Corporate Finance

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Case Study: Planning and decision making associated with the development of a selfmanaged superannuation fund1 On account of the high management fees and recent poor return performance associated with his employer-sponsored superannuation fund, Les Risky has decided to supplement these savings by starting his own self-managed investment fund. Les considers himself to be  relatively knowledgeable regarding financial markets, including the share market and thinks that he can identify profitable share investments as well as so-called professional fund managers can. Les plans to start this investment fund with $10000 of his own savings and will allocate an additional $100 per week from his salary to expand the fund's holdings and investments.

Les has decided to concentrate on investing in shares listed on the Australian Securities Exchange (ASX), as he is most familiar with this market and believes that shares will provide
a higher long-term return than other investments such as property or infrastructure assets. At the moment he is weighing up two possible investment strategies to apply to his investment
funds. These are:

 to invest directly in a portfolio of individual company shares from a variety of industry
sectors, which he plans to personally research and choose.
 to invest indirectly in Australian company shares through industry-managed funds (such
as Colonial First State, ING Australia, AXA Australia Investments, Bankers Trust and

Macquarie Managed Investments). These funds normally invest in a diverse portfolio of shares tracking a particular performance indicator, such as the All Ordinaries Index or the
S&P/ASX 200 index. As a result of Les's disappointment with the performance of his employment-based superannuation plan, which has a similar profile to the second strategy just listed, Les is
favouring the first idea of stock-picking his own personal portfolio of company shares. After some initial research, Les has narrowed his list of preferred investments to the following
companies:

1 Prepared by Darren Henry, La Trobe University. Copyright © McGraw-Hill Australia 2012
Table 1: List of companies

Les has intentionally chosen companies from a range of different industry sectors to try to maximise the potential diversification benefits in forming his investment portfolio, and will look to widen the number of companies included in his portfolio as he invests more funds in
the portfolio through his salary contributions. As part of Les's preliminary analysis of desirable company investments, he accessed historical share price information on his chosen companies and calculated total return and standard-deviation measures, and beta coefficients for prediction purposes using individual share and market-return data for the previous financial year as shown in Table 2.
Using this daily return information, Les also attempted to determine the relationship between the daily share-price movements of these companies by calculating their relative correlation coefficients:

Les has found this information useful for evaluation purposes, but owing to the short time frame of the information he is uncertain about its reliability, and the likelihood that similar share returns will be provided by these companies in future years. He does, however, accept that he could invest in an index-matched managed fund and earn an average long-term return similar to that provided by the All Ordinaries Index. Les is also concerned about the potential risk exposure associated with a small portfolio of shares and is looking to minimise the risk of his portfolio as much as possible.
Les is now at the stage of finalising his initial investment choices and structuring his investment fund, and he has asked for your advice in answering the following questions:
Answer all the questions:
1. Traditional risk and return concepts suggest that a positive relationship should exist between the risk associated with an investment security and the relative return that it provides to the holders. Review the return and standard-deviation information provided in the Table 2, and outline whether Les's selected companies provide results consistent with this expected positive relationship between risk and return. Specify any companies that appear to violate this relationship and should be rejected as investment choices by Les. Also, outline whether the concept of portfolio theory holds—that portfolio risk is minimised by holding a well-diversified portfolio of shares (such as the All Ordinaries Index portfolio). 20 Marks

2. Les has decided to construct his initial portfolio employing equally weighted investments in three of his chosen company shares. Using the above information, recommend to Les the three company shares that he should invest in, taking account of his desire for a portfolio return at least equivalent to that of an index-matched fund while also minimising his risk exposure. Using the historical information provided for the financial year, calculate the actual return and standard deviation of this portfolio. Does it outperform the market-wide All Ordinaries Index over this period? Use the Sharpe and Treynor ratios to evaluate the portfolio on a risk-adjusted basis by benchmarking against the All Ordinaries Index (Note: the average return on 90-day bank bills was 5.20 per cent over this period).

3. As a check on his company selections, Les would like to review the performance of his chosen companies, over this period, against a well-respected asset pricing model. Apply the capital asset pricing model (CAPM) equation, using the data provided above, to predict the expected returns of these shares for the financial year. Compare the companies' actual return performance with that expected by the CAPM, and outline what these results suggest about the accuracy of the CAPM as a return-estimating model. Do your portfolio selections agree with the results of this CAPM evaluation?


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