Reference no: EM131844313

Scenario: Review of the BIT balanced option

You have been hired as the lead consultant for the review of the balanced option. BIT have several questions regarding possible approaches they could use in managing the various asset class exposures in the balanced fund.

Answer all questions - The questions are based on the BIT Fund case study.

Question 1 -

(a) (i) Monthly cash flows into the BIT fund can be large relative to the size of the fund. Explain the difference between time-weighted return and money-weighted return methods and discuss which measure is most appropriate for the fund manager to use.

(ii) Calculate the arithmetic and geometric returns of the fund over the time frame given and discuss why the results are different. Which of the methods noted above is the industry standard for quoting annual returns and why?

(b) Using the information provided (see Appendix 1), calculate the following statistics for the two Australian equity funds, Fund A and Fund B:

(i) Sharpe ratio and

(ii) Treynor ratio.

(c) Analyse the risk performance of the 2 funds including an explanation of the statistics calculated in (b) and primary difference between what each statistic measures.

(d) Briefly discuss the growth investment style by looking at:

• The characteristics of a growth company.
• What metrics are used to determine growth companies?
• Which sectors they are generally found in?
• The level of dividend yields compared to value companies.
• When can growth stocks be expected to out-perform value stocks in terms of the economic cycle and why?

(e) Using the following share data for Winchester Ltd (WIN) calculate whether the shares can be regarded as trading above or below valuation using the CAPM methodology?

risk-free rate = 4.0% p.a.

betaWIN = 1.25

market premium = 4% p.a.

current WIN share price $12.00

WIN 12 month share price expectation = $13.50

no dividend expected over the next 12 months.

(f) Briefly discuss the objective of active asset allocation and arguments in favour active asset allocation and the arguments against this strategy? Do studies support the practice of market timing?

(g) Below is a list of the six (6) factors that constitute the MSCI Factor Indexes and provide building blocks that allow investors to assemble multi-factor allocations based on their preferences for performance and risk, their investment beliefs on individual factors, and their investability constraints.

Choosing any three (3) of these factors, describe the factor and explain what metrics are used to evaluate the factor?

• Value
• Low Size (Small Cap)
• Momentum
• Low Volatility
• Dividend Yield
• Quality

(h) Describe two factors that affect a bond's duration and determine whether an increase in these factors will increase of decrease bond duration, assuming the bond is trading at par?

(i) What is convexity and how is it used when calculating duration?

Question 2 -

Analysis of BIT's fund performance has highlighted that the international exposures of the portfolio have performed poorly in comparison to benchmarks and peers.

(a) Currency weighs heavily on the minds of the trustees and the IC wants you to revisit the current policy. Explain why international equities I the portfolio are un-hedged, while international fixed interest is fully hedged. Comment on whether you think this approach is appropriate or not.

(b) The current international equity allocation is split 85% developed markets and 15% emerging markets.

Motivate a case for increasing the emerging market exposure from the current level.

(c) The investment committee notes that the international equity allocation is over-weight (+5%) and near the top of the allocation range for the asset class. However, before re-balancing they want a view on potential returns from international equities. The have asked for 2 separate methods to be used in determining the expected return using the following inputs:

• dividend = $25 (current year)
• price = $950
• growth = 4.5% p.a.
• long-run PE ratio = 16.0 times
• current PE ratio = 17.5 times
• PE reversion term = 10 years.

Forecast the expected annual return using the Gordon Growth Model and the Bogle Model and explain the reason for any difference between the calculated returns.

(d) Provide a brief overview of what is meant by an ESG overlay to an investment process as well as whether any research is available to support the addition of this overlay to a manager's process in terms of additional returns?

Question 3 -

(a) (i) BIT have been considering the use of index funds for the fund's equity exposures (both Australian and international) to minimise tracking error in the portfolio and reduce costs. They believe their active managers have not achieved the outperformance to justify the fees paid.

As such, the IC wants to review the current policy, whereby equities are actively managed and bonds are indexed. Provide the IC one (1) advantage and one (1) disadvantage of using active managers and motivate the argument for taking an active approach with fixed interest exposures.

(ii) On occasion BIT's funds may receive significant, one-off cash flows, which remain in cash until the next unit price is calculated. Instead of maintaining the exposure to cash over this short period of time, the funds are able to gain exposure to equity market returns by purchasing futures over the S&P/ASX 200.

Discuss the use of futures in this situation, including the advantages of utilising such instruments?

(b) (i) The IC has asked for guidance as to whether the fixed interest allocation should be split evenly as opposed to the current 15% domestic and 5% international exposures. One of the considerations is the expected return for the asset class. Currently your company forecasts a parallel shift upwards in the yield curve for domestic interest rates of 0.5% and a parallel shift upwards in international fixed interest yield curve of 1.5%.

Assume duration of the markets is the same.

Under these assumptions would you motivate an increase change in the fixed interest allocation to international exposures? Motivate your answer and explain how a fixed interest fund manager might change their portfolio if they expect the above scenario?

(ii) Recently the fixed interest allocation was changed from allowing only government bonds in developed countries to any bonds that have an S&P rating of A- or above. This is 3 notches above the lowest rating for investment grade.

Discuss how this policy change might affect the make-up of the fixed interest portfolio and explain the risk and return implications of this change for the portfolio.

(iii) Briefly describe the impact of increasing inflation on the fixed interest asset class and what investments and/or strategies may be available to help hedge a portfolio from this risk?

Question 4 -

(a) In your meetings with BIT, the trustees have expressed interest in significantly increasing their exposure to hedge funds. They are interested in the defining characteristics of hedge fund. List six defining characteristics and provide a brief description of the characteristic.

(b) (i) Dividend and tax information for Fund D is provided in Appendix 1.

Calculate the franking credits generated for the fund as well as the post-tax yield of the holding for BIT (assuming the holding is part of an accumulation portfolio in superannuation). (Note: Show all workings.)

(ii) Discuss one (1) strategy which the fund manager might employ going forward in order to increase the tax-effectiveness of the fund.

(c) The IC is considering purchasing a direct property asset for the Australian property allocation and needs some valuations to consider the appropriateness of the offer price of the asset. They provide you with the following data: NOI $1.5m; cap rate on similar buildings using recent transactions is 6.5%.

(i) What is the cap rate and how does this compare to the risk-free rate?

(ii) Value the property using the cap rate?

(iii) Describe (briefly) the DCF method for valuing a property and discuss the differences between DCF and the cap rate method of valuation.

(d) Calculate the net proceeds on the sale of shares from the portfolio from the BIT fund (assuming the holding is part of an accumulation portfolio in superannuation) that yields the lowest capital gains tax given the following parcels:

• Parcel A - 40,000 shares, held 24 months, cost base $18,
• Parcel B - 40,000 shares, held 9 months, cost base $20.
• Parcel C - 20,000 shares, held for 2 months, cost base $21

The fund manager is looking to sell 40,000 shares at $25.

Attachment:- Case Study.rar