Chapter 5: Client Profiles & Theories of Portfolio Mgmt

What type of investments will fulfill an investor who is seeking "stable income"?

--Portfolios that need to generate regular and stable cash returns may invest in a combination of fixed-income securities, such as U.S. Treasuries, agency bonds, municipal bonds, and corporate bonds, as well as equities that emphasize income over growth, such as preferred stocks, REITs, and dividend-paying stocks. --Stocks that pay no or a low dividend are unacceptable, as is any other investment that does not offer a regular cash return to the investor. --Current income investors may also be concerned about minimizing taxes on investment income so that the maximum amount of money stays in their pocket. If a client is in a high tax bracket and values current income, municipal bonds are an excellent choice, because the interest earned is tax-free.

What type of investments will fulfill an investor who is seeking "capital growth"?

--Stocks are considered the best recommendation for an investor who wants to grow his principal. Over time, stocks produce higher returns than other investments. An equity investor is essentially participating in the business, albeit passively. By taking the risk and uncertainty that comes with being an owner of a business—some businesses do well, some do so-so, and some fail—equity investors are able to reap the long-term financial rewards that come with business ownership. --Mutual funds and ETFs can be a good option for growth investors, because they provide a diversified portfolio of stocks. For investors who do not have a long time horizon because they are older or need the money sooner, stocks from larger, established companies can be appropriate. Large-cap equity funds or ETFs may be appropriate for these investors.

Who is the typical "current income" investor?

--Typical current income clients are retired or soon-to-be-retired individuals who are no longer saving for retirement and who are ready to reduce the amount of risk they've been taking (less equities). Because these customers must use the income from their portfolio to live on, they prefer not to be subject to the gyrations of the stock market. By investing in fixed-income securities, such as bonds and dividend-paying stocks, which generate a regular stream of cash, their portfolio is less volatile. Current income clients may also include disabled individuals, parents of a disabled child, or guardians or trustees of a disabled individual.

What are a few key strategies to optimizing a client's tax situation?

1) Tax-advantaged investments. Investments such as municipal bonds and U.S. Treasury bonds have distinct tax advantages that may benefit individuals in higher income tax brackets. Remember that municipal bonds may not be appropriate for clients in lower income tax brackets, because they offer lower yields than comparable corporate bonds. 2) Tax-advantaged accounts. From IRAs to company retirement plans (e.g., 401(k)s) to section 529 college accounts, certain investing goals can be turbocharged by doing a client's investing in a tax-advantaged account. 3) Tax loss selling. Selling certain positions for a loss to help offset and reduce other positions sold for a gain can help lower a client's tax bill. 4) Avoid duplicating tax advantages. Don't put municipal bonds in an IRA, because the IRA already offers tax deferral. A client will be accepting lower returns than corporate bonds for none of the tax advantages. Moreover, don't put an annuity in an IRA, because they both offer the same tax deferral of earned income.

Call

A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. It may help you to remember that a call option gives you the right to call in, or buy, an asset. You profit on a call when the underlying asset increases in price.

Put

A put is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option believes the underlying asset will drop below the exercise price before the expiration date. The exercise price is the price the underlying asset must reach for the put option contract to hold value. The possible payoff for a holder of a put option contract is illustrated by the following diagram:

Who is the "capital growth" strategy most relevant for?

Again, this is only appropriate for those who are able to live with the ups and downs of the market. This investment approach is highly relevant for anyone with a long time horizon, such as those saving for retirement, especially younger retirement savers who have the time to ride out the short- and medium-term ups and downs of the market, focused instead on maximizing appreciation over time.

At the beginning of the year, your client, Ms. Jones, had a portfolio with an expected return of 4% and a beta of 1.0. The T-bill rate is 2%. At the end of the year, her actual return showed a positive alpha of 2%. What was her actual return on her portfolio?

Alpha levels can be both positive and negative. Alpha = actual return - expected return (2% = actual return - 4%). Thus, her actual return was 6%.

Asset allocation by style vs. asset class

An allocation by style uses categories such as growth and value stocks. An allocation by asset class may use the larger categories of stocks and bonds and further subdivide by types of stocks and bonds (preferred stocks, international stocks, corporate bonds, government bonds, etc.). Quite often, portfolios are strategically allocated into smaller subcategories that are a mix of both style and asset class, such as value stocks, growth stocks, investment grade corporate bonds, corporate junk bonds, etc.

Efficient Portfolio

An efficient portfolio is one that offers the highest expected return for a given standard deviation. Depending on an investment adviser's belief about the efficient market hypothesis, their attempt to build an efficient portfolio may or may not include active management choices.

Wally has been bearish on XYZ and has a short position of 1,000 shares. He has already made significant gains on this short position. He has heard that XYZ has just hired a new CEO, and he is worried that the stock price may start to rise, cutting into his gains. Over the long run, he is still bearish on the stock. What can he do to protect his gains without closing out his short position?

Answer: Buy 10 calls on XYZ Explanation: Buying 10 calls on XYZ allows him to protect his short gains if the price of XYZ increases, because he will be able to cover his short position by purchasing 1,000 shares of XYZ at a fixed strike price. This investment also allows him to hold open his short position and profit further if XYZ continues to decline.

Sandy owns a portfolio of stocks. She likes the stocks she has chosen and does not want to sell them, but she is worried about a decline in the entire market. What can she do?

Answer: Buy a put on a broad index Explanation: If the market decreases and the value of Sandy's stocks declines, the put would become increasingly profitable and would offset some of her losses. Of course, if the market does not decline, Sandy's profits would experience a reduction by the cost of buying the put that went unused.

Apple stock makes up a large portion of Jon's portfolio. This worries his financial adviser, who tries to convince him to diversify. But Jon loves Apple and refuses to sell, convinced that Apple can only continue to rise. What can Jon's financial adviser do to protect his client from a decline in Apple's stock?

Answer: Buy puts on Apple Explanation: If the price of Apple declines, Jon will be able to sell his Apple stock at the strike price. If Apple continues to increase in value, both Jon and his adviser will be happy, because they will benefit from the increase in Apple's price. Remember, though, that they must pay the premiums on the puts even if the puts are not exercised.

Your niece has just graduated from college with a double major in math and computer science. After accepting a job offer from a Silicon Valley Company, she comes to you for advice about investing her signing bonus. She is a smart young woman and she says she wants to start saving for retirement. You tell her that because a bonus is considered earned income, she can use the money to open an IRA. Which of the following asset allocations would be best for the new IRA of your 22-year-old niece: A. 60% equities, 20% bonds, 20% cash B. 40% equities, 40% Treasury securities, 20% gold C. 50% equities, 30% REITs, 20% bonds D. 80% equities, 20% bonds

Answer: D Explanation: Even though equities (stocks) are more volatile than other asset classes, over long periods, they offer the highest returns. Since your niece is just 22 and since she wants to start saving for retirement, the choice with the highest allocation to equities is the best one for her.

Beta

Beta is the measure of a security's systematic variability or risk. It measures how closely the security's returns respond to swings in the market (discussed further under Beta Coefficient). Suppose a security's beta = 1.0. The expected return of that security will be identical to the expected return of the market. In other words, the security can be expected to fluctuate by the same percentage the market fluctuates. A beta greater than 1.0 indicates that the price of the security will move more than the market. A beta of less than 1.0 indicates that the price of the security will move less than the market.

How might puts protect against an economic downturn?

By buying a put, an investor is able to lock in an acceptable sale price for a security, even though she may not be ready or in a position to sell it. This may be especially true of investors who have a substantial capital gain in a security and need to wait up to 12 months for the capital gain to achieve long-term status.

How might calls protect against an economic downturn?

Calls, which give an investor the right to purchase a security in the future at a certain price, can be used in a couple of ways to minimize the risk associated with not being fully invested in a market at a given point. Since calls can be purchased relatively cheaply in a falling market, investors who are feeling optimistic that a turnaround is coming but are afraid to invest their funds can still profit by investing a small portion of their funds into calls. Through this small investment in a call, investors can create the opportunity to profit from an upswing without having to risk investing all their funds in a market that may decline further. Second, in a flat or down market, an investor can increase the income on flat or declining positions by selling calls to other investors on those positions. Known as "writing covered calls," this strategy can generate a decent amount of income to offset the decline in the value of the investor's securities or ensure that otherwise flat performing securities are earning an income.

Capital Appreciation Investing

Capital appreciation investing usually means a portfolio filled with non-dividend paying common stocks that have large growth potential. These stocks usually have high P/E ratios. An important advantage of this type of investing is that capital gains will not be taxed until the stocks are sold, lowering a client's annual tax bill. In addition, as long as the client has a well-diversified portfolio and a long time horizon, the returns on growth stocks usually beat inflation and most other investments. A client who desires capital appreciation typically has a long time horizon (younger or middle-aged), can tolerate risk and does not require regular income. The biggest risk facing a capital appreciation investor is market risk. If there is a large drop in the overall market, this kind of portfolio will take a large hit. As we mentioned earlier, a way to minimize this type of risk is to buy puts on a broad market index.

Dollar Cost Averaging

Dollar cost averaging is a tried and true investing strategy that has a long history of reaping rewards for investors. Under a dollar cost averaging strategy, an investor invests the same dollar amount in a security at regular intervals (weekly, monthly, quarterly, etc.). For example, an investor might invest $100 out of their paycheck in the ABC Mutual Fund every Friday. In doing so, an interesting thing happens. The investor will naturally buy more of the security in weeks where the price has dropped and less of the security in weeks where the price has climbed. For example, if the price of the Acme Exchange-Traded Fund is $10 per share this week, the investor would end up buying 10 shares for their $100 investment. Next week, when the investor sends in his $100, the price has risen to $20 per share, resulting in only five shares being purchased. In the end, a dollar cost averaging strategy results in an investor experiencing a lower per-share cost to purchase a security over a period of time than its average price over the same period.

How does Beta and Alpha come into play when evaluating asset managers?

For active managers, beta is the most commonly used measure today of a stock's riskiness. Beta, as a measure of systematic risk, is also a convenient way to compare the riskiness of similar stocks. Alpha can also be used to judge the success of a portfolio or mutual fund manager. To do this, a beta is calculated for an entire portfolio, and an expected return is calculated for the entire portfolio using CAPM. The alpha of the portfolio is the performance of the fund above its expected return. In fact, calculating the alpha of a portfolio is one of the most common ways to quantify an investment adviser's performance. A positive alpha shows how much better (or worse) the portfolio's actual returns were over the performance that can be explained by the market.

Growth Investing

Growth investing says you should invest in companies that are growing, because the growth of the business will cause the share price to rise. Growth investors pay close attention to the income statement (sales and profits) and less attention to the balance sheet (assets and liabilities). Not surprisingly, investors like to invest in companies that are growing, so investors bid up the share prices of growth stocks. As a result of their popularity, growth stocks have, on average, higher price-to-earnings, price-to-book, and price-to-sales ratios, as well as lower than average dividend yields.

Income Investing

Income investing usually involves fixed-income securities that offer periodic interest payments. Fixed-income investors face several risks. Perhaps the greatest is purchasing power risk. If their total returns cannot keep up with inflation, they may be losing money over time. Default and credit risk are also a worry. If a company is downgraded, a bondholder may have difficulty selling his bonds in the market. Interest rate risk can also be a problem. If interest rates rise, the bondholder will have difficulty selling the bond unless he sells it at a discount. Finally, a fixed-income investor may face liquidity risk if he is unable to find a buyer for his securities. To minimize these risks, an income investor may prefer to fill his portfolio with other income-producing investments, as well as bonds, such as preferred stock, REITs and dividend-paying stocks.

What are the risks associated with current income investors?

Interest Rate Risk -- When interest rates rise, current income investors are exposed to interest rate risk, because the value of existing fixed-income securities and dividend-paying equities drops. Default/Credit Risk -- current income investors face the possibility that the issuer of the income-paying security may not be able to make the payments or, even worse, cease to exist. This can occur, for example, when a REIT or dividend-paying company does poorly and has to reduce or eliminate its dividend or when a municipality goes bankrupt and can't pay its bondholders. Purchasing Power Risk -- Current income investors also face purchasing power risk, because the returns they receive may not keep up with inflation. Reinvestment Risk -- Current income investors are also subject to reinvestment risk, because if they don't spend all the income their investments are generating, they must reinvest it. If interest rates decline, mortgage-backed agency bonds, such as Fannie Mae and Freddie Mac, can be especially susceptible to reinvestment risk. When interest rates drop, homeowners refinance at the new lower rates, which means Fannie Mae or Freddie Mac bondholders receive their principal back early and must reinvest their money at the new lower rates.

Conservative Risk Tolerance

Investors who consider themselves conservative usually cannot tolerate even temporary minor declines in the value of their overall portfolio or moderate to major declines in any one investment. These clients are best directed toward income-producing investments, such as high-grade corporate, municipal, state, or federal bonds. Note that an investor who claims to be aggressive, but is not willing to accept any decline in his investment, is still considered to be a conservative investor.

Moderate Risk Tolerance

Investors with a moderate risk tolerance can stand some prolonged negative fluctuations in their portfolios, but generally need to have a reasonable expectation that their investments will bounce back over time. Moderate risk tolerance investors tend to do well with a diversified portfolio of stocks, perhaps focusing on blue chip stocks, and bonds from large companies and established markets. Lower cost ETFs and no-load index funds may also be a good option.

How can a fixed-income investor save for a target date and reduce interest rate or reinvestment risk?

Laddering - Laddering reduces both interest rate risk and reinvestment risk, because an investor is not stuck at one interest rate for long. Because he has bonds maturing at different times, he will have cash flow to get back into higher paying securities if he desires and if interest rates rise.

Laddering

Laddering is a strategy whereby a fixed-income investor buys multiple bonds or CDs at different maturities in order to avoid being locked into a single interest rate and a single maturity. Laddering is a way to reduce interest rate risk and spread out reinvestment risk.

Portfolio Management Teqniques

Portfolio management techniques are methods by which an existing portfolio strategy or style is translated into the day-to-day management of a portfolio.

Another $10 stock has a beta of 0.5. The expected return in the market is 7% and the risk-free rate 2%. Using CAPM, what is the expected rate of return?

Rf + (B x (Rm - Rf) = Expected Return 2% + (0.5 x (7% - 2%)) = 4.5%

A $10 stock has a beta of 2.0. The expected return in the market, based on its recent performance is 7%, and the risk-free rate as measured by the Treasury bill rate is 2%. Using CAPM, what is the expected rate of return?

Rf + (B x (Rm - Rf) = Expected Return 2% + (2.0 x (7% - 2%)) = 12%.

Risk Premium

Risk premium is the additional return investors expect to earn in compensation for a security's risk. In the context of CAPM, the risk premium for a given security is the difference between the overall market and the riskless rate of return, also called the risk-free rate of return, times the security's beta.

Risk-free Return

Risk-free return is the return that an investor can achieve taking virtually no risk. A typical benchmark that is used for risk-free return is the return on T-bills.

Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital.

Random Walk Theory

The random walk theory states that, because the market is efficient and moves randomly, methodically choosing stocks is about as effective as randomly picking stocks.

Semi-Strong Form Efficient Market Hypothesis

The semi-strong form posits that private information about a security is not immediately reflected in a security's price, but that public information is wholly and immediately reflected. Thus, the only way to beat the market in the long run is with insider information, so a retail investor is better off investing in a low cost index fund or broad based ETF than relying on active management.

Strong Form Efficient Market Hypothesis

The strong form of the theory states that all information, private and public, is reflected in the market price of the security. Investors will always be a step behind the market and, therefore, will not profit from actively managing their investments. They are much better off putting their money in an index fund or an ETF. Note that if the strong form were true, traders with inside information could not profit from their information, because the market will have already absorbed the information. The SEC does not believe that the strong form is true, because otherwise, they would not write rules prohibiting insider trading.

Weak Form Efficient Market Hypothesis

The weak form states that market movements cannot be predicted by charting trends (known as technical analysis), but may be predictable by analyzing the underlying financial aspects of the business represented by a stock (known as fundamental analysis). Weak form efficient market hypothesis is the version that most lends itself to an active management style.

Efficient Market Hypothesis (EMH)

This hypothesis states that the market as a whole has all the information needed to make it operate efficiently, and thus, at any moment, every security in the market is priced at what it is worth. As a result, individual investors and advisers, with their limited access to information, cannot outperform the market on a prolonged basis without incurring more risk than the market. At best, because the market is always right in the long run, they can only hope to match the market's returns, minus their costs of investing.

Rebalancing

This process of adjusting the portfolio back toward the original allocation is called rebalancing.

Total Return Strategy

This strategy of combining capital appreciation and dividend income reinvestment is sometimes called total return.

Now suppose Ms. Jones owns shares of Technix, whose positive alpha is 2%. The market is expected to return 4%. The beta of her stock is 0.5, and the T-bill rate is 2%. What is the actual return on Technix?

To answer this question, you first must know the expected return of the stock. We can then use CAPM to calculate the stock's actual return. First, expected return = risk-free rate + (beta x (market risk - risk-free rate)), or 2% + (0.5 x (4% - 2%)) = 3%. So if alpha = actual return - expected return, or 2% = actual return - 3%, then the stock's actual return is 5%.

Uncorrelated and Negative Assets

Uncorrelated assets are those whose performances are unrelated to one another. When one asset is up, the other asset may be either up or down. Negatively correlated assets are those whose performances are directly opposite to one another. When one asset is performing well, the other is performing poorly and vice versa.

Sector Rotating Strategy

Under a sector rotation strategy, a portfolio manager will attempt to over-concentrate in sectors that are poised to experience above average growth. Simultaneously, they'll sell positions in sectors that are expected to underperform.

Strategic Asset Allocation

Under a strategic asset allocation model, an adviser and client work together to design an ideal mix (on a percentage basis) of major asset classes and sub-classes. Their goal is the optimal level of portfolio performance (growth, income, capital preservation, and tax benefits) given a client's investment goals.

Modern Portfolio Theory (MPT)

Under modern portfolio theory, an investment professional can attempt to achieve a favorable portfolio return by deliberately choosing investments in relationship to one another instead of seeing them as separate unrelated decisions. The relationship sought is a low correlation (as close to zero as possible), meaning a particular investment does not move to any great extent the same as the rest of the portfolio. Investments are chosen based on calculated mathematical probabilities. The goal is to maximize portfolio return for a given amount of risk or, correspondingly, to minimize risk for a given level of expected return. The underlying philosophy of modern portfolio theory, thus, is diversification. Modern portfolio theory assumes that investors are risk-averse and rational and markets are efficient. It proposes that if the assets in the portfolio are diverse and, thus, relatively uncorrelated, the investor can minimize risk and maximize returns. While many advisers and clients embrace some form of modern portfolio theory, they may disagree on how to select the underlying individual investments and when to buy or sell them.

Tactical Asset Allocation

Unlike a strategic asset allocation model, which relies on keeping an optimum portfolio mix to maximize returns, the tactical asset allocation model attempts to time the market, moving in and out of asset classes and sectors based on certain indicators of the direction of the market. Tactical asset allocation is an active management portfolio strategy that rebalances the percentage of assets held in various categories to take advantage of market pricing anomalies and/or strong market sectors.

Value Investing

Value investing, on the other hand, places primary emphasis on share price. Using fundamental analysis, a value investor looks for stocks that are trading below their "intrinsic" value. Value investors like growth as much as growth investors do, but value investors are wary of overpaying for that growth. Value investing seeks, in the words of Benjamin Graham, the father of value investing, stocks that offer a "margin of safety" or the difference between a stock's intrinsic value and its current price. Value stocks then, by definition, on average, have lower P/E ratios, lower price-to-book and price-to-sales ratios, and higher dividend yields.

What type of investments will fulfill an investor who is seeking to "preserve their capital"?

When clients are averse to any decline in the value of their investment, in the language of money, they want to "preserve their capital." Only the most conservative investments will satisfy this goal. FDIC-insured bank CDs, U.S. Treasury securities, and money market mutual funds would all be acceptable recommendations. Any type of investment that puts the principal at risk is not acceptable to this type of investor.

Alpha

When stocks behave differently from expectations, they will have an actual return that deviates from the expected return. The difference between a security's actual return and its expected return is known as the stock's alpha. alpha = actual return - expected return When a stock's alpha is greater than zero, it means that the stock has performed better than its expected return. Thus, given the expected return calculated through CAPM, the stock performed better than expected. When a stock's alpha is less than zero, it means that it has performed worse than its expected return.

Aggressive Risk Tolerance

While investors with an aggressive risk tolerance aren't betting the farm with every investment decision, they can tolerate substantial and even permanent losses on some of their positions. They generally view this as part of the process of attempting to earn above-average returns. Aggressive risk tolerance investors may invest in stocks from smaller companies and less established international companies, as well as lower grade bonds that offer higher yields.

Which type of bond is especially good for college savings?

Zero coupon bonds can be a great investment for college. Unlike other investments, buyers invest a specific amount today and know that they will receive a specific amount at maturity, years in the future. When saving for college, uncertainty is a big concern, but less so with zeros, since you know what you will get and when you will get it. Also, with zero coupons there are no reinvestment worries. And because zero coupon bonds are sold at a discount from their par value, you can buy more zeros today than you can of any other type of bond or security. Another plus: If you're saving for college and you don't want to lock the money into a college savings vehicle, like a 529 plan, buying zero coupon bonds allows you to save for college without giving up the freedom and control you may want to have with the money down the road, for example, if a client's son decides he wants to forgo college and be the next Bill Gates or Steve Jobs. For those in a high tax bracket, municipal zero coupon bonds offering tax-free interest may be appropriate.

A portfolio has a beta of 1.0. The S&P 500 experiences 8% growth, and the portfolio produces an actual return of 12%. The riskless rate is 2%. What is the alpha of the portfolio?

expected return = risk-free return + (beta x (market return - risk-free return)) expected return = 2% + (1 x (8% - 2%)) = 8%. Next we must calculate alpha. alpha = actual return - expected return So, 12% - 8% = 4%.

What are some of the most common needs and situations of people seeking financial advice?

• Capital preservation • Income generation • Investment growth • Retirement planning • College and education saving • Planning for or managing financial considerations upon death or the death of a loved one • Planning for or managing financial considerations upon disability or the disability of a loved one • Reaching a wide variety of other financial goals within a certain time horizon

What are some other non-financial investment considerations of clients'?

• Values -- Some clients do not wish to own, even indirectly, stocks or bonds in companies that are not socially responsible. Since "socially responsible" has a different meaning for everyone, this may or may not include companies that produce alcohol, tobacco, firearms, etc., as well as companies that are not environmentally friendly. • Attitude -- Just like different people go to the gym for different reasons (to lose weight, to train for an athletic competition, to socialize, etc.), clients invest for very different reasons. Some do it because they love it, and investing toward their goals excites them. Others do it begrudgingly, knowing that failure to take care of future goals will only harm them. In either case, an adviser's role with each client should match the client's attitude about investing and educate them to give them options. • Investor experience -- First-time investors may not be comfortable with even the most "common sense" investment choices and may need more education to commit to investments that are appropriate for them. On the flip side, some investors may crave more advanced investment strategies due to their own personal knowledge, research, and experience. An adviser needs to be cognizant of either scenario and the range in-between. • Client demographics --The varying demographic factors that make each client unique (age, gender, religion, etc.) can, but do not always, play into a client's profile. Advisers need to tread cautiously in this area, but be aware of it nonetheless.