Understanding Investments

Objectives
To understand the investments field as currently practiced To help you make investment decisions that will enhance your economic welfare To create realistic expectations about the outcome of investment decisions

Investments Defined

Investments is the study of the process of committing funds to one or more assets

Emphasis on holding financial assets and marketable securities Concepts also apply to real assets Foreign financial assets should not be ignored
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Investments & Financial Assets

Essential nature of investment

Reduced current consumption Planned later consumption

Real Assets
Assets used to produce goods and services (including land, buildings, machinery, and knowledge used to produce goods & services

Financial Assets
Claims on real assets or income generated from them (including stocks & bonds)

Why Study Investments?

Most individuals make investment decisions sometime

Need sound framework for managing and increasing wealth Security analyst, portfolio manager, registered representative, Certified Financial Planner, Chartered Financial Analyst
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Essential part of a career in the field

Investment Decisions

Underlying investment decisions: the tradeoff between expected return and risk

Expected return is not usually the same as realized return

Risk: the possibility that the realized return will be different than the expected return
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The Tradeoff b/w ER and Risk

Investors manage risk at a cost lower expected returns (ER) Any level of expected return and risk can be attained

Stocks

ER

Bonds

Risk-free Rate
Risk
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The Investment Decision Process

Two-step process:

Security analysis and valuation

Necessary to understand security characteristics Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured?
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Portfolio management

Factors Affecting the Process

Uncertainty in ex post returns dominates decision process

Future unknown and must be estimated

Foreign financial assets: opportunity to enhance return or reduce risk Institutional investors important How efficient are financial markets in processing new information?

Individual Investor Life Cycle

The individual investors life cycle can often be described using four separate phases or stages: Accumulation Phase Consolidation Phase Spending Phase Gifting Phase

Accumulation Phase

Early to middle years of careers Attempting to satisfy intermediate and longterm goals Net worth is usually small, debt may be heavy Long-term investment horizon means usually willing to take moderately high risks in order to make above-average returns

Consolidation Phase
Past career midpoint Have paid off much of their accumulated debt Earnings now exceed living expenses, so the balance can be invested Time horizon is still long-term, so moderately high risk investments are still attractive

Spending Phase
Usually begins at retirement Saving before, prudent spending now Living expenses covered by Social Security and retirement plans Changing emphasis toward preservation of capital, but still want investment values to keep pace with inflation

Gifting Phase
Can be concurrent with spending phase If resources allow, individuals can now use excess assets to provide gifts to other individuals or organizations Estate planning becomes important, especially tax considerations

The Portfolio Management Process

A four step process: 1. Construct a policy statement 2. Study current financial conditions and forecast future trends 3. Construct a portfolio 4. Monitor needs and conditions

The Portfolio Management Process

1. Policy statement
Specifies investment goals and acceptable risk levels The road map that guides all investment decisions

The Portfolio Management Process

2. Study current financial and economic conditions and forecast future trends
Determine strategies that should meet goals within the expected environment Requires monitoring and updates since financial markets are ever-changing

The Portfolio Management Process

3. Construct the portfolio
Given the policy statement and the expected conditions, go about investing Allocate available funds to meet goals while managing risk

The Portfolio Management Process

4. Monitor and update
Revise policy statement as needed Monitor changing financial and economic conditions Evaluate portfolio performance Modify portfolio investments accordingly

The Policy Statement

Understand and articulate realistic goals

Know yourself Know the risks and potential rewards from investments

Learn about standards for evaluating portfolio performance

Know how to judge average performance Adjust for risk

The Policy Statement

Dont try to navigate without a map! Important Inputs:

Investment Objectives Investment Constraints

Investment Objectives
Need to specify return and risk objectives
Need to consider the risk tolerance of the investor Return goals need to be consistent with risk tolerance

Investment Objectives
Possible broad goals: Capital preservation
Maintain purchasing power Minimize the risk of loss

Capital appreciation
Achieve portfolio growth through capital gains Accept greater risk

Investment Objectives

Current income
Look to generate income rather than capital gains May be preferred in spending phase Relatively low risk

Total return
Combining income returns and reinvestment with capital gains Moderate risk

Investment Constraints
These factors may limit or at least impact the investment choices: Liquidity needs
How soon will the money be needed?

Time horizon
How able is the investor to ride out several bad years?

Legal and Regulatory Factors

Legal restrictions often constrain decisions Retirement regulations

Investment Constraints

Tax Concerns
Realized capital gains vs. Ordinary income? Taxable vs. Tax-exempt bonds? Regular IRA vs. Roth IRA? 401(k) and 403(b) plans

Unique needs and preferences

Perhaps the investor wishes to avoid types of investments for ethical reasons

Investment Education

The type of information necessary to construct a good policy statement is neither common sense or common knowledge. Many investors fail to diversify. Many fail to plan completely. Data indicates that many Americans have greatly under-invested for the future. The bottom line: If you do not plan for the future, you will likely not be prepared for it.

Asset Allocation Decisions

Four decisions in an investment strategy: What asset classes should be considered? What should be the normal weight for each asset class? What are the allowable ranges for the weights? What specific securities should be purchased?

The Importance of Asset Allocation

The asset allocation decision (which classes and at what weights) is very important. Using fund data:
About 90% of return variability over time can be explained by asset allocation. About 40% of the differences between returns can be explained by differences in asset allocation.

Asset allocation is thus the major factor that drives portfolio risk and return.

Risk/Return History and Asset Allocation

Looking at return data on various asset classes indicate some important factors for investors: Even apparent low-risk investments like Tbills can have considerable reinvestment risk Over long time horizons, stocks have always outperformed low-risk investments.
So the additional risk over shorter time horizons seems to all but disappear over time.

The only way to maintain purchasing power, net of taxes and inflation, is by investing in common stock.

Asset Allocation and Cultural Differences

Differences in social, political, and tax environments influence asset allocation. For instance, 58% of pension fund assets are invested in equities in the U.S.
79% in equities in United Kingdom, where high average inflation impacts this choice 8% in equities in Germany, where generous government pensions and greater risk aversion seem to play a strong role

Active vs. Passive Management

Active Management Finding undervalued securities Market timing Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

Major Classes of Financial Assets or Securities

Debt
Money market instruments Bonds

Common stock Preferred stock Derivative securities

Investments and Innovation

Technology and Delivery of Service Computer advancements More complete and timely information Globalization Domestic firms compete in global markets Performance in regions depends on other regions Causes additional elements of risk

Key Trends - Securitization

Securitization & Credit Enhancement Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities Credit enhancement and its role

Key Trends Financial Engineering

Repackaging Services of Financial Intermediaries Bundling and unbundling of cash flows Slicing and dicing of cash flows Examples: strips, CMOs, dual purpose funds, principal/interest splits

The Future

Globalization continues and offers more opportunities Securitization continues to develop Continued development of derivatives and exotics Strong fundamental foundation is critical Integration of investments & corporate finance

Direct Investment

Non-marketable Financial Assets

Commonly owned by individuals Represent direct exchange of claims between issuer and investor Usually very liquid or easy to convert to cash without loss of value Examples: Savings accounts, Saving Bonds, CoDs, money market deposit accounts (MMDAs)

Money Market Securities

Marketable: claims are negotiable or salable in the marketplace Short-term, liquid, relatively low risk debt instruments Issued by governments and private firms Examples: T-Bills, Negotiable CoDs, Commercial paper, EuroDollars, 3 REPOS, BA

Money Market Instruments

Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds

T-bills

Sold at a discount (no interest coupon), denominations of $10,000 91 and 182 day maturity T-bills issued weekly; 52 week bills issued monthly; sales by auction Competitive bids are orders for a given quantity of bills at a specific offered price. Order is filled if bid is high enough. Noncompetitive bids receive average price of successful bids. Income earned is taxed at Federal but not state or local levels

Money Market Instrument Yields

Yields on Money Market Instruments are not always directly comparable Factors influencing yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Bond equivalent yield

T-bills (contd.)
Consider: $10,000 par value T-bill, purchased for $9,600, matures in 6 months. What is the effective annual interest rate? Answer: 400/9600 = .0417 semiannually Thus APR = (1.0417)x(1.0417)=8.51%

T-bills (contd.)

Bank discount method is quoted in financial pages: T-bills discount from par of $400 is annualized based on 360 day year. Thus $400 discount is annualized as $400x(360/182)=$791.21, then divide this no. by $10,000 to get bank discount yield of 7.912%

Bank Discount Rate (T-Bills)

10,000 - P 360 r BD = x n 10,000 rBD = bank discount rate P n = market price of the T-bill = number of days to maturity

Example 90-day T-bill, P = $9,875 10,000 - 9,875 360 r BD = = 5% x 10,000 90

Bank Discount Rate (contd.)

3 problems with this method:

Formula uses 360-day year Annualization uses simple rather than compounding interest Denominator in first term is par value rather than purchase price

Bond Equivalent Yield

Cant compare T-bill directly to bond

360 vs 365 days Return is figured on par vs. price paid

Adjust the bank discounted rate to make it comparable

Bond Equivalent Yield

r BEY
P = price of the T-bill
n = number of days to maturity

10,000 = P

-P

365 x n

Example Using Sample T-Bill 10,000 - 9,875 365 r BEY = x 9,875 90 rBEY = .0127 x 4.0556 = .0513 = 5.13%

Capital Market Securities

Marketable debt with maturity greater than one year and ownership shares More risky than money market securities Fixed-income securities have a specified payment schedule

Dates and amount of interest and principal payments known in advance

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Capital Market Securities

Major bond types:

Federal government securities - T-bonds Federal agency securities - GNMAs Federally sponsored credit agency securities - FNMAs, SLMAs Municipal securities - General obligation bonds, Revenue bonds, serial bonds

Tax implications for investors

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Capital Market Securities

Major bond types (continued):

Corporate bonds

Usually unsecured debt maturing in 20-40 years, paying semi-annual interest, callable, with par value of $1,000 Convertible bonds may be exchanged for another asset Risk that issuer may default on payments

Securitized assets: Mortgage-backed

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Equity Securities
Represents an ownership interest Preferred stockholders paid after debt but before common stockholders

Dividend known, fixed in advance May be cumulative if dividend omitted

Common stockholders are residual claimants on income and assets

Voting rights important

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Derivative Securities
Securities whose value is derived from another security Futures and options contracts are standardized and performance is guaranteed by a third party

Risk management tools

Warrants are options issued by firms

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Options
Exchange-traded options are created by investors, not corporations Call (Put): Buyer has the right but not the obligation to purchase (sell) a fixed quantity from (to) the seller at a fixed price before a certain date

Right is sold in the market at a price

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Increases return possibilities

Futures

Futures contract: A standardized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed price

A good faith deposit, called margin, is required of both the buyer and seller to reduce default risk Used to hedge the risk of price changes
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Indirect Investing

Investment Company
A financial company that sells shares in

itself to the public and uses these funds to

invest in a portfolio of securities.

Types of Investment Companies

Unit Investment Trust Mutual Funds

Mutual Funds

Mutual Funds are operated by Asset Management Companies (AMC) which exist in the form of a corporation, owned by its shareholders. The AMC launches new funds through the establishment of a Trust Deed, entered between the Asset Management Company and the Trustee, which in most cases is the Central Depository Company of Pakistan Limited, with due approval from the SECP under the Non-Banking Finance Companies (Establishment and Regulation) Rules, 2003 (the Rules). The CDC performs the functions of the custodian and trustee, whereas the AMC can act as the registrar or can appoint an external registrar. Banking/ financial companies maybe authorized to act as distributors/ sales agents. The Board of Directors must also approve and appoint a legal advisor and auditor for legal and compliance affairs.

A. Pooled Diversification
1. Professional Money Managers 2. Combines the Funds of many people with similar investment goals 3. Receive shares of stock in the mutual fund; a pooled common investment. 4. An indirect investment

B. Attractions and Drawbacks of Mutual Fund Ownership

1. 2. 3. 4.

Diversification Full-time Professional Management Modest Capital Investment Services offered

a. Automatic reinvestment of dividends b. Withdrawal plans c. Check writing privileges

B. Attractions and Drawbacks of Mutual Fund Ownership

5. Convenience
a. Easy to acquire b. Paperwork and record keeping c. Prices are widely quoted

6. Lack of liquidity
a. Normally must be sold back to the fund b. No brokerage commissions

7. Variety

B. Attractions and Drawbacks of Mutual Fund Ownership

8. Regulation and Disclosure

All AMCs operating in Pakistan are subject to strict regulation and oversight by the Securities and Exchange Commission Pakistan (SECP). As part of this regulation, all funds must provide investors with full and complete disclosure about the fund in a written prospectus describing:
the funds investment objective, its investment methods, information on how to purchase and redeem shares, information about the investment adviser, risks of investments and; fund fees and expenses.

Unit holders are also to be provided with annual and semiannual reports that contain recent information on the funds portfolio, performance, and investment goals and policies.

What You Should Know

Fees:

All mutual funds have fees and expenses that are paid by investors. These costs are significant because they affect the return on the investment; therefore investors need to calculate their returns net of all such deductions. The fees and any other charges are usually mentioned in the offering documents and the fund brochure printed by the Asset Management Company. Fees generally fall into two categories:
a) management fees and b) load charges.

What You Should Know

Management fees is calculated as a fixed percentage of the average net assets managed by the firm for providing office space and professional management, including all accounting and administrative services. The second category is sales commissions described as front-end loads (sales charges when you buy) or back-end loads (sales charges when you sell). No-load funds, as the name implies, do not have front-end or back-end sales charges. These fees are for undertaking the distribution and selling of the funds.

Taxation on Mutual Funds

The income of mutual funds is exempt from Income Tax, if not less than 90% of the income of the year, as reduced by capital gains is distributed amongst the unit holders as dividend or bonus units.

Taxation on Unit Holders

Holders of mutual funds are subject to Income Tax on dividend income received from a mutual fund (excluding the amount of dividend paid out of capital gains on listed securities) as under: Public Company and Insurance Company 5% If received by any other person, including a nonresident 10% Capital gain on disposition of units in a mutual fund is exempted from tax till such time that capital gain on sale of securities listed on the stock exchanges is exempt from such tax.

Tax Credit

As funds are listed at the stock exchanges, unit holders of the mutual funds, other than a company, are entitled to a tax credit under section 62 of the Income Tax Ordinance, 2001 on purchase of new units. The amount on which tax credit is allowed is the lower of (a) amount invested in purchase of new units, (b) ten percent of the taxable income of the unit holder, or (c ) Rupees Three Hundred Thousand (PKR. 300,000), and is calculated by applying the average rate of tax of the unit holder for the tax year. If the units are disposed within twelve months, the amount of tax payable for the tax year in which the units are disposed is increased by the amount of credit allowed.

How to Develop an Investment Plan?

The first step to successful investing for any investor is to develop a clear understanding of his expected return from the investment and define his risk tolerance to help him identify a suitable choice of investment. 1. Investors need to establish financial goals with respect to the requirements from the investment and time horizon for realizing these goals.

Goals may be immediate such as making a down payment on a home, paying for a wedding, or creating a college fund. Long-term goals could be like paying for college or retirement. Establishing goals helps to assess how much money you need to invest, how much the investments must earn, and when the money will be required.

How to Develop an Investment Plan?

2. Investors need to study the financial markets to understand the options available to them and forecast a realistic market expectation of future performance. Setting realistic expectations about investments and about market performance is an important part of the investment plan. Securities do not always rise in value, and when they fall, the downturns can sometimes be lengthy. A well-conceived, diversified personal investment plan can help against these downturns, and give a measure of comfort during market volatility.

How to Develop an Investment Plan?

3. Investors need to study the financial markets to understand the options available to them and forecast a realistic market expectation of future performance. Setting realistic expectations about investments and about market performance is an important part of the investment plan. Securities do not always rise in value, and when they fall, the downturns can sometimes be lengthy. A well-conceived, diversified personal investment plan can help against these downturns, and give a measure of comfort during market volatility. 4. Investors need to build their investment plan keeping in view liquidity and financial limitations. For instance, investors may need to make payments in the near future which restrict them from committing large sums of money for an indefinite period.

How to Develop an Investment Plan?

5. All mutual funds involve investment risk, including the possible loss of principal.
This principle of investing is known as the risk/ reward tradeoff. When forming a plan, therefore the investor needs to understand his threshold risk tolerance levels. Is stability more important than higher returns, or can short-term losses be tolerated for potential long-term gains?

6. Investors should be able to set risk and return objectives after these considerations.
Risk and return objectives must be set in specific terms for instance an investor may require 15% return p.a. with an expected standard deviation of 2% for the next 5 years.

Risks of Investing in Mutual Funds

Credit risk - potential that an investment (specifically fixed-income securities) will go down when assigned a negative rating (downgraded) by a reputable credit rating service. Default risk - risk associated with an issuer of a debt instrument that may not have the financial ability to meet regular interest payments or is incapable of repaying the debt at maturity. Equity investment risk - risk resulting from changes in a specific company or industry developments and prospects, as well as changes in interest rates, economic conditions and stock market news. Interest rate risk - risk resulting from increased interest rates in the market place, that the income earned from an original investment will not be worth as much as the going market rates. Liquidity risk - inability to sell a security reasonably quickly at the prevailing market price or convert an asset into cash as quickly as possible. Political risk - potential for changes in government to impact the value of an investment. It may also include policy changes made by governments.

Fund Reporting: A Highly Regulated Industry

To keep investors informed about the funds performance the management publishes;
daily returns on their website, monthly fund managers reports and quarterly and annual audited accounts. Legal documents affecting the funds operations

Prospectus/ Offering document - A mutual funds prospectus describes the funds goals, fees and charges, investment strategies and risks, as well as information on how to buy and sell units. The SECP requires a fund to provide a full prospectus before accepting any investment. Trust Deed - Agreement signed, between the trustee and the fund sponsors, which details the appointment of the trustee/ custodian and the roles and responsibilities as trustee and custodian which include safekeeping and possession of the funds assets, movements of the funds assets and their investment.

Fund Reporting: A Highly Regulated Industry

Financial Statements - These statements show the performance of the fund in the outgoing period and help the investor evaluate how successfully the fund has achieved its stated objectives. Shareholder reports typically include two main types of information a) the funds financial statements and performance and b) a list of the securities the fund held in its portfolio at the end of the most recent accounting period. Reports and Website Information - AMCs regularly update their websites with daily fund prices, whereas monthly fund managers reports are added when the month ends, which details the market conditions, reasons for the funds performance and future outlook.

C. Essential Characteristics

Open-ended Funds Close-ended Funds

Hedge Funds
Not technically mutual funds Not subject to SEC regulation Organized as limited partnership Common feature is use of leverage

Net Asset Value

Net Asset Value

If NAV > Market Price, Fund is selling at Discount If NAV < Market Price, Fund is selling at Premium

Mutual Fund Expenses

Load
Front-end Load
Back-end Load

Marketing & Distribution Fees (12-b1)

D. Types of Funds

1. Growth
Goal is capital appreciation

2. Maximum Growth
Highly speculative, seeking large profits from capital gains
a. Often buy stocks of small, unseasoned companies b. Highly speculative

D. Types of Funds (contd.)

3. Income
CURRENT income is main objective
a. Interest income b. Dividend income

4. Balanced Funds
Objective is to earn both capital gains and current income
a. High-grade common stocks (60 - 75%) b. Fixed income securities (25 - 40%)

D. Types of Funds (contd.)

5. Small Company
Invest in small companies.

6. International
Can invest in one region or area of the world Can invest in specific country

D. Types of Funds (contd.)

Bond Funds
Objective is to invest in bonds
a. Income is primary objective b. Two advantages
Liquidity Diversification

D. Types of Funds (contd.)

6. Money Market Funds

Offers the individual investor access to high-yielding money market instruments a. Bank CDs
b. Treasury Bills c. Commercial Paper

D. Types of Funds (contd.)

7. Dual Funds
Invest in Money Market and Invest in Capital Market

8. Exchange-Traded Funds (Indexed Funds)

D. Types of Funds (contd.)

9. Specialty Funds - Single Industry

a. Option trading b. Commodity funds c. Oil drilling d. Cattle funds e. Electronics f. Gold g. Chemicals h. Health

E. Special Services

1. Saving Plans
Investor adds funds on a regular basis

2. Automatic Reinvestment Plans

Dividends and capital gains are reinvested in additional shares

3. Regular Income
Through withdrawal plans, the investor can receive periodic repayment or income
Shares or Dollars

E. Special Services (contd.)

4. Conversion Privileges
Allows the investor the right to switch from one fund to another
a. Must confine switches within the same family of funds b. Usually no transfer charges

E. Special Services (contd.)

5. Check Writing Privileges

a. Shareholders have the right to write checks drawn on the Mutual Fund account

Other Advantages

Professional management Convenience Market accessibility to small investors

F. Mutual Funds Risk

Because Mutual Funds are so well diversified (typically), the inherent risk is similar to that in the Market

Systematic Market

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Assets

However, Specialty Fund risk can vary significantly from overall Market risk

F. Mutual Funds Risk (contd.)

Specialized Stock Funds Hybrid Funds Money Market Funds

Large Capital Stock Funds

International Stock Funds

Bond Funds Small Capital Stock Funds

Less Risk Less Expected Returns

More Risk More Expected Returns

Deadly Mutual Fund Myths

1. The Conventional Wisdom Myth

This is the number one mistake most investors make. Investors look at historic trends that have already made big gains rather than identify funds that are positioned to make profits in the future.

2. The Diversification Myth

If you own at least 10 different mutual funds youll have a diversified portfolio.
Owning 10 mutual funds wont assure you of anything but a lot of work trying to stay on top of them all. In fact, you can have a well diversified portfolio with just 4 to 6 funds or you can have a portfolio of 15 funds with very little diversification.

3. The Momentum Myth

The easiest way to beat the market is to buy last years top-performing funds.
The fact is that last years best funds are just as likely to be this years dogs. Blindly following this strategy is very dangerous for most investors. The very top-performing funds are usually those that took a lot of risk and happened to bet on the right market sector at the right time.

4. The Market Timing Myth

The safest strategy is to move everything into money market funds when the market is declining and switch everything back into stock funds when the market is rising.
This is a losers game. It has been proven over and over that investors are incapable of timing the market or identifying major bull or bear markets.

5. The Long-Term Performance Myth

The best measure of a funds quality is its long-term performance.

There is a fair amount of truth to this statement, but too many investors follow some brokers advice to buy this fund, it has a great 10-year record, without asking some key questions. Who earned that record? Is the manager responsible for its returns still at the helm? If not, the record could be meaningless.

6. The New fund Myth

You

should wait until a fund has at least a 3-year track record before investing.

Some Facts about Mutual Funds

First mutual fund: Boston, 1924. Slow growth, initially. Advent of money market mutual funds, 1972.
Regulation Q.

Total assets in stock and bond mutual funds:

1940: $0.4 billion. 1990: $568.5 billion 2000: $5,120.0 billion.

Global Issues

Worldwide growth in mutual fund investment not as great as in the U.S.

$1,626 trillion in 1992 to $4,833 trillion in 2000
200% growth compared to 340% in U.S.

Larger returns in U.S.stock markets Greatest development in countries with most developed markets Opportunities from declining Japanese markets

Mutual Funds Industry in Pakistan

NATIONAL INVESTMENT TRUST 1962 INVESTMENT CORPORATION OF PAKISTAN 1966 Mutual Funds

Close-ended Funds Opend Ended Funds Voluntary Pension Funds