Investment Portfolio Construction Finance Essay

Question:

Discuss About The Investment Portfolio Construction Finance?

Answer:

Introduction

The selection of appropriate investment approach or strategy is crucial for the investment manager because it sets the overall direction of the investments. Basically, there are two types of investment strategy such as active investment strategy and passive investment strategy. The selection of investment strategy is influenced by risk taking capacity and willingness of the investor. Thus, before finalizing the investment strategy, it is crucial to look into the risk and return preferences of the investor (Fabozzi and Markowitz, 2011). In this context, an investment proposal has been prepared in this document that seeks to provide investment advice to the client. The proposal covers a discussion on the selection of investment strategy and construction of a portfolio. The proposal gives description of the reasons for selection of investment alternative and establishes an alignment between the selected investment strategy and the constructed portfolio.

Investment Philosophy and Strategy

The most commonly applied investment strategies are active investment strategy and passive investment strategy. Under the active investment strategy, the focus of the fund manager is on value creation by exploiting inefficiencies of the market. Under this investment strategy, the fund manager seeks to find out the undervalued stocks and invests money in these stocks to earn profits (Rutterford and Davison, 2007). The investments under this strategy are made with short term objective. Since, the fund manager has to track the market inefficiencies; therefore, this strategy requires extensive research and analysis. The other strategy i.e. passive investment strategy stresses on investing in the stocks which perform in line with market. Under this investment strategy, the fund manager focuses on the long term investments. Further, the trading transactions under passive investment strategy also tend to be low because the funds are tied in for long term. Both the investment strategies are correct at their place, it is the risk and return preferences of the investors which influences the selection of investment strategy. The investors willing to take high risk for higher returns prefer adoption of active investment strategy while the risk-averse investors prefer passive investment strategy (Wermers and Yao, 2010).

In the current case, the investor wants to invest $200,000 to accumulate funds for his retirement. The investor is willing to take high risk to earn high returns. Further, he does not specify the particular types of investment options. The investor is comfortable with direct investment in individual securities as well as indirect investment through managed funds or investment companies. Further, the investor does not any problems whatsoever with the investment in foreign securities. He is quite willing to get the exposure of the international market. Further, the client makes it clear that he wants portfolio aiming at capital growth rather than the one which earns periodic returns in the form of dividends. Thus, considering the investor’s prescriptions, the active investment strategy is selected.

A portfolio with capital growth motive will be constructed under the active investment strategy. The fund manager will be responsible to carry out extensive research to find out undervalued securities. The fund manager will be targeted to earn profits by exploiting the inefficiencies of the market (Wermers and Yao, 2010).

Recommended Portfolio Components

The portfolio is constructed with a combination of securities. However, the selection of securities depends upon the return and risk preferences of the investor. It is the objective of every investor to earn return as high as possible and keep the risk as low as possible. However, the return and risk runs in parallel, which means that if the return increases, the risk will automatically increase. Thus, the objective of portfolio construction becomes optimization of the return and risk (Prigent, 2007).

In the current case, the portfolio for the investor has been constructed as show in the table presented below:

Individual Equity

Max

Price on 07/10/2017

Share/ units purchased

Amount

Cochlear Ltd

Health Care Equipment

10%

Max

153.14

130.00

19,908.20

CSL Ltd

Biotechnology

10%

Max

133.32

135.00

17,998.20

Flight Centre Travel Group Ltd

Hotels, Resorts & Cruise Lines

10%

Max

51.45

389.00

20,014.05

Domino's Pizza Enterprises Ltd

Restaurants

10%

Max

44.93

400.00

17,972.00

REA Group Ltd

Advertising

10%

Max

63.35

284.00

17,991.40

93,883.85

Aberdeen Leaders Ltd

Large, leading companies

10%

1.15

8,694.00

9,998.10

WAM Capital Limited

Smaller companies

18%

2.43

14,908.00

36,226.44

46,224.54

US Equity

10%

Min

iShares S&P 500

US S&P 500

10%

320.83

62.00

19,891.46

Cash

20%

Max

40,000.00

Total

199,999.85

Future sell contract

Rate 5,663, Exposure 50% of $93,884= $46,942

The investor has total funds amounting to $200,000 which he wants to be invested in the individual equities, managed funds, and international equities. The investor has provided specifications regarding maximum and minimum amounts to be invested in the particular type of investment avenues.

Considering the investor’s specifications, the portfolio has been constructed by allocating the total available funds of $200,000 in different asset classes. The investor has specified to invest not more than 50% of the funds in the individual equity securities in aggregate. Further, there is a restriction on investment of amount in the individual securities taken singly. It is stipulated that not more than 10% of the total funds are to be invested in a single company. Five stocks namely Cochlear Ltd, CSL Ltd, Flight Centre Travel Group Ltd, Domino's Pizza Enterprises Ltd, and REA Group Ltd have been selected from the top 100 companies listed on the Australian Stock Exchange. The companies have been selected in such a manner so that perfect diversification is achieved and the risk is reduced to the optimal level. All the companies belong to different sectors or industries as could be observed from the table given above.

The data of risk and return of the companies for previous 7 years has been analyzed to assess the suitability of the stocks for investment. Along with the analysis of stocks, ASX market data has also been analyzed. The data analysis has been presented in the appendix. It could be observed that Cochlear Ltd has provided a monthly average return of 1.30% with standard deviation of 7.55% over the period of 7 years (Appendix). Further, CSL Ltd earned a monthly return of 1.66% with volatility of 5.07%. Flight Centre Travel Group Ltd has earned a return of 3.01% with volatility of 8.30% and Domino's Pizza Enterprises Ltd has provided a return of 1.40% with volatility of 9.16%. REA Group Ltd has been observed to be earning a return of 2.33% with volatility of 8.01%.

The monthly average return on ASX index has been 0.30% with the volatility of 3.59%. This implies that all the five stocks selected in the portfolio are earning returns higher than the overall market return. Apart from this, approximately 28% of the total funds have been invested in the investment companies that further invest the funds in the different avenues. The investment in the investment companies provides larger diversification and reduces the risk further. Besides this, 10% of the total funds have been invested in US equities through 'iShares S&P 500. Further, funds amounting to $40,000 have been kept in cash management account. This cash balance has been kept in account to meet the requirements of marginal pay for short selling of future contracts. The future contract at the rate of 5,663 has been taken to hedge 50% of exposure in individual Australian equities.

Alignment of Portfolio Recommendations with the Investment Strategy

The investment strategy selected for the client is active investment strategy. The active investment strategy requires selection of stocks that have potential to make higher returns. As it is known that higher stock returns would be coupled with higher risk; therefore the stocks having higher volatility in the prices have been selected from the list of top 100 companies. All the stocks provide returns higher than the market return. The primary aim of the active strategy is to beat the market by exploiting the market inefficiencies. The selection of stocks in the current portfolio aligns with this strategy because all the stocks comprised in the portfolio have the potential to beat the market (Haight, Ross, and Morrell, 2008).;

Conclusion

This document presents an investment proposal for a client who seeks to invest a sum of $200,000. From the discussion, it could be inferred that the assessment of risk and return preferences of the investor is the first and primary set in investment planning and portfolio construction. Based on the investors willingness to take risk, active investment strategy has been proposed to the client. Further, a well diversified investment portfolio has been constructed for the client. The portfolio involves individual stocks from Australian equities, investing companies, and exposure to US equity market. Further, since, the active investment strategy is considered risky, therefore, the risk exposure in Australian equities has been hedged with the use of future contracts derivatives. The client is recommended to review the portfolio on a regular basis and switch the positions from time to time as per market trend.;

References

Fabozzi, F.J. and Markowitz, H.M. 2011. Equity Valuation and Portfolio Management. John Wiley & Sons.

Haight, G.T., Ross, G., and Morrell, S.O. 2008. How to Select Investment Managers and Evaluate Performance: A Guide for Pension Funds, Endowments, Foundations, and Trusts. John Wiley & Sons.

Prigent, J. 2007. Portfolio Optimization and Performance Analysis. CRC Press.

Rutterford, J. and Davison, M. 2007. An Introduction to Stock Exchange Investment. Palgrave Macmillan.

Wermers, R. and Yao, T. 2010. Active vs. Passive Investing and the Efficiency of Individual Stock Prices. [Online]. Available at: [Accessed on: 08 August 2017].

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