As an undergraduate in Finance, I’ve been exposed to a steep learning curve at illio where I have picked up a lot of real world experience from various members of the team. However, I had the opportunity to read Alex Post’s Oxford MBA thesis which was part of his Financial Markets Trading module and found it fascinating in how it bridged the world of academia and practical application.
In this three-part article, I summarise his thesis and explore his decision making and rationale for making the short term investment decisions he outlined in his paper. In part I am doing this to help me understand how an MBA student approached finance, but also to help future undergraduates learn too.
For the assignment, Alex was tasked to allocate £100 million capital in equity and/or debt and/or cash in the currencies of his choice with a three-week investment horizon and subsequently provide reasoning for those allocations. He was allotted 4 different instruments and did not have access to borrowing or repo facilities.
What this means in English: Alex was given £100 million and was told to invest in a combination of equity, debt and cash.
Before deciding where to invest, let’s understand how each of these investment vehicles behaves and compares.
The equity market, or the stock market, is the space in which stocks are bought and sold. This term encompasses all marketplaces such as the NYSE, the LSE, the Euronext and the Nasdaq.
Equity, or stock, represents a small part of a company someone can purchase. The owner of an equity stake may profit from dividends, which are a percentage of a company’s profits that is returned to its shareholders.
When investing in equity markets, you must be wary of its volatility, a product of price changes caused by the social, political, governmental and economic forces at play. Strong performance can lead to major gains to the investor and vice versa.
The debt market, otherwise known as the bond market, is an arena in which investments in loans or bonds are bought and sold. Investments in this market typically involve less risk than equity investments and offer a lower overall return on investment, or ROI, for two main reasons. Firstly, the issuer of the bonds must return the face value of the security to its holder on payment date. Secondly, most bonds pay investors at a fixed (or floating) rate of interest, whereas stock issuers have no obligation to pay dividends.
Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity and if they don’t then they would be in default. Stocks make no such promise from their issuer.
Historically the bond market has been less vulnerable to price swings or volatility than the stock market, except for emerging markets whose bonds can be much more volatile.
Bonds are the most common form of debt investment. They are issued either by private companies or the government to raise capital and typically come with a fixed interest rate.
The foreign exchange market, otherwise known as the Forex, FX, or currencies market, is an over-the-counter (OTC)1 global marketplace that determines the exchange rate of the world’s currencies.
Commodity market: The commodity market is a marketplace used for buying, selling and trading raw materials.
This market is split into hard and soft commodities. Hard commodities encompass natural resources that are mined or extracted while soft commodities refer to agriculture or livestock.
Alex noted that a 3-week time horizon is not long enough to take an investment view. Consequently, it is more about protecting the allocation with some upside opportunity. He concluded that a defensive or ‘hedged’ investment thesis is a sensible allocation decision given the aforementioned.
To understand how to allocate his funds defensively, Alex started by forming an economic outlook within his timeframe.
Equity Market - Bearish2
Debt Market – Bearish
FX Market – Reserve Currencies3 Bullish4
Alex noted that in June of 2022 “the global economy is facing unprecedented inflationary pressure and expected market down-turn” (Bloomberg, 2022). Consumer Price Inflation is (CPI) 8.3% in the US and a record 8.1% in the EU” (Mckinsey & Company, 2022).
On the supply side, he cited the war in Ukraine which caused major supply chain disruptions as “Ukraine accounts for 10% of the global wheat and maize trade” (EC, 2022) and China’s zero COVID policy which “brought lockdowns of cities and industries resulting in reduced manufacturing/export capabilities.” On the demand side, he cited the sudden drop in consumer spending in China, the US and Western Europe (11%-26%) in early-stage COVID, which “the personal savings rate to end 2020 at 14.2%, double the rate in December 2019” (Deloitte, 2021).
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From this, Alex asserted that both supply and demand side factors indicate that inflation is here to stay for the medium term at least and that a recession may be on the horizon, hence why global central banks have begun both quantitative tightening and raising interest rates:
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Because of the expected market downturn, Alex allocated 20% of his portfolio into ProShares Short QQQ (PSQ) (alternatives). PSQ is a 3x leveraged exchange-traded fund (ETF), meaning that it seeks to return the daily results of the Nasdaq 100 index times negative three. The Nasdaq 100 tracks the largest, most actively traded U.S companies on the Nasdaq stock exchange. The Nasdaq contains numerous growth shares which have historically been impacted more heavily than value shares by rising rates so, given Alex’s economic outlook, it would be sensible to choose a position that bets against the market.
Alex allocated 30% of his portfolio to a UK Gilt 0.125% coupon Jan 31st 2023 maturity (fixed income), a short duration (seven month) government bond. This is a safe investment as it will not be significantly impacted by interest rate increases and because it is short duration, it can generate some yield over a three-week horizon.
Furthermore, he put 20% into Invesco DB Agriculture Fund (commodities), another ETF which tracks the performance of specific agricultural commodities. The fund aims to reflect the overall price movements of the agricultural sector. Alex anticipated increased supply chain constraints and rising food and energy prices, which would in turn boost the price of the ETF.
Lastly, he kept £30 million in cash. Both ETF investments were done in USD, 40% of Alex’s portfolio: “Any US rate hike will likely strengthen USD as it is expected that the Fed may raise rates the same or more than other central banks. As a Sterling investor, with 40% in USD the rest of the portfolio is in GBP to hedge this FX risk.”
Given the time frame and his defensive / hedged approach, Alex was seeking a slightly positive return of up to 0.25%.
In the next article, I will look at the results as outlined in his thesis.
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