1 FIN 408 -Hybrid Funds Hybrid Funds: Invest in both stocks and bonds, May also invest in convertible bonds and preferred stocks, Generally less risky than the stock funds; may provide better return than the bond funds The level of risk depends on the mix of stocks and bonds, Appropriate for conservative investors.

2 Hybrid Funds Three types of Hybrid Funds:

3 Asset Allocation Asset Allocation: Purpose is to put assets together in such a way as to maximize return at a level of risk consistent with investor’s objectives. Process involves 4 key elements: 1) Investors need to determine the assets that are eligible for the portfolio. 2) Necessary to determine E(R) for these eligible assets over a holding period.

4 Asset Allocation 3) Once returns have been estimated and risk accessed, optimization technique is used. 4) Choose portfolio from efficient frontier, provides maximum return, minimal risk.

5 Approaches to Asset Allocation Three approaches to Asset allocation: Fixed Weight: Fixed percentage of the portfolio to each asset category – 3 to 5 in total. Fixed does not mean equal weight. Common Stock30% Bonds50 Foreign Securities15 Short term Securities 5

6 Approaches to Asset Allocation Allocation does not change over time, may be adjusted after a major market move to keep the desired fixed allocation

7 Asset Allocation Flexible Weight - also known as strategic asset allocation: Weight changes on the basis of market analysis. Favorable domestic inflation forecast compared to foreign may result in revised allocation. Common Stock30% to45% Bonds50to40 Foreign Securities15to10 Short term Securities 5to 5

8 Asset Allocation Weights are changed to capture greater returns in changing market. Tactical Asset Allocation: Form of market timing that uses stock index futures and bond futures to change a portfolio’s asset allocation. Stocks are forecasted to be less attractive than bonds, sell stock index futures and buy bond futures.

9 Asset Allocation Bonds are forecasted to be less attractive than stocks, buy stock index futures and sell bond futures. Requires sophisticated technique, large portfolio, quantitative modeling. Appropriate for large institutional investors.

10 Balanced Fund Balanced fund: Preservation of capital is the main objective Each fund sets its own fixed allocation percentage and discloses them in the investment objective, Traditional balanced fund allocation: 60 % stock; 40% bond bond; Other allocations scheme may be: 555% stock; 35% bond; and 10% cash equivalent. Rarely the leading performers not the worst performer.

11 Convertible Securities Fund Invests in corporate bonds and preferred stocks that can be converted into common stocks The majority of the bond and preferred stock are investment grade securities Small percentage may be invested in nonconvertible corporate bonds, U. S. government securities, foreign securities, and common stocks, Fund is not well known or popular; difficult to understand how the underlying instruments work.