Investment Management
Investment Management
Introduction
This paper entails a discussion of two key principles investment management that are currently in play in today`s financial markets. The first part of the paper entails a discussion on the Capital Asset Pricing Model and its subsequent application to a real life situation. The second part of the paper entails a discussion on assessment of the performances of two respective mutual and pension funds that are invested in Argentinian junk bonds.
According to Levy (2011, pg. 55), the Capital Asset Pricing Model (CAPM) is used in the determination of the required rate of return of various risky assets such as stocks. This required rate of return determines the overall attractiveness of the underlying assets as viable investment options, given the underlying risks that they contain.
According to the stated empirical studies, younger and more sophisticated investors are now investing their overall wealth in different portfolios in comparison to the older and less affluent investors. This proposition is consistent with some of the underlying assumptions that form the CAPM Model. Firstly, the model assumes that investors can borrow varying amounts of investment capital at the prevailing risk free rate (Pahl, 2009, pg. 23). This assumption implies that the investment decisions that the younger investors are making are driven primarily by their ability to access the borrowed funds at the prevailing risk free rate, without having to pay any additional premiums.
Secondly, the CAPM Model assumes that it is possible to buy and sell varying fractional sizes of the shares in various portfolios (Levy, 2011, pg. 56). In this regard, the younger investors are capitalizing on this assumption by buying small portions of different investment portfolios, and gradually increasing their positions as they access more investment capital.
Thirdly, the CAPM Model assumes that the underlying investors are Markowitz Efficient investors. This assumption implies that the investors tend to target different points on the efficient frontier scale based on their risk-return utility function according to Pahl (2009, pg. 24). In this regard the decisions that the younger investors make in regards to their investments are driven by their understanding of this principle, and their expected rates of return based on the investment risk that they are willing to put up.
Fourthly, the CAPM Model assumes that the prevailing capital markets operate in a state of equilibrium, and that market forces will always ensure that this equilibrium is maintained (Levy, 2011, pg. 57). This state of equilibrium and efficiency implies that all the prevailing market information is duly factored into the prices of the security instruments available for investment. In this regard, the younger investors are empowered to make the appropriate investment decisions based on the realization that all the material information has been factored accordingly, and they, therefore, do not expect any informational surprises that may adversely affect their portfolios.
The fifth assumption of the Capital Asset Pricing Model (CAPM) states that all the existing investors in the financial markets have similar homogenous expectations (Levy, 2011, pg. 57). These expectations have primarily influenced their investments in different portfolios because they expect that each of these portfolios will yield significant capital gains on their investments over the short and long runs.
According to Pahl (2009, pg.25), the CAPM Model also assumes that all the investors within a financial market have the same one-period time horizons that are divided into months, years, quarters and so forth. This assumption motivates the younger investors to diversify their portfolios since they expect to compare the performance of each of these portfolios at the end of the preferred one-period time horizon.
Lastly, the CAPM Model also assumes that there are no transaction costs and corresponding taxes (Levy, 2011, pg. 58). This assumption encourages the younger investors to diversify their portfolios, since they expect to receive the absolute gains on their investments without any corresponding reductions or deductions.
According to Hinz (2010, pg. 220), the process of the assessment of the performance of either a pension fund, or a mutual fund is relatively similar, and is determined primarily by the underlying assets in which the funds have been invested. In this regard, the same approaches will be used in the assessment of the performance of the pension and the mutual fund which is invested in Argentinian junk bonds. According to OECD (2010, pg. 89), the first method which can be used in the assessment of these funds is the use of the Sharpe Ratio. This ratio refers to a measure of the average return earned by the funds expressed per unit of the standard deviation of return (OECD, 2010, pg. 90). This method of assessment analyses the excess return of the fund`s performance, and how this return was earned in terms of the corresponding risk, as expressed by the standard deviation. This assessment is ideal for mutual fund due to the junk status of the bonds that characterize the majority portion of this fund.
According to Hinz (2010, pg. 220), the second assessment measure that can be used in the evaluation of the performance of the two funds is the evaluation of the excess return per unit of systematic risk. According to Hinz (2010, pg. 2210, the systematic risk refers to the prevailing macroeconomic factors that currently affect all the existing classes of risky assets in the financial markets. In this regard, this assessment approach can be used to evaluate the performance of these funds, based on the underlying conditions of Argentina as a country, and not necessarily the junk status of the bonds that are invested in the mutual fund.
Third, the performance of the pension fund and the mutual fund which has been invested in Argentinian junk bonds can be evaluated using the excess return per unit of unsystematic risk approach (Hinz, 2010, pg. 222). This approach entails the evaluation of the excess return above the risk free rate that the funds earned, expressed as a unit of their underlying unsystematic risk. According to Hinz (2010, pg. 223), the unsystematic risk of a portfolio refers to the risk factors that are significant only to a particular class of risky assets. In the case of the mutual fund, its systematic risk refers to the junk status of the bonds that characterize this portfolio.
The fourth performance assessment approach that can be used to evaluate the pension and mutual funds is the Rolling Regression for Estimating Weights approach (OECD, 201, pg. 90). This approach entails the evaluation of the intrinsic value which a portfolio has grown by, using the application of the investment principles of selectivity and the timing of the market. This approach assumes that the changes in the composition of a portfolio can result in an increase in its value, even though these changes are made based on the available public information.’
Finally, OECD (2010, pg. 91) adds that the performance of a mutual fund such as the one invested in the Argentinian junk bonds, and the corresponding pension fund can be assessed using conventional discounted cash flow approaches, and the estimation of the fund`s compound rates of return. These approaches are used to determine the face value of these funds at a particular point in time, in comparison to their face value at the beginning of the underlying financial period.
Conclusion
This paper has analyzed two main principles of finance, which are the Capital Asset Pricing Model theory and the process of the assessment of the performance of a mutual and pension fund. The insights discussed in this paper have resulted in the resolution of the financial issues at hand, and they can also be applied in various other financial scenarios going forward.
Reference List
Hinz, R. P., 2010. Evaluating the Financial Performance of Pension Funds. Washington: World
Bank Publications
Levy, H., 2011. The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and
Behavioral Perspectives. Cambridge: Cambridge University Press
OECD., 2010. OECD Principles of Occupational Pension Regulation Methodology for
NJ: OECD Publishing
Pahl, N., 2009. Principles of the Capital Asset Pricing Model and the Importance in Firm
Valuation. NJ: Books on Demand
