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Investment Management


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Investment Management

  1. 1. Oliver McCluskey Connor Brink Pierre Luciat-Labry Henry Yu 260 502 621 260 505 384 260 550 353 260 531 031
  2. 2. 2015 THE FOUR PROFITEERS Page 2 Table of Content Introduction…………………………………………………………………………………3 Methodology………………………………………………………………………..………3 Client Profile………………………………………………………………………………..3 Portfolio Composition……………………………………………………………………...5 Portfolio Allocation…………………………………………………………………………7
  3. 3. 2015 THE FOUR PROFITEERS Page 3 Introduction As members of the Four Profiteers, we understand that planning for retirement is an essential aspect to ensuring your future well-being. It is our goal to relieve any finance-related stress that you may have when planning your retirement. In the following report we have constructed a portfolio plan that meets your return criteria without putting your future finances at risk. This portfolio requires little management on your part, however, we recommend rebalancing the portfolio on a yearly basis in order to maintain the optimal asset allocation. Along with this portfolio, we have made suggestions to improve upon your current investments. This information should enable you to fully enjoy your retirement without the stress of financial burdens. Methodology To construct your retirement portfolio we have taken your financial information and applied it to a passive management strategy. We began by identifying your financial knowledge, risk tolerance and portfolio return based upon your expected future income and expenses. We then analyzed your current assets and liabilities to identify any potential risks that you are overly exposed to as well as any risks that you are not sensitive to. Following this identification we researched assets that would allow the portfolio to take advantage of return premiums from factors that do not affect you, while not increasing your exposure to your current risk factors. From these concepts, along with our understanding of macroeconomic principles, we created a portfolio that is fully tailored to your needs. First, using various Exchange Traded Funds (ETFs) we regressed the monthly returns of several representative industries and firm characteristics to the monthly returns of four risk factors we deemed relevant to your situation. The four factors we identified are: • Recession risk: as modeled by changes in employment, industrial output, retail sales less autos, and manufacturing and trade sales1 . • Interest risk: modeled upon the 1 month Canadian bond2 . • Inflation risk: modeled upon the changes in the Canadian CPI3 . • Market risk: based upon the S&P 500 index4 . We then measure the sensitivity of our chosen assets to changes in each of the four underlying factors. For example, an asset with a positive inflation factor sensitivity of 2 would mean that as inflation averages 1%, this asset would have an expected return of 2%. Then, we performed a statistical analysis (second-pass regression) for all our chosen ETFs by regressing the monthly returns of the ETFs to the four individual risk factors. The output of this regression yielded the aggregate risk premium of each of the four factors. We were able to understand which risk factors were priced in the market and this helped us determine how you could earn a risk premium. Implementing these findings enabled us to create a portfolio with the appropriate weights of assets to maximize your return, while maintaining your portfolio risk to a minimum. Client Profile Through our discussions it was clear that you have a fundamental understanding of finance and are slightly more risk averse compared to the average investor. According to your desires, we have constructed a financial plan that allows you to retire without placing any burdens upon your children as well as offer you the possibility to travel, donate to worthy charities, and engage in other activities of interest.
  4. 4. 2015 THE FOUR PROFITEERS Page 4 Contrary to the average Canadian, you possess zero liabilities, mortgages or debt. We also noticed that a large portion of your current assets consist of reliable, low-risk instruments such as your pension income, rental property income, and fixed income included in your TFSA and RRSP funds. Due to the safe nature of these assets, we have decided to focus the majority of our asset selection on equity instruments to rebalance your overall financial profile and to earn higher returns. Based upon your goal to retire after the age of 60 we have constructed a financial cash flow diagram that offers insightful information upon your needs at retirement. This diagram reveals that your pension, along with your rental income will sufficiently cover your day-to-day living expenses. This alleviates substantial risk, as you will not need to rely upon your investments to maintain your current lifestyle. This allows us to create a portfolio that does not need to take on excess risk to earn extra return. Therefore, the goal of these investments is to increase your wealth without risking losses in order to expand the range of possible activities in which you can engage. Client  Asset   Asset  Type   Value  of  Asset   Present  Value  of  Asset   Primary  Residence  +  Farm  Land   Real  Estate   $1,500,000   $1,500,000   Secondary  Income  Rental  Property   Real  Estate   $500,000   $500,000   Human  Capital  (3  years)   Human  Capital   $225,000   $220,617   TFSA   Financial   $43,938   $43,938   RRSP   Financial     $151,622   $151,622   Pension  Plan   Financial        $3000  /  month   $540,000   Income  from  Rental  Property   Financial      $1,916  /  month   $415,269   Cash   Financial   $100,000   $100,000   $43,938, 4% $151,622, 12% $540,000, 43% $415,269, 33% $100,000, 8% Client Financial Portfolio TFSA RRSP Pension Plan Income from Rental Property Cash ($100,000.00) ($50,000.00) $0.00 $50,000.00 $100,000.00 $150,000.00 2015 2016 2017 2018(retirement) 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 Total Inflows Total Outflows Net Cash Flow (Savings)
  5. 5. 2015 THE FOUR PROFITEERS Page 5 Following the cash flow analysis, we compared your financial position to the average investor for each of the four risk factors. Inflation The inflation factor is priced in the market, with a negative risk premium5 . This means that assets that are negatively correlated to inflation are likely to perform better in times of low inflation, because the demand is lower. Average investors usually demand assets that are positively correlated to inflation, to compensate for the decrease in their purchasing power when inflation increases. Because both your pension and rental income are adjusted for inflation, you are able to earn a risk premium by investing in assets that negatively correlates with inflation. Interest Rates The interest rates factor is priced in the market, with a negative risk premium6 . Average investors usually demand assets that are positively correlated to interest rates, as the amount to be repaid on liabilities, such as mortgages, increases when interest rates rise. Since you have already paid off your mortgages, you are able to invest in assets that are negatively correlated to interest rates, earning you a premium. It is our belief that this premium is caused by lower demand for these assets. Recession The recession factor is priced in the market, with a positive risk premium7 . We assume that this premium is due to the average investors’ risk of losing their job during times of recessions. Therefore, the average investor would not want assets that perform poorly during recessions. Because your current job is secure and your pension is guaranteed, we believe that you should increase your holding of assets that may perform badly during recession and thus earn higher returns in better economic environments. Market The market factor is priced with a positive risk premium8 . The majority of the assets we selected have a positive correlation to the market, which will allow you to earn an additional premium. Portfolio Composition Note on ETFs After choosing to tilt this portfolio towards equity instruments, we have decided to invest more specifically in ETFs. There are three main reasons why this seemed a more appropriate option for you9 : • Diversification: ETFs comprise of vast holdings of assets including equity, bonds, and commodities. Risks that affect single assets are thus minimized, leading to a lower overall portfolio risk. • Lower Management Fees: The management expense ratios for ETFs are some of the lowest in the index fund industry, averaging 0.44%. This is important as lower management fees lead to higher growth in your portfolio. Note on Mutual Funds Currently, your financial portfolio is heavily weighted in mutual funds. More specifically, your 70% allocation into one specific mutual fund (CIG686) that is low to moderately risky poses a potential concern. One option to further diversify your wealth would be to reduce the proportion invested in this asset and use those proceeds to invest in our portfolio. Since this option involves transaction fees, an alternative measure would be to cease investment in this particular mutual fund and instead divert those funds to another mutual fund or ETF.
  6. 6. 2015 THE FOUR PROFITEERS Page 6 We have chosen to build a portfolio based on ETFs in order to achieve low cost diversification across assets, industries, and countries. Taking all of this into consideration, we have chosen to add twelve ETFs that represent various sectors of the U.S., Canadian, and international markets. We also included one fixed-income ETF, and an inflation protected fixed income instrument. 1st Group The first group of ETFs comprises of assets that display all of our four required characteristics. They expose a positive correlation to our recession and market factors, while exposing a negative correlation to inflation and interest rates. These ETFs are following indexes of biotechnology companies (IBB), clean energy companies (PBD), and equities exhibiting growth characteristics (IVW, RPG). We are especially excited about investing in clean energy as it relates directly to your request to invest in assets that are ethical and will help sustain the environment in the future. The biotechnology sector was chosen partially due to your preference and partially due to the large upside potential of the underlying companies. The two growth ETFs were selected to ensure that your portfolio continues to perform well in the future, and because growth stocks’ returns usually exhibit a negative correlation to inflation10 . 2nd Group The second group of ETFs comprises of assets that display three out of four of our required characteristics. They expose a positive correlation to our recession and market factors, while exposing a negative correlation to interest rates. They are positively correlated to our inflation factor, but were retained in the final portfolio for they are invested in different industries, bringing additional diversification effects to our portfolio. These ETFs are following indexes of emerging markets (DEM, AIA), industrial companies (IYJ), consumer services companies (IYC, UCC), and large capitalization companies (MGV). We chose to add an emerging market ETF in order to diversify your portfolio away from the North American markets as well as earn a premium from their perceived risk11 . Consumer services added further diversification to the portfolio. MGV, a large capitalization ETF was added to lower the overall risk of the portfolio as the blue chip stocks it comprises are viewed as reliable investments12 . Industrial companies were added as your long-term investment horizon allows you to tolerate their cyclical business cycles. Gold We have decided to include gold in the portfolio for two reasons. The first is that it exhibits a strong negative correlation to our inflation factor. This will allow your portfolio to be tilted back towards a negative inflation correlation, correcting for the effects from the 2nd group of ETFs. The second reason is that it has historically been used as a hedge against movements in the financial markets, allowing you to decrease your overall exposure to this factor. Fixed Income The last group of assets comprises of a fixed-income ETF (TLT), and inflation-protected treasuries (TIPS). We selected these two assets for their positive correlation to our recession factor, and their negative correlation to our inflation and interest rate factors. Like gold, their small to negative correlation to the market factor will act to balance your portfolio’s overall exposure to the market. We chose TLT on the belief that average investors perceive the strategy of investing in long-term bonds on a short-term horizon as risky. Thus, we believe that you can earn a premium on this investment.
  7. 7. 2015 THE FOUR PROFITEERS Page 7 Portfolio Allocation Following your opinion on different portfolio allocations, we have narrowed down the possibilities to three choices. The portfolios have less than 15% invested in each asset to ensure diversification. These portfolios are built using a combination of our personalized model and the Fama-French model. A word of caution needs to be mentioned on the standard deviations o f these portfolios. We believe that our model gives reliable estimates upon expected returns, however the standard deviations are expected to be higher than our estimates give. We believe that more accurate standard deviations for these portfolios are in the range of 15 to 20%. Safe Portfolio This portfolio was built with the intention to reduce its overall volatility. The standard deviation of this portfolio is equal to 11.40%, while the expected return is 6.48%. Management fees are equal to 0.25%. This portfolio has an emphasis on safe assets, technology, and growth equities. Balanced Portfolio This portfolio combines a balance of risk and return. The standard deviation of this portfolio is equal to 13.61%, the expected return is 7.49%. Management fees are equal to 0.33%. High Return Portfolio This portfolio exhibits the highest return of our selection. The standard deviation of this portfolio is equal to 16.41%, the expected return is 8.50%. Management fees are equal to 0.39%. Recommendation We recommend you select the balanced portfolio, as you expressed your main concern to be the safeness, and the steady growth of your investment. This allocation will provide you with a good compromise in between risk and return, as well as a reasonable management fees ratio. The betas to each factor are equal to 0.51 (Recession), -0.29 (Inflation), -0.46 (Interest Rates), and 0.68 (market). Allocation of recommended balanced portfolio IBB 3% PBD 15% IVW 14% RPG 3% DEM 3% IYJ 10%IYC 13% GLD 11% AIA 4% VGT 5% TLT 8% TIPS 10% MGV 1%
  8. 8. 2015 THE FOUR PROFITEERS Page 8 Bibliography 1. Short, Doug. "The 4 Official Recession Factors Indicators." Http:// August 31, 2013. Accessed March 30, 2015. 2. Data retrieved from Bloomberg Terminal 3. Canada. Statistics Canada. Consumer Price Index, by Province. Accessed March 30, 2015. 4. "GSPC Historical Prices | S&P 500 Stock." Yahoo! Finance. March 30, 2015. Accessed March 30, 2015. 5. United States. Federal Reserve. New York. Inflation Risk and the Cross Section of Stock Returns. By Fernando M. Duarte. New York: Federal Reserve Bank of New York Staff Reports, 2013. Accessed March 30, 2015. 6. Hördahl, Peter. "The Inflation Risk Premium in the Term Structure of Interest Rates." Bank for International Settlements. September 2008. Accessed March 30, 2015. 7. Nestorovski, Metodija, and Aleksandar Naumoski. "Economic Crisis and the Equity Risk Premium." Association of Economic Universities of South and Eastern Europe and the 8. Fernandez, Pablo. "Market Risk Premium: Required, Historical, and Expected." University of Navarra. October 2004. Accessed March 30, 2015. 9. "How to Choose an Exchange-Traded Fund." Wall Street Journal. Accessed March 30, 2015. 10. Zucchi, Kristina. "Inflation's Impact On Stock Returns." Investopedia. Accessed March 30, 2015. 11. Damodaran, Aswath. "Country Default Spreads and Risk Premiums." New York University. January 2015. Accessed March 30, 2015. 12. Wayman, Rick. "Understanding Small- And Big-Cap Stocks." Investopedia. Accessed March 30, 2015.