Investment Management Theory. Today s Discussion. What are Investors Really Looking For? What is Modern Portfolio Theory?

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1 Today s Discussion What are Investors Really Looking For? Ron Florance, CFA The theory of investment management The realities of investors A case study that makes it understandable The new role of the client advisor Southern Arizona Estate Planning Council February, What is Modern Portfolio Theory? Investment Management Theory All investors are risk adverse Risk must be rewarded Reward comes in the form of return Maximize return for each level of risk 3 4

2 5 The History of Modern Portfolio Theory My Friend Harry Dr. Harry Markowitz Portfolio Selection: Efficient Diversification of Investment Doctoral Dissertation in Published in 1959 Nobel Prize 1990 Concept: Efficient or optimal portfolio achieves the greatest expected return for the level of risk assumed by the investor 6 The History of Modern Portfolio Theory Capital Asset Pricing Model CAPM William Bill Sharpe, 1964, Capital Asset Prices: A Theory of Market Equilibrium No opportunity to systematically beat the market Nobel Prize 1990 r f - Risk free rate Capital Asset Pricing Model r p = r f + (r m - r f )β + e β- Beta, risk exposure to capital markets r m Market return, risk premium r p Portfolio Return Concept: Beta, a portfolio s exposure to the market is a key determinant in portfolio return Risk tolerance: How much Beta do you want? 7 8

3 9 Arbitrage Pricing Theory Stephen Ross, 1976, The Arbitrage Theory of Capital Asset Pricing CAPM too restrictive: -Beta is not the only factor which systematically influences return Multiple factors impact portfolio returns: F p = r f + b 1 F 1 + b 2 F e How Does This All Work? Optimal Portfolio On Efficient Frontier On Highest Indifference Curve That is Tangent to Efficient Frontier Return I 1 I 3 I 2 CAPM Line efficient frontier Concept: Factors turn into asset classes Risk Optimal Portfolio 10 What is Reward? Investor Realities Total Return Total Cash Flow Tax Efficiency Net Worth Goal Just doing better than the other guy 11 12

4 Investment Concerns What is Risk? Will I have enough Growth to achieve my desires? Will I have enough Income to live on? Annualized Standard Deviation Risk of losing money Downside Risk Risk of losing buying power Inflation Risk Risk of not achieving wealth goal Wealth Risk Risk of unpredictability Volatility Risk Will I have adequate Liquidity for opportunities? Will my assets combat Inflation? Will my portfolio survive Volatility? Will my portfolio survive a Catastrophe in the markets? 13 Not A Stock/Bond/Cash World 14 Concerns aren t addressed by one asset Asset classes in investment strategies today Fixed Income Equity Alternatives Cash Large Cap REITs Catastrophe Income Volatility Short Term Bonds Inv Gd Bonds Short Term Bonds Gold High-Yield Bonds Inv Gd Bonds Silver Non-US Bonds Target Date Funds US Gov t Bonds Utilities Min Vol Strategies Investment Grade Mid Cap Gold Dividend Equity Intermediate Municipal Bonds Small Cap Silver REIT s Growth/Value Commodities TIPS High Yield Developed-Market Developed Int l Timber Emerging Markets Currency Hedge Frontier Markets Infrastructure Emerging-Market Preferreds Liquidity Inflation Growth Ultra Short Bonds Short to Inter. Bonds High-Yield Bonds Inv Gd Bonds TIPS Dev Mkt Bonds Domestic Equity Silver Large Cap Equity REITs Frontier Markets Gold Tech/Biotech Dev Mkt Equity Global Equity Commodities 15 16

5 17 Total Portfolio Allocation Too much to comprehend Making it Understandable Biotech 2.5% Technology 2.5%% Frontier Markets 1.25% Utilities 1.25% Target Date 2.5% Min Vol 3% TIPS 3.75% Commodities 3% 3% Ultra Short Bonds 4.75% Short Bonds 18.25% Investment REIT s 3.25% 4.75% Dev Mkt Bonds High Yield Bonds 8.75% 6.75 Dev Mkt Equity Global Equity 12.5% 5.25 Large Cap Equity 18 Not Traditional Asset Allocation Desires Based Allocations Growth Segment Helps to provide asset growth for future financial needs Catastrophe 10% Liquidity 15% Volatility 10% Technology Sector 10% Biotech Sector 10% Inflation 15% Growth 25% Income 25% Frontier Markets 5% Silver 5% High Yield Bonds 20% 50% Global Equity 19 20

6 21 Income Segment Liquidity Segment Helps to maintain cash flow for lifestyle expenses Helps to maintain liquidity for opportunistic investments Utilities 5% REIT s 10% Developed Mkts Equity 15% 10% Short Term Bonds 30% Investment 25% Investment Dividend Equity 30% Large Cap Equity 35% 15% High Yield Bonds 15% Developed Mkts Bonds 10% Non-US Bonds 22 Inflation Segment Volatility Segment Helps to protect against the corrosive impact of inflation Helps to maintain portfolio value during heighten market volatility 10% Short Term Bonds Commodities 20% 15% Short-Intermediate Bonds Min Vol Strategy 30% Gold 5% REIT s 5% 25% TIPS 35% Investment Target Date Funds 25% 30% Domestic Equity 23 24

7 25 Catastrophe Segment Helps to maintain value and liquidity in market disruptions Client Focused Allocation Desires Based Allocations Silver 15% Gold 20% 30% Ultra Short Term Bonds 35% Investment Catastrophe 10% Liquidity 15% Inflation 15% Volatility 10% Growth 25% Income 25% 26 Total Portfolio Allocation Now it is more intellectually manageable Other Possible Segments As clients perspectives evolve, so do their desires Biotech 2.5% Technology 2.5%% Frontier Markets 1.25% Utilities 1.25% Target Date 2.5% Min Vol 3% TIPS 3.75% Commodities 3% REIT s 3.25% High Yield Bonds 8.75% Global Equity 12.5% 3% Ultra Short Bonds 4.75% Short Bonds 18.25% Investment 4.75% Dev Mkt Bonds 6.75 Dev Mkt Equity 5.25 Large Cap Equity Emerging Consumer Infrastructure Global inflation Timber Extreme tax efficiency AMT avoidance Low turnover indexing Municipal everything Social Impact Pharmaceuticals Emerging markets Natural resources 27 28

8 29 The New Client Advisor Client Advisor's Role Advisor's role needs to be clearly articulated Segmentation Allocation They know the client best Client centric desire/concerns addressed Financial experience to steer client to real issues Implementation vehicles Which Investment Solutions to pick? Current market conditions Spreads, valuations, capacity, tax circumstance Ongoing monitoring and rebalancing Trading for investment improvement, not just noise Portfolio rebalancing Tax management Client circumstance evolve 30 Moving from Theory to Reality Academia is fine, but reality resonates with clients What is a client s reward? What is a client s risk concerns? What Beta addresses what concerns? How do specific asset classes address specific concerns? Build strategies that emphasize why a client owns an asset. What are Investors Really Looking For? Ron Florance, CFA Southern Arizona Estate Planning Council February, 2016 Change the focus from WHAT an investor owns to WHY they own it 31