(BAFI 1045) T01 & T02 (Investments Setting, Asset Allocation, Professional Portfolio Management, Alternative Assets, & Industry Ethics)

RMIT Classification: Trusted
Investment
Topic 1 : The Investments Setting and
Asset Allocation
and
Topic 2 : Professional Portfolio
Management, Alternative Assets and
Industry Ethics
RMIT University
Reference
• Investment Analysis and Portfolio Management by Frank
K. Reilly, Keith C. Brown, Sanford J. Leeds
• Chapters 1, 2 and 17
RMIT University Slide 2

Learning Objectives
• In this chapter we will discuss:
– What is Investment and why do individual invest
– How do investors measure rate of return on investment
– How do investors measure the risk related to alternative
investment
– What is the role of asset allocation in investment
– What are the four steps of portfolio management
– How professional money management firms can be
organized
– What are some of the ethical dilemmas involved in
professional money management industry

What Is An Investment?
• Investment
– What you do with savings to make them increase
over time
• Reason for Investing
– By investing (saving money now instead of spending
it), individuals can tradeoff present consumption for a
larger future consumption.
• 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
What Is An Investment?
• Inflation
– If investors expect a change in prices, they will
require a higher rate of return to compensate for it
• Uncertainty
– If the future payment from the investment is not
certain, the investor will demand an interest rate that
exceeds the nominal risk-free interest rate
• Investment risk
• Risk premium

Recap: 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
where n = number of years of the investment

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?
End Beginning
value value
HPR =$220/$200 = 1.10

HPY = 1.10 – 1 =0.10 or 10%

1
 350  2 RMIT Classification: Trusted
 
 250 
Example: Your investment of $250 in Stock A is worth

$350 in two years. What are the annual HPR and
HPY on stock A?
Annual HPR = HPR1/n
• Stock A 1
n = 2 years
– Annual HPR=  350  =1.1832

2
 250 
– Annual HPY= 1.1832 – 1 = 0.1832 or 18.32%


• 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)
Holding
period Yield
AM =  HPY / n
where  HPY = the sum of all the annual HPYs
n = number of years
– Geometric Mean Return (GM) Holding period
Return
GM = [ HPR]1/n - 1
where  HPR = the product of all the annual HPRs
n = number of years
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 Beginning Ending HPR HPY

Value Value
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20

AM =  HPY / n
0.15  0.20  0.2
=  0.05 or 5%
3
GM = [ HPR]1/n - 1
1
 1.15  1.20  0.80   1 3
1
 1.104   1
3
 1.03353  1  0.03353or 3.3353%

The common stock of X-Men Inc. had the following historic

prices and holding period return
Time Price of X-Tech Return HPR
(HPY)
3/01/2007 50
3/01/2008 47 0.0600 0.9400
3/01/2009 76 0.6170 1.6170
3/01/2010 80 0.0526 1.0526
3/01/2011 85 0.0625 1.0625
3/01/2012 90 0.0588 1.0588
What was your geometric mean annual yield for the

investment in X-Men?

GM = [ HPR]1/n – 1

= [0.94x1.6170x1.0526x1.0625x1.0588] 1/5 - 1

= 01.1247 – 1

= 0.1247

• 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, the GM is the best measure of an
asset’s long-term performance.

The Portfolio Management Process

Asset Allocation
• What is Asset Allocation

– The process of deciding how to distribute an investor’s wealth
among different countries and asset classes for investment
purposes.
• Asset Class
– Refers to the group of securities that have similar
characteristics, attributes, and risk/return relationships.
1. Stocks
2. Bonds
3. Real estate
4. cash

The Importance of Asset Allocation
• 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

The Importance of Asset Allocation
• Investor: Depending on the type of investors,

investment objectives and constraints vary
– Individual investors
– Institutional investors

The Asset Management Industry
• Financial intermediaries that pool the assets of

individual investors and invest the fund in securities or
other assets
• Major duties
• Investment research
• Management of the portfolio
• Administrative duties
• Management fee is generally stated as a percentage
of the total value of the fund
• Family of funds helps achieve economies of scale

The Asset Management Industry:

Structure and Evolution
• Two Organization Forms
– Contract directly with a management and advisory
firm
– Investment fund company (commingling of
investment)
• Differences between These Two Forms
– Private management and advisory firms develop a
personal relationship with clients
– A Investment company offers a general solution
• See Exhibit 17.1

Exhibit 17.1

Valuing Investment Company Shares
• The NAV for an investment company is

analogous to the share price of a corporation’s
common stock.
• The NAV of the fund shares will increase as the
value of the underlying assets (the fund security
portfolio) increases.
Fund NAV=
 Total Market Value of Fund Portfolio    Fund Expenses 
 Total Fund Shares Outstanding 

• Example: A fund has $1,000,000 of investments,

$700,000 in cash and $300,000 in receivables.
The fund also has $500,000 in liabilities. It has
500,000 shares outstanding.


• Example: The Fidelity Mutual Fund has liabilities of $7,000 and owns the
following six stocks:
COMPANY SHARES PRICE ($)

China Angel Food Limited 1,000 12
Grand Banks Yachts Limited 1,100 15
KSH Holdings Limited 2,500 7
Singapore Airlines 600 18
Huan Hsin Holdings Limited 1,400 22
United Overseas Bank 700 16
The fund began by selling $90,000 of stock at $8 per share.

REQUIRED:
What is the fund’s net asset value (NAV

COMPANY SHARES PRICE ($)
China Angel Food Limited 1,000 12
Grand Banks Yachts Limited 1,100 15
KSH Holdings Limited 2,500 7
Singapore Airlines 600 18
Huan Hsin Holdings Limited 1,400 22
United Overseas Bank 700 16
The fund began by selling $90,000 of stock at $8 per share.
Fund NAV=
 Total Market Value of Fund Portfolio    Fund Expenses 
 Total Fund Shares Outstanding 

Solution

• Closed-End Investment Companies

– Functions like any other public firm
– Stock trades on the regular secondary market
– The fund generally doesn’t issue or redeem
shares once it is established
– The price of the fund is different from its NAV

Valuing Investment Company
• Open-End Investment Companies

– The company continues to sell and repurchase shares
after their initial public offerings
– 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

Discussion
– Open-end funds are obligated to redeem investor's

shares at net asset value and thus must keep cash or
cash-equivalent securities on hand in order to meet
potential redemptions.
– Closed-end funds do not need the cash reserves
because there are no redemptions for closed-end funds.
– Investors in closed-end funds sell their shares when they
wish to cash out.

• Load versus No-Load Open-End Fund

– Load fund carry sales charge and are typically available to
those that invest through brokers or financial advisors
 Offering price = NAV + Sales charge
 Front-end load: paid when shares are bought
 Back-end load: paid when shares are sold
– No-load funds are those which investors can buy or sell into
without paying a sales charge
 Offering price = NAV

• Example
– What is the offering price for the fund if
the NAV is $25.25 and the load is 6
percent?
Offering price = NAV + NAV * Load percentage

= $25.25 + 25.25(0.06)
= $26.77

• 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

Investment Company Portfolios
• Equity funds
– Invest almost exclusively in common stocks
• Bond funds
– Concentrate on various types of bonds to generate
high current income with minimal risk
• Balanced funds
– Diversify outside a single market by combining
common stock with fixed income securities
• Money market funds
– Invest in diversified portfolios of short-term securities

Investing in Alternative Assets

• Increasing trend towards committing financial capital in
non-traditional asset classes
– Hedge Funds
– Private Equity
– Real estate
– Natural resources and commodities
• Management Structure
– Structured as a limited partnership rather than as a mutual fund
to manage the commingled assets
• The Fund “alpha”
– Abnormal returns generated by the fund, implying the superior
performance by the fund management

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
• In calculating this performance fee, investors usually require that
any past losses be recouped before managers receive the
additional payout; this arrangement is known as a high-water
mark
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 organizational structure or are
experiencing financial distress
• Characteristics
– Higher return and low liquidity
– Good sources of diversification

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

Returns to Private Equity

Characteristics/Differences of Hedge fund and Private Equity fund

Returns of different asset

classes

Ethical Dilemmas
• Agency Problem
• Examples of Ethical Conflicts
– Incentive Compensation Schemes
– Soft Dollar Arrangements
– Marketing Investment Management

Standards for Ethical Behavior
• A recent initiative of the CFA Institute has been the creation of a

comprehensive Asset Manager Code
• This code sets forth minimum standards for providing asset
management services to clients, based on the following general
principles:
– Managers must:
• Act in a professional and ethical manner at all times
• Act for the benefit of clients.
• Act with independence and objectivity
• Act with skill, competence, and diligence
• Communicate with clients in a timely and accurate manner
• Uphold the applicable rules governing capital markets

Topic Summary
Concepts reviewed in this topic (these chapters):

• Reviewed basic concepts of Investments
– Measures of return
– AM vs GM
– Portfolio management process
• Reviewed importance of asset allocation
– Two organizational forms
– Closed-end vs Open-end companies
– NAV estimation
– Alternative investment opportunities
– Ethics and regulation

(BAFI 1045) T01 & T02 (Investments Setting, Asset Allocation, Professional Portfolio Management, Alternative Assets, & Industry Ethics)

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RMIT Classification: Trusted

RMIT University Slide 2

RMIT University Slide 3

RMIT University Slide 5

Recap: Historical Rates of Return

= Ending Value of Investment

– Holding Period Yield (HPY)

where n = number of years of the investment

RMIT University Slide 6

Historical Rates of Return

Example: Assume that you invest $200 at the

HPR =$220/$200 = 1.10

RMIT University Slide 7

Historical Rates of Return

Example: Your investment of $250 in Stock A is worth

– Annual HPR=  350  =1.1832

RMIT University Slide 8

Historical Rates of Return

Historical Rates of Return

Suppose you invested $100 three years ago and it is

Year Beginning Ending HPR HPY

RMIT University Slide 10

Historical Rates of Return

 1.03353  1  0.03353or 3.3353%

RMIT University Slide 11

Historical Rates of Return

The common stock of X-Men Inc. had the following historic

What was your geometric mean annual yield for the

RMIT University Slide 12

Historical Rates of Return

RMIT University Slide 13

Historical Rates of Return

– While the AM is best used as an “expected value” for

RMIT University Slide 14

The Portfolio Management Process

RMIT University Slide 15

• What is Asset Allocation

RMIT University Slide 16

The Importance of Asset Allocation

• An investment strategy is based on four decisions

RMIT University Slide 17

The Importance of Asset Allocation

• Investor: Depending on the type of investors,

RMIT University Slide 18

The Asset Management Industry

• Financial intermediaries that pool the assets of

RMIT University Slide 19

The Asset Management Industry:

RMIT University Slide 20

RMIT University Slide 21

Valuing Investment Company Shares

• The NAV for an investment company is

RMIT University Slide 22

Valuing Investment Company Shares

• Example: A fund has $1,000,000 of investments,

RMIT University Slide 23

Valuing Investment Company Shares

COMPANY SHARES PRICE ($)

Grand Banks Yachts Limited 1,100 15

KSH Holdings Limited 2,500 7

Singapore Airlines 600 18

Huan Hsin Holdings Limited 1,400 22