Chapter Two: Managing Investments

2.1. Principles for Managing Financial Assets

Part of the wealth owned by individuals consists of financial assets such as bonds, stocks, bank
accounts, and the like which are not items of material wealth in themselves but only claims
against tangible wealth. In some respects, however, their significance is equivalent to that of the
material wealth they represent, and the processes by which they are created and extinguished are
among those most crucial to the proper functioning of the economy. When an individual
purchases a financial asset, he is in effect allowing some other individual or company to use his
funds. Although the purchase does not necessarily mean that individual savings are being
channeled into real investment, net increments to the stock of financial assets owned by all
individuals which are not offset by increases in the cash balances of the issuers (or by decreases
in their indebtedness to the banking system) result in a flow of savings into real investment,
provided the increments do not arise solely from price increases.
Recent economic thinking emphasizes the tenuous nature of the connection between saving and
investment processes, recognizing that in a highly industrialized economy a considerable part of
all real investment is performed by persons and organizations other than those doing the saving.
Financial assets provide a link, so to speak, in the indirect connection between saving and
investment. More specifically, investors / companies are interested in managing and determining
how different types of financial assets are distributed among individuals classified according to
their income, their occupation, and stratifications of society which are regarded as important in
accounting not only for the economic behavior of individuals but also for their actions in other
respects.
2.2. Managing Corporate Pension Funds
A pension is a form of investment or saving plan designed to provide you with an income to live
on when you retire.
Pension funds may be defined as forms of institutional investor, which collect pool and invest
funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of
beneficiaries. They thus provide means for individuals to accumulate saving over their working
life so as to finance their consumption needs in retirement, either by means of a lump sum or by
provision of an annuity, while also supplying funds to end-users such as corporations, other
households (via securitized loans) or governments for investment or consumption.
Characteristics of Pension Funds
 Risk pooling for small investors, providing a better trade-off of risk and return than for
direct holdings;
 A premium on diversification, both by holding a spread of domestic securities (which
may be both debt and equity) and also by international investment;
 A preference for liquidity, and hence for large and liquid capital markets, which trade
standard or 'commoditized' instruments;
 Ability to absorb and process information, superior to that of individual investors in the
capital market. On the other hand, unlike bank lending, pension funds rely on public
information rather than private, which links strongly to their desire for liquidity;
 Large size and thus economies of scale, which result in lower average costs for investors.
These may arise from; inter alia, ability to transact in large volumes which typically leads
to a lowering of transactions costs. Investors share the costly services of expert
investment managers and thereby save in advisory fees. Size also enables the funds to
invest in large indivisible investments (although there is a tension with desire for
diversification);
 Countervailing power, this may be used to reduce transactions costs and custodial fees.
This countervailing power also gives rise to ability to ensure the most favorable terms
from capital market intermediaries on the one hand, and on the other gives a potential for
improved control over companies in which they invest, thus reducing the incidence of
adverse incentive problems.
Types of Pension Funds
Pension plans established to provide for payments to plan participants after retirement.
i. Defined Contribution Plans
The DCP arrangement is the conceptually simpler retirement plan. The employer, and sometimes
also the employee, makes regular contributions into the employee's retirement account. The
contributions are usually specified as a predetermined fraction of salary, although that fraction
need not be constant over the course of a career.
Contributions from both parties are tax-deductible, and investment income accrues tax-free.
Often the employee is given a choice as to how his account is to be invested. In principle,
contributions may be invested in any security, although in practice most plans limit investment
options to various bond, stock, and money-market funds. At retirement, the employee either
receives a lump sum or an annuity, the size of which depends upon the accumulated value of
the funds in the retirement account. The employee thus bears all of the investment risk; the
retirement account is by definition fully funded, and the firm has no obligation beyond making
its periodic contribution.
ii. Defined Benefit Plans
A typical DB plan determines the employee’s benefit as a function of both years of service and
wage history. As a representative plan, consider one in which the employee receives 1 percent of
average salary (during the last 5 years of service) times the number of years of service.
Amounts participants receive in retirement specified by formula set in advance.
Defined benefit pension plans promise fixed retirement benefits defined by a designated formula.
Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b)
annual compensation [often final pay or an average for the last few years], and sometimes (c)
age. Employers are responsible for ensuring that sufficient funds are available to provide
promised benefits.

Pension Fund Management

 Management of “insured” portfolios
 Some plans are managed by life insurance companies
 Insured plans purchase annuity policies so the life insurance company can
provide benefits to the employees upon retirement
 Retirement benefits are “assured” by credit strength of life insurance
company
 No federal insurance coverage
 Management of trusted portfolios
 Managed by the trust department of a financial institution
 Corporations specify guidelines
 Returns
  Risks
 Some companies have allocation systems to try and minimize risks
 Management of private versus public pensions
 Private business vs. state, municipal pensions
 Private pension portfolios dominated by common stock
 Public pension portfolios more evenly invested in stock, bonds and other
credit instruments
2.3. Management of Mutual funds and Investment Companies
Mutual funds:
A mutual fund is a company that pools money from many investors and invests the money in
stocks, bonds, short-term money-market instruments, other securities or assets, or some
combination of these investments. The combined holdings the mutual fund owns are known as
its portfolio. Each share represents an investor’s proportionate ownership of the fund’s holdings
and the income those holdings generate.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out
nearly all of the income it receives over the year to fund owners in the form of a
distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most
funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's
shares increase in price. You can then sell your mutual fund shares for a profit.
Characteristics of Mutual Funds
Some of the traditional, distinguishing characteristics of mutual funds include the following:

 Investors purchase mutual fund shares from the fund itself (or through a broker for the
fund) instead of from other investors on a secondary market.

 The price that investors pay for mutual fund shares is the fund’s per share net asset value
(NAV) plus any shareholder fees that the fund imposes at the time of purchase (such as
sales loads).
  Mutual fund shares are “redeemable,” meaning investors can sell their shares back to the
fund (or to a broker acting for the fund).

 Mutual funds generally create and sell new shares to accommodate new investors. In
other words, it sells its shares on a continuous basis, although some funds stop selling
when, for example, they become too large.

 The investment portfolios of mutual funds typically are managed by separate entities
known as “investment advisers” that are registered with the Security Exchange
Commission (SEC).
Advantages and Disadvantages

Every investment has advantages and disadvantages. But it’s important to remember that features
that matter to one investor may not be important to you as an investor. Whether any particular
feature is an advantage for you will depend on your unique circumstances. For some investors,
mutual funds provide an attractive investment choice because they generally offer the following
features:

Advantages of Mutual Funds

 Professional Management- Investors purchase funds because they do not have the time
or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive
way for a small investor to get a full-time manager to make and monitor investments.
 Diversification - By owning shares in a mutual fund instead of owning individual stocks
or bonds, your risk is spread out. The idea behind diversification is to invest in a large
number of assets so that a loss in any particular investment is minimized by gains in
others. In other words, spreading your investments across a wide range of companies and
industry sectors can help lower your risk if a company or sector fails.
 Economies of Scale - Because a mutual fund buys and sells large amounts of securities at
a time, its transaction costs are lower than what an individual would pay for securities
transactions.
 Liquidity - Just like an individual stock, a mutual fund allows you to request that your
shares be converted into cash at any time.
  Affordability- Some mutual funds accommodate investors who don’t have a lot of
money to invest by setting relatively low dollar amounts for initial purchases, subsequent
monthly purchases, or both.

But mutual funds also have features that some investors might view as disadvantages, such
as:
 Costs - Investors must pay sales charges, annual fees, and other expenses regardless
of how the fund performs. And, depending on the timing of their investment,
investors may also have to pay taxes on any capital gains distribution they receive
even if the fund went on to perform poorly after they bought shares.
 Lack of Control- Investors typically cannot ascertain the exact make-up of a fund’s
portfolio at any given time, nor can they directly influence which securities the fund
manager buys and sells or the timing of those trades.
 Dilution - It's possible to have too much diversification. Because funds have small
holdings in so many different companies, high returns from a few investments often
don't make much difference on the overall return. Dilution is also the result of a
successful fund getting too big. When money pours into funds that have had strong
success, the manager often has trouble finding a good investment for all the new
money.
 Taxes - When a fund manager sells a security, a capital-gains tax is triggered.
Investors who are concerned about the impact of taxes need to keep those concerns in
mind when investing in mutual funds. Taxes can be mitigated by investing in tax-
sensitive funds or by holding non-tax sensitive mutual fund in a tax-deferred account.
 Price Uncertainty- with an individual stock, you can obtain real-time pricing
information with relative ease by checking financial websites or by calling your
broker. You can also monitor how a stock’s price changes from hour to hour or even
second to second. By contrast, with a mutual fund, the price at which you purchase or
redeem shares will typically depend on the fund’s NAV, which the fund might not
calculate until many hours after you have placed your order. In general, mutual funds
must calculate their NAV at least once every business day.

Different Types of Mutual Funds

When it comes to investing in mutual funds, investors have literally thousands of choices. Before
you invest in any given fund, decide whether the investment strategy and risks of the fund are a
good fit for you. The first step to successful investing is figuring out your financial goals and risk
tolerance either on your own or with the help of a financial professional. Once you know what
you are saving for, when you will need the money, and how much risk you can tolerate, you can
more easily narrow your choices.
Most mutual funds fall into one of three main categories money market funds, bond funds (also
called “fixed income” funds), and stock funds (also called “equity” funds). Each type has
different features and different risks and rewards. Generally, the higher the potential return, the
higher the risk of loss.
Money Market Funds
The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe
place to park your money. You won't get great returns, but you won't have to worry about losing
your principal. A typical return is twice the amount you would earn in a regular checking/savings
account and a little less than the average certificate of deposit (CD).
Bond/ Fixed Income Funds
Bond funds generally have higher risks than money market funds, largely because they typically
pursue strategies aimed at producing higher yields. Unlike money market funds, the SEC’s rules
do not restrict bond funds to high-quality or short-term investments. Because there are many
different types of bonds, bond funds can vary dramatically in their risks and rewards. Some of
the risks associated with bond funds include: credit risk, interest rate risk, and prepayment risk
and so on.
Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the
investment objective of this class of funds is long-term capital growth with some income. There
are, however, many different types of equity funds because there are many different types of
equities.
Although a stock fund’s value can rise and fall quickly (and dramatically) over the short term,
historically stocks have performed better over the long term than other types of investments
including corporate bonds, government bonds, and treasury securities. Overall “market risk”
poses the greatest potential danger for investors in stocks funds. Stock prices can fluctuate for a
broad range of reasons such as the overall strength of the economy or demand for particular
products or services.

Not all stock funds are the same. For example:

 Growth funds focus on stocks that may not pay a regular dividend but have the potential
for large capital gains.
 Income funds invest in stocks that pay regular dividends.
 Index funds aim to achieve the same return as a particular market index.
 Sector funds may specialize in a particular industry segment, such as technology or
consumer products stocks.

Investment Companies
Investment companies are financial intermediaries that collect funds from individual investors
and invest those funds in a potentially wide range of securities or other assets. Pooling of assets
is the key idea behind investment companies. Each investor has a claim to the portfolio
established by the investment company in proportion to the amount invested. These companies
thus provide a mechanism for small investors to “team up” to obtain the benefits of large-scale
investing.
Investment companies perform several important functions for their investors:
1. Record keeping and administration- Investment companies issue periodic status reports,
keeping track of capital gains distributions, dividends, investments, and redemptions, and they
may reinvest dividend and interest income for shareholders.
2. Diversification and divisibility- By pooling their money, investment companies enable
investors to hold fractional shares of many different securities. They can act as large investors
even if any individual shareholder cannot.
3. Professional management- Many, but not all, investment companies have full-time staffs of
security analysts and portfolio managers who attempt to achieve superior investment results
for their investors.
4. Lower transaction costs- Because they trade large blocks of securities, investment companies
can achieve substantial savings on brokerage fees and commissions.
While all investment companies pool assets of individual investors, they also need to divide
claims to those assets among those investors. Investors buy shares in investment companies, and
ownership is proportional to the number of shares purchased. The value of each share is called
the net asset value, or NAV. Net asset value equals assets minus liabilities expressed on a per-
share basis:
Net asset value = Market values of assets minus liabilities
Shares outstanding
Example:

Consider a mutual fund that manages a portfolio of securities worth $120 million. Suppose the
fund owes $4 million to its investment advisers and owes another $1 million for rent, wages due
and miscellaneous expenses. The fund has 5 million shares outstanding.
Fundamental characteristics of Investment Companies
An investment company must have the following fundamental characteristics:
 The entity obtains funds from one or more investors and provides the investor(s) with
investment management services.
 The entity commits to its investor(s) that its business purpose and only substantive
activities are investing the funds solely for returns from capital appreciation, investment
income or both.
 The entity or its affiliates do not obtain or have the objective of obtaining returns or
benefits from an investee or its affiliates that are not normally attributable to ownership
interests or that    are other than capital appreciation or investment income.
Typical characteristics of Investment Companies
An investment company also has the following typical characteristics:
 It has more than one investment.
 It has more than one investor.
 It has investors that are not related parties of the parent (if there is a parent) or the
investment manager.
 It has ownership interests in the form of equity or partnership interests.
 It manages substantially all of its investments on a fair value basis.
Types of Investment Companies
There are two types of investment companies: closed-end and open-end.
A. Open-End Investment Companies
Open-end investment companies (commonly referred to as mutual funds) continuously issue and
redeem ownership shares. The shares of an open-end fund do not trade in a secondary market or
on any organized exchange; instead, investors purchase shares from the company. Likewise,
investors redeem shares by selling them back to the company, where they are retired . Thus, the
equity capital and assets of a mutual fund are increased when shares are sold and are reduced
when shares are repurchased.
Open-end fund company shares are marketed in a variety of ways. Investors may purchase shares
directly from the fund or through a licensed broker. Security regulations require that a prospectus
be made available to the potential investor prior to the actual sale. A prospectus details the
investment philosophy of the fund, assesses the risks in an actual investment, and discloses
management fee schedules, dividend re-investment policies, share redemption policies, past
performance, etc. Any sales or redemption fees (i.e., ‘‘loads’’) must also be disclosed. The
prospectus is updated quarterly to provide current information to potential investors. Generally,
there are minimum initial investment dollar amounts and minimum subsequent investment
amounts; usually the latter is significantly smaller than the former.
B. Closed-End Investment Companies

Commonly referred to as closed-end funds, CEFs do not continuously issue or redeem ownership
shares. Initially, there is a public offering of shares, which is preceded by the issuance of a
prospectus as described above. Like most other initial public offerings, the shares are generally
offered to the public by licensed brokers. At this occasion, however, the similarity ends between
closed-end and open-end funds.
After the shares of the new closed-end fund are offered to the public, the fund invests the
proceeds from the initial public offering in accordance with the policy statement disclosed in the
prospectus. CEFs, however, do not sell new shares to interested shareholders, nor do they stand
willing to redeem shares from their investors. To obtain shares after a public offering is
completed, an investor must purchase shares from other investors in the secondary market (one
of the exchanges or the over-the-counter (OTC) market). There is no legal requirement that there
be any formal relationship between the price of the shares and the fund’s assets.
2.4. The Investment Process

The investment process is description of the steps that an investor should take to construct and
manage their portfolio. These proceed from the initial task of identifying investment objectives
through to the continuing revision of the portfolio in order to best attain those objectives.
The steps in this process are:

a. Determine Objectives- Investment policy has to be guided by a set of objectives. Before

investment can be undertaken, a clear idea of the purpose of the investment must be obtained.
The purpose will vary between investors. Some may be concerned only with preserving their
current wealth. Others may see investment as a means of enhancing wealth. What primarily
drives objectives is the attitude towards taking on risk. Some investors may wish to eliminate
risk as much as is possible, while others may be focused almost entirely on return and be
willing to accept significant risks.
b. Choose Value- The second decision concerns the amount to be invested.
This decision can be considered a separate one or it can be subsumed in the allocation
decision between assets (what is not invested must either be held in some other form
which, by definition, is an investment in its own right or else it must be consumed).
c. Conduct Security Analysis- Security analysis is the study of the returns and risks of
securities. This is undertaken to determine in which classes of assets investments will be
placed and to determine which particular securities should be purchased within a class. Many
investors find it simpler to remain with the more basic assets such as stocks and fixed income
securities rather than venture into complex instruments such as derivatives. Once the class of
assets has been determined, the next step is to analyze the chosen set of securities to identify
relevant characteristics of the assets such as their expected returns and risks. This information
will be required for any informed attempt at portfolio construction.
Another reason for analyzing securities is to attempt to find those that are currently mispriced.
For example, a security that is under-priced for the returns it seems to offer is an attractive
asset to purchase. Similarly, one that is overpriced should be sold. Whether there are any assets
 are underpriced depends on the degree of efficiency of the market. More is said on this issue
later.
Such analysis can be undertaken using two alternative approaches:
• Technical analysis- This is the examination of past prices for predictable trends. Technical
analysis employs a variety of methods in an attempt to find patterns of price behavior that repeat
through time. If there is such repetition (and this is a disputed issue), then the most beneficial
times to buy or sell can be identified.
• Fundamental analysis- The basis of fundamental analysis is that the true value of a security has
to be based on the future returns it will yield. The analysis allows for temporary movements
away from this relationship but requires it to hold in the long-rum. Fundamental analysts study
the details of company activities to makes predictions of future profitability since this determines
dividends and hence returns.
d. Portfolio Construction - Portfolio construction follows from security analysis. It is the
determination of the precise quantity to purchase of each of the chosen securities. A factor
that is important to consider is the extent of diversification. Diversifying a portfolio across
many assets may reduce risk but it involves increased transactions costs and increases the
effort required to manage the portfolio.
e. Evaluation- Portfolio evaluation involves the assessment of the performance of the chosen
portfolio. To do this it is necessary to have some yardstick for comparison since a meaningful
comparison is only achieved by comparing the return on the portfolio with that on other
portfolios with similar risk characteristics.
f. Revision- Portfolio revision involves the application of all the previous steps. Objectives
may change, as may the level of funds available for investment. Further analysis of assets
may alter the assessment of risks and returns and new assets may become available. Portfolio
revision is therefore the continuing reapplication of the steps in the investment process.