Financial Management For Portfolio Management Finance

Factors determining the expected return of a portfolio

Describe about the Financial Management for Portfolio Management Finance.

Portfolio management is an art where finance professionals come up with the right mix of investments so as to increase the returns for the investors. They may use various financial models so as to come up with the right proportions of the investments. However, their personal insights from their vast experiences also come into play. Market efficiency can be explained using the weak form, semi-strong and strong form theories. Mergers and acquisitions have become a buzzword in the business community. It is now a question of when and not if a company will merge with another. Small-time entrepreneurs are also factoring this in their plans as they chart out their strategic plans.

Factors determining the expected return of a portfolio

Expected return is based on the probabilities of returns. It is the sum of the weighted averages of each of the asset’s expected returns. The Fama-French three-factor model specifies three distinct risk factors that are used to explain a portfolio’s expected return.

Size risk: company size is a determinant that explains higher equity returns. When a portfolio has a greater exposure towards small company stocks as compared to a larger company stocks it receives higher yields. Small companies are inherently risky, and thus the investors are rewarded with higher returns. Small companies encounter challenges when raising capital, and so they have a greater risk of failure hence the greater compensation to the investors.

Value risk measured by market-to-book value: the higher the exposure a portfolio has towards value stocks as compared to growth stocks, thegreater the return (Pandey, 2012).

Market risk measured by beta: This is the amount of exposure to the overall stock market. As compared to treasury bills, stocks have got higher returns. In this case, the higher the exposure of a portfolio to stocks relative to bonds, the higher the return (Pandey, 2012).

There is a broad range of choices of security selection philosophies. One may choose to use information such as earnings reports or acquisition announcements. Another method is using technical and charting indicators. Fundamentals such as earnings, cash flows or growth can also be used. Active or passive strategies may be selected. In passive strategies, one invests in a given stock, and then they wait for their investment to pay off. A portfolio manager who buys stocks that have a low price and stable earnings is a passive investor. The same goes for an index fund manager. The opposite is true. An active investor is one who tries to beat the market by picking stocks.

Selection and allocation based on the context of portfolio management

Asset allocation aims to create diversification and balance out risk in a portfolio. There are a number of asset allocation strategies.

One of them is asset allocation for strategic reasons. Here the portfolio is mixed basedon the investor’s profile. It can be sixty percent equities, thirty percent bonds, and ten percent cash. This is a passive management.

Tactical asset allocation

This is whereby the weight of various securities in a portfolio is not fixed, but it can be revised when the prevailing conditions in the market change. Portfolio rebalancing is used to manage risk on a continual basis (Lummer&Riepe, 1994).

When an investor is doing allocation in a portfolio, they need to make various considerations. They should consider their short, and long term goals as this will determine the best mix of their portfolio. An investor should also realize that time is their friend. When they start investing, early they can enjoy the benefits of compounding their money due to the time value of money. They can also put a larger portion of their money into high risk/return investments since they will have more time to recoup any losses they may make (Lummer&Riepe, 1994).

Weak form

This form of market efficiency puts forward that the current share prices are a reflection of all the data of previous prices.  It also suggests that it is not possible for technical analysis to be carried out to assist an investor to make a trading decision since all available data is from the past. However, fundamental analysis can be carried out to determine if there are any undervalued and overvalued stocks. The investors can also study companies’ financial statements.

Semi-strong form

This theory of market efficiency follows the belief that since all public information is used when calculating the current price of stock, investors can thus not use fundamental or technical analysis to achieve greater profits in the market. Subscribers to this theory only believe that it is only information that is not readily accessible in the market that can increase the profits of an investor to a position above the overall general market.

Strong form

The strong form theory postulates that all the information both public and private information is completely considered when arriving at the current stock prices. In this case, there is no type of information that can give an investor a competitive edge on the market. Investors cannot make profits that superceed normal market profits on investments in spite of any information retrieved or research conducted (Berk, DeMarzo, Harford, Ford, Mollica&Finch, 2013). These investors are mostly those persons with excess information on the markets. They may include the insiders in a given firm and also exchange specialists. Since the exchange specialists are at the fore front when it comes to trading shares, they have an advantage in knowing which are the best shares to trade in at the exact moment and they make higher than normal returns due to this knowledge.

Forms of market efficiency

Capital Asset Pricing Model is a method used to compute the required rate of return for any given risky asset. The required rate of return is the rise in value one expects to see as compared to the inherent risk level attributed to the asset. It is used to determine the fair price of an investment. This rate is then used to discount an investment’s future cash flows to their current or present value so as to come to the investment’s fair value. The computed fair value is then compared to the investment’s price in the market. If the price estimated is higher than the market price one may consider the stock to be a bargain. However, if the price estimated is lower, one may then consider the stock to be overvalued (Levy, 2011).

The formula for arriving at the expected return is the risk-free rate added to beta times the difference of the return from the market and the risk-free rate.

Beta in CAPM is used to account for the risk associated with investing in a given security compared to the prevailing risk of the market. The higher the beta, the riskier the security will be in the market. The risk-free rate is that rate which is expected on an investment which is taken to have no risk at all. An example of this would be the US Treasury bill rate. The risk premium is computed by taking beta times the difference between the market return and a risk-free return (Levy, 2011).

CAPM is seen as being objective in nature. Hence, it cannot be used in isolation, and other methods need to be utilized alongside it.

Assumptions of CAPM

Investors are rational and risk-averse.

Capital markets are in equilibrium.

Investors aim to maximize economic utilities.

They are price takers.

All investments are infinitely divisible.

 There is a risk-free asset.

Investors have homogenous expectations.

Arbitrage pricing theory

Arbitrage pricing theory is used to describe the expected return and risk of securities in financial markets. It is used to compute the expected return on a given security based on its sensitivity to various movements in macroeconomic factors.  The macroeconomic factors include GDP growth, interest rate, and inflation. The expected return is then used to come up with the price of the security.

Assumptions of APT

Arbitrage Pricing Theory assumes that capital markets are usually perfectly competitive.

The investors always assume greater wealth than lesser with certainty (Pandey, 2015).

Capital asset pricing model

There exists a frictionless market. That is perfect competition prevails, and there is no transaction cost in the market (Pandey, 2012).

Effects in equity returns include the B/M effect, size effect, and E/P effect, leverage effect, C/P effect and the liquidity pattern.

The Fama-French model which is a 3-factor model is used to explain some of the equity returns. The 3-factor model was seen to explain the cash-to-price effect, B/M, E/P and size effect. It did not explain leverage or liquidity effect. This 3-factor model is an enhancement upon the Capital Asset Pricing Model with two extra factors that are used to capture the return premium of smaller firms over bigger firms and high B/M companies over low B/M companies.

Using the 3- factor model, a B/M, E/P, size and C/P effects were documented in Australia. However, leverage and liquidity effects were not documented. The book- to- market effect compares the book value of a company to the price of the company’s stock. The larger the ratio, the more fundamentally cheap the company will be. The size effect is seen whereby studies have shown that small capitalization stocks outperform large stocks.  This pattern can be explained by the notion that small-cap companies usually have a more volatile business environment. Therefore, when there is a improvement of funding deficiency, this can lead to a substantial appreciation of the price. The small-cap companies also tend to have a lesser stock price which means that price appreciations tend to be greater than those that are found among large cap stocks.

A low price to earnings effect is one whereby stocks with low price-to-earnings ratios produce larger overall returns than portfolios made up of stocks where the price is higher as compared to the earnings per share (Nguyen, Faff&Gharghori, 2009).

Effects seen in the Australian market

A B/M, E/P, size and C/P effects were documented in Australia. To identify the existence of the various effects in the market in Australia, all the available stocks were sorted into sextiles according to each variable of interest. Any excess returns of the portfolio were indicative of an effect. In case a pattern appeared in the mean excess profits of the portfolios, this was enough to report an effect.

In the case of a size effect, the stocks are divided into size sextiles. In case a reduction in profits from the smallest in size portfolio to the largest in size portfolio is documented, a size pattern is reported. Total shareholder returns have been found to be inversely related to company size, and the relationship has been found to be strongest for stocks of lower market capitalization. These results have come about due to a number of factors. Size is usually understood as a way of measuring risk, and smaller firms are riskier and are therefore priced to give greater profits.

Assumptions of CAPM

The size effect makes the small capitalization stocks to appear as a viable instrument since the high returns compensate for the additional risks that are borne.

A merger is said to have occurred when a firm takes on all the assets and liabilities of a different firm. The firm that has carried out the acquisition will retain its identity while the firm that has been acquired will cease to exist. Takeovers are whereby a company may buy out another.

The motives may be strategic in nature. There may be takeovers that undertake a horizontal integration. This is aimed to increase the scale and the market share of the combined firm.  Most mergers are done so as to have an increased market share and also so as to have an international expansion. Mergers also lead to cost energies and revenue synergies. Revenue synergies are realized due to expanded markets, cross-selling and also increases in prices. Cost synergies come about due to economies of scale that are realized in various departments of the company. Mergers offer a good avenue for growing externally rapidly. This type of growth is also less risky as compared to internal growth.

By gaining a significant market share, the company will gain the power to influence prices. An extreme example of a horizontal merger is a monopoly. By merging, a company also reduces its reliance on external suppliers. Mostly, horizontal and vertical mergers give rise to monopolies. This may give rise to some antitrust issues. However, conglomerate mergers give rise to diversified firms. This gives rise to a case of getting several different products and services all under one umbrella. A company may also be motivated to d a merger so as to gain some unique capabilities that it lacks that are possessed by another company. This is a very cost effective method of acquiring unique capabilities as opposed to developing the capabilities internally (Rossi &Volpin, 2004)

Mergers offer personal incentives for managers. The managers enjoy greater prestige in a post-merger bigger company. Their remuneration also increases in the larger company. Managers, therefore, stand to benefit from a merger.  Mostly it is the acquiring firm that gains this. This is because there will be a streamlining of operations to avoid unnecessary duplication. Some of the managers in the acquired will have to go home or get reassigned to different roles. A merger may also unlock hidden value in a struggling company. The company that acquires the struggling one will pay a lower price than the market price since they have to carry out various improvements on it.

Mergers aid in achieving international goals of a company. The company will manage to exploit any market inefficiencies that may exist. There will be a transfer of technology to new markets. Unique products will also be sold in new markets. By trying out new markets, a company will manage to overcome any disadvantageous policies of the government. The company will also manage to offer continued support to international clients (Harford, 2003).

Some companies have been known to merge with other companies so as to manage their tax problems. A firm with a greater taxable income may merge with a firm with big carry forwards tax losses. In this way, the firm will decrease its liability in taxes (Harford, 2003).

Do takeovers increase the value of the target, or the bidder company, and/or aggregate market value?

Takeovers can be carried out through various ways. Mergers are one of those ways. These are negotiated with the target’s manager, and then they are voted upon by the target’s shareholders so that they may be approved. A tender offer is another method. This may be a hostile method in case the managers refused an initial offer from the bidder. The shareholders are approached directly for the purchase of their individual shares.

Proxy contests are yet another method. An interested party may convince the shareholders to use their proxy votes and gain a controlling seat on the board of management.

Takeovers gain substantial wealth for the shareholders of the company. Takeovers lead to an aggregate market value due to the avoidance of closing down companies. Takeovers can save a company from closing down and workers from getting laid off. The takeovers also use assets productively. There is the issue of golden parachutes. This principle may be abused in some cases, but its institution was meant to be in the interest of the shareholders. This principle was instituted to ensure that the executive does everything in their power to maintain their organizations in business despite the many challenges in the market (Goergen&Renneboog, 2004).

Takeovers lead to the elimination of inefficient target management which translates to an overall increase in the total value of the target. There are also potential reductions in various costs such as production and distribution costs. This comes about due to the integration of more efficient production methods or organizational technology. There is also vertical integration as well as economies of scale.

Takeovers bring about a decrease in agency costs through bringing together the various organization specific assets under one ownership. There is also greater utilization of the bidder’s managerial team which brings on a wealth of knowledge. The company also gains some tax advantages. Thus the combined firm will earn cash flows that are greater than the individual cash flows of the bidding and the target firms. Several studies have led t the conclusion that takeover announcements lead to abnormal stock returns surrounding takeover announcements. The positive change in the stock price shows that there is an increased total profitability of the merged companies (Baker &Kiymaz, 2011).

The acquired firm offers extra space for the acquiring firm to effectively manage and utilize management resources so as to enhance the abilities of the acquiring business. When companies that were competitors merge, there is a reduction of competition and an increase in the product prices. This is because there usually exists several businesses at a time offering almost similar products and services in a given market. It can become very expensive for a company to fight all of this competition so as to gain a larger market share. This it does by running some advertising campaigns and also through carrying out some research and development activities to come up with unique characteristics in their products and services. All this is done in a bid to gain more sales and hence profits for the company. Competition thus leads to a reduction in market shares and a drop in the product and service sale rates. When the two companies merge and become one entity, they can then command a bigger market share in the market.

Takeovers lead to a significant increase in the value of the target company through the diversification of products and services in the market. It is very costly and time-consuming for a single company to diversify its products and services. Therefore, it can achieve this by taking over the operations of a company that is offering those different products and services. In this way, the company will remain more profitable than a company that offers just a single product or service (Aswathappa, 2007).

Takeovers aid in the cutting of business operation costs and ultimately the increased profitability of the target. This is because they offer a way of acquiring a business without the large costs involved in the expansion of a single business. There will also be an overall increase in manpower and hence an efficiency in production of goods and services. Costs drop even further if the businesses that have emerged are dealing with the production of the same product. This will mean that as the production yield increases total costs of production and management will drop thus a net increase in profits will be realized. In this way, businesses bring together and streamline their various support functions and also gain new locations.

Takeovers enable a business to venture into new markets without having to deal with all the procedural matters that are involved. This is because they will just acquire an already functional business within the territory of their choice. This saves them the hustle of having to start an altogether new business in that market. Takeovers lead to an increase in profits due to the gain in profits from acquisition of the acquired business’s portfolio. Thus new buyers are going to be attracted to the business which means higher overall returns.

Takeovers make for greater value of the target since they offer an opportunity to improve business efficiency and also improve business abilities in the market. During the takeover process, jobs and posts that are redundant can be eliminated to avoid overlapping duties and responsibilities. This is done in the restructuring and adjustment period when operations are being streamlined and integrated after the takeover.

Most takeovers are driven by one financial motive or another. The company aims to achieve a higher rate of return on the investment they have made and the risk they have undertaken. Hus the financial goals drive this deal majorly. Most private equity firms are driven by financial motives to carry out a takeover. They are professional investors who manage funds that are invested and are mostly used in corporate transactions. The private equity firms may buy out small firms, or they may take on some debt to buy out larger firms. This has been commonplace in developed economies. The private equity firms are merely acting as financial investors in their takeover bids (Baker &Kiymaz, 2011).

The private equity firms launch a fund where investors such as high net worth individuals and pension schemes may contribute to. These persons are looking to gain high returns by entrusting their funds to professional investors. This fund is then invested in the various targeted sectors that have been already identified. The targeted firms are those that have a good growth potential or those where opportunities have been noticed for improvements in profit maybe through cost cutting (Goergen&Renneboog, 2004).

Firms may utilize their surplus funds to acquire a different firm. Thus they avoid sharing out this money as a dividend to the shareholders or using it to repurchase shares which will increase the income taxes for the shareholders. By carrying out the acquisition, the shareholders will not pay any extra income taxes. An acquiring firm may acquire a target so as to utilize their working capital. This is particularly true when a target company happens to have some assets that have not been fully utilized and hence they can be divested by the acquiring company (Cartwright&Cooper, 2012).

Merging leads to the firms enjoying the effects of coinsurance. This is whereby when the two firms merge their assets and liabilities there is a lesser chance of either declaring bankruptcy. Therefore, they can enjoy a better yield on corporate yield.

Conclusion

Overall takeovers have got numerous advantages and therefore one may go ahead and ignore their risks if the returns outweigh the risks. Those risks include acquiring an administrative strain since the firm has grown in size. There may also be associated with brand damage in case the target company does not fit in precisely with the image of the acquirer. But in any case, there is no escaping the fact that they are a common occurrence in the market today. Therefore, most firms have made provisions for them in their strategic plans. There may be different motivations for them but it is the management’s responsibility to ensure that they protect the shareholders’ wealth by negotiating for a fair compensation for them. This is to allow for a friendly takeover as opposed to a hostile one where the acquiring firm will dictate their conditions.

References 

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