Sheffield Hallam University Sheffield Business School MA Banking & Finance

RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

Assignment 1 Limitations of Risk Models
Module leader: Ian Sharpe Student: Lien Thuy Nguyen

Sheffield, 10th March 2011

Executive Summary
The assignment is written to discuss limitations of using risk models to manage risks in financial institutions. The discussion is divided into two main sections. The first one will identify problems in using models for risk management. Recommendations for improvement of these problems then will be given in section 2. .

TABLE OF CONTENTS

CONTENT PAGE
Section 1: Evaluation on objective and investment strategy of Witan Pacific.1 Section 2: Aberdeen Vs Nomura Comparison on investment approach...4 Section 3: Investment performance of Witan Pacific since

31/5/2005..6 Conclusion ..12 Bibliography 13 References ..14 Appendix ..15

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SECTION 1: PROBLEMS IN USING MODELS TO MANAGE RISK IN FINANCIAL INSTITUTIONS

1.1 Overview of Witan Pacific Trust PLC
Overview of the Trust is presented in Appendix 1 (p 15) 1.2 Strategy and Objectives of Witan Pacific Trust PLC

The overall objective of the company is to provide shareholders with a balanced portfolio of investments in the Asia Pacific Region with the aim of outperforming the MSCI AC Asia Pacific Free Index (www.witanpacific.com). While investment trusts Henderson or BlackRock set their main objective to customer based for excellent service, the overall objective of Witan shares the same idea with some other trusts like JPMorgan Asian Investment, or Martin Curries, which also sets its objective on shareholder based. However, whether it is customer or shareholder based, the difference of Witan Pacifics objective from other trusts lies in its risk concern which is stated in the companys objective for balanced portfolio. To achieve this objective, Witan Pacific has drawn out a specific business strategy as below:
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in sterling term)

Use an active multi-manager approach to add value and diversify risk: this approach was introduced in 2004 and appears to be successful when helping Witan awake from slim down process for a long time. The advantage of multi manager approach is visible. It helps to address risk by bringing a balance to portfolio and simplifying portfolio monitoring. This risk concern is extremely important for Witan when most of its investments are equities which is high volatile asset i.e much dependence on stock market condition. Another advantage, according to Mr Caspar Rock (2010), Deputy Chief Investment officer at Architas is that multi-manager funds can switch funds without the client having to pay capital gains tax. Still exist some criticism on this approach due to cost incurring for multi personnel structure, it is my believe that good does more than harm

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and the positive result of the company is an evidence when Witan announced a 6.3% rise in net asset value per share for the first 6 months of 2007, 4 years after the implementation of the approach (Reynard, 2007) and even double benchmark return on October 2010.(Clancy, 2010)

Manage the fund for growth predominantly through capital return: this strategy appears to be similar to any other investment companies, say, JP Morgan investment, Standard Life or Henderson. Growth and capital return is a right strategy to satisfy shareholders, however it needs more details on methods to achieve that.

Employ share buy-backs when the Companys shares are standing at a substantial discount to their net asset value is another main strategy of Witan for discount control purpose. According to Witans report, it has bought back up to 1,186,983 shares at cost of 1,851,193 in 2008 when stock market went down. Obvious benefit of this strategy is to keep the discount stable i.e. the movement of its share prices consistent with asset values of portfolios, which help to ensure shareholders consistent return for the Trusts performance. Buy backs method become popular among trusts recently due to such advantage. However, this strategy seems only work well under positive market condition and when the discount is low. In case of market crashes, it may put Witan into big trouble when the company has no more money to buy back all shares dropping down and even worse is the fact that shares bought back previously are far higher than market value in case of crashes. In my view, this strategy is just a way to attract investor by promising on low discount volatility but actually risk stays the same for the company itself and shareholders. According to Mr Buffet in an interview with Telegraph, buy backs is a foolish strategy in contemporary context of economy which was evidenced by the wounds of RBS in 2006 and Lehman Brother in 2008 with loss of billions (White, 2009).

Deploy tactical gearing giving discretion to the Investment Managers to hold up to 10% of the portfolio in cash or borrow up to 10%: this strategy in my opinion is a good one for liquidity purpose which helps to achieve balanced portfolio and reduce risk.

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And headroom of 10% of the portfolio is a reasonable holding percentage for liquidity management as well.

Distribute as much income as may be prudent on an annual basis to shareholders: this strategy is kind of another commitment to shareholders, which helps to attract investors but may sometimes push Witan in difficult rationale for financing decision.

Control costs and expenses to maintain a total expense ratio of less than 1%: in time of economic crisis, this cost management strategy is actually a right decision to help increase profit of the company and hence return to shareholders.

From Witans objective and strategy, it could be realised that Witan is kind of low risk trust. Therefore, it is suitable to both institutional and retail investors who are not extremely risk prefer. Moreover, Witans business strategy is to exploit growth of stock markets in Asia Pacific area including Japan, hence extremely attractive to investors who wish to generate income from overseas investment. One of the main advantages of this is said to be potential for large gain because different markets are at different stages of economic growth at any one time (Cowdell, 2005). Other is the fact that overseas currency can generate higher profits when sterling falls against the overseas currency.

Despite some constraints pointed out, it seems that Witans objective in general is achievable because multi manger approach along with appropriate business strategy, cost control and liquidity management once well applied will help manage risk efficiently and deliver high performance.

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SECTION 2: ABERDEEN vs NOMURA COMPARISON ON INVESTMENT APPROACHES

Aberdeen and Nomura are two different managers of Witan Pacific each of whom manages approximately half the total assets. They share the same investment philosophies of strong performance through diversified asset portfolio for sustainable competitive edge but their investment approach is totally different. In term of portfolio built up, Aberdeen acts based on bottom up approach which start by seeking out well-managed companies; then, they carry out detailed analyses of companies performance and prospects as a basis for their investment decision (Russell, 2006). This is far different from top down approach of Nomura which starts with economic analysis to identify, first prospering countries then industries or business activity benefit from that prosperity and finally companies with profitable growth. From two approaches chosen by, it can be figured out that Aberdeen takes most concern about potential of companies rather than whether they are located in high indexed country or belong to profitable sector. Particularly, Aberdeen pays most attention to identify high quality companies with low valuations compared to their growth potential to seek high return to shareholders. Meanwhile, Nomura takes priority for country and sector performance before picking stocks for its portfolio.

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In term of investment strategy, it is easily found out that Aberdeens asset (equities investment) is highly concentrated i.e. focusing only on small number of companies with strong balance sheet, cash flow and management, therefore implies higher risk. Conversely, Nomura is more interested in widespread portfolio with large number of stocks to be diversified. As stated in report 2010, Nomura held in excess of 200 stocks while Aberdeens holding is around 50, which is quarter of the former. In term of fund management style, Aberdeen tends to allocate its portfolio in an active way which believes right stock picking may lead to above average performance and that it is possible to time markets by correctly predicting and pre-empting future events ( Thompson Shepherd Ltd) . Therefore, Aberdeen does not pay much attention to index construction but deviate mainly to the index return and base on long term track record to outperform the index. Nomura, however, believes in theory of efficient market hypothesis and optimal cap weighted portfolio and acts to index tracking i.e. tends to passive management style. It controls the size of positions they take against the index and add value to all market conditions over medium and longer term. Although Index tracking has advantages in accessing market returns at low cost, large investment capacity and diversification, its major problem is mispricing in which stock might be overvalued or undervalued, therefore cap weighting will overweight overvalued stock and underweight undervalued stock. This normally happens when market is not efficient. Despite differences in investment approach and management style, both Nomura and Aberdeen channels its fund to Japan and emerging markets including India, Hong Kong, China, Singapore & Australia. Biggest portion of their equities investments are directed towards financial sectors such as Aberdeen Equity Fund in India, Standard Chartered, UOB, OCBC or QBE Insurance group. Another portion is invested in consumer goods and industrials sector named as China Mobile, Toyota, Honda, Canon or Shin-etsu Chemical. For more details, please refer to top twenty largest investment of the company in Appendix 2 (p 19) Up to now, it is still too soon to say whether Aberdeen or Nomura approach is better though the Nomura valuation model did not work to the advantage of

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the Trusts portfolio over year 2008 when markets were in volatile manner according to Chairman Nott (2009). In my opinion, each approach has its own advantages and disadvantages and hence a multi manager strategy is a wise decision to take use of their strength and minimize their weakness in different market conditions i.e. making them support each other in the overall objective and strategy of the company.

SECTION THREE: INVESTMENT PERFORMANCE OF TWO PARTS OF THE FUND SINCE 31/5/2005
The following analysis on performance of Witan since its multi manager approach adoption up to now focuses on four key indicators including performance against benchmark, share price total return, share price movement & NAV and dividends. Performance against benchmark It is commented that multi manager approach helps Witan to wake up so quickly after a long time of recession which can be evidenced by the companys performance from 31/5/2005 to 2010 as demonstrated in the chart below:

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Source: WM Company and Lipper

From the chart, it can be seen that except for slight decrease in April 2006, the MSCI AC index, Witans benchmark, revealed upward trend from 31/5/2005 till second quarter of 2008 when global financial markets crashed leading to unavoidable poor performance. However, positive result has come back since March 2009 with steady increase in economic recovery period. Compared to MSCI AC index, performance of Aberdeen and Nomura in general are quite good. Although both of them underperformed the index in some periods, the gap is not too big. Individually, Nomura even beat both the index and Aberdeen continually from 31/5/2005 till market crash in beginning of 2008. This crash revealed situation of inefficient markets creating condition for mispricing of stock value which is major problem of passive management adopted by Nomura. Also, top down approach which makes Nomura too exposure to Japan market is another

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reason for it recent poor performance. Meanwhile, Aberdeen did not have positive beginning as Nomura. Its performance was just exactly the same or even less than benchmark till end of 2006. However, it has been continuously outperforming the index since then thanks to wise selection of potential stocks from strong and stable companies. Contrast to Nomura, Aberdeen still even beat the index in crisis because its main portion of fund channelled to Asia markets rather than Japan, which were not hit a lot by the storm. Share price total return Despite the fact that Witan in general outperform the index, its performance compared to competitors like JP Morgan or Martine Currie Pacific is still moderate as recognised from the performance chart on next page.

10 year performance JP Morgan, Martin Curries & Witan

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Source: Financial Express Obviously from the chart, performance of Witan is far from the others. JP Morgan without exposure to Japan seems to be the best one with 200% share price total return which currently doubles Witan and one quarter higher than Martin Curries. Martin Curries has the same market with Witan Asia Pacific including Japan but its performance is apparently much better with 150% return currently and big gap with Witan during the period.

Share Price Movement & NAV per share

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Movement of Witans share price and NAV from 2005 to 2010

Witans Discount Movement by half year analysis

Source: citywire.co.uk Another key indicator for the Trusts performance is its share price movement. From the chart, it can be realised that Witans share price steadily increased in 2005 & half year of 2006 before slight decline which can be explained by information about changes in personnel structure and name of the Trust from F.C to Witan having influence on investors confidence. The decline even turned out sharp drop in 2008 when stock markets crashed due to financial storm. From 2009, however, Witans share price is optimistic again to investors with stable

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upwards trend up to now partly thanks to the worlds economic recovery. It is also pointed out from the chart that Witans share price is always lower than its NAV per share which means the market price is at a discount to its values of underlying assets. The gap is quite close for 2005 and half year of 2006 but bigger since then. From the chart of discount/premium movement, it might be seen that discount is quite variable during the period with range from -6 to -14% by half year analysis. To manage the discount appropriately, Witan employs share buy-back policy to enhance NAV per share and support companys share price. A good example is the buy outs of Carousels 5% stake for 65 mil in 2007, which was at 10.2% discount at that time. This buy out, according to Jim Horsburgh, former CEO of Witan, enhanced the NAV of the Trust and that is good news for shareholders. Dividend per share
The following chart demonstrates stable growth in dividends pay-out for Witans shareholders over the period. Although Witans performance went down over crisis as analysed above, its dividend steadily goes up to satisfy investors. This annual growth is due to the companys policy of distributing as much income as may be prudent on an annual basis to shareholders.

Source: Witanpacific.com & jpinvestmenttrust.co.uk

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In compared with JP Morgan which has much better performance as mentioned above, it can be realised that dividend per share of Witan is more stable and even higher than JP Morgan recently, which make Witans shares more attractive in investors choice. While JP retains a lot of its profit for reinvestment, Witan chooses to increase pay-out ratio as one of its strategy to attract investors. In short, Witans performance seems quite good since its adoption of multi manager approach. Despite underperform the index happened sometimes and variation in share price and NAV, the company in general manages its portfolio efficiently with impressive increase in share price total return at low risk and remains satisfactory dividend policy for shareholder at the same time.

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CONCLUSION
From what discussed and analysed above, it might be agreed that Witan is currently on the right way. Its multi manage approach for risk diversification, tactical gearing and attractive dividend pay-out policy appears to be efficient recently. Although some constrains such as risky buy back policy or passive management with high exposure to Japan still remain, investors seems now much more interested in Witan than before with belief in waken up Giant.

BIBLIOGRAPHY
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1. Acharya, Shanta (2002). Asset management: equities demystified. 1st

ed., Chichester, John Wiley & Sons.

2. Clancy, Rebecca (2010). Witan doubles benchmark return. 4th Oct 2010.
[online]. Financial Time Adviser. Last accessed 6th March at http://www.ftadviser.com/InvestmentAdviser/Investments/News/article/2 0101004/983134d4-cbe4-11df-95d8-00144f2af8e8/Witan-doublesbenchmark-return.jsp

3. Cowdell, Jane (2000). Investment. 5th ed., Canterbury, CIB Publishing. 4. Cuthbertson, Keith (2008). Investments. 2nd ed., Chichester, John Wiley &
Sons.

5. Historic reports (2010). JP Morgan Asset Management. [online]. Last

accessed 7thMarch at http://www.jpmorganinvestmenttrusts.co.uk/InvestorInformation/Historic Reports

6. Johnson, Steve (2011). Andrew Bell: outpacing competitors. [online].

Financial Time. Last accessed 6th March at http://www.ft.com/cms/s/0/dba399fe-26c6-11e0-80d700144feab49a.html#axzz1FvqlIZit

7. Lofthouse, Stephen (2001). Investment Management. 2nd ed., West

Sussex, England, John Wiley & Sons.

8. Multi-manager Ways to keep control in the changing market place.

Financial Times. Monday. August 09, 2010.

9. Report & Accounts 2010 Witan Pacific PLC. (2010). [online]. Last
accessed 7th March at: http://www.witanpacific.com/literature

10. Reynard, Cherry (2007). Witan justifies its strategy. [online]. Last
accessed 4th March 2011 at http://www.hemscott.com/companies/investment-trusts/item.do? id=34128

11. Russell, Ray (2006). Introduction to Fund Management. 3rd ed.,

Chichester,Wiley & Sons.

12. Stanyer, Peter (2009). How to understand markets, risk, rewards and
behaviour. 2nd ed., London.

13. Thompson Shepherd Limited. Active or Passive Fund Management.

Investment philosophies (2007).

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14. Witan Share Price. (2011). London South East [online]. Last accessed at
7th March 2011 at http://www.lse.co.uk/shareprice.asp?shareprice=wtan

15. Witan Ordinary Share. (2011). New Model Adviser. [online]. Last
accessed 5th March 20011 at http://citywire.co.uk/new-modeladviser/investment-trusts/investment-trust-factsheet.aspx?FundID=3269

16. White, Garry (2009). Buffet attacks buyback strategy as foolish. The
Telegraph. 3rd May 2009.

REFERENCES
1. Clancy, Rebecca (2010). Witan doubles benchmark return. 4th Oct 2010.
[online]. Financial Time Adviser. Last accessed 6th March at http://www.ftadviser.com/InvestmentAdviser/Investments/News/article/2 0101004/983134d4-cbe4-11df-95d8-00144f2af8e8/Witan-doublesbenchmark-return.jsp

2. Cowdell, Jane (2000). Investment. 5th ed., Canterbury, CIB Publishing. 3. Historic reports (2010). JP Morgan Asset Management. [online]. Last
accessed 7thMarch at http://www.jpmorganinvestmenttrusts.co.uk/InvestorInformation/Historic Reports

4. Johnson, Steve (2011). Andrew Bell: outpacing competitors. [online].

Financial Time. Last accessed 6th March at http://www.ft.com/cms/s/0/dba399fe-26c6-11e0-80d700144feab49a.html#axzz1FvqlIZit

5. Multi-manager Ways to keep control in the changing market place.

Financial Times. Monday. August 09, 2010.

6. Report & Accounts 2010 Witan Pacific PLC. (2010). [online]. Last
accessed 7th March at: http://www.witanpacific.com/literature

7. Reynard, Cherry (2007). Witan justifies its strategy. [online]. Last

accessed 4th March 2011 at http://www.hemscott.com/companies/investment-trusts/item.do? id=34128

8. Russell, Ray (2006). Introduction to Fund Management. 3rd ed.,

Chichester, John Wiley & Sons. P52-53

9. Thompson Shepherd Limited. Active or Passive Fund Management.

Investment philosophies (2007).

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10. Witan Ordinary Share. (2011). New Model Adviser. [online]. Last
accessed 5th March 20011 at http://citywire.co.uk/new-modeladviser/investment-trusts/investment-trust-factsheet.aspx?FundID=3269

11. White, Garry (2009). Buffet attacks buyback strategy as foolish. The
Telegraph. 3rd May 2009.

Appendix 1
Overview of Witan Pacific Trust PLC Witan Pacific is a big British investment trust which is listed in London Stock Exchange. The Trust specialises in investments in Asia Pacific including Japan using MSCI AC Asia Pacific free index 1 as benchmark. It is currently managed by two different managers, Aberdeen and Nomura with two different approaches which help the company to target different customers and reduce risk by diversification. The company has no employees because all of its management over assets and operation is outsourced to third parties. For more information about this investment trust and its recent performance, please refer to tables and chart below: Total returns(%)
29.25% 29.39% 26.43%

Fund / Benchmark
Witan (Ordinary Share) Price Witan (Ordinary Share) NAV FTSE World

Regional weighting
UK 40.0%

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Europe Developed ex-UK North America Region Asia exc Japan Other Countries Cash/Cash Equiv. Japan

19.0% 19.0% 9.0% 7.0% 4.0% 2.0%

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Total Returns on 1000 over

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Source: citywire.co.uk

Appendix 2
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Source: Witan Pacific Annual Report 2010

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