VIII. Investment Strategies

K. Interest Rate Swaps Why use?

1. Used to manage risk associated with changes in interest rates a. Allows for better matching of cash flows associated with assets and liabilities

M. Client Assessment Client Tax Situation

1.) All investment alternatives should be analyzed on an after-tax basis so that the returns from tax-exempt investments are comparable to taxable investments 2.) With combined federal and state rates in excess of 40% for high-income individuals, yields on tax-exempt securities can be both attractive and competitive

A. Formula Investing Div Reinvestment Plans (DRIP) - Benefits

1.) Dividends are automatically reinvested back into the company's stock 2.) Additional purchases of shares can be made without a broker and/or for minimal or no commissions

M. Client Assessment Financial Goals - Examples of Possible Financial Goals

1.) Establishing an emergency fund 2.) Financial independence 3.) Retirement 4.) Providing funding for child or grandchild's college education 5.) Purchasing a second home 6.) Taking a vacation

A. Formula Investing Bond Ladders, Barbells, and Bullets: Bullet Strategy - define

1.) Investors purchasing a series of bonds with similar maturities that are focused around one point in time 2.) The bullet strategy is one in which the average maturity declines by one each year and may be effective in matching duration to the cash needs of an investor 3.) Like the dumbbell strategy, to maintain the original structure, the entire portfolio may require liquidation, resulting in significant transaction costs

F. Short Selling Issues - Dividends

1.) Issuing corporation pays dividend to registered owner—purchaser of the bor-rowed shares 2.) Short seller is required to make payment in lieu of dividends to the investor whose stock was borrowed a.) Retains qualifying dividend status if investor is unaware of short sale involving the stock

F. Short Selling Issues - Voting

1.) Purchaser of borrowed shares has voting rights 2.) Investor whose stock was borrowed loses voting rights a.) Terms of agreement associated with opening a margin accouny

I. Bond Swapping Strategies Tax Swap - Define

1.) These swaps are motivated by current tax law 2.) One such swap involves gaining from a capital loss

I. Bond Swapping Strategies Pure Yield Pick-up Swap - define

1.) This swap involves exchanging a lower YTM bond with a higher YTM bond 2.) The new bond that replaces the old bond will have to be either a longer-term bond or a lower quality bond to make this swap effective

H. Portfolio Immunization Immunized at point of Duration...

A bond portfolio will be initially immunized at the point of duration If an investor were to match the duration of a bond portfolio to the time horizon for a financial goal, then the portfolio would be initially immunized

B. Buy and Hold Define

A buy-and-hold strategy begins with a set percentage of assets in each asset class. Over time this ratio will change as the value of each asset class changes.

J. Wash Sale Rule Define

A wash sale occurs if the taxpayer sells or exchanges stock or securities for a loss and, within 30 days before or after the date of the sale or exchange, acquires similar securities

F. Short Selling Shorting Against the Box - Why?

A. Protects gains B. Defers recognition of gain on sale of security to following year 1.) Must avoid constructive sale classification

A. Formula Investing Bond Ladders, Barbells, and Bullets: Laddered Portfolio - define

Accomplished by establishing a portfolio of bonds with staggered maturities

D. Active Investing Define

Active portfolio management is based on the concept that above-market returns can be achieved through security selection, market timing, or both. Those who believe that active management can outperform the market do not believe that the market is perfectly efficient.

M. Client Assessment Investment Planning Process: Step 6

Adjust and rebalance the client's portfolio

K. Interest Rate Swaps What is it?

An agreement between entities to swap payments on debt a. A fixed interest payment is swapped for a variable (floating) interest payment

C. Passive Investing (Indexing) Risk Levels

Another consideration for these passive portfolios is the risk and asset allocation of the investments. By adjusting the asset mix or allocation, the risk level can be matched with the needs of the investor.

I. Bond Swapping Strategies Intermarket Spread Swap - Strategy

Basically assume two bonds have a really small spread compared to historics (for example, 50bps on a AAA versus a AA). You could get into one or the other hoping the spread widens. So hoping that the AAA yield lowers if you get in the AA or hope yield raises if get into AA. If the yield moves in the opposite direction you are anticipating, you lose.

L. Investment Strategies in Tax-Advantaged Accounts Taxable Accounts - What assets are best to put here?

Because income earned in a taxable account results in a current income tax liability, investing in either appreciating assets or assets that are not subject to income tax is generally better Municipal bonds great here

M. Client Assessment Investment Planning Process: Step 5

Compare the actual realized returns against the expected returns a. Compare returns to a benchmark, such as the S&P 500 Index b. Periodically reevaluate investments in light of changes to a client's situation and changes in the markets

M. Client Assessment Investment Planning Process: Step 3

Determine the appropriate level of risk and return for the portfolio based on the investor's risk tolerance and required return

M. Client Assessment Investment Planning Process: Step 2

Determine the time horizon for investment based on the client's financial objective(s)

M. Client Assessment Investment Planning Process: Step 1

Determine whether the client has the means and commitment to invest

A. Formula Investing Dollar Cost Averaging - Works poorly when..

Does not work well when the market is steadily increasing because in that event, the investor would be better off buying as many shares as possible up front when the price per share is lower

L. Investment Strategies in Tax-Advantaged Accounts Tax Advantaged Accounts -

Generally, distributions from tax-advantaged accounts consist of income that is subject to ordinary income tax rates. Therefore, any fixed-income securities held in a tax-advantaged account should consist of taxable and not municipal (assuming that taxable returns are greater than municipal) securities.

I. Bond Swapping Strategies Rate Anticipation Strategy - Define

If rates are expected to increase, long-term bonds should be swapped for short- term bonds. Opposite is true if expect rates to decline

B. Buy and Hold Example

Index Funds Index funds attempt to match the composition of an index, such as the S&P 500. Because indexes are relatively stable, with regard to the stocks that make up the index, transaction costs and taxes are minimized and research costs are virtually eliminated.

A. Formula Investing Bond Ladders, Barbells, and Bullets: Barbell (Dumbbell) Strategy - Define

Initially acquiring a portfolio of bonds consisting of both very long-term and very short-term maturities

M. Client Assessment Introduction - why?

Investment planning requires examining the financial situation of a client so the client's goals can be met while simultaneously meeting the client's investment needs and requirements

F. Short Selling Shorting Against the Box - Define

Investor takes a short position with the same market value as a long position

G. Margin Transactions Formula For Determining when Margin Call would Occur

Margin Call = Debit Balance / (1-Maintenance Margin)

M. Client Assessment Liquidity and Marketability Needs

One of the first considerations in creating a financial plan is the need for an emergency fund. This fund should consist of liquid assets so as to be easily accessible in the event of an emergency (e.g., loss of job or disability). If a client does not have an emergency fund or access to funds in case of an emergency, investments that have the potential for large price fluctuations, such as common stock, should make up a smaller portion of the overall portfolio. Likewise, investments that do not have efficient markets, such as real estate, should be limited.

A. Formula Investing Div Reinvestment Plans (DRIP) - Tax Implications

Reinvested dividends are treated the same for tax purposes as cash dividends

E. Sector Rotation Define

Sector rotation is an active portfolio management strategy, emphasizing or overallocating certain economic sectors or industries in response to the next expected phase of the business cycle a. This strategy requires investors to time the entry and the exit of specific sectors based on economic business cycles b. For many investors, the ability to accurately identify and transition from one cycle to another may be difficult

D. Active Investing How to Try and Add Value

Security selection and market timing work in concert with each other. In addition to determining which security should be selected, investors must determine when and under what conditions the investment should be purchased (or sold). The real question is what should be invested in today? Two methods that investors use to make security selections are fundamental analysis and technical analysis.

M. Client Assessment Investment Planning Process: Step 4

Select investments suitable to the investor's time horizon, return requirements, and risk tolerance

F. Short Selling Define

Short selling allows investors to take advantage of falling stock prices

A. Formula Investing Bond Ladders, Barbells, and Bullets: Barbell (Dumbbell) Strategy - Actually how it works in practice

The barbell strategy will not maintain its original structure because each year the short-term bonds mature and need to be reinvested. Thus, the maturity of the long-term bonds is reduced. An active management strategy is required to periodically rebalance the portfolio.

M. Client Assessment Financial Goals - Dollar Requirements

The dollar amount of the goal can be a decisive factor in choosing the appropriate investment vehicle Each goal requires a specific compound return over the time horizon for the goal to be achieved. If this required rate of return is high, the client must either accept additional risk or adjust the goal downward to require a lower rate of return. Accepting additional risk provides the possibility for higher rates of return; however, this decision cannot be made in isolation

M. Client Assessment Financial Goals - Define

The financial goals of the client are the driving force behind an investment plan 1.) These goals help to establish the time horizon, the level of risk to be under- taken, and the specific asset classes that should be used to meet objectives 2.) Effective investment plans require that clients establish clear, realistic, and quantifiable goals 3.) These goals should specify the time horizon and the dollar amount required 4.) Because of limited financial resources, goals must be prioritized

M. Client Assessment Analysis and Evaluation of Client Financial Statements

The financial planner uses the client's financial information as a basis for creating a plan to achieve the client's goals The statement of financial position provides the planner with a list of assets stated at FMV and the current balance of any corresponding debt The statement of cash flows details the client's sources of funds and the allocation of funds

A. Formula Investing Dollar Cost Averaging - Goals

The goal is to reduce the effects of market price fluctuations 1) When the market is rising, shares benefit from price increases 2) When the market is declining, additional shares are purchased at lower prices and will yield more shares per dollar invested 3) Does not guarantee a positive return to the investor

A. Formula Investing Dollar Cost Averaging - Define

The process of purchasing securities over time by investing a predetermined amount at regular intervals

A. Formula Investing Div Reinvestment Plans (DRIP) - Define

The term dividend reinvestment refers to dividends being automatically reinvested back into the investment from which they were earned.

M. Client Assessment Financial Goals - Time Horizon: define

The time horizon of each investment goal is an important factor in deter- mining the investment vehicles used to meet the goal

I. Bond Swapping Strategies Intermarket Spread Swap - Define

This swap involves the exchange of one type of bond (e.g., government bond) with another type of bond (e.g., corporate bond). This occurs when investors believe one type of bond is currently mispriced in relation to the other. The goal of this type of swap is to capitalize on a YTM disparity across bond markets.

G. Margin Transactions How it Works

When an investment is purchased on margin, one-half of the funds are put up by the investor and one-half is borrowed from the broker (assumes a 50% initial margin)

A. Formula Investing Dollar Cost Averaging - Works best when..

Works best when markets are declining or fluctuating

H. Portfolio Immunization Steps to Immunize a Portfolio

a. Choose a time horizon that matches that of the investor, such as 10 years b. Purchase bonds with varying maturities, both less than 10 years and greater than 10 years. The duration of the portfolio should be equal to 10 years. An alternative would be to buy all zero-coupon bonds with maturities equal to the desired time horizon. c. The portfolio should be rebalanced every six months to a year. As six months pass, the portfolio should be rebalanced so that the duration equals 9.5 years instead of 10 years. This process continues until the time the funds are needed (10 years) or until the portfolio is rebalanced for a new time horizon.

H. Portfolio Immunization Return on Immunized Portfolio

a. Immunization should provide a stable compound rate of return that equals the YTM, despite interest rate fluctuations b. The portfolio is immunized if the realized rate of return is at least the computed YTM calculated at inception c. Another way to think of immunization is that a bond portfolio is immunized when the actual future value is at least as great as it had been expected at inception

F. Short Selling Strategy

a. Individuals who engage in short selling are pessimistic (or bearish) about the future direction of prices b. The strategy also allows investors to hedge investment risk c. Short sellers are normally wealthy investors, hedge funds, large institutions, and day traders

A. Formula Investing Average Down - Define

a. Purchasing additional shares only when the market price of the shares declines b. The investor reduces the cost basis of an investment by buying more shares as the price of that security decreases c. The investor will be rewarded if the price of the security subsequently increases

A. Formula Investing Shares Averaging

a. The investor purchases the same number of shares every time b. Dollar amount of investment varies c. Not easy to automate (e.g., by way of automatic monthly investing) because the amounts invested are seldom the same

M. Client Assessment Risk Tolerance and Risk Exposure

a. The investor's risk tolerance is vital in determining which investments are chosen for the portfolio b. Risk tolerance is the level of risk an investor is willing to assume regardless of the potential returns c. Some investors are only willing to invest in assets that are no more risky than U.S. Treasuries. The potential returns for these types of investors will be less than for investors who are willing to accept more risk; however, the level of risk tolerance must be considered in the overall analysis.

F. Short Selling 4 Step Process

a. Use a broker to borrow stock from another investor's margin account 1.) Short seller deposits initial margin multiplied by FMV of the stock into broker- age account (margin account) b. Sell the borrowed stock in the open market c. Repurchase the stock in the open market d. Replace the borrowed stock

A. Formula Investing Bond Ladders, Barbells, and Bullets: Laddered Portfolio - 2 Advantages

a.) Because there is a combination of long-term bonds and short-term bonds in the portfolio, the laddered portfolio will generally provide higher yields than a portfolio consisting entirely of short-term bonds b.) Because one bond matures each year, cash is available to the investor. Furthermore, the funds may be used to purchase another bond with a 10-year maturity that will maintain the original structure of the bond portfolio and minimize the risk of increasing interest rates.

I. Bond Swapping Strategies Types: Substitution Swap - Risks

a.) The bonds may not be perfect substitutes for each other b.) The gain may not be sufficient to cover any required transaction costs c.) The workout time, which is the time it takes for the bonds' prices to equal each other, may be longer than originally expected, thereby reduc- ing the realized yield for the swap

F. Short Selling Shorting Against the Box - Not A Constructive Sale

a.) short sale is closed on or before the 30th day following the tax year that the short sale was entered into; and b.) the long position is held (unhedged) for a period of at least 60 days after the close of the short position

G. Margin Transactions Define

allow investors to use leverage with their investments. The initial margin, set by the Federal Reserve, is 50%. The initial margin represents the amount that the investor is required to fund in the margin account. Note: brokerages and exchanges may have stricter terms

C. Passive Investing (Indexing) Define

based on the concept that the markets are efficient in pricing securities, and that it is unlikely that an investor will be able to outperform the market on a consistent basis (similar to the efficient market hypothesis)

C. Passive Investing (Indexing) Advantages

generally are well diversified and have low turnover rates

I. Bond Swapping Strategies Types: Substitution Swap - Define

involves exchanging bonds with identical characteristics (including credit rating, maturity, coupon interest payment, and call feature) selling for different prices. This price difference is an arbitrage opportunity and will last only until the lower-priced bond is bid upward. These opportunities arise when there are temporary market imperfections.

I. Bond Swapping Strategies Define

process of selling one debt instrument and replacing it with another with the goal of increasing the overall rate of return

K. Interest Rate Swaps Define Notional Principal

specific dollar amount on which the exchanged interest payments are based

G. Margin Transactions Key Terms: Maintenance Margin

the level at which an investor will be required to add funds to the margin account. Maintenance margins are usually set at 35% but may differ from broker to broker.

G. Margin Transactions Key Terms: Debit Balance

the loan amount owed to the broker. This amount will include the original amount borrowed plus any accumulated interest.

G. Margin Transactions Key Terms: Initial Margin

the percentage of the original purchase that must be provided by the investor (currently 50%)

G. Margin Transactions Key Terms: Equity

the value of the security less the debit balance

H. Portfolio Immunization Goal

to protect a bond portfolio from interest rate risk (rate fluctuations) and reinvestment rate risk

B. Buy and Hold Major Benefit

transaction costs and taxes are minimized

F. Short Selling Shorting Against the Box - Constructive Sale

transaction is treated as if the taxpayer had sold the long position for the price at which the short was entered into

M. Client Assessment Financial Goals - Time Horizon: Risks or Time Horizon

■■ Investments that are more risky, such as equities, have more volatile returns than Treasury bills ■■ Over a long period, however, the volatility of returns tends to even out and the compound returns are generally higher for riskier investments (equities) ■■ Short-term goals cannot tolerate wide fluctuations in value and, therefore, require less risky investment vehicles