Question Paper
Portfolio Management and Mutual Funds - II (252) - 2004

Section D : Case Study (50 Marks)

Case Study

Read the case carefully and answer the following questions:

1.         Prepare a comprehensive investment strategy for Mr. Pandey clearly stating the investment objectives and constraints.

(10 marks) < Answer >

2.         Construct an investment plan using strategy of dedication with zeros (Zero coupon bonds) so that funds requirement of Mr. Pandey can be met.  Estimate the duration of the resulting portfolio of zero coupon bonds as on October 2004.

(10 marks) < Answer >

3.         The risk-free rate of return is 5% p.a and variance of the market index return is 25(%)². Using Sharpe optimization model, construct an optimal stock portfolio for Mr. Pandey.

(12 marks) < Answer >

4.         Using the results obtained by you in question numbers (2) and (3) above, calculate the  duration of the savings portfolio of Mr. Pandey.

(5 marks) < Answer >

5.      Would you advise Mr. Pandey to invest in Birla Dynamic bond fund? Justify.

(5 marks) < Answer >

6.      Briefly describe the type of active debt management strategy followed by the Birla Dynamic fund.

                                                  (8 marks) < Answer >

Mr. Sudhir Pandey is planning to invest his savings to meet his future needs.  He consulted Intelligent Advisors Ltd., a firm offering portfolio management services. Intelligent Advisors Ltd. manages the portfolios of high net worth investors.  The track record for Intelligent Advisors Ltd. is quite impressive.

A portfolio manager of the company met Mr. Pandey to assess the needs and limitations of the latter’s requirement.  The salient observations made by the portfolio manager are as follows:

·                Mr. Pandey (40) is working as General Manager of a Advertising company.  His wife, Sangeeta is a housewife. They have two children – a son and a daughter.  His son is presently in X standard and wants to go abroad for his higher education.  His daughter is in VI standard and wants to become a pilot. Mr. Pandey earns Rs.80, 000 per month and receives Rs.5.0 lakhs every year as bonus.  Total monthly expenses of Mr. Pandey are Rs.50, 000.

·                The total amount in the savings portfolio of Mr. Pandey is Rs.50 lakhs. His total investment needs are expected to be Rs.80 lakhs and he wants at least 70% of this requirement from his fixed income portfolio. Mr. Pandey plans to obtain substantial capital gains from his investment to finance the 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.

·                The portfolio manager of the Intelligent Advisors advised Mr. Pandey 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 80% of his savings portfolio should be in fixed income securities and balance should be dedicated to equities.

          Year-wise fund requirement of Mr. Pandey is as follows:

Portfolio managers generally advise investors to invest in debt instruments of different credit qualities to increase the return but, for Mr. Pandey the portfolio manager suggested high rated debt instruments.  Portfolio manager advised Mr. Pandey to use dedication strategy using zero coupon bonds.  The following zero coupon bonds are selected for the dedication strategy:

The portfolio managers also suggested the following stocks after considering his risk tolerance level:

Mr. Pandey is also analyzing the possibility of investing in mutual funds and has selected the Birla Dynamic Bond Fund.  The essential details of this scheme are as follows:

Birla Dynamic Bond Fund

Sponsors - The Sponsors of the Mutual Fund are Birla Global Finance Ltd., part of the Aditya Birla Group, which is a premier conglomerate of businesses in India. Sun Life Financial Services of Canada, which is a leading international financial services organization providing a diverse range of wealth accumulation and protection products and services to individuals and corporate customers, is the joint venture partner.

Scheme - An Open Ended Income scheme with an objective to generate optimal returns with high liquidity through active management of the portfolio by investing in High Quality Debt and Money Market Instruments.

Type of the Scheme

Birla Dynamic Bond Fund is an open-ended Income scheme. The scheme offers investors three plans:

1. Retail Plan

2. Institutional Plan

3. Institutional Premium Plan

Each plan offers Growth and Dividend options (with reinvestment facility).

Investment Objective

The objective of the scheme is to generate optimal returns with high liquidity through active

management of the portfolio by investing in High Quality Debt and Money Market Instruments.

Asset Allocation And Investment Pattern

The following table provides the asset allocation (as a % of net assets) of the portfolio.

Instrument Normal Allocation Risk Profile of the Instrument

·                The investments in securitised debt papers will normally not exceed 50% of the net assets of the scheme.

·                Pending deployment of funds of the schemes in securities in terms of the investment objectives of the schemes, the AMC may invest the funds of the scheme in short term deposits of scheduled commercial banks.

·                The scheme may also invest upto 50% of the net assets of the scheme in such derivative instruments as may be introduced from time to time for the purpose of hedging and portfolio balancing and other uses as may be permitted under SEBI (MF) Regulations, 1996.

·                The scheme may also invest a part of its net assets (not exceeding 50% of its net assets) in overseas markets in bonds and Mutual Funds and such other debt instruments as may be allowed under SEBI (MF) Regulations, 1996, from time to time.

Change In Asset Allocation

The above mentioned investment pattern is indicative and may change for short duration.

Subject to the Regulations, the asset allocation pattern indicated above may change from time to time, keeping in view market conditions, market opportunities, and political and economic factors.

It must be clearly understood that the percentages stated above are only indicative.

Investment Strategy/Objective

The investment objective of this Scheme is to optimize returns for the investors by designing a portfolio which will dynamically track interest rate movements in the short term by reducing duration in a rising rate environment while increasing duration in a falling interest rate environment. Since active debt management strategies require an in depth knowledge of and ability to accurately track interest rate movements taking into account various micro and macro factors, it is difficult for an individual investor to adopt such a strategy. Whereas, the investment team of Birla Mutual Fund, through its research and process driven investment strategy, would endeavour to capitalize on the available opportunities in a timely manner. The fund would seek to fulfill the needs of a large number of individuals, HNIs as well as large institutional investors who are susceptible to interest rate risk .In order to maximize returns the fund managers may look at curve spreads both on the gilt as well as the corporate bond markets to gain maximum value out of any security/s.

Section E : Caselets (50 Marks)

Caselet 1

Read the caselet carefully and answer the following questions:

7.         According to the caselet, Fund managers reduce average portfolio duration by picking up debt papers, which have a lower maturity date. Debt paper with lower maturity is less prone to a change in interest rates or expectation of a change in rates as compared to a long-dated paper. Briefly describe other ways of reducing duration of a portfolio?

(7 marks) < Answer >

8.         The caselet states that the hardening of global rates, rising inflation in India, a depreciating rupee and foreign funds pulling out from India are sending bond prices crashing. Discuss.

(10 marks) < Answer >

Debt fund managers are virtually on a firefighting. While debt markets went on a tailspin, debt-dedicated mutual funds are now sitting on a huge pile of cash. As a defensive move, fund managers of gilt funds have aggressively raised cash exposure up to 100 per cent and the average portfolio duration has been pruned up to 9.5 years in May. Bond funds, which invest in government securities and corporate bonds, have raised cash exposure and reduced portfolio duration. Most of the bond funds currently have cash holdings in the range of 10-93 per cent. The average maturity of gilt funds has been brought down from 9.35 years as on April 30 to 6.45 years as on May 31, 2004. Of the 36 gilt funds, 26 schemes have cash holding between 11 per cent to 100 per cent. In fact, out of the total gilt funds, 19 schemes have taken a cash exposure of over 20 per cent. “A strong consensus is being built up on a rate hike. So, now the task of the fund manager is to find a way to control the damage. They have been reducing portfolio maturities and raising cash exposure. The best thing you can do now is to sell and don’t invest,” says Value Research’s chief Dhirendra Kumar.

Fund managers reduce average portfolio duration by picking up debt papers, which have a lower maturity date. Debt paper with lower maturity is less prone to a change in interest rates or expectation of a change in rates as compared to a long-dated paper. Hence, when rates are expected to harden, price of a bond with a lower maturity date falls lesser as compared to a long-dated debt paper. The funds hold cash or cash equivalent instruments to protect the portfolio from value erosion, when bond prices are crashing. The rise in cash holding as well as portfolio duration is sharper in gilt funds as compared to bond funds. Gilt funds, which normally have a higher portfolio duration, hold only long-dated government securities and the fall in NAV is sharper in these schemes as compared to bond funds. Besides, the fear of a rise in rates, the raising of cash holdings in these schemes has been driven by rising redemption pressures. The hardening of global rates, rising inflation in India, a depreciating rupee and foreign funds pulling out from India are sending bond prices crashing.

Caselet 2

Read the caselet carefully and answer the following questions:

9.         The caselet states that the discovery fund is based on the concept of value investing and will invest in companies that are available at a discount to their intrinsic value. Briefly describe the financial parameters used for finding value stocks.

(9 marks) < Answer >

10.       The caselet says that in Wednesday’s market when most equity portfolios are similarly placed in terms of price-to-earnings multiple, there are very limited opportunities for hedging downside risks. With the value investment style, a portfolio consisting of value stocks is therefore likely to complement the fund.” Comment.

(6 marks) < Answer >

Prudential ICICI AMC has launched a new ‘Discovery Fund’, an open-ended scheme, which "will invest in companies that are available at a discount to their intrinsic value. The initial public offer (IPO) is from July 9 to July 23. The offer price is Rs. 10 per unit during the IPO period and thereafter at the applicable net asset value.

This fund is based on the concept of value investing and will invest in companies that are available at a discount to their intrinsic value.  Pankaj Razdan, managing director, Prudential ICICI Asset Management Company Ltd, said, “We are providing investors an opportunity for diversification. In Wednesday’s market when most equity portfolios are similarly placed in terms of price-to-earnings multiple, there are very limited opportunities for hedging downside risks. With the value investment style, a portfolio consisting of value stocks is therefore likely to complement the fund.”   

Prudential ICICI Mutual Fund officials said that the Discovery Fund is an open-ended scheme that aims to provide long-term capital growth by investing primarily in a well-diversified portfolio of companies accumulated at a discount to its fair value. ICICI Discovery Fund is most suited for investments between three to five years.  A senior fund manager said that the fund will invest between 80 per cent to 100 per cent in equity and equity-related instruments and between 0 per cent to 20 per cent in cash and money market instruments. The fund may carry a large cash position in the absence of suitable investment opportunity on a temporary basis. The fund has an entry load of 2.25% on investments below Rs 5 crore and nil for investments of Rs 5 crore and above. The fund has no exit load.  Explaining their investment strategy, the officials added that Prudential ICICI Discovery Fund would invest in stocks of fundamentally strong companies that are underpriced.

Caselet 3

Read the caselet carefully and answer the following questions:

11.       The caselet states that activist funds can be thought of as a cross between “value” investors, who buy shares in basically sound but undervalued companies, and turnaround specialists, who buy and fix broken firms. Thus they invest in public companies that, they think, are lagging their peers because of poor management practices. How do you think that activist funds are different from mutual funds?

                                                                                                 (10 marks) < Answer >

12.       The caselet strongly emphasizes the need for more and more activist funds which can cater to the needs of institutional as well as individual investors. Do you advise setting up activist funds in India? Discuss.

(8 marks) < Answer >

The word “activist” conjures up images of environmentalists hugging endangered trees. These days it is also applied to men in suits concerned about saving their clients' wealth. This year “investor activists” have ousted the chairman of Shell, halted a pricey acquisition at Vodafone and stripped Michael Eisner, Disney's chief executive, of his role as chairman in a fight for control that still continues. This week British companies and institutional investors held a two-day meeting intended to improve frayed relations. Underlying the friction is the idea that good corporate governance leads to good performance, that certain companies are not governed at all well and that it is up to investors to make sure executives buck up. Perhaps the keenest believers in keeping managers on their toes are the small but growing number of investors known as “activist funds”.

Activist funds can be thought of as a cross between “value” investors, who buy shares in basically sound but undervalued companies, and turnaround specialists, who buy and fix broken firms. Thus they invest in public companies that, they think, are lagging their peers because of poor management practices. Through tactics ranging from gentle persuasion to fiery proxy battles, they push these companies into making their corporate governance better and sell at a profit when the market notices the improvement. “The difference is that we catalyse change rather than hoping for it,” says Howard Horowitz, manager of the Watchdog Fund, an activist mutual fund due to be launched.

Market figures are hard to come by given the difficulties of defining the sector clearly, but practitioners estimate that funds specializing in activist strategies manage around $10 billion-worth of assets. The bigger names include Relational Investors, a San Diego firm with $2.5 billion under management, Active Value in Britain and Sparx in Japan.

Public pension funds from Canada to Finland are backing the strategy. Calpers, the guardian of California's public employees' pension money and America's biggest public pension manager, has said that it will put a total of $3 billion into seven such funds this year, 20% more than in 2003. With the launch of the Watchdog Fund, individuals too will be able to invest in activist funds.

Intermittently, investors from Warren Buffett to mutual funds such as Fidelity have been activists in their own right, using their influence to knock companies into shape. Public pension funds, particularly American ones, are old hands. Calpers began publishing “focus lists” of firms with sloppy corporate-governance practices in the 1980s. Hermes, a big British pension manager, started an in-house activist unit, Hermes Focus Funds, which takes money from its parent and other European pension funds, in 1998. It manages over £1 billion ($1.8 billion). More recently, Dutch and Spanish pension funds have targeted Ahold, a scandal-hit retailer, and Santander Central Hispano, Spain's biggest bank.

Suggested Answers
252-1004

Section D : Case Study

1.      Investment Policy

         Returns Required:

·        Mr. Pandey’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.10 lakhs. Equity portfolio should at least produce Rs.24 lakh in 10 years i.e. 9.14% yearly return is required. As Mr. Pandey is contented with just 30% of the amount coming through equity portfolio even debt investment can provide it. As higher risks are involved with equity, it should provide the entire investment needs of Mr. Pandey i.e. 80 lakhs at a return of about 23.11%.

·        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 25.89%.

·        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. Pandey’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 25.89% p.a.

·        Reduction in the risk tolerance level will demand additional investments from Mr. Pandey.

Constraints:

·        Liquidity: Liquidity requirements are almost nil.

·        Investment Horizon: The time period of investment is medium to long term (10 years).

·        Taxes: Mr. Pandey 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.20 lakhs is required for the establishment of the endowment fund. The additional requirement demands a higher return at of course, higher risk tolerance level.

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2.     

         The duration can be calculated as follows

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3.      As utility is given for four stocks we need to first calculate expected return

         =       Utility + Risk Penalty

         =       Utility +

             =       Systematic risk + Unsystematic risk

                   =       bi² sm² + Unsystematic risk.

         Expected return of the stock

         Stocks should be selected as > C and C* = 6.99.

         Z_P      =     

         Z_P      =        =       0.1011

         Z_I      =                = 0.1021

         Z_E         =                = 0.0825

                                                                     __________

                                                                      SZ = 0.2857

Weights

         Wp    =      0.1011/0.2857 = 0.3539 i.e., 35.39%

         Wi     =      0.1021/0.2857 = 0.3574 i.e.,35.74%

         W_E     =      0.0825/0.2857 = 0.0.2887 i.e., 28.87%

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4.      Duration of bond portfolio          =       5.916 years

         For calculation of Duration of equity we should calculate dividend yield of the equity portfolio which includes three selected stocks

         Individual dividend yield of stocks Div / Price

         Weighted dividend yield

         =       0.031 X0.3539 + 0.0778 X0.3574 + 0.0382 X 0.2887 = 0.04987

         Duration of equity portfolio        =      

                                                                  =      

                                                                  =       20.05 years

         Duration of the savings portfolio

         =       20.05 ´ 0.20 + 5.916 ´ 0.80

         =       8.743 years.

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5.      Mr. Pandey can think of investing in Birla dynamic fund because it is primarily dedicated to fixed income securities including govt. securities. As stated in the investment objective of the dynamic fund it will optimize return for investors by investing in fixed income securities which will best track the movement of the interest rates. An active debt management strategy used for managing the dynamic fund will definitely suits the return requirement of Mr. Pandey.

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6.      Birla Dynamic Fund is following Interest rate anticipation strategy which is an active bond management strategy. Since long-term bonds change the most in value for a given change in interest rates, a manager who would want to hold long-term bonds when rates are falling. This would provide the maximum increase in price for a portfolio. The reverse is true in a rising interest rate environment. Long-term bonds fall the most in price for a given rise in interest rates and a manager would want to hold treasury bills. Treasury bills have a very short term and do not change very much in value.

A more sophisticated interest rate anticipation strategy might involve the use of "zero coupon" or "strip" bonds which are far more sensitive to interest rate changes than normal bonds. Zero coupon bonds have no coupon payments and move in price as their term changes or interest rates change. Their high price volatility makes them especially suitable for speculating on interest rate movements. As the saying goes: "when you are right you are very very right and when you are bad you are horrible".

Interest rate derivative securities, such as options and futures, can be used to implement an interest rate anticipation strategy at a lower transactions cost. Market traded or "over-the-counter" (OTC) securities can be used instead of actual bonds to place "bets" on the future course of interest rates.

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Section E: Caselets

Caselet 1

7.      Duration decreases as time to expiration of a bond moves closer to maturity, but duration also increases momentarily on the day a coupon is paid and removed from the series of future cash flows—all this occurs until duration, as it does for a zero-coupon bond, eventually converges with the bond's maturity. Besides the movement of time and the payment of coupons, there are other factors that affect a bond's duration: the coupon rate and its yield. Bonds with high coupon rates and in turn high yields will tend to have lower durations than bonds that pay low coupon rates, or offer a low yield. This makes empirical sense, since when a bond pays a higher coupon rate, or has a high yield, the holder of the security receives repayment for the security at a faster rate. Clearly by selecting higher coupon bond with higher yield will reduce the duration of fixed income portfolio.

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8.      The basic relationship between the price of a bond and prevailing market interest rates is an inverse relationship. This is actually pretty straightforward. For example, if you have a 6% bond (this means that it pays Rs.60 annually per Rs.1000 of face value) and interest rates jump to 8%, wouldn't you agree that your bond should be worth less now if you were to sell it? The relationship between bond prices and inflation rate is also same as the relationship between interest rates and bond prices. An increase in inflation rate increase the risk premium required by the bond investors and therefore discounting factor to be used (yield) for estimation of the price of the bond should be increased to accommodate the higher risk premium. Clearly, higher inflation rate reduces the price of a bond. Depreciation in Indian currency indicates lower return for the foreign investors and any overseas investor would pull out from Indian fixed income market if rupee starts declining. Hence, all three factors acts in similar ways in deciding the lower price of the bond.

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Caselet 2

9.      The following parameters should be used for identifying value stocks

Price to Book ratios: Buy stocks where equity trades at less than or at least a low multiple of the book value of equity. A low price book value ratio has been considered a reliable indicator of undervaluation in firms.  The empirical evidence suggests that over long time periods, low price-book values stocks have outperformed high price-book value stocks and the overall market.

Price earnings ratios: Buy stocks where equity trades at a low multiple of equity earnings.

Investors have long argued that stocks with low price earnings ratios are more likely to be undervalued and earn excess returns. For instance, this is one of Ben Graham’s primary screens.  Studies, which have looked at the relationship between PE ratios and excess returns, confirm these priors. Firms in the lowest PE ratio class earned an average return substantially higher than firms in the highest PE ratio class in every sub-period.  The excess returns earned by low PE ratio stocks also persist in other international markets.

Price to sales ratio: Buy stocks where equity trades at a low multiple of revenues. Jacobs and Levy (1988a) concluded that low price-sales ratios, by themselves, yielded an excess return of 0.17% a month between 1978 and 1986, which was statistically significant. Even when other factors were thrown into the analysis, the price-sales ratios remained a significant factor in explaining excess returns

Dividend Yields: Buy stocks with high dividend yields.

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10.    When equity portfolios are similarly placed in terms of Price earning ratios value stocks with lower price earning ratio provides good addition to the equity portfolio as it gives valuable diversification benefits and lower volatility to the equity portfolio. Value stocks and their counterpart, growth stocks, don't usually move in tandem. By combining both value- and growth-oriented investments an equity portfolio can be diversified. It has become clear that over short-time periods, value and growth stocks often have differing performance cycles. This becomes clear if one looks at growth's relative outperformance in the later 90s and value's relative outperformance in the early 2000s.

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Caselet 3

11.    Mutual funds work on a different approach in comparison with activist funds. Comparing the composition of both the funds, mutual funds are a mix of bond and stocks whereas activist funds are only collection of stocks. Mutual fund holders have no voting rights. On the other hand, activist funds purchase the stocks with the sole purpose of getting voting rights. Trustees act as one of the important persons in the decision making of the companies. This creates a major difference between the mutual fund and the activist fund, as mutual fund managers have to perform on behalf of their investors whereas an activist fund manager has to perform on the behalf of the company as well as the investors. The other distinction is that mutual fund’s sole purpose is to increase the value of the fund however, activist fund’s sole purpose is to improve the corporate governance of the company thereby improving corporate citizenship. Activist funds also follow  socially responsible investing approach by considering social, environmental and empowerment aspects. On the other hand, mutual funds have no such objectives. Comparing the performance record of activist funds with mutual funds, activist funds have outperformed the mutual funds. Calpers is one such fund that has outperformed mutual funds and set an example.

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12.    Activist fund is the only fund available in the market that gives a chance to the retail investor to act as an active shareholder to increase their value. The market- based approach of these funds to improve corporate governance and bringing the turnaround in underperforming companies is the bets part of these funds, whereas no other fund has such type of objectives. The activist funds are still not present in India. However given the multitude of corporate scandals, there will be a welcome move to start these types of funds soon. A majority of companies lack international corporate governance standards and their outlook global to make Indian really shining. It would be good to launch these fund in India, as this will improve the performance of Indian companies. However, Indian investor have to wait for some time as their presence is restricted to a few countries.

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