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Chapter 8 Investment Management

Chapter 8 Investment Management

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Chapter 8 Investment Management

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  1. Chapter 8InvestmentManagement H.L Centre for Professional Education AMFI Module

  2. Equity Portfolio Management • Types of equity instruments • Ordinary shares • Preference shares • Equity warrants • Convertible debentures • Derivatives • Futures • Options H.L Centre for Professional Education AMFI Module

  3. Derivatives • Options • An OPTION Contract has been defined as an agreement between 2 parties in which one grants to the other the right to buy (call option) or sell (put option) an asset under specified condition (price,time), and assumes the obligation to sell or buy it. • Suppose you agree to sell an Option to buy 100 shares of RIL at Rs. 450 on 31 December 2004 to B. Then on 31st December, B may or may not buy from you. However you are obliged to sell if he wants to purchase. • CALL OPTION : Right to purchase • PUT OPTION : Right to sell H.L Centre for Professional Education AMFI Module

  4. Derivatives… • Futures • A Financial FUTURE contract has been defined as “ the simultaneous right and obligation to buy or sell a standard quantity of a specific financial instrument (or commodity) at a specific future date and at a price agreed between the parties, at the time the contract was signed “. Thus it is an exchange version of traditional forward contract H.L Centre for Professional Education AMFI Module

  5. Equity Portfolio Management • Classification of equity shares • By market classification • Large capitalisation companies • Medium capitalisation companies • Small capitalisation companies • By anticipated earnings • Price to earnings ratio • Dividend yield • Cyclical shares • Growth stocks • Value stocks H.L Centre for Professional Education AMFI Module

  6. Dividend Yield • Divided Yields are calculated by dividing the last full-year dividend on the stock by earliest available closing price of stock. A par value (Rs.10) acquired at Inr 100 is being quoted today at Inr 200. If the dividend received for the last FY was Inr 10, then: • Declared dividend is 100% • Dividend Yield for purchaser is 10% • Current Dividend Yield is 5% H.L Centre for Professional Education AMFI Module

  7. Equity Portfolio Management • Fund management organisation structure • Fund manager Performs asset allocation • Security analyst Supports the fund managers through analytical reports (Fundamental, technical and quantitative) • Security dealers Executes actual buying and selling through brokers H.L Centre for Professional Education AMFI Module

  8. Equity Portfolio Management • Equity Research • Fundamental analysis The study of the Financial health of a particular company, by studying the past 3 to 5 years Balance sheets & Profit & Loss accounts • Technical analysis The study of the market movements of share price of a company or industry / sector to predict the future trend • Quantitative analysis The use of mathematical models for equity valuation H.L Centre for Professional Education AMFI Module

  9. Equity Portfolio Management • Approaches to portfolio management • Passive fund management (Index funds) • Active fund management • Growth investment style • Value investment style H.L Centre for Professional Education AMFI Module

  10. Growth Stocks/Value Stcoks • Growth Stocks • High P/E ratio; low dividend yields • Value Stocks : Are shares of companies in mature industries and are expected to yield low growth. However, they have assets whose values have not been recognised. Means good co. shares currently under valued. • Growth versus Value controversy H.L Centre for Professional Education AMFI Module

  11. Equity Portfolio Management • Portfolio management process • Set Investment policy • Perform security analysis and research • Construct a portfolio • Revise the portfolio • Evaluate the performance of the portfolio H.L Centre for Professional Education AMFI Module

  12. Debt Portfolio Management • Classification of debt instruments • Secured v/s unsecured • Government security v/s corporate security • By maturity profile • Money market securities • Debt securities • Interest bearing v/s zero coupon / discounted • Floating coupon v/s fixed coupon H.L Centre for Professional Education AMFI Module

  13. Debt Portfolio Management • Types of debt instruments • Certificate of deposit • Commercial paper • Corporate debentures • Floating rate bonds • Government securities • Treasury bills • Bank / Financial Institution bonds • Public sector undertaking bonds H.L Centre for Professional Education AMFI Module

  14. Debt Portfolio Management • Key characteristics of bonds • Par value • Coupon • Maturity • Call or put options H.L Centre for Professional Education AMFI Module

  15. Debt Portfolio Management • Measures of bond yields • Current yield It is the yield that a bond gives if held till maturity. This is different from the coupon rate because of the price of acquisition Yield = Coupon % X Par Value Market Rate H.L Centre for Professional Education AMFI Module

  16. Debt Portfolio Management • Measures of bond yields • Yield to maturity • It is the total yield that an investor realises on a bond, if he gets all the coupons, and these coupons are reinvested at the same coupon rate, till maturity and the principal is received at maturity • Price of a bond is inversely proportionately to YTM / interest rates H.L Centre for Professional Education AMFI Module

  17. Debt Portfolio Management • Yield calculation • Face value : Rs. 1000 • Coupon : 10% • Tenure : 4 years • Interest payment : Yearly • Price : 1020 • Cash-flows are as under 100 100 100 (100 +1000) 1020 = + + + + (1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4 Solve for ‘r’ r = 9.37% = Yield to maturity H.L Centre for Professional Education AMFI Module

  18. Debt Portfolio Management • Price calculation • Face value : Rs. 1000 • Coupon : 10% • Tenure : 4 years • Interest payment : Yearly • Yield : 9.37pct • Cash-flows are as under • 100 100 100 (100+ 1000) • Price = + + + + • (1 + 9.37%)1 (1 + 9.37%)2 (1 + 9.37%)3 (1 + 9.37%)4Solving for price - Rs.1020 H.L Centre for Professional Education AMFI Module

  19. Approx YTM • AYTM= ((F-P)/n)+(cf) ------------------- (F+P)/2 Where F is the face value of the bond. P= Current Market Value of the Bond Cf= Coupon received at regular intervals in Rs. N= numbers of years H.L Centre for Professional Education AMFI Module

  20. Debt Portfolio Management • Measures of bond yields • Yield curve • Graph of yields of bonds of different maturities • Normally upward sloping because longer the maturity, greater the risk • Good indicator of interest rate trends H.L Centre for Professional Education AMFI Module

  21. Debt Portfolio Management • Risks in investing in bonds • Interest rate risk • Price of bonds are inversely proportional to interest rates • Reinvestment risk • Coupon received may not get invested at the coupon rate itself • Call risk • If bond provides a call option, the bond may get called if interest rates drop. Reinvestment will then happen at lower rates H.L Centre for Professional Education AMFI Module

  22. Debt Portfolio Management • Risks of investing in bonds • Default risk • Credit risk of default on repayment of interest / principal by the issuer • Inflation risk • Rise in inflation results in lower purchasing power on coupon received, making the bond lose value • Liquidity risk • Illiquidity leads to incorrect pricing and desperate sales H.L Centre for Professional Education AMFI Module

  23. Debt Portfolio Management • Yield spreads and credit ratings • G-sec refers to the risk-free return • Benchmark paper is 10year G-sec • Spread is the premium over G-sec rate paid by borrowers according to their credit risk quality • Credit risk is priced using the ratings of credit rating agencies • Higher the rating, lower the spread H.L Centre for Professional Education AMFI Module

  24. Debt Portfolio Management • Concept of duration • Duration measures the sensitivity of the bond portfolio to changes in interest rates (% change in Bond price for a 1% change in yield) • It measures the change in bond prices on a 1pct movement in interest rates • Duration is the weighted average term to maturity of a bond • Duration indicates how quickly the inflows (interim and maturity) on the bond in present value terms are received • Duration of a coupon paying bond is always lower than its term to maturity • Duration of a zero coupon bond is equal to its Maturity H.L Centre for Professional Education AMFI Module

  25. Debt Portfolio Management Don’t fall in love with your investments • Approaches to portfolio management • Buy and hold • Interest rate risk • Credit risk • Duration management • Active management based on interest rate expectations H.L Centre for Professional Education AMFI Module

  26. Debt Portfolio Management • Fund management organisation structure • Fund manager Performs asset allocation • Security dealers Executes actual buying and selling through brokers • Interest rate forecasting unit Economists who do research on interest rates • Risk Managers Oversee risk levels attained by fund managers H.L Centre for Professional Education AMFI Module

  27. Investment Policy and Restrictions • Investment objective and philosophy is laid down by the AMC, to be followed by the fund managers • However SEBI also lays down certain investment restriction in to - • Ensure diversification • Ensure proper investment of investors funds H.L Centre for Professional Education AMFI Module

  28. Investment Policy and Restrictions • Portfolio diversification norms for equities • Maximum equity exposure to single stock is 10pct • Not applicable to index funds • Sectoral funds will have weights of stock in that sectoral index • Maximum investment in unlisted equity is 10pct for close-ended schemes and 5pct for open-ended schemes • Investments in ADR / GDR • Maximum limit to all mutual funds is USD500million • For each mutual fund, maximum exposure is 10pct of total funds managed or USD50mn whichever is lower H.L Centre for Professional Education AMFI Module

  29. Investment Policy and Restrictions • Portfolio diversification norms for debt • For “investment grade” issuer • Maximum debt exposure to single issuer is 15pct • This may be extended to 20pct with AMC / Trustee approval • For “non-investment grade” issuer • Maximum exposure to one issuer is 10pct • Maximum exposure to all issuers together is 25pct H.L Centre for Professional Education AMFI Module

  30. Investment Policy and Restrictions • Approved investment limits • Equity with voting rights • A fund house can own a maximum of 10pct of shares carrying voting rights, under all its schemes • Inter-scheme investments • All inter-scheme investments not to exceed 5pct of net assets • Credit rating on debt schemes • At least one credit rating agency should rate paper as investment grade • Only delivery based purchases / sales • Short selling and carry forward not permitted • Securities to be transferred into the scheme it was purchased for H.L Centre for Professional Education AMFI Module

  31. Investment Policy and Restrictions • Approved investment limits • Temporary investment in bank deposits • Can only be held in scheduled commercial banks • No lending • Cannot lend money. However can lend securities • Unlisted or sponsor issued securities • Cannot buy unlisted security / private placement by associate. • If security is listed, maximum investment is 25pct of scheme funds • Inter-scheme transfer • To be done at market rates in line with fund philosophy • Derivatives • To be used as hedging mechanisms H.L Centre for Professional Education AMFI Module

  32. . Chapter 9 Tracking Mutual Fund Performance H.L Centre for Professional Education AMFI Module

  33. Measuring & Evaluating Mutual Fund Performance • Need for measuring fund performance • To make right investment decisions • Depends upon • Type of fund • Investment objective • Current financial market conditions H.L Centre for Professional Education AMFI Module

  34. Different Performance Measures • Change in NAV • Change in NAV between the two dates in absolute and percentage terms. • Absolute terms- • NAV at the end-NAV at the beginning • Percentage terms • (Absolute change / NAV at the beginning) * 100 H.L Centre for Professional Education AMFI Module

  35. Easily understood & applies to any type of fund • Does not take into account interim dividend declared by the Scheme • Suitable for evaluating Growth funds & accumulation plans of debt & equity funds. H.L Centre for Professional Education AMFI Module

  36. Different Performance Measures • 2) Total Return • Takes into account the dividends distributed by the fund • [(Distribution+Change in NAV) / NAV at the beginning] * 100 • Suitable for all categories of funds, more accurate than the first method • Ignores the possibility of reinvestment of dividend H.L Centre for Professional Education AMFI Module

  37. Different Performance Measures • 3) Return on Investment (R.O.I) • Computes the total return with reinvestment of dividends in the fund at ex-dividend date. • [(Units held + div./ex-d NAV)*end NAV] - begin NAV /begin NAV*100 • Accepted by MF tracking agencies (Credence and Value research) • Suitable for accumulation plans, monthly / quarterly income schemes, debt funds distributing interim dividend. H.L Centre for Professional Education AMFI Module

  38. Different Methodologies-Examples • Computing return • Percentage change in NAV. • Simple total return • ROI or Total return with dividend re-investment • Compounded rate of growth H.L Centre for Professional Education AMFI Module

  39. Percentage Change in NAV • Assume that change in NAV is the only source of return. • Example: • NAV of a fund was Rs. 13.35 at the beginning of a year • Rs. 17.65 at the end of the year. • Percentage change in NAV = (17.65 – 13.35)/13.35 *100 = 32.21% H.L Centre for Professional Education AMFI Module

  40. Annualising the Rate of Return If NAV on Jan 1, 2001 was Rs. 15.55 and the NAV on June 30, 2001 was Rs. 17.70, Percentage change in NAV = (17.70-15.55)/15.55 x 100 = 13.83% Annualised return: = 13.83 x 12/6 = 27.66% H.L Centre for Professional Education AMFI Module

  41. Total Return Investor bought units of a mutual fund scheme at a price of Rs.11.80 per unit. He redeems the investment a year later, at Rs. 12.18 per unit. During the year, he also receives dividend at 8%. The rate of return on his investment can be computed as =((12.18 – 11.80) + 0.80)/11.80 x 100 = (1.18/11.80) x 100 = 10% H.L Centre for Professional Education AMFI Module

  42. Total Return or ROI Method • (Value of holdings at the end of the period - value of holdings at the beginning of the period)/ value of holdings at the beginning of the period x 100 • Value of holdings at the beginning of the period = number of units at the beginning x begin NAV. • Value of holdings end of the period = (number of units held at the beginning + number of units re-invested) x end NAV. • Number of units re-invested = dividends/ex dividend NAV. H.L Centre for Professional Education AMFI Module

  43. ROI Method: Example An investor buys 100 units of a fund at Rs. 10.5 on January 1, 2001. On June 30, 2001 he receives dividends at the rate of 10%. The ex-dividend NAV was Rs. 10.25. On December 31, 2001, the fund’s NAV was Rs. 12.25. What is the total return on investment with dividends re-invested? H.L Centre for Professional Education AMFI Module

  44. ROI Method: Solution • The begin period value of the investment is = 10.5 x 100 = Rs. 1050 • Number of units reinvested = 100/10.25 = 9.756 units • End period value of investment = 109.756 x 12.25 = Rs. 1344.51 • The return on investment is =(1344.51-1050)/1050 x 100 = 28.05% H.L Centre for Professional Education AMFI Module

  45. Compounded Annual Growth Rate • CAGR is the rate at which investment has grown from begin point to the end point, on an annual compounding basis. V0(1+r)n = V1 r =((V1/V0)1/n)-1 Where n is the holding period in years. H.L Centre for Professional Education AMFI Module

  46. CAGR: Example 1 An investor buys 100 units of a fund at Rs. 10.5 on January 6, 2001. On June 30, 2001 he receives dividends at the rate of 10%. The ex-dividend NAV was Rs. 10.25. On March 12, 2002, the fund’s NAV was Rs. 12.25. • Compute the CAGR. H.L Centre for Professional Education AMFI Module

  47. CAGR: Solution • The begin period value of the investment is = 10.5 x 100 = Rs. 1050 • Number of units reinvested = 100/10.25 = 9.756 units • End period value of investment = 109.756 x 12.25 = Rs. 1344.51 • Holding period = 6/01/01 - 12/3/02 = 431 days • The CAGR is =(1344.51/1050)365/431 - 1 x 100 = 23.29% H.L Centre for Professional Education AMFI Module

  48. Returns: Industry Practice • Growth Option: CAGR implicit in the change in holding period NAVs. • Dividend Option: CAGR implicit in the change in value over the holding period, assuming re-investment of dividend at ex-dividend NAV. • Less then 1 year, simple return without compounding or annualisation. • Some funds use simple annualised return, without compounding. H.L Centre for Professional Education AMFI Module

  49. Useful Concepts • Compare the same time periods since returns over different time periods vary due to different market conditions. • Annualised returns applicable only to periods greater than 1 year. • Returns to be computed since the inception of the scheme (Rs.10 as the base amount). H.L Centre for Professional Education AMFI Module

  50. Useful Concepts • Expense Ratio • Total expenses / Average Net assets of the fund • Excludes brokerage commissions • Average of 3 to 5 years to be used to judge the performance of the fund. • Evaluated in the light of fund size and portfolio composition. H.L Centre for Professional Education AMFI Module