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Building PortfoliosBuilding Portfolioswith Stocks, Bonds, and Mutual with Stocks, Bonds, and Mutual
Funds Funds Financial & Retirement PlanningFinancial & Retirement Planning
Jay Taparia, CFAJay Taparia, CFAManaging Director, Sanskar Investments, Inc.Managing Director, Sanskar Investments, Inc.
Lecturer of Finance, University of Illinois @ ChicagoLecturer of Finance, University of Illinois @ Chicago
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The Client Is A Human Being The Client Is A Human Being & Is Capable Of Having…& Is Capable Of Having…
Emotion attached to wealth…Emotion attached to wealth… Goals (if…) that are ST, MT or LTGoals (if…) that are ST, MT or LT A limited life span…A limited life span… Uncertainty about the future…Uncertainty about the future… Irrationality associated with decision-making…Irrationality associated with decision-making… A gambling attitude toward the markets… over-A gambling attitude toward the markets… over-
confidenceconfidence Dreams that could be impossible to reach…Dreams that could be impossible to reach… Dreams that are very possible to reach…Dreams that are very possible to reach… An aversion toward risk… whatever that may beAn aversion toward risk… whatever that may be Annoying you at times…Annoying you at times… And don’t forget that… Life HappensAnd don’t forget that… Life Happens
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Because Of This…Because Of This…
Building portfolios is not only a science, but it Building portfolios is not only a science, but it is an artis an art
Having a nice irrelevant conversation with the Having a nice irrelevant conversation with the client is necessary to build a relationship, client is necessary to build a relationship, but but also to discover new “needs” and “objectives”also to discover new “needs” and “objectives”
Client needs & objectives change over time Client needs & objectives change over time (years even days)(years even days)
Portfolios are managed Portfolios are managed with continuously with continuously changing objectiveschanging objectives
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Individual Investor Life CycleIndividual Investor Life Cycle
25 35 45 55 65 75Age
Accumulation
Long-term: Retirement, Children’s college
Short-term: House, Car
Consolidation
Long-term: Retirement
Short-term:Vacations,Children’s College
Spending Phase Gifting Phase
Long-term: Estate Planning
Short-term: Lifestyle Needs, Gifts
Phases are Shifting
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Portfolio Management ProcessPortfolio Management Process State the ObjectiveState the Objective – Mission statement of the portfolio, – Mission statement of the portfolio,
who and what it serves and why: income, and/or capital who and what it serves and why: income, and/or capital appreciation.appreciation.
Identify the ConstraintsIdentify the Constraints – there are always going to be – there are always going to be constraints: taxes, legal, emotions, etc. constraints: taxes, legal, emotions, etc.
Formulate the Investment PolicyFormulate the Investment Policy – develop the – develop the “business plan” of the portfolio listing out return, risk and “business plan” of the portfolio listing out return, risk and all the other issues associated with the portfolio all the other issues associated with the portfolio
Study Market and Economic ConditionsStudy Market and Economic Conditions to forecast to forecast future trends – This is everything that you learned in future trends – This is everything that you learned in Economic, Industry, Financial Statements, etc.Economic, Industry, Financial Statements, etc.
Monitor PerformanceMonitor Performance – keep in touch with what is going – keep in touch with what is going on in the portfolio, and…on in the portfolio, and…
Reevaluate & Modify the PortfolioReevaluate & Modify the Portfolio – rebalance and/or – rebalance and/or reconfigure according to the policy and marketsreconfigure according to the policy and markets
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Role of the Portfolio ManagerRole of the Portfolio Manager Bottom Line? You need someone to manage the Bottom Line? You need someone to manage the
whole process of investing – whole process of investing – Minimizing individual security risk (company, industry, or Minimizing individual security risk (company, industry, or
unsystematic risk)unsystematic risk) Making sure that the portfolio is well-diversified among Making sure that the portfolio is well-diversified among
industry, country and companyindustry, country and company Managing the tax consequences of the portfolio – esp. for Managing the tax consequences of the portfolio – esp. for
expensive peopleexpensive people Most importantly, making sure the portfolio caters to Most importantly, making sure the portfolio caters to
the client needs via an the client needs via an Investment Policy StatementInvestment Policy Statement – – ReturnReturn – capital gain vs.income – capital gain vs.income Risk ToleranceRisk Tolerance – varies typically according to age – varies typically according to age Tax Issues – Tax Issues – maximizing after-tax returnsmaximizing after-tax returns TimeTime – retirement, college payments – retirement, college payments LiquidityLiquidity – usually driven by time needs – usually driven by time needs Legal IssuesLegal Issues – trust and pensions have special legal – trust and pensions have special legal
issuesissues Other Unique NeedsOther Unique Needs of the client of the client
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Realistic Investor GoalsRealistic Investor Goals
Current incomeCurrent income generate spendable fundsgenerate spendable funds
Capital preservationCapital preservation minimize risk of real lossminimize risk of real loss strongly risk-averse or cash needs are soonstrongly risk-averse or cash needs are soon
Capital appreciationCapital appreciation capital gains for real growth for future needscapital gains for real growth for future needs growth strategy with accepted riskgrowth strategy with accepted risk
Total ReturnTotal Return Capital Gains & IncomeCapital Gains & Income Desire to have “medium” risk exposureDesire to have “medium” risk exposure
What Is Asset Allocation?What Is Asset Allocation?
Cash
BondsStocksAsset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals.
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The Need For Asset AllocationThe Need For Asset Allocation An investment strategy is based on four decisionsAn investment strategy is based on four decisions
What asset classes to consider for investmentWhat asset classes to consider for investment What normal or policy weights to assign to each What normal or policy weights to assign to each
eligible classeligible class The allowable allocation ranges based on policy The allowable allocation ranges based on policy
weightsweights What specific securities to purchase for the portfolio What specific securities to purchase for the portfolio
to satisfy the strategyto satisfy the strategy
90+% of the overall investment return is due to 90+% of the overall investment return is due to the first two decisions, not the selection of the first two decisions, not the selection of individual investments (BHB 1991)individual investments (BHB 1991)
70% of the overall investment return is due to 70% of the overall investment return is due to style (Sharpe 1992)style (Sharpe 1992)
Asset Allocation Policy
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Asset Allocation Policy +Market Timing
Asset Allocation Policy +Market Timing + SecuritySelection
Asset Allocation Policy +Market Timing + SecuritySelection + Other
Is Asset Allocation Important?Is Asset Allocation Important?
91.5%
93.3%
97.9%
100%
806040200
Percent
Contributing Factors of Portfolio Performance
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Returns & Risk Of Different Asset Returns & Risk Of Different Asset ClassesClasses
Higher returns should compensate for riskHigher returns should compensate for risk
Policy statements must provide risk Policy statements must provide risk guidelinesguidelines Measuring risk by standard deviation of returns Measuring risk by standard deviation of returns
over time indicates stocks are more risky than over time indicates stocks are more risky than T-billsT-bills
Measuring risk by probability of not meeting Measuring risk by probability of not meeting your investment return objective indicates risk your investment return objective indicates risk of equities is small and risk of T-bills is large of equities is small and risk of T-bills is large because of different expected returnsbecause of different expected returns
Focusing only on return variability ignores Focusing only on return variability ignores reinvestment risk and many other types of riskreinvestment risk and many other types of risk
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HistoricalHistoricalAsset Performances: A GuideAsset Performances: A Guide
Asset Class ReturnsAsset Class ReturnsHighs and Lows: 1926 - 1999
Small Company
Stocks
Large Company
Stocks
Long-TermGovernment
Bonds
Int.-TermGovernment
Bonds
TreasuryBills
Each bar shows the range of annual total returns for each asset class over the period 1926-1999.
142.9%
54.0%40.4%
14.7%29.1%
0.0%-5.1%-9.2%
-43.3%-58.0%
-100%
-50%
0%
50%
100%
150%Highest Annual ReturnLowest Annual Return
3.8%5.2%5.1%11.3%12.6%
Average Return
DiversifyDiversifyTo Reduce Risk Or Increase ReturnTo Reduce Risk Or Increase Return
Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory.
1970 - 1999
Fixed Income Portfolio
ReturnRisk
9.0%8.5%
Bonds 90%
Cash 10%
Higher Return Portfolio
ReturnRisk
10.9% 8.5%
Bonds41%
Cash20% Stocks
39%
Lower Risk Portfolio
ReturnRisk
9.0%6.1%
Bonds53%
Cash35%
Stocks12%
Assumes reinvestment of income and no transaction costs or taxes.
1926 - 1999
Return Before & After InflationReturn Before & After InflationC
om
po
un
d A
nn
ual
Ret
urn 11.3%
5.1%
3.8%
0%
5%
10%
15%
Stocks Bonds Cash
8.0%
2.0%0.7%
Stocksafter
Inflation
Bondsafter
Inflation
Cashafter
Inflation
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Monitor PerformanceMonitor Performance
Revise IPS as neededRevise IPS as needed
Modify investment strategy accordinglyModify investment strategy accordingly
Evaluate portfolio performance not only Evaluate portfolio performance not only with market return or benchmark portfolio with market return or benchmark portfolio
Consider that relative performance will Consider that relative performance will mean little when relative progress is on mean little when relative progress is on tracktrack
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Reevaluate & Modify PortfolioReevaluate & Modify Portfolio Asset Allocation – Asset Allocation – has fixed income/equity balance has fixed income/equity balance
changed from the design changed from the design Style Under/Over-weights – Style Under/Over-weights – is the portfolio tilted in is the portfolio tilted in
style? style? Industry Selection – Industry Selection – based on the economic based on the economic
environment what might the best sectors be, or is the environment what might the best sectors be, or is the portfolio weighted too much in any 1 sector (i.e. 25%)?portfolio weighted too much in any 1 sector (i.e. 25%)?
Security Concentrations – Security Concentrations – usually anything greater usually anything greater than 10% of the portfolio must be reduced in sizethan 10% of the portfolio must be reduced in size
Security Selection – Security Selection – sell stocks that have poor sell stocks that have poor fundamental issues in the future – and buy those that fundamental issues in the future – and buy those that have positive changes ahead. have positive changes ahead.
Key point – LT focus – not ST turnaroundsKey point – LT focus – not ST turnarounds. Why? . Why? Tax constraints. Tax constraints.
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Understanding How Stocks Understanding How Stocks WorkWork
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What is a Stock?What is a Stock? Legal ownership in a company through Legal ownership in a company through
“shares” – purchase of stock implies you “shares” – purchase of stock implies you own a “slice” or “shareown a “slice” or “share” of the company” of the company
Stockholders have 1Stockholders have 1stst right to purchase new right to purchase new shares issued by the companyshares issued by the company – gives them – gives them right to maintain % share of ownershipright to maintain % share of ownership
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4 Characteristics of Stocks4 Characteristics of Stocks Voting PowerVoting Power - Ownership implies “control” - Ownership implies “control”
having the right to appoint Board of Directors, having the right to appoint Board of Directors, who in turn, elect managementwho in turn, elect management
Residual ClaimResidual Claim – you are last on the food chain – you are last on the food chain to collect your investment if the company goes to collect your investment if the company goes bankruptbankrupt
Limited LiabilityLimited Liability – can only lose the investment – can only lose the investment you make into the company – not more than thatyou make into the company – not more than that
Stock Market ListingStock Market Listing – stocks are traded – stocks are traded between buyers and sellers in stock exchangebetween buyers and sellers in stock exchange
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Return & Risk of StocksReturn & Risk of Stocks Two Ways to Earn a Return on a StockTwo Ways to Earn a Return on a Stock
Appreciation in Stock PriceAppreciation in Stock Price – if the investors – if the investors perceive strong growth in the company’s sales perceive strong growth in the company’s sales & earnings, then investors will demand to buy & earnings, then investors will demand to buy more of the stock. As demand increases, the more of the stock. As demand increases, the price of the stock increases.price of the stock increases.
Dividend PaymentDividend Payment – if the company pays – if the company pays dividendsdividends
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Caveats of Stock OwnershipCaveats of Stock Ownership No Guarantee of ReturnNo Guarantee of Return – you can lose your – you can lose your
investmentinvestment
% Ownership Can Be Small% Ownership Can Be Small – you are just 1 of – you are just 1 of many owners – you have some, but not a whole lot many owners – you have some, but not a whole lot of influenceof influence
Mergers & AcquisitionsMergers & Acquisitions – other companies can – other companies can offer to “buy your share out” and replace your offer to “buy your share out” and replace your shares with theirsshares with theirs
Voting Proxy StatementsVoting Proxy Statements - investors should - investors should take an active role in voting for directors and take an active role in voting for directors and management – they are “owners”management – they are “owners”
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Conceptualizing Financial Conceptualizing Financial StatementsStatements
Financial statements are guided by a set of Financial statements are guided by a set of accounting rules, called GAAPaccounting rules, called GAAP (Generally (Generally Accepted Accounting Principles).Accepted Accounting Principles).
Because of flexibility, financial statements Because of flexibility, financial statements can be manipulatedcan be manipulated to give a “better-than- to give a “better-than-expected” view of earnings.expected” view of earnings.
Ratio Analysis & FootnotesRatio Analysis & Footnotes is one of the key is one of the key tools to understanding a company.tools to understanding a company.
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Conceptualizing CompaniesConceptualizing Companies Companies are dynamic, financial statements are Companies are dynamic, financial statements are
staticstatic One date of releaseOne date of release: summary of 3, 6, 9 or 12-: summary of 3, 6, 9 or 12-
month activitymonth activity LaggedLagged: released approximately one month after : released approximately one month after
quarter- or year-end quarter- or year-end Past-tensePast-tense: information possibly already incorporated : information possibly already incorporated
into the stock price (barring any major surprises)into the stock price (barring any major surprises)
Dynamic forces on companies are qualitativeDynamic forces on companies are qualitative The economic cycleThe economic cycle Industry analysisIndustry analysis Management strategyManagement strategy
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Conceptualizing the 3 Financial Conceptualizing the 3 Financial StatementsStatements
Think of analyzing your own finances…Think of analyzing your own finances…
Financial analysis of companies is similar to Financial analysis of companies is similar to personal financial planningpersonal financial planning Your balance sheetYour balance sheet = a loan application = a loan application Income statementIncome statement = your tax return = your tax return Cash & cash flow statementCash & cash flow statement = Your = Your
checking account and salarychecking account and salary Footnotes to financial statementsFootnotes to financial statements =how =how
you would explain what the numbers really you would explain what the numbers really mean to an IRS auditor or loan agentmean to an IRS auditor or loan agent
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Net income (Profits)Depreciation
Deferred income taxes
Accounts receivableInventoryAccounts Payable
Income from operations
Cash provided by (used for) working capital
Cash flows from operations
Net cash provided by operating activities (Cash Flows From Operations)(CFFO or CFO)
+
=
Net Operating Income=
Other revenues
-
--
+
Statement of Cash Flows(or ... what REALLY happened this year)
Issue of debtRetirement of debtSale of common stockDividends paid
Net cash provided by financing
-
+-
+
=
Cash from financing activities
activities
or+ -
Sale of assetsPurchase of assets
Cash from investing activities
Net cash provided by investingactivities
+-
=
Income Statement(or ... what do you tell the Government you made?)
Sales
Cost of sales (including depreciation expense)
Selling and administrative expenses Restructuring expense
Earnings before taxIncome tax expense
Other expenses-
=-
The sum of the last line in each boxabove = the change in cash balances
Dividends on common stock
Net income transferred to surplus or retained earnings
Dividends on preferred stock-
=
-
=
Net income (Profits)=
Net income available to common stock
or+ -or+ -or+ -
= Gross profit on sales
+/-Gains or losses
Gains or lossesor- +Restructuring charge not spent+
Cash and temporary investments Accounts receivable Inventory Prepaid expenses
Total current assets
Property, plant and equipment Less: Depreciation
Net property, plant, and equipment
Intangible assets and goodwill
Total long-term assets
Accounts payableTaxes PayableShort-term notes payableCurrent portion of long term debt
Total current liabilities
Long-term debt less current portion Deferred tax liability
Total long-term liabilities
Common stock parCapital surplus
Less treasury stock at cost
Total owners' equity
Liabilities + Owners' Equity
Retained earnings
Current liabilities
Long-term liabilities
Owners' equity
Total liabilities + Owners' equity
Current assets
Long-term assets
Total assets
Assets
Balance Sheet(or ... what have you got?)
Deferred tax assets
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Public Filings You Need to Public Filings You Need to KnowKnow
Form 10-K (due 90 days after fiscal year Form 10-K (due 90 days after fiscal year close)close) Income statement (aka Statement of Income statement (aka Statement of
Operations)Operations) Balance SheetBalance Sheet Cash Flow StatementCash Flow Statement Footnotes to the Financial StatementsFootnotes to the Financial Statements Management Discussion and AnalysisManagement Discussion and Analysis Auditor’s ReportAuditor’s Report Liquidity Position and Capital ExpendituresLiquidity Position and Capital Expenditures
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Stock Market Indices (i.e., Stock Market Indices (i.e., Indexes)Indexes)
Price-Weighted IndexPrice-Weighted Index - - each company represented by each company represented by 1 share in index. Gives higher-priced shares more 1 share in index. Gives higher-priced shares more weight in determining performance of the index (e.g., weight in determining performance of the index (e.g., Dow Jones Industrial Average)Dow Jones Industrial Average)
Market Value-Weighted IndexMarket Value-Weighted Index - - weight of companies weight of companies in index based on its market capitalization (stock price x in index based on its market capitalization (stock price x # shares outstanding) – the higher the market value, the # shares outstanding) – the higher the market value, the higher the weight in the index (e.g., S&P 500, NASDAQ)higher the weight in the index (e.g., S&P 500, NASDAQ)
Comparing your portfolio’s performance to the Comparing your portfolio’s performance to the “market” depends on which index you are using “market” depends on which index you are using and whether you are really comparing “apples to and whether you are really comparing “apples to apples” or “ apples to oranges”apples” or “ apples to oranges”
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Costs of InvestingCosts of Investing
CommissionsCommissions – Costs from the broker to – Costs from the broker to implement trades one-way – must remember that implement trades one-way – must remember that you incur the cost when selling alsoyou incur the cost when selling also
Bid-Ask SpreadBid-Ask Spread – brokers who “make a market” – brokers who “make a market” in the stock make the spread as their profit (or in the stock make the spread as their profit (or your cost)your cost)
Market Impact CostsMarket Impact Costs - if you are institutional - if you are institutional (mutual or pension fund), your purchases/sales (mutual or pension fund), your purchases/sales are large enough to move the stock price against are large enough to move the stock price against you while buying or sellingyou while buying or selling
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Buying Stock on MarginBuying Stock on Margin Definition - Borrowing Funds to Buy StockDefinition - Borrowing Funds to Buy Stock - initially up - initially up
to 50% of the equity purchase – called the Initial Margin to 50% of the equity purchase – called the Initial Margin RequirementRequirement
After the Purchase - must maintain at least 30% After the Purchase - must maintain at least 30% equity of the total account valueequity of the total account value – called the – called the Maintenance Margin Requirement – to guard against defaultMaintenance Margin Requirement – to guard against default
Primary ObjectivePrimary Objective - Usually done to make higher returns - Usually done to make higher returns on your equity via “using someone else’s funds” – but can on your equity via “using someone else’s funds” – but can also lose more than if you did not borrow the fundsalso lose more than if you did not borrow the funds
High Risk StrategyHigh Risk Strategy – only meant in cases where client has – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel)tolerance (i.e., loves risk and has nerves of steel)
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Buying Stock on MarginBuying Stock on Margin
Example of Margin TradingExample of Margin Trading $10,000 of GE desired to be purchased with $10,000 of GE desired to be purchased with
$5,000 personal funds and a $5,000 Margin $5,000 personal funds and a $5,000 Margin Loan from brokerLoan from broker
GE’s stock price is $50 per share = # of shares GE’s stock price is $50 per share = # of shares = 200= 200
Interest Rate on Loan is 10%Interest Rate on Loan is 10%EndingPrice
EndingValue
LoanValue
NetEquity
Maint.Margi
n
Rate of
Return
% ChgPrice
$80 16,000 5,000 11,000 68.75% 110% 60%
$50 10,000 5,000 5,000 50.00% -10% 0%
$30 6,000 5,000 1,000 16.67% -90% -40%Bottom Line?
Margin increases gain and loss returns substantially!
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Short SellingShort Selling Definition Definition – Instead of “Buying Low 1– Instead of “Buying Low 1stst, And Selling , And Selling
High 2High 2ndnd,” you are doing this in reverse (Selling High, ,” you are doing this in reverse (Selling High, Buying Low) - Buying Low) - You do this, when you think the stock You do this, when you think the stock price is overvalued and you decided to “short” or sell price is overvalued and you decided to “short” or sell first, in expectation that the stock is going to fallfirst, in expectation that the stock is going to fall
High Risk StrategyHigh Risk Strategy – only meant in cases where – only meant in cases where client has high amounts of liquidity (cash reserves) or client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves has the risk tolerance (i.e., loves risk and has nerves of steel)of steel)
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Procedure to Short SellingProcedure to Short Selling
Borrow the Stock from BrokerBorrow the Stock from Broker – as if you were – as if you were taking a loantaking a loan
Sell the Stock in the MarketSell the Stock in the Market – collecting the – collecting the proceedsproceeds
When Stock Price DeclinesWhen Stock Price Declines – buy the stock – buy the stock back at lower priceback at lower price
Return the Stock to the BrokerReturn the Stock to the Broker – keep leftover – keep leftover funds as profitfunds as profit
Similar Margin RequirementsSimilar Margin Requirements – as in Margin – as in Margin TradingTrading
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Basics on Portfolio Basics on Portfolio ManagementManagement
Always make sure that your portfolio is Always make sure that your portfolio is diversifieddiversified – not just 8-10 securities, but 20-30 – not just 8-10 securities, but 20-30 minimum – across industries and countriesminimum – across industries and countries
Caveat emptorCaveat emptor – there are 7,000 stocks and 10,000 – there are 7,000 stocks and 10,000 mutual funds at a minimum to choose from in the USA mutual funds at a minimum to choose from in the USA – should you be picky about what you buy? YES!!– should you be picky about what you buy? YES!!
Be “street smart” – make sure that what you are Be “street smart” – make sure that what you are buying buying makes sensemakes sense and you know the reasons why and you know the reasons why you are buying it – not just a “hot stock tip” – in other you are buying it – not just a “hot stock tip” – in other words, squeeze the tomatoeswords, squeeze the tomatoes
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Basics on Portfolio Basics on Portfolio ManagementManagement
Make sure your portfolio does not become too Make sure your portfolio does not become too concentrated in 1 name or 1 sectorconcentrated in 1 name or 1 sector. Be receptive . Be receptive to sell if any 1 stock becomes greater than 10% of the to sell if any 1 stock becomes greater than 10% of the portfolio – it may drive future performance, including portfolio – it may drive future performance, including downwarddownward
Just because you made good money on 1 stock Just because you made good money on 1 stock or sector, please be aware that you might get or sector, please be aware that you might get “emotionally attached” to it“emotionally attached” to it – but keep in mind, – but keep in mind, stocks and money never were born with a “heart”stocks and money never were born with a “heart”
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Understanding How Bonds Understanding How Bonds WorkWork
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Definition of a BondDefinition of a Bond Contractual loanContractual loan that pays interest over a fixed term that pays interest over a fixed term Upon its maturity, the principalUpon its maturity, the principal or the investment or the investment
amount is returned to the lender of the bondamount is returned to the lender of the bond Interest rate (called Coupon Rate)Interest rate (called Coupon Rate) is typically fixed is typically fixed
– hence, the alternative name for bonds as “fixed – hence, the alternative name for bonds as “fixed income” securitiesincome” securities
An Income-Based InvestmentAn Income-Based Investment – focus on generating – focus on generating income and less so on capital appreciation <> stocksincome and less so on capital appreciation <> stocks
Bond Contract is called an Bond Contract is called an Indenture AgreementIndenture Agreement – – which has all of the structure details about the bond which has all of the structure details about the bond and disclosures about the company issuing the bondsand disclosures about the company issuing the bonds
Usually denominated in $1,000 unitsUsually denominated in $1,000 units – $50,000 in – $50,000 in Bonds = 50 BondsBonds = 50 Bonds
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Bond ClassificationsBond Classifications
Registered vs. Bearer FormsRegistered vs. Bearer Forms SecuritySecurity
Collateral – secured by financial securitiesCollateral – secured by financial securities Mortgage – secured by real property, normally Mortgage – secured by real property, normally
land or buildingsland or buildings Debentures – unsecuredDebentures – unsecured Notes – unsecured debt with original maturity Notes – unsecured debt with original maturity
less than 10 yearsless than 10 years SenioritySeniority
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Major Classes of BondsMajor Classes of Bonds U.S. Treasury BondsU.S. Treasury Bonds – issued by the U.S. – issued by the U.S.
Government and considered the safest type of bondGovernment and considered the safest type of bond
Corporate BondsCorporate Bonds – issued by corporations to fund – issued by corporations to fund their projects and assets – carry higher risk than the their projects and assets – carry higher risk than the U.S. Treasury bonds due to high risk of default (or non-U.S. Treasury bonds due to high risk of default (or non-payment of interest and/or principal)payment of interest and/or principal)
Municipal BondsMunicipal Bonds – issued by cities, counties, quasi- – issued by cities, counties, quasi-government agencies (like the Illinois State Tollway) government agencies (like the Illinois State Tollway) and states to fund projects and general municipal and states to fund projects and general municipal funding. funding.
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Major Classes of BondsMajor Classes of Bonds Foreign BondsForeign Bonds – issued by foreign governments as – issued by foreign governments as
well as foreign corporations – can be denominated well as foreign corporations – can be denominated either in US Dollars or in foreign currency – considered either in US Dollars or in foreign currency – considered to have multiple layers of risk, both in terms of the to have multiple layers of risk, both in terms of the foreign entities willingness to pay as well as in foreign entities willingness to pay as well as in currency risk termscurrency risk terms
Securitized CertificatesSecuritized Certificates – issued by taking a group – issued by taking a group of assets such as mortgages, auto loans or credit of assets such as mortgages, auto loans or credit cards and packaging them for issuance as a security. cards and packaging them for issuance as a security. Considered to have higher quality than a single asset Considered to have higher quality than a single asset due to diversification. Cash flow is usually less due to diversification. Cash flow is usually less predictable and dependent on changing levels of predictable and dependent on changing levels of interest ratesinterest rates
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Key Characteristics of BondsKey Characteristics of Bonds Par ValuePar Value – stated value of a bond – usually $1000 par – stated value of a bond – usually $1000 par
value per bond. $50,000 par is = to 50 bonds to buy.value per bond. $50,000 par is = to 50 bonds to buy.
Coupon Interest RateCoupon Interest Rate – the amount that is paid each – the amount that is paid each period to a bondholder by the issuer. period to a bondholder by the issuer. Rate is usually Rate is usually quoted as an annual rate, but payments are made quoted as an annual rate, but payments are made usually semi-annually.usually semi-annually.
Coupon PaymentCoupon Payment = Coupon Interest Rate x Par Value = Coupon Interest Rate x Par Value
Maturity DateMaturity Date – when the bond matures – principal – when the bond matures – principal and last coupon payment paid on this day.and last coupon payment paid on this day.
Price (Market Value)Price (Market Value) – what the value of the bond is – what the value of the bond is worth. Better yet, what the market is valuing this worth. Better yet, what the market is valuing this Annuity Stream.Annuity Stream.
M
Bond Value ($)
Years remaining to Maturity
1,372
1,211
1,000
837
775
30 25 20 15 10 5 0
kd = 7%.
kd = 13%.
kd = 10%.
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Bond RisksBond Risks Default RiskDefault Risk – – Risk that you are not going to get your Risk that you are not going to get your
original principal back due to the company going original principal back due to the company going bankrupt.bankrupt.
Interest Rate RiskInterest Rate Risk – as interest rates rise, the price – as interest rates rise, the price (and value) of the bond falls. Capital Loss!!(and value) of the bond falls. Capital Loss!!
Reinvestment Rate RiskReinvestment Rate Risk – has to do with the – has to do with the reinvestment of interest and principal payments. reinvestment of interest and principal payments. Interest PaymentsInterest Payments – what do you do with the – what do you do with the
interest payments (beside spend it) – if rates decline, interest payments (beside spend it) – if rates decline, your return is lower as you reinvest these at a lower your return is lower as you reinvest these at a lower rate.rate.
Principal PaymentsPrincipal Payments – what do you do when you get – what do you do when you get your money (principal) back – if rates decline, your your money (principal) back – if rates decline, your principal gets reinvested at a lower rate. principal gets reinvested at a lower rate.
Keep in mind that Callable Bonds also have Keep in mind that Callable Bonds also have reinvestment rate risk.reinvestment rate risk. The company will only call The company will only call the bonds when rates decline. You have both interest the bonds when rates decline. You have both interest and principal payment reinvestment rate risk.and principal payment reinvestment rate risk.
What is Interest Rate Risk? What is Interest Rate Risk? Also, called Price Risk…Also, called Price Risk…
kd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000+4.8%
-4.4%1,000
+38.6%
-25.1%15% 956 749
Interest rate risk: Rising kd causes bond’s price to fall. Which bond has more risk? 1-year or 10-year?
45
Price
Yield
Prices and Yield / Interest Prices and Yield / Interest RatesRates
46
Default Risk Premium (Credit Default Risk Premium (Credit Risk)Risk)
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D
47
Corporate Bond Spreads – AA Corporate Bond Spreads – AA & BB& BB
4
5
6
7
8
9
10
10-YR US Treasury AA Corporate Rate BBB Corporate Rate
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Benefits of Bonds in PortfoliosBenefits of Bonds in Portfolios
Historically Lower RiskHistorically Lower Risk
Diversification BenefitsDiversification Benefits
Income GenerationIncome Generation
Expand Efficient OpportunitiesExpand Efficient Opportunities
Potential GrowthPotential Growth
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Fixed Income Maturity (Interest Fixed Income Maturity (Interest Rate) RiskRate) Risk
1.5%
-1.3%
5.9%
-4.5%
9.8%
-8.7%-10%
-5%
0%
5%
10%
15%1970 - 1999
Short-TermGov’t Bond
Intermediate-TermGov’t Bond
Average Rise in Price during Declining Interest Rate PeriodsAverage Decline in Price during Rising Interest Rate Periods
Long-TermGov’t Bond
Using Bonds to DiversifyUsing Bonds to Diversify
Risk is measured by standard deviation.Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory.
Original Portfolio
ReturnRisk
10.8%8.0%
1970 - 1999
Stocks50%
Cash50%
Lower Risk Portfolio
ReturnRisk
10.8%7.6%
Stocks38%
Bonds43%
Cash19%
Based on annual data over the period 1970-1999.
Bonds
85%
6%
9%
Stocks
Bonds Produce Greater IncomeBonds Produce Greater Income
1970 - 1999
2%
73%
25%
Capital AppreciationIncomeReinvestment of Income
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Bond Prices & Yields Over TimeBond Prices & Yields Over Time
$0
$.20
$.40
$.60
$.80
$1.00
$1.20
$1.40
$1.60
1925 1935 1945 1955 1965 1975 1985 1999
0%
2%
4%
6%
8%
10%
12%
14%
16%
Bond Yields (%)
Bond Prices ($)
When Yields Increase, Bond Prices Decrease
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UnderstandingUnderstandingHow Mutual Funds WorkHow Mutual Funds Work
54
Definition of an Investment Definition of an Investment CompanyCompany
Financial intermediaries (i.e., middlemen) Financial intermediaries (i.e., middlemen) that collect funds that collect funds from individual investors and invest those funds in a diversified from individual investors and invest those funds in a diversified pool of stocks, bonds, or other assets based on the company’s pool of stocks, bonds, or other assets based on the company’s focus or specialty. (i.e., a bond fund, an international fund)focus or specialty. (i.e., a bond fund, an international fund)
Benefits to the Individual Investor –Benefits to the Individual Investor – Recordkeeping & AdministrationRecordkeeping & Administration – for all holdings in the – for all holdings in the
fundfund Diversification & DivisibilityDiversification & Divisibility – if the investor has a small – if the investor has a small
amount of money they can have instant ownership of many amount of money they can have instant ownership of many stocks, not just one. They can also easily buy more (in stocks, not just one. They can also easily buy more (in increments of $, not 100 share blocks)increments of $, not 100 share blocks)
Professional ManagementProfessional Management – this is of course relative – you – this is of course relative – you must do you homework on management – but it does beat must do you homework on management – but it does beat doing the research yourselfdoing the research yourself
Lower Transaction CostsLower Transaction Costs – due to pooling of funds, – due to pooling of funds, commissions, fees, and market impact costs are lowercommissions, fees, and market impact costs are lower
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Types of Investment Types of Investment CompaniesCompanies
Managed Investment Companies (mutual funds)Managed Investment Companies (mutual funds) Open-End Open-End – issues shares every time a buyer adds money to – issues shares every time a buyer adds money to
the mutual fund – investor buys shares at NAV.the mutual fund – investor buys shares at NAV. Closed-EndClosed-End – trade like stocks on the exchange. Investor – trade like stocks on the exchange. Investor
buys at the current stock prices (which could be higher or buys at the current stock prices (which could be higher or lower than the NAV).lower than the NAV).
Unit Investment TrustUnit Investment Trust – pool of money invested in a portfolio – pool of money invested in a portfolio whose investments are fixed for the life of the fund. Usually whose investments are fixed for the life of the fund. Usually Bonds given that they have a maturity, but also seen used with Bonds given that they have a maturity, but also seen used with stocks for a 1 year term.stocks for a 1 year term.
Commingled Funds (i.e., limited partnerships)Commingled Funds (i.e., limited partnerships) – similar to – similar to Open-Ended Funds, but instead of buying shares, you are buying Open-Ended Funds, but instead of buying shares, you are buying units at NAV. Usually offered by banks & insurance companies.units at NAV. Usually offered by banks & insurance companies.
Real Estate Investment Trusts (REITs)Real Estate Investment Trusts (REITs) – a closed-ended – a closed-ended fund that invests in real estate fund that invests in real estate
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Used as a basis for valuation of investment Used as a basis for valuation of investment company shares.company shares. Selling new sharesSelling new shares Redeeming existing sharesRedeeming existing shares
Market Value of Assets - Market Value of Assets - LiabilitiesLiabilities Shares OutstandingShares Outstanding
Open Ended Funds – Open Ended Funds – NAV is PriceNAV is Price Closed Ended Funds - Closed Ended Funds - NAV is compared to Stock NAV is compared to Stock
Price of FundPrice of Fund
Net Asset Value and PriceNet Asset Value and Price
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Shares OutstandingShares Outstanding Closed-end:Closed-end: no change unless new stock is no change unless new stock is
offered.offered. Open-end:Open-end: changes when new shares are changes when new shares are
sold or old shares are redeemed.sold or old shares are redeemed.
PricingPricing Open-end:Open-end: Net Asset Value (NAV) Net Asset Value (NAV) Closed-end:Closed-end: Premium or discount to NAV Premium or discount to NAV
Open-End and Closed-Open-End and Closed-End Funds: Key DifferencesEnd Funds: Key Differences
58
Money Market Money Market
Fixed IncomeFixed Income
EquityEquity
Balance & Income Balance & Income
Asset AllocationAsset Allocation
Indexed Indexed
Specialized SectorSpecialized Sector
Investment PoliciesInvestment Policies
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Fee StructureFee Structure Front-end loadFront-end load Back-end loadBack-end load
Operating expensesOperating expenses
12 b-1 charges12 b-1 charges distribution costs paid by the funddistribution costs paid by the fund Alternative to a loadAlternative to a load
Fees and performanceFees and performance
Costs of Investing in Mutual Costs of Investing in Mutual FundsFunds
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Exchange Traded FundsExchange Traded Funds
Allow investors to trade funds based on Allow investors to trade funds based on indexes like stock.indexes like stock.
ExamplesExamples SPDRSSPDRS WEBSWEBS HOLDERSHOLDERS
Allow sector specializationAllow sector specialization
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A First Look at Fund A First Look at Fund PerformancePerformance
Benchmark: Wilshire 5000Benchmark: Wilshire 5000
ResultsResults Most funds underperformMost funds underperform Not fair comparison because of costsNot fair comparison because of costs
Adjusted Benchmark: Wilshire 5000 with Adjusted Benchmark: Wilshire 5000 with passive management costs considered.passive management costs considered. The majority of funds still under-perform.The majority of funds still under-perform.
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Consistency of Fund Consistency of Fund PerformancePerformance
Do some mutual funds consistently Do some mutual funds consistently outperform?outperform?
Evidence suggests that some funds show Evidence suggests that some funds show consistent stronger performance.consistent stronger performance. Depends on measurement intervalDepends on measurement interval Depends on time periodDepends on time period
Evidence shows consistent poor Evidence shows consistent poor performance.performance.
63
Rate of Return Calculations for Rate of Return Calculations for FundsFunds
Performance Performance – History has shown that 80% of mutual fund – History has shown that 80% of mutual fund managers do not beat the “market” – so why bother? Main managers do not beat the “market” – so why bother? Main difference is that they are comparing apples and oranges. difference is that they are comparing apples and oranges.
Mutual fund managers charge fees and hence their Mutual fund managers charge fees and hence their performance will be lower.performance will be lower. In other words, you cannot In other words, you cannot get around the fees period – even if you bought the index get around the fees period – even if you bought the index yourself – you would still have commission charges.yourself – you would still have commission charges.
Past Performance does not completely indicate future Past Performance does not completely indicate future performance,performance, but do remember you are investing in the but do remember you are investing in the mutual fund manager. If his/her performance is poor, then it mutual fund manager. If his/her performance is poor, then it is likely that it might remain poor (if he is not fired, that is) – is likely that it might remain poor (if he is not fired, that is) – Money MagazineMoney Magazine flaws as an example of this. flaws as an example of this.
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Wiesenberger’s Investment CompaniesWiesenberger’s Investment Companies
MorningstarMorningstar
Investment Company InstituteInvestment Company Institute
Popular pressPopular press
Investment servicesInvestment services
Information Sources on Mutual Information Sources on Mutual FundsFunds
65
Measuring Fund Performance – Measuring Fund Performance – Category Ranks and RatingsCategory Ranks and Ratings
You can view all mutual funds as 1 peer group – You can view all mutual funds as 1 peer group – but everyone is investing with a different “style”but everyone is investing with a different “style”
Category ratings are used to see who did better Category ratings are used to see who did better within a “category” of style.within a “category” of style.
Certain investment styles perform better than Certain investment styles perform better than others at any point in time – others at any point in time – if that is the case, then if that is the case, then managers must be compared to their peers…managers must be compared to their peers…
Category Style = Investment Objective of the FundCategory Style = Investment Objective of the Fund Helps to determine what funds do well even when Helps to determine what funds do well even when
style is out of favorstyle is out of favor Points out funds that are just riding on the coat tails of Points out funds that are just riding on the coat tails of
their grouptheir group
66
Categories Identify the Real Categories Identify the Real CompetitionCompetition
For example: For example: International EquityInternational Equity ForeignForeign WorldWorld Diversified Emerging MarketsDiversified Emerging Markets RegionalRegional International HybridInternational Hybrid
This reaffirms that returns do not tell the This reaffirms that returns do not tell the whole story – whole story –
10 YR Trailing Return (1/2001)10 YR Trailing Return (1/2001) Janus TwentyJanus Twenty 21.63%21.63% Weitz Partners ValueWeitz Partners Value 21.57%21.57%
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Value Blend Growth
Large
Medium
Small
Morningstar Equity Style BoxMorningstar Equity Style Box
Classifies a fund based on –Classifies a fund based on – Style —Value, Blend, GrowthStyle —Value, Blend, Growth Size — Small, Medium, LargeSize — Small, Medium, Large
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Style Box BreakpointsStyle Box Breakpoints
Market CapitalizationMarket Capitalization Large – Large – >= $10 billion>= $10 billion Medium – Medium – < $10.0 billion, >= $1.6 billion< $10.0 billion, >= $1.6 billion Small – Small – < $1.6 billion< $1.6 billion
Style Types – Relative Valuation Ratios vs. Style Types – Relative Valuation Ratios vs. MarketMarket Value –Value – rel. P/E + rel. P/B <1.75rel. P/E + rel. P/B <1.75 Blend –Blend – rel. P/E + rel. P/B = 1.75-2.25rel. P/E + rel. P/B = 1.75-2.25 Growth – Growth – rel. P/E + rel. P/B >2.25rel. P/E + rel. P/B >2.25
69
Styles <> ObjectivesStyles <> Objectives
FundFund ObjectiveObjective Actual StyleActual StyleOakmark Select Growth Mid Value
Pioneer Cap GrowthSmall Co. Mid ValuePrudential Equity Inc Equity Inc. Mid Value
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Styles <> ObjectivesStyles <> Objectives
FundFund ObjectiveObjective Actual StyleActual StyleVanguard Growth Index Growth Large Large
GrowthGrowthSequoia Growth Large Value
Delafield Growth Small Value
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Value Blend Growth
Large
Medium
Small
Value Blend Growth
TwentyTwenty WeitzWeitz
Current Equity Style BoxCurrent Equity Style Box
Large Cap Growth Mid Cap Value
72
Janus Twenty Top HoldingsJanus Twenty Top Holdings
73
Weitz Top HoldingsWeitz Top Holdings
74
Janus Twenty Portfolio Janus Twenty Portfolio BreakdownBreakdown
75
Weitz Partners Value Portfolio Weitz Partners Value Portfolio BreakdownBreakdown
76
Janus Twenty Sector Exposure
77
Weitz Partners Value Sector Exposure
78
Risk MeasuresRisk Measures
TwentyTwenty WeitzWeitzMorningstar Risk (10 YR) 1.32 0.59Standard Deviation 24.72 14.18
Morningstar Risk Ratio = Fund SD / Market Morningstar Risk Ratio = Fund SD / Market SDSD
It is a Relative Measure of RiskIt is a Relative Measure of Risk
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Five Key Points in Picking Five Key Points in Picking FundsFunds How has the fund performed?How has the fund performed?
Compare with appropriate indexCompare with appropriate index Compare with peer groupCompare with peer group Examine after-tax returns, if relevantExamine after-tax returns, if relevant
How risky has the fund been?How risky has the fund been? Big returns spell riskBig returns spell risk Are you comfortable with the level of volatility?Are you comfortable with the level of volatility? Morningstar risk & standard deviationMorningstar risk & standard deviation
What does the fund own?What does the fund own? Value vs. GrowthValue vs. Growth SectorsSectors U.S. and ForeignU.S. and Foreign
Who runs the fund?Who runs the fund? Who earned the fund’s record?Who earned the fund’s record? Where does this manager come from?Where does this manager come from? What’s the fund family like?What’s the fund family like?
What does the fund cost?What does the fund cost? Low expenses are bestLow expenses are best Load funds aren’t bad if performance is justified, but rareLoad funds aren’t bad if performance is justified, but rare
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Understanding Global Understanding Global InvestingInvesting
Why Invest Globally?Why Invest Globally?
Investment Opportunities – Investment Opportunities – roughly 50% of roughly 50% of the global stock market currently Foreignthe global stock market currently Foreign
Market HistoryMarket History
Growth Potential – Growth Potential – faster growing economiesfaster growing economies
Diversification Benefits – Diversification Benefits – Expand Efficient Expand Efficient RangeRange
Each bar shows the range of annual total returns for each region over the period 1970-1999.
Global Stock Market ReturnsGlobal Stock Market Returns
Highest and Lowest Historical Annual Returns for Each Region 1970 - 1999
United States
International
Europe
37.4%
69.9%79.8%
107.5%
-26.5% -23.2% -22.8%-34.3%
Pacific
13.7% 13.2% 13.8% 13.4%
Average Return
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
83
Domestic Versus GlobalDomestic Versus Global
U.S. BondsU.S. Stocks International Stocks
1970 - 1999
Domestic Portfolio Global Portfolio
Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999.
Average Return
Risk 10.8%
12.0%
40%60%
Average Return
Risk 10.0%
12.0%
40%
18%
42%
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Risks Of Foreign InvestingRisks Of Foreign Investing
Currency RiskCurrency Risk
Economic/Political RiskEconomic/Political Risk
Market Liquidity RiskMarket Liquidity Risk
Differences in Accounting StandardsDifferences in Accounting Standards
Costs of Investing InternationallyCosts of Investing Internationally
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The End!The End!
Thank You!Thank You!
