Investment and Portfolio
Management
Neveen Ahmed
Foundation
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Investment choices
Trading Terminologies
Portfolio Management
IPS
Dimension of investment
Investment classes
Asset allocation & Security selection
Investment Philosophies
Margin trading
Short-selling
Index construction
Mutual Fund
Why do we invest?!
• Moving money from present to future
• Why do we do it?
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•
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Wealth Preservation
Wealth Accumulation
Life Goals
Diversification
Now take 3 minutes Rank your preferred
investment
• 1• 2• 3-
Please select the most accurate statement from the
4 statements below
• 1.Highrisk=high return (in the short and long-run)
• 2.Highrisk=high return(in the short-run)
• 3.Highrisk=high return(in the long-run)
Let’s review the nominal performance of familiar
asset classes from 31 Dec 16 to 31 Dec 18
Year 8
Price Gold
Lebanese stock
market
Interest on
deposit *
2016
1,600,000
118.4
1000
2,000,000
2018
Percentage Change 25%
117.8
1123.6
-0.5%
12.36%
What would be the value of LLB 100,000,000 invested back on 31 Dec 16?
Year
Return on
deposit
2016
Return on Gold Return on
Lebanese stock
market
100,000,000
100,000,000
2018
125,000,000
112,360,000
99,493,243
100,000,000
*Assumption interest rate on US deposit as of end 2010 =
6%
Now, let’s take the analysis one step further –enter
“inflation”
CPI
2016
94
2018
104
Percentage change
10.6%
𝐏𝐞𝐫𝐢𝐨𝐝 𝐑𝐞𝐚𝐥 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧= (𝟏+𝐏𝐞𝐫𝐢𝐨𝐝𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧 / 𝟏+𝐏𝐞𝐫𝐢𝐨𝐝 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞) −𝟏
What would be the “Real” value of LBP100,000,000
invested back on 31 Dec 16
CPI
2016
94
2018
104
Percentage change
10.6%
What would be the REAL value of LLB 100,000,000 invested back on 31 Dec 16?
Year
Year
2016
2016
2018
2018
Nominal R
Real R
Return on Gold Return on
Return on
Return on
ReturnLebanese
on
2stock
y CD deposit
market
Gold
Lebanese
100,000,000stock market
100,000,000
100,000,000
100,000,000
100,000,000
127,400,000
99,493,243
112,360,000
127,400,000
113,4000,000
25%
-0.5%
12.36%
13%
-14%
1.6%
Performance ranking from 31 Dec 2016 to 31 Dec
2018 (based on inflation-adjusted return)
• 1. Return on bank low risk/moderate real return
• 2. Gold moderate risk/highest real return
• 3. EGX30 portfolio high risk/worst negative real return
Now, let’s take a longer-term view –from 31 Dec 10
to 31 Dec 18
CPI
2010
84
2018
104
Percentage change
23.8%
Year
Gold price
Return on Lebanese
stock market
Interest on deposit
2010
1,500,000
94.440
1000
2018
2,000,000
117.852
1,127.8
Percentage Change
33%
23%
12.7%
Assumption interest rate on US deposit as of end 2010 = 6.2%
Now, let’s take a longer-term view –from 31 Dec 10
to 31 Dec 18
Year
Return on Gold
Return on Lebanese stock Return on deposit
market
2010
100,000,000
100,000,000
100,000,000
2018
133,000,000
123,000,000
112,700,000
Nominal R
33%
23%
12.7%
Real R
7.4%
-0.6%
-8.9%
Performance ranking from 31 Dec 2010 to 31 Dec
2018 (based on inflation-adjusted return)
• 1. Gold Moderate risk/ highest real return
• 2. Blom portfolio High risk/ low negative real return ( by 2019 it
turned to be positive return)
• 3. Deposit lowest risk / worst real return
Summing all up
• The popular phrase “high risk/high return” may not hold in the shortterm but usually holds well in the long-term
• We should care about the “real”, or, “inflation-adjusted” rate of
return.
• This is calculated as:
• Period Real Rate of Return =
(1+ Period Nominal Rate of Return) / (1+Period Inflation Rate) − 1
Asset performance
Trading and Securities Markets
Terminologies
Types of Order
• Market Orders: buy or sell orders to be executed immediately at current market
prices. If you are a buyer, the best current price is the lowest Ask Price. If you a
seller, the best current price is the highest Bid Price.
• Limit Orders
• Limit buy: instruct broker to buy shares if market price reaches or is below a specified price.
For example, if I want to buy a stock at a max price of $35/share, the broker will only execute if
it is $35 or lower.
• Limit sell: instruct broker to sell shares if market price reaches or is above a specified price.
• Limit Orders can be specified to be executed:
Fill or Kill, Good for Day, Month, Week, Good till Cancelled
• Stop order
• Stop loss: sell if prices falls to certain price
• Stop buy: buy if price rises to certain price (useful with short sales discussed later)
Trading Glossary
• Primary Markets
• Equity Offerings: IPO and Seasoned Offerings
• Private Placement
• Underwriting
• Secondary Markets
• OTC vs. Organized Exchanges
Trading glossary
• Stock Market Index
• A quantitative tool that measures performance of a stock market. It is used as a performance
benchmark (discussed later in details).
• Market Capitalization
• Stock Price x Number of Outstanding Shares
• Trading Volume
• Number of Shares traded of a company
• Free Float
• % of company’s shares available to trade on the stock market
• Value Traded
• Trading Volume x Stock Price
• Liquidity
• How well can you sell shares without having to change the price
• Most Basic Proxy is Annual Value Traded
Portfolio Management
Portfolio Management
Portfolio management is the art and science of
making decisions about investment mix, matching
investments to objectives, asset allocation for
individuals and institutions, and balancing risk
against performance.
Steps for portfolio Management
1- Planning
Understand your investor’s needs this Involves constructing
Investor Policy Statement (IPS)
2- Execute:
Based on IPS decide on Asset allocation and security selection
and hence construct the investor's portfolio.
3- Feedback:
This includes Portfolio monitoring and rebalancing
Performance measurement and Reporting. Review and monitor
against benchmark
IPS
• IPS is a document drafted between a portfolio manager and a client that outlines general
rules for the manager.
• It is a written document that states the client’s objectives and constraints. Objectives are
return and risk objectives which may be stated in absolute terms or relative terms.
Constraints may include liquidity, unique circumstances, time horizon, legal, and taxes.
• Client needs:
• Risk Objective
• Return Objective
• Constraints
• Liquidity Requirement/income needs
• Time Horizon
• Tax Concerns
• Legal/Regulatory Factors
• Unique Circumstances
IPS
IPS
Constraints
Objectives
Return
Objectives
Absolute
Risk
Objectives
Relative
Willingness
Ability
Review and
monitor
For Risk Objective: willingness
Vanguard questionnaire:
https://personal.vanguard.com/us/FundsInvQuestionnaire
To summaries :A good IPS STATEMENT
SHOULD
• Defines the plan’s objectives
• Describes the criteria and procedures for selecting appropriate
investment options
• Establishes investment procedures, measurement standards, and
investment monitoring procedures
• Reviewed periodically and, if necessary, may be amended to reflect
changes in the capital markets, the Plan’s objectives, or other factors
relevant to the Plan.
DIMENSIONS OF THE INVESTMENT DECISION
for investing for yourself
1. YOU!
5. SECURITY
SELECTION
INVESTING
4. ASSET
ALLOCATION
3. CAPITAL
2.
INVESTMENT
HORIZON
1. KNOW YOURSELF
Investor Lifecycle
20s-30s
ACCUMULATION
40s-50s
CONSOLIDATION
60s+
SPENDING & GIFTING
1. KNOW YOURSELF
Risk Aversion……Risk Tolerance
Aggressive
Moderate
Conservative
2. INVESTMENT HORIZON
• Short term vs. Long term goals
• Active vs. Passive Investments
Save at
35
versus at
25
3. Capital: How much money are we talking
about?
• Contributions:
• Small Periodic Contributions
• Bulk Investments
• Bulk Investments then Periodic Contributions
4. Asset Allocation
Money Market
Capital Markets
• Commercial Paper
• Bills
• CDs
• Derivatives
• Money Market Funds
• Equity (Stocks, DRs)
• Bonds
• Derivatives
• Funds (Mutual, ETF, REITs)
Foreign Exchange
Real Assets
• Currencies
• Cryptocurrencies
• Commodities
• Real Estate
4. Asset classes
• Equities
Also known as stocks and shares, when you invest in equities you buy a small stake in a company with the aim
of capital growth, dividend income, or a blend of the two.
• Bonds
Through issuing a bond ,accompany or government can borrow money in exchange for paying a fixed interest
over certain period, along with paying the initial amount back at the end.
• Commodities
A commodity is a basic good like steel or oil that is most often used in the production of other goods or
services. You can invest in commodity funds, which will often include mining and production companies, or
track the performance of a specific commodity in the world market through a specialized ETF.
• Property
Property funds often invest in commercial property rather than the residential market but you should still
consider your house and any buy-to-let properties you own as part of your investment portfolio.
• Cash
Carrying the lowest investment risk of the five assets, cash can be a useful as set to hold with in a portfolio for
a number of reasons. First, its inherently low investment risk provides good diversification of riskier assets.
Second, holding cash allows you to take advantage of market dips, investing at the low point. Third, easily
accessible savings held in cash can cover sudden unforeseen circumstances, without having to sell better
performing assets.
If we think about Equity , Bonds and money
market instruments as traditional investment
vehicles
Other Alternative Investment are :
• 1- Hedge Fund
• 2- Private Equity
• 3- Mutual Funds.
• Note:
4- Exchange Traded fund (ETF)
Investment Product
Minimum investment
Hedge Funds
$1,000,000+
Private Equity
$1,000,000+
Investment Product
Minimum investment
Mutual Fund
$50+
ETFs
$50+
DISCUSSED
LATER
Asset Allocation Questions
• Portfolio Allocation: Division of Capital across asset
classes?
Theory vs. Practice
• Which financial markets? Currency Exposure?
• Regulation & Flow Restrictions
• Asset Allocation Puzzle
Diversify your portfolio
why?
At Enron's peak, its shares were worth $90.75; when the
firm declared bankruptcy on December 2, 2001, they were
trading at $0.26.
5. Security selection
• Security selection refers to the process by which assets are picked
within each asset class, once the proportions for each asset class have
been defined.
5. Security Selection
• How to select individual securities within each asset class?
• How much to allocate for each security?
• Steps:
• Investment Philosophies
• Quantitative Analysis: Measuring Risk and Return
• Asset Pricing: Fundamental Valuation vs Technical Analysis (Market Timing)
Investment philosophy
• 1- All investment philosophies begin with a view about how human beings learn (or fail
to learn).
• 2-From step 1, you generate a view about markets behave and perhaps where they
fail…. Your views on market efficiency or inefficiency are the foundations for your
investment philosophy.
• 3- You take your views about how investors behave and markets work (or fail to work)
and try to devise strategies that reflect your beliefs.
Example
• Market Belief: Investors over react to news
• Investment Philosophy: Stocks that have had bad news
announcements will be under priced relative to stocks that have good
news announcements.
• Investment Strategies:
• • Buy (Sell short) stocks after bad (good) earnings announcements
• • Buy (Sell short) stocks after big stock price declines (increases)
Efficiency implications
• “No Such thing as a Free Lunch”
• Rationality of Investors
• Passive and Long term Investments perform best
• Focuses on Investing NOT Trading….Even for the Firms
Inefficiency implications
• Behaviors and Investor sentiment matters
• Trading Strategies Work
• Active portfolio Management
Efficiency implications
Impact on portfolio Management
Remember
1. Investing is about YOU: you need a strategy that may not be appropriate for you, given your
objectives, risk aversion and personal characteristics.
2. Not a Fool: So we don’t fall as an easy prey for charlatans and pretenders, with each one claiming
to have found the magic strategy that beats the market.
3. Discipline: Switching from strategy to strategy, you will have to change your portfolio, resulting in
high transactions costs and you will pay more in taxes.
5. Security selection
• There are three different approaches to security selection.
• The first to focus on fundamentals and decide whether a stock is
under or overvalued relative to these fundamentals.
• The second is to focus on charts and technical indicators to decide
whether a stock is on the verge o changing direction.
• The third is to trade ahead of or on information releases that will
affect the value of the firm.
5. Security selection
Active investors
• Fundamental investors can be:
• value investors, who buy low PE or low PBV stocks which trade at less than the value
of assets in place: Usually established companies
• growth investors, who buy high PE and high PBV stocks which trade at less than the
value of future growth
• Technical investors can be:
• momentum investors, who buy on strength and sell on weakness
• contrarian investors, who do the exact opposite
• Information traders can believe that markets learn slowly and buy on good news and
sell on bad news
• Or that markets overreact and do the exact opposite
• They cannot all be right in the same period and no one approach can
be right in all periods.
Investments Approaches (strategies for
security selection )
• Growth and value are two fundamental approaches, or styles, in
stock and stock mutual fund investing.
• Growth investors seek companies that offer strong earnings growth
• While
• value investors seek stocks that appear to be undervalued in the
marketplace
Value stocks
• Value stocks generally have low current price-to-earnings ratios and
low price-to-book ratios.
• Investors buy these stocks in the hope that they will increase in value
when the broader market recognizes their full potential, which should
result in rising share prices.
1. Value Investing
A. The Ben Graham (1934) Way
1. PE of the stock has to less than 40% of the average PE over the last 5 years.
2. Debt-Equity Ratio (Book Value) has to be less than one.
3. Historical Growth in EPS (over last 10 years) > 7%
4. No more than two years of negative earnings over the previous ten years.
5. Price < Two-thirds of Book Value
6. Price < Two-thirds of Net Current Assets
7. Debt-Equity Ratio (Book Value) has to be less than one.
8. Current Assets > Twice Current Liabilities
9. Debt < Twice Net Current Assets
1. Value Investing cont.
B. The Warren Buffet Way:
• Business Tenets: The business the company is in should be simple and
understandable with favorable long term prospects.
• Management Tenets: The managers of the company should be candid
and be leaders and not followers.
• Financial Tenets: High ROE and Profit Margins
• Market Tenets: In keeping with his view of Mr. Market as capricious
and moody, even valuable companies can be bought at attractive
prices when investors turn away from them.
Berkshire Hathaway
2. Contrarian vs. Momentum Investing
• Momentum investing: buying securities that have had high returns
over the past three to twelve months
• Contrarian investing: Purchasing and selling in contrast to the
prevailing sentiment of the time
• AB Contrarian Value Strategy
1. Identify loser stocks over the past year.
2. Conduct fundamental valuation of stock
3. Use passive screeners
• Low D/E ratio
• Low P/E ratio
4. If overall indicate undervalued stock…Buy.
5. Be Disciplined: Sell when price reaches your target price
Deckers
52
3. Growth Investing
Growth stocks are associated with high-quality, successful companies whose
earnings are expected to continue growing at an above-average rate relative to
the market.
Growth stocks generally have high price-to-earnings (P/E) ratios and high priceto-book ratios.
Investors who purchase growth stocks receive returns from future capital
appreciation rather than dividends.
High Growth Company. A company performing better, or expected to perform
better, than its industry or the market as a whole.
Companies generating a return on equity of greater than 15% are
generally classified as high growth companies
3. Growth Investing
• Higher priced than broader market. Investors are willing to pay high
price-to-earnings multiples with the expectation of selling them at
even higher prices as the companies continue to grow
• High earnings growth records. While the earnings of some
companies may be depressed during periods of slower economic
improvement, growth companies may potentially continue to achieve
high earnings growth regardless of economic conditions
• More volatile than broader market. The risk in buying a given growth
stock is that its lofty price could fall sharply on any negative news
about the company, particularly if earnings disappoint Wall Street
Growth Investing Strategies
• Growth Investing Strategies focus on investing in
stocks that pass a specific screen. Classic passive
growth screens include:
• PE < Expected Growth Rate
• Low PEG ratio stocks (PEG ratio = PE/Expected
Growth)
• Earnings Momentum Investing (Earnings
Momentum: Increasing earnings growth)
• Earnings Revisions Investing (Earnings Revision:
Earnings estimates revised upwards by analysts)
• Small Cap Investing
3. Growth Investing
• Investing in the future.
• Buying small cap companies
• Buy companies in IPOs
BLEND INVESTING
Tesla and Facebook
Snapchat
Growth or value... or both?
History shows us that:
•Growth stocks, in general, have the potential to perform better when
interest rates are falling and company earnings are rising. However,
they may also be the first to be punished when the economy is cooling.
•Value stocks, often stocks of cyclical industries, may do well early in
an economic recovery but are typically more likely to lag in a sustained
bull market
Growth AND value Over time
Performance Evaluation
• Who should measure performance?
• Performance measurement has to be done either by the client or by an
objective third party on the basis of agreed upon criteria.
• How often should performance be measured?
• The frequency of portfolio evaluation should be a function of both the
time horizon of the client and the investment philosophy of the portfolio
manager.
However, portfolio measurement and reporting of value to clients should be
done on a frequent basis.
• How should performance be measured?
• Against a market index
• Against other portfolio managers, with similar objective functions
II. Against Other Portfolio Managers
• In some cases, portfolio managers are measured against other
portfolio managers who have similar objective functions. Thus, a
growth fund manager may be measured against all growth fund
managers.
• The implicit assumption in this approach is that portfolio managers
with the same objective function have the same exposure to risk.
Costs of Trading
• Commission: fee paid to broker for making the
transaction
• Spread: cost of trading with dealer
• Bid: price dealer will buy from you
• Ask: price dealer will sell to you
• Spread: ask - bid
• Combination: on some trades both are paid
Conc.
• The Right Investment Philosophy
• Single Best Strategy: You can choose the one strategy that best suits you. Thus, if you are
a long-term investor who believes that markets overreact, you may adopt a passive value
investing strategy.
• Combination of strategies: You can adopt a combination of strategies to maximize your
returns. In creating this combined strategy, you should keep in mind the following
caveats:
• You should not mix strategies that make contradictory assumptions about market
behavior over the same periods. Thus, a strategy of buying on relative strength would
not be compatible with a strategy of buying stocks after very negative earnings
announcements. The first strategy is based upon the assumption that markets learn
slowly whereas the latter is conditioned on market overreaction.
• When you mix strategies, you should separate the dominant strategy from the secondary
strategies. Thus, if you have to make choices in terms of investments, you know which
strategy will dominate.
• Choosing an investment philosophy is at the heart of successful investing. To make the
choice, though, you need to look within before you look outside. The best strategy for
you is one that matches both your personality and your needs.
• Your choice of philosophy will also be affected by what you believe about markets and
investors and how they work (or do not). Since your beliefs are likely to be affected by
your experiences, they will evolve over time and your investment strategies have to
follow suit.
• https://www.barchart.com/stocks/top-100-stocks
• Finally, note that there is no “one” perfect portfolio for every client. To create a portfolio
that is right for an investor, we need to know:
• The investor’s risk preferences
• The investor’s time horizon
• If you are your own client (i.e, you are investing your own money), know yourself.
More on Asset Allocation
More on Asset Allocation
Asset Allocation (As defined by Franklin Templeton)
• Strategic
• (Driven by Investment Objectives)
• Strategic asset allocation refers to long-term asset allocation designed
to meet long-term investment objectives and risk constraints.
• Tactical
• (Drive by External Factors)
• Tactical asset allocation refers to temporary deviations from this longterm allocation.
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
• In theoretical and empirical economics, there is distinction between 1)actual growth rate and 2)trend (LongRun) growth rate. The latter refers to the long-term growth in productive capacity, which is driven by the
expansion in factors of production, particularly 1)labor, 2)capital and 3)technology.
Tactical asset allocation over the business cycle
• Typically, key micro and macro variables vary over each phase in the business cycle as depicted below.
and
Tactical asset allocation over the business cycle
• Generally, you should over weight (OW) risky assets at the early stages of the business cycle and OW safe
havens at the late phase of the business cycle.
and
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Tactical asset allocation over the business cycle
Common Themes
• High inflation in the US High
US interest rates
Strong USD
Tactical asset allocation over the business cycle
• USD Trade-weighted Index –Rising = nominal appreciation, Falling = nominal depreciation
Tactical asset allocation over the business cycle
S&P GSCI
01-Sep-2019
01-Jun-2019
01-Mar-2019
01-Dec-2018
01-Sep-2018
01-Jun-2018
01-Mar-2018
01-Dec-2017
01-Sep-2017
01-Jun-2017
01-Mar-2017
01-Dec-2016
01-Sep-2016
01-Jun-2016
01-Mar-2016
01-Dec-2015
01-Sep-2015
01-Jun-2015
01-Mar-2015
01-Dec-2014
01-Sep-2014
01-Jun-2014
01-Mar-2014
01-Dec-2013
01-Sep-2013
01-Jun-2013
01-Mar-2013
01-Dec-2012
01-Sep-2012
01-Jun-2012
01-Mar-2012
01-Dec-2011
01-Sep-2011
01-Jun-2011
01-Mar-2011
01-Dec-2010
01-Sep-2010
01-Jun-2010
01-Mar-2010
01-Dec-2009
01-Sep-2009
BLOM Annual returns
Bloom Index
180.000
160.000
140.000
120.000
100.000
80.000
60.000
40.000
20.000
0.000
BLOM Annual returns
Min
Max
Avg
-32.75%
22.60%
3.95%
Foundation 2
Neveen Ahmed
Outline
• Margin trading
• Short-selling
• Index construction
• Mutual Fund
• Management style
Margin versus short selling
A. Stock Margin Trading
• Borrow to buy stocks
• Maximum margin is currently 50%; you can borrow up
to 50% of the stock value Set by the Fed
• Maintenance margin: minimum amount equity in
trading can be before additional funds must be put
into the account
• Margin call: notification from broker you must put up
additional funds
• Call Money Rate: interest rate on the loan
• Leverage Ratio: 1/Margin
Margin Trading - Initial Conditions
Suppose an investor buy 1000 shares of X Corp at $70 and borrows
50% of the amount in initial margin.
50%
Initial Margin
40%
Maintenance Margin
1000
Shares Purchased
Initial Position
Assets
Liabilities and Equity
Stock $70,000
Borrowed $35,000
Equity
35,000
Margin=Equity in account =0.5
Value of Stock
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Position
Assets
Liabilities and Equity
Stock $60,000
Borrowed $35,000
Equity
25,000
Margin% = Equity/ value of stock= $25,000/$60,000 = 41.67%
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
Where Equity= 1000P - Amt Borrowed
Why do investors buy on Margin?
Margin
No Margin
You are ‘bullish’ on price of IBM
stock and buy 100 shares at
$100.
You buy 100 shares of IBM at $100 but
use an initial margin of 50%. The
interest on your margin loan is 9%.
Your initial equity is only $5000
T=0
T=0
Value of Stock =$10,000
Value of Stock=$10,000
T=1 year
T=1 year
IBM price goes up to $130
Value of Stock=$13000
Value of Stock=$13000
You return $5450 you borrowed 5000
and interest 450 ,
Return=30%
your return = (13000-5000-450/5000) 1
WHAT IF PRICE GOES DOWN????
Return=51%
CFA Margin Question:
With commissions….What is your return if you buy
shares now on margin and sell them one year later?
•
•
•
•
•
•
•
Share purchased 1,000
Purchase price per share 100
Annual dividend per share $2
Initial Margin requirement 40%
Call money rate (interest rate) 4%
Commission per share $0.05
Stock price after one year $110
Answer:
23.8%
Answer
• Return = (11000-60000 +2000- 2400-50 / 40000) -1
• = 23%
B. Short Selling
• The sale of shares not owned by the investor but borrowed through a broker and later
purchases to replace the loan.
Example: Assume you are ‘bearish’ on XYZ company shares that currently sell for $10 per
share. A short seller would borrow 100 shares of XYZ Company, and then immediately
sell those shares for a total of $1000.
If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100
shares back for $800, return the shares to their original owner, and make a $200 profit.
This practice has the potential for an unlimited loss.
For example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the
short seller would have to buy back all the shares at $2500, losing $1500.
Short Sales Rules:
1. Uptick rule: short sales only executed in an up-market.
2. Short seller pays dividends to lender
3. Short seller must deposit collateral.
Short Selling
Borrower (Short Seller)
Collateral
Broker
Lender (stock owner)
Securities
In class problem
• Suppose you are bearish about COMI stock and the
market price is LE100. You ask your broker to short sell
1000 shares. The short sale margin is 50%, maintenance
margin is 30%.
T=0
Assets
Liabilities
Cash
$100,000
Shares (1000P)
$100,000
Guarantee $50,000
Equity
$50,000
In class problem
• What happens to your margin if price went down to LE70?
T=1
Assets
Liabilities
Cash
$100,000 Shares (1000P)
$70,000
Guarantee $50,000
Equity
$80,000
Return= New Equity-Old Equity=60%
Old Equity
In class problem
• How far can price rise before you get a margin call?
Equity/Value of Stock=30%
$150,000-1000P =0.3
1000P
P=$115.38
EFSA rules for Margin Trading, Short
Selling and Intraday Trading
FYI not required
1. The listed company should publish its financial statements for at least one fiscal year.
2. The market capitalization must not be less than LE 100 million.
3. The number of trading days on the stock should not be less than 95 percent of the total
trading days.
4. The company’s free float should not be less than 10 percent of the total shares.
5. The company’s shares should be traded through at least 80 percent of the member
firms licensed for any of the specialized activities or 65 percent of the whole licensed
member firms, whichever is smaller.
6. Trading on the company’s stocks should be carried out by at least a daily average of 30
traders.
7. The turnover ratio for the stock should not be less than 25 percent (trading
volume/listed shares).
8. All special deals are to be excluded when calculating the criteria related to this activity.
Index Construction
S&P500
0.81%
2.36
DOW JONES
0.90%
2.34
NASDAQ
0.89%
1.66
CRUDE OIL
-0.17%
-.02
Stock Indices
What is in an Index?
• A quantitative tool that measures performance of a stock
market. It is used as a performance benchmark.
• Most widely known indices:
–
–
–
–
–
–
–
Dow Jones Industrial Average (DJIA) USA
S&P500 USA
FTSE100 London
CAC40 France
Nikkei 225 Japan
NASDAQ USA
MSCI (Morgan Stanley Capital International) global stock market
for non-U.S. markets.
Stock Markets capitalization 2018
Factors for Construction
1.
2.
–
Index Objective (Representation)
Criteria for Inclusion in Index (Broad or Narrow)
What are the criteria for including a stock in the index?
Example: S&P500 criteria for inclusion:
1. Market capitalization >$5 billion
2. Four consecutive quarters of profit
3. Adequate liquidity measured by price and volume (annual dollar value
traded to market cap should be at least 0.3)
4. Public float of at least 50%
3.
How it is constructed:
–
–
Price Weighted
Market Value Weighted
Price Weighted Index
• Adding prices of the component stocks and dividing by the number
of the stocks
A
B
Index Value
T=1
25
100
62.5
T=2
30
90
60
-4%
Note that
Price Weighted Index  Higher-priced stocks affect the average more
than lower-priced ones i.e. dominate the index
Stock A’s price increased by 20%
Stock B’s price decreased by 10%
However, overall index fell by -4%
Why? Because price of A is less than price of B
Price Weighted Index
Suppose Stock B Splits 2 for 1 on Day 3
A
B
Index Value
T=2
30
90
60
T=3
31
43
37 ?????
Thus, the index needs adjustment by means of a divisor
Readjust value based on prices in T=2
Price of A + Price of B = 30+45 = 60
d
d=1.25
d
A
B
Index Value
T=2
30
90
30+90/2=60
T=3
31
43
31+43/1.25=59.2
Market Value-Weighted Index Adjusted
by Free Float
• Market Cap x Free Float
• Free Float excludes shares held by:
Shareholders owning more than 5% (strategic owners)
Founders of a Company
 Public Institutions
A
B
Value
Price
Shares
FF%
Price
Shares
FF
T=1
25
20
20.00%
25
4
60%
160
T=2
30
20
20.00%
22.5
4
60%
174
Market Value-Weighted Index
• Steps:
• Calculate the index value by multiplying P times Q of each
asset and sum them up
• To be able to follow the index over time we simplify in
100 or 1000
• To do so divide the index by itself and multiply by 100,
you get index at time zero
• When you calculate the index at later time period
You multiply P times Q for each stock add them up
Then you divide by index at time zero and multiply by
previous index value
107
Market Value-Weighted Index
Stock Price0
A
$ 10
B
50
C
140
Quantity0
P1
40
$ 15
80
25
50
150
Q1
40
160
50
Value weighted series
indexV at time 1
(15  40)  (25 160)  (150  50)

100  106.14
(10  40)  (50  80)  (140  50)
Stock
P2
Q2
A
16
40
B
27
165
C
150
49
indexV at time 2
(16 * 40)  (27 *165)  (150 * 49)

106.14 
(15  40)  (25 160)  (150  50)
= 109.2
109
Pooled Investment Funds
Pooled Investment Funds:
A Pooled Investment Vehicle, also known as a pooled fund, is an investment fund that uses
funds from many numerous individual investors. The funds are then combined into a
single investment fund
Pooled
investment
Mutual
Funds
ETFS
Hedge
fund
Pooled investment funds
• Exchange Traded Fund (ETF)
• They hold a basket of assets, ETFs are more similar to equities than to
mutual funds. Listed on market exchanges just like individual stocks, they
are highly liquid: They can be bought and sold like stock shares throughout
the trading day, with prices fluctuating constantly.
• ETFs can track not just an index, but an industry, a commodity or even
another fund, investor can buy shares from other investor
• Continuously traded: Bought and sold intra day like regular shares
• Hedge Funds
• They invest in more risky assets like derivatives, long term, not subject to
regulation and hence can engage in more aggressive investment.
Mutual Funds
• Mutual funds are the common name for open-end investment
companies. They account for more than 90% of investment company
assets.
• They provide a lower cost for investing your money.
Mutual Fund can categorized as:
• Open end funds
• Open-end funds are mutual fund. They don't have a limit as to how many shares they can issue. When an
investor purchases shares in a mutual fund, more shares are created, and when somebody sells his or her
shares the shares are taken out of circulation. If a large number of shares are sold (called a redemption), the
fund may have to sell some of its investments in order to pay the investor.
• Accept new investment
• Trade at NAV, redeemed
• Bought and sold based on closing prices
• Closed end funds
• It is launched through an IPO in order to raise money and then traded in the open market just like a stock
• Trade at , below or above NAV
• Don’t accept new investment
• Continuously traded: Bought and sold intra day
Mutual Funds (Open Funds)
• Mutual funds are marketed to the public either directly by the fund
underwriter or indirectly through brokers acting on behalf of the
underwriter.
• Direct-marketed funds are sold through various offices of the fund,
over the phone, or over the Internet. Investors contact the fund
directly to purchase shares.
• About half of fund sales are distributed through a sales force. Brokers
receive a commission for selling shares to investors.
Investment Policies of Mutual Funds
• Each mutual fund has a specified investment policy, which is
described in the fund’s prospectus.
• For example, money market mutual funds hold the short-term, lowrisk instruments of the money market and bond funds hold fixedincome securities.
Mutual Fund Example
Investor
Amount invested in $ % of total
Number of shares
Leena
6,000
6%
600
Yasmeen
4,000
4%
400
Ibrahim
20,000
20%
2000
Moataz
25,000
25%
2500
Steve
45,000
45%
4500
Suppose the mutual fund decided to buy a portfolio of small company
stocks and divided the fund on 10,000 shares then each mutual fund
share worth 100,000/10,000= 10$
Investment Policies of Mutual Funds
• Management companies manage a family of mutual funds. They
organize an entire collection of funds and then collect a management
fee for operating them.
• By managing a collection of funds under one umbrella, these
companies make it easy for investors to allocate assets across market
sectors and to switch assets across funds while still benefiting from
centralized record keeping.
Classification of Mutual Funds
• Funds can be classified into one of the following groups.
•
•
•
•
•
•
•
Money Market Funds
Equity Funds
Sector Funds
Bond Funds
International Funds
Balanced Funds
Index Funds
Classification of Mutual Funds
Money Market Funds
• Money market funds invest in money market securities such as
commercial paper or certificates of deposit. The average maturity of
these assets tends to be a bit more than 1 month.
Classification of Mutual Funds
Equity Funds
• Equity funds invest primarily in stock, although they may, at the
portfolio manager’s discretion, also hold fixed-income or other types
of securities.
• Equity funds commonly will hold between 4% and 5% of total assets
in money market securities to provide the liquidity necessary to meet
potential redemption of shares.
Classification of Mutual Funds
Equity Funds
• Equity funds are further classified into the following:
• Income Funds: These funds tend to hold shares of firms with high dividend
yields.
• Growth Funds: These focus on prospects for capital gains.
• Main difference between these funds concerns the level of risk these
funds assume. Growth funds are riskier than income funds.
Classification of Mutual Funds
Sector Funds
• Sector funds concentrate on a particular industry. These funds invests
in a specific industry (such as, biotechnology, utilities, energy, or
telecommunications). They may specialize in securities of particular
countries.
Classification of Mutual Funds
Bond Funds
• Bond funds specialize in the fixed-income sector. For example, these
funds concentrate on corporate bonds, Treasury bonds, mortgagebacked securities, or municipal bonds.
• Many bond funds also specialize by maturity, ranging from short-term
to intermediate to long-term, or by the credit risk of the issuer
(ranging from very safe to “junk,” bonds).
Classification of Mutual Funds
International Funds
• These funds have international focus.
• Global funds invest in securities worldwide, including the United States
• International funds invest in securities of firms located outside the United
States
• Regional funds concentrate on a particular part of the world
• Emerging market funds invest in companies of developing nations
Classification of Mutual Funds
Balanced Funds
• Balanced funds are designed to be candidates for an individual’s entire
investment portfolio. These funds hold both equities and fixed-income
securities in relatively stable proportions.
• Life-cycle funds are examples of balanced funds. In these funds, the asset
mix can range from aggressive (primarily marketed to younger investors) to
conservative (directed at older investors).
Classification of Mutual Funds
Balanced Funds
• Life-cycle funds can be further differentiated as the following:
• Static allocation life-cycle funds: These funds maintain a stable mix across
stocks and bonds.
• Targeted-maturity funds: These funds gradually become more conservative
as the investor ages.
Classification of Mutual Funds
Balanced Funds
• Many balanced funds are in fact “funds of funds”. These are mutual
funds that primarily invest in shares of other mutual funds.
• Balanced funds invest in equity and bond funds in proportions suited
to their investment goals.
Classification of Mutual Funds
Index Funds
• An index fund is a type of mutual fund that tracks a particular market
index: the S&P 500, Russell 2000.
• An index fund tries to match the performance of a broad market
index. The fund buys shares in securities included in a particular index
in proportion to each security’s representation in that index.
• Investment in an index fund is a low-cost way for small investors to
pursue a passive investment strategy—that is, to invest without
engaging in security analysis.
Classification of Mutual Funds
Index Funds
• An example of index fund is the Vanguard 500 Index Fund. This fund
replicates the composition of the Standard & Poor’s 500 stock price
index.
• Because the S&P 500 is a value-weighted index, the fund buys shares
in each S&P 500 company in proportion to the market value of that
company’s outstanding equity.
Mutual Funds
Costs of Investing in Mutual Funds
Costs of Investing in Mutual Funds
Operating Expenses
• Operating expenses are the costs incurred by the mutual fund in
operating the portfolio. These costs may include the following:
• Administrative Expenses
• Advisory Fees Paid to the Investment Manager
Costs of Investing in Mutual Funds
Operating Expenses
• Operating expenses are, usually, expressed as a percentage of total
assets under management. They may range from 0.2% to 2%.
• Shareholders of mutual funds do not receive an explicit bill for these
operating expenses. However, the expenses are periodically deducted
from the assets of fund. Shareholders pay for these expenses through
the reduced value of portfolio.
Costs of Investing in Mutual Funds
Marketing Expenses
• Mutual funds incur marketing and distribution costs. These charges
are used primarily to pay brokers and financial advisers who sell the
funds to public.
• Investors can avoid these expenses by buying shares directly from the
fund sponsor, but many investors are willing to incur these
distribution fees in return for the advice they may receive from their
broker.
Costs of Investing in Mutual Funds
Front-end Load
• A front-end load is a commission or sales charge paid when you
purchase the shares of mutual fund.
• These charges, which are paid to the brokers, may not exceed 8.5%,
but in practice they are rarely higher than 6%.
• Low-load funds have loads that range up to 3% of invested funds. Noload funds have no front-end sales charges.
Costs of Investing in Mutual Funds
Front-end Load
• Loads effectively reduce the amount of money invested. For example,
each $1000 paid for a fund with a 6% load results in a sales charge of
$60 and fund investment of only $940.
Costs of Investing in Mutual Funds
Back-end Load
• A back-end load is a redemption, or “exit,” fee incurred when you sell
your shares. These charges are known more formally as “contingent
deferred sales charges”.
• Funds that impose back-end loads start them at 5% or 6% and reduce
them by 1 percentage point for every year the funds are left invested.
Thus, an exit fee that starts at 6% would fall to 4% by the start of third
year.
Costs of Investing in Mutual Funds
12b-1 Charges
• Securities and Exchange Commission (SEC) in the U.S. allows the
managers of some mutual funds to use their assets to pay for
distribution costs. These funds are called as 12b-1 funds and these
costs are called as 12b-1 charges.
Costs of Investing in Mutual Funds
12b-1 Charges
• As with operating expenses, investors are not explicitly billed for 12b1 charges. Instead, the fees are deducted from the assets of the fund.
• Therefore, 12b-1 fees (if any) must be added to operating expenses to
obtain the true annual expense ratio of the fund.
Costs of Investing in Mutual Funds
• Costs associated with investing in the mutual funds will lower the
return on an investment in a mutual fund.
• The rate of return on an investment in a mutual fund is measured as
the increase or decrease in NAV plus income distributions such as
dividends or distributions of capital gains expressed as a fraction of
NAV at the beginning of the investment period.
Costs of Investing in Mutual Funds
• If we denote the NAV at the start and end of the period as NAV0 and
NAV1, respectively, then:
Costs of Investing in Mutual Funds
Example 1
• Consider a fund with an initial NAV of $20 at the start of the month.
Assume that this fund makes income distributions of $0.15 and
capital gain distributions of $0.05, and ends the month with NAV of
$20.10. What is the monthly rate of return?
Costs of Investing in Mutual Funds
Example 1
• The monthly rate of return is computed as follows:
• Notice that this measure of rate of return includes expenses such as
management fees, but ignores expenses such as front-end loads.
Costs of Investing in Mutual Funds
• The actual rate of return is affected by additional expenses, such as
front-end loads. This is because such charges reduce investor’s actual
rate of return. Actual rate of return should incorporate all expenses.
Costs of Investing in Mutual Funds
Example 2
• Consider a fund with $100 million in assets at the start of the year
and with 10 million shares outstanding. The fund invests in a portfolio
of stocks that provides no income but increases in value by 10%. The
expense ratio is 1%. What is the rate of return for an investor in the
fund?
Costs of Investing in Mutual Funds
Example 2
• The expense ratio is the annual fee that all funds charge their
shareholders. It expresses the percentage of assets deducted each
fiscal year for fund expenses. It may include 12b-1 fees, management
fees, administrative fees, operating costs, and all other asset-based
costs incurred by the fund.
Costs of Investing in Mutual Funds
Example 2
• The initial value of assets equals $10 per share [=$100 million/10
million shares].
• In the absence of expenses, fund assets would grow to $110 million.
• However, the expense ratio of the fund is 1%. Therefore, $1 million
will be deducted from the fund to pay for these fees, leaving the
portfolio worth only $109 million, and the NAV equal to $10.90 per
share.
Costs of Investing in Mutual Funds
Example 2
• The rate of return on the fund is only 9%, which equals the gross
return on the underlying portfolio minus the total expense ratio.
Mutual Funds
Mutual Fund Investment Performance
Mutual Fund Performance
• One of the benefits of mutual funds for the individual investor is the
delegation of management of portfolio to investment professionals.
• Shareholders of mutual funds hope that these portfolio managers can
achieve performance that is better than what they could obtain on
their own.
Mutual Fund Performance
• In order to see whether portfolio managers are performing the
desired job, one has to compare the performance of portfolio
managed by them relative to a benchmark portfolio.
• An important question, therefore is: What is the proper benchmark
against which investment performance ought to be evaluated?
Mutual Fund Performance
• One of the appropriate benchmark for equity fund managers may be
the main index of the stock market.
• In case of the U.S., this index can be Wilshire 5000 index. This is a
value-weighted index of all actively traded U.S. stocks.
Mutual Fund Performance
• The performance of the Wilshire 5000 is a useful benchmark with
which to evaluate professional managers because it corresponds to a
simple passive investment strategy: Buy all the shares in the index in
proportion to their outstanding market value.
• Moreover, this is a feasible strategy for even small investors, because
the Vanguard Group offers an index fund designed to replicate the
performance of the Wilshire 5000 index.
Mutual Fund Performance
• Casual comparison of the performance of Wilshire 5000 index versus
that of professionally managed mutual funds reveal disappointing
results for active managers.
• NOTE: An important point to remember is that active management can
change the constituents of portfolio as they get new information. Passive
management does not do this.
Mutual Fund Performance
• Next figure shows that the average return on diversified equity funds
was below the return on the Wilshire index in 25 of the 41 years from
1971 to 2011.
Mutual Fund Performance
Mutual Fund Performance
• Why are professionally managed funds not able to beat Wilshire 5000
index?
Mutual Fund Performance
• This result may seem surprising. It would not seem unreasonable to
expect that professional money managers should be able to
outperform a very simple rule such as “hold an indexed portfolio.”
• One might argue that there are good managers and bad managers,
and that good managers can, in fact, consistently outperform the
index. To test this notion, we should examine whether managers with
good performance in one year are likely to repeat that performance in
a following year.
Mutual Fund Performance
• Next table shows
the fraction of
“winners” (i.e., tophalf performers) in
each year that turn
out to be winners
or losers in the
following year.
Mutual Fund Performance
• The table shows that 65.1% of initial top-half performers fall in the
top half of the sample in the following period, while 64.5% of initial
bottom-half performers fall in the bottom half in the following period.
This evidence is consistent with the notion that at least part of a
fund’s performance is a function of skill as opposed to luck, so that
relative performance tends to persist from one period to the next.
Mutual Fund Performance
• The table also indicates that the relationship does not seem stable
across different sample periods. While initial-year performance
predicts subsequent-year performance in the 1970s (panel A), the
pattern of persistence in performance virtually disappears in the
1980s (panel B).
• To summarize, the evidence that performance is consistent from one
period to the next is suggestive, but it is inconclusive.
Problem 4
Question
• Consider a mutual fund with $200 million in assets at the start of the
year and with 10 million shares outstanding. The fund invests in a
portfolio of stocks that provides dividend income at the end of the
year of $2 million. The stocks included in the fund’s portfolio increase
in price by 8%, but no securities are sold, and there are no capital
gains distributions. The fund charges 12b-1 fees of 1%, which are
deducted from portfolio assets at year-end.
Problem 4
Question
• What is net asset value (NAV) at the start and end of the year? What
is the rate of return for an investor in the fund?
Problem 4
Answer
• NAV at the start of the year is given as follows:
• NAV = $200 million / 10 million = $20
• All expenses are charged at the end of the year. Therefore, NAV at the
start of year has no expenses for deduction.
Problem 4
Answer
• Value of mutual fund’s portfolio at the end of the year is given as
follows:
• Final Value = $20 * (1 + 0.08) = $21.60
• Given that 1% of 12b-1 fee are charged at the end of the year, the
final value of portfolio will be reduced to $21.384 [=$21.60*(1 0.01)]. Therefore, NAV at the end of the year is $21.384.
Problem 4
Answer
• Total return during the period will also incorporate the amount of
dividend paid. The dividends of the per share basis are the $0.20 [=$2
million / 10 million]. Total return is given as follows:
• Return = [$0.20 + ($21.384 - $20)]/$20 = 7.92%