CU-MBA-SEM-IV-Investment Management

A call option gives the holder the right to buy a fixed no of shares at a given exercise price on or before the expiry date. The writer of the call option is under obligation to sell shares to the holder if he chooses to exercise the call option. A put option gives the holder the right to sell a fixed no of shares at a given exercise price on or before the expiry date. The writer of the put option is under obligation to purchase shares from the holder if he chooses to exercise the put option. 5.3 SUMMARY  We have understood from this chapter that investments can be made in real assets and financial assets. Real assets are tangible in nature examples are investment in residential house, commercial complex, agricultural land, urban & semi-urban land and precious metals like gold, silver platinum. Financial assets can be investment in post office deposits, government securities, life insurance, mutual fund and financial derivatives. Venture capitalists invest in new projects which encourages entrepreneurship providing greater employment opportunities. While the risk is high the returns also are high when the project succeeds.  Investment in government securities in the form of treasury bill, notes and bonds are short term in nature. It provides risk free returns. Conservative investors prefer to invest in government securities.  Post office deposits and life insurance are non-marketable in nature. Investment in post office deposits particularly caters to the needs of small and middle income groups. Post office deposits may be done in the form of savings account, term deposit, recurring deposit, kisan vikas patra, national savings certificates. These deposits give higher returns compared to commercial banks.  Life insurance policies give protection and take care of future income needs. Term insurance gives life insurance cover and has less premium compared to other policies. Endowment policies may be with or without profit sharing; it provides future income for specific needs such as children’s education, retirement income. When an investor needs life insurance cover and money during specified periods of time at some regular intervals he can opt for money back plan. Unit linked plan provides an opportunity to invest in stock market while taking life insurance cover.  A mutual fund is a financial vehicle which collects small investment from many investors to invest in stock, bonds, money market instruments and other assets. It is 51 CU IDOL SELF LEARNING MATERIAL (SLM)

beneficial for small investors since it is professionally managed with the benefit of portfolio diversification.  A derivative is a contract between two parties whose value is based on an underlying financial asset. The underlying asset includes stocks, market indices, commodities, bonds, interest rates and currencies. Futures and options are the two most important financial derivatives. A futures contract is an agreement between two parties to exchange an asset for cash at a predetermined price on a future date. An option contract gives the holder the right to buy or sell an underlying asset on or before a given date at a predetermined price. 5.4 KEYWORDS  AMC - Asset Management Company: They are firms that collect funds from individual and institutional investors to invest in various securities.  NAV- Net Asset Value: NAV is the market value of securities of a scheme divided by the total number of units of the scheme on any particular date. The NAV’s of all mutual fund schemes is declared at the end of the trading day after markets are closed.  SIP - Systematic Investment Plan: It is one of the most convenient ways of investing in mutual funds. It helps the investor to build wealth for the future since there is a financial discipline of investing every month. It helps the investor to start with small savings and build a corpus in a systematic way.  REIT - Real Estate Investment Trust: REIT is companies who generate income from real estate by purchasing real estate of financing income-producing real estate. REIT’s provide a way for individuals to earn income produced through commercial real estate without owning it.  SEBI – Securities and Exchange Board of India: SEBI is a statutory regulatory body established in 1992. It monitors and regulates the capital and securities market in India. It formulates regulations and guidelines to ensure that the interests of investors are protected. 5.5 LEARNING ACTIVITY 1. Why should investors prefer investing in government securities when the returns are less compared to other investments? 52 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________ 2. Which type of investment has reached far and wide across India helping to achieve financial inclusion? Explain two sources of the same ___________________________________________________________________________ __________________________________________________ 5.6 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What do you understand by the term mutual fund? Explain how it is useful for small investors? 2. What are government securities? What are the types of government securities? 3. How are mutual funds in India regulated? 4. Why are precious metals opted for investment? List down the reasons 5. Which type of life insurance should an investor choose to meet future income needs? Long Questions 1. Explain any two types of investment that can be done in post office 2. What are financial derivatives? Explain its types? Which types of investors prefer investing in derivatives? 3. Explain why an investor should be interested in investing in real estate. What is REIT? 4. Which type of investment caters to savings and protection needs of the investor. Explain two types 5. How can a small investor invest in stock market keeping his risk low? Describe in detail. B. Multiple Choice Questions 1. An investor falling in low-income group can invest in ____________ a. Mutual fund 53 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Post office c. Government securities d. Life insurance 2. Mutual provides the benefit of ________________ management a. Group b. Personal c. Professional d. Top 3. ___________ helps an investor to invest without owning it a. Life Insurance b. Mutual fund c. Post office d. REIT 4. ____________ is the best way giving higher compounding benefits to build wealth a. MIS b. SIP c. Term deposit d. NSC 5. __________ is the best insurance for providing protection benefit with low premiums a. Unit-linked b. Endowment c. Term 54 CU IDOL SELF LEARNING MATERIAL (SLM)

d. Money back Answers 1–b, 2–c, 3–d, 4–b, 5-c 5.7 REFERENCES Textbook  Chandra P (2009) Investment Analysis and Portfolio Management, New Delhi Tata McGraw hill Websites  https://www.angelbroking.com  https://cleartax.in  www.cleartax.in  https://inc42.com  https://www.investopedia.in  https://www.wikipedia.org 55 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 6 RISK & RETURN STRUCTURE 6.0 Learning Objectives 6.1 Introduction 6.2 Meaning & concept of return 6.3 Determinants of required rates of return 6.4 Techniques used in measurement of return 6.5.1 Total Return 6.5.2 Types of Return 6.5.3 Methods of measuring return on investment 6.5 Summary 6.6 Keywords 6.7 Learning Activity 6.8 Unit End Questions 6.9 References 6.0 LEARNING OBJECTIVES After reading this chapter you will understand  Concept of Return on Investment  Factors determining rate of return  Measurement of Total return  Types of Return  Methods used to measure return on investment 6.1 INTRODUCTION We had learnt in the previous chapters the various avenues available for investment such as equity shares, preference shares, and units of mutual fund, government securities & bonds, 56 CU IDOL SELF LEARNING MATERIAL (SLM)

post office deposits, life insurance e t c. Each type of investment gives different returns for the investor since the risk assumed is different in each case. The main motive of any investment is to gain returns. However each type of investment carries some risk. Investing in risk free securities like post office deposits, government securities & bonds involves no risk, however the investor is required to compromise in terms of returns. Higher the risk, higher will be the returns. Therefore an investor has to consider the risk-return trade off before investing. Since risk and returns are central for any investment decision we need to understand clearly risk and return and how they should be measured. We also need to understand the various factors determining rate of return. We will be covering concept of risk in the next chapter 6.2 MEANING & CONCEPT OF RETURN Return is the reward that the investor receives for making investment. It is the primary motive behind any investment. An investor takes into account historic returns of an investment as one of the factors while estimating future prospective income. The returns which an investor receives are in the form of current income such as dividend, interest e t c. Current income is the periodic cash flow which an investor receives. When an investor prefers to get regular income periodically he has to invest in risk –free securities. Current income is measured as periodic income in relation to the initial investment done Over a period of time investment made initially may increase or decrease in value that is there will be price appreciation or depreciation. This price appreciation or depreciation to the initial value of investment is the capital return. Thus Return = Current Income + Capital Return Current Income can be zero or positive while capital return may be negative, zero or positive. 6.3 DETERMINANTS OF REQUIRED RATE OF RETURN (analystprep.com, n.d.)The return on a portfolio is influenced by the following factors 1. Asset mix: The asset mix of a portfolio determines the rate of return. You must have understood by now that there is a risk-return trade-off for every asset. Higher the risk, higher will be the volatility and higher will be the returns. Stocks are volatile compared to bonds but give higher returns over the long term. A conservative portfolio gives stable and predictable returns but they are lower compared to stocks. 57 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Positioning of the company: Investments in companies which are strategically positioned enjoy greater market share, take advantage of opportunities and effectively deal with threats. Such companies give higher returns to investors. Companies with high market share get raw material from suppliers at better prices since their order volume is more. Their level of production is high to meet increased market share hence they get the benefit of economies of scale. 3. Fundamentals of the company: Companies that consistently meet their sales targets and profit expectations perform in markets above averages. When the operational efficiency of a company is high it can cut down costs, expand its operations to new markets which in turn increases their profits compared to peers. Also companies which invest in research & development and keep innovating stay ahead of their competitors. Such companies therefore give higher returns compared to competitors. 4. General economic conditions: A growing economy would mean businesses make more investments, more employment opportunities and more demand for goods and services which in turn encourages more production from entrepreneurs. However if the rate of growth is rapid the interest rates will be high. This will discourage consumers to take credit and consequently lower investments by businesses. When there is economic slowdown the employment levels are low meaning lower profits for business and low stock prices. Investors prefer to invest in bonds as it is safer than stocks during such times. 5. Political factors & Legal regulations: When there are strict regulations in force it does not induce investment from entrepreneurs. Higher fiscal deficit would result in government borrowing more to finance its deficit. This reduces the capital available for private firms to invest which in turn increases the interest rates. If the central bank does not intervene at this stage to reduce interest rates it will discourage entrepreneurs from borrowing. For ensuring investor’s confidence and to encourage business, political stability is necessary. Investors do not prefer to invest in countries where there is civil unrest or unstable governments. Apart from the above general factors which affect rate of return on investment following are some important factors which affect the rate of return 58 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Risk of the investment: When the investment is risky as perceived by the investor he may insist on a higher required rate of return. When the investments have less risk a lower return is expected by investors. As discussed earlier stocks carry greater risk than government backed securities, however the returns on stocks are higher compared to risk free securities. 2. Liquidity of the investment: When the investor cannot liquidate his investment in the market for a number of years it increases the risk of the investment which in turn increases the required rate of return. Longer the term to liquidate the asset greater the risk, higher would be the rate of return. 3. Inflation: When rate of inflation is high it erodes the value of money. A nominal required rate of return does not consider the effects of inflation. Thus it delivers misleading conclusions about the viability of the project when a company proposes to invest in a project. From the investors point of view when the rate of return is less than the inflation rate it reduces the purchasing power of money. Therefore required rate should be adjusted for inflation to arrive at the real rate of return Real rate of return = 1 + nominal rate 1+ inflation rate When the inflation rate is expected be high it increases the investor’s required rate of return since the investor has to earn a return over and above the inflation rate. For example: The total return of a stock A during the year was 19%. The rate of inflation during that year was 6%. Thus the real (inflation adjusted) total return would be Real rate of return = 1+0.19 -1 1+.06 =12.26% Since the investor bears some risk by investing in stock he would add some risk premium to the risk free rate. 59 CU IDOL SELF LEARNING MATERIAL (SLM)

6.4 TECHNIQUES USED IN MEASUREMENT OF RETURN 6.5.1 Total Return Assets in the financial market generate two different returns: income by way of dividend or interest payments and capital growth through price appreciation. As studied in our earlier chapter total return of an investment can be calculated as The Total return for a period of an investment = Cash receipts received+ Price change Initial investment The cash received during the period may be zero or positive. Price change can be positive, zero or negative. The above method is used to calculate returns of an investment for a time period 6.5.2 Types of Return: (corporatefinanceinstitute.com, n.d.)Absolute Returns: It can be defined as the absolute gain or loss an investment has generated over a specific period of time. The gain or loss is expressed as a percentage of the total investment. Absolute Return = Current Value – Purchase Value X 100 Purchase Value For example: If an investor has purchased property for R s 100000. Two years later the saleable value of the property is R s 135000. Applying the above formula Absolute Return = 135000-100000 100000 = 35% Thus absolute returns are returns an investment generates over a specific period of time Relative Return: It is a way of measuring the returns of an asset or investment compared to a benchmark (e.g. Index). Relative return is important since the performance of actively managed funds can be measured. It is often used to measure performance of a mutual fund compared to various benchmarks. Relative returns is calculated as the difference between the 60 CU IDOL SELF LEARNING MATERIAL (SLM)

absolute return of an investment and the benchmark of similar investments in the market. Relative return can also be known as alpha in the context of active portfolio management. Note: Alpha is the excess return that a portfolio is able to generate compared to market portfolio. 6.5.3 Methods of measuring Return on Investment (Investment Analysis and Portfolio Management, 2009)The following are the different techniques of measuring return on investment 1. Arithmetic or Mean return When we have assets for different holding periods it is necessary to aggregate the returns into one overall return. An arithmetic mean is a simple process of finding the average of the holding period returns. (Mean) R = Ri ÷ n For example if a stock A has given returns of 10%, 15%. 8% -10% for a four year period then the arithmetic mean of stock A will be R = 10+15+8-10 4 = 5.75% Thus arithmetic mean is the average return of a stock or a portfolio for a given period of time. 2. Geometric Mean Return: Geometric Mean uses the compound interest method for computation of returns. Returns of the year are compounded to the initial value of investment at the start of new year in order to earn returns on returns of the previous year. It provides a more accurate representation of portfolio growth than an arithmetic mean. Geometric mean return is also called time- weighted return. For example using the same returns as shown in the above example for 4 years Geometric mean = [ (1+10%) (1+15%) (1+8%) (1-10%) ] 4 -1 61 CU IDOL SELF LEARNING MATERIAL (SLM)

=5.303% Note that returns as per geometric mean is slightly less than the arithmetic mean. In the world of investments arithmetic mean is most commonly employed than geometric mean because an investment that has an uncertain returns has higher expected terminal value than an invested that earns its compound mean with certainty every year (since geometric mean uses the compounding method to calculate returns) Arithmetic mean is a measure that accounts for uncertainty hence it is the appropriate measure to estimate the discount rate. The discount rate is the interest rate used to determine present value of future cash flows in discounted cash flow analysis. It helps to determine if the future cash flows of a project (in case of companies) or investment (in case of investors) will be more than the initial capital needed to fund the project or investment at present. 3. Internal Rate of Return: The Internal Rate of Return (IRR) is the discount rate that equates the cash flows at year zero to the present value of future cash flows of the investment. Net Present Value is the difference between cash flow at year zero and the future cash inflows discounted to the present. This means that IRR is that discount rate which when used to discount future cash flows makes the Net Present Value (NPV) equal to zero. Note : The general rule is that an investment or project should be undertaken if the IRR is greater than the minimum required rate of return also known as hurdle rate. The higher the internal rate of return of a stock the more an investor would be interested to invest in it. When considering investment options with similar characteristics the investment with the highest IRR would be considered the best. IRR cannot be easily calculated and needs to be calculated using trial and error method or by using software programme. Formula for IRR is ������������1 + ������������ 2 +1���+������������3���3 ……… ������������������ 1+������2 CF0 Cash outflow at year zero =1+������1 1+������������ IRR is that discount rate used to discount cash inflows which equates the cash outflow at year zero i.e. NPV=0 62 CU IDOL SELF LEARNING MATERIAL (SLM)

6.5 SUMMARY Return on investment is the primary motivating factor for an investor to invest. The total return of an investment includes current income in the form of dividend, interest and capital return in the form or price appreciation or price depreciation. Current income can be zero or positive while capital return can be zero, positive or negative. The return on investment is influenced by the following general factors  Asset mix: An aggressive portfolio gives greater return to the investor than a conservative portfolio considering the risk-return trade-off.  Strategic Positioning of the company: If the company is strategically better positioned and has a greater market share it can give better return compared to competitors.  Fundamentals of the company: When the company is consistently able to meet sales targets and achieve profit expectations from the market it gives good returns for the investors,  General economic conditions: In a growing economy demand for goods & services are more, investment by entrepreneurs are more creating more employment opportunities and markets stay positive.  Political and Legal factors: When there is political stability and favourable government regulations it induces investment from businesses and promotes growth in the economy. Return on investment is primarily influenced by the following factors  Risk of the asset: Higher the risk of the asset greater will be the returns and vice versa.  Liquidity of the asset: Longer the term to liquidate the asset, greater will be the risk higher will be the investor’s required rate of return.  Level of inflation: If the rate of inflation is high the investor’s expectation of return will be high. There are two ways in which return on investment can be measured  Absolute return: It is the return an asset or portfolio has generated over a certain period of time. 63 CU IDOL SELF LEARNING MATERIAL (SLM)

 Relative return: It is the difference between the absolute return and the performance of the market usually a benchmark, index such as Nifty. There are three ways of measuring returns on investment Arithmetic mean: It is the average or mean return a stock or portfolio is able to generate for the investor over a given period of time. Mean return R = R1+ R2…..Rn ÷ N Where R = average returns Rn = sum of returns for n period n = no of years Geometric mean: It takes into account the compounding that occurs from period to period. After taking the nth root of the product resulting from multiplying a series of returns minus one GM = [( 1 + ������1)(1 + ������2) … … (1 + ������������)] ������ - 1 Internal rate of return: It is that rate which when used to discount the cash inflows equates the cash outflow done at the initial period. Higher the IRR better for the investor. An investment will be accepted if its IRR is greater than the required rate of return. 6.6 KEYWORDS  Real rate of return: It is the adjusted rate to the nominal rate to consider rate of inflation.  Arithmetic Mean: It is the average return of an asset for a given period of time.  Geometric Mean: It takes into account the compounding effect of return over the initial investment for a period of time.  Absolute Return: It is the returns an asset or portfolio has given over a certain period  Relative Return: It is the difference between the absolute return and the performance of the market 6.7 LEARNING ACTIVITY 1. What do you understand by the term Return on investment? 64 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________ 2. How does government policy affect return on investment? ___________________________________________________________________________ ___________________________________________________ 6.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define Arithmetic mean. 2. What do you understand by the term absolute return? 3. Why should one take into account inflation while calculating return on investment? 4. Which method of computation gives higher returns and why? 5. Which type of return will you consider while investing in mutual fund and why? Long Questions 1. What are the fundamental factors which influence return on investment? Explain 2. Explain how macroeconomic factors influence return on investment 3. What should be the asset mix of an investor if he needs higher returns? Give reasons 4. Explain the different techniques used to calculate return on investment 5. What are relative returns? How is it different from absolute returns? B. Multiple Choice Questions 1. Longer the term of an investment ___________ is the liquidity. a. average b. higher c. lower d. more than average 65 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Relative returns are the _____________of absolute returns and benchmark returns. a. sum b. difference c. average d. ratio 3. When IRR is____________ than the required rate project is accepted. a. different b. lower c. higher d. equal 4. Relative returns is also known as __________ a. beta b. alpha c. Market returns d. average returns 5. An investor’s required rate of return from a stock will be _____________ the risk free rate. a. less than b. equal c. less d. higher Answers 1–c, 2–b, 3–c, 4–b, 5-d 66 CU IDOL SELF LEARNING MATERIAL (SLM)

6.9 REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Websites  (n.d.). Retrieved from bstudies.co.za: https://www.bstudies.co.za>securities  (n.d.). Retrieved from https://saylordotorg.github.io>s17  (2021, May 31). Retrieved from livemint.com: https://www.livemint.com>india  analystprep.com. (n.d.). Retrieved from analystprep.com: https://analystprep.com>types of in..  angelbroking.com. (n.d.). Retrieved from angelbroking.com: https://www.angelbroking.com>  Chandra, P. (2009). Investment Analysis and Portfolio Management. In P. Chandra, Investment Analysis and Portfolio Management (pp. 3-4). New Delhi.  cleartax.in. (n.d.). Retrieved from cleartax.in: https://cleartax.in>nsc-national-savi..  cleartax.in. (n.d.). Retrieved from cleartax.in: www.cleartax.in/s/post-office  commercemates.com. (n.d.). Retrieved from commercemates.com: https://commercemates.com>charac...  corporatefinanceinstitute.com. (n.d.). Retrieved from corporatefinanceinstitute.com: https://corporatefinanceinstitute.com>  dynamictutorialsandservices. (n.d.). Retrieved from dynamictutorialsandservices: www.dynamictutorialsandservices.org>  edelweissmf.com. (n.d.). Retrieved from edelweissmf.com: https://www.edelweissmf.com/investor-insights/mutual-fund-investment-tips-and- articles/pros-and-cons-of-investing-in-government-bonds  efinancemanagement.com. (n.d.). Retrieved from efinancemanagement.com: www.efinancemanagement.com 67 CU IDOL SELF LEARNING MATERIAL (SLM)

 Hindustan Times. (2021, June 5). Retrieved from Hindustan Times: www.hindustantimes.com  inc42.com. (n.d.). Retrieved from inc42.com: https://inc42.com>resources>t..  Investment Analysis and Portfolio Management. (2009). In P. Chandra, Investment Analysis and Portfolio Management (Vol. Third edition). New Delhi, India: Tata Mc Graw Hill.  Investment Analysis and Portfolio Management. (2009). In P. Chandra, Investment Analysis and Portfolio Management (p. 39). New Delhi: Tata Mc-Graw Hill .  investmentpedia.org. (n.d.). Retrieved from investmentpedia.org: https://www.investmentpedia.org>s  investopedia.com. (n.d.). Retrieved from investopedia.com: https://www.investopedia.com>terms>weal...  investopedia.com. (n.d.). Retrieved from investopedia.com: https://www.investopedia.com/ask/answers/052815/how-does-private-placement- affect-share-price.asp  noteslearning. (n.d.). Retrieved from noteslearning: http://noteslearning.com>investme..  noteslearning.com. (n.d.). Retrieved from noteslearning.com: http://noteslearning.com>investme..  samco.in. (n.d.). Retrieved from samco.in: https://www.samco.in/knowledge- center/articles/offer-for-sale/  saylordotorg. (n.d.). Retrieved from saylordotorg: https://saylordotorg.github.io>s17  scripbox.com. (n.d.). Retrieved from scripbox.com: https://scripbox.com>governm..  wizely.in. (n.d.). Retrieved from wizely.in: www.wizely.in 68 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 7 CONCEPT OF RISK 69 STRUCTURE 7.0 Learning Objectives 7.1 Introduction 7.2 Definition of Risk 7.3 Types of Risk 7.3.1 Systematic Risk 7.3.2 Unsystematic Risk 7.4 Calculation of Risk 7.4.1 Variance 7.4.2 Standard deviation 7.4.3 Beta 7.4.4 Alpha 7.4.5 Illustration on risk 7.5 Measurement of individual security risk and return 7.6 Measurement of portfolio risk and return 7.7 Summary 7.8 Keywords 7.9 Learning Activity 7.10 Unit End Questions 7.11 References 7.0 LEARNING OBJECTIVES After studying this chapter you will be able to  Define the concept of risk  List down the types of risk CU IDOL SELF LEARNING MATERIAL (SLM)

 Describe systematic risk and unsystematic risk  Calculate various measures of risk  Calculate individual security and portfolio risk and return 7.1 INTRODUCTION From the discussion in the previous chapters we have understood that investors are rewarded with returns for taking risk. Investors who invest in risk free securities are required to compromise with less returns. Any investor would like to minimise risk and maximise returns. Hence we understand that such risk must be managed. Management of risk involves determining the appropriate level of risk at the initial stage before investing. Individual securities are selected by investors by comparing similar stocks, their returns and risks. A portfolio comprising of many securities needs to be built after calculating the portfolio risk. This bring us to an important discussion as to how risk can be measured. Modern Portfolio theory provides us some tools which help us to determine the total risk of an investor, the risk for which he will be rewarded by the market and the risk which is unavoidable. After studying these concepts you will understand the basis used to measure return and risk and will be able to advise the securities to be selected to meet the objective of the investor. These methods will help you to decide on individual securities to be selected as well as to build a portfolio to maximise returns with the lowest possible risk. 7.2 DEFINITION OF RISK Risk is the possibility that the assets or units within the investment will differ from the expected outcome or fail to meet financial objectives. Risk also includes the possibility of losing out on the original investment made. Risk of a particular security can be assessed considering past behaviours and outcomes. We use past data of returns and risk to project future returns. Though past data may provide a trend to determine expected risks and returns certain factors which are industry or firm specific affects the returns for the investor. There are also other factors at the overall economic level which may affect the returns. 70 CU IDOL SELF LEARNING MATERIAL (SLM)

Hence it becomes necessary to identify and measure risks so that returns may be maximised for the investor. This brings us to the discussion of types of risks in portfolio management. 7.3 TYPES OF RISK (Investment Analysis and Porfolio Management)There are two types of risk in market Systematic Risk: It is also known as non-diversifiable risk. This risk cannot be avoided Unsystematic Risk: It is also known as diversifiable risk. It is unique and specific risk. This risk can be avoided by diversifying one’s portfolio, 7.3.1 Systematic Risk: It is the risk caused due to macro-economic factors which is also called also referred as market risk or non-diversifiable risk. This risk may be due to natural disasters, change in government policy, international economic changes e t c. The Great Recession of 2008 is an example of systematic risk. This risk is caused due to the following factors: a. Market risk: Prices of equity shares tend to fluctuate due to market sentiment and changing psychology of investors. The losses in the security markets may be unrelated to basic risks. This risk is due to changes in the general tenor of the market and are called market risks. b. Interest Rate Risk: The change in the interest rate have a bearing on the welfare of investors. When the interest rate goes up, market price of existing fixed income securities falls and vice versa. This happens because the buyer of a fixed income security would not buy it at its face value if its interest rate is lower than the prevailing interest rate on a similar security. For example a debenture that has a face value of 100 with interest rate of 10% will fall in value when the interest rate goes up to 12%. The change in the interest rate affects the prices of fixed income securities directly and equity prices indirectly. c. Legal Risk: Whenever there is an adverse legislation an otherwise profitable investment is impaired. Favourable government policies in the form of subsidies and tax breaks encourages investment by businesses. d. Inflation: When prices keep rising it leads to rise in cost or production, lowers margins, wage rises consequently reducing profits. Hence the returns expected by investors will change since the real value (inflation adjusted) returns will change. 71 CU IDOL SELF LEARNING MATERIAL (SLM)

7.3.2 Unsystematic Risk It is that risk which emerges from firm specific factors like labour unrest, emergence of a competitor, new technology e t c. This risk can be due to the following factors a. Business Risk: As an equity holder or bond holder an investor is exposed to poor performance. This may be due to cut throat competition, emergence of new technologies, development of substitutes, change in consumer preferences, inadequate supply of essential inputs and so on. The main reason may be incompetent management. b. Financial Risk: This relates to the method of financing adopted by the company where there is high debt used which leads to debt servicing problem. Other short term liquidity problems may be due to increasing bad debts, delay in collection of receivables e t c. c. Default Risk: It is the risk that the borrower may not pay interest and or principal on time. When investors perceive a high risk of default though the default has not occurred it will impact its market price. Following are the differences between systematic and unsystematic risk Systematic Risk Unsystematic Risk Systematic risk is uncontrollable by an It is controllable by an organisation and organisation and macro in nature. micro in nature. It affects all the securities It is security specific risk. It is due to macroeconomic factors e.g. It is due to micro economic factors e.g. Inflation, GDP , interest rates etc. labour unrest , raw material shortage, competition etc. Systematic Risk cannot be eliminated It can be reduced or eliminated through the through the process of diversification process of diversification It is also known as non- diversifiable risk It is known as diversifiable risk 72 CU IDOL SELF LEARNING MATERIAL (SLM)

Market compensates only for systematic risk. Market does not compensate for unsystematic risk because it can be avoided through diversification. Total Risk = Systematic Risk + Unsystematic risk The most commonly used measure of risk in finance is variance or its square root that is standard deviation. We will now discuss the ways in which total risk, systematic risk and unsystematic risk is measured. Following are the formulas for calculating different types of risk. Total Risk is the Variance of the security= σs2 Systematic Risk of the security = (βs x σ m)2 Unsystematic Risk of the security = σs2 - (βs x σ m)2 We will discuss measures of various risk such as variance, standard deviation. alpha and beta in the next section. 7.4 CALCULATION OF RISK Risk of investment can be measured in terms of variance, standard deviation and beta. Let us understand two important terms used while measuring risk correlation co-efficient and covariance. 1. Correlation Co-efficient: It is used to measure the strength of the linear relationship between two variables. A correlation coefficient greater than zero indicates a positive relationship while a value less than zero signifies a negative relationship. A value of zero indicates no relationship between the two variables being compared. This measure is used to study the relationship or the direction in which variables are moving. Correlation Co-efficient is denoted by a ρ (Rho) This measure helps to determine the direction between two variables 73 CU IDOL SELF LEARNING MATERIAL (SLM)

If Correlation= -1 then there is perfect negative correlation between the variables i. e they move in opposite directions. If Correlation= 1 then there is perfect positive correlation between the variables i. e They move in the same direction. If Correlation = 0 then there is no correlation between the variables. A negative correlation or inverse correlation is very important while creating diversified portfolios that can withstand portfolio volatility. For the purpose of calculating Correlation ρ the covariance of the two variables must be calculated. Further each variable’s standard deviation is also needed which we are going to discuss in the next section. 2. Covariance: Covariance is a statistical tool that is used to determine the relationship between the movements of two stock prices. When two stocks move together they are said to have a positive covariance; when they move inversely the covariance is negative. Covariance measures the relationship between the returns on two assets. It is an important tool used to ascertain which securities should be added in a portfolio. The formula for calculating covariance Covariance (for past data) = (Σxy/n) – (Σx/n × Σy/n) For future expected data we consider probability of returns. The formula where probability is given i.e. p Covariance (for future data) = Σpxy – (Σpx X Σpy) Where x = returns of x y = returns of another security or market n = no of years which is given p = probability of occurrence for future data Let’s take a simple example the returns of stock x and stock y for the past 3 years are as follows Year Returns (x) Returns (y) Product of returns 74 CU IDOL SELF LEARNING MATERIAL (SLM)

%% xy 200 1 10 20 253 2 11 23 Σxy = 765 3 12 26 312 Σ x= 33 Σy = 69 Average returns of x = 33/3 = 11% Average returns of y = 69/3 =23% Covariance xy = (Σxy/n) – ( Σx/n × Σy/) = 765/3 - (11 × 23) = 255 – 253 =2 In this example the two stocks have positive covariance. Having understood to calculate covariance the formula for correlation coefficient is Correlation = Covariance xy (σxy) ÷ (σX x σY) OR ρ= ������������������ ÷ (������������ × ������������) We will now understand the terms variance, standard deviation and beta (investopedia.com) 7.4.1 Variance: It is the total risk of a security. While calculating variance we take the square of standard deviation of the security. Variance of a portfolio measures the dispersion of average returns of a portfolio from its mean. It tells us about the total risk of the portfolio. It is a measure of dispersion of returns of a portfolio. The formula for variance For past data =(x2 ÷n) - (Σx/n)2 75 CU IDOL SELF LEARNING MATERIAL (SLM)

For future data= (Σpx2) - (Σpx)2 Where x = Returns of x in % N= no of years ΣX/n = Mean or Average returns 7.4.2 Standard deviation: It is the square root of variance. It is a statistic that measures the dispersion of a dataset in relation to its means. It determines each data point’s deviation from the mean. If the data points are further from the mean there is a higher deviation. A higher standard deviation means higher risk. A volatile stock has a high standard deviation while the standard deviation of a blue chip stock is low The formula for standard deviation For past data = √(������������ ÷ ������) − (������������/������)������ For future data =√(������������������������) − (������������������)������ 7.4.3 Beta: It is a measure of sensitivity in the volatility in the returns of a security or portfolio compared to the market as a whole. We will study this concept in detail when we learn Capital Asset Pricing Model (CAPM) in the 11th chapter. It is the systematic risk of a security. If the beta of a security = 1 it means the stock moves in sync with the market. If beta is more than 1 it means the stock is more volatile than the market If beta is less than 1 it indicates that the stock price is less volatile than the market. In short beta measures the stock’s volatility, the degree to which its price fluctuates in relation to the stock market. The formula for beta is beta β = Covariance σxy / σy2 Where x = security returns y = market returns 76 CU IDOL SELF LEARNING MATERIAL (SLM)

7.4.4 Alpha: Alpha is the risk-adjusted return on an investment. It is the excess return of a manager’s performance in managing the fund portfolio in case of mutual funds. Investors prefer to buy stocks with positive alpha as it may be undervalued. It is the excess returns the fund manager is able to generate. If the alpha is high their fees are also high. We can draw the following inferences from the above discussion on alpha and beta Higher the beta, higher the risk but have the potential to give higher returns. Lower the beta, lower the risk, hence returns will be less. Investors prefer high alpha and low beta stocks since it gives better returns than its competitors. 7.4.5 Illustration on risk Illustration 1 The returns of security x and returns of security y are expected to be as follows Returns x (%) Returns y (%) Probability (p) 30 10 0.2 20 20 0.6 10 30 0.2 Calculate risk of the security x and security y Ans: P x Y px py px2 py2 0.2 30 20 6 4 180 80 0.6 20 30 12 18 240 540 0.2 10 40 2 8 20 320 Σx= 60 Σy=90 Σpx=20 Σpy=30 Σpx2=440 Σpy2=940 77 CU IDOL SELF LEARNING MATERIAL (SLM)

Standard deviation σx = √Σpx2 – (Σpx)2 = √440 − (20)2 = 6.32% Standard deviation σy = √Σpy2 – (Σpy)2 = √940 − (30)2 = 6.324% 7.5 MEASUREMENT OF INDIVIDUAL SECURITY RISK AND RETURN When an investor has to decide which security he should invest in among two securities he will prefer to invest in such a way which will maximise his returns with minimum possible risk. The theory of dominance helps the investor to select which stock is preferable. As per the theory of dominance a. If two securities have same returns then security with lower risk (standard deviation σ) is dominant b. If two securities have same risk than security with higher return is dominant. c. If theory of dominance fails then we can make use of co-efficient of variation Co-efficient of variation tells us the absolute value in percentage form, it helps to bring comparability between two securities. Let’s see some examples regarding selection of two securities Example 1 Security Return Risk Dominance A 14 12 X B 18 12 To be selected 78 CU IDOL SELF LEARNING MATERIAL (SLM)

Example 2 Security Return Risk Dominance 6 To be selected X 21 9 X Y 21 Example 3 Return Risk Dominance Security 24 14 X P 36 11 To be selected Q Example 4 Security Return Risk Dominance L 40 14 Fails M 30 9 Fails In the fourth eg theory of dominance fails here coefficient of variation will be applied by using standard deviation and mean or average returns Co-efficient of variation = Standard deviation / Mean returns X 100 Higher coefficient of variation will mean higher risk and accordingly investor can decide. Formula for expected return of a security 79 Expected return of a security can be calculated as = (ER1 x pi)+ (ER2 x pi) +(ER3 x p3) Where ER1,ER2 and ER3 are expected returns for years 1, 2 & 3 CU IDOL SELF LEARNING MATERIAL (SLM)

Pi is the probability of occurrence. Illustration on individual security risk and return The following are the different state of economy, the probability of occurrence of the state and the expected rate of returns from security A and security B in these different states State Probability Security A returns % Security B returns % Recession 0.20 -15 -20 Normal 0.50 20 30 Boom 0.30 60 40 Solution: Let x signify security A and y signify security B Pi prob x Y Px Py Px2 Py2 Pxy 0.2 -15 20 -3 4 45 80 -60 0.5 20 30 10 15 200 450 300 0.3 60 40 18 12 1080 480 720 Total 25 31 1325 1010 960 Expected returns of security A = ΣPx 80 = 25% Expected returns of security B = ΣPy = 31% Standard deviation of x σx = √Σpx2 – (Σpx)2 = √ 1325 – (25)2 CU IDOL SELF LEARNING MATERIAL (SLM)

= 26.46% Standard deviation of y σy = √Σpy2 – (Σpy)2 =√1010 − (31)2 = 7% From the above we can infer that risk of security B is less compared to A since standard deviation of A is more Expected returns of security B is higher than security A Hence security A must be selected. Covariance of X and Y = ΣPxy – (ΣPx x ΣPy) = 960- (25 x 31) = 185 Correlation Coefficient = Covariance xy ÷ σx xσy = 185 ÷ 26.46 x7 = 0.998 7.6 MEASUREMENT OF PORTFOLIO RISK AND RETURN A portfolio consists of several securities. For calculating the returns of a portfolio we have to consider the returns of each security and their related weights. Expected return of a portfolio = WaRa +WbRb + …… Standard deviation of a portfolio is not the weighted average risk of individual securities. Portfolio risk depends on the interactive risk between each pair of securities comprised in the portfolio. The interactive risk is determined by correlation. Continuing the above illustration figures we had calculated expected return of A as 25% of B as 31%. Standard deviation of A and B were 26.46% and 7 % respectively. If Mr Ram invests Rs 60000 in security A and Rs 40000 in security B the return of the portfolio will be Rp = WaRa +WbRb = 0.6 x 25 + 0.4 x 31 = 27.4% 81 CU IDOL SELF LEARNING MATERIAL (SLM)

For calculating standard deviation of the portfolio we use the following formula== Standard deviation of portfolio σp =√������2������������������2 + ������2������������������2 + 2������������������������ × ������������������ × ������������ × ������������ That is taking the square root of the following formula we get standard deviation of the portfolio W2A σA2+W2Bσ2B2+2WAWB×ρAB×σA×σB √0.60 × 0.60 × 26.46 × 26.46 + 0.40 × 0.40 × 7 × 7 + 2 × 0.6 × 0.4 × 1 × 26.46 × 7 = 252.047+7.84+88.9056 Taking square root of √348.7926 =18.675% Thus overall risk has got reduced though risk of security A was 26.46% by investing in 3: 2 ratio 7.7 SUMMARY  We have understood the term return and risk in detail. Returns given may be based on past data or expected outcomes. In each case the calculation will differ. For past returns we calculate average returns and for future data we take into account probable outcomes which are given.  Risks are of two types’systematic risk and unsystematic risk. Systematic risk arises due to macro factors and cannot be eliminated. Unsystematic risk arises due to micro- economic factors and can be avoided through portfolio diversification. An investor gets rewarded for taking systematic risk while market does not compensate for unsystematic risk. Thus total risk comprises of systematic and unsystematic risk.  Total risk which investor takes while investing is called variance. Taking square root of variance gives us standard deviation which shows how far the returns are dispersed relative to its mean. Higher the standard deviation higher is the risk.  Correlation is a statistical measure that expresses the extent to which two variables are linearly related. When correlation between two securities is 1 it means they move in the same direction; if it is -1 they move in opposite directions. When correlation is zero then there is no correlation. 82 CU IDOL SELF LEARNING MATERIAL (SLM)

 Covariance is a statistical tool used to determine the relationship between the returns on two assets. Risk and volatility can be reduced in a portfolio by pairing assets having a negative covariance.  Alpha is the excess returns a stock or portfolio is able to generate compared to a benchmark or market index. Investors prefer to invest in funds having greater alpha.  Beta measures the relative volatility of an investment. It shows the relative risk compared to the market. A beta equal to 1 means the risk is the same as market risk while a beta greater than 1 means a higher risk compared to market.  Investors prefer low beta high alpha stocks since the stock is giving higher returns for a lower risk.  In the case of selection of individual securities the theory of dominance is used to make investment. Where this theory fails co-efficient of variation which is the ratio of standard deviation to average returns expressed as a percentage is used to make decision on investment.  Expected return of a portfolio is the sum of weighted returns of all individual securities. Standard deviation of a portfolio depends on the interactive risk between each pair of securities comprised in the portfolio. The interactive risk is determined by correlation. 7.8 KEYWORDS  Total risk is also known as Variance which includes both controllable and uncontrollable risk  Standard deviation helps in finding out risk of a stock or portfolio which in turn helps the investor or portfolio manager to take investment decisions. It is found out by taking square root of variance. When two stocks give same returns the stock with a lower standard deviation is chosen since the risk is less.  Variance includes both systematic risk and unsystematic risk. Systematic risk cannot be eliminated while unsystematic risk can be eliminated by portfolio diversification  Beta is the relative volatility of a stock compared to the market. It is equal to exposure to systematic risk. A beta of 1 means the stock has the same risk as market risk  Alpha is the excess return of a fund compared to a benchmark or market index. A high alpha, low beta stock is preferred by investors. 83 CU IDOL SELF LEARNING MATERIAL (SLM)

7.9 LEARNING ACTIVITY 1. What do you understand by the term risk? What are the measures of risk? ___________________________________________________________________________ ___________________________________________________ 2. How do you calculate individual security returns for historical and future data? _______________________________________________________________ 7.10 UNIT END QUESTIONS A. Descriptive questions Short Questions 1. Which types of risk cannot be controlled by an organisation? Discuss 2. Differentiate between alpha and beta. Why do you think it is necessary to consider these before investing? 3. What measures will you exercise to find out risk before investing in a mutual fund? 4. Higher beta means higher risk. Discuss 5. Which factors will you consider to minimise risk when constructing a portfolio? Long questions 1. Unsystematic risk can be minimised. Systematic risk can be managed. Discuss 2. Explain the theory of dominance and co-efficient of variation. 3. The returns of two assets under four possible state of nature are given below State of nature Probability Return on asset 1 Return on asset 2 1 0.10 5% 0% 2 0.30 10% 8% 84 CU IDOL SELF LEARNING MATERIAL (SLM)

3 0.50 15% 18% 4 0.10 25% 27% a. What is the standard deviation of the return on asset 1 and asset 2? b. What is Covariance between the return on assets 1 and asset 2? c. What is the co-efficient of correlation between the returns on assets 1 and 2? 4. Distinguish between Systematic risk and Unsystematic risk 5. The probability distribution of the rate of return on stock A is given below State of the economy Probability Rate of Return % Boom 0.3 16 Normal 0.5 11 Recession 0.2 9 What is the standard deviation of the return? B. Multiple Choice Questions 1. _______________ risk is uncontrollable in nature a. Interest rate b. Inflation c. competition d. both a & b 2. When two securities give the same returns the security with __________ standard deviation is chosen. a. high b. low c. minimum 85 CU IDOL SELF LEARNING MATERIAL (SLM)

d. greater 3. Interest rate risk is ________________ in nature a. Systematic b. Unsystematic c. economic d specific 4. A fund manager’s performance is measured by ______________ of the portfolio a. maximum returns b. Beta c. alpha d. average returns 5. Blue chip stocks have _____________beta. a. market b. High c. low d. Average Answers 1–d, 2–b, 3–a, 4–c, 5-c 7.11REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill 86 CU IDOL SELF LEARNING MATERIAL (SLM)

Website  https://pdfcoffee.com  https://corporatefinanceinstitute.com  https://www.investopedia.com 87 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 8 INVESTMENT COMPANIES STRUCTURE 8.0 Learning Objectives 8.1 Introduction 8.2 Concept of Investment Company 8.3 Functions of Investment companies 8.4 Classification of Investment companies 8.4.1 Types of Mutual fund 8.5 Summary 8.6 Keywords 8.7 Learning Activity 8.8 Unit End Questions 8.9 References 8.0 LEARNING OBJECTIVES After studying this unit you will be able to  Define an Investment company  Explain the functions of an investment company  State the different types of Investment companies 8.1 INTRODUCTION We come across terms like open-ended funds closed-end fund in the context of mutual funds. An investor who wishes to assume less risk invests in mutual fund to gain advantage of professional management. Whether an investor can invest in any type of fund? Whether it is available throughout the year. These questions come in the mind of investors. What are these funds? These funds come in the category of investment companies. (pocketsense.com, n.d.)From this chapter you will understand the term investment company, the types available for the investor to invest. Investors benefit by doing personal research, but 88 CU IDOL SELF LEARNING MATERIAL (SLM)

not all of them can conduct detailed research. Investment companies provide a stable platform where they can rely on to assist them. Investors can stay assured that their hard earned money is used strategically. These companies manage the funds of the public whom they represent. By now you must have understood that Investment companies are formed to collect a pool of money from different investors and invest them in a variety of funds. Investor can choose which type of fund he has to invest depending on his objective. Investors in investment companies are retail and institutional investors. These companies play an important role in the economic growth of the country and enables individuals as well as institutional investors to have a share in the growth of the country. 8.2 CONCEPT OF INVESTMENT COMPANY (www.sec.gov, n.d.)Investment Company is a company (corporation, business trust, partnership or Limited Liability Company) that issues securities to its investors and is primarily engaged in the business of investing in securities. An investment company receives money from investors on a collective basis and invests the money collected in securities. The investors share profits and losses in proportion to their interest in the investment company. The performance of the investment company is based on the performance of the securities it invests and other assets of the company. The fund manager decides the type of security in which the pooled money is to be invested. The objective is to build a diversified and a well-managed portfolio. Investment companies come in different forms exchange-traded funds, mutual funds, money-market funds and index funds. These companies collect funds from retail and institutional investors and invest the funds based on the strategies agreed with the investors. 8.3 FUNCTIONS OF INVESTMENT COMPANIES (bizfluent.com, n.d.)Following are the functions of investment companies 1. Collect Investments: Investment companies collect funds by issuing and selling shares to investors. There are basically two types of investment companies close-end and open-end companies Close-end companies issue a limited amount of shares that can then be traded in the secondary market on a stock exchange. 89 CU IDOL SELF LEARNING MATERIAL (SLM)

Open-end company’s e.g. mutual funds issue new shares every time the investor wants to invest; new units are issued to the investors in mutual fund. Note: Primary market is where new issues of stocks and bonds to the public are done such as Initial Public Offering (IPO) whereas secondary market is commonly referred as the stock market. Examples includes Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) in India. 2. Invest in Financial Instruments: Investment companies invest in financial instruments according to the strategy of which they made investors aware. There are a wide range of strategies and financial instruments that investment companies. These strategies offer different exposures to risk. Investment companies invest in equities (stocks), fixed-income (bonds) currencies, commodities and other assets. 3. Pay out the Profits: The profits and losses that an investment company makes are shared among its shareholders. Investors can redeem their shares for cash from the company or sell their shares to another firm or individual depending upon the type whether close-end or open-end company. Investors receive capital distributions from the company when assets are sold. Thus we have understood that Investment companies are companies which pool funds from a number of retail and individual investors, invest in financial instruments depending upon the strategy agreed upon and distribute profits and losses to its shareholders. 8.4 CLASSIFICATION OF INVESTMENT COMPANIES (businessjargons.com, n.d.)Investment companies are divided into three types:  Open-End Management Investment Company  Closed-End Management Investment Company  Unit Investment Trusts 1. Open-End Management Investment Company: These are also called Mutual Funds. They have no limit on the number of units they can issue. The investor can continuously buy or redeem its units at the current net asset value (NAV). Hence the investor has the convenience and flexibility to buy as many units they want and redeem them. Investors can join the scheme by directly investing in the mutual fund at the applicable net asset 90 CU IDOL SELF LEARNING MATERIAL (SLM)

value price. The unit capital of open-ended funds fluctuate on daily as new investors purchase new units. 2. Closed-End Management Investment Companies: These companies are also called as Investment Trusts. It issues a fixed number of shares through initial public offerings. They raise a fixed amount of capital through issue of fixed number of shares on the stock exchange. The number of shares issued are limited. Hence investors cannot buy as many shares they want and similarly they cannot sell their existing shares before the expiry of the scheme. However the units are traded on the stock exchange and the investor can sell his units in the stock exchange. Investor who wants to invest in this company can do so only through secondary markets. 3. Unit Investment Trusts: These are also called as Unit Trusts, share the similarities of both the closed-end and open-end mutual funds. These companies too hold portfolio of stock, shares, debentures and other money market instruments. Like open end fund the units can be bought and sold directly from the issuing investment company while in some cases they are traded in the secondary market. They have a low minimum investment requirement. The units can be bought and sold any time the investor wants. Thus we can say that investment companies give an advantage to the small investors to make investment in a wide array of securities which otherwise would not have been possible for them. Following are some examples of Asset Management & Investment Companies in India  Bajaj Allianz General Insurance Company Ltd  Barclays Capital  Capital Group  Infrastructure Development Finance Company Ltd (IDFC)  UTI Asset Management  Birla Sun Life Asset Management e t c Note: Real Estate Investment Trust (REIT) are investments traded in stock exchange which allow investors to invest in real estate without having to purchase or manage properties by themselves. There are three REITs in India at present 91 CU IDOL SELF LEARNING MATERIAL (SLM)

 Mindspace REIT  Brookfield REIT  Embassy REIT 8.4.1 Types of Mutual funds Mutual funds can be classified into the following types a. According to the type of investment: Every mutual fund has to disclose in its prospectus the type of investments it will make from the funds collected at the time of its issue. The various types of mutual funds according to the type of investments are as follows: Equity funds Debt funds Diversified/Balanced funds Gilt funds Money market funds Sector specific funds like pharma, FMCG, banks etc. Index funds e.g. ICICI Prudential Nifty Index fund, SBI Nifty Index fund b. According to time of closure of the scheme: These are of the following types Open-Ended Schemes Close-Ended Schemes The above has been discussed in detail above c. According to tax incentive schemes Tax Savings funds Non-tax savings funds d. According to the time of pay-out Dividend Paying Schemes Re-investment schemes. 92 CU IDOL SELF LEARNING MATERIAL (SLM)

8.5 SUMMARY Investment company is a company (corporation, business trust, partnership or limited liability company is formed with the objective to collect funds from investors for which shares or units are issued. Investors may be individual or institutional in nature. They invest these funds in financial instruments like equity, bonds, money market instruments e t c depending upon the terms agreed with the investors. These companies need to disclose in the prospectus the investments proposed to be made from public funds. These funds earn income on the investments made. Such profits or losses are distributed to the shareholders or unitholders. In the context of mutual fund units are issued to the investors for investment made. Investment companies may be of three types  Open-end Management Investment Company  Closed-End Management Investment Company  Unit Investment Trusts Mutual funds may be classified  According to the type of investments made whether equity, debt, balanced, index, money-market e t c  According to the time of closure of the scheme whether open-end or closed-end  According to tax incentives  According to time of pay-out An investor depending upon his return and risk objectives can choose the type of fund to invest. Mutual funds in India have achieved the objective in multiplying the number of investors over the last ten years. Small investors are assured by investing in mutual funds. Investment companies give the benefit to the individual to participate in the stock market with minimum funds. Investors get the benefit of a diversified portfolio managed by professional managers. Such investment companies contribute to the growth of the economy in terms of infrastructure for example IDFC is an investment company which has helped to build infrastructure in our economy thereby promoting overall economic growth 93 CU IDOL SELF LEARNING MATERIAL (SLM)

8.6 KEYWORDS  Open-End Management Investment Company: New units are issued to the investors every time. Unit capital keeps changing. Investors can buy from the mutual fund.  Closed-End Management Investment Company: Fixed amount of capital is raised, thus the number of shares is limited. Investors can buy and sell through exchange. Unit capital is fixed  Unit Investment Trusts: They share similarities of both open-end and close-end funds  Money-market: It involves purchase and sale of large volumes of very short-term debt instruments. Examples of money market instrument are treasury bills, commercial paper, certificate of deposit e t c 8.7 LEARNING ACTIVITY 1. Define an Investment Company ___________________________________________________________________________ ___________________________________________________ 2. List down the types of mutual funds ___________________________________________________________________________ ___________________________________________________ 8.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What do you understand by the term investment trust? 2. List the functions of an investment company? 3. Explain mutual funds according to the type of investments made 4. Which mutual fund should an investor choose if he wants to invest for a short term? 94 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Which type of investment allows the investor to invest in real estate without actually buying it? Long Questions 1. Explain the different types of investment companies 2. An investor wishes to invest in mutual funds comprised of both debt and equity. Which type of fund should he choose and why? 3. Explain in detail functions of an investment company 4. Investment Company helps in promoting overall growth of the economy. Explain 5. Do you think Investment companies in India have succeeded in achieving their objectives? Why? B. Multiple Choice Questions 1. Open-End Mutual funds___________ investors to purchase new units from the fund a. restricts strictly b. does not allow c. allows d. encourages 2. A _______________ fund minimises risk for the mutual fund investor a..equity b. balanced c. moneymarket d. index 3. ___________ funds invest only in government securities 95 a. Debt funds b. Gilt funds c. Balanced fund CU IDOL SELF LEARNING MATERIAL (SLM)

d. Tax saving fund 4. An investor interested in regular income should invest in __________schemes a. Debt b. Growth c. Balanced d. money market 5 _____________ fund invest in the stocks comprised in a market index a. balanced b. index c. money market d. equity Answers 1–c, 2–b, 3–b, 4–a,5-b 8.9 REFERENCES Textbooks  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill  Bhalla V.K (2011) Investment Management Security Analysis and Portfolio Management S Chand & Company Ltd Websites  https://www.sec.gov  https://bizfluent.com  https://businessjargons.com 96 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 9 ASSET ALLOCATION DECISIONS STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 Individual investor life cycle 9.3 Portfolio Management process 9.4 Asset Allocation and its importance 9.5 Summary 9.6 Keywords 9.7 Learning Activity 9.8 Unit End Questions 9.10 References 9.0 LEARNING OBJECTIVES After understanding this chapter you will be able to  Define the stages in the investor life cycle  Define portfolio management and the process  Describe asset allocation  Describe the importance of asset allocation 9.1 INTRODUCTION An investor passes through different stages in his life cycle. The needs, desires and priorities are different at each stage of his life. Accordingly the amount invested, the type of securities chosen, the time period of investment and the risk he is ready to take is different. You will be learning to identity the investor’s stage in his life cycle and decide on the strategy to be followed thereon. Investors can invest based on their personal research and study. However many of them are not equipped to decide the timing and amount of investment to be done. So they may take the advice of financial planners. 97 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial planners when approached by investors have a detailed discussion to decide the course to be followed while investing. Financial planners need to understand the investor’s objectives, time horizon, liquidity required e t c and so are required to follow a process the portfolio management process. Financial planners prepare the investment policy statement and follow a step by step approach to invest on behalf of the investor. You will be learning the process in detail in this unit. You will understand the meaning of asset allocation and its great importance in the overall portfolio management process from this unit. 9.2 INDIVIDUAL INVESTOR LIFE CYCLE (ordunur.com, n.d.)The investor life cycle refers to the different stages of ownership of investments from the initial purchase to the sale of the investment. Initially the investor understands the options available to him in terms of security selection, investment options, budgeting and goal setting. It is where the investor becomes aware of his investment needs and financial planners engage with new clients. An investor passes through various phases in his life 1. Accumulation phase: Individuals early or in their middle career start investing to meet their goals. Their objective may be varied like children’s education, buying a car, buying a house or to provide for retirement. Investors who start early in their career benefit with a huge amount due to the compounding effect over the years. 2. Consolidation phase: Consolidation phase is the phase in which investors are in the middle of their careers. So they earn more, spend more and pay off all their debts. In his phase the investor is ready to take moderate risk and invest in capital market and other securities. Some prefer to invest in low risk securities for capital protection, 3. Spending Phase: This phase starts when an individual retires from his job. At this stage the individual would prefer investing in risk free securities like bond, fixed deposits, post office deposits, debentures and other fixed income securities. However to hedge from inflationary effects the individual may invest in risky assets if he can spare extra money. 4. Gifting Phase: When individuals believe that they have enough extra funds to meet their current and future needs they gift money to family, friends or charitable 98 CU IDOL SELF LEARNING MATERIAL (SLM)

institutions. Donations to charitable institutions confers income tax benefits under Section 80G of the Income tax Act. Most people who start investing early during their life time utilize the time effectively during the accumulation phase making it possible to build a huge corpus later in their life. Investors behave differently and invest in securities according to their risk taking capacity. 9.3 PORTFOLIO MANAGEMENT PROCESS (corporatefinanceinstitute.com, n.d.)Investment Policy Statement (IPS): It is a statement drafted between a portfolio manager and a client which contains the rules and guidelines the portfolio manager has to follow when considering asset allocation in the client’s portfolio. IPS outlines how a portfolio manager has to manage the client’s money. The components of an IPS are scope and purpose, governance, investment, return and risk objectives and risk management. Some of the issues addressed in IPS are asset allocation decisions, risk tolerance of the client, leverage, liquidity requirements e t c. A well- constructed IPS provides a framework for investment decisions made by the portfolio manager and keeps the client committed to a long-term investment strategy. Emotional decisions made by the client can be avoided Portfolio managers, analysts and investors need to analyse the risk-return trade off of the entire portfolio and not of individual assets. The individual assets carry an unsystematic risk which can be diversified by having many individual assets in a single portfolio. The whole portfolio risk is caused only due to systematic risk which is caused due to macro-economic factors. Such factors include GDP growth, inflation, business cycles e t c. (efinancemanagement.com, n.d.)The portfolio management process has the following steps 1. Planning: It is the most crucial stage and forms the foundation of the entire process It comprises of these tasks a. Identification of Objectives and Constraints: This is the foremost task in the planning phase. Any desired outcome that the investor has in terms of return and risk form the objectives of the investor. Any limitation on investment decision and choices become the constraints for the investor. Both are defined at this stage. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Drafting the Investment Policy Statement: Once the objectives and constraints are defined the next step is to formulate an Investment Policy Statement (IPS) which we had discussed earlier. c. Capital market expectations: The next step in the planning is to form expectations regarding capital markets. The portfolio manager forecasts over the long term to choose portfolios that will maximise return for a given level of risk or minimise risk for a given expected level of return. d. Asset Allocation Strategy: This is the final stage in the planning phase. The portfolio manager after considering the IPS and capital market expectations determines the long term weights for various asset classes which is known as strategic asset allocation. Any short term change in the portfolio due to change in the circumstances of the investor or market are tactical asset allocation. However if such change becomes permanent in nature and becomes part of IPS it will be considered as strategic portfolio allocation 2. Execution: Once the planning is completed planning is the next step in the process of portfolio management. It includes; a. Selection of the portfolio: The asset allocation strategy chosen after forming expectations of capital market is combined to select assets for the investor. The portfolio manager uses the portfolio optimization technique while selecting assets that will form the portfolio. b. Portfolio execution: Once the composition of portfolio is decided the next step is execution. Portfolio execution is very much important since high transaction cost can reduce the performance of portfolio. Transactions costs are both explicit and implicit. Explicit costs include taxes, fees, commission e t c. Implicit cost include opportunity cost, bid-ask spread, market price impacts e t c. Thus execution of the portfolio needs appropriate timing and also to be managed properly. 3. Feedback: Feedback is obtained and necessary changes are made taking long term considerations. This stage includes the following 100 CU IDOL SELF LEARNING MATERIAL (SLM)