Review

What is the Modern Portfolio Theory? Draw the mean-variance graph and explain the main principles.

"Portfolio Selection" concept define way to diversify and allocate assets in a port to maximize the expected return given risk tolerance Efficient frontier was introduced in MPT

What is a reasonable sustainable withdrawal rate? What is a reasonable range for equity allocation based on Bengen (1994)?

* 4%, says Bengen. * 50% - 75% is a reasonable range for equity allocation based on Bergen

What are the three elements that impact portfolio performance? Which element(s) is/are most important?

*Investment Policy * Timing * Security Selection Investment Policy is the most important because it encompasses all investment objectives and constraints.

What is Monte Carlo? Discuss simulations, confidence, assumptions, etc.

A problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables. Monte Carlo simulation is named after the city in Monaco, where the primary attractions are casinos that have games of chance. Gambling games, like roulette, dice, and slot machines, exhibit random behavior.

Describe the Wealth Management Process.

1) Client Relationship 2) Client Profile 3) Wealth Management Investment policy 4) Portfolio management, monitoring, and market review

Describe constraints and how they impact the planning process.

1. Time horizon: longer the investment horizon the greater the risk capacity 2. Liquidity and marketability requirements: Marketability - ability to convert asset into cash at market price; Price Volatility- does the price fluctuate greatly, such as stocks 3. Personal tax environment-where to invest the securities, when to take losses/gains 4. Risk tolerance and capacity-asset allocation 5. Legal and regulatory considerations-Required Minimum Distributions Without considering these constraints, the investment plan won't be effective and it will be difficult to achieve the client's goals other than by chance.

What does Rationality encompass? Discuss information, self-interest, and cognitive concerns.

A decision-making process that is based on making choices that result in the most optimal level of benefit or utility for the individual.

What are the main reason behind constructing an IPS and what are the main elements?

A document drafted between a portfolio manager and a client that outlines general rules for the manager. This statement provides the general investment goals and objectives of a client and describes the strategies that the manager should employ to meet these objectives. Specific information on matters such as asset allocation, risk tolerance, and liquidity requirements would also be included in an IPS. For example, an individual may have an IPS stating that by the time he or she is 60 years old his or her job will become optional, and his or her investments will annually return $65,000 in today's dollars given a certain rate of inflation. This would be only one of many points included in an IPS; however, it probably would also include such things as general guidelines outlining what the individual wants to leave behind to loved ones when he or she dies. Main Elements: client description and goals, investment objectives, investment constraints, strategic asset allocation; implementation, monitoring, and review.

Describe portfolio insurance and the costs associated with it.

A method of hedging a portfolio of stocks against the market risk by short selling stock index futures. According to Arnott, portfolio insurance is expensive.

What tax externality is imposed on mutual fund investors that ETF investors are not concerned about?

A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment. In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming "creation units," which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure.

What is judgmental overlay?

A subjective, fundamental overlay is used to reflect factors not detected by the model that may negatively impact a client's portfolio.

What is the difference between a tax-exempt security and a tax sheltered investment?

A tax-exempt security is one which the income produced is free from federal, state, and local taxes, such as a municipal bond. a tax-sheltered investment is one that taxes will eventually be owed, but it is currently growing tax free until withdrawal; a common tax shelter is a 401(k).

What is prospect theory? Explain the differences in how investors react to losses/gains and the relevance of low probability events.

A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former. Also known as "loss-aversion theory."

What are some of the positive and negative attributes of Variable Annuities?

A variable annuity is an insurance contract, under which the insurer agrees to make periodic payments to you in the future. You can purchase an annuity contract by making either one single purchase payment or a series of purchase payments to the insurer. An annuity has two phases: The savings or "accumulation" phase, where you make purchase payments into the contract, and the earnings of the investments accumulate on a tax-deferred basis; and the payout phase, where you receive regular payments from the insurance company for the rest of your life or the life of your spouse. In a variable annuity, your money is typically invested by the insurer in mutual funds, which are professionally managed funds that can invest in stocks, bonds, money market instruments or a combination of the three. Benefits: VAs give the contract holder periodic payments for the rest of his or her life, which protects against the possibility of outliving other assets. VAs are also tax-deferred investments, so you pay zero taxes on any income and gains from the annuity until you withdraw the money; the ability to defer taxable income in the future is the most considerable benefit. This allows your investments to grow and compound year after year, tax-free, and increases your payout at retirement. They often come with a death benefit, and you can designate a beneficiary to the annuity, so if you die before the payout phase, your beneficiary will be guaranteed to receive a specified amount of money. Drawbacks (more disadvantages than advantages): Fees and expenses on variable annuities can be quite high, with numerous fees like administrative costs, insurance and contract charges, underlying fund expenses, and mortality and expense risk charges (average annual fees between 2% and 2.5%, but it is not uncommon to see some variable annuities with annual costs as high as 4%). If you withdraw the money before age 59 ½, you'll be charged a 10% penalty. When you finally start to withdraw money in your later years, all of your gains will be taxed at your ordinary income rate, instead of a lower long-term capital gains tax rate. If your variable annuity goes up a lot in value over the years, the tax hit can be pretty significant.

What is the difference between geometric and arithmetic returns? Which should you use and why?

Arithmetic return is the simple average of returns over a number of periods, use geometric mean to account for compounding interest over multiple years.. If goal is to estimate future value for the next period, arithmetic return is appropriate. Geometric return is the best measure of past performance representing the fixed return required to achieve a specific return over a given period of time.

Discuss where bonds and equities (separately) should be located (sheltered or non-sheltered account) and the logic behind the decision.

Bonds should go to tax-sheltered accounts because they pay out in ordinary dividends while equities should be in non-sheltered tax account because of the advantage of LTCG. This is the concept of asset location aimed at tax-efficiency.

Describe CAPM and the tenets for investing. What are the differences between the CML and SML?

CAPM was created by William Sharpe. It's the theory behind how financial assets are valued by the market (given a required rate of return). Investors use the expected return (Ri) to discount future cash flows in order to come up with an intrinsic value for the asset. It deals with the combination of a risk-free asset and a risky portfolio. Beta is used, which takes into account systematic risk. CML is a line representing the rate of return for a given risky portfolio and a risk-less (risk-free) asset. CML risk is measured by Standard Deviation. SML is a line representing the rate of return for the market's risk. SML risk is measured by Beta.

Give an example of a cap-weighted index and explain the meaning behind "cap-weighted."

Capitalization-weighted index is a type of market indexing whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. Such as the S&P 500, Nasdaq, Wilshire, Hang-Seng and EAFE indexes.

Discuss the tradeoff between a multiple bucket strategy and Professor Evensky's Cash Flow Reserve Strategy? Which approach is better and why? Why would you use the Cash Flow Strategy and how do you replenish reserves?

Cash reserve is a fund set aside in order to ease the panic when their money is tied up for five years. While the bucket strategy has a bucket that is intended for cash/cash equivalents (2yrs worth of living expense). In the CR, when your portfolio need to be rebalance you can replenish the fund. 3. Evaluation: Cash flow strategy wins a. Easy to increase reserves to adjust for inflation, strategy provides flexibility i. Can refund CFP by liquidating bonds in investment portfolio b. Most volatility drain related to cash flow can be eliminated because this strategy provides significant control over timing of investment liquidations c. Strategy is very flexible in meeting unique and changing needs d. Minimizes frequency of transactions (less costs) and enables advisor to manage more efficiently the tax consequences e. Strategy manages the paycheck syndrome as cash flow is consistent and independent of market volatility

What is the difference between a fixed and variable annuity? What factors would you consider when determining whether an annuity is appropriate for a client?

Differences o Variable assumes performance risk of underlying securities portfolio o Variables increase potential for higher return o Variable has no guaranteed return because of principal invested in sub-accounts o Fixed does not hedge for inflation, while variable attempts to keep up w/inflation Appropriate if investor is seeking investments that are: o long-term o stable o grow over time o have tax advantages Think of investor's health, life expectancy..

Describe the Efficient Markets Hypothesis. What are the three forms? If you use portfolio managers which form does this imply you believe in?

Efficient Market hypothesis is concerned with the relationship between stock prices and the actions of buyers and sellers. It means the stock prices fully reflect all available information. Strong: All public and nonpublic information is reflected in the price. No chance to beat market Semistrong: All current public information is reflected in the price. Weak: All past prices of a stock are reflected in today's price. Technical Analysis provides no value. Fundamental analysis can though.

ERISA

Employee Retirement Income Security Act of 1974: This introduced the requirement that fiduciaries consider the concepts of modern investment theory and manage in accordance with the unique nature of the plan. A fiduciary is to act "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

Discuss Modern Investment Theory in Relation to Behavioral Finance. What are the primary differences?

Essentially MPT describes how markets work and behavioral finance explains how people work. MPT is very useful, but it is descriptive, not prescriptive, and relies on assumptions that may not always be valid. Behavioral finance picks up where modern portfolio theory leaves off, completing the circle. MPT is Harry Markowitz! MPT is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket. A core tenet of MPT is that financial markets are efficient. Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Think of modern portfolio theory as how the financial markets would work in the ideal world, and behavioral finance as how financial markets work in the real world. Emotion and psychology play a role when investors make decisions, sometimes causing them to behave in unpredictable or irrational ways.

What are the primary metrics you will look at when assessing the quality of a fixed income/equity investment and why?

Expense Ratio - because it measure the overall expenses for the investment and thus, measures that amount of return that an investor is giving up in fees. Interest Rate Risk, i.e., duration - because volatility of an investment can be a dispositive factor depending on the investor's tolerance. Standard Deviation - because it measures the degree of fluctuation in a portfolio's return; the larger the standard deviation, the greater the magnitude of the fluctuations from the portfolio's average return. Sharpe Ratio - representation of the risk-adjusted return of a portfolio or security; it measures how much return is being obtained for each theoretical unit of risk Beta (risk)- the magnitude of an investment's price fluctuations relative to the ups and downs of the overall market (market is assigned a beta of 1.00); bes used to measure the systematic or market risk of an investment and can be appropriate in evaluating an investment for possible inclusion and diversified portfolio. Alpha (return)- a measure of performance on a risk-adjusted basis; the excess returns of a fund relative to the return of the benchmark index Treynor - risk-adjusted return of a portfolio or security versus the market; an asset's excess return versus a risk-free asset such as T-bills, divided by asset's beta. it is an appropriate measure of a portfolio's return per unit of risk.

FINRA

Financial Industry Regulatory Authority: • Private corporation that acts as a self-regulatory organization • Non-govermnet organization that performs financial regulation of member brokerage firms and exchange market. • SEC acts as the ultimate regulator of the securities industry including FINRA.

Explain Fundamental Indexation and any concerns you have with this approach.

Fundamentally based indexes are indexes in which stocks are weighted by one of many economic fundamental factors, especially accounting figures which are commonly used when performing corporate valuation, or by a composite of several fundamental factors. Created by Graham and Dodd. The two concerns with this approach are: they are driven by exposure to macroeconomic risks that are not captured fully by the CAPM model; and the fundamental metrics of size all implicitly introduce a value bias into the indexes, which has been amply documented as possibly the result of market inefficiencies or as priced risk factors.

Is high turnover a good thing to see in a fund? Why or why not?

Generally speaking, higher turnover suggests active management and realization of gains and losses, thus often carrying negative implications. However, if turnover is used to harvest losses to offset gains and reduce tax liability, then it may be good. A surface inspection is not sufficient, because while high turnover is often unfavorable, this is not always the case.

Describe different types of goals and how you would define a goal.

Goals must be time and dollar specific and prioritized. -Hidden goals: Things that a client often does not consider. -Short term goals: No investments should be considered unless the time horizon is under five years. -Intermediate goals: Consciously anticipated, are finite in time and need to be paid for out of savings (college education, weddings, second homes, boats, and trips). -Lifetime goals: Financial independence. -Wealth transfer goals: Wealth left behind to heirs/charity.

Define and discuss the following biases/heuristics: (Tversky and Kahneman!!!) Availability, representativeness, overconfidence, confirmation, endowment, regret, gambler's fallacy.

Heuristics - refers to experience-based techniques for problem solving, learning, and discovery that give a solution which is not guaranteed to be optimal. It pushes one to either over weight information that is minimally relevant while minimizing important information. Some common heuristics are Representativeness - which is Estimated future probability =f (similarity to past events). This means that for instance in a game of tossing a die you estimate that because there is already 10 heads the next will be a tail. This is related to gamblers fallacy which is a belief that because a fair toss, a coin landing on heads is more likely after a long run of tails. Over confidence - This shows that investors or rather ignorant investors can create an illusion of control and hence promote confidence when it is least warranted. Availability- Estimated Future Probability = f (information in memory). Mental Shortcut based on using what comes to mind. Confirmation bias- this is a set of blinders an investor may wear after making an investment. It ensures the investor will only see information confirming his or her original judgment. Endowment- the endowment effect (also known as divestiture aversion) is the hypothesis that people ascribe more value to things merely because they own them. This is illustrated by the fact that people will pay more to retain something they own than to obtain something owned by someone else—even when there is no cause for attachment, or even if the item was only obtained minutes ago. Regret- If an important decision leaves a negative consequence. Gambler's fallacy - When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

What is the relationship between turnover and tax efficiency? Is it linear/constant? What other metrics should you look at to determine tax efficiency?

High turnover is often indicative of poor tax efficiency. The reason for this is, on average, the greater amount of trading that is taking place, the great amount of returns that will be generated, thus leading to tax implications. Some high turnover funds can be tax efficient if managers are using turnover to harvest losses. This is not a constant relationship. The difference in 0-10% turnover makes a greater impact than the difference in 30-40% turnover. Some investment experts claim that turnover is not a relevant measure of tax efficiency unless the turnover is substantially near zero. Other metrics to consider are tax-adjusted return (for obvious reasons), tax-cost ratio (a tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period; although naturally other things can go wrong that also affect returns), capital gains exposure (measure how much a fund's underlying holdings have appreciated in value, adding up to capital gains that haven't yet been distributed to the fund's shareholders and dividing that number by the fund's total net assets). Another one (not brought up in class but I found it online and thought it was interesting) is tax alpha, which is the portfolio's excess after-tax return relative to a benchmark, adjusted for any excess pre-tax returns.

Name the risks that investors face and how a planner mitigates/manages them.

I have no idea what this question is wanting. Investor risks include interest rate, business, credit, taxability, call, inflationary, liquidity, default, market, reinvestment, social/political/legislative, currency/exchange rate, mortality, to name a few. Planners mitigate, but cannot fully manage, these risks through diversification.

What is the importance of the 5 year mantra? What year mantra would you employ and why?

It is a concept of time diversification. 5 years, specifically, is what Evensky believes is a good minimum standard to use as a criterion for investment time diversification. In the book, he explains that although, most client's time horizon is typically 20+ years, their psychological time horizon is 10 seconds, they would balk at discussing a 20+ year time period. The 5 year mantra serves as the basis for our flow strategy. Namely, he wants to have a significant time window (preferably five years) prior to having to sell the potentially volatile investment for the purposes of flexibility and possibly force them to liquidate positions when the value is down. Thus, the 5 year mantra helps to plan necessary liquidity and invest patiently.

What did Graham & Dodd bring to the world of investments? Describe their investment approach.

Laid the framework for value investing (intrinsic value based on fundamental analysis). Look at low p/e ratios, high dividend yield, low price to book ratio.

Explain mental accounting, framing, and the disposition effect.

Mental Accounting posits that people mentally frame assets as belonging to current income, current wealth or future income and this has implications for their behavior as the accounts are largely non-fungible and marginal propensity to consume out of each account is different. The result is that clients often think of their investments as being allocated to separate pockets. Framing in the social sciences refers to a set of concepts and theoretical perspectives on how individuals, groups, and societies organize, perceive, and communicate about reality. The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value. The disposition effect can be partially explained using loss aversion.

What is the purpose Overlap software?

Mutual fund analysis that shows overlap of stock holdings between mutual funds and the percentage of that overlap.

What is equilibrium accounting and why is this important?

Passive investor: anybody hold market portfolio Active Investor: Anybody do not hold market portfolio. Since aggregate passive investor hold market portfolio, aggregate active investor also hold market portfolio => Equilibrium accounting. If the fees and expenses of active investors are higher than those of passive investors, active investors must in aggregate lose to passive investors. This is the unavoidable arithmetic of equilibrium accounting. And notice that this is not a statement about expected returns or about long-term average returns. In aggregate active investors lose to passive investors every instant. It is, of course, possible that individual active investors add value. But if they do, it's at the expense of other active investors. But real investors cannot ignore costs. If some active investors win, others must lose, and they all pay to place their bets.

What are the 3 Ps and what is the relevance of this in relation to the IPS?

Philosophy, process, and people (management style). The IPS is a way for you to illustrate your strategy that you will use for your client, it is a benefit to both client and advisor because it encourages clarity and disclosure in a contractual format. Therefore, combining the two, the three Ps should be clearly explained in your IPS to ensure consistency and accountability.

Rules Based vs. Principal Based

Rules base- a list of detailed rules that must be followed when preparing financial statements More rules allows for less errors and easy comparison Principle base - Generally Accepted Accounting Principles (GAAP) a set of key objectives are set out to ensure good reporting Inconsistent, making it hard to compare to other statements

Describe the elements of systematic risk and unsystematic risk.

Systematic risk is undiversified risk, meaning everyone is subject to it. This is due to market conditions, measured by Beta. Unsystematic risk is from an individual security. It can be eliminated through diversification.

Define the Sharpe and Treynor Ratios. What do these ratios not consider?

The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated. One intuition of this calculation is that a portfolio engaging in "zero risk" investment, such as the purchase of U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk. The Treynor ratio is calculated as: (Average Return of the Portfolio - Average Return of the Risk-Free Rate) / Beta of the Portfolio In other words, the Treynor ratio is a risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility.

What is Pascal's Wager and how should it influence a planner's decisions?

The argument that you're better off believing in God than suffering the consequences of being wrong. It posits that humans all bet with their lives either that God exists or that he does not. Based on the assumption that the stakes are infinite if God exists and that there is at least a small probability that God in fact exists, Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas they stand to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (eternity in Hell). In terms of influence over planner's decisions, this concepts focuses on the consequences of choices; the consequences are as, if not more, important than the odds of something happening. As planners, we must consider the consequences. In terms of retirement, we must consider not only the likelihood of living well past normal life expectancy, experiencing high inflation, or a market downturn, but also the consequences of each because the consequences could be catastrophic.

How might a portfolio manager inflate alpha artificially?

They could choose a bogus benchmark, or speculative option contracts.

Explain Time Diversification. What does this mean for investing?

Time diversifies risk, meaning the longer the investment horizon, the smaller the risk (standard deviation). It also means that over the long-run a riskier portfolio will earn a higher rate of return than a less-risky one. An investor should no hold funds needed in the short-term in risky investments but should hold long-term funds in a riskier portfolio.

SEC

U.S. Securities and Exchange Commission: Has primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the US.

Identify some alternative investments. Explain the importance of them in relation to the core investments.

Venture capital, private equity, hedge funds, real estate investment trusts (REITs), real asset commodities. The core portfolio provides beta exposure (if it is passively managed), while the alternative investments seek to add alpha.

What is the difference between ETFs and ETNs? How does counterparty risk enter the equation?

When you invest in an ETF, you are investing into a fund that holds the asset it tracks. That asset may be stocks, bonds, gold or other commodities, or futures contracts. An ETN is more like a bond. It's an unsecured debt note issued by an institution. Just like with a bond, an ETN can be held to maturity, bought or sold at will, and if the underwriter (usually a bank) were to go bankrupt, the investor would risk a total default. The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract. In most financial contracts, counterparty risk is also known as "default risk". ETNs are debt instruments subject to risk of default by the issuer as counterparty. In the long term, investors need a credit risk metric for ETNs.

Explain core and satellite investment approach. What are the differences between the core and the satellite? What expectations do you have for each segment of the portfolio?

a. An approach that maintains assets in a core portfolio with a strategic asset allocation (a design to meet long-term goals using long-term risk and return expectations) managed passively and assets in a satellite portfolio with a TAA managed actively (80/20) i. Core portfolio provides beta and satellite portfolio seeks alpha 1. The core portfolio provides long steady returns, and the satellite portfolio gives the opportunity for riskier investments that may offer a higher return.

What is sequence of return risk and how might a planner mitigate the potential impact of this phenomenon?

a. Involves the order in which investment returns occur and the impact of those returns on people who are near retirement, transitioning into retirement, or recently retired b. In a nutshell i. A bear market or period of market losses can have a severely negative impact on the income generating potential of a portfolio belonging to a person who is transitioning into retirement. c. Hedging or downside protection of one's financial assets is critical and can help mitigate sequence of returns risk Star with low risk portfolio in the first ten year, while sequence of return risk is at the highest, and then increase equity allocation later. (Wade Pfau) 5 year mantra and cash-reserve strategy to reduce the risk of pull money out at the wrong time.

Suitability

i. A situation (and sometimes a legal requirement) that an investment strategy meets the objectives and means of an investor. ii. In most parts of the world financial professionals have a duty to take steps that ensure that an investment is suitable for a client iii. Ask - Is an investment appropriate for an investor?

Implications for the profession of planning

i. Implications for planners 1. Full disclosure in writing of conflicts and compensation a. At commencement of relationship b. At each transaction 2. As what you would do if parent/sibling/child were client 3. Never harm the client in order to receive an additional benefit yourself 4. Investment strategy meetings a. Document everything: why this one, why not that one... b. Investigate all products and managers 5. Presentation lists various questions to ask of products such as fixed income and equity investments and annuities 6. Always document everything you do to investigate everything 7. Add specific fiduciary duties explanations to operating policies 8. Adopt specific policies for specific situations 9. Advocate Appropriate Regulatory Structure: Professional Regulatory Organization a. Subject to appropriate government oversight, as individual professionals we adopt principles and rules for adherence to our: i. Duty of Due Care 1. Knowledge, expertise required for entry 2. Continuing education 3. Required peer review assessments ii. Duty of Loyalty iii. Duty of Utmost Good Faith

Third Restatements

i. Reflected ERISA and UMIFA and provided for a dynamic model of trust investment management unique to the needs of the trust ii. It focuses on the trust's portfolio as a whole iii. It also recognized that return on investment is related to risk, that risk includes deterioration of real return, and that the relationship between risk and return may be taken into account in managing the assets iv. A few principles of prudence were also outlined 1. Sound diversification is fundamental to risk management 2. Trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate 3. Trustees have a duty to avoid fees that are not justified 4. Requires a balance of production of current income and protection of purchasing power 5. Trustees may have the authority to delegate as prudent investors would

Duty of Care

is a legal obligation which is imposed on an individual requiring adherence to a standard of reasonable care while performing any acts that could foreseeably harm others.

Duty of Loyalty

is a term used in corporation law to describe a fiduciaries' "conflicts of interest and requires fiduciaries to put the corporation's interests ahead of their own."[1] "Corporate fiduciaries breach their duty of loyalty when they divert corporate assets, opportunities, or information for personal gain.

Explain Skewness and Kurtosis. What impact might these assumptions have on optimization?

· Skewness - measures the asymmetry of the distribution of returns Describes the shift in the relationship between the median and mean and disproportionate distribution trails. · Kurtosis - measure of more extreme distributions and returns different from normal distributions that are merely skewed to the left of right. (fat tails) · Skewness and kurtosis lead to substantially different allocations than traditional mean-variance optimizations. And Post-modern Portfolio Theory (downside risk) does not add much value. And PMPT is still in the academic and experimental stage.

Does MPT suggest that portfolio formation is based on historical data? How might a practitioner formulate expected return and volatility?

• Evensky says that Markowitz doesn't say to use historical data. He believes that there are better methods. Expected Returns: • There are innumerable ways to estimating expected returns. Most common are: o Historical experience o Real rate of return (nominal returns less inflation o Discounted cash flow estimates o Risk premium Approach Volatility: • Don't simply equate risk to volatility. An investment can have higher volatility than another and still be the better choice because the median return was higher. • BETA: Investors calculate future volatility using historical standard deviation and will also look at the investments beta. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Fiduciary

• Principal driven= fiduciary • A fiduciary relationship involves trust, because of this the law imposes duties of loyalty • Conduct of the fiduciary cannot be circumscribed by the client in advance, cannot opt out or waive, the duty of loyalty compels it

What is R-Squared and why is it meaningful?

• R squared is a measure of how correlated an investment is compared to another investment or index. R squared values range from 0 to 100. An R-squared of 100 mean that all movements of a security are complexly explained by movements in the index it's being compared to. Normally an R-squared of 85-100 indicates the fund's performance patterns have been in line with the index. Evensky likes the R-Squared to be above 90% to consider it highly correlated. • It's meaningful for a few reasons. First when diversifying your portfolio it's important to have lowly correlated securities to reduce risk and to anchor your portfolio on the efficient frontier. Next when doing research and comparison it's important to know the r-squared to ensure you are comparing your securities against the proper benchmark.

Define alpha and beta as if you were talking to a construction worker with no investment knowledge.

• Simple Alpha Definition: If a manager of an investment fund is able to beat an index they are being compared to then they will have a positive Alpha. Alpha shows how much additional earnings they are able to earn their investors compared to a basic index investment. • Simple Beta Definition: Beta measure how much extra risk an investment is taking and if that extra risk is paying off. When markets are up it should be paying a lot more when markets are down it should be losing more money because of the extra risk.

Define the equity risk premium and how you might develop forward looking expectations for it.

• The difference between the adjusted return from large company stocks and the return from Treasure bills is called the equity risk premium. • Consider the costs and taxes associated with your investments. Change in tax laws could quickly eat up lots of the equity risk premium.

Why is it important that we have a reasonable estimate of the equity risk premium?

• To set clients expectations. Many professionals argue that the historical risk premium has been high for the US and they expect it to be lower in the future. See reasons above to see why they have been higher. • Planners need to make sure they are using the best possibly estimates so they can make sure clients' portfolios are designed as optimally as possible to give them the best chance they can to reach their goals while mitigating risk. • Help clients invest in the right securities.