Investment Management Lecture Notes

Chapter 1: Investments & Issues

Asset Allocation

  • Definition: Spreading earnings across different asset categories.

  • Importance: Fundamental to achieving portfolio return.

  • Key Considerations:

    • Invest: Consideration of the percentage of the fund allocated in various asset classes.

    • Investment Strategies:

    • Top-down investment strategies emphasize market selection and asset allocation.

Security Selection

  • Definition: The process of choosing specific stocks or bonds for investment.

  • Comparison of Strategies:

    • Bottom-up strategy: Focuses on selecting strong individual stocks regardless of overall asset allocation.

Efficient Markets

  • Definition: A market where asset prices reflect all available information.

  • Management Styles:

    • Passive Management: Long-term holding of bonds without reacting to market changes.

    • Active Management: Frequent buying and selling based on market forecasts and analysis.

Major Participants in Investment Management

  • Business Firms: Entities that order securities.

  • Households: Individuals who save money.

  • Governments: Act as both borrowers and savers.

  • Financial Intermediaries: Institutions that bridge savers and borrowers, including:

    • Banks

    • Insurance Companies

    • Investment Companies

    • Hedge Funds

    • Pension Funds

  • Investment Bankers: Facilitate the sale of new stocks or bonds to the public, ensuring companies acquire necessary funds.

Types of Markets

  • Primary Market: Initial sale of securities, where new stock offers are purchased.

  • Secondary Market: Existing securities are traded among investors (e.g., New York Stock Exchange).

Venture Capital

  • Definition: Investment in private equity, financing new firms (often referred to as angel investing).

  • Participants: Wealthy individuals providing funds to startups.

Private Capital

  • Definition: Investments in privately-held companies; shares are not traded publicly.

  • Relevance of Fintech:

    • Definition: Financial technology innovating the marketplace, often removing intermediaries.

    • Examples:

    • Peer-to-peer lending

    • Robo-advisors

    • Cryptocurrencies

    • Blockchain technology

The Financial Crash of 2008-2009

  • Context before the crash:

    • Early 2000s: Federal Reserve lowered interest rates aggressively.

    • TED Spread: At 0.25% in 2007, signaling stable economic conditions leading to market boom.

  • Contributing Factors to the Crash:

    • Inclusion of non-conforming “Subprime loans.”

    • Low or no documentation loans.

    • Rising loan-to-value ratios.

    • Adjustable-rate mortgages (ARMs).

  • Mortgage Derivatives: CDOs (Collateralized Debt Obligations) consolidated default risks, dividing payments into tranches for different investors.

    • Role of Rating Agencies: Payment by issuers pressured agencies to assign high ratings irresponsibly.

  • Credit-default Swaps: These are insurance contracts against the borrowers' default, increasing risk levels significantly.

  • Systemic Risk: Factors include:

    • High leverage among banks.

    • Illiquid asset positions.

    • Potential market spillovers that disrupt other markets.

  • Dodd-Frank Reform Act:

    • Implemented stricter rules regarding bank capital, liquidity, and risk management.

    • Increased transparency requirements, clarifying the regulatory framework.

    • Volcker Rule: Limits banks' abilities to trade for their own account.

  • Securitization: Pooling of loans into standardized loans that can be traded like securities, improving liquidity.

Investment Fundamentals

  • Investment Definition: The current commitment of money/resources with the expectation of future benefits.

  • Types of Assets:

    • Real Assets: Tangible assets that produce goods and services (e.g., real estate with productive capacity).

    • Financial Assets: Claims on real assets or income they generate, which must aggregate to liabilities (e.g., deposits, insurance).

    • Fixed Income Securities: Pay fixed cash flows over specified periods (e.g., corporate bonds).

    • Equity: Represents an ownership share in a corporation.

    • Derivative Securities: Instruments whose payoffs depend on the values of other assets (e.g., call options, put options, floating-rate bonds).

Role of Financial Markets

  • Market Efficiency: Generally efficient but exceptions exist (e.g., information asymmetry).

  • Capital Allocation: Financial markets guide capital towards promising ventures with growth potential.

  • Price Dynamics: Prices fluctuate based on positive or negative information content; in the long run, firms' prices should find an equilibrium with the market price.

Consumption Timing

  • Concept: Timing of stock purchases and sales based on earnings levels; higher earnings lead to buying stocks, lower earnings lead to selling.

Risk Allocation

  • Definition: Investors choose risk levels based on willingness to accept different risk profiles.

    • High-risk investors prefer stocks for potential high returns; low-risk investors select bonds for steadier income.

  • Comparison of Risk Levels:

    • Bonds (low risk) vs. Stocks (high risk).

    • Bank CDs (low risk) vs. Company CDs (higher risk).

Separation of Ownership and Management

  • Definition: Stockholders own shares, while CEO, CFO, and managers conduct company operations.

  • Agency Issues: Potential misalignment of interests between owners and managers.

  • Mitigation Strategies:

    • Performance-based compensation (e.g., stock options).

    • Possible managerial dismissal by the board.

    • Threat of hostile takeovers.

Stakeholder Capitalism

  • Definition: A broader corporate concept where groups urge companies to address ethical and societal issues beyond profit maximization.

  • ESG Investment: Investment decisions considering Environmental, Social, and Governance factors.

    • Example: Companies that are transparent and socially responsible in treatment and timelines for strategic decisions.

Corporate Governance and Ethics

  • Importance: Trust is critical for corporate functionality; breakdown of trust incurs costly legal and regulatory consequences.

  • Failure in governance ethics can have macroeconomic implications, undermining confidence and support.

  • Sarbanes-Oxley Act: Introduced:

    • Requirements for more independent directors.

    • CFO verification of financial statements.

    • Creation of an auditing oversight board to maintain ethical standards.

Risk-Return Trade-off

  • Principle: Higher expected returns correlate with higher risk (expected return as a function of risk).

  • Examples:

    • Stock investments might present a risk of a 25% loss with an average expected return of 12%.

    • Bonds exhibit lower risk with anticipated gains of approximately 6%.

Measuring Risk

  • Portfolio Systematic Risk: Known as beta, represents the tendency of an investment's returns to respond to market movements.

  • Diversification:

    • Reduces company-specific risk while protecting an investment portfolio through varied asset allocation strategies.