Outcomes
3/11/2011
Learning Describe the key asset classes and their
investment characteristics
Wealth Management Week 3
Asset Classes and Asset Allocation
Explain the role of managed funds and
derivatives for asset allocation
Explain the concept and purpose of
investment policy statement
Suggest and justify asset allocation a given set
of investment objectives and constraints.
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Key Asset Classes
Discuss the theory, evidence and implication
of time horizon and equity investment risk
Explain different types of asset allocation
strategies
Discuss the implication of market efficiencies
for market timing and asset allocation
Shares
Fixed income securities
Derivatives
Real estate
Commodities
Managed funds
Derivatives
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Shares (Listed)
Shares are equity investments that represent
ownership in a corporation
Each share represents a fractional ownership
in the firm
Listed shares offers growth and liquidity
Next to short-term vehicles and home
ownership, shares are the most popular form
of investment vehicle for individual investors
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Shares Unlisted (Private Equity)
Private equity is shares in unlisted companies.
The private equity market is relatively
Informationally inefficient
Illiquid and chunky
Private equity is appropriate for high net worth
investors or indirectly invested via private equity
funds.
Main purpose of this asset class is growth and
diversification.
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Fixed Income Securities
Fixed-Income Securities are a group of
investment products that offer a fixed
periodic return.
bonds
preference shares
convertible securities
Some forms offer contractually guaranteed
returns while others have specified, but not
guaranteed, returns.
Bonds
Bonds are the long-term debt instruments of
corporations and governments
A bondholder has a contractual right to
receive a fixed interest return (known as the
coupon rate) plus the return of the bonds
face value at maturity
Long-term debt instruments issued by
corporations can be classified as
debentures or unsecured notes
There could be large losses if defaulted
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Preference Shares
Like shares, preference shares represent
an ownership interest in a corporation
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Purpose of Fixed Income Allocation
Liability/liquidity/investment constraint
management
Generate income
Unlike shares, preference shares have a
stated dividend rate
Investors typically purchase them for the
dividends they pay, but preference shares
may also provide capital gains
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Property
Residential property accounts for 60% of
household assets.
Property includes residential homes, vacant
land, and a variety of income property,
including warehouses, and office and
apartment buildings
Property investment may have desirable tax
characteristics to some investors
Maturity matching
Less uncertainty of nominal returns over
specific investment horizon compare to
growth assets such as shares and property
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Commodities and Collectables
These assets includes old and other precious
metals, gemstones such as diamonds and
sapphires, and collectibles such as coins,
stamps, artworks, antiques and even wine
These asset classes are for diversification
and typically should not exceed 10% of a well
diversified portfolio.
The main purpose of investing is occupancy,
income and growth.
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Annual Returns Across Assets
http://www.vanguard.com
.au/vnl/calculators/assetcl
ass/AssetClassTool.html
Accessing Asset Classes: Managed Funds
An institution that raises money from fund
investors and invests in and professionally
manages a diversified portfolio of securities
and/or real property is called a managed
fund
Investors in the fund own an interest in the
funds portfolio
The fund manager invests the money to yield
returns in income and/or capital gain
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Accessing and Hedging: Derivatives
Managed funds include unit trusts, cash
trusts, allocated pensions and annuities, and
superannuation funds.
Investors can access some asset classes
only via managed funds, e.g. commercial
properties and commodities.
Derivative securities derive their value from
the value of an underlying security or asset.
They possess high levels of risk because of
leverage and their payoff as a percentage of
capital required is more sensitive to the
underlying asset than holding the underlying
directly.
Derivatives are potentially very useful for tax
management.
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Options
Options are securities which give the
investor an opportunity to buy or sell another
security (the underlying asset) at a
specified price (the exercise price) by a
given date (the expiration date, exercise
date, or maturity)
If you can do this at any time up until the
expiration date, the options are called
American options
If you can do this only on the expiration date,
they are called European options
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There are two basic types of options - puts and
calls
put options give the purchaser the right but
not the obligation to sell the underlying
security; whereas
call options give the purchaser the right but
not the obligation to buy the underlying.
Put and call equity warrants are issued by
banks and other approved institutions, and
traded on the ASX. These warrants in most
respects can be treated like ordinary options.
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Futures
On the SFE you can trade
Shares futures (NAB, Telstra, etc)
Futures are legally binding obligations
stipulating that the sellers of such contracts
will make delivery and the buyers of the
contracts will take delivery of a specified
commodity or financial instrument at some
specific date in the future at a price agreed
on at the time the contract is sold
1000 shares per contract
Initial margin from $180-$4300
Share index futures (S&P/ASX 50,
S&P/ASX200)
Valued at A$25 per index point
$8000 initial margin
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Contract For Difference
The contract for difference (CFD) is a retail,
over-the-counter financial product for accessing
major shares, industry sector indices and
broader share indices.
Market prices are used because interest is paid
on the underlying exposure value.
The CFD is similar to a futures contract in that
the profit or loss is determined by the difference
between the share price at which the position
was opened and the share price at which it is
closed.
CFDs are particularly useful for creating short
position in stocks.
This is different from margin lending where you
borrow the initial principal amount.
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CFD market makers and competitors
www.cmcmarkets.com.au
www.igmarkets.com.au
Investment Objectives and
Asset Allocation
http://www.comsec.com.au/Public/InvestIn/Over
TheCounterCFDs.aspx
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Investment Objective
Clients Investment objective includes
Return expectation
Constraints
Income requirements
Time horizon/liquidity
Taxation considerations
Risk Profile Assessment
Practitioners use questionnaires to establish
risk tolerance or risk profiles.
There are some limitations of questionnaire
based risk profiling.
relatively
Many risk profile instruments map a clients
profile to specific asset allocation.
Risk tolerance
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Investment Time Horizon
Investment time horizon is determined by the
endpoint of their investment process where the
investor will start to withdraw their funds.
Returns should be calculated for the time
horizon relevant for the investor.
Note: this is U.S. result Campbell.
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Investment from Policy Statement
Serves as a plan that guides the investor and
the planner in long-term financial and
investment decision
Identifies the goals of the portfolio
Current Income
Capital Growth
Total Return
Preservation of capital
Identifies asset allocation and performance
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Asset Allocation and Investment Returns
4 sources of investment returns
Asset allocation (active and passive)
Market timing (active)
Industry timing (active)
Stock picking (active)
Asset allocation is arguably more important than
stock picking in a diversified (in more than one
asset class) portfolio.
Asset allocation is also heavily dependent on
your investment objectives and constraints.
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For Each Risk Profile
There is a Strategic (fixed) Asset Allocation
Asset Allocation and Risk Tolerance
It is common to classify investors into 6 profiles
and with an increasing strategic asset
allocation to growth (hence riskier) assets
Defensive investors
Conservative investors
Lets look at a balanced investor.
The investor is looking for some growth, can
tolerate moderate volatility and seeks some
income, and with an investment time horizon
of approximately five years.
Shares
Property
Fixed interest
Cash
Moderately conservative investors
Balanced investors
Assertive investors
Aggressive investors
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4060%
515%
1530%
520%
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Question:
If you are an aggressive (risk adverse)
investor, should you hold any fixed
income securities (stocks)?
Hint: Look at the graph in the last
slide!
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Select an Asset Allocation
Portfolio Rebalancing and Strategic AA
Asset allocation refers to how you spread your
portfolio across different asset classes.
Asset allocation automatically changes as the
value of assets changes.
E.g.
Australianshares
Internationalshares
Australianfixedinterest
Internationalfixed
interest
Property
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Start 6mthlater
30%
36%
22%
26%
25%
18%
15%
8%
11%
9%
If risk attitude and market prices are efficient, then the
new allocation might no longer be optimal.
Rebalancing restore the target allocation.
Strategic Asset Allocation (SAA)
Rebalancing also lead to buy low sell high!
The long run returns of multi-asset class portfolios
have been shown, on average, to be superior to that
of a single asset class portfolio.
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Other Dynamic Asset Allocation Strategies
Tactical Asset Allocation
An active strategy of bounded market timing
This is often related to economic and market
cycles
Sector Rotation
Some Stock Classification for Sector
Rotation
Growth shares are issued by companies expected to
have above average rates of growth in operations
and earnings.
Usually pay low or no dividends.
Typically experience more price volatility.
Relatively high sensitivity to interest rates.
Value shares have
An active strategy of industry timing over
economic and market cycles
a higher payout ratio and dividend yield;
Somewhere between asset allocation and stock
picking
relatively low sensitivity to interest rates;
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BlueChips are issued by large, well established
companies.
Usually pay dividends and have stable prices
relatively to other shares.
Returns are considered more dependable and less
risky.
Tech shares are issued by companies in the
technology sector.
Most are either growth or speculative shares.
a relatively low beta
a low price-earnings ratio
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Income shares are issued by companies which
have a fairly stable stream of earnings.
Pay relatively high dividends.
Attractive to people who seek current income.
Speculative shares are issued by companies
which are considered to have higher risk.
The company, its products, or the industry may be
new or unproven.
Stock prices may be highly volatile.
Some are bluechip shares.
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Efficient market hypothesis
Cyclical shares are issued by companies whose
stock prices move in same direction as the business
cycle.
Most are found in basic industries.
Always have a positive beta.
Defensive shares are issued by companies whose
stock prices usually remain stable during economic
downturns.
Companies usually provide basic needs, such as consumer
goods.
Betas are usually low or even negative.
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An information efficient market is one in which all
available information is embodied in market
prices.
A market is weak form efficient if prices reflect all the
information in the past history of share prices. Then
share prices show no discernible patterns.
A market is semi-strong form efficient if prices reflect
all publicly available information.
A market is strong form efficient if prices reflect all
public and private information.
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How a market becomes efficient?
Critical Thinking
Can a market be information efficient all the
time?
Does an efficient market implies that every high
risk securities will pay a high future return?
Does the efficient market hypothesis requires
the reward for bearing risk is constant over time?
How would you invest in an information efficient
market?
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How do I keep track of the market?
Look at the major indices:
Share price
No. of shares
Share
$
outstanding
A
20.0
50,000
B
30.0
100,000
C
40.0
150,000
Base period market value
the All Ordinaries index which measures the
average price of the top 500 companies by market
capitalisation;
The S&P/ASX20, S&P/ASX50, S&P/ASX100,
S&P/ASX200 and S&P/ASX300;
We take the base period value to be 100.That is, we divide by $0.1m.
Share price No. of shares
Share
$
outstanding
22.0
A
50,000
B
34.5
100,000
C
43.0
150,000
Current period market value
the S&P/ASX Small Ordinaries which shows the
average price of shares in the S&P/ASX300 but not
the S&P/ASX200.
Most indices are company capitalisation weighted
averages prices, except Dow Jones and Nikkei
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Market value ($m)
1.0
3.0
6.0
10.0
Market value ($m)
1.1
3.45
6.45
11.0
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Warning to Market Timers
Index in current period = 11.0 = 110
0.1
i.e. Share prices have risen by an average of
10% between the base period and the current
period.
An accumulation index shows how the value of
an average share investment changes over
time. It includes dividends as well as changes in
share prices.
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1.1*0.9=0.99
The average annual return on the Australian
share market 1979 2006
11.5% if invested whole time
9%
if you missed 10 best days
7.5%
if you missed 20 best days
6.5%
if you missed 30 best days
5.5%
if you missed 40 best days
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Critical Thinking
What arguments would you present for the
case of market timing?
Paul Clitheroes
Ten Keys to Successful Investing
1. Invest in something you understand
2. Consider mainstream assets first
3. Understand that risk equals return
4. Look for an investment that stands on its own merit
5. Diversify
6. Dont try to time the market
7. Use dollar cost averaging
8. Invest in growth assets for the long term
9. Take advice if necessary
10. Take action!
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So when should I buy and sell?
Paul has the following to simple advice:
Start with blue chips.
When is the right time to buy? When you have money.
Dollar cost averaging
Buy regularly to spread the cost
If you dont need the money, dont sell.
Dont try to time the market. You need to be right at
least 67% of the time to make money.
This one is from the creator of CAPM Sharpe in 1972
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