Chapter 7 Selecting a mutual fund for a client

Describe the following investments.

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Explain each of the following factors relative to meeting client needs

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Under each of the following categories of a cash flow statement, list five items that would appear.

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Describe the following investment strategies.

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Identify the following items as they pertain to liquidity.

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Explain how the following relate to or are incorporated in the selection of a mutual fund.

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Identify pertinent considerations in analyzing a client's experience, holdings, and outlook.

- What investing experience does the client have? - What are the current holdings? - What is the client's current investment outlook? - What is the client's outlook on inflation, interest rates, and the economy? - Are there certain investments with which the client has had a good or bad experience?

factors that can change the amount of liquidity needed

- a client's other assets—the more assets, the less the need for liquidity - the types of assets—the more liquid, the less the need for liquidity - the reliability of the client's income—the more reliable, the less the need for liquidity - the client's liabilities—the more liabilities, the more the need for liquidity - the types of liabilities—the more contractual liabilities (such as mortgage payments, alimony payments, and other legal obligations), the more the need for liquidity - the timing of significant expenditures—the closer in time, the more the need for liquidity (e.g., two months before a child's college tuition is due)

Identify the two standard rules in setting goals

1. Make goals specific regarding amounts and time horizons. 2. Goals must be prioritized.

nondiversification

A mutual fund may be a nondiversified investment company, meaning that it is not restricted by the provisions of the Investment Company Act of 1940 with respect to the diversification of its investments. This permits the investment of a greater portion of the fund's assets in the securities of individual companies than would be permitted under a diversified status. At the extreme, a nondiversified fund can have 50% of its assets in just two stocks. Less diversification, of course, means more risk.

high-yield bonds

Also called junk bonds, these securities are below investment grade and therefore have higher credit and default risk than higher quality bonds, may have less liquidity than other bonds, and sometimes are difficult to accurately price, especially if large positions are held in individual issues. For example, even two bonds, each rated B, could have different risk characteristics. One bond might have attained its rating by being upgraded and the other by being downgraded, indicating positive and negative trends, respectively, in their credit quality. Likewise, a high-yield fund emphasizing total return will be more concerned with these trends than will a fund maximizing current income. Knowing the difference is important. High-yield bond funds sometimes own nonrated bonds, which can be a reason for caution if owned to a high degree. While sensitive to interest rate changes like any bonds, the prices of high-yield bonds fluctuate more with business conditions and credit quality changes and less with interest rate changes than higher-grade bonds.

fund services and plans

Although many funds have similar services and plans, if one in particular is needed, it could make a difference in selecting one fund over another. For example, some fund companies offer more funds than others, so if flexibility in exchanging among different funds is important, the one with more selections might be chosen. Another example would be periodic purchase plans, whereby the shareholder's bank account is automatically debited—a feature not available with all funds. Since this service makes additional contributions easy and convenient, some investors might definitely want it.

illiquid and restricted securities

An investment may be illiquid because of the absence of an active trading market, making it difficult to sell promptly at an acceptable price. Restricted securities, such as those acquired in private placements, have contractual restrictions on their resale or cannot be sold publicly until they are registered under the Securities Act of 1933 or have received an exemption from such registration. The inability to sell a security, of course, adds risk to the portfolio, and illiquid securities are usually associated with aggressivegrowth- type funds. Sometimes there is also a question of accurate valuation of these securities. In general, restricted securities add an element of risk that should be considered in selecting a fund. Not more than 15% of an open-end (non-money-market) fund's net assets may be invested in illiquid securities.

List items that typically would appear under each of the following categories: Assets, and Liabilities

Assets: - checking accounts, savings accounts, money market mutual funds, life insurance cash values - stocks, bonds, mutual funds, IRAs, vested portions of pension funds - residence, automobiles, personal property Liabilities: - credit card balances, automobile loan balances, mortgage loan balance

What is the formula for the basic liquidity ratio, and how is it used in evaluating an individual's financial situation?

Basic liquidity ratio = Monetary (liquid) assets/ Monthly expenses It measures the number of months a household could continue to meet its expenses from existing cash and cash equivalent assets after a total loss of income.

analyzing information

Certain considerations include the sufficiency of liquid assets; whether goals are achievable (as discussed in part b., above); whether there is a mismatch between the client's personality, current investments, and stated goals; whether there are tax problems that can be addressed by repositioning certain assets; the impact of the goals' time horizons on the client's invested assets; and retirement planning analysis, including if any funding opportunities are being missed and if the client might run out of money during retirement.

Describe how the debt-to-assets ratio can be used in analyzing a statement of financial position. Show the formula.

Debt-to-assets ratio = Total debt/ Total assets It measures a household's solvency or ability to pay its debts. A ratio of 50% or less is considered adequate

What is the debt-to-income ratio formula, and what percentage shows an income that is adequate for making debt repayments?

Debt-to-income ratio = Gross income/ Annual debt repayments It is a measure of a household's total debt burden. A ratio of 30% or lower indicates adequate income to make debt repayments.

derivatives

Derivatives are instruments that derive their value from another financial asset, such as a stock or bond, or from a currency, an index, or even a commodity. Derivatives can be used to decrease or increase both risk and return, so it is important to understand how they can be and are used. Examples of derivatives include options, futures contracts, options on futures contracts, collateralized mortgage obligations (CMOs), and subsets of mortgage obligations such as interest only (IO) and principal only (PO) securities.

What are some of the questions that should be addressed when examining a client's tax situation?

Do you expect any significant changes in your assets? For example, an inheritance or a divorce could cause significant changes. Do you expect any significant changes in your income level? A major change would usually come from a job loss or change, a sale of a large asset such as real estate, or a year-end bonus. Do you expect any significant changes in your taxable income from items such as mortgage interest deductions, municipal bond interest income, capital gains, retirement plan distributions, and investments in rental real estate? Are you subject to, or might be subject to, the alternative minimum tax (AMT)? This is an alternative way of determining one's tax liability when the person has large deductions in certain categories such as losses from passive activities, accelerated depreciation deductions, and certain itemized deductions. Details of the AMT are beyond the scope of this course.

fund company evaluation

Factors that should be checked during a fund company evaluation are: - low expenses, - the closing of funds, - fulfillment of fiduciary duties by trustees or directors, - the bringing out of "hot" funds, - advertising short-term performance, - the depth and clarity of shareholder communications, - investment policies and restrictions favorable to shareholders, - management ownership of their own funds, - investment personnel turnover, and - the payment of large bonuses for executives, especially in years of poor performance.

fees and expenses

Fees and expenses directly lower shareholder returns and therefore should be considered in selecting a fund. These expenses are especially important with money market funds and bond funds because these funds tend to have lower returns due to the nature of the securities they own. Expenses are important for stock funds as well, however, especially in periods of negative returns when the expenses add to those negative returns. Another important aspect of fees and expenses is that they can be controlled by purchasing funds with low expenses because low (high) expense funds tend to stay low (high). The expense ratio, however, does not include commissions, bid/ask spread costs, or market impact costs

fund performance

Fund performance provides some indication of the portfolio manager's competency, although past performance is not a good predictor of future performance. An investor needs to look beyond the absolute numbers to determine how the performance was achieved and then decide if the factors that caused that performance are temporary (such as chasing hot stocks or sectors) or permanent (such as smart managers having a disciplined investment process that includes controlling risk). The mark of a good fund is performance consistency in both up and down markets. When comparing performances among funds, it is important to compare funds that are of a similar type and a similar style. Funds should not be selected because they have been "number 1" for a period of time—a very common mistake. In general, good performance from investments in various industry sectors is better than if it is from one or two "hot" sectors. A fund should be compared to an index if that fund is reasonably similar to the index. Also, a fund's performance should be compared to its peers over 3-, 5-, and 10-year periods (if available) and on a yearby- year basis in order to assess yearly volatility of returns. Performance should be analyzed on a risk-adjusted basis, using the Sharpe, Treynor, and/or Jensen indexes. The Sharpe and Treynor indexes are used to compare funds based on the excess return earned divided by the fund's standard deviation or by its beta, respectively. The Jensen index produces an alpha that measures how well a fund performed relative to how well it should have performed based on the risk it took.

fund age

Generally, it is best to buy a fund that has at least a five-year record or that has gone through at least one bull and one bear market. However, if a manager has a good record at another fund and then starts their own fund of the same type as before, newness alone is not a good reason for rejecting the fund. New funds can also be considered if they are managed by an investment adviser with a good record in a certain market. For example, an adviser with several excellent stock funds and a team approach presumably will be successful with a new fund in a certain segment, like a small-cap fund.

portfolio turnover

High portfolio turnover has cost disadvantages because it generates higher commissions and more bid-ask transaction costs. It also causes more capital gains and, in particular, shortterm gains, which are taxed at ordinary income tax rates, to be realized. Sometimes it indicates that a portfolio manager is trying to catch the twists and turns of the market (a nearly impossible task) or that there has been a change in investment style or philosophy. Therefore, in various ways, high turnover can be disadvantageous.

Allen Hobson is interested in purchasing a fund that will provide capital growth. He is considering a fund with the following information: stated investment objective: growth a three-year track record of good performance has an alpha of 1.7 has $200 million in assets portfolio manager's tenure—15 months; she has done well 25% of holdings in technology stocks; otherwise well-diversified has above-average annual expenses for a growth fund Discuss how you would use only this information in the mutual fund selection.

His objective apparently matches the fund's objective. A longer track record would be preferable, but coupled with the positive alpha, it appears the fund has performed satisfactorily. The manager's track record is relatively short, but so far her fund has performed well. The fund's concentration in technology stocks raises some concern and indicates a somewhat aggressive approach. The above-average expenses appear to be offset by good performance.

making and implementing recommendations

Investment decisions should be made by the client, but the investment professional can guide these decisions by explaining why a recommendation is appropriate for the client. This can also foster discussion between the investment professional and the client. Implementing the recommendations can be as simple as sending in an order, or it can be complex enough to require the involvement of other professionals, such as an attorney or an accountant, depending on the transaction.

Explain what the investment-assets-to-net-worth ratio indicates, and show its formula.

It indicates how well a household is advancing toward capital accumulation goals. This ratio should be 50% or more, although younger people would be expected to have a lower ratio. Investment-assets-to-net-worth ratio = Investment assets/ Net worth

What is a projected cash flow statement?

It is a planning tool that projects the anticipated amounts and timing of inflows and outflows for a future period.

What is a statement of financial position?

It is a snapshot of an individual's assets, liabilities, and net worth as of a certain date.

What is a cash flow statement?

It is a statement that reveals an individual's cash receipts and disbursements over a specific period of time in the past.

What considerations can be reviewed to assess a person's risk tolerance level?

Questions to ask include the following: - Which types of investments are you comfortable with? Which are you uncomfortable with? - If someone gave you $100,000 to invest, what one investment would you buy, and why? What one investment would you not buy, and why? - If your portfolio started falling in value, at what percentage decline would you become concerned? At what percentage decline would you become fearful? - How important is stability of principal on a scale from 1 (no importance) to 10 (extremely important)? - If a security in your portfolio started falling in value, at what percentage decline would you become concerned? At what percentage decline would you become fearful? - Another approach to assessing risk tolerance is to note matters, such as the following, that would indicate a high-risk profile: - willingness to take on debt - creating wealth on their own, especially by building their own businesses - frequent job changes - ability to make decisions quickly - confidence in their decisions - no tendency to second-guess their decisions - having less concern than normal about investment risks - having more concern about how much they will make on an investment than how much they will lose on an investment - generally having a more optimistic attitude about life - having a job with variable income predictability and lower stability

investment holdings

Reviewing investment holdings leads to a better understanding of the types of securities held and the degree of security and industry concentration in the portfolio. This provides a sense of how the fund is managed. Note complex, difficult-to-understand securities and view them as a red flag that needs close scrutiny. Particular attention should be given to the degree of concentration a fund has within an industry or in its top 10 holdings since the greater concentration, the higher risk the fund is taking.

leverage through borrowing

Some funds may borrow money from banks to buy additional securities. As with any leverage, this can work favorably or unfavorably, but it does add risk to the management of the portfolio. If the investment gains on securities purchased with borrowed money exceed the interest costs of the borrowing, this strategy is favorable; if not, it is unfavorable. There are usually requirements for mutual funds to maintain a certain ratio of assets to borrowings. If this coverage is not maintained due to securities' prices falling, it may require selling some of those securities at a time when doing so is disadvantageous.

tax efficiency

Taxes, like expenses, are a drag on the fund's performance for the investor. A tax-efficient fund provides the investor with more after-tax dollars, and therefore this is an important consideration when selecting a mutual fund for a taxable account. Warning signs that a fund may not be tax efficient or that it will soon make large taxable distributions include high portfolio turnover, owning securities that pay taxable interest and dividends, a change in portfolio managers or the fund's objective, and a large decrease in the fund's net assets. In addition, after a major bear market, capital losses can accrue to offset future capital gains, an advantage for new investors.

inflows

The answer may include any five of the following: gross salaries and wages, Social Security benefits, pension payments and other sources of retirement income (e.g., annuity payments), interest and dividend income, rental income, loan proceeds (money the person has borrowed), withdrawals from savings accounts, tax refunds, proceeds received from the liquidation of assets, and any other source of income (grants, gifts, allowances, court-ordered alimony and/or child support if payee, etc.)

variable outflows

The answer may include any five of the following: medical and dental expenses (not covered by insurance), child care expenses, food and personal care expenses, contributions, housing expenses (utilities, maintenance, and upkeep), entertainment expenses, vacation expenses, taxes (may also be considered a fixed expense, particularly FICA payments), credit card payments, other miscellaneous expenses (postage, gasoline, education, newspapers—any item on which money is spent)The answer may include any five of the following: medical and dental expenses (not covered by insurance), child care expenses, food and personal care expenses, contributions, housing expenses (utilities, maintenance, and upkeep), entertainment expenses, vacation expenses, taxes (may also be considered a fixed expense, particularly FICA payments), credit card payments, other miscellaneous expenses (postage, gasoline, education, newspapers—any item on which money is spent)

investment objective

The client's objective must be clearly understood and matched to the type of fund purchased. The objective must be consistent with the client's risk tolerance level. The fund itself must be examined for correct classification, since some funds are self-described, for example, as growth and income funds but in reality function as growth funds.

Bill Wilson is interested in purchasing a fund that will provide maximum capital growth. He is considering Fund XYZ, which has the following information: stated investment objective: aggressive growth three-and five-year track records of performance 1% below its peers has an alpha of -2.5 has an annual turnover of 200% has $10 billion in assets portfolio manager's tenure—three years 40% of holdings are in health care and telecommunication stocks has below-average annual expense ratio for an aggressive growth fund has a tax-cost ratio with a Morningstar rank of 78 has a Sharpe ratio of 1.1, peer average Sharpe ratio is 1.3 Discuss how you would use this information only in the mutual fund selection process.

The fund's performance is somewhat below average and its Sharpe ratio is weak. It is a large fund, possibly too large since stocks in an aggressive growth fund are often small, rapidly growing companies. It is concentrated in health care and telecommunication stocks, which is not necessarily unusual for an aggressive growth fund, but does indicate a higher degree of risk than found with funds that are more diversified. The below average expense ratio is a favorable factor, however, its large turnover probably means high trading costs, which are not in the expense ratio. This turnover ratio, along with its unfavorable tax-cost ratio ranking, suggests that the fund takes a lot of short-term capital gains. The Sharpe ratio is below average relative to its peers. Overall, there are many negatives with this fund.

fund size

The importance of fund size (that is, total assets) depends to some extent on the type of fund purchased. In general, for money market and bond funds, large size is an advantage in that there are price advantages in trading larger blocks of securities, increased diversification, and there are economies of scale in running large funds. With stock funds, the advantage of a certain size is less clear. Generally, there are advantages in keeping limitations on the size of small-cap funds and micro-cap funds. As these funds become large, it is harder to employ their assets into more and larger positions of stocks in the portfolio because smallcap stocks are harder to buy or sell without moving their prices and because of the difficulty of finding additional attractive small stocks. With large-cap funds and international funds, there is less evidence that size affects performance. Fund size can be controlled by the investment company through a soft close (where additional purchases can be made only by current shareholders) or a hard close (where no additional purchases can be made, even by current shareholders).

Sarah Wilkins is considering the purchase of ABC Bond Fund. She wants income with some degree of capital preservation and has discovered the following information: fund objective: maximum current income invests in bonds rated BB and lower has a 10-year track record of varying performance and is somewhat below the average for its group is run on the committee system has $50 million in assets has an expense ratio that is 50% higher than its peers has an alpha of -2.4 has a Sharpe ratio of 0.62 Discuss how you would use only this information in the mutual fund selection process.

There is some degree of mismatch regarding Sarah's objective and the fund's objective since "maximum current income" suggests a more aggressive approach, which would be contrary to her interest in "some degree of capital preservation." This is confirmed by the low-grade bonds, which indicate a high-yield bond fund. It has a 10-year record that is below average. The committee management has produced this below-average record, indicating that, in this case, it has not worked very well. Asset size is small for a bond fund, which may explain the high expense ratio. The negative alpha also is a warning. The Sharpe ratio, by itself, is not useful, but it would be useful if the fund were being compared to other similar funds (the higher the ratio, the better).

participation certificates

These are equity-linked securities that allow investors to gain economic exposure to a security of a non-U.S. company without a direct investment in that security. They are typically issued by a bank or broker-dealer.

foreign securities

These are securities of foreign companies and foreign governments that are usually denominated in foreign currencies. Besides having exchange rate risk (the risk that exchange rates will change and that the investor will get fewer dollars from incomepayments and/or securities' proceeds, which occurs when the U.S. dollar strengthens against foreign currencies), foreign securities have risks not applicable to domestic securities. These include risks such as those associated with significant political changes, the possible seizure or nationalization of foreign assets, and the possible establishment of currency exchange control regulations or restrictions that might adversely affect the payment of principal or interest. They may also have less liquidity and less public information available about them, and they generally have different accounting, auditing, and financial reporting standards than those of domestic companies. In addition, in many foreign countries, there may be less government supervision and regulation of business practices, stock exchanges, and brokers than is in effect in the United States.

investment policies and risks

These sections of the prospectus should be read because they state the policies that will guide the investment process, as well as the specific risks of owning that fund. Under the policies section, there will be an explanation of the manager's investment flexibility and the fund's investment style. It will identify and explain investment techniques that are or are not permitted. Other signs of risk are significantly above-average performance compared to similar types of funds, a standard deviation much higher than similar funds, degree of concentration (mentioned below), and the worst quarterly loss in the last several years, which can be found in the prospectus.

What is the purpose of footnotes in personal financial statements?

They explain or clarify items or indicate values or circumstances not disclosed in the financial statement.

monitoring performance

This involves noticing changes in the client's situation, time horizons, or even goals, or noticing external changes, like tax law changes, that might affect the client's investments. This process involves periodic client meetings that are two-way exchanges of information.

short selling

This involves selling borrowed securities with the intent of replacing those securities with purchases at lower prices. This is a speculative technique based on accurately predicting the securities that will fall in price. If, instead, the securities increase in price, this technique produces losses until the securities are eventually purchased at the higher price, which can be greater than the original selling price. For example, a $20 stock sold short can rise to $60, which, if then purchased to close the short sale, would result in a $40-per-share loss—twice the original investment.

managing client expectations

This is done by educating the client on securities markets, individual investments, volatility of individual year returns, and long-term investment returns in order to provide some perspective on expected returns. This process should also cover certain ideas: every investment has risk, which is not to be avoided but intelligently controlled; there is no ideal investment; a major bear market can be devastating to an all-stock portfolio, while diversifying with high-grade bonds can temper the effect of such a market; and investing involves trade-offs between risk and return. The client should also understand that some years are negative in securities markets and that good years do not go on forever; this is important so that the client does not get scared out of investments or expect high returns indefinitely.

identifying the needs gap

This is done by using time value of money concepts to determine if goals are attainable and, if not, how to close the gap. This can be done by earning more on the investments, lengthening the time horizon, or adding additional financial resources to the goal.

portfolio management continuity

This relates to whether the manager or team producing a good long-term track record will continue to manage a fund. If the manager who produced that record leaves, that performance may or may not continue, so the fund should be monitored for any significant changes. A portfolio manager who is also a principal of the firm is much less likely to leave than a manager with little, if any, ownership in the firm. If a team of investment professionals is responsible for the performance, then it is likely that the good performance will continue even if one of those individuals leaves.

lending securities

This technique generates income by lending portfolio securities to brokers, dealers, or other types of financial organizations. These loans are collateralized at a minimum of 100%, but there is a risk that, if the borrower fails financially, recovery of the securities loaned could be delayed. There is also a risk that the securities could be lost, or there could be a possible loss of rights to, or a loss of value of, the collateral.

establishing trust

Trust is built over time by having clients' best interests in mind, being concerned about their situations, and striving to best meet their needs. Taking the time to gather data and establish goals enhances trust, as does demonstrating substantial knowledge indifferent investment products.

Answer the following questions regarding the debt service ratio: What does it indicate?What is its formula?What percentage is considered "adequate"?

What does it indicate? - It indicates how much income is needed to repay debts What is its formula? - Debt service ratio = Annual debt repayments/ Annual take-home pay What percentage is considered "adequate"? - a ratio of 35% or less

Review the following goals and explain the degree to which they have been formulated correctly. a. invest for a child's college education in 11 years b. accumulate $30,000 for a down payment to purchase a second home c. accumulate $300,000 for retirement in 22 years

a. invest for a child's college education in 11 years - not specific about amount needed b. accumulate $30,000 for a down payment to purchase a second home - not specific on time horizon c. accumulate $300,000 for retirement in 22 years - This goal is stated correctly because it is specific about the amount and the time horizon.

Why are time horizons so important relative to asset management?

because they directly affect which investments are appropriate and they relate to risk

fixed outflows

housing (rent or mortgage payments), insurance payments, loan payments, court-ordered child support and/or alimony payments

sources of liquid funds

money market funds, bank savings accounts, checking accounts, bank money market accounts, high-quality money market instruments

the foremost consideration regarding funds used for liquidity

safety of principal

List items that should be noted when examining employee financial benefits

stock options, thrift and/or retirement plans, and, in general, financial benefits and incentives from employers

What are two potential tax problems associated with municipal bond ownership?

the alternative minimum tax and increasing income to a point where Social Security benefits become partially taxable

List questions to be answered in reviewing the following items:the client's retirement planning data and information regarding a business owned by the client

the client's retirement planning data - When do the client and spouse plan to retire? Will the client's lifestyle change materially after retirement? How much income will it take to support that lifestyle? And what will be the sources of that income? Is there a plan whereby the client's employer matches contributions, and if so, is this being used? How much of the client's retirement funds are invested in their company's stock? information regarding a business owned by the client - What type of business is it? If a corporation, what tax type is it? Who are the other owners? Will the death of one of them threaten the ongoing existence of the business?

the two requirements regarding liquidity sources

they must be accessible and there must be assurance that most or all of the principal will be available when needed

What is the basic principle in determining the fit of an investment recommendation?

to avoid redundancies and conflicts with current holdings