Investment Policy

AG217

Individual Assignment: Investment Policy

Word Count Approx: 3,317

Alistair Henry

201411354

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Table of Contents

Executive Summary.................................................................................................................3

Stocks in comparison to other asset classes...........................................................................4

Bonds.....................................................................................................................................4

Commodities.........................................................................................................................5

Currency...............................................................................................................................6

Outlook for Bonds................................................................................................................7

Outlook for Commodities....................................................................................................7

Outlook for Currency..........................................................................................................9

Investment Risks and Opportunities for Assets..................................................................11

Bonds...................................................................................................................................11

Commodities.......................................................................................................................11

Currencies...........................................................................................................................13

How the of risk the portfolio will be monitored..................................................................14

Recommendations..................................................................................................................17

References:..............................................................................................................................18

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Executive Summary

This report will give an in-depth view into the alternative asset classes compared to stocks

within a portfolio. It will provide the costs & benefits of each, the opportunities and risks, as

well as how the portfolio’s risk will be monitored.

First of all, the costs and benefits for stocks compared to the other potential asset classes will

be outlined and discussed in this section, so to give an idea of how each performs in certain

markets, along with the risks associated and how revenue can be generated from them.

The second part will give the current opportunities and risks of each asset class by examining

the bond market in regards to interest rates and uncertainties, how commodities are to be

tackled with regards to the China problem as well as how currency fluctuations are to be

handled while avoiding any risk.

The last part of the main body will then give an overview of how the risk of the diversified

portfolio will be monitored and which areas can have the risk mitigated and maintained

overtime.

Recommendations at the end will be used to conclude and advise how the multi-asset

portfolio will be constructed given the alternative asset class analysis within the report.

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Stocks in comparison to other asset classes

The most important difference between stocks and the other assets to recognise is the greater

risk (volatility) involved with stocks, which has been proven to bring higher returns over the

decades than any other asset class. By combining the other suggested asset classes with

stocks, it will be shown how there can still be high returns, while reducing the overall risk of

the portfolio through fixed income options, diversification, hedging risk and so on. As shown

in the chart below showing UK stock market returns vs Gilts by Credit Swisse yearbook,

mentioned by Laurene, B (2012) stocks outperform their closest asset class bonds – in terms

of performance- year on year:

Bonds

Bonds are assets formed from one party taking on debt, and the lender being the bond holder.

This arrangement immediately highlights the biggest probable risk of this asset which is the

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probability of the debt taker defaulting which is the main factor that affects the coupons paid,

yields from bonds as well as the fluctuating price on bond markets. Another substantial risk

which investors should take into account is the liquidity of the bonds, if the investor is

looking to generate their profits from buying and selling bonds short term, it is essential to

know the liquidity of the bonds to prevent purchasing a bond with no demand. As interest

rates have stagnated at 0.5% globally for the last couple years, it makes for very poor market

conditions of bonds issued by central banks such as the Bank of England. The issue faced by

banks in today’s market is that they need to offset the low interest rates of savings account by

making attractive interest rates on bonds, that allow a profit margin. This doesn’t affect zero

coupon bonds as their duration is the up front maturity.

Commodities

Commodities would be a significant part of the portfolio as Batavia, B et al (2012) discussed,

since: “Historically, commodity investments have been seen in a defensive role,

as commodities have given good returns in times of slumping equity (and bond) returns.”

Preventing low returns across the diversified portfolio when markets are bearish.

Commodity’s most significant difference to the main assets such as stock or bonds is that it

does not have any form of consistent income through dividends or coupons. This difference

can make it rather unintuitive to invest in commodities for a portfolio since it does not bring

in any kind of income over the long term, only capital gains once sold on. Commodities can

be used to hedge against the risk of other asset classes’ risk of falling when markets change,

such as the US dollar depreciating, allowing gold to rise in value. Having a constant exposure

to commodities such as gold can be very beneficial while diversifying the portfolio as well.

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While industrial metals have not performed well this year, they are usually good to have for

high demand by industrial economies such as China. As said by Batavia, B et al (2012) “The

returns offered by commodities are comparable to that of stocks, usually exceeding those of

the latter when markets are depressed.” So by allocating a section of the portfolio to

commodities, it will allow good returns even when there are poor market conditions.

Currency

Currency is a slightly less predictable asset than the rest. It is more driven by interest rates

and inflation as well government policy such as quantitative easing (bonds this way too).

Currencies do not provide any kind of constant income, but can be used for diversifying as

well as hedging against commodities to reduce risk to market movement. Currencies such as

the US Dollar and Chinese Yen tend to be negatively correlated, meaning that investing in

this asset class is tricky - to ensure that any chosen currencies do not run with each other as

markets move.

The main difference between currencies and stocks is that currencies are more driven by

countries’ performance and economies, and possibly even political issues. Having currencies

allows for the benefit of international diversification since international assets to this day are

still quite negatively correlated to each other, but as globalization grows, this correlation will

in turn become more positive. Exposure to international diversification is also proven to bring

higher returns as concluded by Bouslama, O. et Ouda, O.B. (2014) “The main conclusion is

that, when a 1% transaction fee is applied at the end of each annual testing period, economic

gains from international equity diversification are still substantial to an American investor. “

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Outlook for Bonds

The outlook for bonds this year is very bearish. Interest rates were speculated to increase at

the end of ’15 or start of ’16, but there is has been no movements as of yet, with US and UK

markets sitting at 0.5% and some even in the likes of Japan at negative interest rates. S&P

also degraded the UK credit rating to ‘negative’ in June 2015 according to Spence, P (2015)

due to uncertainty and risk of the EU referendum, making them less attractive to potential

investors and damaging their liquidity within bond markets. They say there is a one-in three

chance that the UK will be downgraded from a AAA rating, as they’re the only rating agency

out of the big three to still retain this rating.

As the Brexit vote is concluded in the summer, the market will eventually return to

equilibrium and UK Government/Corporate bonds should recover as investors adjust to the

changes or move on with a stay in vote. While the interest rates are still problematic for the

bond market, it should keep current bonds prices stable as interest rates remain low, working

in the hands for investors wanting capital gains through yield rather than bond trading.

Outlook for Commodities

For commodities it’s a year of doom and gloom. As China’s actual growth has fallen below

the forecasted growth as stated by BBC (2016) “The news comes as the International

Monetary Fund said it expected China's economy to grow by 6.3% this year and 6% in 2017.

Beijing had set an official growth target of about 7%”. It has had a huge affect across

industrial and energy commodities caused by it’s inability to match the supply made by the

companies across the globe that depended on them as their main supplier.

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The significant fall of China’s growth had already been predicted earlier by Magnier, M.

(2015) “China is likely to miss its 2015 foreign trade target of 6% year-over-year growth,

down from the 7.5% growth targets it set in 2014 and 8% in 2013, both of which it failed to

reach, economists said.” So it is no surprise what has happened, many of the commodity

companies should have prepared for this and are now catching up by making large cuts to

their projects.

Assets such as steel and copper that are heavily dependent on China have had a very tough

start to the year. Even large coal mining companies in the US have felt the fall in demand as

discussed by Shogren, E. (2016) “Arch Coal, filed for bankruptcy Monday, making it the

second company with large Western mines to seek Chapter 11 restructuring in recent

months”. This significant decline is illustrated in the graph below showing Coal Price over a

12-month period from InvestmentMine (2016):

Many projects in gold have been abandoned this year as the strength of the dollar has

reflected.

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China has taken cutbacks in demand for commodities such as steel, coal and copper, which

has levelled the price of each significantly due to reduced demand. As shown in the graphs

below - taken from World Bank (2015) -, the commodity market is heavily reliant on the

Chinese economy, as it has grown exponentially over the year, along with its demand for

industrial commodities.

Outlook for Currency

The three biggest movements in the market will be the deciders for 2016’s outlook in

currency. The US Dollar has gone from strength to strength, while the Chinese Yen dropped

in value mainly due to their fall in growth for 2016, while wanting to increase their export

exposure by inflating the Yen. Another significant mover has been the Sterling Pound, which

has been knocked down substantially due to the market’s uncertainty of the Brexit vote in the

2016 summer, which investors are unsure of what the British will vote for and what effect the

departure from Europe will have on the UK.

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Carrying on from earlier, as the markets have been falling in the world, foreign currencies to

the Sterling Pound have been rising in their respective markets. The US dollar has been

growing in strength, but as the interest rate issue carries on, this will slow down. Countries

such as Japan have had negative interest rates which is sure to put off investors as they’re

unsure what direction Japanese Yen will take over the year.

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Investment Risks and Opportunities for Assets

Bonds

The current risks for bonds is the increasing uncertainty of interest rates, especially with the

current economic position of the markets. While the bond market does not look good, they

are a significant part of a portfolio, especially from the perspective of creating constant

income via coupons. Opportunities for this year may be in undervalued industrial companies,

as suggested by a fund manager from Fidelity (2016) “I am considering undervalued

opportunities in the industrial sector.” – in regards to the bond market.

There is still monumental risk involved with CDS’s and their counterparts that are based off

of consumer debt rather than a credit worthy corporation or government. This year’s greatest

risks are in the financial sector where banks are struggling to cope with the bonds market and

low interest rates which are making it very difficult for attractive savings accounts in retail to

provide capital to supply the mortgage market, all the while remaining competitive. The

industrial market has also taken a beating, so any kind of corporate bonds in this sector would

obviously provide healthy yields, but substantial risk attached, making them attractive for risk

seeking investors. Lastly, bonds associated with governments within the EU are struggling,

especially in the UK where many investors are selling up and clearing out their UK

government bond cache’s in a bid to save them from any potential risk post-Brexit.

Commodities

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The are some significant opportunities for commodities as of right now. Since oil is at a low

(over the recent period), purchasing stocks in oil while prices are low could be a good

investment short term, not for the long term. As oil will eventually recover due to the reliance

on fossil fuels across all economies, the price will rise to its historical equilibrium, sure to

bring high returns. As shown below, – historically - when oil prices hit this low, the price

eventually recovers as World Bank (2015) predicts in the chart using a range of oil price

indices over different time periods:

While gold has not performed very well in the current market conditions as it should in poor

markets, it would be worthwhile to purchase some stocks in gold while the prices are low,

then sell up when prices gradually creep up, while retaining some as a safety net for any fat

tail events in the future.

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The risks involved are that as markets have plummeted so far this year, even commodities

like gold which have been strong, reliable investments when times are bad, have been

drastically affected by the strength of the Dollar and the fall in China’s growth rate, affecting

all commodities. There isn’t a great deal of certainty as to when oil will rise in price, making

it a risky investment as well as industrial metals needing a significant increase in demand in

order to recover.

Currencies

The market for US Dollars is a huge opportunity as they have gone from strength to strength

by their improving economy and taking the opposite side of China’s poor performance. As

the US Dollar continues to appreciate, buying US Dollars with Sterling Pounds and waiting

till they peak and selling could bring potentially high capital gains from a short term

investment. The Euro is also growing in strength against the Sterling Pound – conversely to

the end of last year where the Sterling Pound finished on a strong position against the Euro-

so buying up Euros could be another opportunity as the Brexit vote comes closer, leaving

more risk of the Sterling Pound depreciating.

Risks this year would be in the Sterling pound and Euros which are undertaking severe

uncertainty from policy makers to investors alike. Due to the pessimistic and cluttered news

on the outcome as well as vote of the UK to stay in or out, it has left many investors panic

stricken as to how the currencies will react, especially if the UK loses its trading links to the

Eurozone. The Sterling Pound has already taken a beating as the date for the Brexit vote

closes in, meaning this currency should be well avoided given the significant risk.

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How the of risk the portfolio will be monitored

A good benchmark to use to manage and monitor the risk of the portfolio would be by using a

function called VAR – Volatility at Risk. The VAR would be used based off of historical

returns as this is the most commonly used risk management by portfolio managers. In terms

of how useful it is as a measure of risk, Strickland, C (2012) points out “In standard VAR

calculations, market price is the only exposure considered.” This is a very good point,

because in cases such as commodities like energy: “risk profile for many energy companies is

also driven by non-market variables such as demand, generation levels, temperature, wind,

rainfall and so on”. While this measurement is useful for assets that are more based on supply

and demand of markets such as stocks, it does fail to address other factors that make up the

aggregate risk of the security. However, this form of risk management allows the fund

manager to consistently assess how much the portfolio can take in losses as well as being a

good performance indictor to investors.

A more concise form of monitoring risk would be to carry out Altman-z scores on an annual

basis for each asset if it is associated with a corporation (e.g. stocks and corporate bonds) so

to prevent any kind of defaulting on assets in the future, protecting the investor’s cash. This

could be done by employees of the fund manager, or even taken from the internet if the

Altman-z scores are published already.

For the bonds, the credit ratings will consistently be monitored to ensure their ability to be

paid and their liquidity. AAA-A –investment worthy - credit bonds will be used to avoid any

defaulting of companies, primarily corporate based bonds on debt such as CDC’s. As learnt

from the 2008 Financial Recession, bonds based on debt can be bad investments with

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unreliable creditors which are hidden by false credit ratings provided by the likes of Moody’s

or Standard and Poor’s. While bonds with credit ratings below ‘A’ can have higher

yields/coupon rate’s, they are not reliable enough securities for a portfolio that must act with

little recklessness. Creating a bond ladder using short term bonds – up to 10 year maturities -

would also reduce the risk of this asset class while making the portfolio easier to monitor the

risk as the fund manager can actively watch how each bond’s price is affected by changes in

the market environment and then act on them in accordance.

Commodities are a difficult asset class to mitigate and handle risk due to their uncertainty. In

order to balance the risk of the portfolio against poor market elements as said by Batavia, B et

al (2012) “And, while commodity returns tend to be volatile, they move to different impulses

from that affecting equity markers, so that the risks of the combined portfolio are lowered.“, a

great proportion of commodity investment will be in Gold which has been a better

performing security in times of crisis, while being negatively correlated to the US Dollar,

meaning when the US Dollar eventually returns to its average value, the price of Gold will

move in the opposite direction – up.

For stocks, it’ll be a more difficult task to monitor the risk of these securities. But by setting

out some policies such as investing in value stocks and not growth stocks, as concluded by

Patel, J.B. et Swensen, R.B (2007) “January 2000 to May 2006, when overall market returns

were lower, value stocks outperformed growth stocks” as not only do they outperform growth

stocks in bad market conditions, “We demonstrate that growth stock returns have

comparatively greater volatility, both in terms of total risk and systematic risk, than do value

stock returns.” By reducing volatility in cases such as this, while maintaining high returns,

gives a good outcome for the overall portfolio. An equal proportion of investment will be in

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small, medium and large cap stocks so to prevent any over exposure to the small or large cap

stocks which have the highest volatility.

In terms of the whole portfolio with the accumulated asset classes, there are several

investment strategies that can be adopted to reduce the unsystematic risk and the exposure

from each different asset classes. Some different strategies include a classic balanced

portfolio, 60% stocks and 40% bonds, which is inapplicable to a portfolio with multiple

assets since the strategy is made for just stocks and bonds. There is also the controversial

‘naïve’ 1/N strategy which is simply investing 1 divided by the number of total classes, in

each asset. Another one is what’s known as the Permanent Portfolio, this calls for 25% in

stocks, 25% in bonds, 25% in cash and 25% in Gold. The Permanent Portfolio strategy would

be used for this portfolio along with some leeway for currency investing since it gives the

most diversified and calculated portfolio compared to the likes of the 1/N which is arguably

random.

As mentioned earlier in the document, the use of international diversification across all asset

classes is a great method of reducing and monitoring risk as discussed by Bouslama, O. and

Ouda, O.B. (2014) “attractiveness of emerging markets in international

portfolio diversification as a substitution to developed ones; this interest is motivated by their

portfolio risk reduction due to the low correlation with developed markets “. Although the

economy of China has performed poorly over the last year, there is still great potential for

international diversification in emerging markets within portfolios. Along with this,

diversification by investing across industry types that are non-correlated –e.g. construction,

banking, pharmacy – will also help to reduce the overall volatility of the portfolio.

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Recommendations

Following on from the main body, the portfolio should adhere to the analysis and suggestions

through out the main body. Emphasis will be put on where the fund should invest in with

regards to each asset class – bonds, commodities and currencies.

For the bond market, the laddered approach should be followed, only investing in investment

worthy bonds such as government or safe corporate bonds, while avoiding the UK due to

uncertainty.

In commodities, investment should be put into the gold market while prices are low to

balance the risk of the portfolio in case of another fat tail event. Oil is another commodity

that should be considered given the current low prices that are bound to increase over the next

couple years.

Lastly, currencies such as the US Dollar should be bought up while prices are still somewhat

increasing for short term capital gains by trading them as soon as they begin to depreciate,

while offsetting the risk of gold commodities.

The methods of monitoring risk should all be followed as they will help to reduce risk in

every asset class while helping to minimise the risk of the entire portfolio together, as well as

giving high returns on investment.

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References:

Batavia, B., Parameswar, N. and Wagué, C. (2012) ‘Portfolio Diversification in Extreme

Environments: Are There Benefits From Adding Commodity Futures Indices?’, European

Research Studies, 16(3), pp. 33–48.

BBC (2016) China economic growth slowest in 25 years. Available at:

http://www.bbc.co.uk/news/business-35349576 (Accessed: 22 March 2016).

Bouslama, O. and Ouda, O.B. (2014) ‘International portfolio diversification benefits: The

relevance of emerging markets’,International Journal of Economics and Finance, 6(3).

Fidelity (2016) 2016 bond market outlook. Available at:

https://www.fidelity.com/viewpoints/investing-ideas/bond-market-outlook-2016 (Accessed:

22 March 2016).

Laurance, B. (2012) Stock market returns since 1900: The 23-year spell when UK shares

failed. Available at: http://www.thisismoney.co.uk/money/investing/article-2097825/Credit-

Suisse-stock-market-returns-1900-The-24-year-spell-UK-shares-failed.html (Accessed: 23

March 2016).

Magnier, M. (2015) China growth in focus as exports and imports fall. Available at:

http://www.wsj.com/articles/chinas-exports-imports-fall-again-1444704325 (Accessed: 22

March 2016).

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InvestmentMine (2016) Coal prices and coal price charts - InvestmentMine. Available at:

http://www.infomine.com/investment/metal-prices/coal/ (Accessed: 12 March 2016).

Patel, J.B. and Swensen, R.B. (2007) ‘Comparative performance of value and growth stock

indexes’, The Journal of Wealth Management, 9(4), pp. 51–61.

Shogren, E. (2016) Huge U.S. Coal company declares bankruptcy. Available at:

https://www.hcn.org/articles/huge-us-coal-company-declares-bankruptcy (Accessed: 22

March 2016).

Spence, P. (2015) UK’s credit rating downgraded to ‘negative’ by S&P on EU referendum

risk. Available at: http://www.telegraph.co.uk/finance/economics/11671596/UKs-credit-

rating-downgraded-to-negative-by-SandP-on-EU-referendum-risk.html (Accessed: 22 March

2016).

Strickland, C. (2012) ‘HOW RELEVANT IS VAR FOR ENERGY MARKETS?’, Energy

Risk, 9(5), pp. 48–50.

World Bank (2016) Commodity markets outlook. Available at:

http://pubdocs.worldbank.org/pubdocs/publicdoc/2016/1/991211453766993714/CMO-Jan-

2016-Full-Report.pdf (Accessed: 21 March 2016).

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