Tag: Investment

The Basics of Asset Allocation

Introduction

In early March 2020, the major outbreak of the COVID-19 virus around the world caused the global stock market to suffer 30% losses overall, hurting a huge proportion of stock market players. However, with the rise of uncertainty, gold, a prominent safe-haven asset, has experienced price spikes. This inverse relationship between gold and the stock market has revealed the importance of a common investment strategy — asset allocation.

Asset allocation is the process of determining the mix of assets in an investment portfolio. It is a key ingredient for an investment strategy to succeed as it will help investors to achieve their investment goals by reducing risk. With proper asset allocation, individual investors will be able to minimize risk on their investment and infuse more certainty on achieving their financial goals. Depending on personal needs, the asset allocation will also help secure investors with sufficient liquidity for their financial obligations or goals.

However, there is no simple formula to find the right asset allocation for every individual as it varies from person to person. In general, an ideal allocation strategy can be built by considering the individual’s financial situation, including time horizon, level of risk tolerance and investment goals.

Common Asset Classes

A wide array of investment products exists in the current financial market. The most common asset class includes equities, fixed income as well as cash and equivalents. There are also other asset categories, namely alternative investments, including commodities, real estate and art pieces which some investors may hold in their portfolio. In this article, the discussion will be mainly focused on the common asset class.

Table: Comparison for stock, bond and cash

Stocks

Probably the most well-known investment. A shareholder will be able to make profit through potential capital growth and dividend income. Given that the stock market is highly volatile, this asset is better suited for investors with high risk appetite. As a return for bearing a higher risk, the potential return for the stock market is also relatively higher compared to other major asset categories.

Bonds

A bond is a fixed income asset that is issued by the government, corporations or municipalities to raise funds for specific purposes. Investing in bonds means an investor is lending money to these entities for a period of time in exchange for interest payments. In general, bonds, especially government bonds, are less volatile than stocks, but potentially generate more modest returns.

Cash Investments

Cash and equivalents such as saving deposits, money market funds and treasury bills are known as the safest investment with minimal risks. These investments offer lower return among the common asset categories but also provide higher liquidity in which investors are allowed to withdraw cash relatively easily. However, investors who put their money in cash investments with a fixed rate of interest payment as return, will be exposed to inflation risk. They may lose purchasing power if the rate of return of the money invested does not pick up with inflation rate.

Key Consideration for Choosing Your Ideal Asset Allocation

Asset Allocation by Investment Goals

To get started, investors need to consider their current financial situation and how much they can afford to put into their portfolio, followed by their desired level of return to fund their goals. For example, a person with a goal of purchasing a house in 10 to 15 years would likely be implementing more aggressive investing plans by investing in riskier assets such as stocks, given that the time horizon is longer. Therefore, different goals will require different investment horizons to achieve. This affects risk tolerance.

Asset Allocation by Time Horizon

The time horizon can be explained as the period of time that one expects to achieve a particular financial goal through holding an investment portfolio. In simple words, it is the duration of an investor’s investment. Most of the time, it centres around the goal of the investment such as retirement funds, education funds and travel funds. Different time horizons will lead to different levels of risk tolerance. Generally, investors with short-term goals tend to avoid taking riskier investments in their portfolios, while long-term investment strategies may encourage investors to invest in a more volatile portfolio as there is more room for economic conditions to change over time.

Asset Allocation by Risk Appetite

Risk appetite, also known as risk tolerance, refers to how much an investor is willing and able to lose his or her initial investment in anticipation of getting a higher return in the future. Among the different types of investment risks, market risks (which include equity risk, interest rate risk and currency risk), liquidity risks, reinvestment risks and inflation risks have received more attention from the majority of investors. An investor’s risk appetite can help in determining the asset mix in the portfolio. Generally, an investor with a higher risk tolerance, will include riskier assets such as stocks and hold a lesser portion of safer assets such as bonds and cash in the portfolio, expecting a higher return in a shorter period of time. On the other hand, a conservative investor will tend to look for less volatile assets to hold in order to preserve their original investment capital.

Rebalancing Portfolio

After designing and implementing specific asset allocation strategies, rebalancing the portfolio is crucial to ensure the overall strategy works well. Since each asset class will perform differently depending on market conditions, rebalancing has to take place in order to bring the portfolio back to its original strategic mix over time. By doing so, investors are ensuring that their investments are still aligned with their investment goals.

Rebalancing can be executed in different ways such as Calendar Rebalancing and Percentage-of-Portfolio Rebalancing (also known as Tolerance Band Rebalancing). The Calendar Rebalancing method is relatively easy to implement as it requires lesser knowledge and monitoring. To use this approach, investors will need to analyse and adjust their portfolio to the original allocation or new allocation if needed on a regular time interval such as every three months, six months or twelve months with the consideration of time constraints and transaction costs.

On the other hand, Percentage-of-Portfolio Rebalancing is a more intensive approach as compared to Calendar Rebalancing. This strategy involves the process of determining the tolerance range for each asset class in a portfolio in terms of change in weightage due to price volatility.

Conclusion

After determining an ideal mix of assets, investors can also improve their portfolio through further strategies such as diversification within the asset classes which might be able to further reduce the impact of specific market volatility. For instance, with the capital assigned to the stock market, investors can invest a relatively high percentage of capital in blue-chip stocks which provide more price stability and small amounts of capital in high volatility stocks. For those with a smaller capital, Exchange Traded Funds (ETFs) will also be able to help them in achieving this portfolio diversification effect. Further diversification can be achieved by allocating capital across more equity funds such as global equity funds.

There are many other tools that can be used to perform asset allocation. For example, some investors prefer to determine an appropriate asset allocation ratio through rule of thumb such as Rule of 100 which suggests investors to subtract their age from 100 in order to know how much they should allocate in equities. However, many of the traditional asset allocation methods have been criticized for utilising inadequate considerations and factors. With digital transformation, platforms such as robo-advisors, also referred to as a computerized investment manager, will be able to take into consideration more personal factors and other relevant information in the process of creating an asset allocation strategy. Therefore, asset allocation will continue to be a key component in a successful investment strategy for many investors but will move towards a more digitalized method.

Researcher: Evon Chew

Reviewer: Millen Lau

Download the article here:[download id=”5351″]

[yikes-mailchimp form=”1″]

March 9, 2021
The Case of Small-Cap Equities

When investors begin to hunt for investment opportunities, companies with well-built reputations are usually the first to pop up in their minds as these companies are portrayed as a relatively secure investment. As a result, many smaller sized firms are left unnoticed. Some investors even consider small-cap stocks as purely speculative instruments due to its deceptively cheap price coupled with heightened volatility.

Before: In the local setting, Securities Commission Malaysia (SC) and Bursa Malaysia announced that the stamp duty for companies of market capitalization ranging from RM200 million to RM2 billion as of 31st December 2017 will be waived from 1st of March 2018 till the 28th of February 2021. This was done to boost retail participation while improving liquidity in small-cap stocks.

After: One way the local government is helping the little guys is by abolishing stamp duty for three years – a type of tax that’s applied to shares trading on the local bourse standing at RM1 per RM1,000 of transaction cost or part thereof, with a maximum charge of RM200. Around a third of listed companies (RM200 million to RM2 billion mid and small-cap firms) have benefited in retail participation and liquidity since March 2018.

Introduction

Small-cap stocks are just a term used to classify companies with small market capitalization where its range of “small market capitalization” may differ by nation. Historically, small-cap stocks are known for its outperformance over major indexes.

Several studies have shown that small-sized firms almost consistently achieve abnormal returns over their larger counterparts (Mid-cap and Large-cap) over a long timeframe.

Source: Banz, 1981.

http://www.business.unr.edu/faculty/liuc/files/BADM742/Banz_sizeeffect_1980.pdf

Drawbacks

Given that most investors’ primary goal is absolute return, why not just dump the entire portfolio in small-sized firms only? If something seems too good to be true, then it probably is. Always remember there is no free lunch on Wall Street.

Survivorship bias

We travel back in time to World War 2. Introducing Sir Abraham Wald, a mathematician who was a member of the Statistical Research Group (SRG) in the USA. The air force was concerned about reducing aircraft casualties and researched the planes that returned from the warfare. The air force found out that most planes received a high number of ballistic penetrations to the wings and tail whereas the engine was mostly left untouched. The military concluded that the wing and tail are vulnerable to ammunition and require a higher degree of armour protection. Wald disagreed and proposed to increase the armour on the engine. While seemingly counterintuitive, Wald’s took account of survivorship bias among the sample of aircraft casualties as the aircraft that took hits in the wing and tail managed to survive. Survivorship bias is a fallacy of focusing on samples containing only data that have unknowingly passed a certain selection process while potentially excluding those that fail to do so. In the world of investing, we tend to focus on winners while avoiding losers. In various researches involving small-cap stocks, samples like the Russell 2000 Index and S&P Small-cap 600 Index are commonly used. It should be noted that any companies that cease to operate will automatically get excluded from the index and is replaced by another company, resulting in inflated returns in small-cap stocks. It is equally important to be aware of the reversed survivorship bias, which is the exact opposite, where winners are excluded from the sample while losers tend to remain in the sample. Small-cap companies that are winners will eventually move up into mid-cap indexes whereas the losers will remain as small-cap companies, potentially understating the returns of small-cap. It has been generally agreed that the survivorship bias is more prevalent than its counterpart, hence most observed returns over small-cap stocks are usually overstated.

Liquidity

Liquidity is the ability to convert an asset into cash without significant loss in value. Since smaller companies receive less analyst coverage in general, it is only natural for these stocks to be thinly traded by both institutional and retail investors. Illiquid stocks have a wide bid-ask spread, further discouraging market participants to trade the stock.

Volatility

Volatility refers to the degree of variation in prices over time. Small-cap equities also have a notorious reputation for having wild price swings. Investors that prefer consistency or those that cannot stomach a huge drawdown in their portfolio are advised to steer clear of small-caps.

Advantages

Despite the mentioned drawbacks of investing in small-cap equities, some factors have been widely agreed on to have contributed to the outperformance in small-cap equities.

Scalability

Scalability refers to the ability to grow in size without compromising profitability. Both small and large companies have their respective advantages over one another. Small companies tend to be more adaptive to changes in business environments and possess concise internal communication whereas large companies have access to cheaper sources of capital and the ability to attain economies of scale. Nonetheless, small companies have the inherent ability to outgrow large companies. Think Microsoft versus any small company, Microsoft has a market cap of approximately 1 trillion dollars as of this date, which is approximately 5% of America’s 2019 GDP. It is more likely that an average small size company can double its market cap within a year compared to Microsoft. For Microsoft to double in size, it would make up approximately 10% of America’s GDP ceteris paribus, which might pose as a structural threat of being too big to fail. Microsoft would have to expand aggressively while frequently acquiring other competitors for it to double in size, which is highly unlikely given the bureaucratic structure of large companies. In other words, almost any small-sized firms with strong fundamentals present a higher chance of abnormal returns due to its ability for unlimited growth.

Institutional trading behaviour

We assume that most huge movements in share prices are caused by institutional volume only. We take an example of a 100-million-dollar fund that invests solely in 20 small-cap stocks where each position will take up an equal weight of 5% in the total portfolio. Assuming Company A has a market cap of 100 million dollars, the fund would have invested 5 million dollars into it. The problem is that this makes the fund a large stakeholder, owning up to 5% of the company’s stock, whereby the fund can influence the business decisions. Traditionally, institutions only invest in stocks which they believe are considered undervalued to profit from the temporary mispricing, not to manage the company or whatsoever. Furthermore, these institution takes time to build their positions in smaller companies due to low liquidity whereby the buying action can cause such drastic short-term upward price movements, increasing their average entry price which is above their ideal entry price. There are also legal restrictions whereby institutional ownership in a company mustn’t exceed a specified cap unless the institution proposes a takeover offer. In other words, institutions generally can invest limited amounts in small-caps to avoid being a huge stakeholder, entering at an inflated average price, or exceeding a designated ownership limit. This, in turn, grants retail investors with capital mobility to buy at attractive prices while gaining a higher exposure towards small-cap equities, potentially granting the opportunity to outperform institutional investors.

Inefficient pricing

As institutions invest only in substantial amounts in small-caps, these companies generally receive less analyst coverage and go under the radar of news headlines. This can lead to share prices exhibiting irrational pricing, potentially being undervalued or overvalued over an extended period. Retail investors can exploit these mispricing by buying undervalued companies and shorting or completely avoiding overvalued companies.

Successful predecessors

Many investors utilize value investing because they have been proven to perform well like Benjamin Graham and Warren Buffett to name a few. If there were to be a father of small-cap investing, it would be no other than Peter Lynch. Peter Lynch is an American investor who is famed for achieving approximately 30% annual return throughout his career in Magellan Fund between 1977 to 1990. His investment strategy was described in his book “One Up on Wall Street”. His primary philosophy is to invest in what you know as the more familiar you are towards a business or industry, the more likely you can spot the next company with huge upsides. Lynch firms believe that the average individual investor can achieve higher average returns than a fund manager because they can spot good investments in their daily lives before Wall Street does. He doesn’t have rigid limitations over his investments where any firm that falls within a favourable expectation will make a justifiable choice. He outlined that he spotted several investment opportunities not in his office but while being out with family or casually shopping. In general, he does have a strong preference for small and fast-growing companies that can be bought at a low end of valuations. Just to name a few, Lynch also finds characteristics like a boring company, low institutional ownership, spin-offs, the availability of share buybacks as an extra advantage.

Conclusion

Some debate whether the observed outperformance in small-cap equities will continue in the future. Nevertheless, a rational investor should always conduct adequate research before buying any stocks regardless of its size.

[tw-toggle title=”References “]

1 Source: Bursa Malaysia. https://www.mnaonline.com.my/documents/10182/13779/Mid+Small+Cap+2018/56b81b41-4e26-4698-8b10-f28682678d59

2 Source: Linnainmaa, 2013
https://www.jstor.org/stable/42002609

Source: Stanhope and Meredith, 2019
https://www.osam.com/pdfs/whitepapers/_4_Commentary_InefficiencyBreedsOpportunitySmallCapEquities.pdf

3 Source: Lynch and Rothchild, 2000
https://web.csulb.edu/~pammerma/fin382/screener/lynch.htm

4 Source: Kalesnik and Beck, 2019
https://www.researchaffiliates.com/en_us/publications/articles/284_busting_the_myth_about_size.html

[/tw-toggle]

Researcher: Cheong Jian Yan

Editor: Gan Chee Hor

Download the article: [download id=”4223″]

[yikes-mailchimp form=”1″ title=”1″ description=”1″]

January 17, 2020
Unit Trust

“Those who fail to plan, plan to fail” – This quote is so famous, it has permeated every nook and cranny. However, not everyone has truly realised and integrated such understanding into their lives, especially when it comes to financial planning.

The areas of financial planning include cash management, risk management, investment planning, tax planning, retirement planning and lastly, estate planning. This article will focus on Unit Trust as an investment planning option and will discuss basic concepts of what it entails.

What Are Unit Trust Schemes (UTS)?
Unit Trust (also termed as Mutual Fund in the United States) is defined as an unincorporated mutual fund structure that allows funds to hold assets and provide profits that go straight to individual unit owners through increased redemption price when the units are redeemed after a period or through dividends.

In simple terms, it is an investment scheme that pools money from many investors; which is then managed collectively by professional fund managers who invest the pooled money into a portfolio of various investment instruments of varying performance, such as but not limited to securities (shares and bonds), properties, commodities and cash equivalents. One of the main benefits of UTS which interests beginner investors is its diversified portfolio which brings upon minimal risks. This will be delved into further in the article.

How does UTS Operate and who are the parties involved?
A tripartite relationship exists in a UTS structure; between (1) the Investors or Owners of Unit Trusts (Unit Holders), (2) the Unit Trust Management Company (UTMC) or the Fund Manager, and (3) the Trustee (bank or insurance company).

Unit Holders who allocate money or invest in a Unit Trust Fund would be naturally concerned about their investments. That is why a UTS is constituted under or governed by a trust deed (be registered with the Securities Commission) entered between a Trustee and the Manager. The trustee holds the assets of the unit trust fund, ensuring that the UTMC invest the assets of the unit trust in line with the terms of the deed and prospectus of the fund, thus safeguarding the interests of the Unit Holders. The UTMC will thus, focus primarily on administering the operations of the UTS through a diversified portfolio of authorised investments. With that in place, Unit Holders are bestowed with comfort and confidence in their investments.

Units
Unit Holders despite holding the rights to the trusts’ assets, do not directly purchase or own the securities in the portfolio. They buy units of the trust fund, not the securities themselves. So, ownership of the fund is divided into units of entitlement. The number of these units are never fixed in a unit trust. When investors open more accounts and invest more in the trust, more units will be created to meet such demands.

If the underlying securities of the trust perform well, the value of the fund increases and the value of each unit increases accordingly; likewise, if the securities do not perform, the fund value and unit value decreases. Thus, the number of units held is dependent on the money invested and the unit purchase price at the time of investment.

Each unit trust has an individual price called the Net Asset Value (NAV) which reflects the value of the overall unit trusts’ assets, like the investments the fund manager has made with the fund. The Net Asset Value can be calculated by dividing the value of the unit trust assets by the number of units issued.

The return on investing in unit trust comes in the form of capital appreciation and distribution, from the pool of assets supporting the unit trust fund. Capital distribution arises from dividends, which if any, will be distributed based on the total units held at the end of the fund’s financial year. Capital appreciation is the increase in the value of the assets of the portfolio. By selling the units at a price higher than initial purchased price, unitholders will profit; if lower, then there will be a loss. Each unit will earn an equal return, which is determined by the amount of distribution together with capital appreciation.

Advantages and Disadvantages of Unit Trust

1. Professional Management v Loss of Control
One of the benefits of UTS is that it is run by experts. Professional fund managers carry out a fund’s investment objectives and strategies and take care of their portfolio trading activities. Not only do they have access to a huge dimension of resource and information, but they have also undergone training in handling investment operations. With experience and comprehensive knowledge in market motion, they can identify potential high yield avenues and predict future performance based on past results. Unitholders can rest assured that the investment of fund assets will abide by fundamental investment principles. This is promising for first-time or amateur investors who lack the time, knowledge and expertise to manage their investments.

On the flip side of the coin, abdicating management of investments and delegating such task to fund managers spells consequences. Unitholders will have no say and no control over the investment decisions of the fund manager. Should the investor have differing opinions about the style of management, he can neither influence nor alter the manager’s decisions.
What can be done by investors is to critically evaluate whether the fund manager is equipped with the resources, experience and skills to properly manage the fund. Investors should also adopt a more hands-on approach and attempt to fully understand the type of funds in the first place such as studying fund prospectus and reports themselves.

2. Diversification v Risk
“Do not put all your eggs in one basket” is one golden rule every investment guru preaches when coming to diversification as a conservative or defensive investment strategy. By diversifying through a broad-based portfolio under unit trusts, the “portfolio effect” comes into play. As assets are diverse, when there is a fluctuation of economic performance, some assets perform better, some not so, all moving in different directions; this reduces if not evens out the losses incurred by assets that perform unsatisfactorily. In contrast, if investors concentrate their capital under only one kind of investment, if adverse events occur, they will be laden with a tragic amount of loss. Basically, as the number and diversity of investment in the portfolio increases, the portfolio’s balance and stability increase, minimising risks of loss, leading to less volatile returns. This acts as one of the most attractive aspects of UTS.

But like a shadow, risks tag along under any form of investments. And those incurred by investing in UTS includes currency risks, market risks, liquidity risks, inflation risks, interest rate risk, risk of legislation change, management risk etc. Notwithstanding that the diversifying character of UTS is capable of drawing in the highest return with the lowest risk, it is still unable to extinguish all possible risks. In such a case, unitholders should often keep an eye on the fund’s performance so that it meets their financial expectations and targets.

3. Investment Costs
Under direct investments, generally, the smaller investor is met with higher investment costs relative to large institutional investors including UTMC fund managers. As fund managers invest in large amounts, costs advantages are reaped through economies of scale. Moreover, large investments open access to high and exclusive institutional rates of return. Small investors are limited from such lucrative opportunities, such as the Malaysian Government Securities market, in which transactions are made in the millions. Access to wholesome yields with low investment cost, this forms part of the reason why investors jump on the bandwagon of investing in unit trust funds.

However, it is to note that the professional expertise and services provided by UTMC are not without costs. Fees can reduce the return of investors and might hamper investor’s motivation for investing in UTS. After considering the annual management and trustee fees, unit trust funds must still generate returns high enough to beat the interest rate of Fixed Deposits and EPF dividends to be a prospective form of investment. This is however contingent on how investors construct their investment plans and strategies to lower costs.

End
CEO of Berkshire Hathaway, Warren Buffet once said: “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes”. For those who echo his sentiment that investing is about minimising risk to engender wealth in the long run rather than generating short-term profits, then UTS which notably sprouts the same principle is an investment option worth exploring.

Writer: Reuben Chong

Reviewer: Vikky Beh

Editor: Bryan Wong

November 8, 2019