Financial Markets: Investment Strategies & Portfolio Management

Financial Markets and Institutions: Module 1

The Value of the Finance Industry

The finance industry plays a crucial role in the economy by facilitating the efficient allocation of capital and managing risk. Its value is generated through several key functions:

The Role of Secondary Markets

• Liquidity: Enabling assets to be quickly converted into cash.
• Price Information: Allowing investors to assess the value of investments.
• Low Transaction Costs: Facilitating cost-efficient trading.
• Risk Sharing: Distributing financial risks among investors.
• Economies of Scale: Enhancing efficiency in financial operations.

How Financial Markets Generate Value in the Economy

1. The Informational Role of Financial Markets

   Stock prices are set in financial markets, serving as informative signals that direct capital to the most productive opportunities. Higher productivity leads to higher stock prices, which lowers the cost of capital and attracts further investment. Efficient allocation of capital depends on the effective functioning of financial markets.

2. Consumption Timing

   Financial markets allow individuals to shift consumption across their lifecycle by engaging in consumption smoothing. Investors prefer a balanced consumption pattern despite fluctuating earnings. When individuals earn more, they invest (e.g., saving for retirement). When they earn less, they sell assets or borrow (e.g., mortgages, student loans). Contract enforcement mechanisms ensure financial obligations are met.

3. Risk Pooling and Allocation of Risk

   Markets allow investors to eliminate firm-specific (idiosyncratic) risk by diversifying portfolios. The law of large numbers suggests that holding small portions of many companies reduces overall risk exposure. Riskier securities are allocated to risk-tolerant investors. The separation of ownership and management can create agency conflicts, where managers may not act in the best interest of shareholders.

4. Economies of Scale

   Financial institutions help reduce duplicated costs of gathering and monitoring information. Large-scale intermediaries conduct efficient monitoring, enforce contracts, and reduce transaction costs. Financial institutions provide denomination intermediation (pooling small investments into large-scale projects) and delegated monitoring (professional management of investments). However, agency conflicts arise in monitoring processes—who monitors the monitor?

Asset Classes: Money Market, Bonds, Stocks, Indexing

Security Analysis

The valuation of individual securities to determine their potential for inclusion in a portfolio.

Investment Approaches

• Top-Down Approach: Starts with asset allocation and then identifies specific securities within each asset class.
• Bottom-Up Approach: Focuses on identifying attractively priced securities, regardless of asset class allocation.

Money Markets vs. Capital Markets

• Money Markets: Trade debt securities with a maturity of less than or equal to 1 year (e.g., T-bills, commercial paper, and certificates of deposit). These are short-term, highly liquid, low-risk debt securities that trade mostly in over-the-counter (OTC) markets.
• Capital Markets: Trade debt (bonds) and equity (stocks) with maturities greater than 1 year. These longer-term and riskier securities include corporate bonds, equities, options, and futures.

Examples of Model Portfolios

1. All-Stock Portfolio: Invests 100% in equities for maximum growth but carries high volatility.
2. 60/40 Portfolio: A mix of 60% stocks and 40% bonds, balancing risk and return.
3. Permanent Portfolio: Designed to perform in all economic conditions, combining stocks, bonds, gold, and cash.
4. Golden Butterfly Portfolio: Similar to the permanent portfolio but with higher return potential, investing in growth stocks, precious metals, and bonds.

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Key Terms

Certificates of Deposit (CDs)

Fixed-term deposits issued by banks with a specified maturity date and interest rate.

Residual Claim

In case of liquidation, common shareholders are paid last.

Preferred Stocks

Hybrid security that pays fixed dividends like bonds but represents equity ownership. Holders get dividends before common shareholders and may have no voting rights.

Price-Weighted Average

An index calculation method where stock prices are added and divided by a divisor. Higher-priced stocks impact the index more (e.g., Dow Jones Industrial Average).

Market-Value-Weighted Average

An index where stock weights are based on market capitalization (e.g., S&P 500).

Investment Companies

Investors in investment companies hold shares in the fund, which gives them a proportional claim over the assets. The Net Asset Value (NAV) represents the value of each share in the fund.

(INSERT EQUATION + liabilities & expense ratio)

Classifications of Investment Companies

• Unit Investment Trusts (UITs)

  Hold a fixed portfolio for the lifetime of the fund and are unmanaged (no buying/selling after initial setup).

• Managed Investment Companies

  Fund managers actively buy and sell securities, and investors pay fees for professional management.

  • Closed-End Funds: Have a fixed number of shares that trade like stocks on an exchange.
  • Open-End Funds: Continuously issue and redeem shares at NAV, meaning the fund size fluctuates based on inflows and outflows (Mutual funds belong to this category).

• Mutual Funds

  Dominates the investment industry and offer different specializations:

  • Money Market Funds: Invest in short-term debt (e.g., commercial paper, CDs).
  • Bond Funds: Specialize in fixed-income securities.
  • Equity Funds: Invest primarily in stocks, with many subcategories (growth stocks, value stocks, small-cap, large-cap, etc.).
  • Sector Funds: Focus on a specific industry.
  • International Funds: (Global, regional, and emerging market).
  • Balanced Funds: Hold both equities and bonds to provide diversification.
  • Lifecycle and Target-Date Funds: Adjust asset allocation over time, becoming more conservative as retirement approaches.
  • Sustainable Funds: Focus on environmental, social, and governance (ESG) investing.

Fees in Investment Companies

Operating Expenses

Cover administration, advisory fees, and management costs (typically a fixed percentage of AUM, e.g., 1.25% per year).

Front-End Load

A sales commission charged when purchasing shares (e.g., 1% of the investment).

Back-End Load

An exit fee when selling shares, which declines over time (or may be zero).

Total Expense Ratio

The combined cost of all fees, reducing investor returns.

Calculating Returns

(General formula)

Since fees and charges are deducted from the portfolio, they reduce NAV₁, impacting investor returns.

(Alternative formula) expresses the return after fees.

• Holding Period Matters: Certain fees (e.g., back-end loads) decrease over time, making long-term investments potentially more cost-efficient.
• Always Account for Fees: When calculating net returns.

Performance of Actively Managed Funds

Historical data shows that actively managed funds tend to underperform market benchmarks:

• Wilshire 5000 Index (broad market index) average return: 12.49%.
• Actively managed equity funds average return: 11.53%.

Exchange-Traded Funds (ETFs)

ETFs combine features of mutual funds and stocks, allowing investors to trade diversified portfolios on stock exchanges.

• Trade Like Stocks: Bought and sold throughout the trading day.
• Track Market Indices: Most follow passive investment strategies.
• Lower Fees: Usually cheaper than mutual funds due to passive management.
• Tax Efficiency: Generate fewer capital gains taxes compared to actively managed mutual funds.

ETFs: Pros and Cons

• Pros: Continuous trading, can be shorted, lower costs.
• Cons: Market-driven prices can deviate from NAV, and brokers may charge transaction fees.

Hedge Funds

Hedge funds pool assets from high-net-worth investors and operate with fewer regulations than mutual funds.

• Private Partnerships: Available only to accredited investors.
• Lock-Up Periods: Investors may be required to keep their money in the fund for a set period.
• Use of Derivatives: Employ high-risk, high-return strategies.
• High Fees: Typically charge “2 and 20" (2% annual management fee, 20% of profits - performance fee).

Basics of Portfolio Choice: Module 2

Diversification, Risk and Return, Two-Fund Separation

(DONT FORGET EQUATIONS END OF PAGE)

Is Risk Equal to Variance?

• For well-diversified portfolios, risk is approximately variance.
• For individual stocks, risk is more about covariance with the economy than just variance.

Modern Portfolio Theory (MPT)

MPT formalizes how to construct optimal portfolios based on expected return, volatility, and correlation.

Assumptions of MPT

• Risk-Averse Investors: Prefer less risk for the same return, or higher return for the same risk.
• Mean-Variance Framework: Investors only care about expected return and variance (no concern for skewness or other factors).
• Frictionless Markets: No transaction costs or restrictions (real-world constraints exist but simplify analysis).

Sharpe Ratio

Measures the excess return per unit of risk. A higher Sharpe Ratio means better risk-adjusted performance. The optimal portfolio maximizes the Sharpe Ratio, lying at the tangency point of the Capital Allocation Line (CAL) and the efficient frontier.

Two-Fund Separation Theorem

All investors should hold a combination of two portfolios:

• The Tangency Portfolio: The optimal risky portfolio, which is the same for everyone.
• The Risk-Free Asset: Allocation depends on individual risk tolerance.

Investors choose their mix (weights) based on their risk preference.

Issues with MPT

• Estimating expected returns and variances is difficult.
• Inputs (returns, correlations) change over time.
• Unconstrained optimization can lead to extreme allocations, requiring constraints on portfolio weights.

CAPM, Passive Strategies, Index Funds, ETFs

(LOTS OF FORMULAS)

Solution to Issues with MPT

A practical solution is to skip the first step of estimating individual security parameters and start with tradable risky portfolios, such as Index Funds and ETFs. These funds are already diversified mixes of individual securities and are considered close enough to the tangency portfolio. This approach leads to the rise of Passive Investment Strategies.

Justification: Capital Asset Pricing Model (CAPM)

In equilibrium, the tangency portfolio is the market portfolio. Expected returns depend only on an asset’s market risk (beta), not total risk.

Assumptions of CAPM

• Investors are risk-averse and seek to maximize returns for a given risk, caring only about mean and variance (returns are normally distributed).
• Homogeneous expectations: All investors use the same estimates for returns, volatility, and correlations.
• All investors can borrow and lend at the risk-free rate.

Active Allocation with Single Index Models