<<

. 33
( 60 .)



>>

Capital preservation
√ √ √
International

Overlay
√ √
Relative return

Absolute return

Bull and/or bear

Long and short




Growth Fund
Typically a growth fund is a euphemism for a fund that is likely to take on
greater risks (relative to, say, an income fund) so as to try to grow the cap-
ital base. In all likelihood, a growth fund strategy is not to stay strictly
indexed, unless of course there is a meaningful growth-type index available
(as perhaps a Nasdaq-type index might be, though even here a concern might
be raised about more Internet-related components of this index as repre-
senting a disproportionate exposure to one particular sector). Generally
speaking, equities, which demonstrate beta values greater than one, are likely
to be strong growth fund candidates.


Capital Preservation Fund
Perhaps at the opposite end of the continuum from a growth-oriented fund
would be a capital preservation fund. As the name clearly suggests, the idea
with a capital preservation fund is more to maintain capital than to expose
it, and typically with securities that tend not to exhibit much volatility. While
it is certainly possible to find some equities within a capital preservation
fund, they would likely exhibit betas of less than one. More typical com-
ponents of a capital preservation fund would consist of relatively strong
(highly rated) bonds.




TLFeBOOK
155
Financial Engineering



Balanced Fund
A balanced fund usually is expected to represent a blend of equity and bond
holdings. The idea is that by diversifying within one fund”such as taking
a more aggressive/growth-oriented position in equities and a more conserv-
ative/preservation stance with bonds”this mix could result in an optimal
best-of-both-worlds strategy for a given investor. Indeed, one school of
thought holds that there is a “life cycle” blend of equities and bonds that is
dynamic in nature. The general idea is that in the early stages of one™s life,
it is quite acceptable to be predisposed to equities rather than bonds; this
would be a time in life when risk taking is more appropriate. In the middle
stages of life, a shift to more of an equal holding of equities and bonds is
more in keeping with hitting stride with income earnings as well as the need
to ensure adequate resources for the coverage of present and future liabili-
ties (as with a home mortgage and/or college educations). And then in the
later stages of life, the notion is that the right strategy is more of a bias to
bonds and capital preservation, if only so that the capital base that was once
exposed (and properly so) is now more protected.


Income Fund
Income funds are closely linked to capital preservation funds in that both
strive to limit capital exposure to an acceptable minimum. Income funds tend
to prefer securities with higher coupons and dividends than capital preser-
vation funds; in short, securities that generate as many “income”-like cash
flows as possible. Again, equities probably would be limited to shares
exhibiting a beta of less than one. Some utilities readily come to mind.
Although higher coupons are paid only when greater credit risk is taken on,
there are some rather aged (though still available) bonds with “large”
coupons relative to their present credit risk profile. For example, a long-dated
security may have been brought to market a while ago when prevailing yields
were much higher and/or when the issuer™s credit rating was worse than what
it has evolved to become. Another possibility for income-oriented funds is
to bias bond holding toward securities, which may embody more complex
structures, as with callables. However, here as well capital preservation pre-
cautions must be maintained.


Tax-Free Funds
As discussed in some detail in Chapter 3, there can be entire segments within
certain markets where designated securities are afforded some type of tax
protection. If due only to the fact that these securities already enjoy a par-
ticular tax advantage, they are not typically sought after as higher-yielding




TLFeBOOK
156 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT



securities. Tax-free yields tend to be lower relative to like-rated securities that
are not tax-advantaged because of the tax-free advantage. While it should
be expected that investors who might not be motivated by a tax-free oppor-
tunity might favor tax-free securities for a particular strategy (as when a total
return-oriented portfolio manager believes that he may have spotted a mis-
priced relationship between taxables and nontaxables and wishes to capture
it), tax-free securities are most likely to be found in “pure” tax-free funds
and less likely to be found anywhere else.


Asset-Liability Management
Just as tax-free investment management can be thought of as a type of “tai-
lored” management style (in this case tailored to tax-oriented strategies),
asset-liability portfolio management might best be thought of as a “tailored”
management style. Simply put, for an entity with fairly well-defined future
liabilities (as with pensions or life insurance policies), it is highly desirable
to put into place a matching (or nearly matching) series of asset streams to
pair off against the anticipated liabilities. Perhaps not surprisingly, bonds are
often a favored asset to use with asset-liability management owing to the
fact that they have fairly well-defined characteristics when it comes to cash
flow generation. Knowing when coupons and/or principal payments are
likely to be made and in what amount can be tremendously helpful when
trying to ensure that promises for timely payments on pension or life insur-
ance policies are kept.
Insurance companies use actuarial tables and the like for the sole pur-
pose of optimally deriving and applying any relevant statistical insights to
better structure and manage life insurance“related commitments.

Yield Enhancement
Closely related to asset-liability management is the portfolio management
approach of yield enhancement. In fact, it might be most helpful to describe
yield enhancement as not so much a distinct investment style vis-à-vis asset-
liability management, but rather as a management orientation as practiced
by banks. A bank™s “liabilities” can be thought of as its outstanding debt in
the form of certificates of deposit or the bonds it has issued into the mar-
ketplace and so on. Just as a corporation must successfully pair off its pen-
sion liabilities with a predictable asset stream (a series of cash flows that
generate payments of specific times into the future) and a life insurance com-
pany must successfully pair off its insurance liabilities with a reliable asset
stream, so must a bank be able to generate a pool of bankable assets (so to
speak). In the old-fashioned world of banking the idea was to be profitable




TLFeBOOK
157
Financial Engineering



simply by extending loans (the asset stream) that paid cash flows (coupons
and principal) at rates in excess of wherever banks had to pay (the liability
stream) to attract money (via certificates of deposit and the like) to be in a
position to extend loans in the first place. In the world of more modern-day
finance, a bank™s assets might very well include some loans but increasingly
also might include investments in market securities such as bonds and equi-
ties. Indeed, just as restrictions and guidelines typically exist for types of
investments that an insurance company might engage in (as presented in
Chapter 5), so too do such guidelines and restrictions exist for banks (also
as presented in Chapter 5). These types of restrictions and guidelines exist
on a global basis.
The reason why the term “yield enhancement” might be applied to banks
in particular relates back to the notion of trying to assemble a collection of
assets with an overall yield in excess of the yield that must be paid out on
the bank™s liabilities. There is typically a maturity element to a bank™s asset
and liability streams, and while it may be relatively straightforward to lock
in a long-term loan or purchase a long-dated bond (both being assets), it may
prove somewhat difficult to pair those off with a multiyear CD certificate of
deposit or comparable product. This paradigm of a bank™s generally running
long-dated asset streams against short-dated liabilities gave rise to the notion
of “gap management,” or managing the differences between a bank™s asset
and liability streams. A number of consulting and software responses exist
to assist banks with gap-management and other needs.


Value Investing
Value investing is often described as a process of separating “solid” com-
panies from more speculative ones. A solid company might be defined in any
number of ways, though criteria might include a long track record of steady
earnings, an absence of large fluctuations in equity price, and/or perceptions
of strong and experienced leadership at the helm. Value-oriented funds may
not turn in the same kind of performance as more opportunistic portfolios
when the market is soaring, though they would be expected to do better than
opportunistic portfolios when markets are steady to weaker.

International Fund
An international fund is simply one that makes a deliberate effort to invest
in securities denominated in currencies other than the home market currency.
Thus, an international fund based in the United States might include secu-
rities denominated in yen, euros, Australian dollars, and so forth.




TLFeBOOK
158 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT



Overlay Fund
Many portfolio managers regard the currency decision as being separate and
distinct from the decision-making process of picking individual equities or
bonds. The rationale is that there are very different drivers behind curren-
cies, bonds, and equities and that they are best treated in isolation or quasi-
isolation. The notion that there are different drivers with currencies is
perhaps reasonable, if only to the extent that they do exhibit very different
risk/return profiles relative to equities and bonds. Yet as discussed in Chapter
2 under interest rate parity, there are meaningful links between key interest
rate differentials and currency movements. Some portfolio managers make
the strategic decision to concentrate exclusively on managing bonds or man-
aging equities; they outsource the job of managing currencies or delegate it
to someone who is more expert in that arena.
There are generally three types of currency management approaches:
quantitative, fundamental, and blend. The quantitative approach involves
a strict adhesion to mathematical models that attempt to signal appropri-
ate times to buy or sell particular currencies. A fundamental approach
claims to actively consider factors such as the state of a particular economy
or capital flows or market sentiment. Note, however, that currency port-
folio managers are not slaves to whatever the models might be saying; the
models are intended to complement personal judgments, not override them.
And finally, there are currency specialists who purport to use a particular
mix of the two approaches.
This is not the place to decide if one approach is better than any other.
The debate should be an internal one to the fund concerned, and directed
to which particular approach would be most consistent with the investment
philosophy of the portfolios”at least until it can be proven that one style
alone is always and everywhere superior to all others.
Table 4.4 summarizes the fund types according to product profile. It is
intended to be more conceptual than a carved-in-stone description of the way
that investment funds use various financial products.


A Last Word
Historically investors have described themselves as being equity investors,
bond investors, currency investors, or whatever. While these labels do have
some value in describing the type of investing investors do, their prominence
may give way to other more meaningful types of classifications. That is, per-
haps instead of describing their investing profile by financial products,
investors may describe their investing profile in terms of credit considera-
tions. At one time in the not too distant past, the distinction between these
two phenomena was not that great. For the United States and much of




TLFeBOOK
159
Financial Engineering



Western Europe, for example, highly rated government debt dominated the
bond landscape in these respective markets (if not globally), and equities
commonly were seen as being the higher-risk investment. Today, however,
there are many flavors of bond products, and investors are increasingly
pushed to define exactly what criteria they will use to distinguish between
a bond or an equity. Is the line in the sand whether or not the security car-
ries voting rights? Is it a matter of where the security sits in the capital struc-
ture of the company balance sheet? Is it a consideration of how the security™s
risk/return profile compares to other product types?
In a world where bonds of certain governments actually go into default7
and where some “equities” exhibit less price volatility and greater returns
relative to same-issuer fixed income products, a more meaningful set of labels
may be of help to distinguish one investment philosophy from another. For
example, instead of investors describing themselves as oriented to a partic-
ular product profile (equities, bonds, currencies, etc.) they would describe
themselves as oriented to a particular market risk profile (high, medium, low,
or any other classifications of relevance). In turn, the market risk profile
approach would encompass risks of product, cash flow, and credit.
Why would investors be interested in such a different way of looking at

<<

. 33
( 60 .)



>>