How do you go about investing in equity funds

Equity fund management is often viewed as an easy option, in the long run equities have generally delivered exceptional returns, outstripping other forms of investment in most long term periods. The reality of equity fund management is somewhat different, however, the market is highly competitive, with an increasingly knowledgeable, demanding and sophisticated client base.


Equity fund manager’s returns are constantly compared with other types of investment and to other fund managers. In addition, equity managers are often constrained in terms of which securities they can buy, since they need reliable data for a reasonably long period to enable them to make sensible comparisons. Thus, few mainstream fund managers would have included lastminute.com in their portfolios since little or no analytical data was available for a reasonable time period.

There are many sources of return and risk on equity portfolios. They include, but are no means limited to:
- Country
- Industry Group (energy, Financials, Technology)
- Economic ‘Theme’ (eg consumer cyclicals, defensive, interest rate sensitive etc)
- Beta (ie weighted average beta giving a measure of overall portfolio risk)
- Company size (based on market capitalization)

Objectives: Maximizing returns:

Equity fund managers are broadly divided into two types, firstly those seeking to achieve the highest possible capital return given the charter of the fund. This charter specifies the market and the universe of securities in which it can invest. The other types of manager are looking to provide an element of income for investors, whilst protecting the client’s capital base from the ravages of inflation. In practice, there is little difference in the way analysis is carried out for each, since it, does not really matter whether dividends are paid out or retained.

The difference will come in terms of the actual stocks picked by the fund manager when constructing his portfolio from the list of preferred stocks (those with good prospects) prepared by the asset management’s house analyst. A growth fund manager will be looking to include stock with the maximum potential for capital appreciation in a given time horizon, whereas the income fund manager will be considered to include stocks with a relatively high dividend held in order to achieve the cash flow required for investors.

Both types of managers will be judged against a benchmark. The measure of a successful fund manager is to constantly beat the peer group benchmark. To achieve consistency the equity fund manager and his research assistants must initially identify, and then build a diversified portfolio from stocks that will out perform other stocks in the indices that constitute the peer group benchmark.

Price Appreciation:

The main source of return from equities is derived from increase in the market price. Like any investment, the price of an equity should be equal to the net present value of the cash flow received in the future by the investor, although this model still holds for equities, it is seen as a longer term relationship. In the short term, equity price are often strongly influenced by prevailing general stock market conditions.

The long term relationship holds the key to whether equity is currently over or under priced and is generally analyzed by looking at the earning of the company. This earning may or may not be paid out to the investors in the form of dividends, but nonetheless provide the basis of the fundamental value of an equity. Like any net present value analysis, one of the key factors relates to the interest rate expectations i.e. if interest rates are expected to rise, then the NPV will fall. If earnings are retained, the company can use them to grow the business.

Assuming that it has a sufficient number of new projects in which it can achieve a worthwhile return. If we compare 1988 – 1992, performance of ICI which traditionally paid a high dividend to Microsoft which re-invested corporate earnings in research and development for new products etc. we can see that the Microsoft investor would have benefited hugely for this policy.

Dividends:

Dividends are payments made to investors representing a portion of the firm’s earnings. If earnings are paid out in the form of dividends, and the fund manager does not need them to meet his client’s income needs, then he has the problem of re-investing them to achieve the same rate of returns. In addition, the fund maybe a subject to income tax. It is for this reason and due to the increasing requirement for investment in technology, that there is an increasing trend towards the non-payment of dividends.

Comparing Equities:

Whether interested in deriving good returns from cash flow (in the form of dividend income) or stock price appreciation (through company growth), a major input to an equity analyst security selection process will be corporate earnings which are the post tax profit for the period. These earnings are derived from the company’s profit and loss account as follows:

Sales revenue – cost of sales = gross profit
Gross profit – distribution cost – administration cost = trading profit.
Trading profit + other incomes – interest payable = pre-tax profit.
Pre-Tax profit – tax payable = post tax profit.

This type of breakdown is useful for analysts, since they can more accurately attribute changes in the stock price. Given this importance of earnings to the price of security, they are the subject of detailed study by analysts who will prepare estimate of corporate earnings going out several years into the future.

Administration:

There is a significant amount of administrative work that must be carried out by the fund manager and his assistants to ensure the smooth running and full investment of the fund. Current holdings within the fund will, from time to time, generate dividend payments, which need to be re-invested. This is important since fund managers are generally measured against total return indices, which assume that dividends are reinvested in the market. In addition, valuable rights issues and other corporate actions may occur, which require the fund manager’s attention. Initial Public Offerings may also be offered to the fund manager, which need to be properly administered to meet with various compliance rules.

When carrying out orders on behalf of the client, the fund managers must ensure that all regulatory checks are carried out on a pre-trade basis. Also checked out on a pre trade basis are any client specific restrictions, such as those preventing the fund manager from investing in firms involved in unethical businesses such as tobacco production or weapons manufacture? In addition, the fund manager must on behalf of himself or his firm and that all clients are treated equally. From a post trade perspective, the fund manager must comply with the requirements for corporate ownership reporting as specified in the companies act. Most funds apart from pension funds are subject to taxation.

A fund manager must keep the implications of his client’s tax position in mind when making investment decisions and also at year end. One way to mitigate this liability is to bed and breakfast a stock building up a large capital gain by selling it on the last day of the at ax year and buying it back on the first day of the next. In this way the capital gain is spread over a number of tax years.


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