To: Mr Bernard Riemann
From: Investment Manager
Date: 28 November 2007
Subject: Construction of Investment Portfolio
Overview:
The investment portfolio recommended is based on the discussion with you. The key points that emerged from our discussions are as follows:
Total investment required to be made is £1,000,000
The portfolio should include at least 5 equity securities and at least 3 debt securities. Besides these some other investment products may also be included. The portfolio break up should be at a minimum:
Equity investments: £400,000
Investment in Debt securities: £200,000
Investment in other products: £350,000
Cash: £50,000
You do not want to invest in ‘very risky’ investments, but are willing to accept some additional risk if there is adequate compensation in the form of increased returns
Investment will be made for a medium to long term. Two months are considered as medium to long term.
Investment in the recommended portfolio will be made on 28th November 2007
Your total wealth is approximately £500,000. This includes:
Business: £3,000,000
Residential Property: £800,000
Loans to Relatives: £200,000
Amounts proposed to invest: £1,000,000
Suggested Portfolio
You are advised to adopt a lower risk and a more diversified institutional approach. This will require you to have a portfolio of assets. In general, riskier investments, such as equities provide the best returns over the long term, but they are also most volatile. However, because you are only planning to invest in short to medium term, you will not be much affected by the volatility. Nevertheless, combining different types of investment in a portfolio can help you minimise and variations especially if the securities in your portfolio are “non-correlated” (i.e. their prices move independently).
On the basis of above information and the investing assumptions (Refer appendix A), the most appropriate asset model for you appears to be: Medium Risk
Individual securities and investment products
You are therefore advised to make your investments in the securities given in the table below:
Asset Class
Investment
Sector
Amount (£)
Percentage of Total
Equity Securities (FTSE 100)
British Airways
Airlines
76,260
7.6%
Land Sec (R.E.I.T.)
Real Estate
94,250
9.4%
Barclays
Banking
78,600
7.9%
Sage Group
Technology
77,480
7.7%
Morrison Supermarkets
Retail
73,255
7.3%
Debt Securities and Funds
Bond
100,000
10%
SWIP Defensive Gilt Securities
100,000
10%
HSBC Gilt & Fixed Interest Inc
150,000
15%
New Star UK Property A Acc
Property Funds
150,000
15%
Cash
100,155
10%
Total
1,000,000
100%
(Source: Yahoo finance)
Rationale for the selection of each security/product
(Refer Appendix B)
Equity Securities
The equity securities are all FTSE 100 securities. These securities belong to five diverse sectors, namely, Airlines, Real Estate, Banking, Retail and a sunrise sector of Technology. These sectors are not correlated thus reduce the portfolio risk.
The rationale for selection of these and not other FTSE 100 securities are:
British Airways Plc. is the leading airline in the United Kingdom and is one of the biggest in the world. It also has holdings in other airlines, such as the Australian, Qantas, and the Spanish Iberia. In addition the airline has recently signed a partnership with the American Airlines and companies such as Cathay Pacific Airways and Finnair. Therefore, it has bright prospects. Though the price trend in the medium term is bearish volatility has been increasing during last month.
The Property sector is represented by Land Securities. Land Securities has a huge amount of real estate all over the UK. It manages a series of properties. The company has played a major role in transforming cities such as Birmingham, Canterbury, Bristol and York by working closely with the city authorities, and with the support of the government. The market is bearish but volatility is increasing. One may make massive profits in the short term.
The banking or financial sector is represented in the portfolio by Barclays. Barclays began its operations in the 17th century in London. It is an international bank with 800 global branches. It is a strong entity in 60 international countries, in Europe, the United States, Africa, and Asia. The group remains a very important member of the UK banking community. Even though the Banking sector may have not performed very well in the past, its prospects are good. An investment portfolio should have at least one category of securities from this sector. Though medium term price trend for Barclays is bearish the boom conditions may benefit the portfolio as its volatility has been increasing.
Sage group represents the sunrise sector in the portfolio. It is a British company that is considered a leader in management software sector. It has its presence in all major European countries and India, South Africa, Australia, the Middle East, and North America. Sunrise industry presents extremely good prospects.
The Morrison Supermarkets Group represents the retail sector in the portfolio. The group specializes in supermarket distribution, offering quality products and increasing diversity. It has purchased Safeway, an owner of more than 500 supermarkets in Great-Britain. Medium term price trend is bullish. This market keeps a relative behaviour greater 16.232 than FTSE 100 INDEX. Volatility has been increasing during last month. It is a good time to make profit in the short term.
Debt Securities/Funds
9% Treasury Loan Bond 2008 are Gilt edged bonds issued by the UK Government that will mature in 2008. These bonds offer the investor a fixed interest rate of 9% for a predetermined, set time. These bonds are especially recommended as you require a fixed, predictable income. These bonds also ensure a guaranteed return of capital. Though these securities like shares are prone to fluctuation, they are much more secure. Though the bond has a redemption date (July 2008), it can be sold at any time for the present market price. Investors are not tied down and there are no penalties for selling the stock. Gilts prove to be the best option in times such as the current times when interest rates are high and look likely to fall. Due to a decline in the interest rates the value of the stock will rise and can be sold profitably.
SWIP Defensive Gilt Securities and also HSBC Gilt & Fixed Interest securities have been included in the portfolio as they will provide a regular income. The investments do not have a minimum or maximum investment period.
New Star UK Property is another place where investment should be made. Though in recent times a few large fund holders have got out of UK commercial property funds, for the next one year the fund is expected to give more or less stable returns.
As you want a return of £500 per month, the portfolio requires that £100,155 should be deposited in the bank. This will carry an interest of 5.75% (at the current rate) and will meet your requirement for £500 per month for the tuition fee of his niece.
Expected returns of the portfolio over the two month investment period
The portfolio is expected to give a return of 1.26% in the two months (Refer xls in Appendix C and E). Each month the portfolio will give £500 per month from the cash deposited in the bank.
Risk attached to the portfolio
The risk percentage is 0.98% for the entire portfolio (Refer xls in Appendix C). Thus at no point of time investment portfolio will fall below the acceptable value over a two-month period.
Total risk of 0.98% indicates how much risk your portfolio will bear over the two month period. This risk is primarily due to high level of expected variance in the share prices of British airways shares and also shares of Morrison Supermarkets. The debt securities and funds have an almost negligible variance and standard deviation. Therefore, this evens out the excessive risk in equity securities.
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Since, debt securities do not have much risk, the individual equity securities need to be closely monitored for risk. The easiest way is to monitor their beta levels. A beta measures a stock’s volatility relative to the market. Stocks with betas of 1 move up or down more or less in along with the market. Stocks with betas of less than 1 tend to be less volatile than the market as a whole. Volatile stocks have betas higher than 1. However, betas too should be examined with care as if the market itself is volatile, then a stock with a beta of 1 or less still could be very risky.
In conclusion, you should take the above portfolio as a recommendation. The market may change very fast and therefore needs to be closely monitored.
APPENDICES
Appendix A: Assumptions for the Report
Mr. Riemann does not have any industry preferences
It should be 10 asset portfolio
The customer would be unhappy if the investment portfolio were to fall more than 10% in value over a two-month period.
The customer would expect a monthly return of around 1%.
The customer expects at least £50,000 of the total £1,000,000 to be retained as cash
The economic conditions are defined as: Boom 0.6 normal 0.3 and recession 0.1
For equity securities only use FTSE 100 and 250 and for debt use popular markets. UK Bonds have been preferred.
Appendix B: Movement of Equity Securities
(Source: Yahoo finance)
Appendix C
Appendix D: Other Documentary Evidence
British Airways
Land Securities
Barclays
(Source: Yahoo finance)
Morrison Supermarkets
(Source: Yahoo finance)
Sage Group
(Source: Yahoo finance)
Std Lf UK Gilt Rtl Inc
SWIP Defensive Gilt A Inc
HSBC Gilt & Fixed Int Inc
(Source: Yahoo finance)
New Star UK Property A Acc
(Source: Yahoo finance)
Appendix E: Calculation of the Return under Boom, Normal Conditions and Recession
Return on equity securities
Return under normal conditions has been calculated. This is based on the movement of the stock prices. The return on the equity stock will arise from sale of shares at a higher price over the near future. On the basis of the past data the share prices under normal conditions have been estimated two months from November 2007. The % increase in the share prices is taken as the return during normal times. Variance in share prices are thereafter taken into account and the boom and recession values are calculated.
Return on debt securities and funds
This is based on the three year total return percentage. Two months percentage is worked out and then adjustments are made for variance.
Return on 9% Treasury Loan Bond 2008
The bond pays a 9% coupon (divided into two semi-annual payments) and matures in July 2008. The bond has been bought at par. The income 9% per annum on the investment will be there until maturity.
Return for 2 months = (9% / 12)*2 =1.5%
If an amount less than par were paid for the return would be=Par/purchase price * coupon = running yield
References
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