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Wealth Management
An Unbiased Approach to Managing Your Investments
Designed for the Affluent Investor
Outline
I. Hedge Funds & Private Equity
• What are Hedge Funds?
• Risk and Return
• Top 10 Takeaways
• Manager Selection a...
What is a Hedge Fund?
A managed portfolio of investments that uses a variety of strategies in
hopes of achieving outsized,...
Hedge Fund Characteristics
•Usually Open to Limited Number of Investors
•Typically Require a Large Minimum Investment (i.e...
What Are Hedge Funds?
-Asset management organization dedicated to the pursuit of absolute returns - implementation vehicle...
Hedge Fund Strategies
Fixed Income Relative
Value
Equity Market Neutral
Convertible Trading
Emerging Market Debt
Relative ...
Manager Incentive Structure
•Frequently use “2 and 20” compensation
•Charges 2% of AUM and 20% of any profits earned.
•Man...
Hedge Funds
Have historically provided steady returns with low volatility
Source: Dow Jones Credit Suisse Core Hedge Fund ...
“Disappointing Returns?”
Annual Returns from 2000-2012
Source: Goldman Sachs, Bloomberg
Do these Dow Jones Hedge Fund Inde...
“Disappointing Returns?”
Source: Goldman Sachs, Bloomberg
Annual Returns from 2000-2012
When you compare the performance o...
Implementation of Hedge Funds
This is not a complete list of pros and cons associated with hedge funds. Please contact you...
What is Private Equity?
• Generally, investments in non-publicly traded entities
• Long history - much of the world’s econ...
Types of Private Equity Investments
Company Life Cycle
Angel Investor
General Venture Capital
Late / Cross-over VC
Mezzani...
Alpha in Private Equity
Chance
Skill
Company selection
Ability to influence strategy
Financial engineering
Informational a...
Manager Selection is Critical
Source: Goldman Sachs Private Equity Group.
Past performance is not indicative of future ret...
Private Equity
Opportunities for greater outperformance
Private equity fund returns are compared with 4-year annualized av...
Implementation in Your Portfolio
• Look for 1940 Act Mutual Funds that provide liquid exposure to the strategies you deem
...
Top 10 Hedge Fund Takeaways
• Hedge Fund does not necessarily equal another Hedge Fund
• A diversified hedge fund portfoli...
Ivy League Endowment Funds
•Source: 2010 Yale University Endowment Report
Historical Investment Returns
Asset Allocation
Yale University Endowment
•Source: 2012 Yale University Endowment Report
Historical Investment Returns
Yale University Endowment
•Source: 2012 Yale University Endowment Report
Historical Investment Returns
Yale University Endowment
•Source: 2012 Yale University Endowment Report
Historical Investment Returns
Harvard University Endowment
Harvard
Policy
Portfolio
Benchmark*
60/40
Stock/Bond
Portfolio*...
Different Methods of Investing
Individual Securities
Investors purchase individual stocks and fixed income securities.
Fun...
Considerations for Investing
Five Considerations when Selecting Types of Investments
1. Management
2. Taxation
3. Costs
4....
Considerations for Investing
Five Considerations when Selecting Individual Securities
Investor must select and manage each...
Considerations for Investing
Five Considerations when Selecting Individual Securities
Short-Term/Long-Term Capital Gains, ...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Five Considerations when Selecting...
Considerations for Investing
Five Considerations when Selecting Individual Securities
Investor makes all investment decisi...
Considerations for Investing
Five Considerations when Selecting Individual Securities
1. Management
2. Taxation
3. Costs
4...
Stock Portfolios
Building your own portfolio
Pros of building your own portfolio
- Flexibility to pick specific investment...
Stock Portfolios
Building your own portfolio
Cons of building your own portfolio
- Lack of investor sophistication
- Many ...
Stock Portfolios
How to do Fundamental Analysis
- Develop your own model
Commercial Research Reports
- Morningstar has cha...
Considerations for Investing
Characteristics of Open-End Mutual Funds
A mutual fund that contracts and expands in share si...
Considerations for Investing
Five Considerations when Selecting Mutual Funds
1. Management
2. Taxation
3. Costs
4. Control...
Considerations for Investing
Five Considerations when Selecting Mutual Funds
1. Management
2. Taxation
3. Costs
4. Control...
Considerations for Investing
Five Considerations when Selecting Mutual Funds
1. Management
2. Taxation
3. Costs
4. Control...
Considerations for Investing
Expense Ratio Example
Fee charged by fund’s manager to manage 0.55%
the fund’s portfolio
Mark...
Share Classes
• A Shares typically have a front-end load that is taken off
your investment, but typically have lower 12b-1...
Share Classes
• Over the long run, A Shares
have lower expenses and
higher relative performance
• For Years 1- 4, B & C Sh...
Considerations for Investing
Five Considerations when Selecting Mutual Funds
1. Management
2. Taxation
3. Costs
4. Control...
Considerations for Investing
Five Considerations when Selecting Mutual Funds
1. Management
2. Taxation
3. Costs
4. Control...
Characteristics of Mutual Funds
1. Mutual funds are essentially an investable portfolio of stocks and/or bonds.
2. Mutual ...
Characteristics of Mutual Funds
Fee example of the Growth Fund of America A shares (AGTHX)
Fees are typically quoted as a ...
Mutual Fund Expenses
“After costs, the return on the average actively managed dollar will be less than
the return on the a...
Characteristics of Mutual Funds
Pros and Cons of Mutual Funds
Pros:
- Professional Management
- Diversification
- Economie...
Characteristics of ETFs
Exchange Traded Funds (ETFs)
ETFs track indices, commodities or a basket of assets like an index f...
Characteristics of ETFs
ETF fees vs. Mutual Fund Fees
SPDR S&P 500 ETF Vanguard Large Cap Index
Both funds track the S&P 5...
Characteristics of ETFs
ETF taxable distributions vs. Mutual Fund taxable distributions
The more an active fund will force...
Characteristics of ETFs
Exchange Traded Funds (ETFs)
Cons of ETFs
Payment of dividends goes into your brokerage account an...
A large component of buying and selling costs for ETFs is the
difference between the bid and the ask
Larger ETFs typically...
• Use limit orders rather than market orders
– Does not rely on a deep order book
– Allows you to set a fair price for the...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Five Considerations when Selecting...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Investor owns a basket of securiti...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
No imbedded capital gains
Managers...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Fees and/or commissions that may v...
Considerations for Investing
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
Custom Portfolio
Management Change...
Considerations for Investing
Five Considerations when Selecting Separate Account Managers
1. Management
2. Taxation
3. Cos...
Review
Which Alternative is Best for you?
1. Management
2. Taxation
3. Costs
4. Control
5. Liquidity
INDIVIDUAL
SECURITIES...
Manager Selection
The following are two distinct discussions:
Investment Managers
Investment Advisors
If Asset Allocation ...
Manager Selection
Two Levels of Manager Evaluation
QUANTITATIVE QUALITATIVE
EVALUATION
Quantitative:
How have managers per...
Manager Search and Selection
Assets Under Management
Length of Track Record
Stability of Personnel
Compliance Record
•Step...
Characteristics of Mutual Funds
Morningstar Mutual Fund Research
Example: Fidelity Contra Fund (FCNTX)
If you research thi...
Characteristics of Mutual Funds
Morningstar Mutual Fund Research
Example: Fidelity Contrafund (FCNTX)
Manager information ...
Does your manager drink his own Kool-Aid?
All fund managers must disclose the amount of personal
funds they have in their ...
Does your manager follow the fund strategy?
Good managers stick to primary fund strategy
Example- If you purchase a value ...
Characteristics of Mutual Funds
Morningstar Mutual
Fund Research
Example: Fidelity Contra
Fund (FCNTX)
Detailed informatio...
Characteristics of Mutual Funds
Morningstar Mutual Fund Research
Example: Fidelity Contra Fund (FCNTX)
Performance compari...
Sub-Styles
•Value Sub-Styles
– Deep Value
– Yield
– Traditional Value
– Value of Growth
– Multifactor Approaches
•Growth S...
Active vs. Passive Management
Beliefs Required to Use Active Management
Manager can add value AFTER FEES and AFTER TAXES t...
Active vs. Passive Management
Luck vs. Skill
Beta
R Squared
Alpha
Active vs. Passive Management
Luck vs. Skill
Beta (β)
R Squared
Alpha (α)
A measure of explainable/expected risk
Represent...
Beta
Beta Considerations
Beta (β) is based on historical price data and can change over
time.
Beta is calculated from pric...
Active vs. Passive Management
Example: Portfolio A vs. Market
Portfolio A 1.2 12% -6%
Market 1.0 10% -5%
BETA
IN UP
MARKET...
Active vs. Passive Management
Example: Portfolio B vs. Market
Portfolio B 0.8 8% -4%
Market 1.0 10% -5%
BETA
IN UP
MARKET
...
Active vs. Passive Management
Beta Rules
Should not stand alone
Validity of beta depends upon the relevance of the Market/...
Active vs. Passive Management
Capital Asset Pricing Model (CAPM)
Beta (β)
R Squared
Alpha (α)
It defines the systematic/ma...
Active vs. Passive Management
Luck vs. Skill
Beta (β)
R Squared
Alpha (α)
Measures the correlation between the portfolio a...
R- Squared
• Example- A fund with an R-Squared value of 85, means that
85% of the fund’s movements can be explained by the...
Active vs. Passive Management
Luck vs. Skill
Beta (β)
R Squared
Alpha (α)
STOCKS
Measures the non-systematic return associ...
Alpha (α)
• A positive alpha of 1.0 means the fund has outperformed its
benchmark index by 1%. A similar negative alpha wo...
Active vs. Passive Management
Capital Asset Pricing Model (CAPM)
Sharpe Ratio
Measures risk-adjusted returns, and tells us...
Sharpe Ratio
Sharpe Ratio Example
If you are deciding whether to purchase one of 2 different mutual funds, using
the Sharp...
Adding Satellite Managers
Satellite Managers
• Any Manager that can add Alpha to a portfolio
• Enhanced Return
• Enhanced ...
Manager Selection
When to Fire a Manager
Consistent under-performance of the
portfolio vs. benchmark and peers
Significant...
Buy High And Sell Low
2 Year returns AFTER
hiring/ firing
2 Year returns BEFORE
hiring/ firing
Fired
Fired
Hired
Hired
Peter Lynch
“All the time and effort that people devote to
picking the right fund, the hot hand, the great
manager, have i...
Warren E. Buffet
“Most investors, both institutional and individual,
will find that the best way to own common stocks
is t...
Passive vs. Active Management
Passive vs. Active Investment Management
• Many asset classes are considered very efficient....
Efficient Markets Hypothesis
The Hypothesis States:
• Current prices incorporate all available information and expectation...
The Failure of Active Management
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2012. Index us...
The Failure of Active Management
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Index us...
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Wealth Management - Week 3

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  • In the last two classes we mentioned that there would be additional investing considerations above and beyond simply taking “long” positions in either stocks, bonds, or cash.
    In the first part of today’s class we’ll start with reviewing hedge funds, their applications, and key points to take away.
    Then we’ll cover private equity and how the introduction of private equity, in certain cases, has led to better-than-average returns (Yale endowment model).
  • In the last two classes we mentioned that there would be additional investing considerations above and beyond simply taking “long” positions in either stocks, bonds, or cash.
    In the first part of today’s class we’ll start with reviewing hedge funds, their applications, and key points to take away.
    Then we’ll cover private equity and how the introduction of private equity, in certain cases, has led to better-than-average returns (Yale endowment model).
    Then we’ll move through some terminology in the Appendix section.
  • In the last two classes we mentioned that there would be additional investing considerations above and beyond simply taking “long” positions in either stocks, bonds, or cash.
    In the first part of today’s class we’ll start with reviewing hedge funds, their applications, and key points to take away.
    Then we’ll cover private equity and how the introduction of private equity, in certain cases, has led to better-than-average returns (Yale endowment model).
    Then we’ll move through some terminology in the Appendix section.
  • Loose constraints - Relaxed constraints on benchmark, short selling, leverage and traded instruments
    Manager/investor incentives aligned - A large portion of manager compensation is performance based, usually with a high water mark. Managers also usually have a high percentage of their personal net worth invested
    Diverse strategies - Hedge funds comprise a large and growing set of strategies. Diversification benefits across managers can be similar to those of individual stocks
    Low correlation to traditional assets - Can give exposure to return drivers that are different to the drivers of traditional asset class returns
    Skill based - Seeks to access to some of the best talent in money management
    Illiquid - Terms include lock-ups, notice periods and typically monthly redemptions at best
    Lightly regulated - Careful consideration of business risks is key
  • Definition of 'Fixed-Income Arbitrage'
    An investment strategy that attempts to profit from arbitrage opportunities in interest rate securities. When using a fixed-income arbitrage strategy, the investor assumes opposing positions in the market to take advantage of small price discrepancies while limiting interest rate risk. Fixed-income arbitrage is primarily used by hedge funds and leading investment banks. The most common fixed-income arbitrage strategy is swap-spread arbitrage. This consists of taking opposing long and short positions in a swap and a Treasury bond. Such strategies provide relatively small returns and, in some cases, huge losses. 
  • Loose constraints - Relaxed constraints on benchmark, short selling, leverage and traded instruments
    Manager/investor incentives aligned - A large portion of manager compensation is performance based, usually with a high water mark. Managers also usually have a high percentage of their personal net worth invested
    Diverse strategies - Hedge funds comprise a large and growing set of strategies. Diversification benefits across managers can be similar to those of individual stocks
    Low correlation to traditional assets - Can give exposure to return drivers that are different to the drivers of traditional asset class returns
    Skill based - Seeks to access to some of the best talent in money management
    Illiquid - Terms include lock-ups, notice periods and typically monthly redemptions at best
    Lightly regulated - Careful consideration of business risks is key
  • Red Line = Hedge Fund Index
    Blue Line = S&P 500
    Green Line = Dow Jones World Index
    -the time period reflected in this chart was particularly volatile; notice how the red line did not see the same levels of decline as the other two lines.
  • Do these Dow Jones Hedge Fund Index returns for the last 13 years look disappointing? Probably not too much, except in 2008 and 2011. But look what happens when we move to the next slide……
  • When you compare the performance of hedge funds to the performance of the MSCI World Index, you can see that there is significantly less volatility and steadier returns.
  • Non-Public – All companies on the S&P 500, at some point, were private companies. Thus, much of the world’s economy is privately held.
  • Some of you may have heard the term “angel investor”, which is essentially An investor who provides financial backing for small startups or entrepreneurs. Angel investors are usually found among an entrepreneur's family and friends. The capital they provide can be a one-time injection of seed money or ongoing support to carry the company through difficult times.
    Venture capital (VC) is provided to firms and small businesses with perceived growth potential. Entails high risk for the investor but with potentially high returns.
    Late stage funding is intended for more mature companies in need of backing for new product and project developments, expansion, growth objectives, or pre-IPO activities.  While some investors focus on early stage, seed stage, and start up capital, late stage private equity can result in larger amounts based on the company’s status, needs, cash flow, revenues, profit, and potential.
    Mezzanine financing is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies. Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range.
    Turnaround financing is exactly as ther name suggests.  In this type of deal, a private equity firm would supply the necessary resources or capital for a distressed company to succeed, thus completing a “turnaround” of the company’s performance. The company is often in a desperate state, which allows for the private equity holders to typically receive a greater potential return, but at the cost of very high risk.
    -Private equity can occur at any time within a company’s life cycle. From startup to growth, or from a mature and successful business to a declining or distressed asset in need of restructuring.
  • Where does value come from in Public and Private markets?
    In public markets, value can be added by Chance, Skill, and Selection; yet, many other factors are difficult to control. In private equity investments there is a significant amount of added control to stakeholders. This can serve as both an advantage and an added risk.
  • The “normal” distribution, which is this bell-shaped distribution on the left, is what allows us to estimate and understand the risks associated with public investments. In the last class where we stated that we can estimate with 95% certainty that returns will fall within 2 standard deviations of the mean, we were referring to a “normal” distribution.
    The private equity distribution of returns is “skewed positive”, meaning that the right tail is longer than the left, and that most of the returns are on the left side, or lower end, of the returns distribution. This is why manager selection is so important, and why it is difficult to evaluate risk and estimate potential returns based off of history.
  • This chart shows how the median returns across these several asset classes are fairly consistent, but the opportunity to achieve outperformance is much more prevalent in private equity deals. Conversely, you’ll notice that there is also a greater opportunity for loss.
  • One Hedge Fund does not necessarily equal another hedge fund.
    Hedge funds, due to their low correlation with typical investments (Stocks and Bonds), can reduce overall volatility and risk in the portfolio.
    The size of the hedge fund is less important than manager selection.
    Make sure that it is easy to determine the investment goals of the fund and if the management style is drifting the target.
    Historical Returns are not good indicators of future performance because of the diverse range of investments and strategies.
    Manager selection is clearly a very important element to any hedge fund’s performance.
  • For the next few slides we’re going to refer to Yale’s endowment fund. Some of you may have heard of Endowment style investing, and Yale’s fund outlines these methods quite well.
    This graphic shows how, over time, Yale’s portfolio reduced US Equity (purple) and US Bonds in an effort to achieve greater diversification through the addition of Private equity (dark purple), absolute return strategies (light blue) and increasing their allocation to real assets.
  • For the next few slides we’re going to refer to Yale’s endowment fund. Some of you may have heard of Endowment style investing, and Yale’s fund outlines these methods quite well.
    This graphic shows how, over time, Yale’s portfolio reduced US Equity (purple) and US Bonds in an effort to achieve greater diversification through the addition of Private equity (dark purple), absolute return strategies (light blue) and increasing their allocation to real assets.
  • This table shows the target figures vs. actual figures for June. The allocation, in most cases is very close to its target, with the exception of holding a 2.7% cash balance instead of allocating those funds to absolute return strategies. Notice the large target allocations to absolute return, private equity, and real estate.
    It should be noted that, because of the size of these endowment funds, liquidity is not a primary concern; thus, high allocations to illiquid private equity and real estate investments are viable.
  • Notice the returns on this chart for the last 5 years. Particularly, in 2011, equity markets were virtually flat while the endowment fund returned 21.9%. Conversely, in 2012 when the S&P 500 returned approximately 16%, the endowment returned 4.7%.
    The endowment fund managers understand that reducing volatility is key to growing a portfolio.
  • Selecting top managers in private markets leads to much greater reward than
    identifying top managers in public markets. On the other hand, poor private manager
    selection can lead to extremely disappointing results as a consequence of high
    fees, poor performance, and illiquid positions. Careful consideration of the degree
    of market opportunity when formulating asset allocation policies and structuring
    portfolios makes an important contribution to investment performance.
  • Just to show that this overperformance by Yale’s endowment fund is not an anomaly, these are the returns for Harvard’s endowment fund vs. their benchmark vs. a traditional 60/40 portfolio. Over time, the return has exceeded their benchmark, as well as outperformed a traditional stock and bond portfolio.
  • Individual securities: like and investor purchasing Apple stock or a Municipal Revenue Bond that is tied to a toll station in New Jersey. It is difficult to achieve diversification using these investments.
    Mutual funds: Funds that invest in several stocks, bonds, or derivatives in an effort to provide broader exposure and diversification to investors.
    Separate Account Managers: An account that an investor owns is managed separately and contains a mix of investments. Similar to a mutual fund, only the individual securities are actually held within the account.
  • Management - Investor must select and manage each transaction Investor is responsible for all decisions
  • Taxation – Short Term Capital Gains (less that 1 year), Long Term Capital Gains (greater than 1 year), Dividend Income (stocks), and Interest Income (Bonds).
  • Costs – Trading costs, commissions (broker), fees (advisor)
  • Control – Every decision is made by the investor. Portfolio isn’t directly affected by the decisions of a mutual fund manager or separate account manager.
    That’s not to say that if certain high-profile fund managers reveal that they recently purchased a security in their fund, that the price of that security may fluctuate based off of that news alone. Example: when Jim Cramer announces the addition of a security to his Charitable Trust on his popular CNBC show Mad Money.
  • Individual Securities can be bought and sold in a matter of days, with the costs of selling at relatively low levels.
  • LET’S TAKE A BREAK
    Pros:
    Supreme Control – Flexibility to choose investments
    Tax Management – Make it easy to track when an investment was purchased, sold, and if the gains are long or short term.
    No Management Fees - …because you are essentially your own manager.
    Liquidity – Ability to move to cash quickly.
  • Cons:
    Individual Investors lack sophistication and tools that some investment professionals have.
    Individual investors lack discipline and are more susceptible to the emotional cycle of investing curve that we covered in the first class.
    Trading costs exist in most cases, but they are significantly higher for individual, or “retail” investors, than they are for managers, or “institutional”, investors. In some cases, a manager will even cover the cost of trades.
    As we know, market timing is extremely difficult; and from last week’s class, we know that the majority of returns come from “asset allocation policy”, which is another reason why discipline is so important.
    Finally, it can, and often should be extremely time consuming. At some point, an computer programmer or doctor or chef must decide whether they are prepared to spend a significant amount of their time researching investments, or reallocate that time towards their already-established area of expertise. The same can be said for retirees that may rather spend their time traveling or enjoying leisurely activities.
  • Developing your own model can be time consuming even if you know what you’re doing. After you have investments in mind, you can research these investments, create watchlists, and in some cases, set up alerts, by using these resources.
  • Moving on to mutual funds……
    Mutual funds come in two main types: Open-end and closed end.
    Open end funds are always available to investors; unlike a stock where there is a fixed number of shares, and in order to purchase the stock there must also be a willing seller.
  • Management:
    Purchase a basket of securities in one transaction
    Purchased and sold in amounts as low as $250
    Easy to Track
    Can be set up for periodic distributions such as monthly income
  • Taxation:
    Mutual funds must distribute their gains and losses each year
    Most funds are not managed for after tax returns
  • (On the next slide we cover costs)
    Costs:
    Fund Pricing
    Internal Costs
    Confusing Fee Structure A,B,C,D,E,F,Y
    Economies of Scale
  • The cost structure for mutual funds contains these various components:
  • A Shares typically have a front-end load that is taken off your investment, but typically have lower 12b-1 fees. A Shares may also have ‘breakpoints’ in the fees at certain investment levels.
    B Shares typically have a back-end load that is taken off when you sell the fund. The back-end load typically decreases the longer you hold the fund. B Shares typically will convert to A Shares after specified period of time.
    C Shares typically have no front-end load or back-end load if held for more than 1 year. C Shares typically do have higher expense ratios and 12b-1 fees.
  • It should be noted that this chart relates to the share classes available to individual investors. In the case of larger investors, “Institutional Shares” may be available….
    The Institutional class of mutual fund shares are available for sale to investing institutions, either on a load or no-load basis. With sizable minimum investments, usually around $500,000 or more, funds will typically waive any front-end sales charges on these shares. 
  • Control:
    Professional management
    Style Drift
    Management Changes
    Owner has no control over purchases or sales
    Shares have to be sold to meet redemption
  • Liquidity
    All purchases and sales are made at NAV
    Mutual Fund transactions occur once per day
    Mutual Fund companies are the purchaser and seller of every mutual fund transaction
    Typically three day settlement of trades
  • Mutual Fund Takeaways
    1. Essentially an investable portfolio of stocks and/or bonds.
    2. Categorized by their style (e.g.- Large Cap Value Fund, Small Cap Growth, Intermediate term bonds, etc)
    3. Mutual Funds are not managed to minimize taxes. Excessive trading can decrease fund performance through increased taxes and broker fees.
    4. Expenses can cut into fund performance. Expenses are categorized as:
    - Initial Fees also known as ‘front load’ fees. These are paid upon initial purchase of a fund. Typically, only ‘A’ shares have a front load
    - Deferred Fees also known as ‘back end’ fees. These are paid when you sell shares in the fund. These fees are typically associated with ‘B’ shares.
    - 12b-1 Fees are associated with marketing and distributions.
    - Management Fees are paid to the manager for the management of the fund.
    - Net Expense Ratio = Total dollar amount of fees / Net Asset Value
  • Sites like morningstar, fi360, Yahoo, and many others have the expense information readily available.
  • Talking Points:
    In both US and non-US strategies, the average actively managed mutual fund is considerably more expensive than the average passively managed fund.
    The graph compares average expense ratios of actively managed funds to those of passive funds. The ratios are presented as simple averages and weighted averages. The weighted average calculation indicates that larger funds tend to have lower expenses than smaller funds.
    Active managers, on average, charge more than twice the fees of passive managers. This is also true in the international fund universe, although the differences are not as large due to the higher costs of investing in non-US markets.
    Nobel laureate William Sharpe has pointed out that active management in aggregate must underperform passive management, not due to controversial financial theories but by the simple laws of arithmetic.
  • Pros:
    - Professional Management
    - Diversification
    - Economies of Scale (lower transaction costs)
    - Liquidity
    - Simplicity
    Cons:
    - Expenses
    - Dilution (larger funds have a disadvantage in placing trades)
    - Taxes
  • Exchange Traded Funds (ETFs)
    ETFs track indices, commodities or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.
    Pros of ETFs
    By owning an ETF, you get the diversification of an index fund. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund.
    ETFs also have better potential tax benefits due to the fact that they are not actively managed.
    ETFs have better transparency than mutual funds as an investor can check the fund holdings at any time.
    ETFs are an easy way to target specific equity sectors or commodities.
  • Mutual Funds Comparison: S&P 500= American Funds Fundamental Investors; Midcap 400= Ariel Appreciation 
    Russell 2000= Royce Special Equity Invmt;   Large Value= American Funds Washington Mutual; Small Value=Allianz NFJ Small Cap Value
    Large Growth= American Funds AMCAP; Small Growth= Vanguard Explorer Inv 
  • Cons of ETFs
    Payment of dividends goes into your brokerage account and are not directly invested back into the fund.
    Rebalancing to target asset allocation can be difficult as attempting to get exact asset weightings is nearly impossible.
    Dollar cost averaging can be difficult and expensive to implement.
    Some ETFs lack liquidity, which can result in higher Bid-Ask spreads and transaction costs.
    Example- ELR (SPDR Dow Jones Large Blend) has an average 3 month volume of 3100 shares, whereas SPY (SPDR S&P 500) has an average 3 month volume of 181,672,000 shares. The result is ELR having a spread that is 5 times larger than SPY on a price basis.
  • Since ETFs trade in much the same way as stocks, these rules should be applied to both stock and ETF trading.
  • Moving on to Separate Account managers.
  • Management
    The Investor actually owns a basket of securities
    Professional management
    All securities held in a separate account
    It is easy to track Performance reports
    Minimum purchase requirements – Often can be $100,000
  • Taxation
    No imbedded capital gains
    Managers will generally hold low cost basis stock
    Managers can be instructed to take gains or losses
  • Costs
    Fees and/or commissions that may vary according to account size. In other words, a stock trade may cost 10 dollars whether you’re buying $100 worth of securities (basically a 10% fee) or $10,000 (…in this case 0.1%)
    Negotiation of management fees are sometimes applicable.
  • Management:
    Custom Portfolio
    Management Changes
    Managers can be directed to make specific transactions
  • Liquidity:
    Liquid
    Three day settlement of trades
    Portfolio not affected directly by redemption
  • In review, which of these options is best for you? Well, that depends on your goals. (Remember, Goals drive investments, investments do not goals)
    Management: depends on the talent of the manager; if you’re a talented manager, then choosing individual securities or a multiple passive fund strategy may be best…but remember the overconfidence bias. If you’re not a great manager, then selecting a separate account manager or active mutual fund manager may be best.
    Taxation: Selecting individual securities gives the most control to the owner, but that doesn’t always mean they are the most tax efficient.
    Costs: Costs can vary across funds and vary across managers. Buying individual securities could be cost efficient or cost inefficient, depending on your goals. For example, imagine trying to by the basket of stocks that is contained within a given mutual fund. The total commissions for buying those shares would likely be much higher than simply buying the fund; however, share class may be a factor in whether or not it is less expensive.
    Control: Buying individual securities gives the owner the most control; which, depending on your situation can either be a pro or a con.
    Liquidity: When comparing any of these to the private equity or venture capital investments we discussed earlier, the are all very liquid. The separate account managers would perhaps be the most illiquid, but even so, the time to convert holdings to cash would only be a few days.
  • LET’S TAKE A BREAK
    Investment Managers are a person or organization that makes investments in portfolios of securities on behalf of clients, in accordance with the investment objectives and parameters defined by these clients. These investment managers can also administer mutual funds and separate accounts.
    In comparison, Investment Advisors (or financial advisors) are professionals that are compensated by fees and not commissions. Therefore, a stockbroker may not qualify as an investment advisor. These professionals can manage accounts, provide recommendations, and give advice without the incentives (and possible conflict of interest) that commissions bring.
    Both Managers and Advisors typically have significant knowledge of types of accounts, investments, and risk; only advisors are considered fiduciaries.
    As we mentioned last week, if most of the returns in a portfolio are from Asset Allocation, then why should we even try to outperform by using active management?
  • Quantitative:
    How have managers performed compared to their respective benchmark?
    What are the costs and fees?
    Minimum investment amounts?
    Qualitative:
    What is the investment strategy and is it in line with my goals?
    Does the manager invest in securities that are aligned with my values?
    The where the quantitative and qualitative standards are met should, in most cases, produce a few different choices for manager selection. This is where you can dig into further evaluation. (next slide references this)
  • Databases such as Morningstar and Mobius typically include over 10,000
    investment managers.
    The following 3-step process can help you select from this huge list of
    managers: READ SLIDE…
    After all of the steps above are complete, the final selection of the managers
    will most likely involve a designated investment committee’s review.
  • Read slide.
    …This explains our discussion of “Style Drift” and how it’s important to stay disciplined in your strategy.
  • In many cases, the purpose of investing in a mutual fund is to achieve greater diversification than one would gain by picking individual stocks or bonds. However, it is important to review the composition of the fund, so that you can understand how much exposure to various holdings you may be taking on.
  • Morningstar, Yahoo! Finance, and many other tools are available for free online. This shows an easy comparison between
  • When screening managers, remember that there will be a lot of gray, and make your decisions accordingly. Not all value managers take the same approach. Similarly, not all growth managers take the same approach.
  • Manager can add value AFTER FEES and AFTER TAXES through Performance, Tax Efficiency, and Risk Control.
    The ability to identify managers who will add value in the future
  • MPT = Modern portfolio theory. These statistics are also available on various websites for free.
  • One study by Gene Fama and Ken French called "The Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of Finance) on the reliability of past beta concluded that for individual stocks past beta is not a good predictor of future beta.
    Betas seem to revert back to the mean. This means that higher betas tend to fall back towards 1 and lower betas tend to rise towards 1.
  • This is a simple example of how a portfolio, or a given investment, with a beta of 1.2 would react compared to the market. You can see that Portfolio A sees 120% of the movement of the market.
  • Similar to the previous example, portfolio B recognizes 80% of the movement, either up or down, in the market.
  • A statistical measure that represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index. For fixed-income securities, the benchmark is the T-bill. For equities, the benchmark is the S&P 500
    R-squared values range from 0 to 100. An R-squared of 100 means that all movements of a security are completely explained by movements in the index. A high R-squared (between 85 and 100) indicates the fund's performance patterns have been in line with the index. A fund with a low R-squared (70 or less) doesn't act much like the index.A higher R-squared value will indicate a more useful beta figure. For example, if a fund has an R-squared value of close to 100 but has a beta below 1, it is most likely offering higher risk-adjusted returns. A low R-squared means you should ignore the beta.
  • A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.
    A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.
  • On this chart below, you can see that this particular fund had an alpha of 3.02, meaning that it outperformed its benchmark by about 3%
  • The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.
  • The previous example dealt with baseball, but the following chart shows mean reversion with investment managers. On average, those who initially fared poorly had higher returns two years later than those who initially performed well, demonstrating mean regression.
    In other words, individuals tend to hire at the top and fire at the bottom, instead of the other way around.
  • Talking Points:
    Peter Lynch achieved an enviable record as portfolio manager for the Fidelity Magellan fund from June 1977 through May 1990.
    Many investors have read his books seeking to learn the secrets of his success. Although Lynch provides many interesting stock-picking anecdotes from his career, he appears to acknowledge the challenge of identifying the next great stock-picker.
  • Talking Points:
    Warren Buffett, chief executive of Berkshire Hathaway, Inc., is considered one of the most successful investors of all time. Although Berkshire is an operating company, not a mutual fund, the impressive long-term price appreciation of Berkshire shares is often attributed to his skill as an investor. Yet in this quote he appears to advise both individual and institutional investors to follow a passive strategy through low-cost index funds.
  • Talking Points:
    Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In 1966, he developed the Efficient Markets Hypothesis, which asserts that current securities prices reflect all available information and expectations.
    This framework has several implications for investors. If current market prices offer the best available estimate of real value, stock mispricing should be considered a rare condition that cannot be systematically exploited through fundamental research or market timing. Moreover, only unanticipated future events will trigger price changes, which is one reason for the apparent short-term “randomness” of returns.
    The hypothesis states that investors may be best served through passive, structured portfolios. Rather than trying to out-research other players in the market, a passive investor looks to asset class diversification to manage uncertainty and position for long-term growth in the capital markets.
  • The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance. Yet active managers test the hypothesis every day through their efforts to pick stocks and time markets. The evidence shows that their efforts are not worth the high cost borne by investors. This slide displays the percentage of actively managed public equity funds that failed to outperform their respective market benchmarks for each major fund category for the five-year period ending December 2011. Most of the fund categories failed to beat their respective benchmark as a group. This is consistent with research, which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses.
    The lone exception is the outperformance of the international small fund manager category during the period. As indicated in the graph, only 26% of this group failed to beat the respective benchmark, which is the S&P Developed ex-US Small Cap index.
  • Research by Eugene Fama and other financial academics has offered evidence that the bond markets are efficient and that interest rates and bond prices do not move predictably. This appears to be the case with all types of issues, from short-term government instruments to long-term corporate bonds. This slide illustrates the formidable challenge that active bond managers face. The graph shows the percentage of active fixed income funds in each category that failed to beat their respective market benchmark for the five-year period ending December 2011. All categories had at least a 60% failure rate, with failure defined as underperforming their benchmark. This is consistent with financial theory and research, which propose that active managers cannot outperform the market as a group, particularly after accounting for management fees, trading costs, and other expenses.
  • Transcript of "Wealth Management - Week 3"

    1. 1. Wealth Management An Unbiased Approach to Managing Your Investments Designed for the Affluent Investor
    2. 2. Outline I. Hedge Funds & Private Equity • What are Hedge Funds? • Risk and Return • Top 10 Takeaways • Manager Selection and Allocation Ideas • Discussion Questions II. Individual Investor Implementation III. Endowment Models
    3. 3. What is a Hedge Fund? A managed portfolio of investments that uses a variety of strategies in hopes of achieving outsized, or attractive, risk adjusted returns
    4. 4. Hedge Fund Characteristics •Usually Open to Limited Number of Investors •Typically Require a Large Minimum Investment (i.e. reserved for the wealthy) •Lack Liquidity •High Fees & Manager Compensation •Often Include Derivatives to Either Hedge Risk or Magnify Returns •Low Regulation and Easy to Establish
    5. 5. What Are Hedge Funds? -Asset management organization dedicated to the pursuit of absolute returns - implementation vehicles for active risk Relaxed constraints on benchmark, short selling, leverage and traded instruments Seeks to access to some of the best talent in money managementSkill based A large portion of manager compensation is performance based, usually with a high water mark – managers also usually have a high percentage of their personal net worth invested Manager/investor incentives aligned Hedge funds comprise a large and growing set of strategies. Diversification benefits across managers can be similar to those of individual stocks Diverse strategies Can give exposure to return drivers that are different to the drivers of traditional asset class returns Low correlation to traditional assets Lightly regulated Careful consideration of business risks is key Terms include lock-ups, notice periods and typically monthly redemptions at best Illiquid Loose constraints Source: Goldman Sachs
    6. 6. Hedge Fund Strategies Fixed Income Relative Value Equity Market Neutral Convertible Trading Emerging Market Debt Relative Value Credit Relative Value Take advantage of mispricing in a company’s stock due to an event. Mergers, Corporate Reorganizations, Restructurings, Acquisitions, or other major events can cause price movement; managers make bets on how the price of a company will react to these movements Long and Short positions in equity, fixed income, futures, and currency markets. Primarily on economic and political views. Managed Futures Global Macro Quantitative Macro Macro Relative Value Event Driven Tactical Trading Global Macro / Long Short Relative Value Source: Goldman Sachs
    7. 7. Manager Incentive Structure •Frequently use “2 and 20” compensation •Charges 2% of AUM and 20% of any profits earned. •Managers often tell investors that they will forgo a bonus until they “make the client whole again”, thus they can still collect the 2% AUM fee until the investor is out of the red. •Given the difficult-to-predict markets of the last several years, many managers have considered the “hole” they are in to be too deep and have resolved to close their hedge funds and relaunch; therefore avoiding the “make whole again” promise to their investors.
    8. 8. Hedge Funds Have historically provided steady returns with low volatility Source: Dow Jones Credit Suisse Core Hedge Fund Index, www.hedgeindex.com/ % Return (12/31/2005 – 2/28/13)
    9. 9. “Disappointing Returns?” Annual Returns from 2000-2012 Source: Goldman Sachs, Bloomberg Do these Dow Jones Hedge Fund Index returns for the last 13 years look disappointing? Probably not too much, except in 2008 and 2011. But look what happens when we move to the next slide……
    10. 10. “Disappointing Returns?” Source: Goldman Sachs, Bloomberg Annual Returns from 2000-2012 When you compare the performance of hedge funds to the performance of the MSCI World Index, you can see that there is significantly less volatility and steadier returns.
    11. 11. Implementation of Hedge Funds This is not a complete list of pros and cons associated with hedge funds. Please contact your financial advisor for more information. Source: Goldman Sachs
    12. 12. What is Private Equity? • Generally, investments in non-publicly traded entities • Long history - much of the world’s economy is in private hands • An illiquid asset class that requires a long term perspective All companies on the S&P 500 at some point were private companies. Thus, much of the world’s economy is privately held.
    13. 13. Types of Private Equity Investments Company Life Cycle Angel Investor General Venture Capital Late / Cross-over VC Mezzanine / Buyout Distressed / Restructuring Private Inv. In Public Co. Going Private Transaction Private Investment in Public Co. Seed Financing Growth Financing Pre-IPO Financing Growth Capital LBO RECAP Late – Stage Growth Fin. Turnaround Investment MatureGrowth / DevelopmentStart - Up Distressed Source: Goldman Sachs
    14. 14. Alpha in Private Equity Chance Skill Company selection Ability to influence strategy Financial engineering Informational advantages Ability to drive operational improvement •Alpha is the non-market expected return – the value added by a manager through skill and insight. Private MarketsSources of Value Creation Public Markets Source: Goldman Sachs
    15. 15. Manager Selection is Critical Source: Goldman Sachs Private Equity Group. Past performance is not indicative of future returns, which may vary. This illustration does not represent the performance of any fund or product managed by GSAM or GS & Co. Distribution of returns from private equity suggests that: • Returns are asymmetrically distributed • Manager selection is rewarded, not asset allocation • Investing in a private equity index is neither possible, nor desirable Public Equity Markets Private Equity Markets Average Return Equals Index Average Return Target Return Estimated 10 - 20% of Private Equity Managers For illustrative purposes only.
    16. 16. Private Equity Opportunities for greater outperformance Private equity fund returns are compared with 4-year annualized average returns of public funds, realized over a period starting three years after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 1990 and 1996. The public data for public fund returns over the years 1993 through 2002. Past performance is not indicative of future results, which will vary. Sources: Venture Economics (private data) and MorningStar Principia (public data).
    17. 17. Implementation in Your Portfolio • Look for 1940 Act Mutual Funds that provide liquid exposure to the strategies you deem suitable for your portfolio. • Strategies that have been historically reserved for the wealthy are now available to individual investors. • “2 and 20” rule will not apply; instead, the net expense ratio will likely range from 1-4%, depending on a variety of factors (turnover, carrying costs, etc.) • Funds have transparency. • Choose either benchmark or benchmark-free strategies. • http://quotes.morningstar.com/fund/wabix/f?t=WABIX
    18. 18. Top 10 Hedge Fund Takeaways • Hedge Fund does not necessarily equal another Hedge Fund • A diversified hedge fund portfolio can dramatically decrease risk • Small doesn’t necessarily mean Good • Monitoring for style drift is important • A diversified hedge fund portfolio may be suitable for a significant allocation • Historical returns are not the best predictors of future returns • Manager selection matters • Most hedge funds are not market neutral • Diversification adds significant value • But just hiring a number of managers isn’t enough
    19. 19. Ivy League Endowment Funds
    20. 20. •Source: 2010 Yale University Endowment Report Historical Investment Returns
    21. 21. Asset Allocation Yale University Endowment •Source: 2012 Yale University Endowment Report
    22. 22. Historical Investment Returns Yale University Endowment •Source: 2012 Yale University Endowment Report
    23. 23. Historical Investment Returns Yale University Endowment •Source: 2012 Yale University Endowment Report
    24. 24. Historical Investment Returns Harvard University Endowment Harvard Policy Portfolio Benchmark* 60/40 Stock/Bond Portfolio* 1 Year -0.05% -1.03% 6.71% 3 Years 10.42 9.17 12.82 10 Years 9.49 7.09 5.86 20 Years 12.29 9.23 7.94 •S&P 500 Index / Citi US BIG •Source: www.hmc.harvard.edu/images/historicalIR_lg11.jpg
    25. 25. Different Methods of Investing Individual Securities Investors purchase individual stocks and fixed income securities. Funds & ETFs A pooled investment where holders own a share of the pool proportionate to their environment. Separate Account Managers Rather than being a portion of a pooled investment, the investors own the actual securities that comprise the portfolio. Mutual Funds are sold by prospectus which contains more complete information including investment objective, fees and expenses. Contact you financial advisor to obtain a prospectus and read it carefully before investing or sending money.
    26. 26. Considerations for Investing Five Considerations when Selecting Types of Investments 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity
    27. 27. Considerations for Investing Five Considerations when Selecting Individual Securities Investor must select and manage each transaction Investor is responsible for all decisions 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity
    28. 28. Considerations for Investing Five Considerations when Selecting Individual Securities Short-Term/Long-Term Capital Gains, Dividend Income, Interest Income 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity
    29. 29. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Five Considerations when Selecting Individual Securities Commissions or fees
    30. 30. Considerations for Investing Five Considerations when Selecting Individual Securities Investor makes all investment decisions Portfolio not directly affected by decisions of other investors 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity
    31. 31. Considerations for Investing Five Considerations when Selecting Individual Securities 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Three day settlement of trades Transactions can be made at the will of the investor
    32. 32. Stock Portfolios Building your own portfolio Pros of building your own portfolio - Flexibility to pick specific investments that fit your goals and risk tolerance - Ability to manage taxes - No management fees - Transparency - Liquidity
    33. 33. Stock Portfolios Building your own portfolio Cons of building your own portfolio - Lack of investor sophistication - Many investors lack discipline to diversify or stick to goals - Trading costs - Market timing is difficult to impossible - Can be time consuming to do the necessary fundamental research and stay up-to-date on relevant news and pricing - Example: Many experts recommend at least 1 hour of research per investment per month. If you own 20 stocks/bonds, that is potentially 20 hours a month of research.
    34. 34. Stock Portfolios How to do Fundamental Analysis - Develop your own model Commercial Research Reports - Morningstar has charts, detailed analysis, valuation projects, rankings, performance history, financial statements, and more - Value Line covers 1700 stocks and provides analysis on safety, timeliness, technical ranks, and earnings forecasts. Stocks are ranked from 1 to 5 with 1 being the best. Since 1965, purchase stocks ranked 1 have outperformed the Dow 19 to 1. - Investors Business Daily provides stock screeners, charts, analysis, and information on institutional purchases. - Other sites include TheStreet.com, Seeking Alpha, Forbes, The Motley Fool, Yahoo! Finance, etc.
    35. 35. Considerations for Investing Characteristics of Open-End Mutual Funds A mutual fund that contracts and expands in share size based on purchases and sales. By continuously selling and buying back fund shares, these funds provide investors with a very useful and convenient investing vehicle. For Open-End Funds, the value of the fund will always equal the Net-Asset Value (NAV).
    36. 36. Considerations for Investing Five Considerations when Selecting Mutual Funds 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Purchase a basket of securities in one transaction Purchased and sold in amounts as low as $250 Easy to Track Can be set up for periodic distributions such as monthly income
    37. 37. Considerations for Investing Five Considerations when Selecting Mutual Funds 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Mutual funds must distribute their gains and losses each year Most funds are not managed for after tax returns
    38. 38. Considerations for Investing Five Considerations when Selecting Mutual Funds 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Fund Pricing Internal Costs Confusing Fee Structure A,B,C,D,E,F,Y Economies of Scale
    39. 39. Considerations for Investing Expense Ratio Example Fee charged by fund’s manager to manage 0.55% the fund’s portfolio Marketing and advertising and broker 0.20% compensation comes out of 12b-1 fees All other fees are accounted for in this total 0.29% This is all of the fund’s annual operating costs 1.04% MANAGEMENT FEE DISTRIBUTION (12B-1) OTHER EXPENSES TOTAL ANNUAL FUND OPERATING EXPENSE This example assumes a non-guaranteed rate of return of 10% per year and disregards tax implications. This does not represent the performance of any particular mutual fund.
    40. 40. Share Classes • A Shares typically have a front-end load that is taken off your investment, but typically have lower 12b-1 fees. A Shares may also have ‘breakpoints’ in the fees at certain investment levels. • B Shares typically have a back-end load that is taken off when you sell the fund. The back-end load typically decreases the longer you hold the fund. B Shares typically will convert to A Shares after specified period of time. • C Shares typically have no front-end load or back-end load if held for more than 1 year. C Shares typically do have higher expense ratios and 12b-1 fees. A vs. B vs. C Shares
    41. 41. Share Classes • Over the long run, A Shares have lower expenses and higher relative performance • For Years 1- 4, B & C Shares had the best performance • B Shares beat A Shares after Year 9 • This example demonstrates the need to consider investment horizon before selecting share class A vs. B vs. C Shares Example Source: Comparing Mutual Fund Classes,
    42. 42. Considerations for Investing Five Considerations when Selecting Mutual Funds 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Professional management Style Drift Management Changes Owner has no control over purchases or sales Shares have to be sold to meet redemption
    43. 43. Considerations for Investing Five Considerations when Selecting Mutual Funds 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity All purchases and sales are made at NAV Mutual Fund transactions occur once per day Mutual Fund companies are the purchaser and seller of every mutual fund transaction Typically three day settlement of trades
    44. 44. Characteristics of Mutual Funds 1. Mutual funds are essentially an investable portfolio of stocks and/or bonds. 2. Mutual funds are categorized by their style (e.g.- Large Cap Value Fund, Small Cap Growth, etc) 3. Mutual Funds are not managed to minimize taxes. Excessive trading can decrease fund performance through increased taxes and broker fees. 4. Expenses can cut into fund performance. Expenses are categorized as: - Initial Fees also known as ‘front load’ fees. These are paid upon initial purchase of a fund. Typically, only ‘A’ shares have a front load - Deferred Fees also known as ‘back end’ fees. These are paid when you sell shares in the fund. These fees are typically associated with ‘B’ shares. - 12b-1 Fees are associated with marketing and distributions. - Management Fees are paid to the manager for the management of the fund. - Net Expense Ratio = Total dollar amount of fees / Net Asset Value
    45. 45. Characteristics of Mutual Funds Fee example of the Growth Fund of America A shares (AGTHX) Fees are typically quoted as a percentage, rather than dollar amount Front load fee Total Fees / NAV Management Fees Marketing Sources: Morningstar
    46. 46. Mutual Fund Expenses “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.” —William F. Sharpe, 1990 Nobel Laureate Average of All Funds Weighted Average, Based on Fund Assets Active Passive Domestic Mutual Fund Expense Ratios Average of All Funds Weighted Average, Based on Fund Assets Average of All Funds Weighted Average, Based on Fund Assets Active Passive Average of All Funds Weighted Average, Based on Fund Assets International Mutual Fund Expense Ratios 1.46% 0.95% 0.91% 0.18% 1.64% 1.08% 1.01% 0.33% William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9. Mutual fund expense ratios as of April 9, 2010. Asset weighting based on net assets as of December 31, 2008. Data provided by Morningstar, Inc. Passive funds are those coded by Morningstar as Index Funds.
    47. 47. Characteristics of Mutual Funds Pros and Cons of Mutual Funds Pros: - Professional Management - Diversification - Economies of Scale (lower transaction costs) - Liquidity - Simplicity Cons: - Expenses - Dilution (larger funds have a disadvantage in placing trades) - Taxes
    48. 48. Characteristics of ETFs Exchange Traded Funds (ETFs) ETFs track indices, commodities or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Pros of ETFs By owning an ETF, you get the diversification of an index fund. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. ETFs also have better potential tax benefits due to the fact that they are not actively managed. ETFs have better transparency than mutual funds as an investor can check the fund holdings at any time. ETFs are an easy way to target specific equity sectors or commodities.
    49. 49. Characteristics of ETFs ETF fees vs. Mutual Fund Fees SPDR S&P 500 ETF Vanguard Large Cap Index Both funds track the S&P 500 index, but the Vanguard Mutual Fund has nearly triple the expense ratio of the ETF. This is not an endorsement and is purely for informational purposes only.
    50. 50. Characteristics of ETFs ETF taxable distributions vs. Mutual Fund taxable distributions The more an active fund will force investors to pay the IRS. Investors who sell out before the day of record for that distribution will not receive the tax bill, while loyal investors who stay in will pay it for the entire amount! ETFs are allowed to make ‘in kind’ trades that are not considered a taxable event by the IRS. Mutual Fund 1.46% 11.53% 0.97% 6.51% 1.7% 6.7% 0.62% 4.21%
    51. 51. Characteristics of ETFs Exchange Traded Funds (ETFs) Cons of ETFs Payment of dividends goes into your brokerage account and are not directly invested back into the fund. Rebalancing to target asset allocation can be difficult as attempting to get exact asset weightings is nearly impossible. Dollar cost averaging can be difficult and expensive to implement. Some ETFs lack liquidity, which can result in higher Bid-Ask spreads and transaction costs. Example- ELR (SPDR Dow Jones Large Blend) has an average 3 month volume of 3100 shares, whereas SPY (SPDR S&P 500) has an average 3 month volume of 181,672,000 shares. The result is ELR having a spread that is 5 times larger than SPY on a price basis.
    52. 52. A large component of buying and selling costs for ETFs is the difference between the bid and the ask Larger ETFs typically have tighter bid/ask spreads 25.68 106.39 26.16 106.4 1.85% 0.01% < $5 Million Assets < $5 Million Assets Bid Spread Ask Bid/Ask Spreads
    53. 53. • Use limit orders rather than market orders – Does not rely on a deep order book – Allows you to set a fair price for the purchase or sale – Market makers can see your order on the exchange and fill it • Stop-loss orders tend to cause the biggest problems – Drops a market order on the exchange when the prices are going down – Tends to place a sell order precisely when liquidity is lowest – Led to major losses in the May 6 “Flash Crash” in the US – Circuit breakers on European exchanges will keep losses smaller, but not prevent them entirely Rules of Thumb for Trading
    54. 54. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Five Considerations when Selecting Separate Account Managers
    55. 55. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Investor owns a basket of securities Professional management All securities held in a separate account Performance reports Five Considerations when Selecting Separate Account Managers
    56. 56. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity No imbedded capital gains Managers will generally hold low cost basis stock Managers can be instructed to take gains or losses Five Considerations when Selecting Separate Account Managers
    57. 57. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Fees and/or commissions that may vary according to account size Negotiated Five Considerations when Selecting Separate Account Managers
    58. 58. Considerations for Investing 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Custom Portfolio Management Changes Managers can be directed to make specific transactions Five Considerations when Selecting Separate Account Managers
    59. 59. Considerations for Investing Five Considerations when Selecting Separate Account Managers 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity Liquid Three day settlement of trades Portfolio not affected directly by redemption
    60. 60. Review Which Alternative is Best for you? 1. Management 2. Taxation 3. Costs 4. Control 5. Liquidity INDIVIDUAL SECURITIES MUTUAL FUNDS SEPARATE ACCOUNT MANAGERS Remember, Goals drive investments, investments do not goals
    61. 61. Manager Selection The following are two distinct discussions: Investment Managers Investment Advisors If Asset Allocation is the key, should we even try active management?
    62. 62. Manager Selection Two Levels of Manager Evaluation QUANTITATIVE QUALITATIVE EVALUATION Quantitative: How have managers performed compared to their respective benchmark? What are the costs and fees? Minimum investment amounts? Qualitative: What is the investment strategy and is it in line with my goals? Does the manager invest in securities that are aligned with my values?
    63. 63. Manager Search and Selection Assets Under Management Length of Track Record Stability of Personnel Compliance Record •Step 1: Database Screening Returns-Based Style Analysis Style/Cycle Analysis Risk-Adjusted Performance Fundamental Analysis •Step 2: Quantitative Analysis People, Philosophy, Process Investment Research Evaluation of Firm Performance Composite •Step 3: Qualitative Evaluation
    64. 64. Characteristics of Mutual Funds Morningstar Mutual Fund Research Example: Fidelity Contra Fund (FCNTX) If you research this fund on the Morningstar website, the first you will notice is the rating: Source: Morningstar Inc.
    65. 65. Characteristics of Mutual Funds Morningstar Mutual Fund Research Example: Fidelity Contrafund (FCNTX) Manager information is also readily available: Source: Morningstar Inc.
    66. 66. Does your manager drink his own Kool-Aid? All fund managers must disclose the amount of personal funds they have in their managed fund. Would you invest in a fund where the manager didn’t have any of his own money in the fund? Note: 46% of US Funds report zero manager ownership. In this example the manager has over $1 million of personal money in the fund. Source: Fund Spy, Russel Kinnel, Morningstar Inc.
    67. 67. Does your manager follow the fund strategy? Good managers stick to primary fund strategy Example- If you purchase a value fund, and you notice the manager has recently purchased a growth stock, it may be time to cash out. Also important to monitor fund strategy with benchmark performance. Example- If you own a growth fund, and it fails to perform when growth stocks are rallying, it may be time to cash out.
    68. 68. Characteristics of Mutual Funds Morningstar Mutual Fund Research Example: Fidelity Contra Fund (FCNTX) Detailed information about the fund’s holdings are available. Source: Morningstar Inc., 2013
    69. 69. Characteristics of Mutual Funds Morningstar Mutual Fund Research Example: Fidelity Contra Fund (FCNTX) Performance comparison Source: Morningstar Inc.
    70. 70. Sub-Styles •Value Sub-Styles – Deep Value – Yield – Traditional Value – Value of Growth – Multifactor Approaches •Growth Sub-Styles – Momentum-Based Growth – Pure Growth – Conservative Growth
    71. 71. Active vs. Passive Management Beliefs Required to Use Active Management Manager can add value AFTER FEES and AFTER TAXES through Performance, Tax Efficiency, and Risk Control. The ability to identify managers who will add value in the future.
    72. 72. Active vs. Passive Management Luck vs. Skill Beta R Squared Alpha
    73. 73. Active vs. Passive Management Luck vs. Skill Beta (β) R Squared Alpha (α) A measure of explainable/expected risk Represents a market, or systematic, risk associated with the portfolio that cannot be diversified away Relies upon how the “market” is defined-- what is the benchmark? Benchmark will always be assigned a beta measurement of 1.00
    74. 74. Beta Beta Considerations Beta (β) is based on historical price data and can change over time. Beta is calculated from price changes, not fundamental or balance sheet items. Portfolio or fund Beta can change if asset allocation changes. Beta is a ‘rear-view mirror’ and doesn’t necessarily predict what lies ahead. Beta tells nothing about the price paid for an asset (value investing). Beta treats up and down price movements equally.
    75. 75. Active vs. Passive Management Example: Portfolio A vs. Market Portfolio A 1.2 12% -6% Market 1.0 10% -5% BETA IN UP MARKET IN DOWN MARKET
    76. 76. Active vs. Passive Management Example: Portfolio B vs. Market Portfolio B 0.8 8% -4% Market 1.0 10% -5% BETA IN UP MARKET IN DOWN MARKET
    77. 77. Active vs. Passive Management Beta Rules Should not stand alone Validity of beta depends upon the relevance of the Market/Index being issued Must be combined with R Squared to insure that the Market/Index is an “apples to apples” comparison
    78. 78. Active vs. Passive Management Capital Asset Pricing Model (CAPM) Beta (β) R Squared Alpha (α) It defines the systematic/market risk imbedded within a portfolio; bulls desire high beta, bears desire low beta It does not define a guaranteed future return and, like all quantitative information, does not stand alone
    79. 79. Active vs. Passive Management Luck vs. Skill Beta (β) R Squared Alpha (α) Measures the correlation between the portfolio and the benchmark/market Determines whether or not statistical information in Modern Portfolio Theory is meaningful Generally 80% correlation or greater is considered statistically significant
    80. 80. R- Squared • Example- A fund with an R-Squared value of 85, means that 85% of the fund’s movements can be explained by the benchmark index. The remaining 15% of the fund’s movements are attributed to other factors, such as specific stock selection. • For index tracking funds, a higher R-Squared value is preferred. • Typically, for actively managed funds, a lower R-Squared value is preferred.
    81. 81. Active vs. Passive Management Luck vs. Skill Beta (β) R Squared Alpha (α) STOCKS Measures the non-systematic return associated with the portfolio-- i.e., the manager’s positive or negative value through their security selection and timing instead of the market’s movements A positive alpha indicates the manager has added value A negative alpha indicates the manager has not added value
    82. 82. Alpha (α) • A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. A similar negative alpha would indicate an underperformance of 1%. • For investors, a higher alpha is more desirable • Alpha is risk-adjusted • Alpha is independent of index returns Sources: fi360.com, Fiduciary Analytics
    83. 83. Active vs. Passive Management Capital Asset Pricing Model (CAPM) Sharpe Ratio Measures risk-adjusted returns, and tells us if the portfolio returns are due to smart investment decisions, or as a result of excess risk. Higher Sharpe Ratios are better.
    84. 84. Sharpe Ratio Sharpe Ratio Example If you are deciding whether to purchase one of 2 different mutual funds, using the Sharpe Ratio will help comparability. Fund 1- 1 Yr Return 20% Fund 2- 1 Yr Return 25% By just examining returns, you may be tempted to pick Fund 2. Assume Fund 1 has a standard deviation of 12% and Fund 2 has a standard deviation of 20%, and the risk free rate is 4%; Fund 1 Sharpe Ratio = 2 Fund 2 Sharpe Ratio = 1.25 Because Fund 1 has a larger Sharpe ratio, it has a greater risk adjusted return than Fund 2. Sources: fi360.com, Fiduciary Analytics
    85. 85. Adding Satellite Managers Satellite Managers • Any Manager that can add Alpha to a portfolio • Enhanced Return • Enhanced Diversification • “Tax-Alpha” • Sources of Alpha • Manager Skill • An Inefficient Asset Class • Non-Correlation to Traditional Asset Classes • Tax-Efficiency • Illiquidity • Non-Transparency • The Use of Satellite Managers Means Accepting: • Active Management Fees (sometimes quite high) • Potential Deviation Away from Strategic Asset Allocation
    86. 86. Manager Selection When to Fire a Manager Consistent under-performance of the portfolio vs. benchmark and peers Significant style drift Dramatic management change Change in buy/sell discipline How do I follow progress in each of the above categories? QUESTION?
    87. 87. Buy High And Sell Low 2 Year returns AFTER hiring/ firing 2 Year returns BEFORE hiring/ firing Fired Fired Hired Hired
    88. 88. Peter Lynch “All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage.”
    89. 89. Warren E. Buffet “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”
    90. 90. Passive vs. Active Management Passive vs. Active Investment Management • Many asset classes are considered very efficient. • ie LargeCap Equities • Most active managers underperform most of the time • Especially due to fees and taxes • Many active managers are “closet indexers”, penalized for tracking error and “style drift”. • Also: • No Shorting • No Leverage • Net of fees and taxes, it is very difficult to add value over time.
    91. 91. Efficient Markets Hypothesis The Hypothesis States: • Current prices incorporate all available information and expectations. • Current prices are the best approximation of intrinsic value. • Price changes are due to unforeseen events. • “Mispricings” do occur but not in predictable patterns that can lead to consistent outperformance. Implications • Active management strategies cannot consistently add value through security selection and market timing. • Passive investment strategies reward investors with capital market returns. Eugene F. Fama, University of Chicago
    92. 92. The Failure of Active Management Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2012. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400 Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P Developed ex. US SmallCap Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Percentage of Active Public Equity Funds That Failed to Beat the Index January 2006-December 2011
    93. 93. The Failure of Active Management Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Index used for comparison: Government Long—Barclays Capital US Long Government Index; Government Intermediate—Barclays Capital US Intermediate Government Index; Government Short—Barclays Capital US 1-3 Year Government Index; Investment Grade Long—Barclays Capital US Long Government/Credit; Investment Grade Intermediate—Barclays Capital US Intermediate Government/Credit; Investment Grade Short—Barclays Capital US 1-3 Year Government/Credit; National Muni—S&P National Municipal Bond Index; CA Muni—S&P California Municipal Bond Index. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Barclays Capital data, formerly Lehman Brothers, provided by Barclays Bank PLC. Fixed Income Category Percentage of Active Fixed Income That Failed to Beat the Index January 2006-December 2011
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