Portfolio Theory and Non-Profit Organizations

This assignment delves into the application of Modern Portfolio Theory (MPT) within various financial contexts. It examines the Efficient Market Hypothesis (EMH) and its relevance to MPT. The analysis extends to the practical use of MPT in non-profit arts organizations, exploring their efficient frontier and asset allocation strategies. The provided readings encompass diverse perspectives on portfolio risk modeling, multifactor analysis, illiquidity risk pricing, and government involvement as fund-of-fund sponsors.

CAPITAL MARKETS AND
INVESTMENT
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Table of Contents
INTRODUCTION................................................................................................................................3
RATIONALE FOR THE CHOICE OF THE PORTFOLIO.................................................................3
EVALUATION, EXAMINATION AND APPLICATION OF THE INVESTMENT THEORIES
AND MODELS....................................................................................................................................7
3.1 Efficient market hypothesis theory............................................................................................8
3.2 Capital assets pricing model......................................................................................................8
3.3 Modern portfolio theory.............................................................................................................9
3.4 Investment styles........................................................................................................................9
CONCLUSION BASED ON PORTFOLIO PERFORMANCE........................................................10
REFERENCES...................................................................................................................................12
2

INTRODUCTION
In the current age, companies started operating in the domestic as well as overseas. It attracts
investors to invest their money in the profitable companies so as to get maximum return. However,
the different level of risk and reward on different nature of securities make it essential for the
investors to make rational and informed investment decisions after carrying out an in-depth
analysis. The present project report aims at creating a portfolio comprising minimum of 5 product
or assets for the purpose of diversification and risk minimizing. Moreover, the report will also
present a critical evaluation of various theories of investment like modern portfolio theory, efficient
market hypothesis, capital assets pricing model and others. Lastly, the designed portfolio will be
evaluated in terms of both the risk and return so as to satisfy the investor return expectations.
RATIONALE FOR THE CHOICE OF THE PORTFOLIO
Portfolio comprises various securities which investors are looking to incorporate for the
investment purpose. There are different types of securities that can be included for the portfolio
construction such as equity, bond, liquid assets like mutual fund, commodities like gold and fixed
income bearing securities as well (Ambrosin and et. al., 2015). Here, with the presented situation, a
portfolio has been designed keeping into account the risk-averse profile of the investors.
Assets allocation: Before making the investment decisions, assets allocation basis needs to
be decided by the investor keeping into account their willingness or ability to accept risk for the
portfolio (Tong, Hu and Hu, 2017). Here, as said earlier, that investor is risk-averse and tries to
minimize the risk as much as he or she can, therefore, assets allocation has been created here as
follows:
Initial investment 150000 Proportion/weight
Bond 45000 30.00%
Equity 22853.5 15.24%
Mutual fund 52146.5 34.76%
Fixed interest 15629.0 10.42%
Commodities (Gold) 14371 9.58%
Total 150000 100%
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Interpretations:
From the chart, it can be seen that it has been decided to give high weight to the liquid
funds. It is because, by investing in mutual funds (M/F), investor can minimize the overall risk of
the portfolio via diversifying the securities. By the purchase of mutual fund, investor can get benefit
of instant diversification as his money is combined with the other investors and invested in varying
securities to provide better yield (Standaert and Manigart, 2017). In the above table, 35% weightage
has been given to the mutual funds afterwards, second maximum allocation has been made to the
bond to 30%. It is because, they are considers as larger safer investment in comparison to the stock
(Auer, 2016). Moreover, they has less impact of daily volatility and at the same time, it deliver fixed
regular return to the investor. However, on the other hand, equity is consider risky investment
because shareholders do not have any right to take back their money, if firm bankrupts or fails
(Kenfack and et.al., 2016). At the same time, dividend highly fluctuates on the basis of volatility in
the earnings and movement in the stock market. Therefore, equity has been given a weightage of
15%. Apart from this, 10.42% and 9.58% funds has been allocated to the fixed interest and gold
commodity.
There are multiple reasons due to which multiple assets are included in the portfolio. Some
of the reasons due to which specific security is included is explained below. Bond: Investment of 30% is made on the bond out of total investment amount. Investment
in the current time period on different products is very risky. This is because currently,
financial markets are not stable and investors are losing money on equity and other highly
risky securities. Thus, in order to hedge position against market risk 30% of investment is
made in the bond (Peltomäki, 2017). However, return on investment is always low in the
bond but in order to secure principal amount corpus 30% is allocated to bond. It is assumed
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that investor is risk averse in nature and market is unstable due to which investment must be
secured. It can be noted that in case of most of stocks beta value is much higher and is above
0.70. In case of some stocks it can be observed that beta value exceed 1. This clearly shows
that in case stock market will be bearish investor will lose huge amount of money on the
invested amount.
 Equity: Investment of 15.24% is made in the equity which is the small percentage of the
invested corpus. Equity is assumed as one of the risky and highly return generated
investment avenue. There are multiple reasons due to which equity is included in the
portfolio and its proportion is kept low in the portfolio. Equity is included in the portfolio
because only by keeping debt in the portfolio sufficient amount of return cannot be
generated on the invested amount (Guerrien, 2011). It can be observed that most of the firms
that are constitutes of the FTSE index have high beta value and due to this reason few firms
are taken in the portfolio. In order to elevate profitability in the portfolio low proportion of
amount is allocated to equity. It is ensured while selecting firms that they have moderate or
high beta value with strong finance fundamentals in the current time period. Software and
tourism are the two industries that are growing at rapid rate in the UK. Thus, due to this
reason two firms namely Intercontinental hotel and Sage group as well as Associated British
foods are included in the portfolio. There is great demand of cars in UK and its economy is
coming on growth track. Due to this reason it is expected that in the upcoming time period
demand of cars increased. Thus, Admiral Group is included in the portfolio. It can be said
that equity portfolio is well diversified and firms are prudently selected in same on the basis
of growth prospective that are present in the specific industry. Reasons for selection of firm
is given below:
1. Associated British foods (ABF)- Associated British foods is a public limited company which is
mainly in food processing retail industry, founded in 1935. There headquarters are Weston Center.
This firm mainly supply food and ingredients. There revenue is 13399 million euro in 2016. Return
of 19.42% and there beta are 1.15.
2. Admiral group (ADM)- It is a motor insurance company with its headquarter in Cardiff, Wales.
Its total revenue is 1016.8 million euro and there operating income is 289.8 million euro and there
net income is 214.1 million in 2016. This company have there return is 7.71% and there beta is
0.637.
3. Baratt Development- It is operating in the home construction business. With elevation in
economic growth of the UK demand for homes will increases in the upcoming time period. Hence,
it is expected that firm will earn good amount of return in the upcoming time period. This company
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have return is 12.51% and there beta is 0.6483. Hence, mentioned firm is included in the portfolio.
4. Intercontinental hotels- It is a British multinational hotels, company headquarter in Den-ham,
UK. It is founded in 2003. It provide hospitality problems. Its total revenue is 1715 million dollar in
2016 and operating income is 707 million dollar in 2016 and its net income is 417 million dollar in
2016. Intercontinental hotels is taken in portfolio as it is working in the tourism industry. Return of
33.85% generated and there beta are 0.9699. Thus, by considering past performance of stock,
anticipated high growth of industry and high beta value it is expected that good amount of return
can be generated by the mentioned firm. Due to this reason mentioned firm is included in the
portfolio.
5. Sage group- It is commonly known as Sage, it is a public limited company, which is software
industry. There headquarters in Newcastle upon Type, England, UK. There revenue is 1569.1
million euro and operating income is 427 million euro in 2016. Beta value is 1.1388 and there
return is 5.91%. So that this firm, included in the portfolio. Mutual fund: Mutual fund is also selected in the portfolio and its proportion in same is kept
at 34.76%. As mentioned above investor wants to minimize risk and due to this reason
investment of mention percentage is made in the mutual fund. It must be noted that when
investment is made on the debt funds then it means that 10% to 20% is made in equity out of
entire corpus that is invested in the debt scheme (Auer, 2016).. Thus, with risk management
moderate return is also earned on the debt funds. Due to this reason substantial portion of
investment is made in the mutual fund scheme. By doing so it is ensured that risk will be
minimum and moderate risk will be earned on the investment. Thus, portion of 34.76% is
allocated to mutual fund scheme in the portfolio. Fixed interest: After making investment in all securities remaining amount is invested in the
bank product at interest rate of 2.50%. Investment in the saving account is not exposed to
market risk and due to this reason it can be said that it is wise decision to make investment
in bank product.
 Commodity: Investment in gold is made because it is observed that when investment in
shares declined received proceeds are invested in safe heaven which is gold. Thus,
9.58% of portfolio is invested in the gold (Tong, Hu and Hu, 2017). This is done to
ensure that in case decline will be observed in the FTSE then in that case loss faced on
equity will be offset by gain that is made on gold.
S.NO Companies Price
Return (%) y-o-
y Beta Industry
1
Associated British foods
(ABF) 2709 19.42% 1.15 Tourism
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2 Admiral group (ADM) 2029 7.71% 0.637 Car insurance
3 Barratt development (BDEV) 572 12.51% 0.6483 Home construction
4 Intercontinental hotels (IHG) 3934 33.85% 0.9699 Tourism
5 Sage group (SGE)
663.
5 5.91% 1.1388
Software and computer
service
Companies Price Stocks
Total
investment
Expected
return Weight
Associated British foods (ABF) 2709 1 2709 22.18% 11.85%
Admiral group (ADM) 2029 1 2029 5.27% 8.88%
Barratt development (BDEV) 572 3 1716 8.46% 7.51%
Intercontinental hotels (IHG) 3934 4 15736 32.86% 68.86%
Sage group (SGE) 663.5 1 663.5 6.59% 2.90%
22853.5 100.00%
Companies Price
Expected
return Stocks
Expected
price
Capital
gain
Total value
at end
Total
capital
gain
Associated British
foods (ABF) 2709 22.18% 1 3310 600.94 3309.94 601
Admiral group (ADM) 2029 5.27% 1 2136 107.01 2136.01 107
Barratt development
(BDEV) 572 8.46% 3 620 48.40 1861.21 145
Intercontinental hotels
(IHG) 3934 32.86% 4 5227 1292.76 20907.04 5171
Sage group (SGE) 663.5 6.59% 1 707 43.73 707.23 44
Total 6068
New value 28921.43
Opening
value 22853.50
Gain/loss 6067.93
S.NO Companies Price
Return (%)
y-o-y Beta
Expected return
Rf + beta(Rm-Rf)
1 Associated British foods (ABF) 2709 0.1942 1.15 22.18%
2 Admiral group (ADM) 2029 0.0771 0.637 5.27%
3 Barratt development (BDEV) 572 0.1251 0.6483 8.46%
4 Intercontinental hotels (IHG) 3934 0.3385 0.9699 32.86%
5 Sage group (SGE) 663.5 0.0591 1.1388 6.59%
Here, Risk free rate is 1% in UK.
Bon
d Item Price Number of units Total value
CAG
R
End
value
Capital
gain
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UK Gilt Treasury Stk 5% 104.351 431 45000 9 49050 4050
Mutual fund Liquid fund 1 2 3 4 CAGR Value at end Capital gain
1 Premier UK money market fund 23.3 10 11 13 14.325 59616.48613 7469.98613
Commodities
(Gold) Gold CAGR
Final
value Lots
Earlier
price Final price
Total capital
gain
1 1026.5 0.48% 1031.39 14 14371 14439.4886 68.48859975
Year Price of gold per ounce % change
2013 1025
2014 733.2 -28.46%
2015 768.3 4.80%
2016 714.8 -6.98%
2017 947.3 32.54%
CAGR 0.48%
Fixed interest Value at end Capital gain
1 2.50% 17683 2053.8
EVALUATION, EXAMINATION AND APPLICATION OF THE
INVESTMENT THEORIES AND MODELS
Theories and models of the investment provide an idea about the operations of capital
market. There are various theories of investment such as efficient market hypothesis (EMH),
Capital assets pricing model (CAPM), modern portfolio, investment style etc. that have been
enumerated underneath:
3.1 Efficient market hypothesis theory
In the field of financial economics, EMH theory stats that stock prices are presented by the
available set of information. Thus, it is not possible for the investor to beat the market by the risk-
adjusting practices because the price of the underlying security fully incorporates all the available
data set. The theory has been propounded by Eugene Fama in the year 1960 demonstrates that stock
can be traded at their true (fair) value hence, there is no any way for the investor to bargain the
prices (Auer, 2016). The supporters of the theory presented that EMH makes it impossible for the
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capital investors to either buy undervalued stock or dispose off their stock at the inflated prices.
Thus, it is pointless to find out the undervalued stock or forecast the future trend through technical
and fundamental analysis. However, the critics argued that as per the theory of EMH, investors only
look towards the historical prices, earnings and past track records, it is because, prices are heavily
influenced by the expectations of the users. Thus, it just simply states that past stock price has a
great impact on the future price (Guerrien, 2011).
It has three forms, weak-form, semi-strong form and strong –form of efficiency. In the first,
future year’s prices cannot be forecasted using historical year’s prices and investor will not be able
to get an excess return through performing technical & fundamental analysis and various
investment strategies (Ang, 2011). However, in the semi-strong form, the prices of the stock fully
adjust the publically available data set. Lastly, in strong-form, price reflects all set of information
and it is often exists in the existence of legal barriers and trading legislations. The theory also has
been criticised due to information biasness (Baker and Riddick, 2013). Besides this, the joint
hypothesis problem presents that it is impossible to test the efficiency of the market. Moreover,
return can only be increased by taking more risk in such situation; expected return will be less in
comparison to other securities which holds more stability.
3.2 Capital assets pricing model
CAPM theory presents the relationship between the expected estimated return and the
systematic investment risk. The model is based on the following equation, stated below:
Expected return = risk free rate + beta ( market risk – risk free rate)
Here, beta is measurement to assess and evaluate the volatility in the market and its impact
on the return. 1 value of it state that stock price moves exact as per the market trends however,
value below 1 indicates less volatility in the market or vice-versa (Dhrymes, 2017). The idea behind
invention of CAPM model is that investors can be compensated in two ways that are risk and time
value of currency which is presented by the Rf. On the other side, difference between market and
risk free rate shows premium that is presented by the SML (security market line). SML indicates the
level of systematic risk on different types of securities along with the expected return. The theory
suggests investors that they can create a diversified portfolio by incorporating riskier assets with the
less risky securities so as to minimize the overall risk of the portfolio (Cao, Han and Wang, 2017).
Modern theories suggests that systematic risk can be mitigated by the help of diversification,
however, in the actual corporate scenario, it is founded that systematic risk cannot be eliminated by
any way therefore, CAPM model is often used by the investors to quantified and analyse such risk
in the portfolio. As per the theory, DCF method is considered as the best model for the evaluation of
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risk and return, in which, future year cash flows are discounted at the WACC (KUEHN, Simutin
and Wang, 2017).
3.3 Modern portfolio theory
This theory is helpful for the investors to maximize their total expected return on the
portfolio by minimizing the risk inherited. MPT model suggests that it is impossible for the investor
to design an efficient frontier that will give greater yield at a given level of risk. The theory assumed
that investors have rationale behaviour and they are risk-averse also. This is the reason why they are
intended to minimize their total risk on the investment to get the expected yield. It is also referred as
the portfolio management theory which believes that efficient frontier can be designed to gain
maximum return at a given level of risk (Chen, 2016). Thus, here investors can put money in more
than one securities and thereby reap diversification benefits so as to minimize their risk on the
portfolio. In this, various components such as beta, alpha, r-squared, standard deviation and sharpe
ratio can be used for making an analysis of the risk-return relationship on different kind of securities
(Grasse, Whaley and Ihrke, 2016).
3.4 Investment styles
In accordance with this theory, active investors are those who need professional money
managers to carefully choose their securities, in contrast, passive management do not depends upon
the professional money managers for deciding the investment structure to gain maximum yield.
However, the second style is value or growth investing, in which, investors make decisions whether
they are interested in investing money in fastly and rapidly growing companies or underpriced
firms, for such purpose, they examine the financial metrics (Del Viva, Kasanen and Trigeorgis,
2017). The growth style showcase exceeding earnings, high return, greater profit margin whilst, in
contrast, value style focuses on acquisition of a firm at a good price therefore, they consider less
price to earning ration, greater dividend and low price to sales ratio.
Lastly, under the small or large cap, they measure company’s sizes which are measured in
the terms of market capitalization. It is computed by multiplying the total number of outstanding
shares with the price of the stock (Peltomäki, 2017). Some of the investors believe that small sized
companies have higher opportunities therefore; they put money in small cap firms to drive better
return. On the other hand, risk-averse investors are interested in their fund security by putting
money in large cap stocks because they are well-established and have strong competitive position.
Here, they expect moderate or slightly less return in comparison to the small caps.
CONCLUSION BASED ON PORTFOLIO PERFORMANCE
Securities Amount Income Capital gain Capital gain %
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Bond 45000 49050 4050 20.55%
Liquidity 52146.5 59616.48613 7469.99 37.90%
Fixed interest 15629 17683 2054 10.42%
Equity 22853.5 28921 6068 30.79%
Commodities (Gold) 14371 14439 68 0.35%
Total 150000 169710 19710 100.00%
From the developed portfolio, it has been founded out that investor will receive highest
capital gain from the liquid securities, mutual fund premier UK money market fund. As the
above presented table demonstrates that capital gain %age from the liquid securities is
derived to 37.90%. Thereafter, equity delivered highest CG to 30.79% because of the rationale
choices of investment in stock of the ABF, Admiral Group (ADM), Barratt Development
(BDEV), Intercontinental hotel Group (IHG) and Sage Group (SGE) and appropriate weight
assigned on the basis of beta and year on year return (He and et.al., 2016). However, on the
other side, on the bond and fixed interest securities, potential capital gain has been computed
to 20.55% and 30.79% respectively. Lastly, on gold commodity the expected capital gain is
lowest to 0.35%.
Initial investment 150000
Weight
(W)
Expected return
E(R) Total return
Bond 45000 30.00% 9% (30.00*9%) = 2.700%
Equity 22853.5 15.24% 27% (15.24*27%) = 4.045%
Mutual fund 52146.5 34.76% 14% (34.76%*14%) = 4.980%
Fixed interest 15629.0 10.42% 13% (10.42%*13%) = 1.369%
Commodities (Gold) 14371 9.58% 0.48% (9.58%*0.48%) = 0.046%
Total 150000 100%
As per the results, it can be seen that there is highest yield expected to be generate by the
investor on equity securities as it is computed to 27% which is comparatively higher from others.
Good performance, high earnings, favourable movement in stock prices and less risk are the reasons
behind better yield. However, mutual fund and fixed interest bearing securities will gain an annual
return of 14% & 13% respectively. Besides this, on the bond, it is expected to have an annual return
of 9% computed to 2.7% weighted return (Sekhar, 2017). On the commodity gold, it is computed to
the lowest to 0.046% because of lower compounded annual growth rate (CAGR) of 0.48%. Thus,
the weighted return of the portfolio is computed to the 0.046%. From the results, the portfolio return
is computed here as follows
Portfolio return = 2.7% + 4.045% + 4.980%+ 1.369% + 0.046%
= 13.140
As per the findings, it is identified that the designed portfolio will generate a return of
13.14% from all the securities in which investment will be made by the investor. It is near to the
annual return on the FTSE 100 as currently, it is 15.16% at a closing price of 7327.59GBP (FTSE
11

100 Index’s share price, 2017). Hence, after evaluating the results, it becomes clear that the
designed portfolio will drive good return to the investor and drive good return for the risk taken by
investing the money.
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REFERENCES
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Chen, J.M., 2016. Modern Portfolio Theory. In Postmodern Portfolio Theory. Palgrave Macmillan
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Del Viva, L., Kasanen, E. and Trigeorgis, L., 2017. Real Options, Idiosyncratic Skewness, and
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Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection.
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Kenfack, H. and et.al., 2016. The pricing of illiquidity risk on emerging stock exchange markets: A
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KUEHN, L.A., Simutin, M. and Wang, J.J., 2017. A labor capital asset pricing model. The Journal
of Finance. 12(3). pp.16-39.
Peltomäki, J., 2017. Investment Styles and the Multifactor Analysis of Market Timing
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Standaert, T. and Manigart, S., 2017. Government as fund-of-fund and VC fund sponsors: effect on
employment in portfolio companies. Small Business Economics. 12(4). pp.1-17.
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Tong, J., Hu, J. and Hu, J., 2017. Computing equilibrium prices for a capital asset pricing model
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