The Investing Environment

Introduction

This article is part of course FE523 Investment Analysis and Portfolio Theory.

An investment is the current commitment of money or other resources in expectation of reaping future benefits.

Real Assets versus Financial Assets

There are two types of assets :

• Real assets
• Financial assets

The material wealth of a society is ultimately determined by the productive capacity of it’s economy, that is the goods and services its member can create. The capacity is a function of the real assets of the economy: the land, building, machines and the knowledge that can be used to produce goods and services.

The financials assets such as stocks and bonds, are securities that do not contribute directly to the productive capacity of the economy.

while real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors.

Are the following assets real or financial?

a. Patents
b. Lease obligations
c. Customer goodwill 
d. A college education 
e. A $5 bill

A patent : Real asset. A patent represents a legal right to an invention or a process. It is an intangible asset that provides a competitive advantages.

Lease obligations: Financial asset ( or liability).

Customer goodwill : Real asset.

A college education: Real asset.

A $5 bill: Financial asset. Currency is a claim on the government that issues it and is a medium of exchange.

In summary:

• Real Assets have value because they have physical or intangible properties that can be used to produce goods and services.
• Financial assets, on the other hand, derive their value from a contractual claim. They don’t have a physical worth but represent a claim to assets or income streams.

Financial Assets

Three broad types of financial assets: fixed income, equity, derivatives.

Fixed income or debt securities promise either a fixed stream of income or a stream of income determined by a specific formula. ( can be calculated easily depending on that ). For this reason, the investment performance of debt securities typically is least closely tied to the financial condition of the issuer.

At one extreme, the money market refers to debt securities that are short term, highly marketable, and generally of very low risk. Examples of money market securities are U.S. Treasury bills or bank certificates of deposit (CDs). In contrast, the fixed-income capital market includes long-term securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations.

Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equityholders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments, therefore, is tied directly to the success of the firm and its real assets. For this reason, equity investments tend to be riskier than investments in debt securities.

Finally, derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $20 a share, but it can be quite valu- able if the stock price rises above that level.2 Derivative securities are so named because their values derive from the prices of other assets. For example, the value of the call option will depend on the price of Intel stock. Other important derivative securities are futures and swap contracts. 

Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.

Financial Markets and the Economy

Real assets determine the wealth of an economy, while financial assets merely represent claims on real assets. 

The Informational Role of Financial Markets

Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects. To paraphrase Winston Churchill’s comment about democracy, markets may be the worst way to allocate capital except for all the others that have been tried.

Consumption Timing

How can you shift your purchasing power from high-earnings periods to low-earnings periods of life? One way is to “store” your wealth in financial assets. In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By so doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your consumption to periods that provide the greatest satisfaction. 

Allocation of Risk

Virtually all real assets involve some risk. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines. 

Simply, thought financial markets, corporations can provide different types of financial securities, such as low risk bond and high risk stocks, people with different risk tolerance then can buy the one of their choices.

Both buyers and sellers benefits from this, seller able to accumulate the capital, while buyers able to buy the securities of their favorite type or risk tolerance.

Separation of Ownership and Management

Financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management.

However, there can be some conflict in interest of parties, these potential conflicts of interest are called agency problems because managers, who are hired as agents of the shareholders, may pursue their own interests instead.

Several mechanisms have evolved to mitigate potential agency problems. First, com- pensation plans tie the income of managers to the success of the firm. Second, while boards of directors have sometimes been portrayed as defenders of top management, they can, increasingly have, forced out management teams that are underperforming. Third, outsiders such as security analysts and large institutional investors such as mutual funds or pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable. Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring management, unhappy shareholders in principle can elect a different board.

Corporate Governance and Corporate Ethics

We’ve argued that securities markets can play an important role in facilitating the deploy- ment of capital resources to their most productive uses. But market signals will help to allocate capital efficiently only if investors are acting on accurate information. We say that markets need to be transparent for investors to make informed decisions. If firms can mis- lead the public about their prospects, then much can go wrong.

In 2002, in response to the spate of ethics scandals, Congress passed the Sarbanes-Oxley Act to tighten the rules of corporate governance. For example, the act requires corporations to have more independent directors, that is, more directors who are not themselves manag- ers (or affiliated with managers). The act also requires each CFO to personally vouch for the corporation’s accounting statements, created an oversight board to oversee the audit- ing of public companies, and prohibits auditors from providing various other services to clients.

The Investment Process

An investor’s portfolio is simply his collection of investment assets. Once the portfolio is established, it is updated or “rebalanced” by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio.

Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. 

Investors make two types of decisions in constructing their portfolios. 

1. The asset allocation decision is the choice among these broad asset classes,
2. while the security selection decision is the choice of which particular securities to hold within each asset class.

Asset allocation also includes the decision of how much of one’s portfolio to place in safe assets such as bank accounts or money market securities versus in risky assets. You may choose to invest your savings in safe assets, risky assets, or a combination of both.

“Top-down” portfolio construction starts with asset allocation. The decision to allocate your investments to the stock market or to the money market where Treasury bills are traded will have great ramifications for both the risk and the return of your portfolio.  A top-down investor first makes this and other crucial asset allocation decisions before turning to the decision of the particular securities to be held in each asset class.

Security analysis involves the valuation of particular securities that might be included in the portfolio. Both bonds and stocks must be evaluated for investment attractiveness, but valuation is far more difficult for stocks because a stock’s performance usually is far more sensitive to the condition of the issuing firm.

In contrast to top-down portfolio management is the “bottom-up” strategy. In this pro- cess, the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation. 

Markets Are Competitive

Financial markets are highly competitive. Thousands of intelligent and well-backed ana- lysts constantly scour securities markets searching for the best buys. This competition means that we should expect to find few, if any, “free lunches,” securities that are so under- priced that they represent obvious bargains. This no-free-lunch proposition has several implications. Let’s examine two.

The Risk-Return Trade-Off

Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments. Actual or real- ized returns will almost always deviate from the expected return anticipated at the start of the investment period.

If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk. We conclude that there should be a risk–return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.

How should one measure the risk of an asset? What should be the quantitative trade-off between risk (properly measured) and expected return? One would think that risk would have some- thing to do with the volatility of an asset’s returns, but this guess turns out to be only partly correct. When we mix assets into diversified portfolios, we need to consider the interplay among assets and the effect of diversification on the risk of the entire portfolio. Diversification means that many assets are held in the portfolio so that the exposure to any particular asset is limited. 

Efficient Markets

Another implication of the no-free-lunch proposition is that we should rarely expect to find bargains in the security markets. the hypothesis that financial markets process all available infor- mation about securities quickly and efficiently, that is, that the security price usually reflects all the information available to investors concerning its value. According to this hypothesis, as new information about a security becomes available, its price quickly adjusts so that at any time, the security price equals the market consensus estimate of the value of the security. If this were so, there would be neither underpriced nor overpriced securities.

One interesting implication of this “efficient market hypothesis” concerns the choice between active and passive investment-management strategies. Passive management calls for holding highly diversified portfolios without spending effort or other resources attempt- ing to improve investment performance through security analysis. Active management is the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes—for example, increasing one’s commitment to stocks when one is bullish on the stock market. If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.

• whether you can beat the market ?
• are those price in the market are correct ?

The Players

From a bird’s-eye view, there would appear to be three major players in the financial markets:

1. Firms are net demanders of capital. They raise capital now to pay for investments in plant and equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the firm.
2. Households typically are net suppliers of capital. They purchase the securities issued by firms that need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures. Issuance of Treasury bills, notes, and bonds is the major way that the govern- ment borrows funds from the public.

Corporations and governments do not sell all or even most of their securities directly to individuals. For example, about half of all stock is held by large financial institutions such as pension funds, mutual funds, insurance companies, and banks. These financial institutions stand between the security issuer (the firm) and the ultimate owner of the security (the individual investor). For this reason, they are called financial intermediaries. Similarly, corporations do not market their own securities to the public. Instead, they hire agents, called investment bankers, to represent them to the investing public.

Financial Intermediaries

Financial intermediaries have evolved to bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government).  These financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.

For example, a bank raises funds by borrowing (taking deposits) and lending that money to other borrowers. The spread between the interest rates paid to depositors and the rates charged to borrowers is the source of the bank’s profit. In this way, lenders and borrowers do not need to contact each other directly. Instead, each goes to the bank, which acts as an intermediary between the two. The problem of matching lenders with borrowers is solved when each comes independently to the common intermediary.

Financial intermediaries are distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial. 

Other examples of financial intermediaries are investment companies, insurance com- panies, and credit unions. All these firms offer similar advantages in their intermediary role. First, by pooling the resources of many small investors, they are able to lend con- siderable sums to large borrowers. Second, by lending to many borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might be too risky. Third, intermediaries build expertise through the volume of business they do and can use economies of scale and scope to assess and monitor risk.

Investment companies, which pool and manage the money of many investors, also arise out of economies of scale. Here, the problem is that most household portfolios are not large enough to be spread across a wide variety of securities. In terms of brokerage fees and research costs, purchasing one or two shares of many different firms is very expensive. Mutual funds have the advantage of large-scale trading and portfolio management, while participating investors are assigned a prorated share of the total funds according to the size of their investment. This system gives small investors advantages they are willing to pay for via a management fee to the mutual fund operator.

Investment companies also can design portfolios specifically for large investors with partic- ular goals. In contrast, mutual funds are sold in the retail market, and their investment philoso- phies are differentiated mainly by strategies that are likely to attract a large number of clients.

Like mutual funds, hedge funds also pool and invest the money of many clients. But they are open only to institutional investors such as pension funds, endowment funds, or wealthy individuals. They are more likely to pursue complex and higher-risk strategies. They typically keep a portion of trading profits as part of their fees, whereas mutual funds charge a fixed percentage of assets under management.

Economies of scale also explain the proliferation of analytic services available to inves- tors. Newsletters, databases, and brokerage house research services all engage in research to be sold to a large client base. This setup arises naturally. Investors clearly want infor- mation, but with small portfolios to manage, they do not find it economical to personally gather all of it. Hence, a profit opportunity emerges: A firm can perform this service for many clients and charge for it.

Investment Bankers

Just as economies of scale and specialization create profit opportunities for financial intermediaries, so do these economies create niches for firms that perform specialized services for businesses. Firms raise much of their capital by selling securities such as stocks and bonds to the public. Because these firms do not do so frequently, however, investment bankers that specialize in such activities can offer their services at a cost below that of maintaining an in-house security issuance division. In this role, they are called underwriters.

Investment bankers advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth. Ultimately, the investment bank- ing firm handles the marketing of the security in the primary market, where new issues of securities are offered to the public. Later, investors can trade previously issued securities among themselves in the so-called secondary market.

Venture Capital and Private Equity

While large firms can raise funds directly from the stock and bond markets with help from their investment bankers, smaller and younger firms that have not yet issued securities to the public do not have that option. Start-up companies rely instead on bank loans and investors who are willing to invest in them in return for an ownership stake in the firm. Sources of venture capital are dedicated venture capital funds, wealthy individuals known as angel investors, and institutions such as pension funds.

Most venture capital funds are set up as limited partnerships. A management company starts with its own money and raises additional capital from limited partners such as pen- sion funds. That capital may then be invested in a variety of start-up companies. The man- agement company usually sits on the start-up company’s board of directors, helps recruit senior managers, and provides business advice. It charges a fee to the VC fund for oversee- ing the investments. After some period of time, for example, 10 years, the fund is liqui- dated and proceeds are distributed to the investors.

Venture capital investors commonly take an active role in the management of a start-up firm. Other active investors may engage in similar hands-on management but focus instead on firms that are in distress or firms that may be bought up, “improved,” and sold for a profit. Collectively, these investments in firms that do not trade on public stock exchanges are known as private equity investments.