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
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Read the case
carefully and answer the following questions: |
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Explain the concept of contra investing and the possible advantages of such investing. Explain whether contra investing is really a new concept or ‘old wine in a new bottle’. (9 marks) |
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Using constant proportion portfolio insurance strategy for asset allocation as suggested by Mr.Brijesh, determine the value of investment to be made in /withdrawn from Risky Assets and Risk Free Assets for the periods January, February and March 2006. (Show the calculations separately for SBI Magnum Contra Fund and Kotak Contra Fund, assuming that investment in those funds is mutually exclusive.) (4 + 4 = 8 marks) |
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Construct a minimum variance portfolio using both SBI Magnum Contra Fund and Kotak Contra Fund. (9 marks) |
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Compare the performance of individual funds with that of portfolio constructed in Q. No. 3 above using Sharpe, Treynor and Fama measures, interpret the results and observe where there is any diversification effect. (16 marks) |
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Constant proportion portfolio insurance strategy suggested by Mr. Brijesh is one of the dynamic strategies for asset allocation. Explain how constant-proportion portfolio insurance strategy differs from buy and hold strategy. (8 marks) |
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Mr. Roshan, a small investor in the market, who is
not affordable to invest in stocks in this bull phase is planning for alternatives
and is advised by a portfolio manager, Mr.Brijesh to opt for contra Mutual
Funds. Mr. Brijesh also suggested him to adopt constant
proportion portfolio insurance strategy for asset allocation, as this
strategy is expected to provide positive benefits in bullish phase. The total
value of assets of Mr.Roshan for investment as on January 1st 2006
was Rs.2,50,000 and the floor value
was Rs.2,00,000. The multiplier is 2.5. Contrary investing means different things to
different people. Some view it as buying or selling in the opposite direction
in which the market is heading. So in this current market, a contrarian would
be the one who dolefully predicts the end of the For the
first time in Here is a look at the players and the Net Asset
Values of their growth schemes.
Comparative
analysis of Magnum Contra Fund and Kotak Contra Fund
Treasury Bills are trading in the market at a rate of 6% p.a. |
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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
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Read the caselet carefully and answer the following
questions: |
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According to the caselet, the portfolio manager of a Portfolio Management Service (PMS) has an investment approach different from mutual fund or pension fund managers, as there is a unique portfolio for every client. Briefly explain the salient features of portfolio management style of PMS. (8 marks) |
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According to the caselet, taking the specialized services of a portfolio manager has several advantages. Explain the possible advantages that accrue to a high net worth investor when he invests through a PMS? (9 marks) |
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“If you don't know who you are, the stock market is an expensive place to find out.” –George Goodman This is true for all those who have a sizable amount to invest in the capital markets, but do not possess the financial knowledge and the ability needed to do so. So do you have extra money, and looking for ways to increase the wealth by investing somewhere, but have no clue about investments? If yes, Portfolio Management Service (PMS), a hot new service, is the right one for you. A Portfolio Management Scheme is one where your funds are managed separately for you. In a Mutual Fund (MF), the funds are pooled and then common investments are made. There is no client-wise segregation of portfolios in mutual funds. Sure, one can invest in mutual funds to maintain a well-diversified portfolio, but PMS offers many more advantages over mutual fund investments. People who are not financially savvy, but would like to invest in the capital markets should avail this service. Such people usually invest in mutual funds and tend to pay very high costs, and sometimes also see a decrease in their portfolio size. In addition to this, they try to chase performance sectors by investing in high-risk sectoral funds. Hence, taking the specialized services of a portfolio manager has several advantages. Individual investors can access a multitude of investment
avenues available in the market: From direct investment in equities to mutual
fund investments and fixed deposit schemes. However, when you have a large
amount of money to invest, usually upwards of Rs. 5 lakh, a point where the
portfolio size achieves a critical mass, and where you can have a dedicated
portfolio manager managing your portfolio, you can save on brokerages and
fees to various brokerages and fund houses, and manage portfolio risk along
with undertaking growth investing. Portfolio Management Services (also known as private Portfolio Management, Equity Advisory services or Wealth Management Services) are highly specialized services that are tailor-made for the needs of the client. These
services entail that the management company assigns a dedicated portfolio
manager to one large client or some smaller clients (these clients are high
net worth individuals or HNIs). The account of the client is managed by a
relationship manager on the front-end. The relationship manager interacts
with the investor and acts as a single point reference for all interactions
with the firm. It is the portfolio manager at the backend who manages the
portfolio. The portfolio manager of a PMS has an investment approach
different from mutual fund or pension fund managers. As we know, there is a
unique portfolio for every client, so there are certain peculiarities in this
portfolio management style. |
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Read the caselet carefully and answer the following
questions: |
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According to
the caselet, convexity as a measure of the interest rate sensitivity is
superior to duration. Explain. (8 marks) |
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As the time passes on, the effects of coupon payment and time to maturity on the duration of the bond are conflicting in nature. Explain, how do these two factors influence the duration of bond individually as well as collectively. (9 marks) |
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Duration and convexity have traditionally been used as tools for asset liability management. To avoid exposure to parallel spot curve shifts, an organization (such as an insurance company or defined benefit pension plan) with significant fixed income exposures might structure its assets so that their duration matches the duration of its liabilities—so the two offset. This technique is called duration matching. Even more effective (but less frequently practical) is duration-convexity matching, in which assets are structured so that durations and convexities match. Specifically,
duration can be formulated as the first
derivative of the price function of the bond with respect to the
interest rate in question. Then the convexity would be the second derivative
of the price function with respect to the interest rate. The price
sensitivity to parallel interest rate shifts is highest with a zero-coupon
bond, and lowest with an amortizing bond (where the payments are
front-loaded). Although the amortizing bond and the zero-coupon bond have
different sensitivities at the same maturity, if their final maturities
differ so that they have identical bond durations they will have identical
sensitivities. That is, their prices will be affected equally by small,
first-order, (and parallel) yield curve shifts. They will, however start to
change by different amounts with each further incremental parallel rate shift
due to their differing payment dates and amounts. Convexity is also useful for comparing bonds. If
two bonds offer the same duration and yield but one exhibits greater convexity,
changes in interest rates will affect each bond differently. A bond with
greater convexity is less affected by interest rates than a bond with less
convexity. Also, bonds with greater convexity will have a higher price than
bonds with a lower convexity, regardless of whether interest rates rise or
fall. Convexity is a risk management figure,
is superior to duration and is used similarly in the way gamma is used in
derivatives risks management; it is a number used to manage the market risk a
bond portfolio is exposed to. If the combined convexity of a trading book is
high, so is the risk. However, if the combined convexity and duration are
low, the book is hedged, and little money will be lost, even if fairly
substantial interest movements occur. |
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Caselet 3
END OF SECTION E
END OF QUESTION PAPER
Suggested
Answers
Portfolio
Management and Mutual Funds - II (252) : July
2006
Section D : Case Study
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Contra investing is a way of investing
where by the Fund Manager uses an approach, which is different from the
conventional style of investing. It means using unconventional
wisdom to create wealth. In
other words Contrarian investing is investing in securities of companies,
which are currently out-of-favour. Contrarian
investing” or investing contrary to the market, means investing in these
fundamentally strong, temporarily under-valued companies, in order to benefit
when the market recognizes their true worth. Often prices of certain stocks maybe at a low due to extreme investor reaction towards a company based on recent news or information such as poor results, adverse publicity, legal issues or any negative information all of which may create doubts / apprehension about company's future prospects. Many think that a contrarian would always go against the majority - that a contrarian investor is acting differently from the current market trend. Thinking the contrarian way means training one's mind to dwell in directions opposite to general public opinion. Contrarians stand against the common wisdom in the hope of making a profit. ·
·
Potential for higher
value creation when market recognises their fundamental value ·
Scope for investing
in a particular sector which the market overlooks ·
Lower downside risk
for investors, as often these stocks are available at valuations lower than
their intrinsic value. ·
Acts as a hedge for
an Equity portfolio ·
Good blend of value
investing and aggressive growth ·
To diversify your
portfolio by adopting a contrarian strategy No
market capitalization restrictions. Traditionally, the very purpose
of fundamental analysis or fundamental investor is to purchase undervalued
stocks and to sell overvalued stocks. This is what contra investing also
explains. Hence, it can be said that contra investing is not at all a new
concept. |
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SBI Magnum Contra Fund (Rs.)
Kotak Contra
Fund (Rs.)
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Variance of SBI Magnum Fund = 281.09/7 = 40.16 (%)2 Variance of Kotak Fund = 260.72/7 = 37.25 (%)2 Covariance between SBI Magnum and Kotak = 241.76/7 = 34.54 (%)2 Minimum variance portfolio = WS
= = WK = 1 – 0.3253 = 0.6747 = 67.47%. |
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Return on minimum variance portfolio
Market variance = 279.69/7 = 39.96(%)2 Market standard deviation = 6.32% Variance of minimum variance portfolio = 254.55/7 = 36.36(%)2 Covariance between market and minimum variance
portfolio = 229.56/7 =32.79 (%)2 Beta of minimum variance portfolio = 32.79/39.96 = 0.82 Covariance between SBI Magnum and market = 228.84/7 =32.69 (%)2 Beta of SBI Magnum = 32.69/39.96 = 0.82 Covariance between market and Kotak Contra = 229.90/7 =32.84 (%)2 Beta of Kotak Contra = 32.84/39.96 = 0.82 Standard deviation of SBI Magna Fund = 6.34% Standard deviation of Kotak Fund = 6.10%
Interpretition : Ranking is same for all
funds under three measures. Required rate of return on three funds is same as
beta value is same for all. However, total selectivity is high for SBI Magna
fund followed by combined portfolio and is negativefor kotak. Similarly
superio stock selection skills are visible in case of SBI Magna Fund and
negative in case of Kotak. However, the SBI Magna Fund was in existence since
1999, whereas Kotak fund is less than one year old. It can be conclued that
there is no significant decrese in risk (standard deviation) even with the
minimum variance portfolio. There is no much diversification effect, as there
is negligible reduction in standard deviation and no change in beta. |
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Buy and Hold Strategy : A
buy-and-hold strategy is featured by an initial mix say 60% stock and 40%
treasury bills, which is initially bought and then held. These can be termed as minimum risk and
maximum return strategies. In fact, these strategies do not require regular
rebalancing, and they are even easy to analyze. ·
The
relationship between the portfolio’s value and the stock market’s value is
linear. ·
The
value of the portfolio directly proportional to the value of the stock
market, the slope being equal to the proportion of stock in the mix. ·
The
value of the portfolio will not fall below the value of inlitial investment
in bills. Constant proportion portfolio insurance: The constant proportion portfolio insurance strategy is a constant
proportion strategy with multipliers greater than one. The implementation of
this strategy calls for selection of the multipler and a floor below which he
does not want the portfolio value to fall. The floor actually grows at the
rate of retun on bills, and should be less than one at the initial stage. The
value of investment in risky assets is equal to the product of multiplier and
cushion (total assets – floor). When the market is bullish, the CPPI strategy
peroforms well. It involves buying stocks as their prices rise with the
divestment of funds in bills. When the market is bearish, it involves the
sale of stock and reinvestment of proceeds in bills to ensure that the value
of total assets does not below floor. Thus, buy and hold strategy results in pay-off diagrams that are
straight lines. Constant proportion portfolio insurance strategy concave
strategies, as the stock is bought when the price rises and sold when price
falls. |
)
)
= 0.3253 = 32.53%
)
)
)
Section E: Caselets
Caselet 1
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1. Prudent, long-term approach: The portfolio managers' investment philosophy should be to provide prudent, long-term performance consistent with clients' objectives and risk profile. He needs to select core holdings of high quality investments at reasonable prices to provide capital appreciation. 2. Controlled risk through broad diversification: Risk control is a very important feature for constructing the client's portfolio. A portfolio manager manages risk through broad diversification in various asset classes, and if need be, invests in foreign markets as well. . 3. Strategic as well as opportunistic investments: Even while the portfolio manager makes long-term strategic investments, he also takes advantage of opportunities that dynamic markets provide. 4. A tax-efficient investment strategy:
Since the post-tax return is the true measure of performance for taxable
investors, and those going for PMS are usually high net worth investors,
achieving the best post-tax rate of return is reflected in the investment approach of the portfolio
manager. |
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· Individual attention to a client’s portfolio is the main advantage in a PMS. · Management by professionals with vast experience and knowledge of markets. · Quick decision-making as the portfolio manager takes all decisions pertaining to the kind of investments and its entry/exit time. · Customized portfolio based on client's risk-return appetite. · Transparency through reports on a regular basis. · Efficient back-office management. Investments, bank accounts, demat accounts, etc., are handled directly by the PMS. ·
PMS offers flexibility. Investors can enter
any time and keep on adding money on a regular basis like in a systematic
investment plan. Withdrawals to meet regular requirements too can be planned
through a PMS. And, as there is no lock in, investors can exit at any time. |
Caselet 2
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Duration is a linear
measure of how the price of a bond changes in response to interest rate
changes. As interest rates change, the price is not likely to change
linearly, but instead it would change over some curved function of interest
rates. In other words, for any given bond, a graph of the relationship
between price and yield is convex. This means that the graph forms
a curve rather than a straight-line (linear). The degree to which the
graph is curved shows how much a bond's yield changes in response to a change in
price. The more curved the price function of the bond is, the more inaccurate
duration is as a measure of the interest rate sensitivity. Thus, convexity
which is a measure of the curvature of how the price of a bond changes as the
interest rate changes, provides better results as a measure of interest rate
sensitivity. |
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The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. In case of coupon paying bonds, it is important to note, that duration changes as the coupons are paid to the bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no longer on the time line, which means it is no longer counted as a future cash flow that goes towards repaying the bondholder. Duration increases immediately on the day a coupon is
paid, but throughout the life of the bond, the duration is continually
decreasing as time to the bond's maturity decreases. This shortening of the time line, however, occurs
gradually, and as it does, duration continually decreases. So, in summary,
duration is decreasing as time 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 – ultimately the net effect of both time to maturity and
coupon payment is decrease in duration. |
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Caselet 3
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Firstly, with the increasing wealth, the investor's risk appetite will increase and thus cause a change in his behavior. Secondly, the time horizon of investment decides the need for liquidity, hence an investor with longer investment horizons does not need immediate liquidity and he can wait for an asset with a modest return to recuperate. Thirdly, an investor has multiple investment goals and she classifies such goals based on their importance. Fourthly, investors do not maximize the outcome of their investment strategies. They will rarely engage in the exhaustive search required for an optimal solution. Finally, there is a lack of information to the investor, because of the cost of information. The various factors, as explained above, affect the
behavior of the investors and the wealth manager to properly define,
understand and identify the true nature of the investors. |
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An association with the wrong investment advisor can spell disaster for investors. It is time to change your investment advisor, if 1. The advisor only recommends the season’s favor If your investment advisor recommends only the season’s flavor without paying much attention to your investment goals and risk consideration, in such a case it is possible that the advisor is more interested in receiving commission than in your investment objectives. 2. The advisor convinces you that a Rs.10 NAV is cheaper Just by comparing mutual fund New Public Offers (NPOs) with equity Initial Public Offers (IPOs), advisors can do enormous damage to their investors. 3. The advisor’s Unique Selling Proposition (USP) is ‘commission offered’ It is a universally followed practice that the advisor refunds to the client a part of the earnings that he gets as commission. Thus, wealth should be created by investment rather than by commissions. 4. Lump sum investing is the consistent advice offered. When the markets are on high, if the advisor advises you to invest lump sum amount, then he is ambitious and positive or he fails to comprehend the market behavior. In both the cases, it could be harmful to the investor’s cause. 5. Advisor’s role is restricted to delivery and pick up of forms An investment advisor’s role should include
building the investor’s portfolio by paying greater attention to goals, risk
profile and time horizon. Delivering services should follow later. |