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The Case for Constructing Global Investment Portfolios

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Ignoring foreign markets can substantially reduce the investment choices for U.S. investors The rates of return on non-U.S. securities often have substantially ... – PowerPoint PPT presentation

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Title: The Case for Constructing Global Investment Portfolios


1
The Case for Constructing Global Investment
Portfolios
  • Ignoring foreign markets can substantially reduce
    the investment choices for U.S. investors
  • The rates of return on non-U.S. securities often
    have substantially exceeded those for U.S.-only
    securities
  • The low correlation between U.S. stock markets
    and many foreign markets can help to
    substantially reduce portfolio risk

2
Relative Size ofU.S. Financial Markets
  • Overall value of the total investable capital
    market has increased from 2.3 Trillion in 1969
    to 70.9 Trillion in 2003 and the U.S. portion
    has declined to less than half.
  • This trend is likely to continue

3
Global Bond Portfolio Risk
  1. Macroeconomic differences cause the correlation
    of bond returns between the United States and
    foreign countries to differ
  2. The correlation of returns between a single pair
    of countries changes over time because the
    factors influencing the correlation change over
    time

4
Risk of Combined Country Investments
  • Diversified portfolios reduce variability of
    returns over time
  • Correlation coefficients measure diversification
    contribution
  • Compare correlation of return among U.S. bonds
    and stocks with returns on foreign bonds and
    stocks

5
Summary on Global Investing
  • Relatively high rates of return combined with low
    correlation coefficients indicate that adding
    foreign stocks and bonds to a U.S. portfolio will
    reduce risk and may increase its average return

6
Global Investment Choices
  • Fixed-income investments
  • bonds and preferred stocks
  • International Bonds
  • Equity investments
  • Special equity instruments
  • warrants and options
  • Futures contracts
  • Investment companies
  • Real assets

7
International Bond Investing
  • Investors should be aware that there is a very
    substantial fixed income market outside the
    United States that offers additional opportunity
    for diversification

8
International Bond Investing
  • Bond identification characteristics
  • Country of origin
  • Location of primary trading market
  • Home country of the major buyers
  • Currency of the security denomination
  • Eurobond
  • An international bond denominated in a currency
    not native to the country where it is issued

9
International Bond Investing
  • Yankee bonds
  • Sold in the United States and denominated is U.S.
    dollars, but issued by foreign corporations or
    governments
  • Eliminates exchange risk to U.S. investors
  • International domestic bonds
  • Sold by issuer within its own country in that
    countrys currency

10
Equity Investments
  • Returns are not contractual and may be better or
    worse than on a bond

11
Equity Investments
  • Common Stock
  • Represents ownership of a firm
  • Investors return tied to performance of the
    company and may result in loss or gain

12
Classification of Common Stock Categorized By
General Business Line
  • Industrial manufacturers of automobiles,
    machinery, chemicals, beverages
  • Utilities electrical power companies, gas
    suppliers, water industry
  • Transportation airlines, truck lines, railroads
  • Financial banks, savings and loans, credit unions

13
Acquiring Foreign Equities
  • 1. Purchase of American Depository Receipts
    (ADRs)
  • 2. Purchase of American shares
  • 3. Direct purchase of foreign shares listed on a
    U.S. or foreign stock exchange
  • 4. Purchase of international mutual funds

14
American Depository Receipts (ADRs)
  • Easiest way to directly acquire foreign shares
  • Certificates of ownership issued by a U.S. bank
    that represents indirect ownership of a certain
    number of shares of a specific foreign firm on
    deposit in a U.S. bank in the firms home country
  • Buy and sell in U.S. dollars
  • Dividends in U.S. dollars
  • May represent multiple shares
  • Listed on U.S. exchanges
  • Very popular

15
Purchase or Sale of American shares
  • Issued in the United States by transfer agent on
    behalf of a foreign firm
  • Higher expenses
  • Limited availability

16
Direct Purchase or Sale of Foreign Shares
  • Direct investment in foreign equity markets-
    difficult and complicated due to administrative,
    information, taxation, and market efficiency
    problems
  • Purchase foreign stocks listed on a U.S. exchange
    limited choice

17
Purchase or Sale of Global Mutual Funds or ETFs
  • Global funds - invest in both U.S. and foreign
    stocks
  • International funds - invest mostly outside the
    U.S.
  • Funds can specialize
  • Diversification across many countries
  • Concentrate in a segment of the world
  • Concentrate in a specific country
  • Concentrate in types of markets
  • Exchange-traded funds or ETFs are a recent
    innovation in the world of index products

18
Special Equity Instruments
  • Equity-derivative securities have a claim on
    common stock of a firm
  • Options are rights to buy or sell at a stated
    price for a period of time
  • Warrants are options to buy from the company
  • Puts are options to sell to an investor
  • Calls are options to buy from a stockholder

19
Futures Contracts
  • Exchange of a particular asset at a specified
    delivery date for a stated price paid at the time
    of delivery
  • Deposit (10 margin) is made by buyer at contract
    to protect the seller
  • Commodities trading is largely in futures
    contracts
  • Current price depends on expectations

20
Financial Futures
  • Recent development of contracts on financial
    instruments such as T-bills, Treasury bonds, and
    Eurobonds
  • Traded mostly on Chicago Mercantile Exchange
    (CME) and Chicago Board of Trade (CBOT)
  • Allow investors and portfolio managers to protect
    against volatile interest rates
  • Currency futures allow protection against changes
    in exchange rates

21
Investment Companies
  • Rather than buy individual securities directly
    from the issuer they can be acquired indirectly
    through shares in an investment company
  • Investment companies sell shares in itself and
    uses proceeds to buy securities
  • Investors own part of the portfolio of investments

22
Investment Companies
  • Money market funds
  • Acquire high-quality, short-term investments
  • Yields are higher than normal bank CDs
  • Typical minimum investment is 1,000
  • No sales commission charges
  • Withdrawal is by check with no penalty
  • Investments usually are not insured

23
Investment Companies
  • Bond funds
  • Invest in long-term government, corporate, or
    municipal bonds
  • Bond funds vary in bond quality selected for
    investment
  • Expected returns vary with risk of bonds

24
Investment Companies
  • Common stock funds
  • Many different funds with varying stated
    investment objectives
  • Aggressive growth, income, precious metals,
    international stocks
  • Offer diversification to smaller investors
  • Sector funds concentrate in an industry
  • International funds invest outside the United
    States
  • Global funds invest in the U.S. and other
    countries

25
Investment Companies
  • Balanced funds
  • Invest in a combination of stocks and bonds
    depending on their stated objectives
  • Index Funds
  • These are mutual funds created to equal the
    performance of a market index like the SP 500

26
Investment Companies
  • Exchange-Traded Funds (ETFs)
  • These are depository receipts for a portfolio of
    securities deposited at a financial institution
    in a unit trust that issues a certificate of
    ownership for the portfolio of stocks
  • The stocks in a portfolio are those in an index
    like the SP 500 and dozens of country or
    industry indexes
  • ETFs can be bought and sold continuously on an
    exchange like common stock

27
Real Estate Investment Trusts (REITs)
  • Investment fund that invests in a variety of real
    estate properties
  • Construction and development trusts provide
    builders with construction financing
  • Mortgage trusts provide long-term financing for
    properties
  • Equity trusts own various income-producing
    properties

28
Direct Real Estate Investment
  • Purchase of a home
  • Average cost of a single-family house exceeds
    100,000
  • Financing by mortgage requires down payment
  • Homeowner hopes to sell the house for cost plus a
    gain

29
Direct Real Estate Investment
  • Purchase of raw land
  • Intention of selling in future for a profit
  • Ownership provides a negative cash flow due to
    mortgage payments, taxes, and property
    maintenance
  • Risk from selling for an uncertain price and low
    liquidity

30
Direct Real Estate Investment
  • Land Development
  • Buy raw land
  • Divide into individual lots
  • Build houses or a shopping mall on it
  • Requires capital, time, and expertise
  • Returns from successful development can be
    significant

31
Direct Real Estate Investment
  • Rental Property
  • Acquire apartment buildings or houses with low
    down payments
  • Derive enough income from the rents to pay the
    expenses of the structure, including the mortgage
    payments, and generate a good return
  • Rental property provides a cash flow and an
    opportunity to profit from the sale of the
    property

32
Real Assets
  • Antiques
  • Art
  • Coins and Stamps
  • Diamonds

33
Historical Risk-Returns on Alternative Investments
  • World Portfolio Performance
  • Reilly and Wright (2004) examined the performance
    of various investment alternatives from the
    United States, Canada, Europe, Japan, and the
    emerging markets for the period 1980-2001

34
Reilly and Wrights 2004 Study
  • Asset Returns and Total Risk
  • Positive relationship between rates of return and
    total risk
  • Return and Systematic Risk
  • Beta explained the returns better than did the
    total risk measure
  • Correlations between Asset Returns
  • U.S. equities have high correlation with Canadian
    and U.K. stocks but low correlation with emerging
    market stocks and Japanese stocks
  • U.S. equities have zero correlation with world
    government bonds, except U.S. bonds

35
Real Estate
  • Negative correlation between residential and farm
    real estate and stocks
  • Low positive correlation between commercial real
    estate and stocks
  • Potential for diversification
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