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Portfolio Management 101

There are four general steps in portfolio management (investment) process:

1. Write a Investment Policy Statement
2. Develop an investment strategy
3. Implement the plan by constructing the portfolio and allocating the assets
4. Monitor, update, and rebalance the portfolio

An Investment Policy Statement provides investment discipline by requiring investors to articulate their needs, goals, and risk tolerance, ensuring that goals are realistic, and providing an objective measure of portfolio performance.

Investment objectives should be expressed in terms of both risk and return so that meeting the return objective does not expose the investor to more risk than he is prepared to tolerate.

Risk tolerance depends on an investor’s psychological profile and other personal factors, including family situation, wealth, income, age, and insurance coverage.

Common return objectives are:

• Capital Preservation – minimizing the risk of loss in real term.
• Capital Appreciation – managing real growth in the portfolio to meet some future need.
• Income – meeting specified spending needs.
• Total Return – growing a portfolio through capital appreciation and reinvested income.

Investment constraints include:

• Liquidity – for cash spending needs (anticipated and unexpected)
• Time Horizon – when funds will be needed
• Tax – the tax treatments of various accounts, and the investor’s marginal tax bracket
• Legal – restrictions on investments in retirement, personal, and trust accounts
• Unique Needs – constraints because of investor preferences or other factors not already considered

Target allocations to different asset classes can explain approximately 90% of the differences in portfolio returns over time.

Differences in average asset allocations across countries exist due to differences in 1) social factor, 2) demographic, 3) legal constraint, 4) tax laws, and 5) historical inflation rates.

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Tags: Portfolio Management

Alternative Investment 101

Charateristics

Charateristics that generally apply include:

• Lower liquidity than traditional investments
• Accurate market values difficult to determine
• Limited historical performance data

Exchange Traded Funds (ETF)

Special type of fund that invests in a portfolio of stocks or bonds designed to mimic performance of a specified index

Advantage of ETFs

• Efficient method of diversification
• Trade similar to traditional equity investments
• Some ETFs patterned after indexes with active future/ option market and better risk management
• Exact composition is known at all time
• Typically, very efficient operating expense ratio; no load to purchase or redeem shares
• Decreased capital gains tax liability

Disadvantage of ETFs

• Some countries have fewer indexes than U.S. for ETFs to track (results in mid- or low-cap stocks no being well represented)
• Ability to trade intraday may not be significant to investors with longer time horizon
• ETFs with low trading volume may have large bid-ask spreads
• Larger investors may choose to directly invest in an index portfolio, resulting in lower expenses/ lower tax consequences

Valuation of Real Estate Investments

• Valuation method: cost method, sales comparison method, and income method.
• Income method uses a discounted cash flow model similar to that for a perpetuity:

Value = NOI/ Market cap rate

• Net operating income (NOI) equals gross operating income less estimated vacancy, collections, and other operating expenses, (including property taxes, but excluding income taxes). NOI does not include depreciation of financing costs.

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Tags: Alternative Investment, ETF, Real Estate

Hedge Fund Basics

Definition

A Hedge Fund is an investment vehicle that aims to produce the maximum return irrespective of market conditions, normally utilising hedging techniques to eliminated specific risks

Legal Structure

Hedge funds may take several legal forms, including limited partnership and limited companies.

Fee Structures

Fees normally come in two parts:

• Base Fee: A standard asset management charge irrespective of outcome
• Incentive Fee: Additional fee based on performance

Types of Hedge Funds

• Long/Short Funds: Take speculative position on direction market will move in and use leverage to increase gains
• Market Neutral Funds: Aim to offset systemic risk and profit from picking underperforming/ overperforming assets
• Global Macro Funds: Take speculative positions on currency, interest rate and global securities
• Event-driven Funds: Use the principles of traditional hedge funds to take advantage of other mis-priced assets (e.g. merger speculation, bond rating upgrade/ downgrade)
• Fund of Funds: A portfolio of hedge fund investments may be put together to gain the same diversification benefits of traditional portfolio investment.

Fund of Funds Advantages & Disadvantages

Advantages:

• Allow investor with small capital access to this vehicle
• Provides risk diversification
• Avoids exclusion of funds that limit no. of investor
• Uses experts to select funds to invest in

Disadvantages:

• Fees – fund manager and fund-of-funds manager!
• Lack of transparency of what investor invests in

Hedge Fund – Risk

• Illiquidity of assets reduce flexibility
• Potential for mispricing. Investments in esoteric, infrequently traded securities may lead to difficulty determining true value, and causing large margin requirement
• Counterparty credit risk on non-marketable assets
• Settlement errors. Risk of counterparty failure to deliver security as agreed on settlement day.
• Short covering. Risk that managers who short sell as a strategy will have to cover their shorts and repurchase securities at price higher than where they originally sold.
• Margin calls. Can result in forced selling of assets, possibly at a loss, on an already highly leverage position.

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Tags: Hedge fund