Investment Management 254:
Chapter 1: Background and Issues:
Definition:
• An investment is the commitment of current resources (current cash and assets) in
the expectation of future benefits (increased cash and assets in the future).
Real vs Financial Assets:
• Table 1.1. Balance sheet, US households 2014
- Real assets = real estate and consumer durables (assets that will be used over
longer periods of time including motors and furniture)
- Financial assets = financial investments eg deposits (in bank on which you earn
interest), pension fund contributions, investment in corporate entities (equity
investment), share investments in the form of mutual fund investments and
debt securities (when you make loans to corporate entities)
- If you make a financial investment in a company/corporate entity you buy
shares in that company/give a loan to the company in a form of a debt security
then the company will use those funds to acquire typically real assets again.
- What are the real assets for a company like? For a company they typically buy
PPE and they acquire human capital and they use these real assets at their
disposal to increase their productive capacity which ultimately contribute to
GDP.
- Financial asset of individual households actually becomes funding for the real
assets in the corporate sector and those assets are then employed to contribute
to the overall economy.
Financial Assets
• Asset classes
, - Common stock = ownership stake in entity, residual cash flow (you will get paid
after all debt and preference shareholders have been paid) → the return on
common stock is linked to company success
- Fixed income securities = money market instruments (shorter term
instruments), bonds (longer term instruments)→ have an expiration date, debt
instrument/ loan - receive a fixed payment/ payment based on specific formula
(can be a floating rate such as an inflation liked instrument) preferred stock
- Derivative securities = contract, value derived from underlying market condition
→ come in the form of futures, forwards and options and they trade based on
the value of an underlying financial asset such as a stock or a bond
Financial Markets and the Economy:
• The Informational Role of Financial Markets → financial markets indicate the
collective feeling towards assets – if the market is optimistic with regards to the
value of assets in the market, prices will rise, pessimistic = fall
• Consumption timing → during some periods of life income > expenses = use money
not spending and save it. Financial markets allow you to make investments in
financial assets which grow. When you come to expenses > income (retire) financial
assets should be enough to carry you during this time
• Allocation of risk → different financial assets carry different levels of risk (share
investments > fixed income investments in terms of risk)
• Separation of ownership and management → allow you to make a financial
investment in a company which ultimately leads you to becoming an owner but you
don’t need to be involved in the management of that company.
• The value of an economy is reflected in the value of the real assets in that economy
because the real assets ultimately contribute to the GDP of an economy. None the
less, financial assets and the financial markets in which they trade, allows us to make
the most of these real assets at our disposal in the economy.
The investment process (2 steps):
• Asset allocation → refers to your allocation of funds to the broad asset classes.
These can include equity, fixed income, property and derivatives
• Security selection → choosing specific securities within each of these asset classes
you have chosen
• Investment process has 2 approaches: “Top-down” vs. “bottom-up”
- Top-down → first do asset allocation (decide what % of your funds to put in
each of the different asset classes eg decide 20% equity, 30% in property etc.)
next step = do security selection within each of the asset classes eg within equity
you would choose the specific shares/companies you want to invest in
- Bottom up → start by seeking attractively priced securities, asset allocation
happens by itself (if you see a lot of mispriced stocks/shares you will allocate a
lot of your funds towards equities). Asset allocation can become quite
concentrated because you don’t specify how much you want to invest, happens
by itself where the mispriced securities lie
,Markets are competitive:
• Risk-return trade-off → how you approach investment process. “no such thing as a
free lunch” → looking for underpriced securities is in vain (won’t find in the market)
therefore the only way to increase your returns is to take on higher levels of risk =
risk-return trade off (higher risk = higher return)
• Efficient Markets → competitive market = a lot of market participants constantly
analyzing the market and reacting upon mispricings, how competitive the market is
influences how efficient the market is. Efficient market = market where there is no
mispriced securities. Dilemma = how should we manage portfolios?
- Passive management → holds a diversified portfolio over the long term
- Active management → constantly seeking for underpriced securities, moving in
and out of investments and asset classes depending on your expectations
- It would make sense in an efficient market (no underpriced to pick up) that
passive management would make more sense
The Players:
• Firms (demanders of capital), Households (providers of capital), Government
(providers/demanders of capital depending on if the budget is in a deficit/surplus.
Deficit = finance with some form of financial assistance and issue government
bonds). Who brings these players together?:
- Financial Intermediaries → institutions such as banks/ investment companies
- Investment Bankers → raise money for listed companies, specialize in the
issuance of new securities and new types of securities
- Private company space: Venture Capital and Private Equity firms → who raise
funds for these forms of enterprises
Financial Crisis of 2008:
• Antecedents of the Crisis:
- Low interest rates
- A stable economy
- Housing market boom
- A search for higher-yield investments
• Changes in housing finance
- 1970s: Fannie Mae and Freddie Mac bundle mortgage loans into tradable pools
(securitization)
- Subprime loans: loans above 80% of home value, no underwriting criteria, higher
default risk
• Mortgage derivatives
- CDO
- CDS
• The shoe drops
• Dodd-Frank reform act
- Stricter rules for bank capital, liquidity, risk management
- Mandated increased transparency
, - Clarified regulatory system
Chapter 2: Asset Classes and Financial Instruments:
• Preferred stock under equities → double check classification in book
Money market:
• Money market instruments are fixed income, short term investments. It’s a shorter
term investment on which you will realize a predetermined income/return therefore
relatively safe and low risk investment. These types of products are issued by the
corporate and government sector. Some instruments have large capital
requirements and are therefore more suitable for the institutional investor.
• T-Bills → treasury bill is issued by the reserve bank, so SARB. Maturities range
anything from 1 – 12 months. Minimum investment R100 000 required. Government
uses this funding to manage liquidity.
• Certificates of Deposit → fixed deposit with a bank. Typically on values larger than
R1 million. Terms are typically negotiable.
• Commercial Paper → issued by companies and is used to finance inventory and
other ST liabilities. Typically the maturity is less than 270 days.
• Eurodollars → dollars in nominated deposits at foreign banks outside the US. Similar
to certificates of deposit but now it is the liability of a non-US bank
• Repos → repurchase agreement is an agreement between banks, asset managers or
corporate entities. The idea is that you buy the asset today with the contract stating
that the issuer will buy back the asset tomorrow at a higher price.
The bond market:
• Similar to money market in that you are promised a stream of fixed income
payments on your investment. Difference = bond market is for assets that are for
longer term in nature, so for instruments with longer maturities
• Government Bonds → issued by govern. Come in forms of retail bonds and also
bonds for the institutional investor.
