FNCE20003 Introductory Personal Finance Lecture 5 PDF

FNCE20003 Introductory Personal Finance Lecture 5 Asset allocation and investment choices I Lecturer – Tony Cusack August 2024  Lecture 5 topics Asset returns Investment portfolio construction – asset allocation decisions Investing in debt / bonds Investing in equ...

FNCE20003 Introductory Personal Finance Lecture 5 Asset allocation and investment choices I Lecturer – Tony Cusack August 2024  Lecture 5 topics Asset returns Investment portfolio construction – asset allocation decisions Investing in debt / bonds Investing in equity / shares August 2024 FNCE20003 Lecture 5 2  Risk and return August 2024 FNCE20003 Lecture 5 3  Investment risk ‘pyramid’ August 2024 FNCE20003 Lecture 5 4  Returns on assets historically numerous empirical studies provide evidence that different investments performed as you would expect, given their relative risk, i.e. – shares/equity > real property > bonds in Australia, studies have shown that long-term returns on equities have averaged 10-11.5% p.a. (but much short-term volatility) the equity (risk) premium has historically been in the vicinity of around 4-6% this illustrates a basic principle of corporate finance, i.e. expected return is a function of risk there is also evidence that ‘real’ (inflation-adjusted) rates of return have remained relatively constant over time August 2024 FNCE20003 Lecture 5 5  Vanguard Index Chart | Vanguard Australia August 2024 FNCE20003 Lecture 2 6  Investment portfolio construction broadly speaking, constructing a diversified investment portfolio is a two-step process: 1. Asset Allocation (the ‘macro’ decision) – refers to the percentage of available funds invested in the different asset classes (i.e. equity, cash / fixed interest, and property) 2. Security Selection (micro decision) – refers to selection of, and investment in, individual securities within each asset class each step depends on investor risk tolerance (as previously covered), so there is currently no standard model for either August 2024 FNCE20003 Lecture 5 7  Investment strategies due to differing risk profiles, many alternative investment strategies arise as variations of the above – e.g. there are different types of asset allocation strategies, e.g. strategic, tactical and dynamic – also, there are active v. passive management styles empirical studies have consistently shown that around 90% of portfolio return arises from asset allocation it implies that there is little value added in the second category, i.e. selection of specific assets (individual stocks, property) within the asset classes – is this consistent with theoretical diversification principles? August 2024 FNCE20003 Lecture 5 8  Strategic asset allocation strategic asset allocation (SAA) is based on setting target (%) allocations amongst asset classes the objective is to identify efficient allocation amongst the classes, then “buy and hold” it can be viewed as the allocation that managers would choose if they believed that aggregate asset classes are efficiently priced – i.e. they are of the belief that no abnormal profits are to be earned from switching investments between asset classes most managers will periodically rebalance the portfolio back to those targets as investment returns skew the original asset allocation percentages August 2024 FNCE20003 Lecture 5 9  Tactical asset allocation tactical asset allocation (TAA), on the other hand, represents the asset allocation that managers would choose if they believed that certain asset classes are (relatively) mispriced – generally, this refers to temporary mispricing – it is relative mispricing in the sense that, for example, the equities market is ‘overheated’ vis-a-vis the bond market under this strategy, managers attempt to outperform a passive benchmark by engaging in market timing this is an active (or aggressive) application of the asset allocation decision empirical evidence suggests that most managers are poor at market timing August 2024 FNCE20003 Lecture 5 10  Dynamic asset allocation a third category is often identified – dynamic asset allocation (DAA) – but different users apply the label in different ways DAA is the term often applied to the periodic rebalancing of portfolio weights under SAA and TAA strategies however, others use DAA to describe market timing motivated switches under a TAA strategy finally, some use DAA to describe a strategy to replicate return distributions, such as switching funds between asset classes to replicate an option payoff – this can include portfolio insurance and stop-loss strategies – i.e. a defensive rather than active / aggressive type of asset allocation August 2024 FNCE20003 Lecture 5 11  Asset allocation summary the foregoing implies that there are at least four broad strategies, ranging from fully passive management to fully active, i.e. – SAA and stock selection – buy & hold [passive] – SAA - buy & hold; stock selection – trade – TAA - active; stock selection – buy & hold – TAA - active; stock selection – trade [active] also note variations, such as incorporation of target return or loss limitation under DAA strategies, per previous slide August 2024 FNCE20003 Lecture 5 12  Asset allocation example consider an investment fund manager with $100 million to invest on behalf of personal investors, i.e. this is a pool of funds to be ‘managed’ – the first decision is to determine the proportions of available funds to be allocated to each asset class – this decision will be based on the risk-return profile of investors, market conditions and research / forecasts assume it is decided to allocate the funds as follows: Property 20%; Equities 50%; Cash 30% – is this consistent with Mutual Fund Separation Theorem? Does it matter? August 2024 FNCE20003 Lecture 5 13  Asset allocation example the fund’s investment philosophy will determine subsequent actions if it has adopted a passive investment strategy, then the initial asset allocation (strategic) will remain in place over the investment horizon, typically subject to periodic re-balancing alterations alternatively, the managers may follow an active management strategy, which would mean reacting to updated market sector forecasts, in an attempt to enhance profit from timing aggregate market movements either way, the next step is to allocate the funds to the different asset management teams (e.g. $50m will be allocated to the equities team for them to determine the appropriate specific equities investments) August 2024 FNCE20003 Lecture 5 14  Asset allocation example each asset team decides as to how the funds will be specifically invested in equities (bonds, property) – this is the stock selection decision – will again depend on the risk profile of the fund, plus any other restrictions (regulatory?) and relevant considerations again, this element can also be managed actively (trading) or passively (buy and hold) e.g. actively managing the equities portfolio would involve continually buying and selling shares with the objective of locking in gains arising from share price movements – buy low, sell high August 2024 FNCE20003 Lecture 5 15  Investment assets: cash / bonds we now address the first specific class of investment asset: cash (on deposit) and fixed interest securities, or bonds – hereafter, we focus on bonds in discussing this asset class a bond may be defined as “a contract between the issuer (borrower) and the investor (lender), evidencing the issuer’s obligation to make specified cash payments to the investor on specified future dates” the specified cash payment obligations are the principal (amount borrowed), plus payment for use of the funds, i.e. interest note that differences in regularity of interest payments leads to two broad categories of bonds: coupon-paying bonds, and zero-coupon bonds August 2024 FNCE20003 Lecture 5 16  Coupon-paying bonds coupon-paying bonds comprise a regular fixed payment of interest (i.e. the “coupon”, C), plus repayment of principal at maturity (F) the coupon rate is not necessarily the market interest rate (although they are usually close at issue date – why?) cash flows to investor: t=0 1 2 n -1 n -P +C +C +C +C+F August 2024 FNCE20003 Lecture 5 17  Coupon-paying bonds interest rates are conventionally quoted on a nominal, per annum basis coupon payments are also determined on this basis, on the face value of the bond however, payments are often made more frequently than annually (usually six-monthly) e.g. bond with quoted rate of 7.75% p.a. payable half-yearly; FV = $100,000 – coupons = 7.75%/2 x 100,000 = $3,850 the valuation of coupon-paying bonds clearly needs to take into account both the timing and amount of coupons August 2024 FNCE20003 Lecture 5 18  Coupon bond sample August 2024 FNCE20003 Lecture 5 19  Zero-coupon bonds (ZCB) ZCB make no payment of interest over the life of the bond, just a once-only payment of principal (par or face value) at maturity ZCB are issued at a discount to par, so the effective interest = F – P the most common types are commercial (including bank-accepted) bills and treasury notes – bank-accepted bills are those that have been issued by a corporate entity to raise short-term funds, and have obtained a bank guarantee (“bank- accepted”) for creditworthiness ZCB are also known as pure discount securities August 2024 FNCE20003 Lecture 5 20  Bond valuation as with other financial assets, the valuation of bonds is based on present value principles the key variables are therefore cash flows, time to maturity, and yield – then simply discount to determine PV note that as the day-to-day changes in interest rates are typically small, yield changes are typically referred to in terms of basis points – a basis point is usually 0.01 of 1% (i.e. 100 basis points = 1%) – sometimes referred to as ‘pips’ August 2024 FNCE20003 Lecture 5 21  Coupon bond valuation example assume an 8% Commonwealth bond of par value $100,000; what is its PV given a quoted yield of (i) 6%; (ii) 8%; and (iii) 10%? i. PV = $4,000/1.03 + $4,000/(1.03)2 + $4,000/(1.03)3 + $104,000/(1.03)4 = $103,717.10 [alternatively, use PVIFA for coupons – see Excel] other solutions: (ii) $100,000 (iii) $96,454.05 – the 2nd one should be obvious this example illustrates one of the most important principles of bond valuation – the inverse relationship between price and yield August 2024 FNCE20003 Lecture 5 22  ZCB valuation valuation of a ZCB is straightforward, since it involves the discounting of one cash flow, the FV (which is the only payment under these bonds) as they are typically short-term (within one year), the discount factor must incorporate the life of the security as follows: P = FV / [1 + (r x d/365)] where: r = i rate (quoted p.a.); d = days to maturity e.g. $1m 90-day bill, quoted r = 5% PV = $1,000,000 / [1 + (0.05 x 90/365)] = $987,821 [= discounted issue value] [interest earned = $12,179 for 3 months] August 2024 FNCE20003 Lecture 5 23  Investment in bonds whether or not bonds are coupon paying, in each case there will be a final (capital) payment at maturity bonds are typically of a short- to medium-term life in terms of diversification and portfolio selection, bonds are obviously an important asset class are bonds a high risk or low risk investment? – Low risk: hold to maturity, fixed return that ranks before return on equity – High risk: trade bonds on the basis of interest rate forecasts; buy and sell prior to maturity leading to profits or losses on capital August 2024 FNCE20003 Lecture 5 24  Risks of bonds whilst bonds are widely considered to be a safe investment class, investors need to be aware of some potential pitfalls and risks, such as: 1. Interest rate risk 2. Reinvestment risk 3. Inflation risk 4. Credit / default risk 5. Liquidity risk 6. Rating downgrade risk August 2024 FNCE20003 Lecture 5 25  Other bond types due to the enormous size and sophistication of world debt markets, there are many alternative bonds types available for investment, including: – Convertible – Callable – Annuity – Asset-backed – Indexed – “Junk” / speculative (non-investment grade) what is the significance of “investment grade” for bond issues? August 2024 FNCE20003 Lecture 5 26  Australian bond market the Australian bond market comprises both government and corporate issues governments are low default risk borrowers, whilst corporate bonds are higher risk / higher return – many corporate bond issues obtain a credit rating to enhance creditworthiness of the issue currently, the value of non-government bonds outstanding is around $1.4 trillion, which includes issuance by financial and non-financial corporations – this is equivalent to a little over 50% of the value of companies listed on the ASX, which is a lower level than in recent years – (total ASX market capitalisation was reported at $2.6t in May 2024) August 2024 FNCE20003 Lecture 5 28  See: Bond Issuance | Chart Pack | RBA August 2024 FNCE20003 Lecture 5 29 August 2024 FNCE20003 Lecture 5 30  10-Year Government Bond Yields August 2024 FNCE20003 Lecture 5 31  Cash Management Trusts / Bond ETFs for the small investor, historically a problem with bond investments is the need to have a large sum to invest – e.g. purchase of a bank bill, minimum FV = $100,000 the existence of cash management trusts (CMT) eliminated this problem – a CMT is a managed fund, comprising a pool of investors’ funds applied to investing in money market securities of various maturities – daily ‘dividends’ (interest) are credited, which can be withdrawn or re-invested this means that, via a CMT, small investors can hold a diversified portfolio of debt investments recently, bond ETFs have become (far) more prevalent than CMTs August 2024 FNCE20003 Lecture 5 32  Equity v Debt debt, represented by bonds as an investment class, imposes a contractual obligation on the firm to make regular payments of interest and principal to the lenders equity therefore represents a residual claim on the cashflows generated by the assets of the firm – dividends are paid after interest, and capital is returned only after borrowings (and all other obligations) are repaid – this is the reason for an equity risk premium equity may be generated from both internal (retained earnings) and external (new issues) sources (e.g. IPO listing of a company’s shares) August 2024 FNCE20003 Lecture 5 33  Equity investment principal methods of equity capital raising: – flotation, i.e. Initial Public Offering (IPO) (see recent ones) – rights issue – private placement – dividend reinvestment plan these methods differ with respect to cost, time to implement and the potential for a transfer of wealth from old shareholders to new shareholders investors in equity may participate in any of these capital raising methods in addition, an investment in equity can be direct (purchase shares) or indirect (e.g. purchase units in managed funds) August 2024 FNCE20003 Lecture 5 34  How risky are shares? as noted, long-term returns on equities typically been stable and higher than other assets (many studies have verified this) on the other hand, short-term investment in equities can lead to losses due to volatility in markets (see a chart) many investors lost significant amounts of investment asset value in the Covid pandemic, and before that, the Global Financial Crisis for instance, in 2008 the S&P/ASX200 Index dropped from a level of nearly 7000 to below 3500 points – i.e. in 2008, about half of the value of equities in the market was lost – this obviously had severe consequences for retirees August 2024 FNCE20003 Lecture 5 35  Direct investment in shares the following are some of the practical issues that arise in relation to direct share investments: 1. How / where do buy shares? 2. Which shares to buy? (i.e. the micro decision) 3. Finding share price information 4. Use of brokers 5. Transaction costs 6. Documentation of ownership 7. Taxation of share-related income 8. Valuation of a share August 2024 FNCE20003 Lecture 5 36  Investing is shares in Australia in relation to public companies, shares are listed and traded on the Australian Stock Exchange (ASX) – you can buy and sell listed shares by contacting a broker and setting up an account – the ASX provides a detailed education service to assist people who are new to investing, see video on investing first steps it is also possible to invest in shares in private companies, typically referred to as unlisted companies – the problem is identifying such shares; usually this will involve some personal relationship with the company principles / owners August 2024 FNCE20003 Lecture 5 37  Which shares to buy? in a theoretical context, this is one of the ‘micro’ parts of the portfolio construction decision it is also linked to the portfolio theory, in the sense that adding more assets will enable diversification benefits on the ASX, there is access to numerous and varied industries, e.g. – banks, retail, communications, transport, media, chemicals, biotechnology, mining, resources, etc. broadening the focus past Australian shares, international equities are also available for investment and provide even further potential diversification benefits (e.g. access to industries such as aeronautics) August 2024 FNCE20003 Lecture 5 38  Which shares to buy? how do investors go about selecting specific stocks / equity securities from the vast range available? in broad terms, there are different recognised methods, including: 1. Fundamental(s) analysis 2. Technical analysis (also known as ‘charting’) 3. Random selection each of these methods has a finance theory implication – e.g. random selection is consistent with portfolio theory / diversification there is a huge industry associated with providing stock selection services, typically based on 1. or 2. August 2024 FNCE20003 Lecture 5 39  Share Price Forecasting Game based on what we’ve just covered, tomorrow there will be a quick Share Price Forecasting game uploaded to Canvas participation is voluntary, but any winner(s) – there might be none, there might be many – will receive up to 2% bonus marks in the subject – i.e. theoretically, you can get 102% in the subject the game: forecast the closing share price for two companies, Bapcor (BAP) and Karoon Energy (KAR), as per official ASX closing price on 13th September 2024 it will open under Quizzes on 10.00 am Wednesday 21st August and will close at 5.00 pm on Friday 23rd August – you must submit by that time to participate winners will be announced on the LMS August 2024 FNCE20003 Lecture 5 40