bolton financial services, llc chartered wealth management seminar january 27-29, 2006 jeffrey d....

Bolton Financial Services, LLC

Chartered Wealth Management Seminar

January 27-29, 2006

Jeffrey D. Lewis, CFA


Type of Capital Market Instruments

a) Treasury Bills

b) Certificate of Deposits/Commercial Paper/Repos/Federal Funds

c) LIBOR (London Interbank Offer Rate)

d) Treasury Notes and Bonds (benchmark for all capital market pricing)

e) International Government Bonds (Bunds, Gilts, JGBs, World Bank)

f) Corporate Bonds (high grade)

g) Eurobonds (high grade)

h) Municipal Bonds

i) Mortgage Backed Securities


Type of Capital Market Instruments (cont.)

j) Preferred Stock

k) Common Stock

l) Junk Bonds

m) Emerging Market Bonds

n) Real Estate

o) Private Equity/Leverage Buyouts

p) Venture Capital

q) Options

r) Futures


Widely Known Financial Indices

a) Bonds: Lehman, Merrill Lynch, Salomon Brothers

b) U.S. Equities: S&P 500, Russell 1000, Russell 3000, Dow Jones

c) Foreign Equities: Nikkei, FTSE 100, CAC-40, DAX, MSCI

d) Other: VIX, GSCI, CRB


Major Market Participants

a) Individuals

b) Institutions (Pensions, Endowments, Government bodies): Invests for the beneficiaries. Theoretically has a perpetual life.

c) Mutual Funds: Common name for an open-ended investment company with professional management. Generally only long. Goes by different names in other countries (unit trusts, etc.)

Money Market: Invests only in short-term, highly-liquid instruments)

Fixed Income:

Balanced: Invests in some blended proportion of both equities and fixed income.

Equities, both foreign and domestic. Can invest in a variety of market capitalizations (large, mid, and small) or styles (value, growth, or blend)

Index Funds: Replicates the performance of a particular index, usually at a low cost)

Sector Funds: Invests in a particular sector, such as healthcare, commodities, technology, etc

Exchange Traded Funds: Very much like mutual funds, but with several major exceptions. They usually trade throughout the trading session (mutual funds only mark prices at the end of day) and they generally mimic some index

d) Hedge Funds: Non-regulated investment entities that are able to trade a market both long and short.


Markowitz (Mean-Variance) Efficient Frontier

The efficient frontier was first defined by Harry Markowitz in his groundbreaking 1952 paper that launched portfolio theory. That theory considers a universe of risky investments and explores what might be an optimal portfolio based upon those possible investments.

Consider an interval of time. It starts today. It can be any length, but a one-year interval is typically assumed. Today's values for all the risky investments in the universe are known. Their accumulated values (reflecting price changes, coupon payments, dividends, stock splits, etc.) at the end of the horizon are random. As random quantities, we may assign them expected returns and volatilities. We may also assign a correlation to each pair of returns. We can use these inputs to calculate the expected return and volatility of any portfolio that can be constructed using the instruments that comprise the universe.


Markowitz (cont.)

The notion of "optimal" portfolio can be defined in one of two ways:

1. For any level of volatility, consider all the portfolios which have that volatility. From among them all, select the one which has the highest expected return.

2. For any expected return, consider all the portfolios which have that expected return. From among them all, select the one which has the lowest volatility.

Each definition produces a set of optimal portfolios. Definition (1) produces an optimal portfolio for each possible level of risk. Definition (2) produces an optimal portfolio for each expected return. Actually, the two definitions are equivalent. The set of optimal portfolios obtained using one definition is exactly the same set which is obtained from the other. That set of optimal portfolios is called the efficient frontier. This is illustrated in Exhibit 1:


Markowitz (cont.)

In Exhibit 1, the green region corresponds to the achievable risk-return space. For every point in that region, there will be at least one portfolio constructible from the investments in the universe that has the risk and return corresponding to that point. The yellow region is the unachievable risk-return space. No portfolios can be constructed corresponding to the points in this region.

The gold curve running along the top of the achievable region is the efficient frontier. The portfolios that correspond to points on that curve are optimal according to both definitions (1) and (2) above. Typically, the portfolios which comprise the efficient frontier are the ones which are most highly diversified. Less diversified portfolios tend to be closer to the middle of the achievable region.

Efficient FrontierExhibit 1


Markowitz (cont.)

The objective of portfolio management is to find the optimal portfolio for an investor/client. Such a portfolio should have two characteristics:

A) It should lie on the efficient frontier; and

B) It should have no more risk than the client is willing to incur.


Capital Asset Pricing Model (CAPM)

A second key tenet of modern finance is the Capital Asset Pricing Model (CAPM). Whereas the Markowitz theory is concerned solely with risky assets, investors have the ability to invest in a risk free asset. CAPM decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk of holding the market portfolio. As the market moves, each individual asset is more or less affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is unique to an individual asset. It represents the component of an asset's return which is uncorrelated with general market moves.

According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk, but through diversification, the investor's net exposure is just the systematic risk of the market portfolio.


CAPM (cont.)

E(r) = ά + Β(rm-rf)+e

The expected return of an asset/portfolio equals alpha + beta (return of market-risk free rate) + an error term.

Alpha is the abnormal rate of return on a security in excess of what would be predicted by CAPM.

Beta is the measure of systemic risk of a security, or the tendency of a security’s returns to swing in response to swing in the broad market.

Rm=is the market risk (typically to whatever the security is benchmarked)

Rf=is the appropriate treasury bill or bond rate.

E is the error term.

Each security has two sources of risk: market risk, attributable to the sensitivity to macroeconomic factors as reflected in Rm, and firm-specific risk, as reflected in e.

Again, e can be diversified away.


CAPM (cont.)

Points that lie on this equation intersect the Efficient Frontier, as shown below.

For example, suppose a stock has a beta of 0.8. The market has an expected annual return of 0.12 (that is 12%) and the risk-free rate is .02 (2%). Then the stock has an expected one year return of .02+ 0.8 (.12-.02) = 10%

What this means is that an investor prefers the highest returning portfolio satisfying a given level of risk. It implies that diversification is the key to building an optimal portfolio. For example, two assets on their own may be too risky, but, when combined, construct a much better portfolio.


CAPM (cont.)

What this theory forms the basis of is asset allocation. Strategic asset allocation is a very important contribution to how our portfolios perform over time. It is a technique that factors in risk, or volatility. If an investor wasn’t concerned about risk, he or she would probably not be interested in diversifying and/or asset allocation. Since most investors do care about risk, and want to make sure they have enough money available to meet their long-term goals, asset allocation will be very important in their planning process. Strategic asset allocation is to allocate portfolio holdings to asset classes based on the long-term expectations for returns, risk and correlation. Market timing, also known as tactical asset allocation is to make investment decisions based solely on recent price movements and volume data. Security selection is the active management of specific securities within an asset class.


CAPM (cont.)

Brinson, Hood, and Beebower (1986) and Brinson, Singer, and Beebower (1991) offer statistical evidence in their study of the importance of strategic asset allocation on portfolio performance. As shown in the results of their study, asset allocation is very important in the portfolio construction process. The results show that over 90 percent of the volatility in our returns is due to our asset allocation policies. Does this mean that market timing and security selection add no value to investment performance? No, they are also a value-added part of our portfolios. However, for long-term planning purposes, they do not play as an important of a role as strategic asset allocation in helping us meet our financial goals.

The Importance of Asset AllocationResearch shows that a properly allocated portfolio is the most critical factor in explaining the difference in returns across portfolios.

Source: Brinson, Gary P.; Hood, L. Randolph; and Beebower, Gilbert L. 1986. "Determinants of Portfolio Performance." Financial Analysts Journal, Vol. 42, No. 4 (July/August 1986) pp: 39–48.


Active vs. Passive Investing

There is much debate on whether markets/securities are efficient. The Efficient Market Hypothesis (EMH) holds that securities already reflect all available information. This is the basis for index investing, which maintains that investors are unlikely to meaningfully outperform for extended periods of time, and, therefore, should invest in the most cost effective means possible. Active investing means that outperformance is possible through fundamental or technical analysis.

In reality, I believe that the truth lies somewhat in the middle. I do believe that the core part of an investor’s portfolio should be indexed . However, there are parts of the market that are inefficient, either by a portfolio manager having particular insight into that sector, or manager skill, or lack of institutional coverage. In additions, markets tend to overshoot/undershoot “expected” markets (i.e., the NASDAQ bubble, the Japanese market in both the 1980s and 1990s, the Holland Tulip bubble in the 1720s, etc.). Examples include small-cap stocks, venture capital, some alternative managers, etc. It is those markets where your time should be devoted to finding outstanding managers able to out-perform for extended periods of time.


Fixed Income/Bonds

A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations, and municipalities issue bonds when they need capital. As simple as this sounds, there are a myriad of ways that bonds are issued, where on the capital structure bonds are, or what entity issues them. These factors (and more) affect how bonds are priced and what their future price will be.


Bond Pricing

What Determines the Price of a Bond in the Open Market? Bonds can be traded in the open market after they are issued. When listed on the open market, a bond’s price and yield determine its value. Obviously, a bond must have a price at which it can be bought and sold. A bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. Yield is therefore based on the purchase price of the bond as well as the coupon.

A bond’s price always moves in the opposite direction of its yield, as illustrated above. The key to understanding this critical feature of the bond market is to recognize that a bond’s price reflects the value of the income that it provides through its regular coupon interest payments.


Bond Pricing (cont.)

Factors that affect bond yields:

1) Interest Rate

2) Inflation

3) Reinvestment

4) Default/Credit Risk

5) Call Risk

6) Exchange Rate Risk

7) Embedded Options

8) Liquidity

9) Taxation


Bond Pricing/Duration

Duration: To estimate how much a specific bond’s price will move when interest rates change, the bond market uses a measure known as duration. Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid, as illustrated below.

As you can see from the illustration, duration is less than the maturity. Duration will also be affected by the size of the regular coupon payments and the bond’s face value. For a zero coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero coupon bonds attractive to investors expecting a decline in rates.

The end result of the duration calculation, which is unique to each bond, is a risk measure that allows us to compare bonds with different maturities, coupons and face values on an apples-to-apples basis. Duration tells us the approximate change in price that any given bond will experience in the event of a 100 basis point (1/100 of a percent) change in interest rates. For example, suppose that interest rates fall by one percent, causing yields on every bond in the market to fall by the same amount. In that event, the price of a bond with a duration of two years will rise two percent and the price of a five-year duration bond will rise five percent.


The Yield Curve

The Yield Curve is a graph depicting the term structure of interest rates. It plots the yields of bonds of the same class (corporates, governments, etc.) and quality with maturities that range from the shortest to the longest term. The yields are plotted on the y-axis, and time to maturity on the x-axis. The curve will show whether short-term interest rates are higher or lower than long-term interest rates.

In general, the yield curve is positive. Investors usually receive a higher yield for the extra risk of tying up their money long term. However, if short-term rates are higher, the curve is considered to be a "negative (or inverted) yield curve". And, if a small variation exists between short-term and long-term rates, the curve is considered to be a "flat yield curve".


Bond Valuation

Bonds can be valued by a variety of means. For the purpose of this course, we will discuss only a couple.

1) Current Yield: Coupon/Current Price of Bond

2) Yield to Maturity (YTM): This is the interest rate that makes the Present Value of a bond’s payments equal to its price. YTM= Σ [C/(1+i)t] + [Principal/(1+i)T]

3) Yield to Call (YTC): Many bonds are callable by an issuer at some point before maturity. If a bond is called, a borrower will not receive all of the interest payments. A call provision always favors the issuer; for this reason, callable bonds are issued at a higher coupon than a non-callable bond, ceteris paribus. YTC is interest rate that makes the Present Value of a bond’s payments equal to its call price. YTC= Σ [C/(1+i)t] + [Principal/(1+i)T], where Principal equals the call price and the time is the number of periods until the first call date.


Rationale for Fixed Income

For an investor, bonds serve three primary factors:

1) Income: Most bonds provide the investor with "fixed" income. On a set schedule, perhaps quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment-a check that can be spent or reinvested in other bonds. Stocks might also provide income through dividend payments, but dividends tend to be much smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments.

2) Diversification: A stock market investor faces the risk that the stock market will decline. To offset this risk, investors have long turned to the bond market because the performance of stocks and bonds is often non-correlated: market factors that are likely to have a negative impact on the performance of stocks historically have little to no impact on bonds and in some cases can actually improve bond performance.

3) Protection against Economic Slowdown or Deflation: Stock and other risky securities are subject to economic shocks; bonds can be viewed as the part of the portfolio that provides stability. For many investors, if a high-quality bond is held to maturity, then they will receive a fixed rate of return plus their principal.


Fixed Income Management

There are three main ways an individual can manage a bond portfolio:

1) Active Management: One option is to invest with an "active" bond manager that will employ various strategies in an effort to maximize the return on a bond portfolio and outperform the market’s return as measured by a selected benchmark.

2) Indexing: A second option is to invest with a "passive" manager whose goal is to replicate (rather than outperform) the returns of the bond market or a specific sector of the bond market.

3) Ladder: A third option is to invest in a "laddered" bond strategy, in which maturing bonds are passively reinvested in new bonds without any attempt to maximize returns.


Equities

Common stocks, also known as equities, represent ownership shares in a corporation Each share allows an owner to vote on matters of corporate governance and to share in the financial benefits of ownership.

Equities possess two important features of ownership:

1) Limited liability: The most that a shareholder can lose in the event of failure of the corporation is their original investment.

2) Residual Claim: Stockholders are the last in line of all those who have a claim on the assets and income of a corporation.

There are two basic ways to make profits with stocks: capital gains and dividends. Capital gains (or losses) reflect the up (or down) movement of a security’s price. Capital gains are not taxable until they are realized. Dividends are profits the company distributes to shareholders. Most companies pay dividends in the form of cash, although you may hear of occasions when a company uses stock instead.


Stock Sectors

One of the ways investors classify stocks is by type of business. The idea is to put companies in similar industries together for comparison purposes. Most analysts and financial media call these groupings “sectors” and you will often read or hear about how certain sector stocks are doing. One of the most common classification breaks the market into 11 different sectors. Investors consider two of there sectors “defensive” and the remaining nine “cyclical.”

Defensive stocks include utilities and consumer staples. These companies usually don’t suffer as much in a market downturn because people don’t stop using energy or eating. They provide a balance to portfolios and offer protection in a falling market. However, for all their safety, defensive stocks usually fail to climb with a rising market for the opposite reasons they provide protection in a falling market: people don’t use significantly more energy or eat more food.

Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down, however when one sector is going up another may be going down. Here is a list of the nine sectors considered cyclical:

•Basic Materials; Capital Goods; Communications; Consumer Cyclical; Energy; Financial; Health Care; Technology; and Transportation


Equity Valuation

There are a myriad of ways to value an equity security. Quite frequently, most analysts use a combination of valuation methodologies to triangulate the value. Some of the most common are below:

1) Price to Book (P/B): This is the ratio of the price per share divided by book value per share. Some analysts view this ratio as a useful measure of value.

2) Price to Cash Flow (P/CF): This is the ratio of price per share divided by cash flow (cash flow from operations, EBITDA, free cash flow) per share. Since net income can be manipulated, this ratio is less affected by accounting decisions.

3) Price to Earnings (P/E): The ratio of price per share to earnings per share. This is the most widely used ratio.

4) Comparable Analysis: Compares the valuation of similar companies (capitalization, industry, etc.).

5) Dividend Discount Model (DDM): The stock price should equal the present value of all expected future dividend in perpetuity.


Equity Styles

Style boxes break down the U.S. stock market into nine investment styles, and they have become popular thanks in large part to Morningstar. They attempt to divide equity management strategies by the capitalization (large vs. small) and style (growth vs. value) characteristics of a portfolio.

These style boxes have become a very useful tool in the asset allocation process, because they enable an investor to make a specific allocation to a certain segment of the market through either manager selection or an exchange-traded fund.

The Style Box This tool breaks the market down into a matrix of nine investment styles


Manager Styles

At various times, different investment styles can produce different performance results. It is therefore important to generally have an equity portfolio that is well diversified across a range of styles.

1) Price Driven: Followed by value-oriented managers who attempt to acquire investments that appear “cheap.”

2) Earning Growth: Followed by growth-oriented managers who attempt to acquire the securities of companies that have above average growth or earnings prospects, or by momentum-oriented managers who look for securities that have, and are expected to continue to exhibit, positive earnings momentum.

3) Market-Oriented: Followed by managers that do not prefer value over growth. This group of managers tend to believe that the market is efficient and attempt to acquire portfolios that match the overall composition of the broad market index.

4) Small Capitalization: Followed by managers who concentrate their portfolios in small companies.


International Investing

It is important not to forget that well over two-thirds of the world’s market capitalization lies outside the United States. An well-diversified investor should generally have a significant percentage of his assets invested internationally, either directly or through a professionally managed vehicle.

Traditional arguments for international investing rest on academic studies, which show that foreign assets added to domestic portfolios raise the Markowitz mean-variance efficient frontier above that of a portfolio with only domestic holdings. In other words, global diversification provides higher returns for a given level of risk or lower risk for a given level of return. History indicates that the U.S. and foreign markets seem to alternate their periods of strong performance. This suggests to prudent investors that an excellent way to insulate portfolios against these unpredictable swings is to include both a U.S. and an international component within their portfolios.


International Investing


Options

A call option gives its holder the right, but not the obligation, to purchase an asset for a specified price—called the exercise or strike price, on or before some specified expiration date.

A put option gives its holder the right, but not the obligation, to sell an asset for a specified price—called the exercise or strike price, on or before some specified expiration date.

An option is described as in the money when its exercise would produce profits for its holder. An option is out of the money when its exercise would be unprofitable. Options that are at the money when the exercise price and the asset price are equal.

An American option allows its holder to exercise the right to purchase (if a call) or sell (if a put) the underlying asset on or before the expiration date. European options allow for exercise only on the expiration date.

Options can trade on a listed exchange such as the AMEX or the CBOE. More frequently, options can be traded over-the-counter or negotiated privately.


Call Options


Put Options


Option Valuation

Options are valued by a number of methods, many of them proprietary. In all cases, option pricing models are derived from two basic formulas: the binomial (two-state) and the Black-Scholes equations.

The basic inputs of the formulae are the following:

Asset Price S

Exercise Price X

Volatility σ

Time to Expiration T

Interest Rate I

Dividends D


Incentive Stock Options

An ISO is a type of compensatory stock option that can be granted only to employees and confers a U.S. tax benefit. The tax benefit is not having to pay ordinary income tax on exercise on the difference between the exercise price and the fair market value of the shares issued (however, the holder may have to pay U.S. alternative minimum tax instead). Instead, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. Long-term capital gain is taxed in the U.S. at lower rates than ordinary income.

Although ISOs have more favorable tax treatment than non-ISOs (aka NSO or NQSO), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO.

With ISOs, all the taxes are paid when you sell the stock and it is subject to capital gains taxation. This favorable treatment applies only if you sell the ISO shares more than two years after the option-grant date (the date you received the option) and more than one year after you actually bought the shares by exercising your ISO. (If you sell sooner than that on either front you have what the IRS calls a "disqualifying disposition.”)


Non-Qualified Stock Options

Nonqualified options are usually granted pursuant to a stock option plan that was adopted by the company's board of directors and approved by the shareholders. The board of directors, or a committee appointed by the board (usually called the compensation committee), may decide who receives the awards and the specific terms of the options. In some cases options are granted according to a formula.

When you exercise a NQSO, the spread between your exercise price and the market price — your profit — is generally taxed at ordinary income rates in that year's tax return. (In unusual cases, where the options are traded in a securities market, the tax may accrue on the grant date.)

After you exercise the option, of course, you own the stock and your new tax basis is the market price on the exercise date. You now have a choice. If you hold the stock for more than a year after the exercise date, it appreciates, and if you sell, your gain is taxed as a capital gain. If it appreciates and you sell it before more than 12 months are up, it is taxed as regular income. In either case, if you sell for less than the market price on the exercise date, you have a loss that can offset other gains.


Alternative Investments

Within the last decade or so, sophisticated investors (and increasingly more mainstream ones) have allocated a portion of their assets to vehicles which tend to be uncorrelated to stocks, bonds, and cash. In general, there are five types of alternative asset classes, of which one we will discuss in some detail:

1) Real Estate: Investments generally made in commercial real estate with the expectation that income from rents and increase in property values will result in a profit. Institutions and high net-worth individuals will usually invest through private structures; most retail investors will invest via REITs.

2) Private Equity/Leverage Buyouts: an investment in the equity securities of companies that have not "gone public" (are not listed on a public exchange). Private equities are generally illiquid and thought of as a long-term investment. Investors in private securities generally receive their return through one of three ways: an initial public offering, a sale or merger, or a recapitalization.

3) Venture Capital: Funds made available for startup firms and small businesses with exceptional growth potential. Managerial and technical expertise are often also provided by Venture Capital firms. The exit strategy is generally an initial public offering or a merger.

4) Commodities: More generally, a product which trades on a commodity exchange; this would also include foreign currencies, financial instruments, and physical commodities (grains, metals, livestock, energies, etc.) Most physical commodities do well in an inflationary environment.

5) Hedge Funds


Hedge Funds

Hedge Funds are a privately organized investment vehicle that manages a concentrated portfolio of public securities and derivative investments on public securities, that can invest both long and short, and can apply leverage.

Mutual Fund Hedge Fund

Regulation SEC registered investment vehicles Private investment vehicles (not regulated)

Minimum Investment

Usually small minimum investments Large minimum investments required (average $1 million)

Investors Not limited to the number of investors and investors can purchase many funds

Are limited to 499 investors ("limited partners") who can invest in any one fund

Availability Available to the general public Must be an accredited investor (net worth must exceed $1 million or individual income must have been in excess of $200,000, or joint income must have been in excess of $300,000 in the past two years

Liquidity Daily liquidity and redemption Liquidity varies from monthly to annually

Short Selling Maximum 30% of profits from short sales. Manager may short sell often

Leverage Less leverage More leverage

Down Markets Some funds are defensively managed and others, like index funds, hold during bad markets.

Most hedge fund strategies try to hedge against downturns in the markets, but effectiveness depends on the fund.

Definition A public pool of investment capital organized to invest in a portfolio composed of often predetermined type of securities.

A private pool of investment capital organized into a LP to invest in a portfolio made up of a variety of securities

Fees Limits Imposed by the SEC Hedge funds typically charge high fees, a combination of 1-2% of assets plus a percentage of the profits (usually 20%)


Why do Investors Choose Hedge Funds

Over the last 10 years, one can see the returns the S&P 500 index, the Lehman Long-term Government Index, the MSCI EAFE Index, the NASDAQ Composite Index, and the HFRI Hedge Fund of Fund Index:


Type of Hedge Fund Strategies

Convertible Arbitrage: This strategy is identified by hedge investing in the convertible securities of a company. A typical investment is to be long the convertible bond and short the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting principal from market moves.

Dedicated Short Bias: Dedicated short sellers were once a robust category of hedge funds before the long bull market rendered the strategy difficult to implement. A new category, short biased, has emerged. The strategy is to maintain net short as opposed to pure short exposure. Short biased managers take short positions in mostly equities and derivatives. The short bias of a manager's portfolio must be constantly greater than zero to be classified in this category.

Emerging Markets: This strategy involves equity or fixed income investing in emerging markets around the world. Because many emerging markets do not allow short selling, nor offer viable futures or other derivative products with which to hedge, emerging market investing often employs a long-only strategy.

Equity Markets Neutral: This investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency neutral, or both. Well-designed portfolios typically control for industry, sector, market capitalization, and other exposures. Leverage is often applied to enhance returns.

Event Driven: This strategy is defined as 'special situations' investing designed to capture price movement generated by a significant pending corporate event such as a merger, corporate restructuring, liquidation, bankruptcy or reorganization. There are three popular sub-categories in event-driven strategies: risk (merger) arbitrage, distressed/high yield securities, and Regulation D.


Type of Hedge Fund Strategies (cont.)

Fixed Income Arbitrage: The fixed income arbitrageur aims to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, US and non-US government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities arbitrage. The mortgage-backed market is primarily US-based, over-the-counter and particularly complex.

Global Macro: These managers carry long and short positions in any of the world's major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and or events. The portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets.

Long/Short Equity: This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short US or European equity, or sector specific, such as long and short technology or healthcare stocks. Long/short equity funds tend to build and hold portfolios that are substantially more concentrated than those of traditional stock funds.

Managed Futures: This strategy invests in listed financial and commodity futures markets and currency markets around the world. The managers are usually referred to as Commodity Trading Advisors, or CTAs. Trading disciplines are generally systematic or discretionary. Systematic traders tend to use price and market specific information (often technical) to make trading decisions, while discretionary managers use a judgmental approach.

Restricted/Concentrated Stock

Many private investors (as well as many institutions) hold concentrated or restricted equity positions. This section will give you an overview of certain methods on how to deal with this issue.

Restricted Stock is stock that is acquired though an employee stock option plan or other private means and which may not be transferred. Restricted stock may be forfeited if any of the SEC rules related to it are broken.

Concentrated Stock is stock that has been accumulated over time, through ownership in a public company, or through a sale of a private company to a public one.

Both Restricted and Concentrated Stock tend to have a low cost basis for an investor. Therefore, if a holder were to sell, he would trigger substantial capital gains taxes. In addition, many holders of these types of stock have an emotional attachment to the stock which make them reluctant to sell.

The choice between retaining the position (and the associated risk) or liquidating (and paying the capital gains tax and using the after-tax proceeds to diversify) is a difficult one. In most cases, an investor—with the guidance of her advisors—will most likely employ a mixture of strategies.


Asset Allocation Decision

The Investor’s view of future stock performance will determine the best asset allocation strategy

Investor’s View of Stock

Potential future stock price scenarios

Compare the present value after-tax results of the various scenarios

Analyze the probability of certain events occurring

Four main type of strategies:

1) Outright Sale: Cash received immediately, but taxes are not deferred

2) Costless Collars are best for investors who want to protect against stock price depreciation and receive average market returns Cash can be obtained through a credit line.

3) Variable Prepaid Forwards generate inexpensive cash to diversify. The cash is inexpensive because the investor is selling a more valuable call .

4) Exchange Fund: The investor contributes certain concentrated equity positions of low basis or restricted shares in exchange for units of a professionally managed and diversified equity portfolio.


Summary of Hedging, Monetizing, and Diversification Strategies


Strategy Diversify Defer Taxes Hedge Monetize Outright Sale Yes No Yes Yes Protective Put Option No* Yes Yes No* Zero Premium Collar No* Yes Yes No* Prepaid Variable Rate Forward Yes*** Yes Yes No* Exchange Fund Yes Yes Yes** No* Charitable Remainder Trust Yes Yes Yes Yes Borrowing on Margin Yes*** Yes No Yes * Except if combined with a loan.** Since the position is almost completely diversified, there exists relatively little upside or downside exposure to the single position.*** Diversification may be obtained when proceeds are reinvested into other investment vehicles.

Methods to Sell Stock

Depending on how quickly a shareholder wants liquidity and how sensitive he is to price, he may employ one or a variety of methods to sell stock on the market.


Block Bid

• In order to remove economic risk, Shareholder may choose to have a bank purchase a number of shares through a block bid.

• Because the bank takes significant market risk, by outright purchasing the number of shares, block bids are typically priced at a discount to current market prices (5-10%).

• Shareholder may choose to accept a block bid for all or a portion of the Initial Hedge at any time during execution

• Block bids require no additional signals to the market or regulatory disclosures than outright sales and are entirely private transactions between Shareholder and the bank.

Daily Sales

• A bank, at Shareholder’s direction, will sell shares in the public markets each day at prevailing market prices.

• The bank will be the seller; Shareholder will not be known to the market.

• The bank and Shareholder determine on a daily basis the appropriate number of shares to sell, so as not to unduly influence the market price of underlying stock.

• Useful guide is 20% of daily trading, although the percentage may well increase.

10b5-1 Sales

•Allows Shareholder as a corporate insider to trade his stock during blackout periods.

•Shareholder can enter into a selling plan and implement it during an open trading window. The selling plan may either:

• Specify the amounts (a number of shares or a specified dollar value of securities), prices (the market price on a particular date, a limit price, or a particular dollar price) and dates (specific day or days of the year) of the transactions;

•Provide a written formula for determining the amounts, prices and dates of the transactions; or allow a broker discretion.

Issues to Consider with Hedging

Investor’s objectives will determine the best structure

Downside Protection: Amount of stock price depreciation the investor is willing to accept

Upside Potential: Expected/desired amount of potential stock price appreciation over the term of the structure

Cash Requirement: Amount of cash investor wants get out of the structure

Use of proceeds

Length of Hedge: Tax deferment


Zero Premium Collar

This strategy reduces the risk to stock price depreciation while maintaining stock price appreciation up to the call strike

Description:

Combination of a long put position and short call position

Shareholder buys protection and finances the purchase through the sale of potential stock price appreciation, above the call strike

Advantages:

Shareholder protects downside and retains stock price appreciation up to the call strike.

A properly structured collar should not trigger a tax event.

No upfront out-of-pocket expense.

Flexibility to customize a structure that meets a Shareholder’s objectives.

Shareholder has option of cash settlement and therefore has no obligation to deliver shares at maturity

Shareholder may borrow up to 90% of the put strike for a non-purpose loan and 50% of the total position for a purpose loan

Disadvantages:

Shareholder relinquishes stock price appreciation above the call strike


Collar Diagram


Prepaid Variable Rate Forwards (PVRF)


What is a Prepaid Variable Rate Forward Transaction?

Forward contract entered into by Shareholder to receive cash proceeds today in exchange for a number of shares of common stock (or cash value) at maturity. The PVRF structure enables the Shareholder to completely hedge downside price risk, retain significant upside in the underlying stock, and raise proceeds, while deferring capital gains taxes

Amount of shares exchanged at maturity is a function of the common stock price at maturity.

PVRFs allows Shareholder to retain appreciation in the stock by retaining shares after the maturity of the PVRFs (as a function of the variable conversion rate of shares at maturity).

PVRFs enables Shareholder to:

Receive proceeds today

Completely hedge downside price risk

Retain significant upside in the stock

Defer taxes

Execute quietly and quickly

Generate positive perception by communicating bullish view on the stock

PVRF Mechanics


Floor Price equal to the underlying stock price at the time of issuance.

Conversion Rate is a function of the underlying stock price at maturity.

Rate mechanism ensures that Shareholder retains the appreciation in the underlying stock up to the Cap Price and, in a “Soft-cap” structure, a fraction of all appreciation beyond the Cap Price.

Shareholder has no exposure to downward movements in the underlying stock.

Legal and Regulatory Considerations


Before entering into a derivatives transaction, the following legal restrictions and disclosure requirements must be addressed: Rule 144 Restrictions: Holders of Unregistered Stock or “Control Stock” (stock held by an Affiliate) subject to: Rule 144 Volume and Manner of Sale limitations for one year.

Volume limitation: The greater of 1% of shares outstanding OR the average weekly trading volume over the prior four calendar weeks, may be sold in any 3-month period.

Manner of Sale: No solicitation, except for market makers or block positions who have been contacted within the last 10 business days. Shareholder must file form 144. Section 16 Restriction: Affiliate - Officers, Directors and/or Large Stockholders (usually over 10% owner, including any “group” of which the owner is a part).

In addition to the above, affiliates would also have to file a Form 4 by the 10th day of the month after the month in which the transaction was executed.

Legal Restrictions

Rule 144 Stock

No sales for 1 year except in a bona fide private placement

Form 144 concurrent with sale

Volume limitation: Between years one and two, the greater of 1% of shares outstanding OR the average weekly trading volume over the prior four calendar weeks, may be sold in any 3-month period

Manner of Sale: No solicitation, except for market makers or block positions who have been contacted within the last 10 business days

Original Private Placement status may be questioned if sold immediately after receipt Prospectus Stock Bolton Financial Services, LLC

Holding Period

Filing Requirements

Additional Requirements

Prospectus Stock

No holding period after and so long as prospectus is effective

Public Offering process and prospectus delivery requirement.

Seller (and broker) adopts 1933 Act disclosure liability upon sale

Blackout periods: material non public information in existence

Registered sales can be effected in the open market or via broad underwriting.

Rule 145 Stock

No holding period requirement; immediate sale possible

No filing required

No 1933 Act disclosure liability

Rule 144 volume and manner of sale limitations for one year

No sale restrictions after 2 years


Portfolio Management

Portfolio Management is a dynamic, continuous, and systematic process that involves four elements:

1) Identify and evaluate the investor’s objectives, preferences, and constraints that will be the basis for developing a policy statement that will guide further investment actions.

2) Develop and implement strategies that offer the best means of achieving the investor’s objectives, while staying within the constraint and preferences already determined.

3) Monitor market and investor conditions. The former is required to determine the relative values, expected returns, and risks of various asset classes and securities in the marketplace, which are in a continual state of flux. The latter is necessary to know how the investor’s needs, circumstances, and objectives change over time.

4) Adjust the portfolio to balance changing market conditions with changing investor preferences.


Portfolio Management Basics

Below is a little mnemonic to help remember the seven topics to cover in order to set a basic investment policy.

R Risk

R Return

L Liquidity Needs

L Legal constraints

T Time Horizon

T Taxation

U Unique needs and preferences


Risk Tolerance

The amount of risk that an investor is willing to take must precede any discussion of return objectives. Every investor desires to have a portfolio that returns 20%+, but there are far investors than can stomach a 20%+ drawdown.

Determine how much volatility in portfolio value the client can accept. What are the probable emotional reactions of the investor to an adverse outcome? How much volatility can be comfortable accepted as measured by the client’s level of “risk aversion”?

What this will lead to is a determination of how conservative or aggressive an investor is. Conservative investors tend to look for asset classes with low volatility, while aggressive ones tend to desire asset classes with higher volatility.


Return Requirements

The investment policy statement should state the form in which the investor desires to receive his or her returns. Three issues have to be addressed:

1) Is the objective of the investment program to produce current income, in the form of current yield, or long-term capital growth?

There is a misconception that current income needs must be met from the current yield (i.e. bond interest or dividends), whereas capital gains should always be reinvested for the future. In fact, it makes little difference whether current needs are met by cash yield, or by selling off part of its principal value. Indeed, with U.S. long-term capital gains tax rate of 15% versus a 35% marginal tax rate on interest income, it may make more sense to subject a taxable investor to capital gains taxes.

2) How important is it to generate nominal as opposed to real returns? The more importance that is attached to real returns, the more inflation protection must be built into the portfolio.

3) In what currency is it best to measure returns?


Liquidity

The degree of liquidity that is required is based upon the probable need for ready cash. Liquidity needs fall into four categories:

1) Emergency cash (3-6 months of normal expenditures)

2) Cash needed to meet known upcoming obligations (charitable commitments, home purchase, etc.)

3) Cash needed to pay taxes

4) Cash needed to provide investment flexibility.


Legal Constraints

The legal constraints on a portfolio must be understood and explicitly recognized in an investment policy statement. The most important legal constraints are:

ERISA, which governs most qualified retirement portfolios.

The Prudent Man or Prudent Investor rules, which govern most personal trust portfolios.

The Uniform Management of Institutional Funds Acts (UMIFA) that governs most charitable and endowment fund portfolios.

Compliance with all local, state, and national laws.

The general fiduciary duties of loyalty, care, prudence, impartiality, and discretion that govern all persons who are entrusted with the management of assets for others.


Time Horizon

The amount of volatility that can be accepted in an investor’s portfolio are affected by the investor’s time horizon. The longer the time horizon, the more the portfolio can be managed using concepts related to Modern Portfolio Theory. In other words, an investor can choose among a wide variety of asset classes and can withstand periods of portfolio fluctuations in order to achieve higher expected returns.

As the time horizon shrinks, more importance must be attached o the current outlook and the likely relative performance of various asset classes. An investor will be more like to shift a higher proportion of assets into low risk ones.


Tax Considerations

Investment managers should attempt to maximize the investor’s after-tax returns. This requires a knowledge of the investor’s tax situation, as well as how the returns on various securities are taxed.

From an investment perspective, two types of taxes are important:

Ordinary income taxes that are applied to the current income generated from investments, such as dividends, interest, and rent, as well as from wages. Currently the top marginal rate is 35%.

Capital gains taxes that are applied to the net realized gains on the purchase and sale of assets. Currently, the top rate is 15%.

There are other types of taxes that must be taken into consideration. State and local taxes on income and capital gains increase the effective tax rates. The interest income from municipal bonds are not subject to federal taxation, and interest income from Treasury securities are not subject to state taxation. Estate and gift taxes can also be an important consideration.

Tax considerations also give rise to asset location. Should a particular asset be placed in a taxable or tax-exempt account? Should an invest utilize life insurance (other than for the death benefit)? Should a trust be utilized, or should the investor keep the asset in her name?


Unique Needs

The investment manager must ascertain if the client prefers to invest, or not to invest, in certain types of securities, industries, or companies. Client instructions should be well-understood and adhered to under the fiduciary duty to be obedient to one’s trust.


Investment Policy Statement

Once you have gone through RRLLTTU with a client, one can now formulate an investment policy statement (IPS). The IPS is the linkage between the client’s objectives and constraints and the client’s advisors. A properly constructed portfolio policy provides support for the advisors to follow a well-conceived, long-term discipline, rather than one based on ad-hoc revisions spawned by short-term events.

The IPS ideally contains 5 sections:

Purpose and Background

Investment Policy and Asset Class Guidelines: This section specifically and clearly contains the strategic policy guidelines of the portfolio. It should address Risk Tolerance; Asset Classes included; Time Horizon; and Expected Rate of Return that is reasonable in the long-term.

Securities Guidelines: Generally a list of securities or assets classes n which an advisor is prohibited from investing.

Selection of Money Managers: Provides the search criteria for selecting money managers.

Duties of Persons Involved in the Management Process


Sample Asset Allocation Worksheet


Case Studies

bolton financial services, llc chartered wealth management seminar january 27-29, 2006 jeffrey d....

Documents

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money market

llc major market participants

bonds benchmark

junk bonds

financial indices

blend index funds