The client is aged 40 years with a net asset of $900,000 out of which $700,000 comes from the equity held in the owner-occupied house and $200,000 in the form of annual income. The risk tolerance capacity of the client is expected to be moderately high. As the client is currently aged 40 years, it is expected that the time horizon of the client is more than 10 years. As the client has a sufficient annual income, the liquidity requirement of the client is expected to be low and illiquid asset classes may be included into the portfolio. The client is assumed to have no reservation against investing into Alternative Investment Fund, given the client achieves the desired rate of return.
As the client is fairly young aged 40 years, the general thumb rule of asset allocation would be followed to allocated capital into assets. The 110 rules, the 120 rule, and the new portfolio thinking rule are three asset allocation thumb guidelines. According to the 110 regulations, the percentage allocation in securities should equal the difference between 110 and the age as of date, multiplied by 1.25. Similarly, according to the 120-investment guideline, the percentage allocation in securities should be the difference between 110 and the current age, with the resultant figure indicating the proportion to be invested in the stock market (Simaan & Simaan, 2019). The client here would redeem benefits if the capital is allocated within three asset classes; ordinary shares, Commonwealth bonds and Event Driven Hedge funds. The three securities represent three asset classes which are equities, bonds and alternate investment. The following section presents the return characteristics, risks associated with them and the correlation with each other of each one of the asset classes chosen for the purpose of investing the client’s money:
The capital of a company/corporation is divided into little equal units known as "shares" when it starts a business; the firm cannot start without shares. The capital of the company is also handled through shares, which the shareholders profit from. Any investment in a company that makes the investor a portion of that company is referred to as a stock investment. Investors purchase a company's stock with the goal of selling it at a higher price later. If the firm's stock value rises in the future, the price of its shares will rise as well (Bhattacharjee & Singh, 2017). Stocks are the securities that a company issues to obtain capital and to satisfy the expectations of investors. When a person buys stock in a firm, he becomes a shareholder and becomes a part of the company's profits. The stock market is where public companies sell their stock and where brokers help investors buy and sell shares (Ratzinger, et al 2018). There are two ways in which an investor can earn profits from investing into stock or ordinary shares of a company:
- Rise in the prices of the stocks - Stocks are riskier than any other type of investing and if the price of the company's shares rises during the investors' ownership tenure, they can sell them for a higher price than they paid at the time of acquisition. Investors can profit from stock investments in this manner and including a stock investment in the portfolio gives the portfolio an opportunity to earn super normal returns.
- Dividend income - A dividend is a payment provided to investors in lieu of profits and retained earnings by a corporation. When a corporation has excess profits or retained earnings, they are either reinvested in the company or shared equitably among stockholders of the same class on a per-share basis. When a dividend is declared, it is due on a specific day known as the payment date (Budagaga, 2017). The company's investors can profit from their investments in this way. Dividend income is one of the primary reasons that investors invest into a stock as it guarantees a stable source of income which is necessary for a person who is aged and has high liquidity requirement.
The first step in beginning a stock investment is to choose an investing strategy. A person might approach stock investment in a variety of ways. You may begin investing in the stock market through a variety of firms. The stock has a high correlation with the economy as the economy performs well, the companies within the economy tends to replicate the performance of the economy. The correlation between the bonds and the equities are also negative as the bond market suffers in case the economy is booming as investors feel happy investing in stocks. There are multiple risks that are associated with stock investments which are discussed below:
- There are risks associated with the projects undertaken by the company whose stock is purchased by us.
- Industry specific risks defines the governmental policy risks which can impact the performance of the stock.
- Competitive risks – The risk of impact in the financial performance due to actions caused by the competitors is also an important risk factor to consider before investing into stocks.
Investment bond can be defined as an instrument which an issuer owes to the holder in the form of money. The issuer is responsible for paying the regular and periodic return in the form of coupon payments to the holder of the bond (Huang, et al 2015). The principal of the bond is paid towards the maturity of the bond and the bond is then said to be fully redeemed. Bond in simpler terms can be defined as an agreement which allows and investor to earn interest on the amount of capital lent at a regular interval. The bond issuer can be anyone; government, agencies, corporations and many others. In order to finance using bonds, regular interest payment would be required to be made with the full amount of the raised debt to be paid at the end of the maturity period. There are multiple types of bonds like the zero-coupon bonds, corporate bonds, convertible bonds and many others but here the client would be feeling safe if the investment of his capital is made into government bonds. Government security bonds are investment bonds issued by the current government of a country (Banerjee, Kearns & Lombardi, 2015). These kinds of investment bonds are considered the safest debt instruments to invest in. There are certain advantages of investing into a bond which includes;
- Investing into a government bond ensures the safety of the capital as the risk of default is virtually non-existent. The bonds also provide steady income which is beneficial to the portfolio.
- Taxes - The interest generated on municipal bonds may be free from state and local taxes for residents of the states where they are issued (Liaw, 2020).
The risks that are associated with the asset class are shared below:
- The bonds come with credit risk which is the risk of the issuer defaulting and denying payments of the regular coupon.
- The values of the bonds are highly volatile due to interest changes which act as a major hurdle in deciding an investment in the asset class. Risk of inflation is also present which reduces the price of the cash flows received from the bonds.
This is a hedge funds strategy which is highly risky and with comes with a huge amount of return potential. A hedge fund is a private placement investment aggregated from sophisticated or institutional investors and managed by investment management organisations. It is difficult for a small investor to invest into a hedge fund due to a high level of minimum capital required (Bebchuk, Brav & Jiang, 2015). The fund's name is derived from the fact that it is intended to offset losses from other investments. As a result, hedge funds invest in portfolios that are built using high-risk management approaches in order to produce large returns even in the worst-case scenarios. Hedge funds are very opaque in nature and the strategies used by the funds to generate super normal returns are not disclosed to the world. Hedge funds are open-ended funds which essentially requires an investor to contact the management of the firm to buy shares of the fund based on the NAV of the fund (Brav, et al 2018). Despite outperforming mutual funds, hedge funds have experienced financial difficulties as a result of their complicated financial investing tactics. Hedge funds' primary goal is to maximise return on investment (ROI). Hedge fund profits are subject to capital gains taxes.
Event driven hedge funds are hedge funds which invests in strategies like mergers and acquisitions, bankruptcy or a spinoff. Merger arbitrage is one of the major strategies of a hedge funds as based on the likelihood of the merger getting through, the event driven strategy fund would look for opportunities in the merger and acquisition buying the stock of the target companies and the selling the stock of the acquirer. As the individual is a small investor, he or she may find a difficult to invest in the hedge fund due to the large amount of initial investment is required by the fund (Kirchner, 2016). As a result, the client can get exposure to this asset class by liquid alts which are traditional limited partnership structures have been replaced by liquid alternatives (liquid alts)—mutual funds, closed-end funds, and ETF-type vehicles that invest in various hedge fund-like strategies. The strategy is a risky one and requires a longer time period to yield return. It also acts as a diversifier as it has low correlation with all other types of investment asset classes.
Based on the financial situations and the risk-taking capacity of the client, it is recommended that the client invest 60 percent of the capital into equities followed by a 30 percent exposure into government bonds and the remaining 10 percent going into hedge fund strategies using the liquid alts method.
Banerjee, R., Kearns, J., & Lombardi, M. J. (2015). (Why) Is investment weak?. BIS Quarterly Review March.
Bebchuk, L. A., Brav, A., & Jiang, W. (2015). The long-term effects of hedge fund activism (No. w21227). National Bureau of Economic Research.
Bhattacharjee, J., & Singh, R. (2017). Awareness about equity investment among retail investors: A kaleidoscopic view. Qualitative Research in Financial Markets.
Brav, A., Jiang, W., Ma, S., & Tian, X. (2018). How does hedge fund activism reshape corporate innovation?. Journal of Financial Economy
Budagaga, A. (2017). Dividend payment and its impact on the value of firms listed on Istanbul stock exchange: A residual income approach. International Journal of Economics and Financial Issues, 7(2), 370-376.
Huang, T., Wu, F., Yu, J., & Zhang, B. (2015). International political risk and government bond pricing. Journal of Banking & Finance, 55, 393-405.
Kirchner, T. (2016). Merger arbitrage: how to profit from global event-driven arbitrage. John Wiley & Sons.
Liaw, K. T. (2020). Survey of green bond pricing and investment performance. Journal of Risk and Financial Management, 13(9), 193.
Ratzinger, D., Amess, K., Greenman, A., & Mosey, S. (2018). The impact of digital start-up founders’ higher education on reaching equity investment milestones. The Journal of Technology Transfer, 43(3), 760-778.
Simaan, M., & Simaan, Y. (2019). Rational explanation for rule-of-thumb practices in asset allocation. Quantitative Finance, 19(12), 2095-2109.
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