Module 5

INVESTMENT
MANAGEMENT
Learning Outcomes
 Define investment management .
 Discuss the objectives of investment
management.
 Differentiate investment and speculation;
investment and gambling.
 Explain the investment avenues
 Discuss risk management .
What is investment ?

• Investment is defined as a sacrifice made now to obtain a

return later. It is current consumption that is sacrificed.
• Investment is putting money into something with the
expectation that it will generate income or the value will
appreciate in future or profit.
• “Commitment of funds made in the expectation of some
positive rate of return.”
• Investment is the employment of funds with the aim of
achieving additional income or growth in value.
Expectation of return is
an essential element of
investment .
Financial Meaning :
Economic Meaning :
Investment is the
commitment of a person’s Net additions to the
funds to derive future economy’s capital stock
income in the form of which consists of
interest, dividend, goods and services that
premiums, pension or are used in the
appreciation in the value of production of other
their capital. goods and services.
Who are the Investors?
Institutional Investors
 Pension Funds
 Defined-Benefit Plans
 Defined-Contribution Plans
 Hybrid and other Plans
 Foundations and Endowments
 Foundations
 Endowments
 The Insurance Industry
 Life Insurance Companies
 Non-Life Insurance Companies
 Banks and other Institutional Investors
Financial investment involves funds
in various assets such as stocks,
bonds, real estate , mortgages, etc.
 Investment vs. Speculation
Basis Investment Speculation
Time Horizon Long Term-beyond 12 Short term-holding assets from
months one day up to one year
Risk Limited High
Source of Income Earnings of Enterprises Change in Market Price
Stability of Income Very Stable Uncertain
Use of Funds Own Funds Own Funds, borrowed funds
Type of Contract Creditor Ownership
Psychological Attitude Cautious and Conservative Aggressive and Daring
of Participants
 Investment vs. Speculation
Points of Investor Speculator
Comparison
Planning Usually investors have A speculator has a very
Horizon longer investment short planning horizon. His
horizon which leads to holding period normally
few years. extends from few days to
Investors generally opt few months.
for larger investment
horizon.
 Investment vs. Speculation
Risk An investor normally is willing to Speculators knowingly or
assume a reasonable and unknowingly is ready to
moderate level of risk and he is take very high level of risk.
rarely ready to assume high level Generally, he is ready to
of risk. lose basic capital also.

Return Expectation An investor usually seeks a Speculators usually has a

reasonable rate of return at limited very high return
risk offered by the asset classes. expectations and for that
he is ready to bear high risk
also.
 Investment vs. Gambling
Points of Difference Investment Gambling
Planning Horizon Longer Planning Short Planning
Basis for Decisions Scientific Analysis of intrinsic Based on tips and rumors
works of the security
Nature Planned Activity Unplanned Activity
Risk Commercial Risk Artificial Risk
Return Expectation Risk-return trade off determines Negative returns as
return expected
Motive Safety of principal and stability of Entertainment wide
returns earnings
 Investment Avenues
Real Estate Commodities Miscellaneous Debt Equity

Apartments,
Plots,
Gold Cash, FDs,
Art Shares /
Commercial Silver Bonds,, Fixed Stocks
Maturity Plans Mutual Funds
Mutual Equity,
Funds
Mutual Mutual Funds Diversified
Fixed Income
Real estate, Funds Balanced
Balanced
Funds
mutual Gold, Floating Rate Insurance
funds Liquid
ETFs
Investment Avenues
Equity Shares Fixed Income Securities

Mutual Fund Schemes Deposits

Tax Sheltered Schemes Life Insurance Policies

Real Estate Precious Objects

Money Market Financial Derivatives

Investments
Risk/Return Trade Off

Higher Risk
Return

Low Risk High Potential

Low Return
Return

Standard Deviation ( Or Risk

Short Term Investment Long Term Investment
Avenues : Avenues :
Savings Account Time Deposits
Money Market Funds Public Provident Funds
Bank Fixed Deposit Bonds and Debentures
Life Insurance
 Options and Futures

Ordinary Shares
High Return and Higher
Mutual Funds Potential Return

Savings Accts. And

Corporate Bonds
Gift Edged Instruments
Low Risk and Low Return
Security Markets
Two types of security markets:
• Primary markets
• Secondary markets
 Primary market is a market for new
issues of securities.
 Secondary market is trading of
already issued securities among
investors .
 Securities Market

Government Securities Corporate Securities

( gilt edged securities)
Primary Secondary
Over the Counter Market (new issues) ( old issues)
stock exchanges
New issues old issues

Structure of Securities Markets

Capital Market
The capital market consists of primary
market and secondary market. Newly
formed ( issued) securities are bought or
sold in primary markets. Secondary markets
allow investors to sell securities that they
hold or buy existing securities.
Financial Market
Equity
Capital Market
Derivatives
Bonds Financial Markets
Commodities Markets
Money Market
Future Markets
Foreign Exchange Markets

Capital market Primary Market

Secondary Market
 Financial Market

Is a mechanism that allows people to buy and

sell ( trade) financial securities ( such as
stocks and bonds) , commodities ( such as
precious metals or agricultural goods) and
other items of value at low transaction costs
and at prices that reflect the efficient-market
hypothesis.
Functions of Primary Market
Underwriting

FUNCTIONS OF Distribution
Origination PRIMARY
MARKET
1.Origination – it refers to the work of investigation ,
analysis and processing of new project proposal.
Therefore, origination is the origin of new issues.
2. Underwriting – it is an agreement between the
underwriter and the issuer whereby the underwriter
promises to subscribe to a speficied number of
securities in the event of public not subscribing to it.
Major Functions of Exchange

• Provision of market place

• Monitors trading
• Listing of securities
• Monitoring listed securities
• Supervision of trading participants
 Functions and Purposes
• The stock market is one of the most lucrative ways a company
is able to raise money.
• Investors find the liquidity that an exchange offers; by quickly
and easily selling securities as beneficial .
• The health of an economy is measured by the activity of its
stock market.
• Rising share prices affect , for example , business
investments and the wealth of households and their
consumption.
Functions and Purposes

Stock Brokers/ Buyer

Exchange Brokerage
houses Seller
 Role and Functions of a Stock Exchange

• To bring companies and investors together so that investors can

put risk capital into companies and companies can use the capital.
• Provide an orderly regulated markets for securities.
• Facilitate continuous , ready and open market for selling and
buying securities.
• Promote savings and investment in the economy by attracting
funds from the investors.
• Facilitate takeovers by means of acquiring majority of shares
traded on the stock market.
Portfolio Management as a Process
Portfolio Management as a Process
 Portfolio management is an integrated set of steps undertaken in a consistent
manner to create and maintain appropriate combination of investment assets.
 Planning Step
 Investor’s Objectives and Constraints
 Investment Policy Statement (IPS)
 Forming Capital Market Expectations
 Creating Strategic Asset Allocation
 Execution Step
 Portfolio Construction and Revision
 Portfolio Optimization
 Tactical Asset Allocation
 The Feedback Step
 Monitoring and Rebalancing
 Performance Evaluation
 Investment Objectives
 Risk Objective largely determines return objective
 How to measure risk?
 Absolute vs Relative
 Downside Risk: Value at Risk (VaR)
 What is the investor’s willingness to take risk? Institutional vs. Individual
 Investor’s ability to take risk?
 Return Objectives
 How is Return Measured? Total/Nominal/Real
 Stated Return Desire
 Required Return
 Investment Constraints
 Liquidity
 Time Horizon
 Tax Concerns
 Legal and Regulatory Factors
 Unique Circumstances
Defined-Benefit (DB Plan)
 Plan sponsor is obligated in terms of the benefits to plan participants.
 Promise made by a plan sponsor generates a future financial liability or
“pension liability”.
 Return Objective
 To achieve returns that adequately fund pension liabilities
 Overhang of trillion dollars liabilities

 Risk:
 DB plans payout of the pension assets, which are invested in the market.
 Market Risk
 Longevity Risk
 Liquidity Risk
 Funding status – under-funded/over-funded
 Overall low risk tolerance
Defined-Contribution (DC Plan)
 Plan sponsor is obligated in terms of contribution to
pension fund rather than benefits to plan participants.
 Promise for DC Plan is for the current stage – there is no future financial
liability.
 DC Plan sponsor bears the legal risk of investing
 DC plans are portable
Foundations
 Usually grant making institutions funded by gifts and investment
assets – usually created by single donor to fund philanthropic goals.
 Investment portfolio provides the dominant source of revenue
 Purchasing power of its corpus is either maintained or not.
 US tax laws essentially mandate minimum level of annual spending.
 Foundations can vary widely in their investment goals and time
horizon.
 Foundations, generally, don’t fundraise or reach out to donors.
 Risk & Return Objectives:
 Foundations can have higher risk tolerance
 Most Foundations want to preserve corpus and target returns accordingly
Endowments
 Long-term funds (inter-generational) generally owned by
non-profit institutions like universities, hospitals, museums
etc.
 Preserve purchasing power of the principal gift and to use
fraction of returns as spending for designated cause.
 Risk & Return Objectives:
 Return objective is to provide significant, stable, and sustainable flow of
funds to support designated programs.
 Risk is related to spending policy; Averaging rules dampen short term
volatility while striving for long term target returns.
 Risk tolerance depends on the endowment’s role in operating budget.
Risk Management as Process

• Risk management is a process involving:

– Identifying Risk factors
– Quantification of exposure to risk
– Map various risks in to risk estimation calculation
– Identify overall risk exposure
– Continuous measurement of exposure
– Adjustment to exposure according to agreed risk exposure limits
– Alteration based on new information
Portfolio Risk Universe

Systematic Risk: Influences large number of assets, difficult to diversify

Unsystematic risk: Influences small number of assets, manageable
Credit and Default Risk: Associated with Bonds and Stocks
Geo-political Risk: Related to policies and internal situation of a region or country
Foreign Exchange Risk: due to financial policies of various countries
Interest Rate Risk: Related to Fed policy
Market Risk: Related to market volatility
Headline Risk: Avoid Bad Publicity
Asset Class

Traditional Alternative
Stocks Hedge Funds
Bonds Private Equity
REITS Private Real Estate
Commodities Natural Resources
 Asset Class Characteristics
Asset Class/Strategy Risk Characteristics

Public Equity Market beta/high Volatility High return/Growth

Private Equity Illiquid/high Volatility Higher return/Growth
Real Estate (REITS) Market beta/high Volatility High return/Growth/Inflation
Protection

Real Estate (Private) Illiquid/regional/Volatile High return/Inflation protection

Bonds Low Volatility Low return/Risk minimizing

TIPS Low Volatility Low return/Inflation protection

Natural Resources/Real Illiquid High Return/Inflation

Assets protection
Portfolio Construction: Risk Reward Trade-off

 Rational portfolio choices based on the efficient risk (Modern Portfolio

Theory).
 Capital Markets Expectations
 Asset class and strategy diversification
 Use of quantitative methods in portfolio management
 Risk budgeting
Endowment Management
Investment Strategy Implementation
• Manager searches
• Manager evaluation
• Investment Portfolio Monitoring
• Portfolio risk management
• Performance measurement
• Performance reporting
• Performance and attribution analyses
• Capital markets monitoring
•
Investment Risk Management

360 degree risk management

 Risk minimization is one of the three objectives
 Investment decisions are based on better risk adjusted returns and
downside risk protection.
 Investment portfolio is diversified across asset classes, markets, and
strategies to mitigate risk.
 Manager selection is based on stringent quantitative and qualitative due-
diligence.
 Risk reporting is part of the culture
Types of Risks

• Market Risk
• Manager Performance Risk
• Counter-party Risk
• Manager Business Risk
• Concentration Risk
• Style drift Risk
• Fraud Risk