt to reduce the proportion of assets in equities. This approach will fit the strategy of young retail investors, as income is likely to be generated each year. |
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