Professional Documents
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Understanding Financial Instruments and Mutual Funds (Jay Taparia)
Understanding Financial Instruments and Mutual Funds (Jay Taparia)
Understanding Financial Instruments and Mutual Funds (Jay Taparia)
1
The Client Is A Human Being
& Is Capable Of Having…
Emotion attached to wealth…
Goals (if…) that are ST, MT or LT
A limited life span…
Uncertainty about the future…
Irrationality associated with decision-making…
A gambling attitude toward the markets… over-
confidence
Dreams that could be impossible to reach…
Dreams that are very possible to reach…
An aversion toward risk… whatever that may be
Annoying you at times…
And don’t forget that… Life Happens
2
Because Of This…
Building portfolios is not only a science, but it is
an art
3
Individual Investor Life Cycle
Spending Phase
Accumulation
Gifting Phase
Consolidation
Long-term:
Retirement, Long-term:
Children’s Retirement Long-term:
college Estate Planning
Short-term:
Short-term: Vacations, Short-term:
House, Car Children’s College Lifestyle Needs,
Gifts
25 35 Phases
45 are Shifting
55 65 75
Age
4
Portfolio Management Process
State the Objective – Mission statement of the portfolio,
who and what it serves and why: income, and/or capital
appreciation.
Identify the Constraints – there are always going to be
constraints: taxes, legal, emotions, etc.
Formulate the Investment Policy – develop the
“business plan” of the portfolio listing out return, risk and
all the other issues associated with the portfolio
Study Market and Economic Conditions to forecast
future trends – This is everything that you learned in
Economic, Industry, Financial Statements, etc.
Monitor Performance – keep in touch with what is going
on in the portfolio, and…
Reevaluate & Modify the Portfolio – rebalance and/or
reconfigure according to the policy and markets
5
Role of the Portfolio Manager
Bottom Line? You need someone to manage the whole
process of investing –
Minimizing individual security risk (company, industry, or
unsystematic risk)
Making sure that the portfolio is well-diversified among
industry, country and company
Managing the tax consequences of the portfolio – esp. for
expensive people
Most importantly, making sure the portfolio caters to the
client needs via an Investment Policy Statement –
Return – capital gain vs.income
Risk Tolerance – varies typically according to age
Tax Issues – maximizing after-tax returns
Time – retirement, college payments
Liquidity – usually driven by time needs
Legal Issues – trust and pensions have special legal issues
Other Unique Needs of the client
6
Realistic Investor Goals
Current income
generate spendable funds
Capital preservation
minimize risk of real loss
Capital appreciation
capital gains for real growth for future needs
Total Return
Capital Gains & Income
7
What Is Asset Allocation?
Cash
The Need For Asset Allocation
An investment strategy is based on four decisions
What asset classes to consider for investment
the strategy
9
Is Asset Allocation Important?
Contributing Factors of Portfolio Performance
0 20 40 60 80 100
Percent
Returns & Risk Of Different Asset
Classes
Higher returns should compensate for risk
11
Historical
Asset Performances: A Guide
12
Asset Class Returns
Highs and Lows: 1926 - 1999
Highest Annual Return
150% 142.9%
Lowest Annual Return
Average Return
100%
54.0%
50% 40.4%
29.1%
14.7%
0% 12.6% 11.3% 5.1% 5.2% 3.8%
-5.1% 0.0%
-9.2%
-50%
-43.3%
-58.0%
-100% Small Large Long-Term Int.-Term Treasury
Company Company Government Government Bills
Stocks Stocks Bonds Bonds
Each bar shows the range of annual total returns for each asset class over the period 1926-1999.
Diversify
To Reduce Risk Or Increase Return
Fixed Income Portfolio
Bonds
Stocks 90% Cash
12% 20% Stocks
Cash
35% 39%
Return 9.0%
Risk 8.5% Bonds
Bonds
53% 41%
Risk is measured by standard deviation. Risk and return are based on annual data over the
period 1970-1999. Portfolios presented are based on Modern Portfolio Theory.
Return Before & After Inflation
15%
1926 - 1999
Compound Annual Return
11.3%
10%
8.0%
5.1%
5%
3.8%
2.0%
0.7%
0%
Stocks Stocks Bonds Bonds Cash Cash
after after after
Inflation Inflation Inflation
Assumes reinvestment of income and no transaction costs or taxes.
Monitor Performance
Revise IPS as needed
16
Reevaluate & Modify Portfolio
Asset Allocation – has fixed income/equity balance
changed from the design
Style Under/Over-weights – is the portfolio tilted in
style?
Industry Selection – based on the economic environment
what might the best sectors be, or is the portfolio weighted
too much in any 1 sector (i.e. 25%)?
Security Concentrations – usually anything greater than
10% of the portfolio must be reduced in size
Security Selection – sell stocks that have poor
fundamental issues in the future – and buy those that have
positive changes ahead.
Key point – LT focus – not ST turnarounds. Why? Tax
constraints.
17
Understanding How Stocks
Work
18
What is a Stock?
Legal ownership in a company through
“shares” – purchase of stock implies you
own a “slice” or “share” of the company
19
4 Characteristics of Stocks
Voting Power - Ownership implies “control”
having the right to appoint Board of Directors, who
in turn, elect management
20
Return & Risk of Stocks
Two Ways to Earn a Return on a Stock
Appreciation in Stock Price – if the investors
perceive strong growth in the company’s sales
& earnings, then investors will demand to buy
more of the stock. As demand increases, the
price of the stock increases.
Dividend Payment – if the company pays
dividends
21
Caveats of Stock Ownership
No Guarantee of Return – you can lose your investment
22
Conceptualizing Financial
Statements
Financial statements are guided by a set of
accounting rules, called GAAP (Generally
Accepted Accounting Principles).
23
Conceptualizing Companies
Companies are dynamic, financial statements are static
One date of release: summary of 3, 6, 9 or 12-month activity
year-end
Past-tense: information possibly already incorporated into the
Industry analysis
Management strategy
24
Conceptualizing the 3 Financial
Statements
Think of analyzing your own finances…
25
Balance Sheet Income Statement Statement of Cash Flows
(or ... what have you got?) (or ... what do you tell the Government you made?) (or ... what REALLY happened this year)
Assets
Current assets Cash flows from operations
Cash and temporary investments Sales
Income from operations
Accounts receivable - Cost of sales (including depreciation Net income (Profits)
Inventory expense)
+ Depreciation
Prepaid expenses
+ Restructuring charge not spent
Total current assets = Gross profit on sales - or + Gains or losses
Long-term assets + or - Deferred income taxes
- Selling and administrative expenses
Property, plant and equipment - Restructuring expense Cash provided by (used for) working capital
Less: Depreciation + or - Accounts receivable
+/-Gains or losses
Net property, plant, and equipment + or - Inventory
Deferred tax assets = Net Operating Income + or - Accounts Payable
Intangible assets and goodwill = Net cash provided by operating
+ Other revenues
Total long-term assets activities (Cash Flows From
- Other expenses Operations)(CFFO or CFO)
Total assets
= Earnings before tax
- Income tax expense Cash from investing activities
Liabilities + Owners' Equity + Sale of assets
= Net income (Profits)
- Purchase of assets
Current liabilities
Accounts payable
Taxes Payable = Net cash provided by investing
Short-term notes payable activities
Current portion of long term debt - Dividends on preferred stock
Total current liabilities = Net income available to
Cash from financing activities
Long-term liabilities common stock
Long-term debt less current portion - Dividends on common stock + Issue of debt
Deferred tax liability - Retirement of debt
Total long-term liabilities = Net income transferred to + Sale of common stock
surplus or retained earnings
Owners' equity - Dividends paid
Common stock par
Capital surplus = Net cash provided by financing
Retained earnings activities
Less treasury stock at cost
Total owners' equity
The sum of the last line in each box
Total liabilities + Owners' equity above = the change in cash balances
26
Public Filings You Need to
Know
Form 10-K (due 90 days after fiscal year
close)
Income statement (aka Statement of
Operations)
Balance Sheet
Auditor’s Report
27
Stock Market Indices (i.e.,
Indexes)
Price-Weighted Index - each company represented by 1
share in index. Gives higher-priced shares more weight in
determining performance of the index (e.g., Dow Jones
Industrial Average)
28
Costs of Investing
Commissions – Costs from the broker to
implement trades one-way – must remember that
you incur the cost when selling also
29
Buying Stock on Margin
Definition - Borrowing Funds to Buy Stock - initially up to 50% of
the equity purchase – called the Initial Margin Requirement
High Risk Strategy – only meant in cases where client has high
amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves
risk and has nerves of steel)
30
Buying Stock on Margin
Example of Margin Trading
$10,000 of GE desired to be purchased with
= 200
Ending Ending Loan Net Maint. Rate of % Chg
Interest Rate on Loan is 10%
Price Value Value Equity Margin Return Price
$80 16,000 5,000 11,000 68.75% 110% 60%
$50 10,000 5,000 5,000 50.00% -10% 0%
$30 6,000 5,000 1,000 16.67% -90% -40%
Bottom Line?
Margin increases gain and loss returns substantially!
31
Short Selling
Definition – Instead of “Buying Low 1st, And Selling
High 2nd,” you are doing this in reverse (Selling High,
Buying Low) - You do this, when you think the stock
price is overvalued and you decided to “short” or sell
first, in expectation that the stock is going to fall
32
Procedure to Short Selling
Borrow the Stock from Broker – as if you were
taking a loan
Sell the Stock in the Market – collecting the
proceeds
When Stock Price Declines – buy the stock back at
lower price
Return the Stock to the Broker – keep leftover
funds as profit
Similar Margin Requirements – as in Margin
Trading
33
Basics on Portfolio
Management
Always make sure that your portfolio is
diversified – not just 8-10 securities, but 20-30
minimum – across industries and countries
34
Basics on Portfolio
Management
Make sure your portfolio does not become too
concentrated in 1 name or 1 sector. Be receptive
to sell if any 1 stock becomes greater than 10% of the
portfolio – it may drive future performance, including
downward
35
Understanding How Bonds
Work
36
Definition of a Bond
Contractual loan that pays interest over a fixed term
Upon its maturity, the principal or the investment
amount is returned to the lender of the bond
Interest rate (called Coupon Rate) is typically fixed –
hence, the alternative name for bonds as “fixed income”
securities
An Income-Based Investment – focus on generating
income and less so on capital appreciation <> stocks
Bond Contract is called an Indenture Agreement – which
has all of the structure details about the bond and
disclosures about the company issuing the bonds
Usually denominated in $1,000 units – $50,000 in Bonds
= 50 Bonds
37
Bond Classifications
Registered vs. Bearer Forms
Security
Collateral – secured by financial securities
land or buildings
Debentures – unsecured
38
Major Classes of Bonds
U.S. Treasury Bonds – issued by the U.S.
Government and considered the safest type of bond
39
Major Classes of Bonds
Foreign Bonds – issued by foreign governments as well as
foreign corporations – can be denominated either in US
Dollars or in foreign currency – considered to have multiple
layers of risk, both in terms of the foreign entities
willingness to pay as well as in currency risk terms
40
Key Characteristics of Bonds
Par Value – stated value of a bond – usually $1000 par value per
bond. $50,000 par is = to 50 bonds to buy.
Coupon Interest Rate – the amount that is paid each period to a
bondholder by the issuer. Rate is usually quoted as an annual rate,
but payments are made usually semi-annually.
Coupon Payment = Coupon Interest Rate x Par Value
Maturity Date – when the bond matures – principal and last coupon
payment paid on this day.
Price (Market Value) – what the value of the bond is worth. Better
yet, what the market is valuing this Annuity Stream.
41
Bond Value ($)
1,372 kd = 7%.
1,211
kd = 10%. M
1,000
837
775 kd = 13%.
30 25 20 15 10 5 0
Years remaining to Maturity
Bond Risks
Default Risk – Risk that you are not going to get your original
principal back due to the company going bankrupt.
43
What is Interest Rate Risk?
Also, called Price Risk…
Price
Yield
45
Default Risk Premium (Credit
Risk)
46
Corporate Bond Spreads – AA
& BB
10
4
4-96
7-96
1-97
4 -97
7-97
1-98
4 -98
7-98
1-99
4-99
7 -99
1-00
4-00
7 -00
1-01
10-9
10-9
10-9
10-9
10-0
7
6
0
10-YR US Treasury AA Corporate Rate BBB Corporate Rate
47
Benefits of Bonds in Portfolios
Historically Lower Risk
Diversification Benefits
Income Generation
Potential Growth
48
Fixed Income Maturity (Interest
Rate) Risk
1970 - 1999 Long-Term
15% Gov’t Bond
Intermediate-Term 9.8%
10% Gov’t Bond
5.9%
Short-Term
5% Gov’t Bond
1.5%
0%
-1.3%
-5%
-4.5%
-10% -8.7%
Average Rise in Price during Declining Interest Rate Periods
Average Decline in Price during Rising Interest Rate Periods
49
Using Bonds to Diversify
1970 - 1999
Original Portfolio Lower Risk Portfolio
Cash
19%
Stocks Stocks
50% 38%
Cash
50% Bonds
43%
6%
9%
25%
73% 85%
Stocks Bonds
Based on annual data over the period 1970-1999.
Bond Prices & Yields Over Time
When Yields Increase, Bond Prices Decrease
$1.60 Bond Prices ($) 16%
Bond Yields (%)
$1.40 14%
$1.20 12%
$1.00 10%
$.80 8%
$.60 6%
$.40 4%
$.20 2%
$0 0%
1925 1935 1945 1955 1965 1975 1985 1999
52
Understanding
How Mutual Funds Work
53
Definition of an Investment
Company
Financial intermediaries (i.e., middlemen) that collect funds from
individual investors and invest those funds in a diversified pool of stocks,
bonds, or other assets based on the company’s focus or specialty. (i.e., a
bond fund, an international fund)
money they can have instant ownership of many stocks, not just one.
They can also easily buy more (in increments of $, not 100 share blocks)
Professional Management – this is of course relative – you must do
54
Types of Investment
Companies
Managed Investment Companies (mutual funds)
Open-End – issues shares every time a buyer adds money to the
mutual fund – investor buys shares at NAV.
Closed-End – trade like stocks on the exchange. Investor buys
at the current stock prices (which could be higher or lower than
the NAV).
55
Net Asset Value and Price
Used as a basis for valuation of investment
company shares.
Selling new shares
56
Open-End and Closed-
End Funds: Key Differences
Shares Outstanding
Closed-end: no change unless new stock is
offered.
Open-end: changes when new shares are
sold or old shares are redeemed.
Pricing
Open-end: Net Asset Value (NAV)
57
Investment Policies
Money Market
Fixed Income
Equity
Asset Allocation
Indexed
Specialized Sector
58
Costs of Investing in Mutual
Funds
Fee Structure
Front-end load
Back-end load
Operating expenses
12 b-1 charges
distribution costs paid by the fund
Alternative to a load
Examples
SPDRS
WEBS
HOLDERS
60
A First Look at Fund
Performance
Benchmark: Wilshire 5000
Results
Most funds underperform
61
Consistency of Fund
Performance
Do some mutual funds consistently
outperform?
62
Rate of Return Calculations for
Funds
Performance – History has shown that 80% of mutual fund
managers do not beat the “market” – so why bother? Main
difference is that they are comparing apples and oranges.
63
Information Sources on Mutual
Funds
Wiesenberger’s Investment Companies
Morningstar
Popular press
Investment services
64
Measuring Fund Performance –
Category Ranks and Ratings
You can view all mutual funds as 1 peer group – but
everyone is investing with a different “style”
65
Categories Identify the Real
Competition
For example: International Equity
Foreign
World
Regional
International Hybrid
Large
Medium
Small
67
Style Box Breakpoints
Market Capitalization
Large – >= $10 billion
Medium – < $10.0 billion, >= $1.6 billion
Small – < $1.6 billion
68
Styles <> Objectives
Fund Objective Actual Style
Oakmark Select Growth Mid Value
Pioneer Cap Growth Small Co. Mid Value
Prudential Equity Inc Equity Inc. Mid Value
69
Styles <> Objectives
Fund Objective Actual Style
Vanguard Growth IndexGrowth Large Growth
Sequoia Growth Large Value
Delafield Growth Small Value
70
Current Equity Style Box
Twenty Weitz
Value Blend Growth Value Blend Growth
Large
Medium
Small
72
Weitz Top Holdings
73
Janus Twenty Portfolio
Breakdown
74
Weitz Partners Value Portfolio
Breakdown
75
Janus Twenty Sector Exposure
76
Weitz Partners Value Sector
Exposure
77
Risk Measures
Twenty Weitz
Morningstar Risk (10 YR) 1.32 0.59
Standard Deviation 24.72
14.18
78
Five Key Points in Picking
Funds
How has the fund performed?
Compare with appropriate index
Compare with peer group
Examine after-tax returns, if relevant
How risky has the fund been?
Big returns spell risk
Are you comfortable with the level of volatility?
Morningstar risk & standard deviation
What does the fund own?
Value vs. Growth
Sectors
U.S. and Foreign
Who runs the fund?
Who earned the fund’s record?
Where does this manager come from?
What’s the fund family like?
What does the fund cost?
Low expenses are best
Load funds aren’t bad if performance is justified, but rare
79
Understanding Global
Investing
80
Why Invest Globally?
Investment Opportunities – roughly 50% of
the global stock market currently Foreign
Market History
Each bar shows the range of annual total returns for each region over the period 1970-1999. Average Return
Domestic Versus Global
1970 - 1999
U.S. Stocks U.S. Bonds International Stocks
18%
40% 40%
60%
42%
Economic/Political Risk
84
The End!
Thank You!
85