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Introduction to Investments

Case: Rina Castillo: Implementing


Asset Allocation Principles
Investments
Course Objectives
• Understanding of the stock market
investments
• Understanding what the investment
opportunities are
• Make good investment decisions
• Recognizing where investment problems and
controversies arise and knowing how to deal
with them
Session
Plan
Evaluation
Reference Books
• Charles P. Jones; Investments: Principles and Concepts, Wiley Publication,
Twelfth Edition

• Frank K. Reily and Keith C. Brown; Investment Analysis and Portfolio


Management, Cengage Publication, Tenth Edition

• George Foster; Financial Statement Analysis, Pearson, Second Edition

• Edwin J. Elton and Marting J. Gruber; Modern Portfolio Theory and


Investment Analysis, John Wiley, Fifth Edition

• Robert A. Strong; Practical Investment Management, Cengage, Third


Edition
Risk comes from not knowing
what you are doing
—Warren Buffett
The Investor
• Rina Castillo lived the American Dream • She also had an unquenchable thirst for
knowledge, which she tried to satisfy through
• A recent graduate of the Stanford School of
books from one of her local libraries
Engineering, she was the first in her family
not only to leave her native Mexico but also • By the time she was old enough to help out
to attend and graduate from a university in the family’s market, Castillo began
suggesting improvements to deep-rooted
• Her parents and family were exceedingly
practices in order to simplify distribution and
proud of her, but her success did not come
without a lot of hard work and sacrifice enhance customers’ shopping experiences
• While Castillo’s home state in Mexico was • In doing so, she helped increase margins
dependent on subsistence farming and had along with customer loyalty
high levels of poverty, her parents owned a • When not in school or at the family’s market,
retail market, selling groceries, meat, and Castillo could be found at the library reading
poultry up on the United States and the elusive
American Dream
• The steady income from this family
occupation, though quite meager, helped • She read about Sergey Brin, founder of
subsidize Castillo’s education in Mexico and, Google, who immigrated to the United States
ultimately, in the United States from the Soviet Union when he was only six
• Castillo was also fortunate enough to receive • Then there was Jerry Yang, founder of Yahoo,
scholarships to finance the remainder of her who moved to California from Taiwan when
university tuition he was ten
• Castillo’s parents knew from a young age that • Both men had studied at Stanford University
their daughter was brilliant at one time or another, so that university in
particular interested her
• She had always been drawn to puzzles as a
child, which helped hone her logic and
The Company
• While a student at Stanford, Castillo felt a • Less than a year later, AdCambio received an
strong urge to reciprocate the support that unsolicited offer from Google, the world’s
had been given to her by both her parents largest media company, to purchase the ad
and her home country network for $110 million, split between $60
million in cash and $50 million in stock
• She created AdCambio, an advertising
network for small businesses in Mexico • According to the terms of the deal, Castillo
would be able to sell her stock ratably over
• This had the benefit of increasing value to
ten years if she remained employed with the
consumers by allowing small businesses,
such as Castillo’s family market, to reach their company for three years after the acquisition
potential consumers on mobile devices • In doing so, she could expect $5 million per
within the Mexican market year for the next ten years in addition to an
initial cash payout of $50 million, net of $10
• Given the appeal of technology start-ups in
million in taxes
the Silicon Valley, Castillo was able to expand
the business rapidly, growing to nearly 30 • Castillo was wholly unprepared for the offer
employees in less than three years by Google, the sale of AdCambio, and the
flurry of media attention that followed
• AdCambio’s annual revenues had soared to
roughly $15 million by the time Castillo • After all, her desire to enrich the lives of the
graduated from Stanford members of the Mexican community was
much stronger than her immediate desire for
money—or fame
The Plan
• Almost immediately, • Of course, she was also
Castillo began to contacted by a number
receive an of parties interested in
overwhelming number her willingness and
of calls from advisors ability to give to
looking to assist her in charities, family, and
the management of even unemployed
her new wealth close friends
• The calls came from
investment advisors,
estate planning
lawyers, tax
consultants, mutual
Finding an Investment Advisor
• While Castillo had helped manage the small-scale • Instead of listening to their “pitch,” she turned
finances of her family’s market, she had no real the tables and started asking them questions:
background in investment management • What experience do you have, especially with
• Always hungry for knowledge, she was more than people in my circumstances?
happy to do some initial research on her own • What training and experience do you have?
• To begin with, she studied the roles, • How long have you been in the business?
responsibilities, and compensation arrangements
• Do you have any professional certifications,
of advisors licenses, or designations?
• She found that, at the least, an investment • What other firms have you been registered with?
advisor is responsible for helping clients What is the status of those firms today?
determine risk tolerance, analyzing investment
options, providing investment recommendations, • How long has your firm been in business?
maintaining records of the services they provide, • Have any arbitration disputes have been filed
and complying with all regulatory, legal, and against your firm? H
ethical standards • Have you personally been involved in any
• Most importantly, she discovered that a primary arbitration cases?
role of investment advisors is to educate clients,
discussing their financial goals and devising a
plan to accomplish those goals
• But how would Castillo go about choosing an
investment advisor?
• She had already received dozens of phone calls
from individual advisors and teams of advisors
• How could she possibly decide which advisor
would help her best determine and meet her
goals?
• Castillo began by meeting with several advisors
Finding an Investment Advisor
• What is your investment philosophy? • If you weren't making extra money,
• Describe your typical client would your recommendation be the
• Do you have any references that you same?
can provide? • Are you participating in any sales
• How do you get paid? contest?
• By commission per transaction? • You've told me what it costs me to buy
this stock (or bond, or mutual fund);
• Amount of assets you manage? By the how much will I receive if I sell it
hour? Flat rate? Based on today?
performance? Another method?
• Where do you send my order to be
• Do you make more if I buy this stock executed? Can we get a better price if
(or bond, or mutual fund) rather than we send it to another market?
another?
• Are you registered as an investment
advisor? If so, may I see a copy of the
Form-ADV and Form-ADV part II?
• Who are your references?
Finding an Investment Advisor
• After meeting with potential • Instead, Castillo felt that the fee-
advisors, Castillo settled on an only structure of the advisor she
advisor with a long history, clean chose was most aligned with her
record, numerous glowing objectives
references, and plenty of services, • Because the advisor was not
including tax, legal, and estate reliant on commissions, she felt
planning advice that the advice would be more
• She was particularly drawn to this objective and more appropriate
advisor because of the unique for her very large portfolio, which
hourly fee structure might necessitate frequent trades
• She decided against competing and active asset allocation
advisors who charged based on
commissions because they had an
incentive to perform more,
potentially unnecessary,
investment transactions in order
to generate increased revenue for
the firm
• Castillo also steered away from
Finding the Right Fund Allocation -
Personal Portfolio
• With her advisor selected, Castillo needed to • Although she expected to take more frequent
figure out how to best allocate her funds trips to Mexico to visit her family, she did not
anticipate a drastic increase in her living
• Because of her humble upbringing, she lived
expenses following the sale of her business
a modest life with very few expenses
• She paid a small monthly rent on her • Castillo put together a balance sheet and
apartment and biked to AdCambio’s office income statement and determined that she
each day would need at least $190,000 per year after
taxes in order to maintain her current
• AdCambio offered generous benefits lifestyle—a scant amount compared to her
including full health coverage, gym new wealth
membership, retirement plan, massage
services, and life insurance, all of which were • Next, Castillo needed to determine how
comparable to the benefits offered by Google much risk she felt comfortable taking with
her investments and if she wanted to reserve
• Even the majority of her food expenses were some cash for another start- up
covered by the plentiful meals offered by her
company • After all, she was still quite young and had a
lot of passion for programming so she could
• Finally, because she spent the majority of her try to develop another successful venture
time working, she had very few expenses for once her lock-up agreement ended with
travel or entertainment Google in three years
• Alternatively, since she already possessed a
good amount of knowledge about
technology start-ups, she could reserve some
cash to co-invest with other venture funds
Finding the Right Fund Allocation – Private
Foundation
• One thing Castillo knew for sure was that she • This was double the mandatory distribution
wanted to find a way to support ongoing requirement of 5 percent and roughly aligned
development in her hometown in Mexico with average private foundation distributions
• This included increasing business literacy, • With the help of her advisor, Castillo decided
particularly for women, as an impetus for to allocate $60 million to the foundation with
economic and social improvement $30 million in cash and $30 million in Google
stock
• She also wanted the foundation to make
grants to her hometown libraries and set up • Her personal portfolio, then, would consist of
scholarships benefiting the youth in the the remaining $40 million—$20 million in
Mexican community cash and $20 million in Google stock
• She wondered whether the best way to do •
that was with a private foundation
• If Castillo did create a foundation, she
planned to fund it partly with cash and partly
with Google stock
• Since she would be able to sell the stock over
the next ten years, and she expected the
price of Google’s stock to rise, funding the
foundation with stock seemed to be ideal
since she could deduct the fair market value
of the stock and not pay taxes on the long-
term capital gain
• Finally, Castillo expected to allot the
foundation’s funds during her life with a
Investment Strategy
• Once Castillo allocated her funds, her next step
was to start thinking about an investment
strategy
• Because Castillo’s foundation and personal
• Her advisor recommended the use of an portfolio were 50 percent funded with Google
investment policy statement to define her stock, her initial allocation to domestic equities in
investment goals and risk tolerance both portfolios was 50 percent
• Key components of the statement that required
• However, this allocation was expected to change
consideration were: over time as she sold her Google holdings
• An overall objective of the portfolio, such as
• Since Google’s stock was highly correlated with
preservation, income, or growth the S&P 500, she decided against allocating any
• An assessment of risk tolerance with particular additional funds to that asset class
attention given to the investment time horizon
• Instead, she allocated the remaining funds to
• Special attention devoted to investment international equity, fixed income, alternative,
constraints, such as legal, regulatory, ethical or and cash assets
religious considerations
• Because foundations typically have a longer time
• A measure of maximum downside potential for horizon and in Castillo’s case, more asset value,
the portfolio than a personal portfolio, Castillo and her advisor
concluded that she could take on slightly more
• A benchmark against which to gauge the risk in the foundation
performance of the portfolio
• As a result, her percentage allocation to riskier
• An indication of how often the portfolio would be
alternative investments was double that of her
rebalanced
personal portfolio and triple the value
• In addition, the percentage allocation to
international equity was 50 percent higher in the
foundation and more than double the value (see
Investment Implementation
• With her asset allocations determined, it was • As a result, Castillo and her advisor decided
time to get into the real work of to employ a passive strategy in the
implementing her investment plan management of her fixed income allocation
• Active versus Passive Strategies • On the other hand, active managers had, on
occasion, been shown to add value in the
• The first issue to consider was whether to
management of international equities—
invest in active or passive strategies
particularly with respect to currencies—and
• According to Castillo’s advisor, it was difficult certain alternative assets such as real estate
to determine the merits of one strategy over and commodities
the other because advocates of both
strategies had produced compelling evidence • Accordingly, Castillo and her advisor
supporting their respective conclusions concluded that active managers for those
portions of the foundation and personal
• Academic studies had overwhelmingly portfolio would be best
supported passive management by showing
that investment managers are incapable of
beating the market over the long term,
especially net of fees and taxes
• In response, the active management
community selected sustained periods of
time during which active managers delivered
superior returns, particularly in certain
markets, to demonstrate their ability to add
value
• In general, research had found that all
categories of actively managed bond funds,
Manager Selection
• From her research, Castillo discovered that • With her advisor’s help, Castillo performed a series of
investment advisors had two options for screens based on specific requirements such as asset
implementing the investments in each asset class— class, fees, manager tenure, turnover, style, and
individual management and pooled (or commingled) capitalization
management • With her universe narrowed down, she then
• Pooled management included open- and closed-end reviewed each manager’s philosophy, process,
mutual funds, exchange-traded funds (ETFs), people, and performance on a case by case basis
exchange-traded notes (ETNs), and hedge funds, • It was important for Castillo to understand exactly
while individual management included separately who would be managing her money, how they
and unified managed accounts planned to do so, and why they invested the way that
• In most cases, separately managed accounts were the they did
most economically feasible of the individual • After all, understanding each of these concepts gave
management options but they did not always her specific insight into their performance
command top talent—something that was very • And while past performance is no guarantee of future
important to Castillo results, a historical performance attribution could
• Due to her advisor’s independence from any specific give her perspective into whether a manager’s
products along with her large asset base, Castillo was historical performance was attributable to luck or skill
free to choose from a seemingly endless repository of
pooled investment managers
• The challenge with such an expansive universe, of
course, was evaluating each manager and identifying
those who could demonstrate consistently superior
performance
• The first step was finding a way to narrow down the
universe of managers
Manager Selection
• In the end, a small number of very • Her advisor suggested that this occur as
profitable investments seemed to be less frequently as daily or annually depending
sustainable relative to a high proportion of on the items being reviewed
moderately profitable selections • At a minimum, though, Castillo’s advisor
• Other important items Castillo discussed concluded that monthly performance
with her advisor in the evaluation of reviews should be conducted to ensure
investment managers included historical adherence to the stated fund philosophy
holdings and exposures, investment • Particular attention should also be paid to
discipline, risk analytics, investment any adverse fund developments such as
manager ownership in the fund, and tax the departure of key managers, excessive
efficiency growth in assets under management,
• Given the size of her assets, Castillo’s excessive concentration in any one position
advisor also encouraged her to conduct (unless specifically authorized by the fund’s
onsite meetings with the actual fund philosophy), or any other departures from
managers a stated investment style
• Once Castillo had identified an ideal
investment manager, the final step in the
manager selection process was ongoing
monitoring and review
Fixed Income
• In her discussions with her • While the cost of purchasing
advisor, Castillo discovered individual bonds for a
that, in general, fixed income laddered portfolio was quite
products tended to be less low, investment managers
volatile than equities, which benefited from economies of
resulted in lower fees, on scale
average • In other words, because
• This was true whether Castillo investment managers traded
decided to purchase individual in large volumes, they could
bonds, such as a ladder, if she often do so for less
held a managed account, or if
she owned a bond mutual
fund or ETF
• However, as Castillo had
already discovered indirectly,
fees for actively managed
funds were greater than index
Alternative Investments
• Through her dealings in Silicon Valley, Castillo had • An additional fee of 1 percent and 10 percent
heard of venture capital and private equity funds, were added to the management and incentive
but she was unaware of how many different fee, respectively, for hedge fund of funds
types of alternative investments were available • Fund of funds held a portfolio of investment
for her portfolio. funds such as mutual funds, hedge funds, private
• Typical alternative investments included hedge equity funds, or venture capital funds
funds, private equity funds, venture capital, real • They served to diversify risks associated with
estate, and commodities holding a single investment fund and included an
• Each product served to further diversify her additional layer of due diligence performed by
portfolio due to its low correlation to her existing the fund of fund manager
or planned holdings
• In addition, the illiquid and infrequently traded
nature of alternative assets made them less
efficiently priced and prime for greater returns
• Because of the greater degree of investment
analysis required, alternative assets commanded
a higher fee structure and minimum investment
relative to mutual funds and ETFs
• Hedge funds, for example, typically charged both
a management fee, calculated as a percentage of
assets under management, and a performance
fee based on profits
• Management fees typically ranged from one to
two percent per annum, while performance fees
ranged from 10 to 20 percent per annum
• The standard “two and 20,” referred to the
standard fee arrangement in the industry, which
had come under pressure as a result of criticism
Alternative Investments
• However, management fees were typically higher • Liquidity was an important consideration for her
than those of traditional investment funds foundation because she planned to distribute 10
because they included the fee charged not only percent of assets on an annual basis
by the fund of fund manager, but also the • It was also an important consideration for her
underlying funds personal portfolio if she wanted the flexibility of
• Because of her large asset base, Castillo could starting another venture after her lock-up with
also invest in a venture capital or private equity Google.
fund, which, along with other alternative
investments, typically had high minimum
requirements
• She did have to consider, however, the lengthy
investment periods, typically five years,
mandated by some alternative investment funds
Rebalancing and Continued Review
• Once she implemented her investment strategy, • First and foremost, her advisor was responsible
Castillo’s next step was to articulate a clear plan for providing tailored reports evaluating Castillo’s
for rebalancing her portfolios in order to maintain investment performance and financial position
her target asset allocation on a monthly basis
• Instead of assigning an arbitrary time frame • They would also be responsible for tracking
within which to rebalance the portfolios, Castillo portfolio changes, taxable gains and losses,
and her advisor decided to employ threshold capital distributions, and any news pertaining to
rebalancing, in which they waited until an asset’s relevant investment managers
portfolio contribution reached a certain deviation • Finally, Castillo instituted quarterly conference
before adjusting it back to policy calls with her advisor in order to maintain and
• They set this threshold at five to ten percent but ensure effective communication
also agreed to review the portfolio at least
annually to minimize drift and turnover
• The final step in Castillo’s investment
implementation was to delineate the continuing
role of her advisor
Readers
• 5 ICI Research Perspective, • 9 Colleen M. Jaconetti, CPA,
“Trends in the Expenses and CFP®, Francis M. Kinniry Jr.,
Fees of Mutual Funds, 2012,” CFA, Yan Zilbering, “Best
April 2013. 6 This rule Practices for Portfolio
generally holds true for Rebalancing,” Vanguard, July
equities as well 2010.
• 7 “Does “2 and 20” Still Exist?
Results of Preqin’s Hedge Fund
Terms and Conditions Survey –
Fees Special Report,” Preqin
press release, July 29, 2009,
https://www.preqin.com/docs
/press/Preqin%20HF%20Fees
%20Survey %20Report%20July
%2009.pdf (July 4, 2013).
8 “Hedge Fund Launches Rise
as Investor Risk Tolerance
Returns,” Hedge Fund