The current economic situation of UK - Essay Example

Introduction The current economic environment is considered as one of the challenging environments wherein there has been an economic meltdown and world is potentially going through a recession. The overall investor confidence is therefore relatively shaky as the overall investment environment is becoming more volatile in nature. The economic performance of the UK’s economy during last 2 years is considered as not impressive as the forecasts for economic growth are indicating the economy will grow at really sluggish rate. Such environment therefore require that the investment management strategies must be designed in such a manner that they can protect the investors capital and must also provide consistent returns that are in-line with the expectations of the investors. Morris Capital is going to face a situation in which there may be a gap between its inflows and outflows and as such its liquidity may be drained in coming periods. Based on this, it is estimated that the fund withdrawals will be 3% more than the inflows received by the firm owing to the fact that its investment strategy allow investors to start withdrawing the funds after five years. Considering this situation, the Investment Committee of Morris Capital is going to meet in March 2010 to further discuss the strategic allocation of the assets as well as outline the future course of action. This report will therefore provide an overview of the current investment environment and provide alternatives for plausible asset allocation along with the recommendations for the future course of action that may be taken. Current economic situation The current economic situation of UK is relatively more unstable owing to the financial meltdown that occurred during 2007. The overall situation is not considered as healthy as the estimates indicate that the UK’s economy will grow at a very sluggish rate as IMF’s forecasts indicate that the UK’s economy is its worst after 1930s. During 2009, UK’s economy experienced a growth rate of just 0.1%1 during the last quarter of 2009 indicating the overall state of the economic conditions. Source: Office for National Statistics, UK The above graph indicates that for year 2009, the UK’s economy experienced negative growth whereas the economic performance started to worsen during the last quarter of 2007. Though the forecasts for the current year are positive however, UK economy as a whole will still be experience a growth rate of 0.2% during 2010 and as such there is a very low probability that the investors’ confidence will remain high in such volatile economic environment.(Swint,2009). Further, UK is also facing budget deficit and there is a growing political pressure and concern regarding the overcoming of the deficit as early as possible and as such it is expected that the new government may be announcing some relief for the consumers as well as investors to further ease up the tight economic situation faced by the country. UK’s budget deficit went as high as £90Billion during 2009 which is expected to cause a drastic cut in the government spending.(Seager,2009). Thus the overall environment for investment may suggest that the overall strategic direction of the investment management firms and their investment strategies must be re-designed to ensure that the investors remain insulated from the adverse economic shocks. Asset Management Industry in UK Asset Management industry is generally considered as more popular because it attempts to minimize the various risks and offer consistent streams of cash flows to its investors on regular basis. Due to these inherent characteristics of the funds, those investors who are risk averse often tend to invest more in funds rather than investing directly into equities or other instruments.(Hodge,1995). However, despite the fact that funds are considered as relatively more secure in terms of their risk profile, there are still chances that the fund may not be able to offer the desired results to the investors. The current economic situation therefore clearly indicates that the fund industry is also being hit due to the adverse economic situation, low interest rates, and low performing stock exchanges. The overall size of the asset management industry in UK is approximately £3000 Billions with 30 companies managing almost 580 funds in the market.2 The total gross sales of all the asset management firms for the year ending on 31st Dec 2009 is well above £11.00Billion showing an increase on year on year basis. Such high volume of the industry indicates the overall depth and breadth of the industry and its reach and influence in the market. It is also because of this reason more than 15 million investors have invested their funds through asset management firms to manage their wealth and provide consistent streams of cash flows to them. According to the Investment Management Association, the asset management industry in UK is classified four broader classes including capital protection, income, and Growth as well as Specialist funds. These classes therefore further decide upon their relative investment strategies and invest into securities that suit their overall investment objectives as well as risk profile. It has also been argued by the Investment Management Association that the UK’s overall competitiveness is relatively not good as compared to the asset management industry in other parts of the world. To allow the asset management companies to become more competitive, it has been recommended that the stamp duty on the funds shall be abolished and a new type of fund called “Contractual fund” will enable the industry to become more competitive in the long run. (www.investmentuk.org) The above discussion therefore indicates that despite the economic downturn, funds were able to procure more business as well as earn higher returns for their investors. However, there still remains a doubt over the future economic performance of the economy as a whole which may directly or indirectly affect the performance of the funds. What is also significant to understand that the overall asset composition and allocation strategies of the firms must also be tailored in a manner that they continue to provide the desired cash flows to their investors while at the same time keep their overall risk profile in control so that the investors remain protected against the adverse economic shocks. Morris Capital A closer look at the asset allocation of the Morris Capital will suggest following composition of portfolio: This composition of portfolio indicates that the fund has the largest investment into UK equities followed by the investment in UK equities. The investment into UK corporate bonds and Government bonds is 15% and 20% respectively. The above composition however, indicate that the total porfolio may not be as liquid as it can be and it is because of this reason that a withdrawl ratio of 3% is considered as worrisom to look into in order to strategically place the investments into different assets so as to achieve the desired liquidity to meet the withdrawls requests. Since the overall strategy of the fund indicates that the investors are able to withdraw their funds after five years therefore it becomes an obligation for the firm to pay off the claims on time. However, due to competitive pressures, there may arise a gap between the cash inflows and outflows and as such the firm may require external borrowing or liquidate its portfolio in order to meet the witdhrawl requests. Another critical option available to the firm will be to re-evaluate its investment strategy and make its asset allocation in such a manner that it becomes able to pay off the claims on time without signicantly reducing its portfolio. Asset Allocation Strategies Given the above situation, it therefore becomes imperative that the Morris Capital must look for plausible strategic alternatives for making asset allocation in order to secure itself against the increasing withdrawals. However, to build an optimal asset portfolio, it is critical that the overall asset composition shall be made in such a manner that it not allow the portfolio to remain liquid but also remain earning also.(Wyatt,2009). Strategic asset allocation strategy requires that the underlying portfolio shall be rebalanced periodically in order to ensure that it remains at appropriate risk level whereas on the other hand it also provide the acceptable returns. Similarly, the tactical asset allocation strategy requires that the firm must change the percentage of different asset classes in order to take advantage of the market anomalies. (Wang, Tahir & Camilleri, 2005).Given the overall strategy of the firm and its basic purpose i.e. to provide returns for the educational expenses of the children, it is therefore more prudent that the strategic allocation shall be made according to the policy of the fund and overall asset allocation must be rebalanced periodically to allow swift and quick withdrawal of the same. Some Strategic Alternatives While recommending the strategic alternatives, it is therefore critical that the following assumptions must be made: 1. Asset allocation shall be made in a manner that allows enough liquidity. 2. Asset allocation shall be made keeping in view the medium term allocation of the funds as against long term horizon. 3. There will be no significant increase in the overall risk profile of the portfolio and as such focus will be on liquidity management and cash flows. Based on the above assumptions, following alternatives can be conceived: I. The overall asset allocation shall be based on the medium term time horizon and as such only those instruments shall be taken into consideration that can be liquid enough within that time horizon. II. Exposure to the commercial property market in current environment may be more risky and less liquid. As such the investment made into this class of asset shall be reallocated to the investment to be made in the cash and short term investment instruments such as providing overdrafts to the firms require urgent working capital. III. Since investment into the overseas equities carries significant risk specially the risk of volatility in foreign exchange rates, it is therefore critical that the firm must reduce its asset allocation into the overseas equity. This is also critical due to the fact that the overseas investments are made mostly into the equities of the developing or emerging markets however, such markets carry their own risks and as such this type of investment may be more illiquid considering the issues in the repatriation of the funds etc. IV. Investment into short term government securities shall also be increased as the investment into UK Government or corporate bonds may not be entirely liquid in nature. As such investment into gilt securities will offer more liquidity to the overall portfolio and firm may be able to meet its withdrawal requirements.(Gibson,2007). V. In order to ensure that the cash inflows increase cash outflows, it is also critical that the overall nature of investment shall be changed. Since the basic purpose of the fund is to offer returns for the education of children therefore the basic risk strategy shall be more conservative in nature. As such this requires that the firm must continue to look for alternative channels that can offer consistently higher returns. Recommendations Based on the above discussion and strategic alternatives, following is recommended: A. There is a need to rebalance the whole portfolio considering the fact that the overall policy mix of the portfolio does not support the intended objectives of the firm. B. Risk strategy shall be based on the overall strategic direction of the firm i.e. since the purpose is to offer the returns for education of the children; it is therefore recommended that more passive investment strategy shall be adapted. C. More exposure shall be taken in UK equities as compared to the exposure in overseas securities. This will not only allow the firm to achieve above average returns but also maintain the liquidity however, the investment shall also be made into the blue chip companies so that the overall risk in the equities remains within acceptable range. D. Exposure in commercial properties shall be systematically reduced and the share of the investment into short term investments as well as cash shall be increased to maintain the desired level of liquidity. The active investment strategy shall be considered for this type of investment. This report therefore recommends that more passive strategy with focus on equities shall be adapted. References 1. Camilleri, D & Tahir, M (2005) ptimal asset allocation and risk management. Asian Review of Accounting. 13 (1) 1-14 2. Gibson, R (2007). Asset Allocation: Balancing Financial Risk. 4th ed. New York: McGraw-Hill Professional, 3. Hodge, S (1995) OPEN-ENDED INVESTMENT COMPANIES. Journal of Financial Regulation and Compliance. 3 (4) 321 – 328 4. IMA CALLS FOR TWO MEASURES TO IMPROVE UK COMPETITIVENESS (2007) Investment Management Association, Available: http://www.investmentfunds.org.uk/press/2007/20070802.asp Last accessed: 24th February, 2010 5. Seager, A (2009) UK budget deficit hits record £90bn Guardian, Available: http://www.guardian.co.uk/business/2009/apr/22/budget-deficit-record Last accessed 24th February, 2010 6. Swint, B (2009) IMF Raises 2010 U.K. GDP Forecast, Predicts Economic Growth Bloomberg, Available: http://www.bloomberg.com/apps/news?pid=20601102&sid=aCEXOQgC50KA Last accessed 22nd February, 2010 7. Wyatt, W (2009) Dynamic Strategic Asset Allocation Watson Wyatt, Available: http://www.watsonwyatt.com/asia-pacific/pubs/investbriefing/pdf/Dynamic-Strategic-Asset-Allocation.pdf Last accessed 28th February, 2010 Read More