Investments and Derivatives

Investments and Derivatives

Executive Summary

Problem

All workers face a risk of insufficient real returns on their retirement savings as a result of inflation risk. Therefore, our team has been appointed by the Dubai International Financial Centre to recommend an optimal investment portfolio for expatriate workers in the UAE for their Gratuity Fund.

Solution

To reduce the inflation risk, our team will use the Life Stage Model (LSM) as it gives younger members exposure to classes of assets that have a higher probability of generating high real returns in the long term. For older members, their contributions are invested in asset classes that offer high levels of protection for their capital. Table 1 shows how the contributions of individual workers will be allocated to different portfolios founded upon the various life stages of the members. Individuals in the diverse portfolio stages will be transferred to the subsequent portfolio in four quarterly groups a year prior to the next life stage to ensure that they are not discriminated against by the constant fluctuations in the investment sector. Moreover, we will use a mix of different assets to diversify the portfolio to limit the risk exposure and optimize returns for the employees.

Business model

The investment proposal is for a total of 5000 expatriate workers in the UAE, 250 of whom are between 20-30 years, 750 between 30-40, 2250 aged between 40-50, and 1750 between 50-60 years old. The gratuity fund will be invested in high-return assets that will generate high than average returns that will make profits for the team and the workers.

Competitive advantage

The proposed investment strategy will use the Vanguard 500 Index Investor index as a benchmark to identify opportunities to shift assets and monitor the risk exposure of the entire portfolio. The Vanguard 500 Index will be used as it is low-cost, balanced, and diversified, ensuring that the portfolio will perform well as it will incorporate high-growth assets. The strategy will also use the Modern Portfolio Theory (MPT) to model returns as it maximizes profits and lowers the market risk to the set of underlying assets. Moreover, the team managing the portfolio has been subjected to a rigorous selection process and has a proven track record in portfolio management.

Assumptions

The MPT assumes that asset returns are normally distributed, that investors are rational and risk-averse, that there are no tax and trading costs, and that investors can borrow unlimited capital at the same risk-free rate.

The team

The team comprises of three highly skilled investment analysts who have extensive experience in the investments sector, having worked on various projects for companies like Merrill Lynch, Vanguard Personal Advisor Services and J.P. Morgan with excellent results. Besides, they have won numerous awards and recognitions for their excellence in managing gratuity funds.

Regulations

The proposed investment strategy will adhere to all rules and regulations that pertain to the investment sector in the UAE, including the Federal Decree on foreign investments, the Commercial Agency Law, the Commercial Companies Law, and the Competition Law.

Introduction

An investment is an allocation of capital to an asset or endeavor with an expectation of future profit or income generation. Most employers contribute to employee gratuity funds as a token of appreciation and to cater to the employee’s needs after retirement. Such funds are invested in low-risk assets and earn returns that are payable to the employee on retirement. However, the returns on such investments may get eroded over time as a result of inflation and investment risk. To this end, it is imperative for investment analysts to correctly analyze all risks associated with a particular investment and select and accurately allocate capital to different assets to ensure diversification of the investment portfolio and reduce risk while maximizing returns. This paper will, therefore, put forward a portfolio to manage a $1 billion Gratuity Fund.

All investments are prone to risk, and as such, investors are unable to determine the payoff associated with a particular investment. To this end, investors hold portfolios of uncorrelated assets to reduce investment risk, as portfolio characteristics differ from the characteristics of individual assets. Investors then need to create different portfolios using different combinations of assets, determine the expected return and risk of each portfolio, and select the optimum portfolio that provides the highest returns for the least amount of risk. The yield on the entire portfolio will be determined by assigning a weight to each individual asset held. Holding large portfolios of assets is also beneficial as it reduces the average risk on individual securities within the portfolio.

Main body

When constructing the different portfolios, we will have to select the asset composition of the risky portfolio and decide allocation to individual assets. Historically, Treasury Bills are a safer investment instrument compared to long-term bonds and stocks. However, since high-risk investments provide higher returns, we will diversify the portfolio to accommodate all asset classes. Diversifying the portfolio will help to reduce the aggregate risk and increase the probability of extra returns by reducing the amount of random noise. Diversification also helps in the prevention of adverse outcomes that result from investing a lot of capital in a single asset.

To cater to different clients, we will incorporate both short-term and long-term investments. Therefore, most of the capital will be allocated to bonds and money-market investment instruments as most of the clients are nearing retirement age. Although such assets generate lower returns than stocks, they have less risk of suffering huge losses in the short term. For our younger clientele, we will also incorporate stocks as they have the potential to generate high returns. The portfolio will be rebalanced annually to mitigate the effects of stock market plunges and any other macroeconomic factors that may adversely affect the portfolio returns. In addition, gold, precious metals, REIT, and other instruments will be included in the portfolio to provide a hedge against hyperinflation.

The Modern Portfolio Theory is an investment tool that allows investors to minimize their risk and maximize returns on their investment. For the approach to be implemented, an investor must have estimates of expected future investment returns, co-variances, and variances. However, expected future returns on an investment are difficult to predict as they are dependent on changing investor expectations of stock valuation. The aggregate change in expectations is difficult to forecast as there are many different options to choose from and because they are impossible to observe.

When calculating expected returns, the first step is to use the historical performance of a particular class of assets to calculate its normal returns. For the historical data to produce accurate returns, the data series has to be long, and the asset’s performance has to be constant over a long period. Nonetheless, changing macroeconomic conditions and technological disruptions make it difficult to assume stationarity. Investors believe that accurately estimating one asset class and pricing other assets similar to that class is the best approach of predicting future returns, as assets are priced based on their relative risk. Therefore, one can use the one-year return of a treasury bill as a benchmark for determining expected returns for other asset categories.

However, using historical data to predict future returns on an asset is problematic as historical averages are misleading if the returns change over time, and the historical pricing structure was modified. The approach also takes into account past trends as it is backward-facing at the expense of future changes. We will, therefore, use the Ross recovery theorem, a forward-looking method of determining expected returns to forecast returns for this investment. The approach deviates from the popular belief that derivatives give insight into the future expectations of market participants by disentangling the degree of aversion to risk and the measure of probability. In so doing, we will be able to obtain the marginal probabilities with which to calculate expected returns.

After constructing the portfolios and determining the returns and risks associated with each, the next step is to select the optimum portfolio. After obtaining the expected returns, co-variances, and variances of the portfolios, we will calculate the set of portfolios with the lowest variance, resulting in the efficient frontier. Thereafter, we will calculate the allocation of capital that yields the highest Sharpe ratio, which we will maximize subject to no constraints to obtain the optimal portfolio. Since this investment strategy will use the Life Stage Model, the separation property will be used to determine four different optimal portfolios based on the age and risk profile of the workers.

The LSM will use Aggressive, Moderate, Conservative, and Protected investment portfolios. The workers will be assigned to a category by default based on their age unless they elect otherwise. This investment approach will be used as most members of Gratuity funds are ill-equipped or unwilling to make their own investment decisions regarding retirement funds. The model’s design enables it to balance the risk and return of a fund member from the time of joining to their retirement. LSM will mitigate inflation risk by placing a younger member’s contribution to aggressive and moderate risk portfolios that have high returns, and offering more protection to their investment as they approach retirement age. The asset allocation of the members in the LSM portfolios is shown in table 1.

Younger workers with a long investment horizon have capital growth as their primary investment goal, and as a result, they will be placed in the first stage that targets an annual return of 5.5%. The second stage is focused on offering both the growth and protection of capital for workers with 5-10 years before retirement. The Conservative portfolio option, with a target return of 3%, is for workers with 2-4 years before retirement, while the protected portfolio is for employees with less than two years before retirement.

Conclusions

Each of the portfolios created will use an asset mix of short term treasury bills, cash, emerging markets, commodities, REIT, US Large and Mid-Cap Value stocks, Precious metals, International ex-US Value, Intermediate-Term and Long Term Tax-Exempt bonds, corporate and global bonds, and gold. The asset allocations to the different portfolios are shown in charts 1-4 in the appendix. The assets will be susceptible to income risk, price risk, inflation risk, horizon risk, liquidity risk market, and interest rate risk. However, the aggregate risk to the overall portfolio will be significantly reduced as a result of diversification.

Diversifying the portfolio may complicate the rebalancing process and make it expensive. However, it offsets financial risk and business risk within the portfolio, reducing the probability of a loss in a company or industry-specific asset. However, since inflation and currency fluctuations are experienced industry-wide, diversification will not offset them. Therefore, the portfolio could suffer adverse outcomes from rising inflation rates and falling currency prices as they will affect every asset within the portfolio. Table 2 will outline the projected rates of return for each item on the Aggressive Portfolio.

For members in the Moderate, Conservative, and Protected portfolios, most of their investments will be in Intermediate Term bonds, corporate and global bonds, short term treasury bills, and the International ex-US Value index as they are short-term investment vehicles that have less risk of loss. For members in the Aggressive Portfolio, most of the asset allocation will be in risky assets like cash, US Large and Mid-Cap Value stocks, and Long Term Tax-Exempt bonds as they have the probability of generating high returns over a longer horizon. Additionally, all portfolios will have an equal allocation in commodities, RIET, gold, and precious metals to hedge against hyperinflation.

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Appendix

Table 1

Table 2