Strength Through Structure Strategies for the Goal-Focused Investor

Transcription

1 Strength Through Structure Strategies for the Goal-Focused Investor

2 Introduction In a world that offers a bewildering array of investment options, there is a need for an approach that delivers clarity and a cohesive structure. Your financial advisor uses such an approach, distilling the investment universe down to the essential components that help you achieve your financial objectives. Combining current academic and industry research with practical application and experience, our innovative approach attempts to maximize return and minimize risk. By focusing on the structure behind the strategies, your financial advisor can assist you in developing sound investment strategies aligned with your current and future goals.

3 CONTENTS Philosophy Engineered Asset Classes 2 Asset Class Selection and Diversification 3 Structured Versus Active and Passive 4 Asset Class Strategies The Role of Bonds and Short-term Maturities 7 U.S. Market: The Cornerstone of an Effective Portfolio 8 International Investing 9 Small Company Investing 10 Value Company Investing 11 Implementation Tax Strategies 13 Working with a Fee-based Financial Advisor 14 The Benefits of Planning with Structured Asset Classes 15

4 Philosophy Engineered Asset Classes As the central building blocks of your portfolio, asset classes are the tools your advisor uses to help build a portfolio and manage your investments. What Is an Asset Class? An asset class generally refers to a group of securities that have similar features, with stocks, bonds and cash being the three main classes. These major asset classes can be further refined into smaller, more concise groups, such as domestic or international stocks and large or small company stocks. The more qualifications used to describe the asset class, the more specific and targeted an asset class becomes. How Are Asset Classes Created? Asset classes can be narrowed down from the three broad categories (stocks, bonds, cash) to more targeted categories. 1 The process of narrowing down the broader categories is typically what differentiates most investment strategies from one another. The foundation of our approach to asset class investing consists of: Academic research based on Modern Portfolio Theory Investment industry research Institutional investment management Investor goals and investment objectives These components help to determine the asset classes we use in our investment strategies, making these asset classes truly engineered to work effectively in a portfolio. A structured portfolio of wellengineered asset classes may be the best method for attaining investment goals that are appropriate to your needs and risk tolerance. 1 Fama, Eugene F. and Kenneth R. French. The Cross- Section of Expected Stock Returns. Journal of Finance 47 (1992). 2 Philosophy

5 Asset Class Selection and Diversification The next component of a structured investment approach is selecting the appropriate asset classes, a key determinant of a portfolio s performance. Allocating your assets across the right asset classes may help reduce short-term investment risk and stabilize returns, thereby reducing the volatility of your portfolio. Effective diversification may be achieved by diversifying investments across bonds and domestic and international stock markets. These asset classes are academically engineered to deliver market rates of return with varying dimensions of risk. In addition, these asset classes remain fully invested in their respective strategies and do not deviate from them. Using Nobel Prize-winning research known as Modern Portfolio Theory, 1 your advisor will structure your portfolio according to your specific preferences. Modern Portfolio Theory and other research give us the tools to construct an investment portfolio that we believe has the potential to deliver higher returns for the level of volatility that you are willing to accept. In addition, our approach incorporates small cap stocks and value stocks two classes of stocks that have historically outperformed the market as a whole. 2 It is important to note that asset allocation and diversification do not assume or guarantee better performance and cannot eliminate the risk of investment losses or volatility. Overall, the potential benefits of this approach include: Reduced volatility through a basket of stocks, as the overall risk of the portfolio should be less than any individual stock in it Global diversification intended to cushion the investor s downside during periods of domestic market decline Lower volatility for the overall portfolio by combining asset classes from different market segments and geographies 1 Harry Markowitz. Portfolio Selection. Journal of Finance 7.1 (1952). 2 Fama, Eugene F. and Kenneth R. French. Size and Book-to- Market Factors in Earnings and Returns. Journal of Finance 50 (1995). Our approach combines portfolio design and management tools with the proven investment principles of Modern Portfolio Theory. The integration of these components creates investment synergy. Our asset class selection process is intended to produce greater returns, while also seeking to minimize investment risks. The asset classes fulfill different functions within the portfolio, working together to heighten the combined effect. Simply put, the interaction of effective, complementary asset classes is investment synergy. Strength Through Structure 3

6 Structured Versus Active and Passive After the selection of your asset class mix, the next consideration is how those assets are managed. Since the 1970s, investment managers have generally fallen into two schools of thought active and passive each reflecting a different belief system about the behavior of capital markets. It may be useful to think of active and passive management as representing two opposing points of a spectrum. We use a structured investment strategy that we believe combines some of the most effective elements of both active and passive strategies. Active management runs counter to the Efficient Market Hypothesis, which holds that stocks are correctly priced since everything that is publicly known about a stock is reflected in its market price. 1 Because prices reflect this information quickly and accurately, it is extremely difficult to capture returns in excess of market returns without taking levels of risk that are greater than the market. In contrast, active managers attempt to beat the market through stock picking and market timing, undermining asset class ex- posure to keep up with more promising securities. In addition, the increased turnover associated with active management may result in higher fees, trading costs and tax consequences. At the other end of the investment spectrum, passive management is a buy-andhold approach to money management that does not attempt to make forecasts regarding market performance. A passive manager will purchase every stock that makes up the particular index the fund is supposed to be tracking. This technique typically tracks commercially-defined benchmarks and asset classes, thereby foregoing transaction costs and turnover in favor of tracking. Like passive investment strategies, the structured approach is guided by the belief that current market prices are the best estimate of value. In contrast to active management, a structured approach asserts that any new development would be automatically priced into that stock, making it almost impossible to beat the market consistently. The structured approach differs from the passive approach in that it does not follow a specific index. Rather, structured manage- 4 Philosophy

7 Investment Styles Active Management Beat the Market Strategy Goal to Outperform Market Index Stock Picking & Market Timing Increased Turnover Potential for Higher Fees, Trading Costs & Tax Consequences Passive Management Buy & Hold Strategy Efficient Market Hypothesis No Market Performance Forecasting Tracks Commercially-defined Benchmarks & Asset Classes Sacrifices Transaction Costs & Turnover in Favor of Tracking Diversification Structured Management a Exposure to Specific Dimensions of Risk Identified by Academic Research a Efficient Market Hypothesis a Potential for Lower Transaction Costs & Turnover a Exposure to Market Rates of Return a Diversification a Structured Investment Portfolios Focused on Investor Goals ment attempts to capture the returns of a specific asset class. For example, the structured approach tries to enhance returns by capitalizing on the effect of small company stocks. Over long time periods, small company indexes have often outperformed large company indexes, but generally with greater volatility. A structured approach establishes small company parameters and then invests accordingly; therefore, the size of the company is often more important than the company itself. Academic research has identified a more sophisticated approach to investing using a structured management strategy. 2 This approach combines diversification, the potential for lower costs and reliable asset class exposure often associated with passive strategies, plus the added value of active strategies such as engineering and trading. The result is a structured asset class strategy that provides exposure to specific dimensions of risk identified by academic research. 1 Fama, Eugene F. Random Walks in Stock Market Prices, Financial Analyst Journal, Sept./Oct (Reprinted Jan./Feb. 1995) 2 Fama, Eugene F. and Kenneth R. French. The Cross-Section of Expected Stock Returns. Journal of Finance 47 (1992). Strength Through Structure 5

8 Asset Class Strategies The goal of engineered asset class selection is to identify different academically-based strategies to build a balanced and diversified portfolio. As detailed in the following sections, your financial advisor has access to a range of investment strategies that are intended to work together in an integrated and complementary way. Our first strategy for building a diversified portfolio is the bond component, which is intended to reduce portfolio volatility. Next, the U.S. market is introduced as the portfolio s stock cornerstone, because it offers a full array of small, large, value and growth elements. Our approach then builds upon this foundation by adding strategies that target international investments, exposure to the smallest of the small listed companies, as well as lower-priced value stocks. The combined result of these asset class strategies is a broadly diversified portfolio. 6 Asset Class Strategies

9 RISK & REWARD EXAMINED FOR BONDS ( ) 12% 10% 8% 6% 4% 2% 0% 1-Month Treasury Bills 6-Month Treasury Bills 1-Year Treasury Notes 5-Year Treasury Notes 20-Year Govt. Bonds REDUCING VOLATILITY Annualized Compound Return Volatility (Annualized Standard Deviation) Reducing bond maturities may dampen volatility. However, longer maturity instruments generally entail more risk without consistently greater returns, as indicated by the volatility line. Sources: One-Month Treasury Bills, Five-Year Treasury Notes, and Twenty-Year Government Bonds courtesy of Ibbotson Associates. Six-Month Treasury Bills courtesy of CRSP ( ) and Merrill Lynch (1978-present). One-Year Treasury Notes courtesy of CRSP (1964-May 1991) and Merrill Lynch (June 1991-present). Notes: Past performance is not indicative of future results. Bonds are represented by baskets of Treasury instruments with varying maturities in which investors cannot directly invest. Assumes dividend reinvestment. All investments involve risk, including loss or principal. Standard deviation annualized from quarterly data. Data as of October 31, The Role of Bonds and Short-term Maturities The principles of a structured investment approach are applied through asset class strategies. The first strategy employed in building a diversified portfolio is the bond component. The primary role of bonds in a long-term, growth-oriented portfolio is to reduce portfolio volatility. Investors seeking to achieve the appropriate risk/return balance for their portfolios should consider including bonds in their asset class mix. Bonds may also provide a steady flow of income that will generally be higher than the yield from stock dividends. Research by Eugene Fama and Kenneth French at the University of Chicago demonstrates that short-term bond strategies are less volatile than long-term strategies. 1 This leads to our belief that bond investments should be limited to securities with maturities of five years or less. Not only do longer maturity instruments generally involve more volatility, but the returns for longer maturities are not consistently greater. Historically, utilizing shorter-term bonds instead of longer-term bonds has resulted in a greater reduction of portfolio volatility. 2 However, bonds do carry their own forms of risk, including interest-rate risk and creditquality risk. By using bonds to reduce overall portfolio volatility, exposure to stock asset classes can be increased where expected returns are higher. 1 Fama, Eugene F. and Kenneth R. French. Business Conditions and Expected Returns on Stock and Bonds. Journal of Financial Economics 25 (1989): Ibid. Strength Through Structure 7

10 U.S. Market: The Cornerstone of an Effective Portfolio The next strategy in a structured asset class approach introduces domestic stocks. The U.S. market offers a wide range of stocks that include the largest of the large down to the smallest of the small listed companies, as well as those we consider value and growth stocks. Adding this component is intended to create a broadly diversified foundation for an effective portfolio. However, while stocks have outperformed bonds historically, they have also been more volatile. 1 Investors should carefully consider their ability to invest during volatile periods in the market. Based on the three-factor model developed by Eugene Fama and Kenneth French, 2 our view of market returns is represented by three factors: the portfolio s exposure to the market itself, size (i.e., small vs. large) and price (i.e., value vs. growth). These factors are the structural components of asset class selection, or how we distinguish between asset classes. Think of the entire U.S. stock market as a haystack divided according to size and price factors. Finding a stock that is a superior performer can be as difficult as looking for a needle in the haystack. Research suggests that rather than looking for the needle, the investor should consider investing in the whole haystack, or owning securities we believe represent the entire U.S. stock market. With our approach, a portion of your portfolio is invested in all segments of the U.S. market, which should prevent you from missing out on any of the market s performance. 1 Fama, Eugene F. and Kenneth R. French. Business Conditions and Expected Returns on Stock and Bonds. Journal of Financial Economics 25 (1989): Fama, Eugene F. and Kenneth R. French. Size and Book-to- Market Factors in Earnings and Returns. Journal of Finance 50 (1995). A PORTFOLIO S FOUNDATION Rather than looking for a needle in the haystack, we buy the entire haystack. A portion of your portfolio is invested in all segments of the U.S. market small, large, value and growth to potentially capture all of the market s performance. SMALL GROWTH VALUE LARGE 8 Asset Class Strategies

11 International Investing The next step in developing an effectively diversified portfolio is to diversify internationally. The diversification benefits of investing in world markets have long been acknowledged. 1 While the U.S. stock market is one of the world s largest, more than half of the world s stocks are located outside of the United States. 2 Historically, international markets and asset classes within those markets have not moved in unison with the U.S. market. Incorporating both international and domestic elements into a portfolio is a means of achieving increased diversification, just as combining different patterns of performance serves to lower the volatility of the overall portfolio. Investors should be aware of additional risks associated with international investing, such as increased volatility, currency fluctuations and differences in auditing and financial standards. We offer international stock strategies that encompass developed small and value markets. Like its U.S. counterpart, an international approach is designed to provide diversified exposure to small and value companies with higher costs of capital and higher potential returns. In addition, participating in the expansion of foreign markets and the resulting diversification may help to minimize the potential short-term impact of any one company, asset class or country, thereby reducing an investor s overall portfolio risk United States 66% United States 47% 2004 International 34% International 53% l World Market Capitalization As displayed in the pie charts above, international markets have expanded dramatically since Our approach capitalizes on this expansion by diversifying internationally. Data Source: MSCI Blue Book, Fama, Eugene F. and Kenneth R. French. Value Versus Growth: The International Evidence. Journal of Finance 53 (1998): MSCI Blue Book, Strength Through Structure 9

12 Small Company Investing Another essential strategy is known as the size dimension. Research and history indicate that over a long period, smaller companies have often provided higher returns than larger companies. 1 Therefore, long-term increases in returns are sought by adding the small-cap element to your portfolio. We recognize the important role that this size effect plays in effective diversification. That is why we offer exposure to the smallest of the small listed companies. This segment consists of smallcap companies (generally defined as companies with a market capitalization in the bottom 10%) and micro-cap companies (a subset of the smallcap companies with market capitalization in the bottom 5%). Because small company investments are subject to price fluctuations and are more volatile than large company investments, investors should consider the additional risks associated with such investments. However, investing in a crosssection of small companies in the U.S. and major international markets may help to deliver the size effect and the added benefit of diversification. 1 Fama, Eugene F. and Kenneth R. French, Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics 33 (1993): Through our association with Dimensional Fund Advisors, an institutional investment manager, we practice a disciplined and selective approach to buying and trading. Many managers do not invest in the small company marketplace because of the additional trading costs and low liquidity. We turn this into an advantage with block trading by larger institutional managers, which consists of purchasing or selling large quantities of a single stock. Our managers use their reputation and trading expertise to negotiate discounted block trades in this area, resulting in a cost-effective way to purchase small stocks. In addition, Dimensional Fund Advisors is highly selective when reviewing purchase options. When stocks are considered small, rather than immediately investing (as practiced by index fund and passive strategies), our managers may wait to select the best trading opportunities and attempt to receive a wholesale price. This patient approach to buying helps our institutional investment managers select the best trading opportunities. In addition, a hold range further decreases portfolio turnover and trading costs for all strategies. These practices result in a wholesale approach to buying in which the discount makes the trade worthwhile. 10 Asset Class Strategies

13 Value Company Investing The next means of diversification is the value dimension. Long-term capital appreciation may be achieved through value company investing, as lower-priced value stocks have historically outperformed higherpriced growth stocks. 1 However, investing in distressed companies may involve greater risk of price fluctuation and potential loss. GROWTH SMALL VALUE Our value strategy targets large-cap stocks with high book values in relation to their market values. This is determined by the Book-to-Market (BtM) ratio. Simply put, the BtM is the ratio of a company s assets compared to its market value. A high BtM ratio is often interpreted as a value stock, as the book value per share is high relative to the stock price. Adding the value dimension to a portfolio may lead to both increased diversification and the expectation of higher returns. LARGE l THE VALUE ADVANTAGE 2 Historically, research suggests that as a portfolio increases its investments in small and value stocks, the portfolio s return also increases. 3 1 Fama, Eugene F. and Kenneth R. French. Size and Book-to- Market Factors in Earnings and Returns. Journal of Finance 50 (1995). 2 Ibid. 3 Past performance is no guarantee of future results. Let s divide companies into groups according to their excellence. Excellent companies generally have high growth rates, solid profit margins and firstrate management, while unexcellent companies are the opposite. Most investors would presume that the stocks of excellent companies have higher returns than those of unexcellent companies, but research shows otherwise. For a given level of future earnings, a lower price paid typically means a higher expected investment return. 4 Why would value stocks have higher returns than growth stocks? Imagine that an excellent company and an unexcellent company go to the same bank for a loan. The excellent company would get the lower interest rate, of course, because it is a safer, healthier company. The stock market works the same way it would demand a higher return from the unexcellent company because it represents a higher risk. Therefore, lower-priced value stocks typically have higher expected returns than higher-priced growth stocks. 4 Fama, Eugene F. and Kenneth R. French. The Cross-Section of Expected Stock Returns. Journal of Finance 47 (1992). Strength Through Structure 11

14 Implementation After selecting the right course of action to meet your investment objectives, your financial advisor plays a key role in helping to implement and manage that vision. The successful execution of your customized portfolio is accomplished with the guidance of your financial professional and a range of strategies and tools. The following sections detail how the portfolio implementation process can help enact your investment plan and fulfill your specific objectives. Among the essential considerations are: I. The role of tax management in your long-term investment strategy II. The advantages of working with a feebased financial advisor III. The potential to realize your goals through planning and the use of structured asset classes 12 Implementation

15 Tax Strategies After selecting your customized portfolio strategy, the next consideration is how it will be implemented and managed. One important consideration is the role taxation issues can play in your long-term investment strategy. With this in mind, we offer a tax management system that is intended to help you keep as much of what you have earned as possible. Investment strategies that maximize returns may often be tax inefficient. While the expected rate of return may be higher for small-cap and value asset classes, investors often end up paying more taxes than with large-cap asset classes. These funds can be very tax inefficient unless they are tax managed. Most managers (if they tax manage at all) do so in the large-cap growth asset class where there may be little or no value added. We target specific asset classes where tax management has proven to be beneficial: small and value asset classes. 1 Asset Class Returns SMALL - CAP ASSET CLASS NON - TAX MANAGED TAX SMALL - CAP ASSET CLASS TAX MANAGED Our Synervest Approach manages Seeks to Minimize Tax tax within within an asset class Asset Class TAX Our approach carefully considers the tax impact of asset classes. We seek to accomplish this by: Minimizing sales of securities whenever possible Realizing net capital gains that are long term in nature Realizing losses to offset gains when it is prudent to do so Note: This hypothetical example is for illustration only and is not intended to reflect the return of any actual investment. l TAX SENSITIVE APPROACH Our approach targets specific small and value asset classes where tax management has proven to add value. By reducing the impact of taxes within asset classes, our tax management strategies are intended to help investors keep more of their returns. 1 Diversification, Low Portfolio Turnover Key to Tax-Efficient Investing, Association for Investment Management and Research, AIMR Exchange, May/June Strength Through Structure 13

16 Working with a Fee-Based Financial Advisor One essential task of your professional financial advisor is to develop customized investment solutions that help you realize your long-term financial objectives. This can be achieved by combining various asset classes into a balanced, diversified portfolio that takes into consideration your risk preferences, tax situation and personal circumstances. You and your advisor share a common purpose to help increase your net worth and achieve your investment goals. Fee-based advisors work hard to maximize your portfolio s performance because they benefit from the growth of your investments. Your fee-based advisor s compensation is directly linked to the success of your investments. In addition, working with a fee-based advisor gives you access to institutional pricing, which should result in the ability to put more money to work up front. Finally, your registered investment advisor is guided by a fiduciary responsibility to you. This holds that your best interests as a client must be placed before the interests of your advisor. Further, your advisor takes responsibility and will be held accountable for the recommendations he or she provides. This fiduciary responsibility, coupled with a commitment to helping you achieve your investment goals, makes your feebased advisor a valuable person to have on your side. Advantages of Working with a Fee-based Financial Advisor Commitment to helping you achieve your financial security Customized plan to help build and preserve your wealth Fiduciary responsibility for the recommendations advisor provides Access to institutional pricing and professional management Advisor compensation directly linked to your investment success 14 Implementation

17 INVESTMENT POLICY FINANCIAL PL ANNING TAX PREPARATION INVESTMENT STRATEGY C L I E N T ESTATE PLANNING CHARITABLE GIVING A D V I R S O INSURANCE TAX PLANNING The Benefits of Planning with Structured Asset Classes Ultimately, the success of an investment portfolio is measured by whether or not the plan accomplishes your objectives. With this in mind, your financial advisor can customize a portfolio designed to help you focus your attention on goals and the realization of these goals rather than on random performance values. Your financial advisor has access to a range of structured investment strategies targeted toward achieving consistent asset class exposure while still capturing the inherent returns in the stock market. Over time, this structured investment approach adds value by providing higher reliability and a level of confidence that is not available to approaches that rely on forecasting and conjecture. As one of their principal benefits, structured asset classes adhere to a clear strategy and strict parameters in the selection and purchase of stocks and bonds. This welldefined structure assists in maintaining reliable asset class exposure and reducing style drift by staying fully invested in the respective strategy of each asset class. The end result is a portfolio that is intended to maximize returns for your desired level of risk. With complementary components that fit together like the pieces of a puzzle, your financial advisor can help design a portfolio that delivers the full range of asset classes. The importance of your investment decisions cannot be understated. The preservation and growth of your assets may be essential to the financial well-being of you and your family. That is why we are dedicated to providing strength through structure, or integrated and comprehensive solutions that work in concert with the guidance of your financial professional. Strength Through Structure 15

18 16 If you are ready to create a structured investment portfolio based upon your financial goals, now is the time to speak to your financial advisor about developing your asset allocation strategy. Your advisor can provide you access to a unique process and a collection of robust tools to develop a customized approach and build upon that foundation over time.

19 Investing in securities involves risk, including the potential loss of principal invested. Past performance of any investment or asset class does not indicate future results. A diversified portfolio does not assure a profit or protect against loss. Foreign investments involve special risks, including greater economic, political and currency fluctuation risks, which may be even greater in emerging markets. Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure and are not as well established as larger blue-chip companies. Historically, smallercompany stocks have experienced a greater degree of market volatility than the overall market average. In general, the bond market is volatile; bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longerterm securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss Loring Ward Advisor Services. All rights reserved. Loring Ward Advisor Services is a division of LWI Financial Inc. In some circumstances, securities may be offered through Loring Ward Securities Inc., member NASD/SIPC. # (2/07)

20 Loring Ward Advisor Services 3055 Olin Avenue, Suite 2000 San Jose, California ht tp://advisors.loringward.com