BFF5935 Portfolio Management

BFF5935 Portfolio Management

and Theory
and Theory Prescribed Text: Reilly & Brown, Investment Analysis & Portfolio
Management, (12th Ed.). Cengage Learning

Unit Overview & Topic Schedule & Assessment Summary:

Lecture 1 – Assets & Investments Please refer to the ‘Overview’ on Moodle

Formal Announcements will be posted on Moodle:

Chief Examiner: Dr. Manapon Limkriangkrai, CFA
Queries are to be sent via Monash student email – Please do not use private
email or Moodle message. Also please have ‘BFC5935’ in the email title

[SWUFE]
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Topic Overview Introduction

Readings: Ch1; Ch2; Ch4 What is an investment? Why do we save?
 Tradeoff between current and future consumption
 Investment process  Positive Return is driven by:
 Investment asset classes Time value of money
 Different return measures Inflation [INF]
 Financial Planning: Uncertainty -> RISK [Risk Meme]
 Investor characteristics Who are the potential investors?
 Elements of IPS  Individual investors
 Relationship between return and risk  Institutional investors
Government
Funds
Corporations etc.
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Asset Allocation Asset Allocation

 Asset Allocation: It is the process of deciding how to
distribute an investor’s wealth among different 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
 Institutional
Source: Brailsford et al. ( 2015) Chapter 1 – Figure 1.1
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 Asset Allocation Asset Allocation
 Investor preferences Asset Classes
 Investors differ in terms of risk aversion Growth Assets: Equity & Property
 Holding periods may vary  High risk
 High capital growth
 How are investment assets classified?  Moderate income
 Cash (e.g. bank deposits)
 Fixed Interest (e.g. treasury & corporate bonds) Defensive Assets: Fixed Income & Cash
 Property (direct & indirect)  Low risk to no risk (i.e. risk free)
 Equity (e.g. domestic & international shares)  Steady income

 Different levels of return and risk

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Asset Allocation Asset Allocation

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Source: Vanguard Investments

Asset Allocation Investor Life Cycle

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Source: Vanguard Investments

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Investor Life Cycle Financial Planning
 Life Cycle Phases (Exhibit 2.1) Investor Policy Statement [IPS] is a summary document of
 Accumulation phase: Early to middle years of working a specific investor containing the information related to
objectives, constraints, circumstances
career (Exhibit 2.2)
 Consolidation phase: Past midpoint of careers. Earnings
greater than expenses  Study Current Financial and Economic conditions and
 Spending/Gifting phase: Begins after retirement forecast future trends
 Determine strategies to meet goals
 Life Cycle Investment Goals  Requires monitoring and updating

 Near-term, high-priority goals

 Long-term, high-priority goals
 Lower-priority goals
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Financial Planning Financial Planning

Investor Characteristics Return Objective
Constructing the policy statement begins with a profile  The return objective may be stated in terms of an
analysis of the investor’s current and future financial absolute or a relative percentage return.
situations and a discussion of investment objectives and
 Capital Preservation: Minimize risk of real losses
constraints
 Capital Appreciation: Growth of the portfolio in real
terms to meet future need
Situational Profiling: Stage of Life
 Current Income: Focus is in generating income rather
than capital gains
Psychological Profiling: Personality Typing
 Total Return: Increase portfolio value by capital gains
and by reinvesting current income with moderate risk
exposure
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Financial Planning Financial Planning

Risk Objective Constraints:
Ability to Take Risk (Quantitative Measurement)  Liquidity
Generally depends on an investor’s current net worth and • Vary between investors depending upon age, employment,
income expectations and age. tax status, etc.
•More net worth allows more risk taking • Planned vacation expenses and house down payment are
some of the liquidity needs.
•Younger people can take more risk
 Time Horizon
Willingness to Take Risk (Subjective Assessment) • Influences liquidity needs and risk tolerance.
• Longer investment horizons generally requires less liquidity
A careful analysis of the client’s risk tolerance should and more risk tolerance.
precede any discussion of return objectives. • Two general time horizons are pre-retirement and post-
17 retirement periods. 18

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 Financial Planning Financial Planning
Constraints:  Construct the Portfolio
 Taxes  Allocate available funds to minimize investor’s risks and
• Capital gains or losses: Taxed differently from income meet investment goals
• Realized capital gains: When the asset has been sold at a
profit  Monitor and Update
[MTR]
 Evaluate portfolio performance
 Legal and Regulatory Environment  Monitor investor’s needs and market conditions
 Revise policy statement as needed
 Unique Circumstances  Modify investment strategy accordingly

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Performance Measurement Performance Measurement

The Notion of Required Rate of Return
Holding Period Return (HPR) [in Text] ->
[Note: We will have: HPR = Price Relative and
 The minimum rate of return an investor require on an
HPY = Return in BFC5935]
investment, including the pure rate of interest and all
other risk premiums to compensate the investor for taking HPR [Price Relative] =Ending value / Beginning value
the investment risk. Holding Period Yield (HPY) [Return]
HPY=HPR-1
Example 1: 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 = 220/200 = 1.1
HPY = HPR-1 = 1.1-1 = 0.1=10%
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Performance Measurement Performance Measurement

Performance Measure Across Time
Computing Mean Historical Returns  Aggregating returns across time: n
We now have HPY = ri
Arithmetic Mean Return (AM)
Arithmetic sum = rt   rt
t 1
AM=  ri / n  n 
where  HPY=the sum of all the annual HPYs
Geometric sum = rt   
 t 1
(1  r t )   1

n=number of periods
 Averaging returns across time: n
1
Geometric Mean Return (GM) Arithmetic mean = rt 
n  rt
t 1
GM= [ (1+ ri)] 1/n -1 1
 n n
where  HPR=the product of all the annual HPRs
n=number of periods
Geometric mean = rt  
 t 1
(1  r t )  1


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Performance Measurement Performance Measurement
The geometric return is often preferred to the arithmetic
return as it is more consistent with the actual return Portfolio Returns: weighted average of the returns on
received by the investor. the securities comprising the portfolio.
Example: Assume the following values of an investment;
N
1
 Equal-weighted portfolio return: R 
N

i 1
ri

N
 Vi 
 Value [Dollar]-weighted portfolio return: R     ri
i 1  Vp 

N
 Pi 
Arithmetic AVG Return: (100-50)/2 = 25%  Price-weighted portfolio return: R     ri
i 1  Pp 
Geometric AVG Return: [(1+100%).(1-50%)]1/2-1= 0%
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Performance Measurement Performance Measurement

Asset No. Of Shares Initial Price End Price Value Return % Stock Market Indices
A 200 $6 $6.24 $1,200 4%
B 100 $18 $17.10 $1,800 -5% The major indices on the ASX are:
C 500 $4 $4.40 $2,000 10%
Ex 1.14 [p.24]
• the All Ordinaries index which measures the average
Equal-Weighted Return = (0.04 + (-0.05) + 0.10)/3 = 3% price of the top 500 companies by market capitalisation;

Value-Weighted Return = (1200/5000)(0.04) + (1800/5000)(- • The S&P/ASX20, S&P/ASX50, S&P/ASX100, S&P/ASX200,

0.05) + (2000/5000)(0.1) = 3.16% S&P/ASX300 and S&P/ASX Small Ordinaries.

Price-Weighted Return = (6/28)(0.04) + (18/28)(-0.05) + • For further details:

(4/28)(0.10) = -0.93% http://www.asx.com.au/products/capitalisation-indices.htm
[ASX]

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Performance Measurement [Index] Performance Measurement

Sector breakdown of ASX200

(Sources: www.asx200list.com)
Sources: Standard & Poor’s 29 30

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 Expected Return Expected Return
 Investor would be interested in the expected return on a
future risky investment.
 Risk refers to the uncertainty of the future outcomes of an
investment
n
Computing Expected Rate of Return:  p i ( ri )
i 1
Formally:
E(r) = p1(r1) + p2(r2) + ... + pn(rn)

where P i = Probability for possible return i

R i = Possible return i
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Expected Return Risk

 Risk refers to the uncertainty of an investment; therefore the
measure of risk should reflect the degree of the uncertainty.
 The risk of expected return reflect the degree of uncertainty
that actual return will be different from the expect return.
 The common measures of risk are based on the variance of
rates of return distribution of an investment

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Risk Return Distribution

Variance:
The distribution of returns
 What would a histogram plot of the returns for an
investment look like?
 Symmetric? Are the returns clustered towards the middle?
Extreme returns?
Standard Deviation:   The properties of the returns is known as the return
distribution.

Coefficient of variation: CV   This distribution can be summarised according to 5
E (r )
measures;
[CV] Mean and median, variance, skewness and kurtosis.

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Return Distribution The Normal Distribution
 Completely described by Mean and Standard Deviation
 Mean is the average return.  The distribution is symmetric with no Skewness (= 0) or
no Excess Kurtosis (= 0) (Normal kurtosis = 3)
 Median is the value ranked at the 50th percentile. If K. > 3 (or +ve for Excess K.) then Leptokurtic Dist. &
If K. < 3 (or -ve for Excess K.) then Playtokurtic Dist.
 Variance/Standard Deviation measures how dispersed
the returns are from the average return.

 Skewness is a measure of symmetry.

 Kurtosis measures the relative number of

observations that fall in the extreme ends of tails of
the distribution. 37 [Source: my.ilstu.edu] 38

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