Topic 1 - Investment Background

Defining Investment: A current commitment

of $ for a period of time in order to derive
future payments that will compensate for:
The time the funds are committed
The expected rate of inflation
Uncertainty of future flow of funds

Reason for Investing: By investing (saving

money now instead of spending it),
individuals can tradeoff present consumption
for a larger future consumption.
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Financial Assets
Common Stock
Ownership stake in entity,
residual cash flow

Asset
Class
es
Derivative
Securities

Fixed Income
Securities

Contract, value derived

from underlying
market condition

Money market
instruments,
Bonds, Preferred stock
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Brief Review of Historical Rates of Return

Return over A Holding Period
Holding Period Return (HPR)
Ending Value of Investment

HPR
Beginning Value of Investment

Holding Period Yield (HPY)

HPY=HPR-1
Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n 1
where n=number of years of the investment
3

Historical Rates of Return

Example: Assume that you invest $200 at the beginning of
the year and get back $220 at the end of the year. What
are the HPR and the HPY for your investment?

HPR=Ending value / Beginning value

=$220/200
=1.1
HPY=HPR-1=1.1-1=0.1
=10%
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Historical Rates of Return

Example: Your investment of $250 in Stock A is worth $350
in two years while the investment of $100 in Stock B is
worth $112 in six months. What are the annual HPRs and
the HPYs on these two stocks?

Stock A
Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
Annual HPY=Annual HPR-1=1.1832-1=18.32%

Stock B
Annual HPR=HPR1/n = ($112/$100)1/0.5 =1.2544
Annual HPY=Annual HPR-1=1.2544-1=25.44%
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Historical Rates of Return

Computing Mean Historical Returns
Suppose you have a set of annual rates of
return (HPYs or HPRs) for an investment. How
do you measure the mean annual return?
Arithmetic Mean Return (AM)
AM= HPY / n
where HPY=the sum of all the annual HPYs
n=number of years

Geometric Mean Return (GM)

GM= [ HPR] 1/n -1
where HPR=the product of all the annual HPRs
n=number of years
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Historical Rates of Return

Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows the
annual ending values and HPR and HPY. This example
illustrates the computation of the AM and the GM over a
three-year period for an investment.

Year
1
2
3

Beginning
Ending
Value Value
100
115.0
115
138.0
138
110.4

HPR

HPY

1.15
1.20
0.80
7

0.15
0.20
-0.20

Historical Rates of Return

AM=[(0.15)+(0.20)+(-0.20)] / 3

= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]1/3 1

=(1.104)1/3 -1=1.03353 -1 =3.353%

Comparison of AM and GM
When rates of return are the same for all years, the
AM and the GM will be equal.
When rates of return are not the same for all years,
the AM will always be higher than the GM.
While the AM is best used as an expected value
for an individual year, while the GM is the best
measure of an assets long-term performance.
8

Historical Rates of Return

A Portfolio of Investments
Portfolio HPY: The mean historical rate of return for
a portfolio of investments is measured as the
weighted average of the HPYs for the individual
investments in the portfolio, or the overall change
in the value of the original portfolio.
The weights used in the computation are the
relative beginning market values for each
investment, which is often referred to as dollarweighted or value-weighted mean rate of return.
See Next Slide
9

Computation of HPY for a

Portfolio

10

The Portfolio Management Process

1. Policy Statement
Specifies investment goals and acceptable risk
levels
Should be reviewed periodically
Guides all investment decisions

2. Study Current Financial and Economic

conditions and forecast future trends

Determine strategies to meet goals (asset allocation)
Requires monitoring and updating
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The Portfolio Management Process

3. Construct the Portfolio
Allocate available funds to minimize investors
risks and meet investment goals

4. Monitor and Update

Evaluate portfolio performance
Monitor investors needs and market conditions
Revise policy statement as needed
Modify investment strategy accordingly
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What is Asset Allocation?

Asset Allocation: It is the process of deciding
how to distribute an investors wealth among
different countries and asset classes for
investment purposes.
Asset Class: It refers to the group of securities
that have similar characteristics, attributes, and
risk/return relationships.
Investor: Depending on the type of investors,
investment objectives and constraints vary
Individual investors
Institutional investors
13

The Investment Process: Asset Allocation

Asset Allocation
Primary determinant of a portfolio's return
Percentage of fund in asset classes, for example:

10%
30%

60%

Equit
y
Bond
s
Bills

25% 25%

50%

Top Down Investment Strategies starts with Asset Allocation. Top-down investing is an
investment approach that involves looking at the "big picture" in the economy and financial
world and then breaking those components down into finer details. After looking at the big
picture conditions around the world, the different industrial sectors are analyzed in order to
select those that are forecasted to outperform the market. From this point, the stocks of
specific companies are further analyzed and those that are believed to be successful are
chosen as investments.
14

Financial Markets and the Economy

Risk Allocation
Investors can choose desired risk level
Bond vs. stock of company
Bank CD vs. company bond
Is there always a Risk/Expected Return

trade-off?

15

Markets Are Competitive

Risk-Return Trade-Off
Assets with higher expected returns have higher
risk
Stocks

Average Annual Return

Minimum (1931)

Maximum (1933)

About 12%

46%

55%

Stock portfolio loses money 1 of 4 years on

average
Bonds
Have lower average rates of return (under 6%)
Have not lost more than 13% of their value in any one

year
16

Markets Are Competitive

Markets are
Security
Selection:
Asset Allocation

Active
Management

Passive
Management

Inefficient

Efficient

Actively Seeking
Undervalued
Stocks

No Attempt to
Find
Undervalued
Securities

Market Timing

No Attempt to
Time Market
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18

19

The Importance of Asset Allocation Reviewed

An investment strategy is based on four decisions

What asset classes to consider for investment
What policy weights to assign to each eligible class
What allocation ranges are allowed based on policy
weights
What specific securities to purchase for the portfolio

According to research studies, most (90%) of the

overall investment return is due to the first two
decisions, not the selection of individual
investments.
20

The Asset Management Industry: Structure and

Evolution

Two Organization Forms

Contract directly with a management and advisory
firm
Commingling of investment capital of several
clients in an investment company

Differences between These Two Forms

Private management and advisory firms develop a
personal relationship with clients
A Investment company offers a general solution

See Example Next Slide

21

Operating Structure of Asset

Management Companies

22

Types of Investment Companies: Open vs. Closed

Open-End Funds

Closed-End Funds

Shares
Outstanding

Change when new

shares are sold or old
shares are redeemed

No change unless new

stock is offered

Pricing

Fund Share Price =

Net Asset Value (NAV)

Fund Share Price may

trade at a premium or
discount to NAV

Closed-End Versus Open-End Investment

Companies

Closed-End Investment Company

Functions like any other public firm and its stock
trades on the regular secondary market
The fund generally doesnt issue or redeem
shares once it is established
The price of the fund is different from its NAV
It is a puzzle for modern finance why close-end
funds often sell at a discount from NAV
It is often a means of investing in a pool of
assets from a foreign country
24

Closed-End Versus Open-End Investment

Companies

Open-End Investment Companies

The company continues to sell and repurchase
shares after their initial public offerings (IPOs)
The fund stands ready to issue or redeem
shares at the net asset value (NAV)
Investors who buy or sell the shares may have
to pay sales charges (the load)
These funds are normally called mutual funds

25

Closed-End Versus Open-End Investment

Companies

Load versus No-Load Open-End Fund

The offering price for a share of a load fund
equals the NAV of the share plus a sale charge.
A no-load fund imposes no initial sales charge
so it sells shares at the NAV.
Several variations exist between the full-load
fund and the pure no-load fund
Low-load fund
Funds have contingent, deferred sales loads
26

Closed-End Versus Open-End Investment

Companies
Fund Management Fees
Charge annual management fees to compensate professional
managers of the fund
The fee typically is a percentage of the average net assets of
the fund varying from about 0.25 to 1.00 percent
Management fees are a major factor driving the creation of
new funds
Mutual fund fees have been declining due to the industry
consolidation

Soft dollars: Value of research services

brokerage house provides free of
charge in exchange for business
27

Closed-End Versus Open-End Investment

Companies
Global Investment Companies
Funds that invest in non-U.S. securities are generally
called either international funds or global funds
International funds often hold only non-U.S. stocks
from such countries as Germany, Japan, Singapore,
and Korea
Global funds contain both U.S. and non-U.S.
securities
A increasing large number of non-U.S. investment
companies that offer both domestic and global
products in their local markets
28

Valuating Investment Company Shares

The NAV for an investment company is
analogous to the share price of a
corporations common stock.
The NAV of the fund shares will increase as
the value of the underlying assets (the fund
security portfolio) increases
Total Market Value of Fund Portfolio Fund Expenses
Fund NAV/share=
Total Fund Shares Outstanding

29

Costs on Investment Performance: Example

Fund A is no-load with .5% expense ratio, Fund B is no-load with 1.5% total expense
ratio, and Fund C has an 8% load on purchases and a 1% expense ratio. Gross return
on all funds is 12% per year before expenses.

Fees and Mutual Fund Returns

* After front-end load, if any.

Investing in Alternative Asset Classes

Basic Concepts
Alternative Assets
Hedge funds
Private equity

Management Structure
Structured as a limited partnership rather than as a
mutual fund to manage the commingled assets

The Fund alpha (See Example Next Slide)

Excess returns generated by the fund, implying the
superior performance by the fund management

31

SML for Traditional and Alternative Asset

Classes

32

Hedge Funds
The Characteristics
As a private partnership, hedge funds are generally
less restricted in how and where they can make
investments
Less correlated with traditional asset class
investments, providing diversification benefits
Hedge fund investments are far less liquid than
mutual fund (or even closed-end fund) shares
There are severe limitations on when and how often
investment capital can be contributed to or removed
from a partnership
Performance allocation and high-watermark
See Example Next Slide
33

Characteristics of Hedge Fund

Investments

34

Private Equity
Basic Concepts
Refers to any ownership interest in an asset (or
assets) that is not tradable in a public market
Typically fund either new companies or established firms
that are seeking to change their organizational structure or
are experiencing financial distress
Generally far less liquid than public stock holdings and are
therefore considered to be long-term positions within an
investors overall portfolio

Characteristics
Higher return and low liquidity
Good sources of diversification

See Example Next Slide

35

Asset Class Return, Risk and

Correlation Statistics

36

Private Equity
Returns to Private Equity Funds
Private equity commitments should be viewed
as long-term, highly illiquid investments
The return pattern known as the J-curve
effect
Average annual returns for these investments tend
to be quite high over time
The initial years of a new private equity
commitment usually produce negative returns
37

Ethics and Regulation in the Professional Asset

Management Industry

Agency Problem
Regulation in the Asset Management Industry
Principal securities laws that govern investment
companies
The Securities Act of 1933
The Securities Exchange Act of 1934
The Investment Company Act of 1940
The Investment Advisers Act of 1940
The Employee Retirement Income Security Act of 1974
The Pension Protection Act of 2006
The Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010

38

Ethics and Regulation in the Professional Asset

Management Industry
Regulatory agencies
The U.S. Securities and Exchange Commission
(SEC) is the main federal agency responsible for
regulating professional asset management
activities in the United States
U.S. Department of Labor: For protection of pension
plans, including 401(k) plans
The Financial Industry Regulatory Authority (FINRA): the
largest independent regulator for all securities firms
U.S. Commodity and Futures Trading Commission:

monitors futures and commodities trading activities

U.S. Internal Revenue Service: setting and enforcing of
tax policies
39

Ethics and Regulation in the Professional Asset

Management Industry

Standards for Ethical Behavior

The CFA Institute Code of Ethics
The CFA Institute Standards of Professional
Conduct
The CFA Institute Centre for Financial Market
Integrity
Asset Manager Code of Professional Conduct

Examples of Ethical Conflicts

Incentive Compensation Schemes
Soft Dollar Arrangements
Marketing Investment Management
40