Making Informed Investment Decisions

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Making Informed Investment Decisions
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Your Investment Objective?

• SAFETY
• LIQUIDITY
• RETURNS

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(No Transcript)
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Bonds v/s Equities

• Bonds
• Yield curve and interest rates drive bond prices
• Invest in bonds for
• Interest payment
• Capital gain

• Equities
• Earnings drives stock prices
• Form of ownership
• Invest in stocks for
• Dividends
• Capital appreciation

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Bonds v/s Equities (Contd.)

• Bonds
• When the company is doing well
• Bond holder will keep collecting the coupon
  interest and get his investment principal back
  when the bond matures
• When the company is in trouble
• Bondholders have a senior claim on the company
  assets unlike equity holders
• The bonds value will go down at a lesser degree
  than the stock price

• Equities
• When the company is doing well
• The company will increase the dividend. The
  shareholders will also enjoy capital appreciation
  of the stocks
• When the company is in trouble
• Dividend will be cut first
• If the company is to go out of business, the
  shareholder is the last one to get paid
• Sometimes the stocks could be worth nothing

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BONDS
Bonds are long-term debt security with
contractual obligations regarding interest
payments and redemption
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Bond Features

• Bond holders have senior claim than the
  stockholders
• Bonds pay higher interest rates than Savings
  Accounts / Deposits
• Bonds provide relatively steady and predictable
  stream of income
• Bonds offer return of principal on maturity
• Bonds are less volatile as compared to equity
• Bonds tend to perform better in a falling or
  stable interest rate environment
• Bonds help Portfolio Diversification

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Bond Types
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Bond Types (Contd.)
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Bond Types (Contd.)
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Who Issues Bonds?

• Federal Govt. / Municipal Govt. / Govt. Agencies
• Non Govt. Agencies
• Corporations

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How are Bonds rated?

• Ratings are assigned by independent bond rating
  agencies like Moodys Investors Service or
  Standard and Poors Corporation
• Ratings reflect the credit quality of the bond
• The credit quality reflects the ability of the
  issuer to pay periodic interest as well as repay
  principal amount borrowed upon maturity
• Usually, a low credit rating demands a higher
  yield and a high credit rating demands a lower
  yield
• US treasury securities have the highest possible
  credit rating. THEY ARE CONSIDERED VIRTUALLY FREE
  OF CREDIT RISK
• Emerging market debt is largely speculative grade
  and commands a higher yield. Some countries have
  been upgraded recently

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Credit Ratings

• Bond Yield Risk free Rate Credit Spread
• Credit Spread is a function of the credit rating
  of the Issuer

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Construction of Yield Curve
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Yield Curve Shapes
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Price v/s Yield

• As interest rates decrease, price of the existing
  bonds increase

• As interest rates increase, price of the existing
  bonds decrease

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Bond Price Behaviour

• Bond prices move inversely to interest rates
• Price changes are not symmetrical
• Bond prices go up faster when rates fall than
  they go down when rates rise
• A bonds price volatility is directly related to
  the bonds term to maturity
• The longer the term to maturity, the more the
  price volatility
• Price volatility increases at a decreasing rate
  as term to maturity increases
• Bonds price volatility is inversely related to
  the bonds coupon rate
• The higher the coupon, the lower the price
  volatility
• Assuming a constant percentage change in market
  yields, then as the level of yields rises, the
  price volatility of bonds decreases
• The higher the YTM, the lower is the price
  volatility

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Bonds Quantitative Analysis
Example on Excel
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Bonds Quantitative Analysis (Contd.)

• Yield
• Yield to Maturity (YTM) Measures the net yield
  that will be received if held till maturity
• Yield to Call (YTC) Measures the net yield that
  will be received if retired at the 1st call date
• Dirty Price
• Present value (PV) of all the future cashflows
  discounted _at_ YTM / YTC
• Accrued Interest
• The amount of interest over a period received by
  the buyer even though it was earned by the seller
• Accrued Interest Par Value Coupon Rate
  (Settlement date Previous coupon date) / 360
• Accrued Interest 100 7.25 (11/Sep/08
  12/Aug/08) / 360 0.604
• Clean Price
• Clean Price Dirty Price Accrued Interest
• The Price quoted in the market is always Clean
  Price
• Duration
• Sensitivity of bond price to change in yield

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Which of the Issues are erroneously reported?
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Which Bond would you choose?
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Risks of Bond Investing

• Market Related Risks
• Interest rate risk
• Inflation Risk
• Re-investment risk
• Currency Risk for international investing
• Company Specific Risks
• Credit Risk
• Liquidity Risk
• Call Risk
• Event

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Investment Strategy - Laddering

• Liquidity
• Since the investment is spread over various
  maturity spectrums, there is constant flow of
  liquidity
• Consistent returns
• A good mix of bonds ensures consistent average
  returns
• Lower risk
• Due to diversification over sectors, tenor and
  credit quality, ladders tend to have lower risk

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QUESTIONS
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MUTUAL FUNDS
A Mutual Fund is an investment company that pools
money from shareholders and invests in a
diversified portfolio of securities
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Why Mutual Funds

• Professional money management
• Reduced risk through diversification
• Earn competitive returns on your investment
• You dont need a lot of money to get started
• Ready access to your money
• Cheaper
• Convenient Flexible
• Automatic withdrawal plans are available
• Less risk of bankruptcy or fraud
• Monitoring mutual funds is simple

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Definition

• Mutual Funds are pooled investment vehicles which
  allow investors
• to indirectly invest in a diversified portfolio
  of assets

• They are managed by professionals/ Fund Managers
• Investors own assets bear the risk and rewards of
  investing
• Issuers of fund are paid for their services by
  investors

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Benefits of a Mutual Fund
Professional Management
Service
Mutual Funds
Diversification
Affordability

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Structure of Mutual Funds
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Structure of Mutual Funds (Contd.)
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Before You Invest

• SIX Key Questions to Ask Yourself
• Investment Goals
• 2. Investment Strategy
• 3. Risk Returns
• 4. Fees Expenses
• Investment Manager
• Fund Services

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Open Close Ended Funds

• Open Ended
• Unlimited sales, subject only to demand
• Available year long
• Bought and sold through Fund House
• Fund House obliged to buy back fund if investor
  desires to sell

• Closed Ended
• Limited supply
• Operate in fixed duration
• Penalty for early redemption
• Listed on stock exchanges
• Can be sold on market for market price regardless
  of Net Asset Value

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Types of Mutual Funds

• Money Market Funds for high stability of
  principal, liquidity and income
• Bond Funds, both tax-exempt and taxable funds to
  generate income
• Fixed-Income Funds invest in government or
  corporate securities which offer fixed rates of
  return
• Balanced Funds invest in a combination of both
  stocks and bonds
• Equity Funds invest in shares of common stocks
• Specialty/Sector Funds to diversify holdings
  within an industry

Each category will have a further classifications
- geographical, style, thematic
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Costs of Mutual Funds

• Transaction Costs (One time)
• Front End Load Charges on the purchase price
  when units are initially bought (applicable for
  A class fund)
• Sales charges on reinvested dividends
• Back End Load Redemption fees (applicable for
  B class fund)
• Fees associated with B shares usually decline
  with time and become zero if held for a
  particular period, generally 4 years
• Switching fees
• Operational Fees (Recurring)
• Management fees paid to fund managers for their
  expertise and services. Can range from 0.05 -
  2.00
• Cost of shareholder mailings, and other
  administrative expenses

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Expense Ratio

• The expense ratio is simply how much money (in
  percentage) the mutual fund company takes off for
  itself to cover operating, administrative, and
  other expenses
• It is the cost of owning the fund
• It also represents the amount of the investors
  money that is not invested. The lower the expense
  ratio, the more money is actually invested
• The typical expense ratio are
• Money Market Fund 0.50 to 1.00
• Bond Fund 1.00 to 1.50
• Equity Fund 1.50 to 2.50

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Net Asset Value

• NAV (Market value of existing portfolio total
  fund inflows market movements dividends
  other income - expenses)/number of units
  outstanding
• When the NAV per unit of a fund moves from 1.00
  to 2.00, it does not necessarily mean that the
  fund is now more 'expensive' and therefore less
  attractive
• It is not possible to use the same valuation
  measurements, example Price to Earnings ratio
  (P/E), Price to Book ratio (P/B), etc, for funds
  as for stocks
• A fund's potential to show good future
  performance should therefore be judged on such
  factors as its past returns and risk, the outlook
  for the market, the fund manager's experience and
  investment process
• The fund's NAV per unit at any level, including
  at launch, is no indicator of value

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Prospectus Shareholder Reports

• Prospectus Funds goals, Fees Expenses,
  Investment Strategies Risks, as well as
  information on how to buy sell shares
• Shareholder Reports Includes Funds financial
  statements and performance and a list of
  securities the fund held in its portfolio at the
  end of the most recent accounting period
• Some Mutual Funds offer a streamline version of a
  Fund Prospectus called a Fund Profile. It
  contains answers to key questions to consider
  before investing in MF

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How to Analyze Fundfact Sheets

• Why read a fund fact sheet?
• Important items in a Fact Sheet
• Fund Profile
• Managers Review Outlook
• Fund Details Inception Date, NAV, AUM,
  Currency, Minimum Investment Amount, Load,
  Management Fee, Liquidity, Manager Vintage
• Performance
• Asset Allocation
• Risk Statistics

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Statistics used in portfolio management

• Mean µ average return, usually stated in
  terms of average annualized returns
• Standard deviation s measure of total
  volatility
• Tracking error a measure of how much a
  portfolio deviates from its benchmark
• Beta ß measures sensitivity of portfolios
  behavior relative to a benchmark
• Correlation ? measures directional
  relationship between two assets
• R-squared ?2 how much of a portfolios
  behavior is explained by the benchmark
• Alpha risk-adjusted return that is unexplained
  by the benchmarks performance
• Sharpe ratio excess return (vs. risk-free rate)
  per unit of risk
• Information ratio excess return (vs. benchmark)
  per unit of tracking error

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Example

• Which is a better Fund?
• Fund A
• Fund B

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Dollar Cost Averaging

• When market is down, more shares are bought
• When market is high, fewer shares are bought
• Overall, average price paid/share is less than
  theaverage cost incurred if you bought in one go

Staged purchases over time can reduce the impact
of stock market volatility
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Power of Automatic Investing

• Systematic Approach to long-term investing
• Effective strategy with funds / stocks that can
  have sharp ups downs
• Says NO to market timing

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Risks Associated with Mutual Funds

• No investment is risk-free
• Business Risk
• also called unsystematic risk. Factor of
  individual corporates and can be reduced by
  diversifying portfolio
• Market risk
• also called systematic risk. Cannot be reduced.
  However, long term investment can help eliminate
  losses from the market cycle
• Credit risk
• the possibility that a loan will not be repayed.
  Diversification will help minimise the risk
• Liquidity risk
• May be avoided by investing in open-ended funds
• Currency risk
• Foreign assets are bought in other currencies

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QUESTIONS
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PORTFOLIO APPROACH
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Risk v/s Returns
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Importance Of Asset Allocation
Source 1. Roger G. Ibbotson, Does Asset
Allocation Policy Explain 10, 90 or 100 Percent
of Performance?, Financial Analyst Journal,
January/February 2000 Brinson, Singer and
Beebower, Determination of Performance II An
Update, Financial Analyst Journal, May/June
1991. Based on US pension fund data 1977-1987.
Studies that employ different statistical
interpretations produce different results. 2.
Based on US pension fund data 1977-1987. Real
results may vary.PAST PERFORMANCE IS NOT
INDICATIVE OF FUTURE RESULTS.
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Risk Reward Analysis
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Risk Asset classes
Long term expected return
Volatility of actual return
Risks Increases!!
The greater the risk, the more the clients could
potentially lose and fall short of their
objective.
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Asset Class Behaviour

• Different asset classes react differently to
  different stages in the economic cycle

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Achieving Asset Allocation-Diversification
Different asset classes perform well at different
timesdiversify!
Best
Best
Worst
Worst
For illustrative purposes only. Past performance
is not indicative of future results, and
investments can go down as well as up. The chart
represents unmanaged indices in which investors
cannot directly invest. Calculations assume
reinvested dividends but take no account of fees,
expenses or taxes. Data source SP Micropal Ltd.
Indexed performance in sterling 30 April 1996 to
30 April 2006.
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Risk Diversification
An assets Total Risk Systematic risk
Unsystematic risk
Total Risk
Unsystematic Risk caused by events unique to the
firm, which can be eliminated, i.e. diversified
away, when combined with other assets in a
portfolio.
Unsystematic Risk
Systematic Risk caused by macroeconomic events
such as unexpected changes in the business cycle
and inflation, which cant be eliminated when
combined with others in a portfolio.
Systematic Risk
Portfolio risk falls as the number of asset in
the portfolio increases.
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Sample Direct MF portfolio (Balanced)
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Experience the Citi Difference

• PORTFOLIO APPROACH

• PRODUCTS
• Bonds / Perpetuals
• Mutual Funds
• Alliance Bernstein, Blackrock, Fidelity, Franklin
  Templeton, Henderson, Invesco, JP Morgan, MFS
  Meridian, Pioneer, Schroder
• Hedge Funds
• Off the shelf products
• MFS, Zurich, Alico
• Trust Services
• CITCO
• Structured Notes
• Structures based on Client Need
• Treasury Products (FX Gold)
• Direct trades, Premium Accounts, Accumulators

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Important Information

• Any person considering an investment should
  consider the appropriateness of the investment
  having regard to their objectives, financial
  situation, or needs, and should seek independent
  advice on the suitability or otherwise of a
  particular investment.
• Investments are not deposits or other
  obligations of, guaranteed or insured by Citibank
  N.A., Citigroup Inc., or any of their affiliates
  or subsidiaries, or by any local government or
  insurance agency, and are subject to investment
  risk, including the possible loss of the
  principal amount invested.
• Investors investing in funds denominated in
  non-local currency should be aware of the risk of
  exchange rate fluctuations that may cause a loss
  of principal.
• Past performance is not indicative of future
  performance, prices can go up or down.
• Some investment products (including mutual
  funds) are not available to US persons and may
  not be available in all jurisdictions.
• Investors should be aware that it is his/her
  responsibility to seek legal and/or tax advice
  regarding the legal and tax consequences of
  his/her investment transactions.

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Thank You
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Zero Coupon Bonds

• Zero Coupon Bonds are bonds which do not pay
• any coupon during the life of the bond

• Pitfalls
• Price Most sensitive to the interest rate change

• Benefits
• Guaranteed lump sum at maturity
• Sold at a deep discount
• No Reinvestment Risk
• Liquid market
• Possible to generate positive capital gain if
  sold before maturity
• Use for funding for education, deposit for down
  payment and other long term needs

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Callable Puttable Bonds

• A provision included in the legal document giving
  the Issuer and/or bondholder an option to take
  some action against other party
• Options granted to Issuers or borrowers (Callable
  bonds)
• Options granted to Bondholders (Puttable Bonds)
• Embedded Options make it difficult to project the
  cash flows of a bond
• It affects the value and the total return of the
  bond

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Perpetuals

• Fixed income instruments which pay a DIVIDEND at
  a fixed rate
• DO NOT HAVE A STATED MATURITY. However, they are
  callable (solely at the discretion of the issuer)
• Typically issued by Banks for Capital Adequacy
  reasons
• Subordinated to all senior debt of the issuer,
  implying that no repayment to perpetual holders
  is made until all higher ranking creditors are
  repaid in full
• However as the underlying are preference shares,
  dividends on perpetuals have to be paid out
  before those on ordinary shares
• Dividends are non-tax deductible for the issuer
  and pay gross to the investor
• Trading below par
• Yield to call represents best case and yield to
  maturity represent worst case
• Trading above par
• Its the other way round. Yield to call represents
  worst case and yield to maturity represents best
  case

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US Govt Securities

• Treasury Bills
• (T-Bills)
• Short term money
• market instruments
• One year or less
• to maturity
• Sold at discount
• Bid/ask at 1/32

Treasury Notes (T-Notes) Intermediate instruments
One to ten years to Maturity Standard coupon
Treasury Bonds (T-Bonds) Widely quoted benchmark
rate Ten to thirty years to maturity The Long
Bond Standard coupon
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Are Treasury Securities Risk Free?

• Virtually free of credit risk
• These securities are credit risk-free instruments
  against which all other investments are measured
  and priced
• However, they are not immune from interest rate
  risk which can result in significant fluctuation

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Yield Curve Shifts
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Current Implied USD Fwd Yield Curve
Source Bloomberg
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Yield v/s Maturity

• Long Maturity
• Demand higher return for the risk
• More sensitive to the interest rate change than
  short maturity securities of the same quality
• Short Maturity
• Safer, willing to accept lower rate of return
• Less sensitive to the interest rate change than
  long term securities of the same quality

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Performance Mean (µ) a basic statistic

• Mean return is an assets average return.
  Mean returns are often stated in terms of average
  annualized percentages

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Standard Deviation (s)-measures volatility
Standard deviation (s) is a measure of
volatility. It indicates the dispersion of
returns around the average, or mean.
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Tracking error

• Measure of the portfolios deviation from its
  benchmark
• Mathematically - volatility of excess returns
  over benchmark
• Benchmark has 0 tracking error
• Index funds have low tracking errors because they
  closely track the benchmark index

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Beta-ß

• Measures the historical risk / price fluctuation
  of an individual stock or a fund in comparison to
  the entire market
• Example - If the market increases by 10 and the
  fund
• increases by 20 - beta of 2.0
• increases by 5 - beta of 0.5
• Decreases by 5 - beta of -0.5
• Beta value measures just the part of a funds
  volatility that is attributable to market risk
• How volatile is my investment in absolute
  terms? - Standard Deviation will measure total
  volatility from all causes

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Correlation (?)
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R-squared (?2 or R2)
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Manager Skill Alpha (a)
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Using alpha (a) and beta (ß)
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Sharpe Ratio Information Ratio
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Sample Direct MF portfolio (Growth)
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Sample Direct MF portfolio (Enh. Growth)