ASSET ALLOCATION

Arief Widijatmoko, SE, MMT, CA, Ak

1
Questions to be answered

 Why should investors have a global

perspective regarding their investments?
 What has happened to the relative size of
U.S. and foreign stock and bond markets?
 What are the differences in the rates of return
on U.S. and foreign securities markets?
 How can changes in currency exchange rates
affect the returns that U.S. investors
experience on foreign securities?
Questions to be answered

 Is there an additional advantage of

diversifying in international markets beyond
the benefits of domestic diversification?
 What alternative securities are available?
What are their cash flow and risk properties?
 What is the historical return and risk
characteristics of the major investment
instruments?
Questions to be answered

 What is the relationship among returns for

foreign and domestic investment
instruments? What is the implication of these
relationships for portfolio diversification?
Reasons for the expansion of
investment opportunities

1. Growth and development of foreign

financial markets
2. Advances in telecommunications
technology
3.  Mergers of firms and security exchanges
The Case for Constructing
Global Investment Portfolios
1. Ignoring foreign markets can substantially
reduce the investment choices for U.S.
investors
2. The rates of return on non-U.S. securities
often have substantially exceeded those
for U.S.-only securities
3. The low correlation between U.S. stock
markets and many foreign markets can
help to substantially reduce portfolio risk
Relative Size of U.S. Financial Markets

1. The share of the U.S. in world capital

markets has dropped from about 65 percent
of the total in 1969 to about 48 percent in
2000
2. The growing importance of foreign
securities in world capital markets is likely to
continue
Relative Size of
U.S. Financial Markets

 Overall value of the total investable capital

market has increased from $2.3 Trillion in
1969 to $63.8 Trillion in 2000 and the U.S.
portion has declined to less than half.
 This trend is likely to continue
The Case for Global Investments

Rates of return available on non-U.S.

securities often exceed U.S. Securities due to
higher growth rates in foreign countries,
especially the emerging markets
The Case for Global Investments

Diversification with foreign securities can

help reduce portfolio risk because foreign
markets have low correlation with U.S. capital
markets
Global Bond Portfolio Risk

1. Macroeconomic differences cause the

correlation of bond returns between the
United States and foreign countries to differ
2. The correlation of returns between a single
pair of countries changes over time because
the factors influencing the correlation
change over time
Risk of Combined Country Investments

 Diversified portfolios reduce variability of returns

over time
 Correlation coefficients measure diversification

contribution
 Compare correlation of return among U.S. bonds

and stocks with returns on foreign bonds and

stocks
Global Bond Portfolio Risk
 Low positive correlation
 Opportunities for U.S. investors to reduce
risk
 Correlation changes over time
 Adding non-correlated foreign bonds to a
portfolio of U.S. bonds increases the rate of
return and reduces the risk of the portfolio
Global Equity Portfolio Risk

 Low positive correlation

 Opportunities to reduce risk of stock

portfolio by including foreign stocks

Summary on Global Investing

 Relatively high rates of return combined

with low correlation coefficients

indicate that adding foreign stocks and
bonds to a U.S. portfolio will reduce risk
and may increase its average return
Global Investment Choices
 Fixed-income investments
 bonds and preferred stocks
 Equity investments
 Special equity instruments
 warrants and options
 Futures contracts
 Investment companies
 Real assets
Fixed-Income Investments
 Contractual payment schedule
 Recourse varies by instrument
 Bonds
 investors are lenders
 expect interest payment and return of
principal
 Preferred stocks
 dividends require board of directors approval
Savings Accounts
 Fixed earnings
 Convenient
 Liquid
 Low risk
 Low rates
 Certificates of Deposit (CDs)
- instruments that require minimum deposits
for specified terms, and pay higher rates of
interest than savings accounts. Penalty
imposed for early withdrawal
Money Market Certificates

 Compete against Treasury bills (T-bills)

 Minimum $10,000
 Minimum maturity of six months
 Redeemable only at bank of issue
 Penalty if withdrawn before maturity
Capital Market Instruments

 Fixed income obligations that trade in

secondary market
 U.S. Treasury securities
 U.S. Government agency securities
 Municipal bonds
 Corporate bonds
U.S. Treasury Securities

 Bills, notes, or bonds - depending on

maturity
 Bills mature in less than 1 year
 Notes mature in 1 - 10 years
 Bonds mature in over 10 years
 Highly liquid
 Backed by the full faith and credit of the
U.S. Government
U.S. Government Agency Securities

 Sold by government agencies

 Federal National Mortgage Association (FNMA or
Fannie Mae)
 Federal Home Loan Bank (FHLB)
 Government National Mortgage Association
(GNMA or Ginnie Mae)
 Federal Housing Administration (FHA)
 Not direct obligations of the Treasury
 Still considered default-free and fairly liquid
Municipal Bonds
 Issued by state and local governments usually

to finance infrastructural projects.

 Exempt from taxation by the federal

government and by the state that issued the

bond, provided the investor is a resident of that
state
 Two types:
 General obligation bonds (GOs)
 Revenue bonds
Corporate Bonds

 Issued by a corporation
 Fixed income
 Credit quality measured by ratings
 Maturity
 Features
 Indenture
 Call provision
 Sinking fund
Corporate Bonds
 Senior secured bonds
 most senior bonds in capital structure and have the
lowest risk of default
 Mortgage bonds
 secured by liens on specific assets
 Collateral trust bonds
 secured by financial assets
 Equipment trust certificates
 secured by transportation equipment
Corporate Bonds
 Debentures
 Unsecured promises to pay interest and principal
 In case of default, debenture owner can force
bankruptcy and claim any unpledged assets to pay off
the bonds
 Subordinated bonds
 Unsecured like debentures, but holders of these bonds
may claim assets after senior secured and debenture
holders claims have been satisfied
Corporate Bonds
 Income bonds
 Interest payment contingent upon
earning sufficient income
 Convertible bonds
 Offer the upside potential of common
stock and the downside protection of a
bond
 Usually have lower interest rates
Corporate Bonds
 Warrants
 Allows bondholder to purchase the firm’s common
stock at a fixed price for a given time period
 Interest rates usually lower on bonds with
warrants attached
 Zero coupon bond
 Offered at a deep discount from the face value
 No interest during the life of the bond, only the
principal payment at maturity
Preferred Stock

 Hybrid security
 Fixed dividends
 Dividend obligations are not legally binding, but
must be voted on by the board of directors to be
paid
 Most preferred stock is cumulative
 Credit implications of missing dividends
 Corporations may exclude 70% of dividend
income from taxable income
International Bond Investing

Investors should be aware that there is a very

substantial fixed income market outside the
United States that offers additional opportunity
for diversification
International Bond Investing

 Bond identification characteristics

 Country of origin
 Location of primary trading market
 Home country of the major buyers
 Currency of the security denomination
 Eurobond
 An international bond denominated in a currency
not native to the country where it is issued
International Bond Investing

 Yankee bonds
 Sold in the United States and denominated is
U.S. dollars, but issued by foreign corporations
or governments
 Eliminates exchange risk to U.S. investors
 International domestic bonds
 Sold by issuer within its own country in that
country’s currency
Equity Investments

Returns are not contractual

and may be better or worse
than on a bond
Equity Investments

Common Stock
 Represents ownership of a firm
 Investor’s return tied to performance of
the company and may result in loss or
gain
Classification of Common Stock
Categorized By General Business Line
 Industrial: manufacturers of automobiles,
machinery, chemicals, beverages
 Utilities: electrical power companies, gas
suppliers, water industry
 Transportation: airlines, truck lines,
railroads
 Financial: banks, savings and loans, credit
unions
Acquiring Foreign Equities

1. Purchase of American Depository Receipts

(ADRs)
2. Purchase of American shares
3. Direct purchase of foreign shares listed on
a U.S. or foreign stock exchange
4. Purchase of international mutual funds
American Depository Receipts (ADRs)

 Easiest way to directly acquire foreign shares

 Certificates of ownership issued by a U.S. bank that
represents indirect ownership of a certain number of
shares of a specific foreign firm on deposit in a U.S.
bank in the firm’s home country
 Buy and sell in U.S. dollars
 Dividends in U.S. dollars
 May represent multiple shares
 Listed on U.S. exchanges
 Very popular
Purchase or Sale of American shares

 Issued in the United States by transfer

agent on behalf of a foreign firm
 Higher expenses
 Limited availability
Direct Purchase of Foreign Shares

 Direct investment in foreign equity

markets- difficult and complicated due to
administrative, information, taxation, and
market efficiency problems
 Purchase foreign stocks listed on a U.S.
exchange – limited choice
Purchase International Mutual Funds

 Global funds - invest in both U.S. and foreign

stocks
 International funds - invest mostly outside the
U.S.
 Funds can specialize
 Diversification across many countries
 Concentrate in a segment of the world
 Concentrate in a specific country
 Concentrate in types of markets
Special Equity Instruments
 Equity-derivative securities have a claim
on common stock of a firm
 Options are rights to buy or sell at a stated
price for a period of time
 Warrants are options to buy from the
company
 Puts are options to sell to an investor
 Calls are options to buy from a stockholder
Futures Contracts

 Exchange of a particular asset at a

specified delivery date for a stated price
paid at the time of delivery
 Deposit (10% margin) is made by buyer at
contract to protect the seller
 Commodities trading is largely in futures
contracts
 Current price depends on expectations
Financial Futures
 Recent development of contracts on financial
instruments such as T-bills, Treasury bonds, and
Eurobonds
 Traded mostly on Chicago Mercantile Exchange
(CME) and Chicago Board of Trade (CBOT)
 Allow investors and portfolio managers to
protect against volatile interest rates
 Currency futures allow protection against
changes in exchange rates
Investment Companies
 Rather than buy individual securities
directly from the issuer they can be
acquired indirectly through shares in an
investment company
 Investment companies sell shares in itself
and uses proceeds to buy securities
 Investors own part of the portfolio of
investments
Investment Companies
 Money market funds
 Acquire high-quality, short-term investments
 Yields are higher than normal bank CDs
 Typical minimum investment is $1,000
 No sales commission charges
 Withdrawal is by check with no penalty
 Investments usually are not insured
Investment Companies

 Bond funds
 Invest in long-term government,
corporate, or municipal bonds
 Bond funds vary in bond quality selected
for investment
 Expected returns vary with risk of bonds
Investment Companies
 Common stock funds
 Many different funds with varying stated
investment objectives
▪ Aggressive growth, income, precious metals,
international stocks
 Offer diversification to smaller investors
 Sector funds concentrate in an industry
 International funds invest outside the United
States
 Global funds invest in the U.S. and other countries
Investment Companies

 Balanced funds
 Invest in a combination of stocks and
bonds depending on their stated
objectives
Real Estate Investment Trusts (REITs)

 Investment fund that invests in a variety of

real estate properties
 Construction and development trusts
provide builders with construction financing
 Mortgage trusts provide long-term
financing for properties
 Equity trusts own various income-producing
properties
Direct Real Estate Investment

 Purchase of a home
 Average cost of a single-family house exceeds
$100,000
 Financing by mortgage requires down
payment
 Homeowner hopes to sell the house for cost
plus a gain
Direct Real Estate Investment

 Purchase of raw land

 Intention of selling in future for a profit
 Ownership provides a negative cash flow due
to mortgage payments, taxes, and property
maintenance
 Risk from selling for an uncertain price and low
liquidity
Direct Real Estate Investment

 Land Development
 Buy raw land
 Divide into individual lots
 Build houses or a shopping mall on it
 Requires capital, time, and expertise
 Returns from successful development can be
significant
Low-Liquidity Investments
 Some investments don’t trade on securities
markets
 Lack of liquidity keeps many investors away
 Auction sales create wide fluctuations in
prices
 Without markets, dealers incur high
transaction costs
Antiques

 Dealers buy at estate sales, refurbish, and

sell at a profit
 Serious collectors may enjoy good returns
 Individuals buying a few pieces to
decorate a home may have difficulty
overcoming transaction costs to ever
enjoy a profit
Art

 Investment requires substantial

knowledge of art and the art world
 Acquisition of work from a well-known
artist requires large capital commitments
and patience
 High transaction costs
 Uncertainty and illiquidity
Coins and Stamps
 Enjoyed by many as hobby and as an
investment
 Market is more fragmented than stock
market, but more liquid than art and
antiques markets
 Price lists are published weekly and
monthly
 Grading specifications aid sales
 Wide spread between bid and ask prices
Diamonds

 Can be illiquid
 Grading determines value, but is
subjective
 Investment-grade gems require
substantial investments
 No positive cash flow until sold
 Costs of insurance, storage, and appraisal
Returns of Stocks, Bonds, and T-Bills
 Ibbotson and Sinquefield (I&S) examined nominal and
real rates of return for seven major classes of assets in
the United States
 1. Large-company common stocks
 2. Small-capitalization common stocks
 3. Long-term U.S. government bonds
 4. Long-term corporate bonds
 5. Intermediate-term U.S. Treasury bills
 6. U.S. Treasury bills
 7. Consumer goods (inflation)
Derived Series: Historical
Highlights (1926 - 2001)
 I & S computed geometric and arithmetic mean

rates of return
 They derived four return premiums

 1. Risk premium
 2. Small-stock premium
 3. Horizon premium
 4. Default premium
Returns of Stocks, Bonds, and T-Bills

 Returns and risk increase together

 Rates of return are generally consistent

with the uncertainty of returns

World Portfolio Performance
 Ibbotson, Siegel, and Love examined the
performance of assets around the world
 Asset return and risk relationship is
confirmed
 Coefficients of variation range widely,
showing benefits of global diversification
 Correlations between asset returns vary by
global regions
Art and Antiques
 Market data is limited
 Results vary widely, and change over time,
making generalization impossible, but
showing a reasonably consistent
relationship between risk and return
 Correlation coefficients vary widely,
allowing for great diversification potential
 Liquidity is still a concern
Real Estate
 Returns are difficult to derive due to lack of
consistent data
 Residential shows lower risk and return than
commercial real estate
 During some short time periods REITs have
shown higher returns than stock with lower risk
measures
 Long term returns for real estate are lower than
stocks, and have lower risk
Real Estate

 Negative correlation between residential

and farm real estate and stocks

 Low positive correlation between

commercial real estate and stocks

 Potential for diversification
The Internet
Investments Online

www.wiso.gwdg.de/ifbg/finance.html
www.global-investor.com
www.nfsn.com
www.emgmkts.com
www.datastream.com
www.www.euro.net/innovation/Finance_Base/Fin_ency.html
www.sothebys.com
 Appendix Chapter 3
Covariance and Correlation
Covariance
absolute measure of the
extent to which two sets of
numbers move together
over time
Covariance
Correlation
relative measure of a
given relationship
Correlation
End of Chapter

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