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Module 4

Asset Allocation &


Selection

6583
1996, 20022011, College for Financial Planning, all rights reserved.
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Table of Contents
Introduction ..................................................................... 1

1 Asset Allocation .......................................................... 5


The Brinson Study .......................................................... 11
Implications for Investment Professionals and
Their Clients .............................................................. 12
Returns of Major Asset Classes Over Time ................. 15
The Variability of Returns ............................................. 19
The Critical Importance of Time Horizons in
Asset Allocation ........................................................ 20
Related Theory ................................................................ 23
Practicing Asset Allocation............................................ 28
Four Approaches to Asset Allocation .......................... 34
2 Asset Classes, Characteristics & Performance ....... 39
Common Stocks .............................................................. 39
Preferred Stock ................................................................ 42
Bonds and Other Debt Instruments ............................. 45
Cash Equivalents ............................................................ 71
Real Estate ........................................................................ 73
Mutual Funds .................................................................. 77
Exchange-Traded Funds (ETFs).................................... 85
Exchange-Traded Notes (ETNs) ................................... 90
3 Stock Valuation Methods ........................................ 92
Sources of Corporate Stock Value ................................ 92
A Model for Common Stock Valuation ....................... 93
Price/Earnings Ratios .................................................... 96
Price/Sales Ratios ......................................................... 100
The Growth-Oriented Intrinsic Value Model ........... 101
4 Bond Valuation Methods ........................................ 102
Factors Determining the Value of a Bond ................. 102
Non-Interest-Rate Factors in Bond Pricing ............... 106
Rules of Thumb for Bond Values................................ 109
5 Fundamental Analysis ............................................ 110
The Method of Fundamental Analysis ...................... 110
Economic Analysis........................................................ 112
Industry Analysis.......................................................... 118
Company Analysis ....................................................... 119
6 Technical Analysis & Market Timing ................... 122
Hirt, Block, and Basu .................................................... 123
Burton Malkeil ............................................................... 124
Charles Ellis ................................................................... 125

Summary ....................................................................... 127

Module Review ............................................................ 129


Questions ....................................................................... 129
Answers.......................................................................... 144

References ..................................................................... 163

Glossary ........................................................................ 165

Appendix ....................................................................... 170


Investment Characteristics Matrix ............................. 170

Index .............................................................................. 173


Introduction

T
he modern investment professional can offer clients a menu of
investment products that would make investment professionals of
past generations envious, if not confused. Fifty years ago, the
product universe for brokerage firms and their representatives was
essentially limited to stocks and bonds. Even within these two important
classes of financial instruments, choices were limited. Today, broker-
dealers offer life insurance, real estate and oil and gas partnerships,
brokered bank CDs, mortgage-backed securities in many forms, options,
and an array of mutual funds and ETFs to suit every conceivable
objective.

While these innovative vehicles provide new ways to serve clients, the
proliferation of financial products has been a mixed blessing. For
investment professionals, being knowledgeable about these many classes
of assetsincluding their market behavior and performance, risks, and
marketabilityis one challenge; mixing them together into portfolios that
serve the clients investment objectives and need for diversification is yet
another.

At the same time that the universe of financial products was expanding,
knowledge about the investment performance of different classes of
assets was being developed, as were the financial theories, which today
form the foundation of securities analysis and portfolio management.
Thus, two developments were under way: one being a methodology for
evaluating individual securities and the other being the quantitative
methods for managing classes of assets within portfolios. Today,
knowing how to select investment assets and being able to group them
into coherent portfolios are major tools for the investment professional;
and the broad menu of investment products available are the raw
materials to which those tools are applied.

Introduction 1
1996, 20022011, College for Financial Planning, all rights reserved.
Total return data and information on the volatility of stocks, bonds, and
T-bills have been compiled for various time periods, reaching back to the
1920s. Are you familiar with the relative returns and risks of these
investment categories? Are you using this information to educate and
assist your clients? The practice of asset allocation includes several
approaches. Are you familiar with them and the methods for selecting
securities as part of the asset allocation process?

This module describes the rationale and methods for allocating client
funds across different classes of assets, with the final objective being
superior risk-adjusted returns. It also provides a review of the many
different types of securities and investment vehicles found in those asset
classes in terms of their investment characteristics, risks, and historic
performance. Finally, it describes the methods used for selecting
individual securities.

The chapters in this module are

Asset Allocation

Asset Classes, Characteristics & Performance

Stock Valuation Methods

Bond Valuation Methods

Fundamental Analysis

Technical Analysis & Market Timing

Upon completion of this module, you should be able to understand


characteristics of major asset classes and principles of asset allocation, asset
valuation, and investment analysis.

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To enable you to reach the goal of this module, material is structured
around the following learning objectives:

41 Identify suitable allocation principles for individual accounts.

42 Identify the returns of major asset classes over various time horizons.

43 Calculate potential returns of client portfolios.

44 Identify approaches to asset allocation.

45 Identify characteristics, potential risks, and performance of various


assets available to fulfill the asset allocation policy.

46 Calculate a common stock value using established valuation


methods.

47 Explain how time value of money concepts apply to bond valuation.

48 Identify factors affecting the market value of bonds.

49 Explain the terminology and concepts of fundamental analysis.

410 Describe a working definition of technical analysis.

411 Describe the results of major studies regarding technical analysis


and the larger issue of market timing.

Look for the boxed objectives throughout this module to guide your
studies.

Introduction 3
1996, 20022011, College for Financial Planning, all rights reserved.
4 Asset Allocation & Selection
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Chapter 1
Asset Allocation
Reading the first part of this chapter will enable you to:

41 Identify suitable allocation principles for individual accounts.

This chapter explains the concept of asset allocation and its theoretical
underpinnings.

T
he investing public has looked to investment firms, their analysts,
and their investment professionals for two skills: securities
selection and when to buy or sell securities. Virtually all New
York Stock Exchange firms have research departments charged with
finding and reporting on stocks that are either underpriced or overpriced
by the market. Investment opportunity is represented in these mispriced
situations. Many investment professionals do some level of their own
research, particularly with respect to small, local companies that have not
yet gained the attention of the research community.

At the same time, the public looks to investment professionals for advice
on the timing of their buys and sells. Is this a good time to be loading up
on stock? Should I be taking a profit on these bonds? Market timing
questions are almost always a part of the clients conversation with his or
her investment professional. One key concept regarding asset allocation is
never put so much of ones portfolio in one investment so that, in the event that
investment collapses, a persons lifestyle is affected. This concept was
illustrated in recent years where various companies went bankrupt and
employees who had most or all of their retirement funds in their
companys stock suddenly found their plans for retirement drastically
changed. Many investment advisors recommend no more than 10% of
ones portfolio in their companys stock.

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Asset allocation is one of the most important considerations in investing
because the asset allocation of a portfolio determines its risk/return
characteristics. With the large losses that occurred in 2008, some people
asserted that asset allocation does not work because almost everything
fell in price. While most types of securities did have significant negative
returns, there were positive returns in cash equivalents (albeit small) and
Treasury securities. If these two categories each made up, say, 50% of a
portfolio, they could have had a major impact in preventing large losses
to a portfolio. Mitigating losses not only keeps emotions in check, but also
results in less time needed to recover the losses caused by a bear market.
Therefore, a case can be made that asset allocation is as important as ever,
with the key being the right mix of assets. Diversification of asset classes,
then, should be thought of as a risk-reducing strategy to lessen the risk of
large portfolio losses.

Obtaining the right mix is difficult because having a variety of asset


classes means that one or more of them will usually be a drag on portfolio
performance. For example, assume a portfolio of stocks, bonds, and cash
equivalents. When the stock market is rising, the lower returns from
bonds and cash will hinder performance. When the stock market is
declining, the returns from stocks will hinder performance. The natural
reaction is to put money in the asset classes performing the best. In
addition, there is the tendency to not want to rebalance out of a category
that is doing well. For example, in October 2007 when stock markets were
reaching new highs, it would have been difficult to convince investors to
sell off stocks and put the proceeds into Treasury securities or a money
market mutual fund, yet such rebalancing would have proven to be a
wise move.

Asset allocation, of course, would be easy if investors had the foresight to


select the best-performing asset class in the coming year. All of ones
financial assets would go into that category to obtain the highest returns.
Unfortunately, predicting market movements is very difficult, and the

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top-performing assets one year can be the worst or nearly the worst in the
next year.

For example, Callan Associates ranks annual returns from nine asset
categories:

the S&P 500 index,

S&P/Citigroup 500 growth,

S&P/Citigroup 500 value,

the Russell 2000 index,

Russell 2000 growth,

Russell 2000 value,

the MSCI EAFE index,

MSCI emerging markets index. and

the Barclays Capital (formerly Lehman Brothers) Aggregate Bond


index.

A review of this data shows significant changes in these rankings over


time and from year to year. For example:

For 1995 through 1998, the S&P/Citicorp 500 growth index is the top-
performing financial asset; it is second best for 1999. However, for
2000 through 2006, this category is second or third from the bottom.

For 1999, the Russell 2000 value index has the lowest return from
eight categories, but has the best return in 2000 and 2001. At the same
time, in 1999 the MSCI emerging markets is the best performer,
quickly becoming the worst for 2000.

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For 2002, the top-performing asset class is the Barclays Capital
Aggregate Bond index; yet in 2003 through 2006, that asset class ranks
the last of eight categories.

For 2003 through 2007, the MSCI emerging markets index is the
highest-ranking category; however, in 2008 it is the lowest-ranking
category. Then, in 2009, it is the best category.

For 2008, the Barclays Capital Aggregate Bond index is at the top in
performance of all categories; but in 2009 and 2010 it is in last place.

There are many other examples of these types of changes in returns from
year to year. Some investors believe they can time market movements;
however, in order to do this, those investors would have to be able to
predict most of the changes in returns shown above. This is a very
unlikely event, especially with the tendency of investors to buy into
investments after their prices have moved up. The point is that market
timing of asset categories is virtually impossible over any length of time
(though short-term predictions have the greatest chance to be correct
when good analysis, momentum investing, or simply good luck are
involved). Instead, investors should have various asset categories in their
portfolios to be in a position to benefit from those higher performing
assets. Even in 2008, when most asset categories delivered double-digit
negative returns, even a 1.8% return from a money market mutual fund
looked good.

It is important to remember that the asset allocation of a portfolio should


be tailored to the individuals goals, needs, preferences, and individual
circumstances. As such, the asset allocation models often seen in financial
magazines, while interesting in a general sense, should not be directly
applied to individual clients; that is, if an asset allocation model in a
financial magazine, for example, recommends a stock/bond allocation of
60%/40% for someone between the ages of 50 and 60, a client in that age
range should not automatically be switched to the 60%/40% ratio. This

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ratio might be used as a starting point but then altered depending on the
clients situation. However, there are some general principles that should
be kept in mind.

In most cases, as a person ages, the portfolio should become more


conservative, with a lower allocation to stocks and a higher allocation to
bonds. In addition, the quality of the securities in the portfolio should
increase as the clients age increases. That is not to say that the quality of
securities for a young investor should be low, but rather that some
speculative stocks are more appropriate for younger investors who
generally can take more risk than older investors who have less time to
recover losses that might come from these lower-grade investments.

A person retiring at age 65 in good health has a life expectancy of over 20


years, so some allocation to stocks would be appropriate to counter
purchasing power risk. A major risk and concern for a retiree is outliving
his or her financial resources. This is called longevity risk. One situation
that increases longevity risk is to have a large part of the portfolio in
stocks and encounter a major bear market shortly after retiring. Such a
sudden, large loss to a portfolio can impact a retirees financial well-being
for the rest of his or her life. One measure to protect against this is having
three to five years, if possible, of living expenses in safe investments, such
as 1-yearstaggered maturities in Treasury notes or certificates of deposit.
These can be used to pay these living expenses rather than having to sell
stocks at depressed prices. The disadvantage of this strategy is the
relatively lower returns from these securities but that is the trade-off for
capital preservation. A three- to five-year time frame usually would be
sufficient to ride out a bear market.

Another measure to counter longevity risk is using fixed annuities that


pay over the lifetime of the retiree. A portion of the portfolio could be
allocated to low-cost fixed annuities from high-quality life insurance
companies that will pay a fixed dollar amount for as long as the retiree
lives. Of course, being a fixed dollar amount, these payments are subject

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to purchasing power risk, which itself can be countered with some
allocation to high-quality common stocks. There are now, however,
annuities that increase their payouts with inflation. The payout on
immediate fixed annuities is tied to current interest rates so, if possible, it
is best to initiate a payout during periods of relatively high interest rates.

Key questions for retirees are:

1. How much of a portfolio should consist of stocks?

2. What should be the withdrawal rate (the percentage of the portfolio


withdrawn each year)?

A reprinted article in the March 2004 Journal of Financial Planning


(Bengen) addressed the question of how long an investors money would
last assuming certain withdrawal rates and certain stock/bond
allocations. The study assumed withdrawals beginning between 1926 and
1976, with special attention to periods that included major bear markets.
Bengen makes a strong argument that with a 4% withdrawal rate and
50% to 75% of the retirees portfolio in stocks (with the remaining part of
the portfolio in intermediate-term Treasury notes), the money in the
portfolio will not run out in any 30-year period. Such an allocation to
stocks at first glance seems high, but Bengens studies came to this
conclusion (it is suggested you read this article and draw your own
conclusions). The overriding consideration of managing a retirees
portfolio is balancing the needs for cash flow (which might include some
principal as well as investment income), capital growth, and capital
preservation.

Despite the time and effort given to securities selection and market
timing, doubts about their efficacy have circulated for decades. As early
as the 1960s, academics challenged the value of equities research with the
efficient market hypothesis, which stated that, at least for U.S. equities
markets, bargains could not be found on any consistent basis. All of the

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important information about a companys performance and prospects
was already reflected in the market price of its shares. Scholarly opinion
on the value of market timing has been even more negative. Nevertheless,
stock picking and market timing continue to play an important role in the
investment professional-client relationshipjust as they do in the world
of institutional money management, where both the managers and their
clients are thoroughly conversant with academic opinion.

The Brinson Study


A major landmark in the debate over how money should be managed
both for institutional and individual accountsoccurred in 1986 with the
publication of Determination of Portfolio Performance by Brinson,
Hood, and Beebower (1986), in which they reported the results of a study
of the performance of 91 large pension funds over a 10-year period (1974
through 1983). Brinson and his colleagues sought to explain the
differences between the performance of these 91 funds in terms of their
investment practices, which fell into three categories:

1. Security selection. Each fund was professionally managed by


experienced individuals making individual securities selections.

2. Market timing. Each fund moved from equities to bonds, to cash in


response to what the managers perceived to be impending changes in
market conditions.

3. Asset allocation policy (called investment policy in the study). Each


fund had a policy as to the positioning of its assets in terms of the
categories of assets in which it would invest, and in terms of the
proportions that would be allocated across these categories.

Using statistical methods to sort the contribution of each of these


activities, the Brinson study concluded that, on average, 93.6% of the
variance between total returns of these large pension funds was attributable

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to how they allocated their assets. Securities selection and market timing
counted for very little. Brinson and his associates found confirming
evidence in another study, this time of 82 large pension plans between
1977 and 1987. Once again, the data indicated that asset allocation policy
was the overwhelmingly dominant contributor to total return, and that
active securities picking and market timing by plan managers did little to
improve performance (Brinson, et al. 1991).

Brinsons findings have formed the basis for the practice of asset
allocation in dealing with client investments. Asset allocation is the
process of distributing portfolio investments among various asset
categories: equities, cash equivalent investments, bonds, real estate,
foreign securities, and, in some cases, precious metals.

Implications for Investment Professionals


and Their Clients
Some individuals in the investment profession must surely find Brinsons
conclusions disconcerting. Coupled with the efficient market hypothesis
and the growing body of evidence that market timing is not effective, the
Brinson studies must lead many investment professionals to ask: If these
studies are valid, how do I add value to my clients investment
decisions? The answer is to direct more energy and attention to the part
of the investment process that produces the greatest payoff for the client
(the asset allocation decision) and less energy and attention to those parts
whose contributions to the investment process are less productive
(securities selection and market timing).

Here, more time and effort need to be spent on determining the


investment objectives of the client and what balance of stocks, bonds, real
estate, or other investments will best serve those objectives; less time
should be spent on forecasting earnings for particular companies. Client
counseling and education also become more important.

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An investment strategy in which the asset allocation decision is pivotal
implies a larger role for the client. Merely acquiescing to or rejecting ideas
put forward by the investment professional is insufficient; rather, the
client must be explicit about personal investment objectives and risk and
liquidity concerns over a longer horizon. When discussing risk, it is
important to remember that, during a bull market, most clients believe
they can handle higher risks in their portfolio; when a subsequent bear
market occurs, those clients often discover that they actually are not
willing to take those higher risks.

Asset allocation policy is not, as we will soon see, a useful way of


managing money for short-term profits. It is most effective when the
client takes an active role in learning about the major classes of assets and
in working with the investment professional in developing an allocation
policy to guide future investment decisions. Securities selection and
market timing play a role in this process, but to a much lesser extent.

Is Diversification Dead?
After the bear market between October 2007 and March 2009, some financial
professionals raised the question, Is the concept of diversification dead? It
seemed as if the price of most asset categories were down; and, in many
cases, those categories were down significantly. Based on the experiences of
that period, the idea of international stocks providing portfolio
diversification was shaken as those stocks fell even more than U.S. stocks.
Likewise, commodity ETFs and especially long-only commodity ETFs
(another expected diversifier) fell in price as the weakening global economy
lessened the demand for commodities. Real estate prices, whether in the
form of REITs or actual properties, also fell significantly.

However, there were asset classes that did not go down even in this worst
economic period since the Great Depression. Of the three basic asset
classes (cash equivalents, bonds, and stocks), only stocks, in general, were

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down. (Although high-yield bonds, which tend to follow stock prices,
were also down.) This can be seen using selected Vanguard funds, for the
year ended December 31, 2008:

Fund 2008 % gain (loss)


Prime money market 2.77
Intermediate-term bond index 4.93
Intermediate-term Treasury 13.32
High-yield corporate (21.29)
REIT index (37.05)
Total stock market (U.S.) (37.04)
Total international stock index (44.10

The table shows that money market funds preserved capital as expected.
Although the 2.77% return on money market funds was a small return,
that was, of course, much better than losing over 37% (total stock market
return). Bonds of high quality also provided a positive return and
preserved capital. This was especially true for Treasury securities funds
as investors were in a flight to safety. However, high-yield bonds, which
tend to follow the performance of stocks more than higher quality bonds,
performed poorly as investors sold off risky assets.

In conclusion, both cash equivalents and bonds (generally) performed


reasonably well, while stocks performed very poorly. Therefore, even in
that period of financial crisis, two of the three categories provided
diversification for a cash/bonds/stocks portfolio. Of course, a key issue is
the proportion of these three categories. That is how a good financial
adviser provides value to their clients, not only in helping the client
determine the right allocation, but also with monitoring and rebalancing
those choices.

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Returns of Major Asset Classes Over Time
Reading the next part of this chapter will enable you to:

42 Identify the returns of major asset classes over various time horizons.

The asset allocation approach to investing is based upon the fact that
different broad categories of investments have, over time, exhibited
different rates of return and different levels of price volatility. These
differences are documented in Table 1, which illustrates data from the
beginning of 1926 through the end of 2010 for the asset classes indicated.
In the table, company size refers to capitalization (cap), which is the
total number of shares outstanding times the price per share. The
geometric mean return is the same as the compound rate of return.

Table 1: Summary Statistics of Annual Total Returns


Geometric
Mean Standard
Asset Class Return Deviation

Large-company stocks 9.9% 20.4%


Small-company stocks 12.1% 32.6%
L-T corporate bonds 5.9% 8.3%
L-T U.S. government bonds 5.5% 9.5%
Intermediate-term U.S. government bonds 5.4% 5.7%
U.S. Treasury bills 3.6% 3.1%
Inflation 3.0% 4.2%
Source: Ibbotson SBBI 2011 Classic Yearbook. Used with permission.

The above data is based on the following information:

S&P 500 (large-company),

primarily the smallest NYSE stocks (small company),

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maturities near 20 years for long-term corporate bonds and long-term
U.S. government bonds,

maturities near five years for intermediate-term U.S. government


bonds, and

approximately 30-day maturities for Treasury bills.

The Ibbotson data helps financial advisors and investors keep their
perspective about the long-term returns of major asset classes and about
the relative relationships of long-term returns and long-term risk levels,
as measured by standard deviation.

The following provides a brief discussion of the investment classes


typically employed in the asset allocation process.

Treasury bills. Treasury bills, the safest asset on this list, return a
compound annual growth rate of 3.6% over this long period. It is
important to note that, after taxes, the portfolio values for most clients
would have lost ground to inflation, which grew at a compound rate of
3.0%if they had allocated all their assets to this category.

Long-term government bonds. This category, with a compound rate of


return of 5.5%, outperforms T-bills by a margin of 1.9%. While this may
not seem like much, compounding $1 over an 85-year period at 5.5%
equals $94.72. Compounding 3.6% over that same 85-year period equals
$20.21. The power of compounding can be easily seen when comparing
these two returns, where a 1.9% difference in returns is almost four times
the dollar difference over that period.

Corporate bonds. These did somewhat better than the government bonds,
as one would expect, owing to their greater credit risk. These bonds
provided a total annual compounded return of 5.9% over the period
covered.

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Large-company stocks. Large-company stocks produced a 9.9% annual
compounded return over the period of the data. Compounded over 85
years, $1 would have an ending value of $3,053.54, a dramatic difference
from the $20.21 for Treasury bills. This clearly shows that, long term,
being an owner (that is, being a stockholder) is much more profitable
than being a short-term lender (by owning T-bills). This also
demonstrates that there is a long-term risk of being too conservative by
investing only in safe assets. It also supports Brinsons finding that
asset allocation is the major determinant of portfolio performance.

Intermediate-term U.S. government bonds. Intermediate-term


government bonds provided a return of only 0.1% less than long-term
government bonds, but with a significantly lower standard deviation. For
this reason many investment advisors recommend intermediate
government bonds rather than long-term government bonds.

Small-company stocks. These securities posted a 12.1% compounded


growth rate during the study period, with $1 compounding to $16,461.79,
significantly better than the return of large-company stocks. This does not
mean that there will not be periods of several years when large-company
stocks will be the better performers (such as 1995 through 1999). It does
mean, however, that over long periods of time, investors who maintain a
significant allocation in small-company stocks and funds can expect to
have portfolios that perform better than if they had been left out. This
category does have a much higher standard deviation (risk) than the
other categories as will be discussed in more detail later.

Non-U.S. stocks. It is difficult to generalize about the performance of


non-U.S. stocks, as the term takes in the emerging and inefficient markets
of developing nations and the established markets of Japan and European
industrial nations, which have tremendous breadth and depth.
Performance data from January 1970 through December 2010 was
obtained from Ibbotson Associates and is shown in the table below. The
Europe, Australasia, and Far East (EAFE) index, which was developed in

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late 1969 by Morgan Stanley Capital International, is a common index
used for international stocks. Because almost 25% of its weighting is in
Japanese stocks, some investors feel it is not an adequate index to
represent the performance of international stocks.

Once the domain of sophisticated institutional money managers, the


growing number of international mutual funds has made this asset
category accessible to the retail investment professional and his or her
clients. Recent studies have indicated that international stocks may not
offer as much diversification as commonly thought. Nevertheless, small-
cap international stocks seem to provide more diversification than large-
cap international stocks because the latter are more closely tied to the
global economy. Also, they still provide investment opportunities beyond
those in the United States. As we will see later, this category has
characteristics aside from strictly total return that make it useful to the
practice of asset allocation.

Real estate (equity REITs). The total return of real estate, like that of
foreign stocks, is likewise difficult to assess in that it takes in assets in
many forms in many locations. One measure of performance is the rates
of return based on data on the Web site of the National Association of
Real Estate Investment Trusts (NAREIT) in the table below for the period
January 1, 1972, through December 31, 2010 (for comparison, the S&P 500
index and EAFE for the period 19702010 is provided):

S&P 500 index (19702010) 10.0%

EAFE index (19702010) 10.1%

Equity REITs 12.0%


Sources: Ibbotson SBBI 2011 Classic Yearbook; National Association of Real Estate
Investment Trusts (www.nareit.com)

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The Variability of Returns
Anyone experienced in the investment business understands the
relationship between return and riskthe latter being expressed as the
variability of returns and measured by standard deviation. This
understanding does not, however, extend to all clients, many of who
expect their investment professionals to put them into an investment with
the return of small stocks and the variability of T-bills.

Ibbotson calculates the standard deviation for the asset categories in their
data, which is shown in Table 1. (For the period between 1970 and 2010,
the standard deviation for EAFE is 22.8%; it is 17.9% for U.S. stocks.
Between 1972 and 2010, the standard deviation for equity REITs is 18.9%)
The standard deviation of each asset category provides a picture of the
extent to which actual annual returns fall nearer or farther from the
average. Thus, T-bill returns fall in a narrow band around the average;
small stock returns are all over the mapsometimes well below average,
sometimes well above average.

An important point is worth noting here: greater returns come with


greater risk (variability of returns). One implication of an asset with
greater return variability (higher standard deviation), such as common
stocks, is that in any given year the possibility of a loss is more likely than
with an asset with low variability, such as Treasury bills.

What does standard deviation tell us, aside from the obvious notion that
assets with higher standard deviations are riskier? Actually, we can read
more into the number. If the standard deviation of common stocks is 20%,
for instance, and the compound mean for returns of this asset class is
11%, we can determine an upper end for returns by adding 20% and 11%
to get 31%. The lower end is 11% minus 20%, or 9%. The upper and
lower figures (+31% and 9%) constitute a range within which, according
to statistical theory, about 67% of all the common stock returns are likely
to occur. The probability is about 33% that a given year will produce a

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return for common stocks that is either higher than +31% or lower than
9%. Furthermore, 95% of the returns will fall within two standard
deviations and 99% of returns will fall within three standard deviations.

The Critical Importance of Time Horizons in


Asset Allocation
Given the superior performance of common stocks, why does anyone
invest in bonds, T-bills, and similar debt instruments? This is a question
some people asked at the end of 1999. The answer is clear to most
investment professionals: the fear of volatility and loss of principal. The
client whose funds are earmarked for a down payment on a home or a
college tuition payment two to three years hence may legitimately be
concerned with the possibility that stock prices would be depressed just
when he or she needs the moneythe greater potential return of stock
notwithstanding. On the other end of the spectrum, the person who
retires in good health at age 60 with a large nest eggand says that he
must invest in government bonds because he cannot afford to lose
principalmay be losing purchasing power over his remaining life
span. Taxes, inflation, and the consumption of fixed interest payments
will steadily eat away at the purchasing power of his nest egg. In other
words, a major risk in the short term is holding investments that might
fall in value just when the money is needed for a financial goal. Likewise,
a major risk in the long term is being in safe investments whose returns
do not overcome the effects of taxes and inflation. We can then
characterize the time-related considerations of traditional investment
categories as shown in Table 2.

Table 2: Time Horizons and Investment Considerations


Short-term
Investment Category Considerations Long-term Considerations
Stocks Loss of principal Great potential for gain
Debt investments Safety of principal (high grade, Erosion of purchasing power
short-term debt in particular) by taxes and inflation

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Some investors with goals that have long time horizons look at the higher
returns from stocks and conclude that that is where they will put all of
their money regardless of the higher volatility of stocks. The problem
with this thinking is that in a bear market it is easy to get caught up in the
widespread fear that stocks will continue to go down. Riding out a bear
market seems like it would be relatively easy to do, knowing that stocks
eventually will rebound. This was especially true when stocks were doing
well, such as in the 1990s, when any correction was an opportunity to buy
stocks that would go up later. However, many of todays investors have
now experienced a true bear market during 20072009 and realize that
stocks do not always just go up. History suggests that many, at some
point in a bear market, will become discouraged and sell stocks before the
market turns upward again. In other words, even though common stocks
are right for long-term goals, if client portfolios have volatility that
exceeds the clients ability to tolerate risk, it could lead to bad investment
decisions. For this reason it is important to construct the clients portfolios
with volatility in mind and within their risk tolerance levels so they will
not sell near the bottom of a bear market. At the same time, low volatility
investments can protect the portfolio to some degree against the bear
market and provide cash flow during the time needed for stocks to
rebound.

As a guideline, the time frame for a goal should be five years or longer
when common stocks for that goal are used (However, due to the 200709
bear market, some investment advisors are now using 10 years as a
guideline). Nevertheless, keep in mind, however, that there have been
periods when U.S. stocks went several years with low returns. For
example, in the 10-year period ending December 31, 2009, the S&P 500
index had a total return of 9.95%. During the same time frame other
asset classes, notably bonds, performed better. During that time, the BC
Aggregate Bond index was up 6.33%, illustrating another reason for a
diversified portfolio.

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Regarding debt instruments, as will be explained later, the shorter the
bonds years to maturity, the more likely the objective of safety of
principal will be met. For example, a 3-year bond will have more safety of
principal than a 10-year bond, which, in turn, will have more safety of
principal than a 20-year bondassuming the credit quality of each bond
is high. A short-term bond will not only fluctuate less in price but, for
corporate and municipal bonds, also be less likely to be affected by
changes in credit quality over that short period of time. If the time frame
for a financial goal is one year or less, the most appropriate investment
will be one with little, if any, fluctuation, such as a money market
instruments or a money market fund.

In dealing with clients, these issues should be addressed before beginning


any discussions about allocating their funds. The investment professional
should determine the clients time horizon and be attentive to whether
the clients concerns are rational or off the mark. If the client has a long-
term horizon but a misplaced concern for current volatility, some
education by the investment professional is in order. Volatility of stocks,
in particular, should not be a major issue for this investor if the investor is
properly diversified among different industries and specific issues. In
fact, volatility of a diversified portfolio, over time, works to the advantage
of the investor because over time that volatility is in an upward direction.
Investment advisor Roger Gibson, who has done much work in asset
allocation techniques for the individual investor, made the following
comment:

A proper understanding of time horizon issues can dramatically


alter a clients risk tolerance. It is my experience . . . that many
investment issues for clients involve a misperception of risk. The
client with a long time horizon must be provided with an
appropriate frame of reference regarding investment
performance, a rational basis for understanding that stocks go up
and down and that broad market common stock losses are not
permanent, that time is on their side to weather through the

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volatility, and that their biggest risk may be inflation
(Gibson 1990, 92).

Helping the client to think logically about two major risksprice


volatility and the erosion of purchasing power by inflationand how to
protect against both is one of the important ways that investment
professionals can add value to the clients investment experience. It also
produces an important ingredient in the asset allocation decision process.

Related Theory
The preceding materials suggest that, based upon the clients investment
objectives and tolerance for volatility, funds should be allocated to one or
more categories. These categories may include the following:

small-cap common stocks,

mid-cap common stocks,

large-cap common stocks,

international stocks,

real estate,

international bonds,

corporate and/or government bonds, and

short-term debt instruments such as T-bills and bank CDs.

Nontraditional asset categories, such as commodities and precious


metals, could also be legitimately considered. Before discussing how to
help the client develop a policy for allocating funds across these different
categories, it is worth reviewing some of the principles underlying
portfolio management. (You may want to refer to the previous module,
which offers a more complete discussion of this subject.)

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The Diversification Effect
Diversification is the act of acquiring assets that have different risk
characteristics, react differently to a given economic scenario, and whose
returns increase or decrease at different times and to different degrees.
Companies can succeed or fail on the basis of their products,
competitiveness, and management. This uncertainty of the companys
future represents a business risk to shareholders. There is no avoiding
this risk if we own shares only in one company. But even within a portfolio
of one asset category, purchasing many different issues reduces the chance
of a single issue causing havoc with the entire investment. In a portfolio
composed entirely of stocks, for example, the purchase of many issues
representing different industries reduces the portfolios business risk. The
good fortunes of some companies will likely balance the misfortunes of the
small proportion that experience difficulty. Unfortunately, however,
when the tide goes out, all the boats go down. A general decline in the
economy tends to send the entire stock market into decline, depressing the
share prices of good companies and bad. This is market risk, one type of
systematic risk that cannot be reduced through diversification.

Correlation
Investors can diversify away some of this systematic risk by putting some
of their assets into a different system, in this case, a category other than
the U.S. stock market. That system might be debt securities, precious
metals, real estate, or foreign securities. The extent to which this second
level of diversification reduces risk for the investor depends upon the
extent to which the two categories are affected by the same economic and
supply-and-demand forces, that is, the extent to which the two categories
are correlated. Two investments are said to be correlated if their rates of
return tend to move together. This same concept applies to assets within
the same system, such as common stocks. Here, the returns of companies
within the same industry may move together, while returns of companies
in very different industries might move quite differently. For example,

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we would expect the shares of all electric utility companies to have strong
positive correlations. As heavy borrowers, utilities are interest-rate
sensitive. If the economy strengthens, and, as a result, interest rates rise,
utility stocks are likely to fall, but cyclical stocks are likely to rise due to
the economic improvement. The shares of an electric utility company and
a capital equipment company, then, would likely be negatively, or at least
weakly, correlated.

Table 3 is a selective display of some major asset categories, indicating the


extent to which their returns are correlated over the long term. A value of
1.00 is a perfect correlationmeaning that these two categories move up
and down in perfect harmony. A value of 1.00 indicates that the two
move in completely opposite directions. A value of 0.00 indicates no
relationship one way or the other. Most practitioners view anything
between 0.00 and 0.50 as a very weak correlation between two
investments, making them suitable assets to include together in a
portfolio. Among statisticians, this figure is referred to as the correlation
coefficient. The correlation coefficient measures the association between
the returns of assets, and it ranges in value from +1 to 1. Knowledge of
these correlations is valuable in the execution of effective asset allocation.
(These categories are the same as was defined under rates of return
previously.) Also, the equity REIT correlations are for the period 1972
2010.

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Table 3: Correlation of Returns Among Asset Classes (19702010)
Inter.-
Large Small L-T L-T term
Intl. co. co. Equity Corp. Govt Govt
stocks stocks stocks REITs bond bond bond T-bill Inflation
Intl. 1.00
Stocks
Large co. .66 1.00
stocks
Small co. .49 .71 1.00
stocks
Equity .N/A .57 .79 1.00
EITs
L-T Corp. .06 .29 .13 .24 1.00
bond
L-T Govt -.08 .08 -.07 .00 .89 1.00
bond
Inter.-term -.14 .08 -.08 00 .88 .91 1.00
Govt
bond
T-bill -.05 .09 .01 -.01 .03 .08 .32 1.00
Inflation -.10 -.10 .04 -.04 -.39 -.34 -.16 .65 1.00
Source: Ibbotson SBBI 2011 Classic Yearbook. Used with permission.

Effect of combining different asset classes. The correlation values in


Table 3 suggest the extent to which different categories of investments
interact within a clients portfolio. Clearly, L-T govt bond returns are not
correlated with those of large-cap common stocks (.08). So, if stock
returns were increasing, for example, the returns on these bonds would
not necessarily also be increasing. This has some logic because if stocks
are increasing, inflation might be increasing somewhat due to a stronger
economy. If inflation is increasing, even modestly, interest rates are
increasing so bond prices will decrease to some degree.

Because of this very low correlation, L-T govt bonds would be


considered a good asset with which to diversify a portfolio of stocks,
which proved to be the case in 2008. Remember, however, these
correlations are based on past returns over almost 30 years so there is no
certainty that this relationship will exist in any given future year.

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However, it is likely that at least a low correlation would exist in the
future and therefore L-T bonds could be expected to diversify a stock
portfolio.

Correlations do not have to be negative to provide diversification in a


portfolio. Any correlation less than +1.0 will increase diversification, but
the larger the difference from 1.0, the more the diversification effect. The
above table shows a low correlation between stocks and bonds. Often, but
not always, bond and stock returns move in opposite directions. Interest
rates typically fall during economic downturns. If economic conditions
deteriorate, earnings decrease, causing stock prices to decrease. Falling
interest rates, however, generally causes bond prices to increase. For
example, during the years 2000, 2001, and 2002, when stock prices fell,
high-grade bond prices increased, due to falling interest rates. In 2007
2008, interest rates also decreased, but only U.S. Treasury securities
increased because of credit concerns with municipal and corporate bonds.
Therefore, just because interest rates fall does not mean that all bond
prices will increase if there are worries that certain bonds have greater
credit risk.

Notice the negative correlations between bonds and inflation. This is not
surprising because bond prices (and therefore returns) react negatively to
increases in inflation. Also note the absence from this matrix of strong
negative correlationsin the range of 0.50 to 1.00. In practice, it is very
rare to find assets that have strong negative correlations. Instead,
diversification is implemented by combining assets with minor negative
correlations, or even low positive correlations.

Lastly, there is a tendency for asset correlations to increase during bear


markets. As someone has said, in a market crash the only thing that goes
up is correlations. This was illustrated during the 2008 bear market when
most asset classes fell in price. While Treasury securities went up in price
due to a flight to quality, most other bonds fell in price. Both corporate and
municipal bonds experienced price declines with the lower-rated bonds

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falling the most. The lesson from 2008 was that the best diversifiers were
Treasuries and cash equivalents.

Practicing Asset Allocation


Reading the next part of this chapter will enable you to:

43 Calculate potential returns of client portfolios.

So far in the discussion, the foundation concepts have been given for asset
allocation; namely, how different classes of investment assets behave
individually, as well as together in portfolios. But how is asset allocation
practiced? The first step in this process is to develop an asset allocation
policy. This policy will determine the overall risk/return relationship of
the clients portfolio, rendering it critically important and worthy of much
thought and discussion with the client. Asset allocation needs to be
developed with a long-term perspective. Too many investors concentrate
on the short term, chasing what is currently in favor, usually with poor
investment results.

For example, in 1999, when stocks were performing extremely well, most
investors would have resisted adding bonds to a portfolio; bonds would
have curtailed short-term portfolio performance and, therefore, would
have appeared to be a big mistake. However, the time to rein in market
risk in a portfolio is when the bull market rages. By 2003, such a change
would have had positive effects on the portfolio, as the bonds would not
only have reduced risk, but increased the return of the portfolio as well as
interest rates fell. Helping a client establish an appropriate long-term
asset allocation policy, while emphasizing its importance, can be an
important way by which the investment professional adds significant
value for that client.

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It is worth noting, however, that no less an authority than Warren
Buffett's teacher, Benjamin Graham, in his classic book, The Intelligent
Investor, thought that a roughly even split between stocks and bonds at
virtually all times was the prudent course for the vast majority of
investors. Any more than half of one's assets exposed to stocks seems to
cause inordinate pain in precipitous and protracted market downdrafts,
while any less than half of one's assets exposed to stocks seems to cause
inordinate envy and greed during market surges. The former encourages
selling near bottoms, while the latter encourages buying near tops: two
classic forms of investor bad behavior.

Asset allocation policy determines both the categories of investments


suitable for the clients portfolio and the percentage of funds that should
be assigned to each. In this step, two decisions must be made:

Decision 1. What assets should become part of the clients investment


mix? This decision goes back to the risk/return characteristics for each
category of investments, the clients risk tolerance, the clients time
horizon, and any particular needs for the client to receive regular
investment income. The asset decision should be made in close
consultation with the client. The asset allocation policy is not to be
made casually or without the cooperation of the client, as it is to be the
general framework for managing the clients funds over a long period.

Decision 2. What weights should be assigned to each asset category?


Given that there are between three and six likely asset categories and
that there are numerous possibilities for weighting each, thousands of
potential allocations are possible. The question is, Which allocation
scheme is best for the client? One of the worst strategies to follow is
to chase performance and, therefore, increase allocations to those
investments with the highest returns for the past year. There are
myriad examples of this; one of the more recent is when investors
were heavily buying Treasury securities in 2009 after their run-up in
2008. Long-term Treasuries were down about 17% in 2009.

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While, in general, investors with 20 years or more until retirement are
heavily in stocks, Decision 2 becomes more difficult as the asset allocation
must serve two contrary risks:

1. protect against market risk by having low volatility fixed-income


securities, and

2. protect against inflation risk with stocks.

In addition, the asset allocation can be fine-tuned with factors specific to


the individuals circumstances. If a person has reliable sources of income
beyond their investments and/or longevity runs in their family, they
might invest more in stocks. If they already have a large nest egg or they
will need to use their assets for another goal other than retirement, they
might invest less in stocks.

Table 4 proposes a number of hypothetical portfolios, with A being the


most conservativethat is, the least subject to principal fluctuationand
C being the most aggressive. For purposes of illustration, the decision has
been made to limit the number of asset categories to three. The weights
are assigned in the figure.

Table 4: Hypothetical Portfolios


T-bills Corporate Bonds Large-cap Stocks

Portfolio A 100% 0% 0%
Portfolio B 20% 30% 50%
Portfolio C 0% 0% 100%

Both the expected return and volatility of each portfolio can be calculated
using historic data about the category. The reliability of these calculations
will depend, of course, on how closely the future resembles the past. Just
as an example, consider Portfolio B. Its expected return is calculated as
follows:

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Expected return =

Sum of each percentage weight Expected return of each asset category

or

Expected return = .20 (3.6%) + .30 (5.9%) + .50 (9.9%) = 7.5%

Intuitively, we would like to estimate the expected volatility of a portfolio


in the same way, simply substituting historic standard deviation for
historic total compounded return. Thus, for Portfolio B:

Expected volatility = .20 (3.1%) + .30 (8.3%) + .50 (20.4%) = 13.3%

Unfortunately, this is not feasible except in the theoretical case where all the
assets in the portfolio are perfectly correlated, that is, when each has a
correlation coefficient of +1 with respect to every other member of the
portfolio. The perfect correlation is almost never present in practice. The
more likely scenario is one in which the various assets in the portfolio are
less than perfectly correlated to one another. The mathematics of
determining the expected volatility for multi-asset portfolios is intensely
difficultand far beyond the scope of this module. The combination of
different assets with imperfect correlations produces a slightly better
expected return for a given amount of risk than would be obtained by an
undiversified combination of assets.

Figure 1 shows a simple portfolio of two assets, A and B. A is a T-bill with


about a 4.0% expected return and a standard deviation of about 3%; B is a
small-company stock with an expected return of about 12% and a
standard deviation of about 33%. Assume for a moment that these two
assets are perfectly correlated (+1). That being the case, if all of the
portfolios funds were in the T-bill, the risk/return expectation would be
point A in the chart. If all funds were in the small stock, point B would
define the expected outcome and risk. Owing to their perfect correlation,

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any spreading of funds between the two assets would result in some
point along line AB in the chart, depending on the allocation mix.

But T-bills and small stock returns are imperfectly correlated, with the
result being that any mixing of these assets produces an expected
risk/return outcome somewhere along the curved line shown in Figure 2.
Every point on this curved line produces a slightly better return for the
same amount of risk compared to the straight line in Figure 1. That can be
the advantage of asset diversification, and it is the backbone of modern
portfolio theory.

Figure 1: Portfolio of Perfectly


Correlated AssetsTwo assets perfectly correlated

% of
Return

Standard Deviation

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Figure 2: Portfolio of Imperfectly
Correlated AssetsTwo assets less than perfectly correlated

% of
Return

Standard Deviation

There are numerous computer software programs to help optimize the


mixing of different securities to get the highest expected return for a
given amount of risk, or for a given level of return taking the lowest risk.
However, they should be used with some caution because results from
these programs are only as good as the accuracy of the inputs. These
inputs are the expected returns and the standard deviations of each asset,
in addition to the correlation coefficients between each asset. The most
difficult of these variables to input accurately is the expected return. In
spite of this, optimization programs are one commonly accepted tool to
use in asset allocation.

The investment professional should use his or her knowledge in


establishing and maintaining appropriate asset allocations for their
clients. For example, he or she knows that over time adding government
bonds to a portfolio of common stocks will lower both the return and risk
of the portfolio, resulting in buffering the portfolio from great swings in
total return. What the investment professional cannot precisely measure
is the extent to which adding bonds will lower return and risk. However,

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he or she can understand the general consequences of adding these bonds
and use that understanding to determine if such a change to the portfolio
is appropriate for a particular client.

Four Approaches to Asset Allocation


Reading the next part of this chapter will enable you to:

44 Identify approaches to asset allocation.

In practice, there are four basic forms of asset allocation: strategic, tactical,
dynamic, and core/satellite.

Strategic Asset Allocation


The allocation process described so far in this module is often referred to
as strategic asset allocation. Its focus is the identification of the asset
mix that will provide the optimal balance between expected risk and
return for a long investment horizon. Strategic asset allocation creates
efficient portfolios from different asset classes, which provide that
optimal balance. In this sense, it is closely related to the traditions of
modern portfolio theory.

Once the asset mix is determined and the weightssuch as 60% stocks,
30% bonds, and 10% cash equivalentsare assigned, there is an implicit
understanding that the balance within the portfolio will remain the same,
or within the assigned range.

Strategies are implicitly long term in nature. At first glance, one would
expect this to be nothing more than a passive buy-and-hold strategy. But
strategic asset allocation requires the active intervention of the investment
professional. With fluctuating asset prices, some asset classes will
naturally do better than others. This will automatically unbalance the

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portfolio relative to the weights originally assigned to each asset category.
If the weighting of the asset classes within a portfolio has shifted due to
differences in investment performance, the risk/return relationship of the
portfolio has also shifted. The shift may, in fact, position the portfolio at a
much higher risk level than the investor intended.

By rebalancing, the portfolio repositions assets that have gone up in value


to those that have either gone down in value or at least have not
appreciated as much. In a real sense, this is a form of buying low and
selling high. It also is a way by which to tighten the range of returns
around the target return. In other words, it reduces the possibility of very
high returns, but also reduces the possibility of large losses.

One approach to rebalancing is to set up a range of percentages


acceptable for an asset class; when the allocation falls outside that range,
then initiate rebalancing. For example, if an investor wants a 50%
allocation to stocks, the range might be 40% to 60%. When stocks make
up less than 40% or more than 60% of the portfolio, then rebalancing back
to 50% is done. If this is done within a tax-deferred account, such as an
IRA or 401(k), there are no current tax consequences.

Recognition of the importance of rebalancing occurred by early 2003 after


investors suffered over three years of large stock market lossesa period
during which bonds appreciated in price. Investors who did rebalance
their portfolios periodically were rewarded with higher returns and low
risk. Over the short term, rebalancing can lower returns (such as during
the 19961999 period if stocks were sold and replaced by bonds), but over
the long term, rebalancing can provide steadier returns (mainly through
avoiding large losses) and lower risk.

Portfolio B in the preceding Table 4, for example, started with an asset


mix that was 20% T-bills, 30% corporate bonds, and 50% common stocks.
One robust year in the equities market could very well result in that mix
becoming 15% T-bills, 25% corporate bonds, and 60% stocks! Thus, the

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intervention of the investment professional (with the clients approval)
becomes necessary to rebalance the mix to the original strategic balance.

Tactical Asset Allocation


Despite the abundant evidence that beating the market through either
securities selection or market timing cannot be accomplished consistently,
the investment professionalor the clientmay have special abilities or
resources that can be used to improve the investment return of the
portfolio. The client may be the most eager to joust with the market. This
approach means a periodic revision of the asset mix, moving funds from
one category that appears to be overvalued to one that appears
undervalued.

Tactical asset allocation attempts to improve portfolio returns through


periodic revision of the asset mix, such as changing the stock allocation of
the portfolio from 50% to 70%. It uses securities selection and market
timing approaches to do this. Tactical asset allocation may be as simplistic
as moving money away from the asset category that has been most
successful to one that has been the most unsuccessful. The theory here is
that the most successful asset class has either become fully valued or
overvalued, and the least successful asset class has become undervalued.
Naturally, caution is advised with any such simple strategy. Sector
rotation (moving, for example, from financial services stocks to capital
goods stocks) and market timing are typical methods of implementing
this approach to asset allocation.

Dynamic Asset Allocation


Sometimes called dynamic hedging strategy, this approach to asset
allocation changes the asset mix as the market changes. The risky assets
are sold to buy riskless assets as the portfolio loses value, and riskless
assets are liquidated in favor of risky assets as their values rise. Robert
Ferguson describes dynamic asset allocation (DAA) as follows:

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[DAA programs] involve shifting a portfolios mix between a
risky asset and a safe asset, so that the portfolios expected return
will fall between the expected returns on the two assets. The
investor can specify any minimum return that does not exceed the
return on the safe asset; the higher the minimum return, the lower
the proportion of the portfolio allocated to the risky asset and vice
versa. The key to a DAA program is changing the allocations as
the risky assets behavior changes (Ferguson 1986).

Because of the technical difficulty involved in dynamic asset allocation,


its primary users are institutional investors.

Core/Satellite Asset Allocation


This approach involves a combination of strategic and tactical asset
allocation enabled by dividing a portfolio into a core holding of stocks
and bonds, often in low-cost, broad-based index mutual funds or
exchange-traded funds (a basket of stocks or bonds that follow an index
and trade like stock), and a satellite portion. The core may represent 70%
to 80% of the total portfolio. It might be divided into, say, 60% stocks and
40% bonds, and maintained at those proportions through periodic
rebalancing. The remaining part of the portfolio, the satellite portion, is
used to take advantage of particular opportunities that add return,
diversification, and/or reduce risk to the portfolio. For example, the
satellite might include investments in actively managed small-cap funds,
real estate investment trusts, commodity funds, sector funds, junk bond
funds (containing low-grade bonds for higher yield), or other specialized
investments that complement the portfolio. Notice that the core segment
captures overall market movements (beta) when invested in broad-based
index funds, while the satellite segment tries to capture performance
beyond what the overall market provides (alpha).

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Public Allocation Recommendations by Investment Firms
The optimal asset mix must be determined with respect to the unique
financial objectives, time frames, and risk tolerances of the client. As with
many things, one size does not fit all. This is intuitively obvious.
However, it may be disconcerting for clients of some of the nations
largest investment firms to read in The Wall Street Journal or other
business periodicals that the firms they are doing business with are
publicly recommending a very different asset mix than the one
recommended by their investment professionals.

We are recommending that investors be 50% in stocks, 40% in


intermediate-term bonds, and 10% in cash, might be a general asset
allocation mix at a certain time. To the investor, who has just worked out
an allocation strategy with a representative of this same firm that is 40%
stocks, 40% long-term bonds, and 20% cash, the Journal article must be
disconcerting. Why, she might ask, are the top people in this firm
recommending one thing, while my investment professional is
recommending another?

Investment professionals of these firms know that the article in the Journal
is not intended as a long-term recommendation tailored to the unique
requirements of individual investors, but simply a general guideline.
Accordingly, it does not adhere to the first principle of asset allocation,
which is to tailor the allocation to the particular needs of the client, a
responsibility of the investment professional.

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Chapter 2
Asset Classes, Characteristics &
Performance

O
nce the asset allocation process is understood, and an allocation
policy is developed in concert with the client, the important
business of implementing the policy must begin. As mentioned
in the introduction, the modern investment professional has a large menu
of different investment securities and investment products available for
that purpose. This chapter of the module provides a brief review of those
securities and products.

Reading this chapter will enable you to:

45 Identify characteristics, potential risks, and performance of


various assets available to fulfill the asset allocation policy.

Common Stocks
A share of common stock represents a fractional ownership interest in the
issuing corporation. The shareholders ownership interest can be readily
transferred to another party, either directly or, much more likely, through
a brokerage firm. Some of the characteristics of common stock that matter
most to investment professionals and their clients are discussed here.

Shareholders receive dividends on a pro rata basis, that is, the owner
of 25% of the common shares is entitled to 25% of all declared
dividends. However, the company, represented in its board of
directors, is under no obligation to declare a dividend. The 2003 tax
law taxes certain dividends, called qualified dividends, at a maximum

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1996, 20022011, College for Financial Planning, all rights reserved.
15% rate, thereby making dividend paying stocks (both common
stocks and preferred stocks) much more attractive.

Common shareholders vote on the election of corporate board


members and other proposals of special interest. Some corporations,
however, have two classes of common stockvoting and nonvoting.

Common shareholders are residual owners of the firm, meaning


that their interests are subordinate to those with whom the
corporation has contractual obligations: creditors and bondholders. In
cases where the corporation is liquidated and its assets distributed,
common shareholders stand at the end of the line formed by the
aforementioned, preferred shareholders, andof coursethe tax
collector. As with dividends, common stockholders are entitled to
whatever is left over on a pro rata basis, once these other parties
interests have been satisfied. On the positive side, common
shareholders are the beneficiaries of the success of the corporation,
which can be in the form of increasing dividends and share price
appreciation.

Unlike bonds, common shares have no maturity; they end only when
the issuing corporation ceases to exist. Some common shares have a
par value. Unlike the par value of a bond, those of a common stock
have no relationship to the market value of the stock or its worth
upon liquidation. Par value for common stock is, except for the
balance sheet, strictly an historic artifact.

Investment characteristics and performance. Common stocks, as noted in


the discussion of asset allocation, have outperformed all other financial
instrumentsand by a wide margin. Just to reiterate, Ibbotson has
calculated that an investment in large-company stocks would have grown
at a compound rate of 9.9% during the years 1926 through 2010. Stocks
have also been a remarkably reliable hedge against inflation, outpacing
increases in the cost of living in all but a handful of periods (those of a

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bearish trend in the stock market). Inflation had a compound rate of 3.0%
during the years 1926 through 2010, much lower than the 9.9% for large-
company stocks. The return of bull markets always more than made up
for the ground lost during these years.

Investment risks. Volatility of share prices is the measure of risk for


common stocks and is the reason so many conservative investors tilt their
portfolios away from heavy stock positions, even though, over time,
common stocks have been the investors best investment. Price
fluctuations in the short term are the real concern of conservative
investors, and these fluctuations can be substantial.

As described in the previous module, beta is often used as a measure of


risk. Beta measures the risk of a particular issue in terms of its volatility
relative to the market of all stocks. The two major risks for common stock
are market risk and business risk. The following are more precise sources
of common stock risk.

A downturn in economic growth. When growth declines, so do investor


expectations of future corporate earnings. Gloomy investors also react
to economic downturns by reducing the amount they will pay for a
dollar of earnings (the P/E ratio). Thus, even firms with continuing
earnings growth may see their share prices decline.

Rising interest rates. Rising interest rates generally result in lower


common stock prices.

Loss of product or service competitiveness. Witness the recent declining


fortunes of Kmart, various steel companies, and numerous
technology-related companies.

Failures of management. This includes failing to innovate, to lead, to


control operations, and so forth.

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Government actions. These include cuts in government spending in
particular areas, legislative and regulatory mandates, and changes in
tax policy.

These are just a few of the important market and business risks that
underlie share price volatility.

Preferred Stock
Like common stock, preferred stock represents an equity interest in the
corporation, but as the name implies, it enjoys a preferred position
relative to common shares. In general, this preferred position puts it
ahead of common shares with respect to dividend payments and payouts
made in liquidation.

Note: This section covers what is commonly called regular preferred


stock. This stock should not be confused with preferred securities, called
trust-preferred securities, that are most often issued by bank holding
companies and are, in fact, debt paying interest income instead of
dividends.

Dividends on so-called preferreds are usually fixed (although some


dividends fluctuate with designated market rates). By the terms of the
articles of incorporation, the common shareholders generally cannot
receive any dividends until the stipulated dividends are paid to the
preferreds. Most preferreds have some form of voting rights, although
this right is typically limited to veto power over the issuance of debt or
other preferreds that would be placed in a superior position with respect
to dividend payouts.

For tax reasons, corporations prefer to issue bonds rather than preferred
stock because interest is tax deductible while dividends are not. Like
bonds and other interest-bearing debt, preferreds require periodic cash
payouts by the corporations. However, unlike interest payments,

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dividend payouts are not a contractual obligation and can be missed
during financial difficulty, upon the direction of the board of directors,
without incurring a state of default. On the other hand, if a corporation
owns the preferred stock of another company, part of the dividend
received, generally 70%, is tax free to the owning corporation. Therefore,
corporations sometimes purchase preferred stock. The disadvantages of
preferred stocks are that their income stream is less secure than that of
bonds and, being fixed, they do not offer the prospect of increasing
dividend payments as common stocks do.

Preferred stocks have become more popular with individual investors


seeking current income because of a change in the taxation of preferred
stock dividends. This dividend income used to be taxed at ordinary
income tax rates. But with the enactment of the Jobs and Growth Tax
Relief Reconciliation Act of 2003 (JGTRRA), qualified dividends
(commonly preferred stock dividends are such) became subject to a
maximum federal tax rate of 15%.

Investment characteristics and performance. The tax difference to the


issuer between debt and dividends notwithstanding, preferreds exhibit
most of the investment characteristics of fixed-income securities. Except
for a handful of participating preferred issues that may share in the
success of the issuing firm, preferreds have few rights to anything but a
stream of fixed dividend payments.

If the preferred stock has a cumulative feature, any unpaid preferred


dividends must be paid before dividends on common stock can be paid.
Because of the fixed dividend payments, the share price, like the price of
a bond, fluctuates inversely with changes in interest rates. This can be
seen in the basic valuation formula for preferred stock that is the annual
dividend divided by the market yield on similar grade preferred stock or
the investors required rate of return, which is used in determining if the
investor wants to invest in the stock.

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1996, 20022011, College for Financial Planning, all rights reserved.
D
V
k
where
V = Intrinsic value of the stock
D0 = Current-year dividend
k = Market yield or investors required rate of return

Also like bonds, preferreds can be callable, that is, the issuer may
redeem them at its option. Some preferreds can be converted into the
issuing companys common stock.

Investment risks. Investment risks associated with preferred stocks


include the following:

Interest rate risk. When prevailing market interest rates rise, the market
value of preferred shares declines, just like bonds.

Purchasing power risk. Because of the fixed dividend payments,


preferred stocks are subject to this risk.

Business risk. Unlike a bond, which is required by law to make regular,


fixed payments to securities holders, the stock issuer is under no
contractual obligation to preferred shareholders. If it does not have
the profits or the cash to pay dividends, it cannot be compelled to do
so, and the preferred shareholders cannot force the corporation to
liquidate to meet its obligationsas creditors can.

Reinvestment risk. The callable feature is invariably exercised when the


investor can reinvest only the proceeds at a lower rate. For example,
investors who bought callable preferreds with a dividend yield of
12% to 14% during the high interest period of 19781982 had their
shares called away from themat a specified call price (generally par
plus a small premium)when interest rates plummeted in the mid- to
late-1980s. The yields on equivalent securities in which they could

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reinvest the called proceeds were then very much lower. Even with
more common non-callable preferreds, there was the risk of
reinvesting dividend payments at lower rates.

Bonds and Other Debt Instruments


Debt instruments are a major asset class that pay interest and principal
when due. For this reason, they appeal to investors seeking current
income and the eventual return of the principal they invest. The variety of
securities in this class is too numerous to cover here in detail, but in no
field of finance has innovation and new product creation been more
productiveor led to more confusion. STRIPS, CMOs, CDOs, pass-
throughs, inverse floaters, and a host of others are products of financial
engineering new to the marketplace in the past quarter century. Each has
unique investment, risk, and trading characteristics. For a complete
discussion of these products, consult one of the many books listed in the
reference chapter at the end of this module.

Investment Characteristics and Performance


Debt instruments, also called fixed-income securities, are issued by
corporations, federal and state governments and their agencies, and
municipalities. Typically, they are issued at their par value (also called
face value, principal value, or maturity value) and promise to pay their
par value at a specified date in the future (maturity date) and to make
periodic interest payments, almost always semiannually, at a specified
rate (coupon rate) at specified dates. This promise is a legal obligation of
the issuer. The two major risks associated with debt instruments are
interest rate risk and purchasing power risk.

The rights of the bondholders and the promises of the corporate issuer
are contained in a legal document called the indenture. The indenture
spells out the terms of the issue and appoints a trustee to look after the

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bondholders interests and ensure that the indenture provisions are met.
The trustee, usually a bank or trust company, acts in a fiduciary capacity
on behalf of the bondholders. Investment grade bond ratings include the
ratings of AAA, AA, A, and BBB by Standard & Poors, and Aaa, Aa, A,
and Baa by Moodys. Non-investment grade ratings are BB or Ba and
lower, also referred to as high-yield or junk bonds. A rule of thumb
regarding buying junk bonds: When the yield differential on junk bonds,
as compared to the yield on Treasury bonds with the same maturity, is
8% or more, junk bonds are a buy. If that yield differential is 4% or less,
junk bonds are expensive.

Because the typical debt instrument has a fixed coupon rate, the market
value of the security increases when prevailing interest rates decline, and
declines when interest rates move higher. Some, such as T-bills and zero-
coupon bonds, do not pay periodic interest income but instead are
purchased at a discount to their face value. The interest earned is the
difference between the purchase price and either the sale price or the face
value paid at maturity. The best measure of return on a bond is total
return, which includes not only interest income, but also any difference
between the investors purchase price and selling price or, if held to
maturity, the maturity value.

Municipal Bonds
Municipal bonds include those issued by states, local governments, and
their political subdivisions. These entities issue two major types of
municipal bonds (called munis):

general obligation bonds (GOs), and

revenue bonds.

General obligation bonds are secured by the issuers general taxing


powers and, therefore, are considered to be of higher quality than

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revenue bonds. While this is generally true, it is not ironclad; as
demonstrated in 1995 when voters in Orange County, California, voted
down a proposal to increase taxes, which were, in part, to make payments
on bonds already issued. Also, as more municipalities face budget
problems, some of which are considerable, investors can no longer
assume that GOs are automatically high quality.

Revenue bonds are issued to finance a project, the revenues from which
are pledged toward making the bond payments. For example, airport
revenue bonds may be used to construct an airport, which will generate
landing fees, concession fees, fueling fees, and leasing revenues to pay for
the bonds. Since the revenues of the project are the only revenue source
available to meet the obligations of the bonds, revenue bonds are
generally considered to be higher risk than GOs.

In the final analysis, each issue must be analyzed on its own to determine
its quality. Often overlooked, but extremely important, is the legal
opinion for each issue. This document confirms the legality of the
issuance, upon which rests all of the bondholders legal security rights
should it be necessary to go to court to enforce them. Analyzing
municipal issues can be difficult as there is a 1975 legal provision called
the Tower amendment, which prevents the SEC from requiring state and
local governments to file information with the SEC. Therefore, municipal
bond analysis is best left to experts.

Municipal bonds tend to be bought and held by individuals, so the


trading in them, and therefore their liquidity, can be limited. This can
result in a larger bid-ask spread than for more liquid debt instruments
like Treasury securities. Liquidity can become an even greater problem
when investors are fearful and sell their municipal bonds and reinvest in
Treasuries in a flight to safety. About 33% of municipal securities are
owned by mutual funds.

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Tax feature. The central investment feature of most municipal bonds is
that they generally pay interest that is free from federal taxation (there are
a minority of municipal bond issues that pay taxable interest). Three
additional key points are:

1. The interest income from some municipal bonds also is free from
state, and in some cases local, income taxes if the bondholder lives in
the issuers locality. Bonds with interest income that is free from both
federal and state tax are called double tax-exempt bonds; bonds with
interest income that is free from federal, state, and local income tax
are called triple tax-exempt bonds. An example of a triple tax-exempt
bond is a New York City issue that is free from federal, New York
state, and also New York City income taxes.

2. Some municipal bonds pay interest that can either become or already is
taxable. So-called private activity bonds are subject to the alternative
minimum tax (AMT), which is a complicated federal tax imposed if the
bondholder has certain tax-preference items (such as accelerated cost
recovery deductions and private activity bond interest) that otherwise
could be used to lower the investors tax liability. This is significant in
that it could result in taxes being paid on tax-free bonds. General
obligation bonds are not subject to AMT.

3. In addition, as mentioned previously, a small number of municipal


bonds pay interest that is taxable at the federal level. One of the most
prominent of such issues is Build America Bonds. These were created
under the American Recovery and Reinvestment Act of 2009, which
authorized state and local governments to issue these taxable
municipal bonds in 2009 and 2010 for capital projects. The interest paid
on these bonds, directly subsidized by the federal government to
municipalities, is equal to 35% of the total coupon interest paid to
investors.

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Treasury Securities
U.S. Treasury securities include Treasury bills (which will be covered
subsequently under Cash Equivalents), Treasury notes, and Treasury
bonds. These are highly marketable securities because they are readily
sold between investors in an active market. The U.S. Treasury also issues
savings bonds, Series EE and I, which do not have an active market but
can be bought and redeemed at financial institutions. The marketable
securities discussed below have a minimum denomination of $100 and
are sold in multiples of $100. Interest on Treasury securities is taxable at
the federal level but free from state and local taxation.

Treasury notes. T-notes have maturities of over one year and up to 10


years. T-notes are issued with interest paid every six months based on the
coupon rate, just like most corporate and municipal bond issues. At
maturity, the face value of the notes is then payable. Treasury notes are
not callable.

Treasury bonds. T-bonds have maturities of over 10 years and up to 30


years. Like notes, Treasury bonds pay interest every six months and pay
face value at maturity. Like all new issues of Treasury securities, T-bonds
are sold on a book entry basis so there are no actual securities issued.
Some older issues, however, still exist for which actual securities were
issued. Most issues are not callable, but a few are callable five years prior
to maturity.

Treasury inflation-protected securities (TIPS) are U.S. government


securities designed to protect investors purchasing power from inflation.
For this reason, the coupon rate on TIPS will be lower than on other
Treasury securities with the same maturity. Because inflation is the enemy
of bond buyers, TIPS have become very popular. The initial offering of
these bonds by the Treasury came in early 1997. They have maturities of 5,
10, and 30 years and pay interest every six months. The interest rate
(coupon rate) remains fixed throughout the life of the security. Semiannual

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adjustments to the principal value (face value) are linked to changes in the
Consumer Price Index (CPI). Therefore, the dollar amount of interest paid
increases every six months because the fixed rate is applied to a higher face
value (assuming some inflation during that time).

At maturity these bonds will pay the greater of their face value or their
inflation-adjusted value, so in the unlikely event of deflation, an investor
would at a minimum get back the face value of these securities. However,
even though these securities protect against purchasing power risk, they
still do have interest rate risk because interest rates and inflation do not
necessarily move in lockstep. Therefore, a TIP bond with a duration of
six, for example, could fall about 6% in value with a 1% increase in
interest rates.

In contrast to traditional bonds that are negatively affected by inflation,


TIPS are not highly correlated to traditional bonds. Therefore, they can be
useful in creating a diversified portfolio. In periods of high demand
(generally when inflation is or expected to increase or there is a flight to
quality), these securities can become overvalued. If inflation turns out to
be less than expected, TIP prices could fall. A rule of thumb, then, is to
buy them only when they have a real yield greater than 2% compared to a
regular Treasury security of the same time to maturity.

One disadvantage with TIPS is that, although the inflation increases are
not paid out until the bonds principal is repaid at maturity, the
bondholder must pay annual federal income taxes on the phantom
payout (the amount of principal increase in the year) in addition to the
interest payments. Consequently, many investment professionals
recommend they be held in a retirement account

To assess if regular Treasuries provide a better yield than inflation-


indexed bonds, simply compare the yield of the Treasury bond with the
after-inflation yield of the inflation-indexed bond (the maturity of both
bonds must be the same). For example, if a 10-year Treasury bond yields

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5.7% and the 10-year inflation-indexed bond has a fixed rate of 3%, then
both bonds yield the same if inflation is 2.7%. If inflation increases to
more than 2.7%, the inflation-indexed bond will pay more, and vice versa.

TIPS Sold at a Negative Yield


On October 25, 2010, for the first time ever, the U.S. government sold a
TIPS issue at a negative yield. A $10 billion issue of 4.5 year TIPS with a
coupon of 0.5% sold at $105.50 priced to yield .55%.

Why would investors purchase a bond with a negative yield? The short
answer is investors expectations for inflation. The only way an investor
could earn a positive return on these bonds is if inflation (and, therefore,
the bond price) increases enough to offset the inherent negative yield-to-
maturity. Buyers of this issue, then, were expecting inflation to increase
due to the Feds effort to pump more money into the economy through
their announced quantitative easing by purchasing U.S. government
securities in the open market. The intent was to stimulate the economy by
bringing long-term interest rates down, which would lower rates on
mortgages and other loans. (Normally the Fed would spur economic
activity by reducing short-term interest rates, but with those rates close to
zero, that tool had already been used.) Presumably this would entice
consumers to buy houses and cars, and businesses to invest, all of which
would increase economic activity. In turn, this would cause inflation to
increase (on October 15 the Fed chairman had stated that inflation was
too low).

Another effect of very low U.S. rates is the dollar weakening against other
currencies. This, in turn, makes imported goods cost more for U.S.
citizens, thereby adding to inflation. The other possible reason for
investors buying a negative yield Treasury security is if they were
expecting deflation, with the thought that they would be better off with a
small negative yield if prices were to fall more than 0.55%. This reasoning
was dismissed by most bond experts due to price increases in
commodities and basic materials at the time.

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Treasury STRIPS (separate trading of registered interest and
principal securities). Created in 1985, Treasury STRIPS are derived
from Treasury notes and bonds. Government securities dealers
present standard Treasury notes and bonds to the Treasury, which
then separates each interest and principal payment into individual
securities, each with their own CUSIP number. Consequently, a STRIP
is not issued or sold directly to investors by the U.S. Treasury; but
payment of interest and principal on the note is a government
obligation, so there is no risk of default. For example, a 10-year
Treasury note has 20 interest payments, since it pays interest
semiannually. In addition, it has one principal payment at the end of
the 10 years.

A dealer will take these individual components and sell each future
payment to investors. Each of these payments becomes a zero coupon
security (which, therefore, has no reinvestment risk) in that the investor
pays a discount for the payment and receives the face value of the
payment when it becomes due. The difference is the interest the
investor earns over the lifetime of the security, which is the basis for the
securitys yield-to maturity. The interest accreted each year is subject to
federal, but not state, income taxation; even though no cash payment is
made. For this reason, STRIPS are best held in a tax-deferred account.

STRIPS are excellent securities for situations in which a specific dollar


amount is absolutely needed at a certain time in the future. Being zero
coupon securities, they have higher interest rate risk than a Treasury
coupon bond having the same years to maturity. Being a fixed income
security, STRIPS are subject to purchasing power risk. STRIPS are
traded in the secondary market, but are less liquid than traditional
Treasury bonds and notes, so they have greater bid/ask spreads.

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Corporate Bonds
Corporations issue bonds primarily to finance their growth or increase
their efficiency. For example, the proceeds of a bond sale may be used to
build a new production plant, modernize an existing plant, or purchase
state-of-the-art technology to improve productivity. Interest on these
bonds is tax deductible for the corporation, but taxable at the federal,
state, and, if applicable, local levels to the bondholder. U.S. corporations
primarily issue four types of bonds:

1. Mortgage bonds. These bonds are secured by property, usually real


estate. In theory these bonds are safer than unsecured bonds because
the assets backing them can be sold to pay the bondholders. In
practice, this may or may not be the case, depending on the nature of
the assets. For example, utility companies use mortgage bonds to
finance power plants, and they pledge those plants to pay the
bondholders if necessary. Since there are very few buyers of power
plants, that security might not be sufficient to pay the bondholders, if
the issuer defaults.

2. Debentures. These are unsecured bonds. Investors here must depend


on the general creditworthiness and earning power of the corporation
to make the required interest and principal payments. The lack of
security makes them more risky than secured bonds of the same
corporation. In the end, however, it is the companys ability to
generate earnings that determines whether payments are made. Some
debentures are subordinated, meaning that they are redeemed only
after the general debt of the corporation is redeemed. As a result,
subordinated debentures have greater risk.

3. Equipment trust certificates. These bonds are secured by specific


equipment, such as airplanes or railroad cars, which can be
transported and, therefore, are easier to sell than the fixed assets
securing mortgage bonds. Although this security decreases the risk of

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owning these bonds, it is not assurance that payment will be made in
full, since the market for these assets can soften, particularly in a
recession.

4. Convertible bonds. These bonds can be converted into the underlying


stock of the issuer at the option of the bondholder so they are
sometimes referred to as a hybrid. Convertibles offer income, although
at a lower rate than the issuers straight debt, but they have the
possibility of appreciation if the issuers stock increases in value.

The value of convertibles lies strictly in terms of the underlying stock;


called the conversion value. For example, a convertible bond that can be
converted into 40 shares when the stock is $20 per share has a
conversion value of 40 $20 = $800. These bonds typically trade at a
price higher than their conversion value, unless the company is
having business problems. Convertible bonds are usually issued by
young, growing companies trying to conserve cash. The lower the
rate those companies pay on convertibles, the lower are interest costs;
the convertibility feature also makes it possible for issuing companies
to convert debt to equity in the future.

On the downside, the bond, at worst, will trade as if it were a straight


bond without the conversion feature; thereby providing a floor on the
bonds price. This is called the bonds investment value, and these
bonds are called busted convertibles. If, however, the issuing company
encounters significant financial difficulty (as certain telecom
companies in 2001 and 2002), that investment value can be very little.
The fundamental rule when buying a convertible bond is to buy it
only if you like the prospects of the underlying stock.

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Should the Client Buy Tax-Exempt Municipals or
Corporate Bonds?
Some clients simply hate to pay taxes and buy lower-yielding
municipal bonds without a great deal of thought, not realizing that
their after-tax yield might actually be lower. To determine taxable
equivalent yield to municipal yields, use the following formula:

Tax -exempt yield


Taxable equivalent yield
(1 M arg inal tax bracket)

Thus, if a client is in the 33% marginal tax bracket and wants to


purchase some municipals with a tax-exempt yield of 5%, a taxable
yield on a corporate or other bond with taxable interest of 7.46% would
produce the same amount of after-tax income.

.05
.0746 or 7.46%
(1 .33)

If a municipal bond is free from both federal and state income taxation
(a double tax-exempt bond), the taxable equivalent yield formula
factors in both the federal and state marginal income tax brackets.
Assume the same facts as above but the state tax bracket is 6%. Then
the calculation is as follows:

.05 .05
.0794 or 7.94%
(1 .33)(1 .06) .63

Zero Coupon Bonds


In April 1981, J.C. Penney Company, Inc., issued the first zero-coupon
notes: $200 million worth of them to be exact. These notes had a face
value of $1,000, payable on maturity in May 1989, but were issued at a

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price of $334.27. Unique to this issue was the fact that the notes would
pay absolutely no periodic interest payments. Anyone with a financial
calculator or yield tables could compute the yield to maturity, assuming
semiannual compounding, on this transaction as 14.18%. (Another way of
looking at it would be to say that $334.27 invested at a compound rate of
14.18% over an eight-year period would grow to $1,000.) Note: Even
though there are no payments, semiannual payments are assumed when
calculating a yield-to-maturity.

Zeros were an immediate hit with investors and soon were issued by
municipalities, corporations and government securities dealers who sold
the interest and principal components from Treasury bonds. These
components became zero coupon securities known as STRIPS, mentioned
earlier.

Because all the implied interest was embodied in the discount, there were
no semiannual coupons and no interest payments to reinvest. For those
bond investors who had no need for current income but wanted to
accumulate a set amount for an investment goal, zeros are a good choice as
long as the credit quality of the issuer is strong. Credit quality is very
important because the only payment received is at maturity. If the issuer
defaults before maturity, the investor receives no (or limited) return of
principal and no interest payments except paid taxes on the accrued
interest (if held in a regular account). For this reason, the most popular zero
coupon bonds are issued by the U.S. Treasury, which has no default risk.

Federal tax authorities spoiled some of the party by ruling that the
theoretical accrual of interest was just as taxable as interest paid out
regularly (an exception being for municipal zeros, which pay tax-free
income). This ruling has not bothered clients with Keoghs, IRAs, or other
non-tax-paying accounts, for whom zeros continue to be a popular
funding instrument.

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The Ibbotson data on total returns (from interest and capital appreciation)
shown earlier indicates that short-term debt instruments, namely T-bills,
have outpaced inflation by a compound rate of only 0.6% between 1926
and 2010. That rate has been just enough to keep the investors
purchasing power intact before taxes. Government and corporate bonds
turned in a slightly better record.

Yields. The return, or yield, on a debt investment is not always easy to


determine and is often a point of confusion for both investment
professionals and clients. Three types of yields need to be understood:
current yield, yield-to-maturity, and yield-to-call.

Current yield. This is the percentage earned annually. The formula is


straightforward:

Annual interes t payment


Current yield
Market price of the debt ins trument

The simplest case to consider is that of a bond that is priced exactly at its
face value and has no accrued interest. In this specific case, the coupon
rate defines the yield. For example, a bond with a face value of $1,000 has
an 8% coupon rate and matures in exactly three years. The stream of cash
flows represented in this situation appears as follows (for simplicity, in
this example interest is paid in one annual payment).

Time
0 (Purchase Date) End Year 1 End Year 2 End Year 3

-$1,000 +$80 +$80 +$80

Here, the investor pays out $1,000 and receives three positive cash flows
of $80, $80, and $1,080 over three years. In this case, the current yield is
$80 $1,000, or 8%. Current yield is a function of the annual interest
(coupon) and the bonds market price.

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Yield-to-maturity. Most bonds purchased in the secondary market, and
some new issues, are not priced at face value. They are priced either at a
premium or at a discount to face value. In the example given above, the
three-year bond might have been purchased for $950, creating the
following set of cash flows:

Time
0 (Purchase Date) End Year 1 End Year 2 End Year 3

-$950 +$80 +$80 +$80


+$1,000

By definition, the investor will have a current yield of 8.42% on the


purchase date ($80/$950). However, this does not describe the total
return over the life of the bond because the investor will receive the full
$1,000 principal value at maturity$50 more than he or she paid for it
along with the last coupon payment. This entire set of cash flows is
accommodated in a calculation of the yield-to-maturity (YTM), the
underlying math of which is based upon the time value of money
principles discussed in the previous module. (Yield-to-maturity is also
known as internal rate of return in the language of modern finance.) To
determine YTM, this equation must be solved for i:

$80 $80 $80 $1,000


$950 = 1
+ 2
+ 3
+
(1 + i) (1 + i) (1 + i) (1 + i) 3

Bond departments have the computing power to figure the YTM on their
inventory. In this case, the YTM is 10%. The YTM is the total return on the
bond and therefore is usually the best return measure unless the bond is
called before maturity, in which case yield-to-call is the more accurate
total return measure. In actual practice, the YTM would be calculated
based on $40 payments every six months. Also note that the value of $950
equals the present value of the income payments plus the present value of

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the maturity value. Using a financial function calculator set to two
payments per year, the keystrokes would be as follows:

950, PV

40, PMT

1000, FV

6, n

I/YR = 9.97%

With the HP-10BII, note that the $950 is a negative input representing a
cash outflow (as if buying the bond), and the N is 3 2 = 6 payments to
adjust for semiannual payments. Also, this calculation inputs four values
and solves for the fifth, unlike most financial function calculations that
input three values and solve for the fourth.

Yield-to-call. Many bonds have a call provision that allows the issuer
to redeem its outstanding debt on or after a certain date prior to
scheduled maturity. For example, an 8.5% February 1, 2023, bond may
have a call provision allowing the issuer to redeem the bonds at any time
after January 31, 2013. Very often, bonds pay call premium when the
bonds are calledoften one years interest. The likelihood of bonds being
called is great if prevailing interest rates are such that the issuer can sell
new bonds at a lower rate (say, 6%). Some bond issues have different call
dates with different call premiums. This creates two additional yields to
call: (1) yield to first, which is the yield to the first call and (2) yield to
worst, which is the lowest yield based on the different call dates and call
premiums. Yield-to-call uses the same calculation as YTM to determine
the yield, except it figures cash flowincluding the call premiumup
until the earliest date in the call provisions.

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Investment risks. The Ibbotson data indicate that the volatility of returns for
bonds and Treasury bills is far less than that of stocks. Further, this
volatilityas measured by standard deviationgenerally decreases as the
term of debt securities decreases. However, standard deviation is not a term
that fully explains risk to the typical client. Some of the more traditional
terms that follow may be appropriate.

Default risk. A debt instrument is a promise to repay, but economic


circumstance can jeopardize that promise: witness the default on
several issues of Washington Public Power System service bonds in
the mid-1980s. And whoever thought that a public utility would
default? Default occurs whenever any of the provisions of the bond
issue are not met; however, it is most commonly associated with
missed interest payments or failure to repay the bond principal on
maturity. At one point in 2001, Enron bonds were very high
investment quality bonds, but they went into default within a few
months of holding that high rating.

On the one extreme are issues of the U.S. government, considered not
to have any default risk; while on the other extreme are high-yield
bonds (also called junk bonds), which are issued by companies of low
credit standing. Junk bonds are generally defined as those with
ratings of less than investment grade, specifically rated BB or Ba and
lower by Standard & Poors and Moodys, respectively. Investors
typically rely on these two rating services as measures of
creditworthiness.

High-yield bond prices, because of default risk, are directly affected


by the business prospects of the issuer which, in turn, are affected by
the state of the economy. Therefore, they are less sensitive to interest
rate risk than high-grade bonds. That is, although they do have
interest rate risk, high-yield bond prices are largely impacted by their
issuers creditworthiness, since that increases or decreases the
likelihood of default on its bonds.

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Purchasing power (or inflation) risk. Because the interest and principal
payments received from debt securities are usually fixed in dollar
amounts, those cash flows are subject to an erosion of purchasing
power over time. Since inflation is the enemy of bond owners, even a
hint of higher inflation can cause bond prices to fall.

Call risk. Most bonds have a call provision that allows the issuer to call
in the bond before its maturity date. The issuer will do this when
interest rates have fallen below the rate at which the bond was issued.
The issuer will refinance those bonds with new bonds at the lower
rate. This is disadvantageous to the bond investor, however, because
the higher rate bonds are redeemed, leaving the investor to reinvest at
lower interest rates.

Reinvestment (or reinvestment rate) risk. As interest payments and,


ultimately, principal are paid, these payments need to be reinvested.
There is a risk, called reinvestment risk, that interest rates will be low
when this reinvestment occurs. Obviously, that risk is more
substantial when reinvesting principal than when reinvesting interest
payments. Therefore, it is important to select bonds with different
maturities so that reinvestment is not made all at one time.

Currency (exchange rate) risk. In recent years, many investors have sought
the higher yields that often prevail in foreign (non-U.S.) capital markets.
Foreign debt securities subject American holders of these securities to the
risks just mentioned, plus the risk that the value of the currency in which
the debt is denominated will lose value relative to U.S. currency. For
example, consider a British bond paying annual interest of one British
pound. If the pound falls in value from $1.60 to $1.30, the U.S. investor
has had a cut in income, even though the coupon stayed at one British
pound. The reverse, of course, is also possible; if the U.S. dollar is the one
that loses relative value, a U.S. investor benefits by the fact that one unit
of foreign currency converts into more U.S. dollars.

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Interest rate risk. Investors who find their purchasing power eroded by
inflation might seek relief by selling their bonds. If so, they will
discover that the market value of their bonds had dropped. For
example, if new $1,000 bonds of the same quality and maturity are
issued with 9% yields, no one would pay $1,000 for the previously
issued 6.5% bonds. The determination of price in these situations is
based upon the calculation used to determine yield-to-maturity. Here,
however, the YTM is a known factorthe market interest rate of a
particular type, quality, and maturityand the unknown factor is the
price, or market value (Vb). To determine that price, we simply use
our same formula for discounting cash flows to their present value:

$65 $65 $65 $65 $1,000


Vb = 1
+ 2
+ 3
+ n
+
(1 + i) (1 + i) (1 + i) (1 + i) (1 + i) n

Here, i is the market interest rate (9%), n is the years to maturity (say
20 years), PMT is $65, maturity value (FV) is $1,000, and we solve for
the price (PV or Vb) of the 6.5% bond, which would be $772, assuming
for simplicity annual interest payments. In essence, the above formula
is discounting the bonds cash flows (interest and principal) back to a
present value. This concept will be expanded upon later in Chapter 4.

The degree to which bond prices fluctuate in the market depends


primarily upon four things:

The coupon rate. The smaller the coupon rate, the larger the
fluctuations in market value as interest rates change. The most
obvious example here is the zero-coupon bond, which experiences
sharp price volatility when prevailing rates change.

The time to maturity. The greater the time to maturity, the greater the
price fluctuations.

The change in interest rates. The larger the change in interest rates, the
more the change in a bonds price.

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The credit risk of the debt instrument. Greater risk contributes to greater
price volatility.

Duration
A measure of the price sensitivity of a bond to a change in interest rates
(interest rate risk) is duration. Defined as the weighted average time it
takes to receive a bonds payments, the usefulness of duration is tied to
the fact that a bonds duration multiplied by the change in interest rates
gives an approximation of the change in the bonds price due to the change
in interest rates. For example, if a bonds duration is 9 and interest rates
increase 2%, the bonds price will fall about 18%. A bonds (or a bond
portfolios) duration itself can change over time with interest rate
changes, so it is advisable to check with a bond specialist or bond
portfolio manager to determine the duration of the bond. The duration of
a zero-coupon bond equals its number of years to maturity.

Calculation of Duration
Assume you have a three-year, $1,000 par value bond with a coupon
rate of 7%, current price of $973.79, and the market rate for comparable
bonds is 8%. Calculating duration for this bond would be as follows
(technically each six-month payment should be a separate calculation,
but for simplicity we will assume annual interest payments):

Number of
each Amount of each Present value interest
payment payment factor at 8%
1 $70 .926 = $ 64.82
2 $70 .857 = 119.98
3 $1,070 .794 = 2,548.74
$2,733.54

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2733.54
Duration = 2.81 years
973.79

The duration for this bond is 2.81 years. In practice, duration calculations
are done using computer software. If the example above was a zero
coupon bond, the duration would be three years (equal to the maturity)
and more price sensitive to interest changes than a coupon bond. You
will not be expected to calculate duration for the final examination.

Changes in interest rates produce opposite effects between the value of


the bonds and reinvestment rates. For example, if interest rates increase,
bond prices decrease but the rate at which cash flow from the bonds can
be reinvested increases. These two opposite forces can be immunized
against interest rate changes when the duration of a bond equals the time
frame for a financial goal. That is, if an investor has a goal to be achieved
in five years, he or she should buy a bond with a duration of five years.
Duration is the best indicator of a bonds degree of interest rate risk
because, in addition to factoring in the change in interest rates, it also
considers the bonds coupon rate and time to maturity.

There are two practical applications for duration:

1. A quoted duration can be used to determine how sensitive the bond


portfolio is to changes in interest rates. Duration is multiplied by the
expected change in interest rates to determine the approximate change
in value for the bond or bond portfolio:

Duration (Dur.) Expected interest rate change (i) = Approximate


change (+ or ) in bond or portfolio value ( value). Keeping in mind
the inverse relationship of changes in bond prices to changes in
interest rates, this can be shortened to:

value = Duration i.

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The negative in front of the duration represents the inverse
relationship of changes to bond values with changes in interest rates.

Example. A bonds duration is found to be 4.3 years, and your


research department is anticipating a 1.5% (150 basis points) increase
in the market interest rate. The approximate impact on the market
value of the bonds is 4.3 1.5 = 6.45%. (Because the interest rate
was anticipated to increase, the bond price would decline by
approximately this percentage.) A bond with a duration of 8.6 is
about twice as volatile as a bond having a duration of 4.3.

2. Developing a bond portfolio with a duration equal to the clients time


horizon will immunize the portfolio against the inverse-related
consequences of interest rate changes.

Immunization is the process by which a fixed-income portfolio is created


so that the impact of fluctuating interest rates is minimized over a
specified time horizon. For this to be effective, the duration of the
portfolio should be equal to the duration of the investors cash needs.

Example. Mrs. Barns wants to develop a large bond portfolio, with the
ultimate objective of saving for retirement, which begins in 10 years.
With this in mind, you will want to find a mutual fund bond portfolio
with a duration of 10 years, not a maturity of 10 years.

The duration of a bond or a bond portfolio can be affected by any of


several variables. A shorter duration can be produced by buying bonds
with the following characteristics:

higher coupon rates

shorter maturities

call features and sinking fund provisions

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For mortgage-backed securities and other investments with call features,
effective duration is less reliable, especially when interest rates change
rapidly.

The duration of all bonds, except zero-coupon bonds, is reduced as


market interest rates (yield to maturities) increase. The duration of zero-
coupon bonds is equal to maturity because there are no periodic interest
payments to dampen the effects of interest rate changes. However, the
duration of a coupon bond is always less than its years to maturity. The
duration for a bond or a bond portfolio must be recalculated when
interest rates change and when some bonds mature.

The duration of a bond portfolio is calculated by summing the duration


of the individual bonds in the portfolio weighted by each bonds
proportion in the portfolio.

Example. Your client, Mr. Gertz, has three bonds in his current portfolio,
each representing a different percentage of the entire portfolio.

Weighted
Bond Duration Weight = Duration
A 6 .20 1.2
B 9 .30 2.7
C 15 .50 7.5
11.4

For Mr. Gertzs bond portfolio, the duration is 11.4. This means that for
each 1% change in interest rates, the portfolio can be expected to change
in value by about 11.4%. As you may expect, the high duration of Bond C,
and the fact that it represents half of the portfolio, will skew the weighted
portfolio duration.

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Mortgage-Backed Securities
While discussion here of debt instruments has been fairly general, special
attention needs to be given to mortgage-backed securities, whose
complexity makes them a source of confusion to many investors.

Investment characteristics. The U.S. mortgage debt market has inspired a


number of financial innovations, both in the design of mortgages and in
ways of pooling and packaging them into marketable securities, known
generally as mortgage-backed securities (MBSs). Today over $6 trillion
worth of these popular securities are outstanding in a number of forms:
pass-throughs, collateralized mortgage obligations (CMOs), stripped
MBSs, and so forth. For purposes of this discussion, attention is given to
the pass-through security, the major issuers of which are the following:

Ginnie Mae (formerly known as the Government National Mortgage


Association or GNMA),

Freddie Mac (formerly known as Federal Home Loan Mortgage


Corporation or FHLMC), and

Fannie Mae (formerly known as Federal National Mortgage


Association or FNMA).

To understand pass-throughs and how they differ from other fixed-income


securities, it is useful to understand how they are made. Figure 3 is a
model of a mortgage pool put together by a lending institution and
repackaged into MBSs. Here, 10 mortgage loans on single-family homes
(each for $100,000, with the same interest rate and the same term) have
been formed into a $1 million mortgage pool. Ownership interests in the
pool, its cash flows, and underlying assets are sold to investors in the form
of pass-through securities. This process is known as asset securitization,
and from its origins with home mortgages, it has been applied variously to
auto loan receivables (by GMAC) and even credit card receivables.

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Each of the 10 new homeowners in our example makes a monthly
payment, part of which is interest on the mortgage and part of which is a
repayment of the principal of the mortgage. The cash flow from these 10
mortgages is passed through (less servicing fees) to the pool, and from
the pool to its owners.

Figure 3: Anatomy of a Pass-Through Security

GNMA or other
financial entity
10 Mortgages @$100,000
Monthly
Payments
Monthly mortgage
payments of principal
and interest and
prepayments

Holders of mortgage
backed securities

Investors typically buy pass-throughs for their yields, often with the idea
of having monthly investment income during retirement. Many
mistakenly believe that they have purchased a traditional bond by
another name. There are, however, important differences, as follows:

Unlike most other bonds, which make coupon payments


semiannually, pass-throughs make monthly payments.

Unlike bond payments, the monthly distributions of pass-throughs


represent interest and return of principal. Since all of the loans in a
pass-through are amortized over a certain time period, such as 30
years, part of each monthly payment by the homeowner is interest
and part is principal. In practice, however, rarely is a mortgage held

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for 30 years because individuals move or refinance and therefore pay
off their original mortgage.

Because there is no way to know when mortgages will be paid off,


there is no maturity for a pass-through. Without a maturity, there can
be no yield-to-maturity. In addition, the proportions change over
time. For example, the monthly payment by a homeowner on a
$100,000 mortgage at 10% over 30 years is $877.57. The first of these
360 monthly payments is for $833.33 in interest and $44.24 in
principal repayment. Since the principal amount owned on the
mortgage is reduced with each payment, the portion of each monthly
payment represented by interest decreases over time. Again, for the
same mortgage, by the 222nd payment, $600.69 is interest while
$276.88 is principal repayment. Since these cash flows are passed
through to the investors, those investors must realize that their pass-
through security is self-liquidating, and if they do not reinvest the
payment represented by principal they are depleting their investment
assets.

Total payments can change greatly over time. During periods of high
interest rates, investors in a new GNMA at 10% may think that they
have locked in an attractive rate for a very long period. Experience
shows, however, that dramatic drops in home mortgage rates result in
many people refinancing their existing mortgages. Thus, a pool may
experience 50% or more prepayments (thereby encountering
reinvestment risk). When this happens, a large chunk of the principal
value of the underlying mortgage pool is paid to the GNMA
investors. The size of subsequent payments of interest and principal is
thus reduced, although the interest rate on the outstanding principal
(the mortgages not refinanced) stays the same.

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Bond Buying Investment Strategy
Some investors have found that buying callable bonds that happen to
be trading at discounts can be a good strategy. If they hold the bonds to
maturity, the normal YTM prevails. If they are lucky and interest rates
fall significantly, the bond will be called, and a nice capital appreciation
will be the result. The same applies to mortgage-backed securities
when discounted issues can be found. An unanticipated flood of
prepayments will result in return of principal that was purchased at
discount.

Determining yields on pass-throughs. If mortgagors can pay off their


home loans at any time, how can a reliable yield be calculated?
Professional fixed-income money managers operate with assumptions
about the prepayment rate for any given mortgage pool to estimate their
future cash flows and their expected yields. This forecasted prepayment
rate allows them to calculate an anticipated yield to maturity, which is
different from a regular bonds yield to maturity (where cash flows can be
precisely predicted). A variety of forecast methods are used by
institutional money managers to gain precision in the prepayment rate
and, by extension, the anticipated yield to maturity. Like all forecasts,
however, these have not been entirely reliable. This means that the yield
on a pass-through can only be estimated. Most quoted yields contain an
explicit assumption about the prepayment rate.

Risks and returns on pass-throughs. GNMA backs the timely payment of


interest and principal with the full faith and credit of the U.S.
government. FHLMC and FNMA are government agencies that also back
timely payments. Although they are without the full faith and credit of
the government, their default risk is considered slight. Thus, GNMAs are
equivalent to Treasury issues as to default risk. However, for equivalent
maturities, GNMAs generally provide higher yields than Treasuries of
about 50 to 120 basis points, depending upon market conditions. The

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higher yield reflects the uncertainty of cash flows borne by the pass-
through investor. As with the interest on other fixed-rate debt, the market
value of pass-throughs is sensitive to changes in market interest rates
(interest rate risk). However, if interest rates fall, a pass-through will not
increase in market price as much as conventional bonds because of the
increased likelihood of prepayments from individuals refinancing their
mortgages (prepayment risk). Likewise, the risk of having to reinvest
interest and return of principal (reinvestment risk) each month applies.
GNMAs, like other bonds, have purchasing power risk.

Cash Equivalents
Cash equivalents are assets that can be converted to cash with little, if
any, loss of principal. Common types of cash equivalents are checking
accounts, savings accounts, certificates of deposit, money market funds,
money market accounts, and money market instruments. Money market
instruments are short-term (one year or less) obligations of various
issuers such as banks, corporations, and the U.S. government. Although
the market value of these securities fluctuates inversely with interest
rates, those fluctuations are very minor. Some of the major types of
money market instruments, all of which pay interest that is taxable at
both the federal and state levels except Treasury bills, include the
following:

Treasury bills (T-bills). Treasury bills have a maturity of up to one


year and are issued at a discount. That is, they are issued for less
than face value and mature at their face value. For example, an
investor might pay $9,700 for a T-bill maturing to $10,000 in six
months. The $300 difference received at maturity is interest income.
This interest is free from state income tax. The minimum
denomination is $100, and they are sold in multiples of $100.

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Negotiable certificates of deposit (CDs). These are large CDs
($100,000 or more) issued by depository financial institutions that
mature within one year. They pay a fixed rate of interest that is
taxable at both the federal and state levels. Quality is generally high
but depends on the issuing bank. Amounts over $250,000 are not
supported by federal deposit insurance.

Eurodollar certificates of deposit. These are negotiable dollar-


denominated CDs issued by foreign branches of major American and
foreign commercial banks, sold at face value, generally issued in
amounts of $1 million or more, and are not FDIC-insured. Interest
rates on these CDs are somewhat higher than those of U.S. CDs
because there are no reserve requirements on offshore CDs and
because there is some (if slight) political risk. Eurodollar CDs have no
maximum maturity, but are generally issued with maturities of three
to six months, and can be as short as seven days.

Yankee certificates of deposit. These are U.S. dollar-denominated CDs


issued by foreign banks from their branches in the United States.
Maturities of one year or less usually pay interest at maturity. Term
Yankee CDs have maturities of two to five years and pay interest
semiannually or annually. The most prominent issuers are banks
headquartered in Japan, Great Britain, Canada, and Germany

Commercial paper. Commercial paper is the short-term, unsecured


IOUs of corporations. Corporations use commercial paper as an
alternative to borrowing from banks. Only major corporations usually
issue it, and the quality, while generally high, depends on the
creditworthiness of the issuer. Usually sold at a discount with interest
payable at maturity, commercial paper typically offers maturities of
up to 270 days.

Bankers acceptances (BAs). Bankers acceptances are issued at a


discount from face value and are time drafts that finance international

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trade. BAs are drawn by one party (drawer) on a bank (drawee) and
accepted by the bank as its commitment to pay the drawer or a third
party (payee) a specific sum on a specific future date. When the bank
stamps accepted on the draft that bank promises to pay the draft at
maturity, thereby substituting its creditworthiness for that of the
importer. The drawer (exporter) can then hold the BA, or it can be
sold in the money market. Credit quality depends on the
creditworthiness of the accepting bank. Principal amounts are usually
in round denominations of $500,000, or $1 million, or in odd amounts
between $25,000 and $499,000 depending on the transactions being
financed. Maturities generally are between 30 and 180 days.

Repurchase agreements (repos). These involve two simultaneous


transactions: (1) the purchase of securities (which are collateral) by an
investor from a bank or dealer and (2) a commitment by that bank or
dealer to repurchase the securities at the same price, plus interest, at a
date in the future. Repo maturities range from one day to one year,
with most trades being under three months. The smallest trade
usually is $1 million.

There are also money market instruments, such as demand notes and
short-term tax-exempt notes, issued by municipalities that pay interest
free from federal taxation.

Real Estate
In the United States, over 50% of American households are owners of
their own homes; surely the vast majority of the investment professionals
clients have some form of investment in real estate. Data indicates that,
over time, the market value of existing homes has exceeded the rising cost
of living. According to information from the Federal Housing Finance
Authoritys House Price Index from 1991 to December 2010, U.S. home
prices increased about 3.20% per year. Missing from this performance
data, however, are the costs associated with home ownership. And, of

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course, certain geographical areas did better or worse than 3.20%, along
with large changes in prices for certain localities during this period.

Direct real estate investing can take many forms: raw land, commercial
property, apartment buildings, and so forth. One popular form of direct
ownership is buying a rental house. The old adage that the three things
that matter when investing in real estate are location, location, location
certainly applies to buying a rental property. In areas with strong local
economies in which jobs are plentiful (low unemployment rates), incomes
are rising, and/or there is a significant migration, properties usually offer
attractive price appreciation.

By 2006, there were concerns of a housing bubble in areas where there


was large appreciation due to both high demand for housing and the
existence of speculators who would buy homes with the intent of holding
them only a few months or even less and then selling at a profit, called
flipping. These purchases were made all the easier by loose lending
standards, even to the point of some of the loans being called liars loans
because of the misinformation on the loan applications. By 2008, these fears
in some areas were realized and compounded by significant problems with
subprime mortgage loans to people with weak credit histories and/or large
amounts of debt. A large number of foreclosures and short sales continued
into 2011, which kept prices depressed in many regions.

One measure of value in the housing market is a house price/earnings


ratio. This is calculated by dividing the house price by the annual rental
income that house could generate.

Example. A house can be purchased for $200,000 and rented for $1,400 a
month. The annual rental income then would be $16,800. So
$200,000/$16,800 = 11.90, the housing P/E. These P/Es can be used to
judge relative value by comparing it to historic P/Es in that location.

To calculate the P/E for an entire city, Edward Leamer of UCLA


developed the following ratio: median home price/annual rent for a two-

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bedroom apartment. This P/E relative to historic P/Es in the same area
gives some indication whether prices are overvalued or undervalued.
Like with stocks, the higher the P/E, the more risk that prices are high. A
situation where home prices are increasing but rents are flat is a warning
sign; a situation where home prices are increasing but rents are
decreasing is a real indication of a housing bubble.

Over the past 30 years, broker-dealers have been active in offering clients
what may be termed indirect real estate investments. These have been
mainly real estate limited partnerships (RELPs) and real estate
investment trusts (REITs). RELPs and REITs make it possible for the
passive investor to acquire a smaller or larger stake in real estate without
the normal and sometimes onerous burden of being a direct property
owner. (The tax consequences of such forms of ownership vary.) Real
estate can be an attractive addition to a portfolio because it offers returns
that outpace inflation and diversification due to its low correlation with
other assets in a portfolio.

Real Estate Limited Partnerships


RELPs are partnership interests in real property. As passive partners, the
investors are limited partners, meaning that the extent of their liability
for losses is limited to the amount of their investment. A general
partner has day-to-day responsibility for the purchase, management,
distribution of gains/losses on a pro rata basis, and eventual sale of the
property. The partnership status of the investor often has certain tax
benefits, but often not to the extent of directly owned real estate.

Real Estate Investment Trusts


REITs are entities formed to invest in real estate mortgages (mortgage
REITs), outright ownership of property (equity REITs), or a combination
of the two (hybrid REITs). Mortgage REITS can provide above average
income, equity REITS can provide capital appreciation, and hybrid REITS

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can provide some income and capital appreciation. To qualify as a REIT,
an entity must meet a number of requirements:

at least 90% of REIT income (other than net capital gain) must be
distributed annually (in this way, the entity is not taxed but the
investor is taxed);

the REIT must derive most of its income from passive, real-estate-
related investments; and

REIT assets must be primarily real-estate-related.

In many ways, they resemble mutual fundspooling investor funds,


purchasing a diversified set of property interests, managing those
interests, and pay dividends to investors. Unlike a RELP, ownership
interest in a REIT takes the form of common stock, and these stocks are
traded either over the counter or on exchanges. As was shown in Table 3,
equity REIT correlations are similar to the correlations of stocks relative
to bonds, T-bills, and inflation, and highly correlated with small company
stocks. Dividends from REITs are not qualified dividends and therefore
are taxed at ordinary income rates.

Investment performance and risk. The variety of real estate investments is


so broad and their characteristics so unique that generalizations about
performance are difficult to formulate. The most obvious risk is the
possibility that the price of the real estate will go down. For several years,
many people saw real estate prices only increase. However, as evidenced
since 2006, real estate prices can declinesometimes significantlyafter
a period of large price increases and during a period of easy money.

For many investors, the poor liquidity of many real estate investments is
a major problem. For anyone who has had to sell a home, the illiquidity
and high transaction costs of direct ownership are painfully obvious. The
liquidity of RELP interests is very limited and, in many cases, virtually
nonexistent. While a few partnerships have appeared to buy units of

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other real estate partners, transactions are inevitably at fire-sale prices.
There are some organized secondary market activities for limited
partnership units, but these fall far short of the efficiency and liquidity of
equity markets.

Also, direct and partnership interests in real estate entail tax-reporting


responsibilities that small investors may find onerous, given the size of
their dollar commitment. REITs, on the other hand, suffer no such
liquidity problems, and, as traded shares, are often followed by
investment research providers. Thus, a performance record for a
particular REIT can often be obtained. As was seen earlier, the longer-
term performance of equity REITs (January 1972 through December 2010)
provided a total annual compound return of 12.0%, nearly 2% higher
than the S&P 500 index. REITS, however, can have significant swings in
return from year to year. For example, the Vanguard REIT index mutual
fund in 2008 was down 37.05%, but up 29.68% in 2009.

Mutual Funds
A mutual fund is an open-end investment company that pools the money
of many investors and hires an investment advisor to invest that money
in an attempt to achieve one or more financial objectives. These financial
objectives can be broadly classified as current income, capital
appreciation (growth), and capital preservation. Mutual funds are offered
for sale through a legal document called a prospectus. More detailed
information about the fund can be found in its Statement of Additional
Information (SAI).

Pooling of the money is key to mutual fund investing. By pooling the


financial resources of thousands of shareholderseach with a different
amount to investinvestors gain benefits they may not be able to obtain
otherwise. Benefits include access to the expertise of the professional
money managers, diversification of securities, and a variety of services.

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The directors or trustees of a mutual fund have the overall responsibility
to oversee the management of the funds affairs. At least 75% of the board
must consist of independent directors. Directors have a fiduciary duty to
the shareholders and their responsibilities include, but are not limited to,
continuous review and oversight of the funds operations and portfolio
management; the performance of the investment advisor including, of
course, the funds performance; and the reasonableness of the funds fees
and expenses.

Asset Selection
The funds investment advisors employ a portfolio manager (or a team of
managers) who invests these pooled funds in a variety of stocks, bonds,
or other securities selected from a broad range of industries, government
agencies, and authorities. The specific securities selected are those that
the advisor believes meet the funds objective, as explained in the funds
prospectus. Each mutual fund investor owns a percentage of the funds
portfolio and shares in any income and gains according to that same
percentage, subject to operational expenses and fees that must be borne
by the class of shares in which he or she is invested. Likewise, all
investors of the same class of fund receive the same rate of return or yield
per share.

To achieve their objectives, portfolio managers may invest in 50, 100, or


more different securities, seeking diversification among companies and
industries so as to reduce investment risk. But diversification is not
simply a numbers game. Owning 50 different common stocks may
provide diversification among companies, but not necessarily among
industries. For example, a fund could be classified as diversified and have
80% in, say, technology stocks or even 12.5% of its assets in one stock and
12.5% in a second stock as long as it met other diversification rules of the
Investment Company Act of 1940. Also, owning this many stocks does
not represent diversification by asset class.

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Mutual Fund Pricing
Mutual funds are required by law to redeem their outstanding shares on
any business day upon a shareholders request based on the net asset
value calculated after receipt of the redemption order. Net asset value
(NAV) per share is computed by taking the amount of the funds total
assets (its cash and securities), subtracting the funds liabilities (such as
securities bought but not yet paid for), and dividing that amount by the
number of shares outstanding. For example, if a fund had $1 million in
assets, $40,000 in liabilities, and 100,000 shares, its net asset value per
share would be $9.60, computed as follows:

$1,000 ,000 $40 ,000


$9.60
100 ,000

Mutual funds sell and redeem their shares once a day as of the close of
trading on the New York Stock Exchange at 4:00 p.m. Eastern time. The
NAV is priced based on these closing prices, and all orders throughout
the day are based on the NAV of these closing prices. This is called
forward pricing.

The pricing of the funds individual securities is generally the closing


market price for a given business day Sometimes, however, a fund might
use fair value pricing. This pricing, at times, is necessary because securities
in a mutual fund are not always priced correctly due to a funds share
price being calculated once a day, at 4:00 p.m. Eastern time. At that time,
international stocks and some seldom-traded securities, such as certain
junk bonds and small-cap stocks, may not have traded in several hours. If
some significant event occurs without these prices being adjusted,
investors could take advantage of these stale prices. To more accurately
price the portfolio in such situations, fair value pricing, approved by the
SEC in 1981, was instituted to adjust the prices of the funds securities
when they might not reflect their true value.

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For example, in one dayon October 19, 1987the U.S. stock market fell
over 20%. With such an event, it was a virtual certainty that the following
day international stock markets would also plunge. Without fair value
pricing, a U.S. investor could sell his international stock fund based on its
stocks closing prices several hours earlier and, therefore, before the drop
in prices the next day. This is called time zone arbitrage. Fair value
pricing can be based on other information such as the prices of futures
contracts tied to stocks, or the funds projection of what the shares will be
worth when the market opens the next morning. In the case of private
placements, fund managers often decide the prices on private placement
securities, a practice that can lead to mispricing and potential abuse. In
late 1999, the SEC issued guidelines concerning when fair value pricing
should be used.

In practice, however, the fair value of a security must also be based on the
price a fund might reasonably expect to receive upon (the securitys)
current sale. In 2004, the SEC instituted a requirement that fund
companies use fair value prices at any time market quotations for their
portfolio securities are not readily available (including when they are not
reliable). They must also disclose when and how they implement fair
value pricing in their prospectuses.

Shareholder Transaction Expenses


These are expenses for buying or redeeming shares of the fund. A sales
commission is called a load. Shares sold without a sales commission are
called no load. Some funds assess a load at the time of purchase, called
a front-end load; these are called Class A shares. Only purchasers of A
shares are subject to breakpoints, which are dollar levels at which the
commission percentage decreases. For example, there may be a front-end
load of 5% for purchases up to $50,000, 4% for purchases of $50,001 to
$100,000, and additional commission discounts as the amount of the
purchase increases. The specific breakpoints vary from fund to fund, as
spelled out in their prospectuses.

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Some funds assess a load that diminishes yearly, called a contingent
deferred sales charge or back-end load, if redeemed within in a certain
number of years and on a descending scale, such as 6% the first year, 5%
the second year and so on. These are Class B shares. Purchasers of B
shares typically pay higher annual expenses than for A shares. But after
several years, B shares are usually (but not always) converted and those
annual expenses usually decrease enough to be in line with the lower
annual expenses of A shares.

A level-load fund, or Class C shares, has an asset-based sales charge; it uses


the annual 12b-1 fee as a sales charge. Under NASD rules, the maximum
portion of the 12b-1 fee that may be devoted to distribution costs is 0.75%
of assets. This fee is used to recover the sales commission. A 0.25%
service fee may also be imposed to cover annual trailing commissions
to the salesperson, for a total 12b-1 fee of up to 1.0%, which is included in
the funds expense ratio. It should be noted that the SEC has proposed to
rescind the 12b-1 fee and replace it with Rule 12b-2, which would allow a
marketing and service fee that would be limited to 0.25% per year.

A redemption fee is a fixed percentage of the amount redeemed, typically


1% or 2%, charged if shares are sold within a given periodsuch as 60
days or one year from the date of purchase to discourage short-term
trading (this fee goes back into the fund, which is advantageous to
remaining shareholders). Another common fee usually associated with
IRA accounts is a maintenance (or account) fee. This is a fixed charge, such
as $10 per year, for recordkeeping and reports. This fee is sometimes, in
effect or simply outright, a low-balance fee, which is a fee charged when a
shareholders account falls below a specific dollar level, such as $1,000.

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Operating Expenses
Every mutual fund incurs operating expenses, which are paid out of a
funds income. The prospectus contains a list of three types of expenses:

1. The management (investment advisory) fee, which is paid to the


investment advisor for its services in managing the fund;

2. 12b-1 fees, which originally were for the purpose of paying marketing
and advertising costs incurred in promoting the funds but more
commonly have been used to pay investment representatives for
service to their clients; and

3. other expenses, which pay for administrative or outside services such


as shareholder recordkeeping and reports, auditing, custodial
services, legal services, proxy solicitations, annual meeting costs,
directors fees, state and local taxes, and so on.

These fees and expenses are incorporated in the funds expense ratio,
which is the funds annual operating expenses divided by the funds
average assets.

An important expense not included in the expense ratio is transaction


costs. These are:

1. commissions, and

2. the bid/ask price differences when selling or buying.

Commissions are measurable. A study conducted by Morningstar in


March 2010 reported that, for 2009, the average domestic equity fund
paid .29% of assets in commissions, and international equity funds paid
.30% (although some individual funds paid .63% to over 1% in
commissions). With large trades and trades in stocks with low liquidity,
there is also a market impact cost, which is the change in bid or ask prices
due to these trades.

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Types of Mutual Funds
There are numerous types of mutual funds classified by the types of
securities within the funds. The three broad categories are

stock funds,

bond funds, and

money market funds.

Stock funds can be broken down by capitalization size and investment


style (growth, value, or a blend of growth and value), as well as U.S. and
international stocks. Global or world stock funds own both U.S. and
foreign stocks. Sector funds concentrate on a certain industry, such as
technology or energy, or a theme, like leisure, and generally have a
higher risk/potential return profile than diversified stock funds.

Bond funds can be categorized by the typical grades and maturities of the
bonds, by issuer (U.S. government, corporations, and municipalities),
and, again, U.S. or foreign bonds.

Money market funds maintain their NAV at $1 per share and can be
divided into taxable and tax-exempt money market funds. Some funds
combine these asset categories. Balanced funds own both stocks and
bonds, often in about a 60%/40% stock/bond ratio. Asset allocation funds
often own a combination of stocks, bonds, REITs, precious metals stocks,
and money market securities. An increasingly popular type of asset
allocation fund is the target-retirement or target-date fund. These funds
allocate their assets among stocks (sometimes including international
stocks), bonds, and cash equivalents (and sometimes other asset classes)
according to an anticipated retirement date, such as 2030. As the time
frame increases, more is invested in stocks and less in bonds and cash
equivalents. Over time and nearing the anticipated retirement date, these
funds become more conservative by lowering the allocation in stocks and
increasing the allocation in bonds and cash equivalents.

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If a fund uses a type of security in its name, such as U.S. Government
Income Fund, 80% of its assets must be in that security, in this case U.S.
government securities. If a municipal bond fund has tax-exempt or
tax-free in its name, 80% of its assets must be in municipal bonds that
pay interest that is not subject to the alternative minimum tax.

The risk/return profile of a given mutual fund depends on the


characteristics of the underlying securities and the degree of
diversification within the fund. For example, stock funds generally offer
higher risk/higher return, but if a fund has 70% of its portfolio in, say,
technology and telecommunications stocks even though it is not a sector
fund per its prospectus, that fund has a very high risk/higher expected
return profile. Bond funds relative to stock funds have a lower risk/lower
return profile, but that profile can be significantly different depending on
the duration, issuer, and the grade of the bonds in the portfolio. Money
market funds have an even lower risk/lower return profile than bond
funds and are appropriate as a place for emergency funds or as a
temporary parking place when trying to decide where to invest next.

Distributions and Taxation


To qualify as a regulated investment company (RIC) under the Internal
Revenue Code, a fund must distribute at least 90% of its taxable income
or, in the case of a municipal bond fund, net tax-exempt interest income.
A RIC is taxed as a conduit, meaning that it will not be taxed on the
income and gains it distributes. Another distribution requirement is that
to avoid a 4% excise tax, the fund must distribute at least 98% of ordinary
income and 98% of net realized capital gains for the 12-month period
ending October 31 of a calendar year (in practice, virtually all mutual
funds make such distributions).

Taxable interest income, nonqualified dividends, and short-term capital


gains distributions (profits on securities held one year or less and then
sold) are taxed at ordinary income tax rates. Cash dividends that are

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qualified dividends (the fund will report to its shareholders if they are
qualified on IRS Form 1099-DIV) are taxed at the maximum rate of
15%. Reinvested dividends are taxed the same way as if those dividends
were paid in cash. Except for income distributions from municipal bond
funds or distributions into tax-sheltered accounts, dividend
distributions are taxed in the year paid. However, dividend or capital
gains distributions declared within the last three months of the year but
paid the following January are taxable as though they were paid on
December 31. Dividend and capital gains distributions that are
reinvested increase the basis in the mutual fund, so it is important to
keep accurate records of such distributions. Long-term capital gain
distributions are also taxed at a maximum rate of 15%.

Return of capital distributions lower the basis in the fund; for example, if
a shareholder invested $1,000 and received a $50 return of capital
distribution, the shareholders basis is now $950. Bond and money market
funds generally distribute income monthly; stock funds usually distribute
income quarterly or annually. Capital gain distributions are usually made
in December.

Exchange-Traded Funds (ETFs)


As regulated open-end investment companies, exchange-traded funds
are, with a few exceptions, open-end investment companies that trade
throughout the day like stock. More specifically, ETFs are a basket of
securities that follow common indexes or a group of securities created by
the sponsor of the ETF. For example, there are ETFs that track, among
others, the S&P 500 index, the Dow Jones Industrial Average, and many
industry funds. As such, they are passively managed, because they follow
the indexes and are, with a few exceptions, not actively managed (the first
actively managed ETF, an ultrashort bond fund, began trading March 25,
2008; and as of December 31, 2009, there were 21 active ETFs). Investors
like the transparency of ETFs in that they disclose their holdings daily, a

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feature that active ETFs dont like for fear that some investors might use
that information to their advantage. When following an index, the ETF
might not track the index exactly (called tracking error) due to trading
costs, fund expenses, and situations in which an ETF uses a sample of the
securities in an index rather than buying all the securities in that index.

As the popularity of ETFs has increased, the sectors covered by ETFs have
become more specialized and have expanded greatly to include styles
(large-, mid-, and small-cap growth and value) and even one that tracks
the 25 largest and most liquid Chinese stocks. In addition, more ETFs are
being offered to give investors the ability to take leveraged or short
positions in various sectors. Most ETFs are stock portfolios, but there are
some bond ETFs. There now are also inverse ETFs and leveraged ETFs.
Inverse ETFs increase when the benchmark decreases and leveraged
ETFs, called double-beta ETFs, provide twice the performance of their
benchmark. There is also the possibility of more actively managed ETFs
being offered in the next year or so.

Because they trade like stock, they offer trading flexibility desired by both
individuals and institutions: ETFs can be bought on margin and sold
short. Also, some ETFs have options on them.

Expenses
Most, but not all, ETFs have very low annual expenses, in the range of 9
to 20 basis points (100 basis points equals 1%). These expenses are usually
slightly less than those of index funds because ETFs do not have the
expenses involving shareholder services. As more and more ETFs come to
market, in some cases those that are more specialized in particular have
had higher annual expenses approaching 1%. Therefore the expenses of a
specific ETF should be identified and not just assumed to be low

ETF shares are like any other stock trade, thus there are commissions
when shares are bought or sold. Because of these commissions, the ETFs
cost advantage can be offset with frequent trades, depending on the cost

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of trading. Commissions on trades range widely; and may be inexpensive
or expensive (especially on small trades). If the commissions are high,
ETFs might not be conducive to dollar cost averaging.

Tax Efficiency
A major attraction of ETFs is that they generally are very tax-efficient
(although there are exceptions to this, such as taxable bond ETFs and
ETFs that directly hold precious metals, which are taxed as collectibles at
a 28% rate, and ETFs that use derivatives extensively like inverse ETFs).
Tax inefficiency of a mutual fund is a function of the taxable income from
the underlying securities and the sale of securities in the fund at a profit.
These sales are primarily due to the portfolio manager changing
securities or making sales due to shareholder redemptions. Because they
are generally index funds, ETFs usually have only a limited number of
sales when adjusting to changes in the indexes they follow.

Also, shareholders cannot redeem shares with the investment company;


rather, they must sell their shares on the exchange. Therefore, there are no
forced sales by the portfolio manager due to heavy redemptions. An
exception to this is large investors, called authorized participants, who can
redeem shares from the fund in blocks of, typically, 50,000 shares. If they
redeem shares, they are paid with shares of the underlying stocks (called an
exchange in-kind), so the fund does not have to sell securities to meet
those redemptions (large investors can also buy shares in 50,000 blocks by
exchanging shares of the underlying stocks for shares of the ETFs).

Also, the ETF manager in this way can exchange those securities with the
lowest cost basis, thereby being more tax-efficient. ETFs, however, can
and do make capital gains distributions due to rebalancing the portfolios,
usually by selling stocks that are taken out of the underlying indexes and
replacing them with shares of stocks added to the indexes. Although
most of these distributions are modest, in a few instances these
distributions have been significant.

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Dividends
ETFs can also pay nonqualified dividends, which are taxed at regular
income tax rates, if they sell or redeem stocks that do not meet the
qualified dividend holding period requirement. To be qualified the
stock must be held for at least 61 days of the 121-day period that begins
60 days before the ex-dividend date. Small ETFs are more likely to pay
nonqualified dividends because as the demand for them decreases, they
are more likely to have to sell stock that does not meet this holding period
requirement. In contrast, larger ETFs have more shares and therefore can
sell those that have been held for longer periods.

Net Asset Value


Most of the time, ETFs trade at or near their net asset values (NAV);
usually within 0.50% of the NAV. According to an article, dated January
26, 2011, on Morningstars website,

U.S. equity ETFs with more than $100 million in assets and
average trading volumes greater than 100,000 shares per day had
an average deviation from NAV of 0.08% in 2010. In contrast, the
average bond ETF in 2010 traded an average deviation of 0.26%.

This difference is largely due to the lower liquidity of the underlying


bonds, which trade less frequently than stocks. Another reason is that a
bond ETFs NAV is the average bid price of the portfolios bonds. If an
authorized participant has to create new ETF shares due to market
demand, it will buy the bonds in the open market, paying the asked
price for them. The participant then sells these newly created shares at a
price slightly higher than they paid for the bonds and, therefore, at a
premium to NAV.

ETF prices can vary more from NAV during unsettled times because the
price of an ETF is determined by supply and demand like any traded
security. For example, on February 27, 2007, after stocks fell in the

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Chinese market, one ETF that tracks the Chinese market fell 9.9%, even
though the index it was tracking had fallen 2.1% during Chinese trading
hours. Another example occurred on September 18, 2008, when a high-
yield bond ETF closed at an 8.4% discount to the value of its securities.
These divergences from the NAV are exceptions but yet can occur (of
course, the buyer of this ETF would benefit from this situation).

Also, corporate bond ETFs tend to vary from NAV because corporate
bonds have much less liquidity than Treasury securities. In the same
January 26, 2011, Morningstar website article mentioned previously, it
was reported that the average deviation from NAV in 2010 for
government ETFs was 0.07%, but for corporate ETFs it was 0.44%. During
periods of market stress, these deviations can be even larger. For
example, in the first quarter of 2009, one high-yield bond ETF traded
from a premium of 12% to a discount of 4.9%. Nevertheless, the value of
the underlying securities is by far the major factor in determining an
ETFs price. The Amex updates an intraday indicative value, or IIV, as a
reference value (called intraday value for domestic funds and
indicative optimized portfolio value for non-U.S. portfolios, which
reflects changes in foreign exchange rates) for each ETF at 15-second
intervals during the trading day. This value is determined by calculating
the last sales price of each of the stocks in the ETF.

Bid/Ask Spread
Another factor to consider when trading ETFs is the bid-ask spread on
them. These spreads can increase depending on market conditions.
Factors increasing these spreads are general market volatility, amount of
trading volume in the ETF (wider for small ETFs), amount of trading in
the underlying investments, as well as whether some of those securities
are overseas where their trading is closed for the day. Spreads can be as
low as .02% for very active ETFs to over 1% for tiny ETFs.

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Exchange-Traded Notes (ETNs)
Exchange-traded notes (ETNs) are unsecured debt securitieswith
maturities of 30 years not being unusualtypically issued by large
commercial banks or investment banks. Like ETFs, they track an index or
benchmark, trade like stock, and can be shorted. As a result, from the
investors perspective, ETNs look and seem like ETFs. Unlike ETFs,
however, ETNs do not hold a basket of stocks, but rather represent
promises by the issuers to match the returns of an index or commodity,
minus fees. As such, investors need to be concerned about the
creditworthiness of the issuer; in the event of default, investors would
wait in line for payment with other creditors, as there are no securities to
back the ETNs. Being debt securities, ETNs do not have voting rights.
Also, these debt securities do not pay interest during their term and are
not rated (although their issuer will typically have a rating).

One advantage of ETNs is that index-tracking error is eliminated. ETNs


are often issued to track commodity indexes and currencies, which are
not widely available as ETFs or mutual funds. Their annual fees might
range from 40 to 90 basis points. ETNs must register with the SEC under
the Securities Act of 1933 and are offered by prospectus, but do not have
to comply with the Investment Company Act of 1940 as do ETFs and
mutual funds. As such, ETFs and mutual fund regulations prohibit direct
ownership of commodities and restrict the level of financial futures and
debt leverage. ETNs are not governed by the same laws so this makes is
much easier to offer commodity indexes.

Some ETN issuers publish an intraday indicative value to represent an


intrinsic value of the ETN. This is not a net asset value (again, because
this is a debt security), but rather a reference point only; the actual price
for investors of the ETN will be its current market price, which might
differ from its indicative value.

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In addition to being sold on an exchange, large redemptions (typically
50,000 units) may be made directly with the issuer under the terms stated
in the prospectus. A redemption fee might apply. Investors holding the
units to maturity will receive a cash payment tied to the performance of
the index between the purchase date and maturity date, less fees.

Tax Advantage of ETNs


ETNs have an important tax advantage that mutual funds do not.
Exchange-traded notes are treated as prepaid forward contracts, the
owner of which pays an initial amount in order to receive a future
payment depending on the performance of the index at a specific time. As
such, for federal income tax purposes an investor does not recognize any
income or capital gains until the ETN is sold or redeemed. As a result, an
investor holding an ETN for more than one year is taxed at the 15% long-
term capital gain rate. Mutual funds and ETFs are taxed on realized
income and capital gains annually.

However, on December 7, 2007, the IRS ruled that any financial products
linked to a single currency should be treated like debt for federal tax
purposes, even if they are publicly listed on an exchange like ETNs. The
effect of this is that any interest accrued by the ETN, as well as any gains
regardless of the holding period, is taxable at ordinary income tax rates.
While this ruling affects only currency ETNs, it is unclear if the taxation
of other ETNs will change in the same way. There is an effort by mutual
fund interests to change the taxation on ETNs to make it the same as ETFs
and mutual funds.

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Chapter 3
Stock Valuation Methods
Reading this chapter will enable you to:

46 Calculate a common stock value using established valuation


methods.

W
hat is a particular stock really worth? This simple question
goes to the heart of a great deal of thinking and analysis in the
investment community. By extension, the same question
generates thinking and activity in real estate, the art world, and even
descends to the level of the individual trying to trade in a used car. How
do you determine the dollar value of an asset?

The methods offered here include the dividend discount model,


price/earnings ratios, price/sales ratios, and the growth-oriented
intrinsic value model. You will be able to apply these methods to the
value appraisal of a stock.

Sources of Corporate Stock Value


Two terms are frequently used in the process of valuing corporate stock:

Intrinsic value. Benjamin Graham defined this as that value which is


justified by the facts, e.g., assets, earnings, dividends, definite
prospects, including the factor of management.

Market value. This is determined by the current price established by a


free and open system of buyers and sellers.

Stock valuation is an attempt to find discrepancies between these two


values and thereby establish profitable buy/sell opportunities. Success in

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this effort requires an awareness of the sources of common stock value:
future earnings and the dividends those earnings make possible.

A Model for Common Stock Valuation


If the intrinsic value of a share of common stock is based upon its
earnings and the dividends they produce, we can construct a theoretical
model that helps us visualize this valuation process. Below is a dividend
discount model based upon the time value of money concepts described
in the previous module. In this model, the value of a stock is the present
value of the stream of all future dividends, where Vs is the intrinsic value
of the stock, D is each years dividend, and k is the rate of return that
reason would dictate as required for an investment of this type or risk.

D1 D2 D3 Dn
Vs = 1
+ 2
+ 3
+
(1 + k) (1 + k) (1 + k) (1 + k) n

Thus, the value of the stock is the sum of all of these discounted
dividends (which, in this case, assumes the dividend is constant). In this
model, dividends (the numerators in the equation) extend out n years
into the future. Since we know that the value today of monies received in
the future diminishes as time expands, the denominator of the equation
[(1 + k)] grows larger in each period [(1 + k)2, (1 + k)3, and so forth.]. As
the (1 + k) grows larger, it causes the present value of the D in that period
to grow smallercontributing less to the present value of the stock. The
role of k, the required rate of return, also plays an important role. The
investor who views the stream of dividends as less certain would tend to
assign a larger value to k, and as k becomes larger, D/(1 + k) becomes
smaller, reducing the present value of the stock.

The above formula simplifies to


D
V
k

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where
V = Intrinsic value of the stock
D0 = Current-year dividend
k = Required return

Since this formula assumes a constant dividend, it has the most


applicability to valuing preferred stock. For example, if a preferred stock
pays a $2.00 annual dividend and the investor believes a discount rate of
12% is appropriate, then $2.00/.12 = $16.67, the value of the preferred
stock.

Common stocks, however, provide the opportunity for a growing


dividend. If the dividend is assumed to grow at a constant rate, then a
version of the above formula can be used, called the constant growth
dividend discount model (DDM).

D 0 (1 g )
V
k g

where
V = Intrinsic value of the stock
D0 = Current-year dividend
k = Required return
g = Dividend growth rate

As can be seen, calculating the intrinsic value of a stock using the


constant growth DDM requires three inputs:

1. current-year dividends of the stock

2. estimated growth rate of the stocks cash dividends

3. required return for the stock

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A stocks current-year dividend is easy to obtain from numerous sources,
including The Wall Street Journal and various Internet business sites.

Calculating the estimated growth rate of dividends is more difficult. If we


assume that the payout ratio (the percentage of a companys earnings
paid out in dividends) will remain constant (an important assumption in
the DDM), then we can use the estimated growth rate of earnings as the
estimated growth rate of dividends.

The required return is the return the investor needs in order to induce
him or her to purchase the stock. This will be a function of the risk the
investor believes is inherent in purchasing this particular stock.

Assume a stock has a current annual dividend of $1.60, which is


estimated to grow at 13.6%. Also assume this stock is considered above
average in risk so the investors required return is 18%. Using these
inputs for the equation, the computation of the intrinsic value of this
stock using the constant growth DDM is as follows:

D 0 (1 g ) 1.60 (1 .136 )
V $41.31
k g .18 .136

If the current market price is less than $41.31, then the stock is
undervalued (and therefore could be considered a buy) according to
this model. If the current market price is more than $41.31, then the stock
is overvalued according to this model.

Although difficult to apply to actual valuation situations, this model is


useful in helping us to understand how risk, time, and dividends impact
the value of a stock. But what about stocks that pay no dividends?
Growing companies reinvest earnings in the firms operations. How does
this model apply to them? The answer is that dividends are strictly a
reflection of earnings. A company with growing earnings may choose to
defer dividend payments, but eventually owners expect to be paid

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either by smaller dividends now or larger ones later. Thus, dividends
would appear in the valuation formula at a later time period and,
perhaps, in larger dollar amounts.

Price/Earnings Ratios
Institutional investors use the dividend discount model as just one of
several cuts at valuing stocks. However, the model has limitations since
dividends (or, rather, the earnings that support them) are difficult to
forecast more than one year in advance. Determining a suitable value for
kthe required rate of returnis also difficult. As a result, many
investors rely on other methods for estimating stock value; the
price/earnings (P/E) ratio is one of them. When both current stock price
and company earnings are known, the P/E ratio indicates how much
investors are willing to pay for $1 of current earnings.

How can P/E information be used? P/E information on one company is


valuable when trying to determine the intrinsic value of a comparable
company in the same industry. Here are a few examples:

If the price of that second company is lower relative to its earnings,


the stock may be undervalued. Or, perhaps, the first stock is
overvalued.

P/E ratios can be used to gain a sense of how a company is priced


relative to the entire market or to its particular industry. For example,
the P/E ratio of XYZ Corporation might be compared to the broader
market, as represented in the S&P 500. Figure 4 shows XYZs
price/earnings ratio in the context of the broader market. The
growing gap between XYZs P/E ratio and that of the market may
suggest an overpriced situation.

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Figure 4: Average Yearly P/E Ratios of XYZ Corporation and the S&P 500

P/E Ratio

XYZ Corp

S&P 500

Time

Using P/E ratios as a valuation tool, we can obtain an estimate for share
value using the following method:

Determine the price-to-earnings ratio that seems appropriate for the


stock in question, given the riskiness of the stock and the other
evidence of what the investing public is willing to pay for common
stocks, stocks in that industry, and so forth (for example, P/E = 10).
Some industries, and therefore some stocks, have much higher or
lower average P/Es than the broad market average. The average P/E
for the electronic components industry, for example, has fluctuated
between 40% and 100% above the S&P 500 P/E. Therefore, some
analysts will state that a certain growth company, for example, should
sell at a premium of 20% to the market as measured by the S&P 500
index. In such a case, if the S&P 500 index P/E was 18, then this
stocks P/E should be 18 1.2 = 21.6.

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Obtain the current earnings for the particular stock (or an average of
several such forecasts): for example, $2.50 per share.

Solve the equation for P:

P/E 10
P E 10
P $2.50 10 $25

To extend this method to the future price of the stock (here Pf), simply
substitute a forecast of future earnings (Ef) and multiply that by the
current ratio figure, as indicated below:

Pf E f current P / E ratio
$3 10
$30

This valuation method presents two challenges for the investment


professional: (1) obtaining an accurate earnings forecast, and (2) selecting
the appropriate P/E ratio. Earnings forecasts are readily obtainable for
most stocks covered by stock analysts, but these often contain surprises.
And P/E ratioswhat investors are willing to pay for $1 in earnings
fluctuate as those investors become optimistic and pessimistic in turn. For
example, in 1982, when the economy was in a recession, the S&P 500
index P/E was about 7; in late 1999a period of low inflation, good
earnings growth, and high investment optimismthe P/E was over 32.
Furthermore, in the euphoria of early 2000, some stocks with P/Es as
high as 50 or even 100a point of extreme valuationwere selling. The
higher the P/E on a stock, the more vulnerable that stocks price is to any
changes in the companys business or investor sentiment about the stock.
One rule of thumb is that the P/E of a stock should not be greater than
the companys rate of earnings growth.

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Another way to look at the P/E ratio is: Price = Earnings P/E. From this
equation, for the price to increase, the earnings must increase, the P/E
must increase, or both. A stocks price over the long run is determined by
its earnings. From this formula it can be seen that if earnings increase and
the P/E ratio stays the same, the price must increase. However, if
earnings increase at a rate greater than expected, the P/E ratio can be
expected to increase as investors become more optimistic about the
company, thereby adding a second lift to the price of the stock. On the
other hand, if earnings increase but investors become less enthusiastic
about the stocka situation typical for a company that was growing
rapidly but is now growing less rapidlythe stock price could be
stagnant or possibly decrease even though earnings increase. An example
of such a company is Wal-Mart, where earnings have continued to grow
but at a less rapid rate than in prior years. As a result, investors no longer
are willing to pay as much for a dollars earnings so the P/E has come
down. Therefore, it is important to consider not only changes in earnings
but also changes to the stocks P/E.

The relationship between earnings and the P/E ratio can be used in
another way, called the PEG ratio. This simply divides the P/E of a
stock by its estimated future earnings growth rate, which can be for one
year, three years, or five years. In general, a ratio of 1 is considered to be
fair value, over 1.0 is overvalued, and under 1.0 is undervalued. The
more over 1.0 or under 1.0, the more overvalued or undervalued,
respectively. Therefore, if a company has a P/E of 10 but an estimated
earnings growth rate of 14%, that stock is considered undervalued.
Likewise, if the P/E is 14 and the earnings growth rate is 10%, the stock
is considered overvalued.

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Price/Sales Ratios
While the P/E valuation approach is straightforward and generally
accepted within the investment community, it has at least one problem:
many of the stocks that growth-oriented clients want to buythose in the
developmental stages of their evolutiondo not have earnings. Even
large, established firms have periods in which they have losses instead of
positive earnings. Also, reported earnings can be manipulated within the
boundaries of generally accepted accounting principles. So, how can the
investment professional make an estimate of their value? One approach is
to consider the price-to-sales (P/S) ratio, which can be determined even if
no earnings are present.

The price-to-sales ratio indicates what the market is willing to pay for $1
of a companys sales; the ratio is determined by looking up the market
price of the shares and by obtaining a figure for sales of that company on
a per share basis. P/S as a value estimator is based on the premise that
profits and value are ultimately related to sales, which are not subject to
the same manipulation as earnings and which are generally more
consistent than reported earnings, thus giving a truer picture of company
performance. One way to use this technique is to compare the P/S ratio of
a company to the P/S ratio of its peers.

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The Growth-Oriented Intrinsic Value Model
One more tool the investment professional may use in the quest for the
true value of a stock is a mathematical model that relates the historic
growth rate of the stocks earnings, its current earnings, the prevailing
interest rate on high-grade bonds, and two numeric constants. This model
is represented below:

37.5 8.8g
Stock value EPS

Aaa bond rate

In this formula, 37.5 and 8.8 are constants determined from statistical
analysis of years of stock market performance. Earnings per share (EPS)
may be current or forecasted. The letter g is the historic growth rate of the
stock in question. It is obtainable from the companys annual report, Value
Line, or Standard & Poors. The Aaa bond rate is the current rate on the
highest-quality long-term corporate issues. By substituting these values
into the model, the investment professional may obtain an estimate of
intrinsic value against which current market value may be evaluated.

For example, assume stock ASAP has earnings of $4.50, an historic


growth rate of 5%, and the Aaa bond rate is 6%. The intrinsic stock value
would be calculated as follows:

Stock value $4.50 ( 37.5 [ 8.8 5]) 6


$4.50 13.583
$61.12

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Chapter 4
Bond Valuation Methods
Reading this chapter will enable you to:

47 Explain how time value of money concepts apply to bond valuation.

48 Identify factors affecting the market value of bonds.

E
very investment professional understands that when prevailing
rates of interest rise, the market value of outstanding bonds
declines, and vice versa. But how are these values actually
determined, and what factorsother than interest rate changesimpact
the value of fixed-income securities?

Factors Determining the Value of a Bond


The Bond Valuation Model
Earlier in this module, we demonstrated the concept behind the pricing of
a share of common stock by means of the discounted dividend model,
which determined share value by discounting its stream of estimated
dividend payments to the present. A variation of this useful model was
employed in determining the yield-to-maturity of a bond, during earlier
discussion of bonds and their characteristics. In that instance, we knew
the price of the bond ($950), the size of each annual interest payment
($80), and the face value of the bond due at maturity ($1,000) in three
years. The equation appeared as follows:

$80 $80 $80 $1,000


$950 = 1
+ 2
+ 3
+
(1 + i) (1 + i) (1 + i) (1 + i) 3

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There, we were solving for ithe interest rate that would discount these
three cash flows to the present value of $950. In determining the value of
a bond, we use the same method but solve for the price (Vb) as follows:

I I I P
Vb = 1
+ 2
+ n
+
(1 + i) (1 + i) (1 + i) (1 + i) n

where
I = the coupon payment
i = the yield-to-maturity for this particular bond
P = the face value of the bond repayable at maturity
n = the number of periods between now and maturity

This formula basically states that the price or value of a bond equals the
present value of the stream of future income payments plus the present
value of the face value or maturity value of the bond to be received in the
future. As before, the size of (1 + i) increases exponentially as it moves
further away from the present. That increase in the denominator
progressively reduces the present value of each successive coupon
payment and the final repayment of the bonds face value. Thus, if we
had a bond that paid $100 in interest each year, and if the yield-to-
maturity (market yield or discount rate) for bonds with its risk,
maturity, and other features was 12%, the present value of the first years
cash flow would be

$100
PV $89.29
1 .12 1

The present value of the second years payment would be

$100
PV $79.72
1.12 2

Thus, each $100 coupon payment adds less and less to the present value
of the bonds as they move into the future. If this were a bond due in

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exactly three years with a face value of $1,000, we could compute its
value (Vb) as follows:

$100 $100 $100 $1,000


Vb = 1
+ 2
+ 3
+
(1 + .12) (1 + .12) (1 + .12) (1 + .12) 3
$100 $100 $100 $1,000

1.12 1.254 1.405 1.405
$89.29 $79.72 $71.17 $711.74
$951.92

This process indicates that the value of a bond is worth the present value
of the stream of interest payments plus the present value of the maturity
value. Investment professionals can solve this easily with a financial
calculator, by setting the calculator for 2 P/YR and inputting:

1000, FV

50, PMT

6, N

12, I/YR

Solving for PV, $950.83

Note that the better way to calculate the PV of a bond is to assume


semiannual payments, which requires adjusting the interest payment and
N as shown. The answer is slightly different due to the semiannual
calculation.

For our purposes here, the important points to note, however, are these:

Every coupon payment, even though it is of an equal amount,


contributes less and less to the bonds present value as it moves out
into the future. Note how the same $100 coupon is progressively
worth $89.29, then $79.72, and then $71.17.

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Any increase or decrease in i, the required interest rate, increases or
decreases the denominator in the equation, correspondingly affecting
the present value. This is the mathematical logic underlying the
inverse relationship between the movement of market interest rates
and the movement of bond values.

Zeros and interest rate swings: The most dramatic evidence of this
logic is seen in the market prices of zero-coupon bonds. Since they
pay no coupons, all of the payout from these debt securities comes in
the future; there are no fixed, intermediate payments to lessen the
whipsaw effect of interest rate movements on the value of the bonds.
Also, their values gyrate more intensely as their maturities lengthen.
To demonstrate, consider the pricing of a zero with a 10-year maturity
when rates are at 8% (set calculator for 2 P/YR):

1000, FV

20, N

8, I/yr
0, PMT

Solving for PV, $456.39

Note: Semiannual compounding is assumed so the N must be doubled.

If market rates rise to 10%, this bond will fall by 17.4%, to roughly $377.
The effect of the same interest rate change on the same bond with a 20-
year maturity is much more dramatic:

1000, FV

40, N

8, I/yr
0, PMT

Solving for PV, $208.29

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Assuming interest rates increase to 10%, this bond will drop to $142.05, or
by 31.8%, if rates rise to 10%.

Thus, we can state that a bonds value is theoretically determined by the


timing of its cash flows, the size of its cash flows, and market interest rates.

It is important to note that the market interest rates are directly affected
by inflation rate changes. Because bonds generally pay a fixed amount of
interest and (upon maturity) principal, inflation can and usually do affect
the purchasing power of those payments. Therefore, any changes in the
inflation rate will directly impact bond prices. If bond investors expect
increased inflation, bond prices will fall, and vice versa. Changes in the
inflation rate and in interest rates generally move together because
changes in inflation or the expectation of inflation changes will cause the
Federal Reserve Board to increase or decrease interest rates. Keep in mind
that the Fed has the most direct impact on short-term interest rates (and
specifically the federal funds rate); long-term interest rates are market-
driven but will also react to changes in the inflation rate, and in many
cases, more quickly than the Fed.

Non-Interest-Rate Factors in Bond Pricing


As we have seen, market interest rates play a substantial role in the
valuation of fixed-income securitiesboth when they are originally
issued and as they trade in the market. The prevailing interest rate acts as
a pivot point around which bond values fluctuate.

Factors other than prevailing market interest rates affect the value of
bonds, notably changes in the inflation rate, the creditworthiness of the
issuer and, in the case of bonds denominated in foreign currencies,
fluctuations in exchange rates. These factors include the following aspects.

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Credit Risk
As with any investment, a risk/return relationship prevails with respect
to bonds. Aside from interest rate risk, bondholders are subject to the risk
of the issuer defaulting on its obligations to pay interest as due and
principal on maturity. At issuance, the market perception of that credit
risk is reflected in the coupon rate. Thus, bonds issued by a highly
creditworthy entity (public or private) have a lower coupon rate than
those issued by an entity whose ability to repay is questionable. The
lower-rated entities must offer a higher return to attract buyers for their
debt issues. Creditworthiness is reflected in the familiar Standard &
Poors and Moodys bond ratings. Periodically, the creditworthiness of an
issuer will change, and the value of its bonds will change in turn. If
Company X has its bond rating downgraded from A to BBB, investors
will demand a higher return from the companys bonds, owing to the
added credit risk. Since, in our valuation model, any increase in i
negatively impacts the present value of future cash flows, the value of
Company X bonds will decline in the market.

Differences in credit risk between bonds of the same maturity account for
the difference or spread between yields of high-rated bonds and lower-
rated bonds. This spread tends to be greatest during periods of high
market rates and during times of uncertainty and less during periods of
low market rates and during times of economic prosperity.

Currency (Exchange Rate) Risk


The growing popularity of cross-border investing has encouraged many
to invest in debt securities denominated in non-U.S. currencies. The
advent of international bond funds has made this form of investing
available to individual investors, and higher interest rates in other parts
of the world have made them attractive. While this form of investing has
many meritsdiversification being the most prominentclients should
understand that these securities contain another level of

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risk/opportunitynamely, possible changes in the currency exchange
rates. For example, if an American investor purchases a bond
denominated in British pounds sterling, the market value of that
investment will be subject to the usual market interest rate risk and credit
risk previously discussed and also to the risk that the value of the British
pound in which coupons and principal are denominated will be devalued
relative to the U.S. dollar. This can be a major consideration if currency
swings are large.

For example, in 1981 the British pound was at $2.48 but fell to $1.10 in
1985. In this situation, the U.S. dollar was said to be strengthening against
the pound because it takes fewer U.S. dollars to buy one pound. This is
disadvantageous for a U.S. investor holding a British security. In this
case, if that security paid a dividend of one pound, the U.S. investor used
to receive a dividend in 1981 of $US 2.48 but by 1985 received a dividend
of $US 1.10 even though the security paid one pound in dividends both
years. If the situation were reversed, the dollar would be weakening
because it takes more U.S. dollars to buy one pound and would be
advantageous to the U.S. investor because he would receive more U.S.
dollars for that one pound dividend.

To take another example, consider a situation in which a U.S. holder of a


bond denominated in British pounds sterling earned a total annual return
of 10%, but the value of the pound declined against the U.S. dollar by 5%
over the same period. In this case, the total return in U.S. terms is
determined as follows:

Value of the Investment 110.0% (original value + 10% return)


Adjusted value of pound .95
Return adjusted for currency change 104.5% 100% = 4.5%

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Reinvestment Risk
The valuation model presented here contains a key assumption that may
or may not hold in the real world. The mathematics of the model is based
upon the logic of compounding and assumes that all cash flows are
reinvested at the same interest rate (i) as that in effect when they were
received. The extent to which the investor is successful in reinvesting at
the same interest rate determines the actual yield-to-maturity of the bond
investment and, by extension, the bonds value.

Rules of Thumb for Bond Values


Financial scholars have produced mountains of research findings with
respect to the behavior of bond values in environments of changing
interest rates and credit ratings. We can summarize these as follows:

The value of a bond is a function of four factors: (1) its face value at
maturity, (2) the size of its coupon, (3) years to maturity, and (4)
prevailing market interest rates (the four factors used in our time
value of money calculations of a bonds price).

Bond prices move inversely to bond yields.

The prices of long-term maturities are more volatile than those of


short-term maturities, given the same change in market yields.

Bond price volatility is inversely related to the size of the coupon;


thus, everything else equal (same grade, same number of years to
maturity, and same change in market yields), bonds with large
coupons fluctuate less than those with small coupons.

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Chapter 5
Fundamental Analysis
Reading this chapter will enable you to:

49 Explain the terminology and concepts of fundamental analysis.

M
ost investment advisors use elements of fundamental analysis
in their attempts to identify superior securities to purchase, to
maximize return for a specified level of risk, and to achieve an
appropriate level of portfolio diversification. Although the efficient
market hypothesis and its supporting research suggest that fundamental
analysis cannot be shown to produce superior returns, many successful
investors believe that there is significant value in this form of analysis.

Given the nature of their responsibilities and training, few investment


professionals are in a position to practice fundamental analysis in the
fullest sense, although manyparticularly with respect to small, local
companiesdevelop the knowledge and expertise of the professional
securities analyst. Most investment professionals are, in fact, consumers
of the fundamental analysis conducted by their own research
departments and outside vendors. This being the case, this chapter is
presented as an overview of fundamental analysis and not as a full
treatment of its complex methodology.

The Method of Fundamental Analysis


Fundamental analysis involves an in-depth look at the many variables
that impact the intrinsic value of a security (here common stock), and it is
conducted within the larger context of industry and economic analysis.
Fundamental analysis takes a top-down approach that starts with

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macroeconomic elements, such as the business cycle, economic activity
forecasts, and implications of fiscal and monetary policy.

Economic analysis is followed by industry analysis, which attempts to


identify industries that will do well in future years, given the economic
forecast. Industry analysis considers issues that affect whole industries,
such as the aggregate demand for products, costs of inputs, government
regulation, technological advances, and the dynamics of national and
international competition. It also is used to identify the correlation of an
industry with the larger business cycle.

Finally, fundamental analysis comes down to the level of the individual


company, addressing issues of performance and potential. Financial
statement analysis plays a large role in this micro-level evaluation of the
firm.

Figure 5 provides an overview of the top-down approach of fundamental


analysis and indicates some of the concerns of the analyst in each part of
the process. Owing to the limitations of this module, we will address just
a few of those concerns.

Figure 5: The "Top-Down" Process of Fundamental Analysis

Economic Analysis Inflation Expectations


Federal Reserve Policies Public Confidence
New Tax Policies Economic Analysis Economic Trends
Unemployment Trade Issues
Wage Rates Savings Rate

Competition Cost Structure


Technology Demand Factors
Change Industry Analysis Business Cycle
Accounting Financial Norms
Conventions

Earnings Financials
Dividends R&D
Cost of Capital Strategy
Company Analysis Competition
Cash Flow
Products Management

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Economic Analysis
Investors know that changes in stock prices are generally tied to the
economic environment, typically leading the economy as subsequently
mentioned. If the economy of the nation is depressed, the business
prospects for most individual firms are negatively affected.

Business Cycles
Economy watchers use the term business cycle to define the stages of
expansion, recession, and recovery that the economy appears to rotate
through as time passes. These stages are shown in Figure 6. Here, an
expanding national economy (Period 1) eventually runs out of steam at
time t1, and begins an extended downturn, or recession, as measured by
economic outputGross Domestic Product (GDP), which is the market
value of goods and services produced by labor and property located in
the U.S. Typically, this downturn (Period 2) is characterized by increased
unemployment, a reduction in interest rates, slackening in both consumer
demand and purchases of capital equipment, and decreased lending
activities. At some point, always determined in retrospect, the cycle
reaches a low point (t2). From this point, recovery and then economic
expansion take place (Period 3). Recovery and expansion are evidenced at
first by longer hours worked by the employed and increased economic
output, then by a reduction in unemployment and an increase in
consumer spending. Typically, an upswing in capital spending and plant
expansion occurs later, during the revived national economy. As a
general rule, the late stages of an expansionary period are characterized
by high interest rates, high capacity utilization in the manufacturing
sector, increasing wage demands by labor, and inflation.

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Figure 6: Business Cycles

Economic Period 1 Period 2 Period 3


Output

t1 Time t2

Business cycles do not always fit this neat pattern, nor do the cycles
repeat themselves at predictable intervals. Since World War II, the U.S.
economy has experienced expansions averaging 49 months and
contractions averaging 11 months. But these are merely averages. The
expansionary period that began in 1991 lasted a record-setting 10 years.

What Is a Recession, Really?


The nation is officially in recession when it records two or more back-
to-back quarters of negative Gross Domestic Product as measured by
the National Bureau of Economic Research.

Stock Prices and the Business Cycle


The relationship between the ups and downs of the national economy
and movement in stock prices, although not perfectly correlated, is well
established. Research on the business cycle conducted by the National
Bureau of Economic Research has resulted in stock prices being classified
among its leading economic indicators. Likewise, research conducted

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by Goldman, Sachs & Co. has confirmed the fact that stock price
movements are correlated to movements in the general economy, but
usually in anticipation. During periods of recession, stock prices (in the
aggregate) have been shown to move upward in advance of actual
economic recovery; during periods of expansion, stock prices typically
declined before the expansion reached its peak. While the predictive
power of stock prices is not absolute, empirical evidence indicates that
stock price movements anticipated business cycle peaks between 1953
and 1980 by an average of 7.7 months. During the period 1948 to 1982, the
market anticipated the bottom in the business cycle by an average of 4.4
months (with a range of 3 to 8 months) (Benderly and McKelvey 1987).

Another example: Stock prices hit a high on March 10, 2000 (as measured
by the Nasdaq Composite Index), about a year-and-a-half prior to the
negative GDP growth in the third quarter of 2001 and one year before the
economy reached its peak in March 2001 (as determined by the National
Bureau of Economic Research). Some analysts attribute the time gap to
extraordinarily high valuations in March 2000, and only later to a
downturn in economic activity. More recently, stock prices bottomed in
March 2009; and economic growth did not turn positive until the third
quarter of 2009.

These examples illustrate that

1. the averages above are just averages and exceptions do occur; and

2. stock market movements generally precede changes in the economy


(although sometimes stock prices change due to factors other than the
economy such as, in this case, unreasonable valuations).

One measure that ties the economyas represented by yields on


Treasury notesto the stock market is the Fed model. While this stock
market model is not an official model from the Federal Reserve Board nor
is it endorsed by the Fed as the name might suggest (the name was

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actually coined by a Wall Street economist and strategist), it has its basis
in a 1997 Fed report to Congress in which the Fed hinted about how it
might value the stock market.

The core of this model compares the yield to maturity on 10-year


Treasury notes to the earnings yield of the S&P 500 stock index. The
earnings yield is next years projected earnings for the stocks in the S&P
500 index divided by the price of that index (the earnings yield is the
inverse of the P/E ratio). The theory is that if the earnings yield is greater
(or less) than the 10-year Treasury note yield, then the stocks are
undervalued (or overvalued).

Example. Assume the Treasury note yield is 4.50% and the forecast of
earnings for the S&P 500 index is $60.00. Based on these numbers, $60.00
.0450 = 1,333, the fair value of the S&P 500 index. If the index is below
(or above) 1,333, then the stocks are undervalued (or overvalued).

As with any valuation measure, it should not be used as the only


indicator of valuation and it does have its limitations. One major
limitation is that back-testing of this model shows it has mixed results as
a valuation measure. Another limitation occurs when interest rates move
quickly, in which case the fair value may also change quickly. In
addition, earnings estimates might not always be accurate. Nevertheless,
the Fed model is followed by many investors and investment firms.

In dealing with its limitations, followers of the Fed model generally do


not use reported earnings, but instead use operating earnings, which are
normally higher because they ignore one-time accounting charges. A
large problem that must be dealt with is that bond yields and earnings
yields are not comparablebond interest is fixed while corporate profits
tend to increase with inflation. One way around this is to substitute
Treasury Inflation-Protected Securities (TIPS) for the 10-year Treasury
notes. Because yields on TIPS consist of the inflation rate plus a small
fixed rate, the bonds and the interest they pay grow with inflation. In

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addition, since stocks are riskier, some argue that the earnings yield
should be two to three percentage points above the TIPS bond yield to be
fairly valued. As seen here, there are many ways to modify the Fed model
to account for what are perceived to be its limitations. In total, this model
is worth some consideration.

Government and the Economy


Ever since the New Deal era, the federal government has attempted to
influence the cycle of expansion and recession by means of fiscal and
monetary policies. With regard to the economy, the goal of government
policy has been, and continues to be, full employment, economic growth,
and stable prices.

Fiscal policy refers to the governments ability to tax, spend, and manage
its debts. In times of recession, government fiscal policy aims to stimulate
the economy through tax reduction (so that consumers have more money
to spend on goods and services) and increased government expenditures,
which also tend to increase the level of economic activity.

Monetary policy refers to changes in the supply of money and credit to


the general economy. In the United States, this is the domain of the
Federal Reserve System, which has the dual mandates of

1. promoting economic growth, and

2. keeping inflation under control.

The Fed has the ability to directly influence short-term interest rates
(long-term rates are determined by market forces, and are therefore
indirectly affected by monetary policy), usually through open market
operations that cause changes in the federal funds rate (the rate that
banks charge other banks for borrowing reserves). Other short-term rates
then follow. During periods of recession, the Fed generally increases the
money supply, loosens credit restrictions, and attempts to drive down

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interest rates, as these actions tend to stimulate the economy. The reverse
prevails during times of expansion, when inflation is the Feds key
concern. The current level and direction of interest rates have critical
influences on economic growth and stock and bond prices.

The Business Cycle and the Investment Professional


The broad cyclical movements of the general economywith their
effects on interest and stock priceshave obvious implications for the
investment professional. If the investment professional and clients
subscribe to the tactical asset allocation strategy mentioned earlier, the
business cycle situation plays an important role in determining the
rebalancing of assets from stocks to bonds to cash. At the late stages of an
expansion, and before stocks have begun moving downward, it may be
wise to sell stocks to purchase bonds, especially those with reasonable
call protection. If all went true to form (which is certainly not assured),
stock prices would decline and, as a recession got rolling, interest rates
would decline, thus increasing the market value of the bonds. A
converse situation would apply as the trough of recession drew near.

The downside of this neat picture is that we can never be sure of where we
are in the business cycle or be able to forecast future economic activity
with precision. Economists are not bashful about making forecasts, but as
J.K. Galbraith observed: We have two kinds of forecasters today, those
who dont know and those who dont know they dont know.

The second problem in planning investment moves to correspond with


changes in the business cycle is the high variability of the markets
predictive power. The study, which indicated that stock prices anticipate
economic downturns by an average of 7.7 months also, indicated that the
range for this average was 1 month (meaning that the stock market
trailed movement of the economy by one month) to 12 months.

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Obviously, keying investment strategy to the business cycle is no game for
traders; it is better suited to investors willing to hold their positions over
extended periods. This is the perfect game for the patient contrarian, who
is content to buy when everyone else is discouraged with the economy
and the stock market, and sell when the economic picture is the
brightestand sit for long months in between these conditions.

Industry Analysis
A number of academic studies support the idea that some industries
dramatically outperform both the market and other industries. Thus, it is
not enough to simply determine that the stock market is promising; time
spent on determining the prospects of different industries should be time
well spent.

Industry analysis is conducted to pin down the key factors that influence
the stock performance of an industrys constituent firms. These key
factors include the following:

a forecast of industry profitability

growth in sales and earnings

the competitive structure of the industry

how the industry reacts to general business cycles

financial norms

the impact of government regulation

Stock analysts typically specialize in one industryautos, energy,


retailing, and so forthso that they can learn the dynamics of
competition, pricing, technology, and other items that affect the universe
of individual companies in those industries. Very often, a particular

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industry will have a unique exposure to the business cycle just described.
Some industries that are heavy users of natural resources or commodity
materials are able to operate more profitably during economic
slowdowns. Recessions reduce the prices of their major material inputs.
Others, such as autos, may be the first to feel the pinch of a recession as
consumers grow fearful and reduce their discretionary spending. The
growing importance of technology in industries as diverse as computers
and financial services is another reason that specialization among
analysts is important; it also explains why many stock analysts are
recruited from within the industries they are assigned to cover.

Company Analysis
Company analysis seeks answers to many of the same questions as those
pursued through industry analysisfuture earnings prospects, the cost of
capital and other productive inputs, cash flow, and so forthbut with the
goal of determining the performance and potential of a particular firm. It
probes areas unique to the individual firm. These include the following:

Financial Statements
These provide quantitative measures of the firms liquidity, performance,
and ability to finance future growth. Certain areas of the financial
statements, such as contingent liabilities, underscore areaspatent
disputes, legal entanglements, and so forththat could grow into big
problems for the company.

One of the most common uses of financial statements is as a source of


data for use in ratio analysis. Ratios indicate the relationship between two
different values. Price/earnings ratios and price/sales ratios, mentioned
earlier, are examples of ratios used by investment analysts. Ratios allow
analysts to compare one company to another in one respect or another or

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the same company from one year to the next. Generally, ratios used in
company analysis fall into one of four classes:

1. Liquidity ratios, which provide a measure of a companys ability to


meet its short-term financial obligations. The most basic of these is the
current ratio, which equals current assets current liabilities. (Current
assets are cash, cash-equivalent securities, receivables, and the value
of inventory; current liabilities are debts and accounts payable that
need to be settled within a year.) If a company has fewer current
assets than current liabilities or even a slight margin of assets over
liabilities, its ability to keep its head above water with creditors is
questionable. Another important liquidity ratio is the quick ratio, also
called the acid test ratio. This is current assets minus inventory
divided by current liabilities. This ratio distinguishes between degrees
of liquidity of current assets by subtracting the generally less liquid
current asset, inventory, from the numerator.

2. Profitability ratios, which measure the relative profitability of a


company. One important profitability ratio is net earnings on net worth,
also called return on equity. For example, if a firm has net earnings of
$100,000 and the amount of shareholders equity and retained
earnings, or net worth on the balance sheet, is $1 million, the ratio is
1:10. Thus, the company is earning 10 cents on each dollar of
shareholder capital. Another version of this ratio is return on common
equity, which is net earnings minus preferred stock dividends divided
by equity minus preferred stock. One other important profitability
ratio is net earnings on total assets, also called return on assets.

3. Debt ratios, also called leverage or capitalization ratios, measure the


extent to which the firm finances its assets by debt. Two important
debt ratios are the debt-to-equity ratio, or total debt net worth, and
debt-to-assets ratio, or debt total assets.

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4. Activity ratios, which measure the rate at which a company is
turning its inventory or accounts receivable into cash. Three
important activity ratios are inventory turnover, which is cost of goods
sold divided by average inventory; average collection period, which is
receivables divided by sales per day; and receivables turnover, which is
annual sales divided by accounts receivable.

As with many aspects of industry and company analysis, the analysis of


financial statements is a complex subject. It requires a solid
understanding of accounting principles and conventions that are beyond
the scope of this module. Fortunately, all basic textbooks on investing
have a complete chapter on this important subject.

R&D and New Product Development


For many companies, new products still in the pipeline will make or
break future earnings. Good examples of new products from the past
include the first Xerox photocopier, the Ford Taurus, the Apple
Macintosh, and Sun Microsystems RISC chip workstations. In many
cases, management is betting the company on a new family of products,
and company analysis must assess the prospects of those new products
and their probable effect on future company earnings.

Management and Strategy


Difficult to assess and impossible to quantify except in retrospect, good
management and a competitive strategy make all the difference in the
contest between companies for market share and profits.

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Chapter 6
Technical Analysis & Market
Timing
Reading the first part of this chapter will enable you to:

410 Describe a working definition of technical analysis.

M
aking money in the stock market sounds simple. One need
only make good on this formula: Pp < Ps. Here, Pp is the
purchase price, which must be less than Ps, the selling price. In
street language, buy low, sell high. Fundamental analysis purports to
achieve this result by identifying situations in which lack of knowledge or
insight has resulted in a mispricing of certain stocks. Technical analysis
seeks to identify opportune buying and selling situations using data
drawn directly from action within the market itself.

Technical analysis attempts to predict future stock prices by analyzing a


range of market information related to supply and demand. Internal
market factors, such as price performance and transaction volume, are
stressed in technical analysis to identify trends and reversals of those
trends to time the buying and selling of securities to take advantage of
market imperfections. Some techniques attempt only to predict the
direction of the aggregate market; others focus on when to buy or sell
specific stocks. A variety of technical indicators are used in analyzing the
aggregate market and individual stocks, and the charting of price patterns
is one of the standard techniques used in individual stock analysis.

Some feel very strongly that ignoring the story in the charts can be
dangerous. While the fundamentals of a company may look good on the
surface, the market might be reflecting something that the fundamentals

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will bear witness to only at a later date (That is, the market is efficient and
prices do reflect all information, even before many investors hear of a
problem!).

Technical analysts employ dozens of approaches to reveal good buying


and selling situations: odd-lot theory, point-and-figure charts, moving
averages, insider transactions, and many more. Most investment
professionals are familiar with a number of these methods, and many
incorporate some form of technical analysis into their buy/sell decision-
making process.

Hirt, Block, and Basu


Technical analysis uses past market data, such as price and volume, to
identify the best time to buy and sell securities and is based on the
following handful of assumptions (Hirt, Block, and Basu, 2006, 103):

Demand and supply determine stock market prices.

Stock prices move in trends (less minor fluctuations) that are fairly
persistent over time.

Trend reversals are the result of important supply/demand shifts.

Shifts in supply and demand can be detected sooner or later in charts

Price movement patterns repeat themselves over time.

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Reading the next part of this chapter will enable you to:

411 Describe the results of major studies regarding technical analysis


and the larger issue of market timing.

Burton Malkeil
Many today view technical analysis as a form of capital markets
astrology. The academic community, which over the years has back-
tested both the recommendations and methods of technical analysts
against actual market data, has found no evidence of value in its
methods. As early as 1973, Burton Malkiel chided technical analysis in the
first edition of his book, A Random Walk Down Wall Street, when he wrote
the following:

The history of stock-price movements contains no useful


information that will enable an investor consistently to
outperform a buy-and-hold strategy in managing a portfolio
(Malkiel 1985, 132).

Any number of subsequent tests of technical methods have failed to show


any basis for their effectiveness. Critics contend that since technically
oriented investors are frequent traders, transaction costs eat into
whatever successes they might enjoy. On the other hand, an argument
can be made that technical analysis is more art than science, so the
academic community cannot completely duplicate the decisions that are
made by experienced technical analysts.

Even investors who think they are too scientific to use technical methods
nevertheless practice some form of market timing, a related practice.
Earlier discussion of investing in response to the cycles of the economy is
one form of market timing; sector rotation from financial services
stocks to capital goods stocks is another. The benefits of successful timing

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could be substantial. For example, the market (as represented by the
DJIA) has, on average, risen by more than 23% in every year in which a
recession has ended (Lawrence 1991). The investor with a good
forecasting sense would have done exceptionally well by plunging into
the market in anticipation of a turn in the business cycle. But even here
there is plenty of evidence that market timing is more hope than promise.

Charles Ellis
Charles Ellis reported a study of the experience of 100 large pension
funds with market timing. None reported any improvement in their
investment performance; almost 90% reported losses (Ellis 1993). More
recent research is more positive about the effects of market timing.
Writing in the Financial Analysts Journal, George Kester found long-term
historic data to show that small-firm stocks, in conjunction with cash
equivalents, offered better opportunities than large-firm stocks with
respect to market timing (Kester 1990, 6368). The opportunity to add real
value to portfolio performance with this method improved as the
frequency of portfolio rebalancing diminished.

Overall, the best advice to the investment professional with respect to


timing client portfolios would be to

avoid high levels of trading based upon technical information or


market timing; this (according to the thesis advanced by Burton
Malkeil, in A Random Walk Down the Street) is a proven losers game;

use market timing only infrequently and in the broad sense


rebalancing portfolios from one asset class to another in response to
very long-term movement in the economy or the industry; and

educate clients to the fact that stocks are their best friend over the
long term; stocks may be down one year out of three, but those are far

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better results than any long-term results achieved through furious
trading based upon market timing.

William Sharpe, a noted finance professor and winner of the Alfred


Nobel Prize in Economics in 1990, may have said it best:

A manager who keeps assets in stocks at all times is like an


optimistic market timer. His actions are consistent with a policy of
predicting a good year every year. While such a manager may
know that such predictions will be wrong roughly one year out of
three, such an attitude is nonetheless likely to lead to results
superior to those achieved by most market timers (Sharpe 1975,
6069).

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Summary

T
his module has addressed the concept and practice of asset
allocation, along with the critical importance of asset allocation. It
has reviewed the broad categories of assets from which individual
securities may be selected. Further, it has discussed the methodologies
typically used to select individual securities from those categories.
Together, knowledge of these subjects makes it possible for investment
professionals to more effectively serve the investment objectives of their
clients.

Asset allocation can be viewed narrowly or broadly. Seen narrowly, it is a


blueprint for dividing and directing the clients funds over a number of
investment categories for long periods. Some clients and their investment
professionals may view this approach as mechanical, unimaginative,
passive, and dull; for others, it may be the ideal way to handle their
money. Seen more broadly, however, asset allocation is sufficiently
flexible to accommodate the most active investor:

once the appropriate asset classes and weights have been


determined in consultation with the client, the investment
professional can apply his or her favored methods of securities
selection;

the full spectrum of investment productsstocks, fixed-income


vehicles, mutual funds, REITs, and so forthcan be drawn upon to
implement the asset allocation policy; and

tactical asset allocation provides opportunities for the investment


professional and the client to apply market timing toolseither
broadly based timing that relates to the business cycle or trading-
oriented approaches based upon technical analysis.

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For many investment professionals, asset allocation is a more planning-
oriented, a more effective, and a more professional way to deal with
clients. It is a framework for educating clients about potential risks and
returns and, as such, builds trust and higher levels of business.

Valuation is a very important topic in investments. This module presents


some valuation methods for both stocks and bonds. Too often investors
forget that the value of an investment and the price of an investment can
be very different. Astute investors take advantage of these differences by
buying undervalued securities that usually increase to or even beyond
their fair market value.

Having read the material in this module, you should be able to:

41 Identify suitable allocation principles for individual accounts.

42 Identify the returns of major asset classes over various time horizons.

43 Calculate potential returns of client portfolios.

44 Identify approaches to asset allocation.

45 Identify characteristics, potential risks, and performance of various


assets available to fulfill the asset allocation policy.

46 Calculate a common stock value using established valuation


methods.

47 Explain how time value of money concepts apply to bond valuation.

48 Identify factors affecting the market value of bonds.

49 Explain the terminology and concepts of fundamental analysis.

410 Describe a working definition of technical analysis.

411 Describe the results of major studies regarding technical analysis


and the larger issue of market timing.

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Module Review

Questions

41 Identify suitable allocation principles for individual accounts.

1. What three categories of investment practices did the Brinson study


evaluate?

2. What conclusion did the Brinson study reach?

3. What is one implication of recognizing the importance of asset


allocation in a clients investment strategy?

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42 Identify the returns of major asset classes over various time horizons.

4. List average (geometric) rates of returns for the following investment


classes, as well as inflation, since 1926.

a. T-bills

b. long-term U.S. government bonds

c. long-term corporate bonds

d. intermediate-term U.S. government bonds

e. large-company stocks

f. small-company stocks

g. equity real estate investment trusts (REITs) since 1972

h. international stocks (represented by EAFE) since 1970

i. inflation

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43 Calculate potential returns of client portfolios.

5. Calculate the expected returns of the following portfolios using


historic data (from Table 1):

a. T-bills 50%, long-term government bonds 50%

b. T-bills 20%, corporate bonds 20%, small-company stocks 60%

c. long-term government bonds 20%, small-company stocks 20%,


large company stocks 60%

44 Identify approaches to asset allocation.

6. Define the following types of asset allocation.

a. strategic

b. tactical

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c. dynamic

d. core/satellite

45 Identify characteristics, potential risks, and performance of various


assets available to fulfill the asset allocation policy.

7. List several characteristics of common stock.

8. List several sources of risk for common stock.

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9. List characteristics of preferred stock.

10. List sources of risk for preferred stock.

11. List the characteristics of bonds.

12. List investment risks of bonds and other debt instruments.

13. Identify the characteristics of municipal bonds

14. Explain the following Treasury securities.

a. Treasury notes

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b. Treasury bonds

c. Treasury inflation-protected securities (TIPS)

d. Treasury STRIPS

15. Explain the following regarding corporate bonds.

a. indenture

b. trustee

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c. interest taxation

d. mortgage bonds

e. debentures

f. equipment trust certificates

g. convertible bonds

16. List characteristics of mortgage-backed securities.

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17. List sources of risk for mortgage-backed securities.

18. Identify the characteristics of the following money market


instruments.

a. Treasury bills

b. negotiable certificates of deposit

c. Eurodollar certificates of deposit

d. Yankee certificates of deposit

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e. commercial paper

f. bankers acceptances

g. repurchase agreements

19. List forms of real estate investments.

20. List risks of real estate investments.

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21. Describe the major characteristics of mutual funds.

22. Describe the characteristics of exchange-traded funds (ETFs).

23. Describe the characteristics of exchange-traded notes (ETNs).

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46 Calculate a common stock value using established valuation
methods.

24. Define the following terms.

a. intrinsic value

b. market value

25. Describe the dividend discount model of stock valuation.

26. Assume a preferred stock pays an annual $3.00 dividend and the
required rate of return is 11%. What is the value of this stock?

27. Assume a common stock pays a quarterly dividend of $0.40 that is


growing at 7% a year. The investors required rate of return is 12%.
According to the constant growth dividend discount model, what is
the value of this stock?

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28. XYZs earnings are estimated to be $3.60 per share next year. The
current P/E ratio is 12. What price would you estimate for XYZ next
year?

29. Use the growth-oriented intrinsic value model to calculate the price of
the following stock: XYZs forecasted earnings are $1.10 per share,
and the stock has grown at a rate of 7.5% in the past. The current Aaa
bond rate is 5.8%.

47 Explain how time value of money concepts apply to bond valuation.

30. Explain how time value of money concepts apply to bond valuation.

48 Identify factors affecting the market value of bonds.

31. Identify factors that can affect bond values.

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49 Explain the terminology and concepts of fundamental analysis.

32. List several variables that fundamental analysis takes into account for
each of the following areas.

a. economic analysis

b. industry analysis

c. company analysis

33. Explain the Fed model.

34. List the stages of the business cycle and typical characteristics of each
stage.

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35. Explain how the following government policies affect the economy.

a. fiscal policy

b. monetary policy

36. Define and provide examples of each of the following types of ratios
used in financial statement analysis.

a. liquidity ratios

b. profitability ratios

c. debt ratios

d. activity ratios

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410 Describe a working definition of technical analysis.

37. What is meant by technical analysis?

38. List several assumptions used in technical analysis.

411 Describe the results of major studies regarding technical analysis


and the larger issue of market timing.

39. Describe several conclusions that can be drawn from major studies
regarding market timing.

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Answers
41 Identify suitable allocation principles for individual accounts.

1. What three categories of investment practices did the Brinson study


evaluate?
security selection, market timing, and asset allocation policy

2. What conclusion did the Brinson study reach?


On average, 93.6% of the variance between total returns of large
pension funds was attributable to how assets were allocated.
Securities selection and market timing counted for very little.
Therefore, more attention should be given to the part of the
investment process that produces the greatest payoff for the client
(the asset allocation decision) and less attention given to those parts
whose contribution to total return are less (securities selection and
market timing).

3. What is one implication of recognizing the importance of asset


allocation in a clients investment strategy?
Clients must be active in determining their asset allocation and be
explicit about personal investment objectives and risk and liquidity
concerns over a longer horizon.

42 Identify the returns of major asset classes over various time horizons.

4. List average (geometric) rates of returns for the following investment


classes, as well as inflation, since 1926.

a. T-bills

3.6%

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b. long-term U.S. government bonds

5.5%

c. long-term corporate bonds


5.9%

d. intermediate-term U.S. government bonds


5.4%

e. large-company stocks
9.9%

f. small-company stocks
12.1%

g. equity real estate investment trusts (REITs) since 1972


12.0%

h. international stocks (represented by EAFE) since 1970


10.1%

i. inflation
3.0%

43 Calculate potential returns of client portfolios.

5. Calculate the expected returns of the following portfolios using


historic data (from Table 1):

a. T-bills 50%, long-term government bonds 50%

0.5(0.036) + 0.5(0.055) = 4.6%

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b. T-bills 20%, corporate bonds 20%, small-company stocks 60%

0.2(0.036) + 0.2(0.059) + 0.6(0.121) = 9.2%

c. long-term government bonds 20%, small-company stocks 20%,


large company stocks 60%

0.2(0.055) + 0.2(0.121) + 0.6(0.099) =9.4%

44 Identify approaches to asset allocation.

6. Define the following types of asset allocation.

a. strategic
The identification of the asset mix that will provide the optimal
balance between expected risk and return for a long-term
investment horizon. That mix is maintained with periodic
rebalancing by repositioning higher-performing assets into lower-
performing assets.

b. tactical
the use of securities selection, sector rotation, and market timing
to periodically revise the asset mix of a portfolio

c. dynamic
changing the asset mix of a portfolio as the market changes;
sometimes called dynamic hedging strategy and primarily used
by institutional investors

d. core/satellite
This approach involves a combination of strategic and tactical
asset allocation enabled by dividing a portfolio into a core holding
of stocks and bonds, often in broad-based, low-cost index mutual
funds or exchange-traded funds (a basket of stocks or bonds that

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follow an index and trade like stock), and a satellite portion. The
core may represent 70% to 80% of the total portfolio. It might be
divided into, say, 60% stocks and 40% bonds, and maintained at
those proportions through periodic rebalancing. The remaining
part of the portfolio, the satellite portion, is used to take advantage
of particular opportunities that add return, diversification, and/or
reduce risk to the portfolio. For example, the satellite might include
investments in actively managed small-cap funds, real estate
investment trusts, commodity funds, sector funds, junk bond funds
(containing low-grade bonds for higher yield), or other specialized
investments that complement the portfolio.

45 Identify characteristics, potential risks, and performance of various


assets available to fulfill the asset allocation policy.

7. List several characteristics of common stock.


shareholders receive dividends on a pro rata basis
shareholders vote on the election of corporate board members
shareholders are residual owners of the firm, meaning their
interests are subordinate to creditors and bondholders
shares have no maturity

8. List several sources of risk for common stock.


a downturn in economic growth
high interest rates
loss of product or service competitiveness
failures of management
government action

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9. List characteristics of preferred stock.
dividends usually fixed, usually qualified, and are not tax-
deductible to the paying corporation
preferred shares are paid dividends ahead of common shares
limited voting rights
dividends are generally 70% tax-free to owning corporations, and
they can have participating, cumulative, callable, and convertible
features

10. List sources of risk for preferred stock.


interest rate risk
purchasing power risk
business risk
reinvestment risk

11. List the characteristics of bonds.


issued by corporations, federal and state governments and their
agencies, and municipalities
a promise to repay the principal amount at a specified date in the
future
make periodic interest payments at a specified rate at specified
dates
usually issued at par value
total return consists of interest and any capital gain or loss
can provide taxable or tax-free income
rated investment grade (top four grades) or non-investment grade
(below the top four grades)

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12. List investment risks of bonds and other debt instruments.
default risk
purchasing power risk
interest rate risk
call risk
reinvestment risk
currency risk (for foreign bonds)

13. Identify the characteristics of municipal bonds.


Municipal bonds are either general obligation bonds (GOs) or
revenue bonds. GO bonds are secured by the issuers general taxing
powers and, therefore, in theory are more secure than revenue bonds.
Revenue bonds are issued to finance a specific project, the revenue
from which is used to make the bond payments. Municipal bonds are
generally free from federal income tax (a minority of municipal bond
issues are federally taxable). Issues bought by residents of that
locality are usually free from state and local income taxes as well.
Some bonds, known as private activity bonds, are subject to the
alternative minimum tax (AMT). Public purpose bonds are not subject
to AMT. Some municipal bonds are subject to federal income tax.

14. Explain the following Treasury securities.

a. Treasury notes
T-notes have maturities over one and up to ten years, are sold at or
near face value, pay interest semiannually, have a minimum
denomination of $100 face value, and are sold in multiples of $100.

b. Treasury bonds

T-bonds have maturities over 10 and up to 30 years, are sold at or


near face value, pay interest semiannually, have a minimum
denomination of $100, and are sold in multiples of $100 face value.

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c. Treasury inflation-protected securities (TIPS)

These bonds offer a rate of return that increases with inflation as


measured by the Consumer Price Index (CPI). As inflation
increases, the bonds principal increases at the same percentage
as the increase in the CPI. The coupon rate stays fixed, but is paid
on that larger principal. These are excellent securities to offset
inflation; in contrast to traditional bonds that are negatively
affected by inflation. Therefore, they can be useful in creating a
diversified portfolio. However, because they are relatively new and
have a much smaller market than traditional Treasury bonds, they
are less liquid than other Treasury securities.

Also, although the inflation increases are not paid out until the
bonds principal is repaid at maturity, the bondholder must pay
annual taxes on the phantom payout (the amount of principal
increase in the year). Currently, maturities of these bonds are 5,
10, and 30 years. Demand for these securities can be expected to
directly relate to changes in the inflation rate. The minimum
denomination is $100 and they are sold in multiples of $100 face
value.

d. Treasury STRIPS

These are zero-coupon instruments sold at deep discounts to face


value, with the difference being interest instead of periodic interest
payments. The Treasury does not issue or sell STRIPS directly to
investors. The STRIPS program lets holderstypically
government securities dealers of marketable Treasury notes and
bondsseparate them into individual interest and principal
components.

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15. Explain the following regarding corporate bonds.

a. indenture
The indenture spells out the terms of the issue.

b. trustee
The trustee acts as a fiduciary on behalf of bondholders to ensure
that the indenture provisions are met.

c. interest taxation
Interest is fully taxed at both the federal and state levels.

d. mortgage bonds
Bonds are secured by property, usually real estate.

e. debentures
These are unsecured bonds.

f. equipment trust certificates


Bonds are secured by specific equipment, usually airplanes or
railroad cars.

g. convertible bonds
These bonds can be converted into the underlying stock at the
option of the bondholder.

16. List characteristics of mortgage-backed securities.


major issuers are GNMA, FHLMC, and FNMA

make monthly payments

payments represent interest and principal; total payments can


change over time (due to refinancings)

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17. List sources of risk for mortgage-backed securities.
uncertainty of cash flows
interest rate risk
purchasing power risk
reinvestment risk
FHLMC and FNMA have a slight potential for default risk (since
they are not backed by the full and faith and credit of the U.S.
government)

18. Identify the characteristics of the following money market


instruments.

a. Treasury bills
U.S. government obligations, issued at a discount to face value.
The minimum denomination is $100 and they are sold in multiples
of $100. Interest on Treasury bills is free from state income
taxation but taxable at the federal level.

b. negotiable certificates of deposit


CDs of $100,000 or more, pay a fixed rate of interest taxed at both
the federal and state levels, quality depends on the issuing bank

c. Eurodollar certificates of deposit


U.S. dollar-denominated CDs issued by foreign branches of major
U.S. and foreign banks, not FDIC insured, no reserve
requirements on these CDs, no maximum maturity but usually are
three to six months

d. Yankee certificates of deposit


U.S. dollar-denominated CDs issued by foreign banks from their
U.S. branches, maturities of one year or less pay interest at
maturity, maturities longer than one year pay interest
semiannually or annually

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e. commercial paper
unsecured IOUs of corporations, usually sold at a discount with
maturities up to 270 days

f. bankers acceptances
discounted time drafts used mainly in financing international trade,
the bank stamping accepted promises to pay the draft at
maturity, maturities are generally 30 to 180 days

g. repurchase agreements
the agreement involves purchasing securities and a commitment
to buy back those securities plus interest within typically one day
to one year, smallest trade is usually $1 million

19. List forms of real estate investments.


Investing can take many forms: home ownership, raw land,
commercial property, apartment buildings, RELPs, and REITs.

20. List risks of real estate investments.


Prices of real estate can fall, especially after periods of high price
increases and when loans are easy to get. Real estate is also subject
to low liquidity (REITs are the exception), high transaction costs, and
complex tax reporting requirements.

21. Describe the major characteristics of mutual funds.


A mutual fund is an open-end investment company that pools the
money of many investors and hires an investment advisor to invest
that money in an attempt to achieve one or more financial objectives.
A large number of individual securities in a funds portfolio provides
issue diversification. Funds price their shares as of the close of
business at the New York Stock Exchange, which is 4:00 p.m.
Eastern time. Orders placed before that time are based on the net

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asset value of the fund as of that time, called forward pricing. Fair
value pricing is pricing used at the discretion of the fund. It more
accurately reflects the value of certain securities than the last market
price of those securities. Fair value pricing is used widely with
international funds.

A funds trustees or directors, 75% of which must be independent


directors, have a fiduciary duty to the shareholders and their
responsibilities include, but are not limited to, continuous review and
oversight of the funds operations and portfolio management, the
performance of the investment advisor including, of course, the funds
performance, and the reasonableness of the funds fees and
expenses

Mutual funds are offered without a sales commission, called no load,


or with a sales commission, called a load fund. A front-end load is one
assessed at the time of purchase. A contingent deferred sales charge
is assessed at the time shares are redeemed on a sliding scale. A
level-load assesses a small, flat sales commission during the time the
fund is owned. A redemption fee, usually 1% to 2%, is charged if the
fund is sold within a certain period (such as 60 days), the proceeds of
which go into the fund, not to the seller of the fund. A maintenance (or
account) fee is a charge for recordkeeping and reports, or sometimes
is, in effect, a low balance fee.

Operating expenses consist of the investment advisory fee,


sometimes a 12b-1 fee, and other expenses. A funds annual
operating expenses divided by its average net assets is its expense
ratio. Transaction costs are not included in the expense ratio.

There are various types of mutual funds depending on the underlying


securities. Stock funds can be broken down by capitalization size and
investment style as well as U.S. and international stocks. Bond funds
are categorized by duration and grade and by U.S. government,
corporate, and municipal as well as U.S. and international. Global

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funds invest in U.S. and international securities and balanced funds
invest in both stocks and bonds.

Mutual funds pay distributions from its securities, namely interest


income, dividend income, and realized short-term and long-term
capital gains. Taxable interest income is taxed at the marginal federal
and state income tax rates of the shareholder. If the dividends are
qualified, the maximum tax rate is 15% on them, the same rate as
realized long-term capital gains. Short-term capital gains are taxed at
the shareholders marginal tax rate.

22. Describe the characteristics of exchange-traded funds (ETFs).


ETFs are open-end investment companies based on an index and
traded like stock throughout the business day. Like stock, they can be
bought on margin and sold short (but do not require an uptick), and
incur a commission when bought and sold. They usually have low
expenses, are tax-efficient, and trade at or very near net asset value.
Large investors selling in 50,000 share blocks receive stock (an in-
kind exchange) rather than a cash settlement, which does not create
a tax event for shareholders.

23. Describe the characteristics of exchange-traded notes (ETNs).


Exchange-traded notes (ETNs) are unsecured debt securitieswith
maturities of 30 years not being unusualtypically issued by large
commercial banks or investment banks. Like ETFs, they track an
index or benchmark, trade like stock, and can be shorted. As a result,
from the investors perspective, ETNs look and seem like ETFs.
Unlike ETFs, however, ETNs do not hold a basket of stocks, but
rather represent promises by the issuers to match the returns of an
index or commodity, minus fees. As such, investors need to be
concerned about the creditworthiness of the issuer; in the event of
default, investors would wait in line for payment with other creditors,
as there are no securities to back the ETNs.

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46 Calculate a common stock value using established valuation
methods.

24. Define the following terms.

a. intrinsic value

value which is justified by the facts, according to Benjamin


Graham

b. market value

the current price established by a free and open system of buyers


and sellers

25. Describe the dividend discount model of stock valuation.


The value of a stock is the present value of the stream of all future
dividends.

26. Assume a preferred stock pays an annual $3.00 dividend and the
required rate of return is 11%. What is the value of this stock?
$3.00/.11 = $27.27

27. Assume a common stock pays a quarterly dividend of $0.40 that is


growing at 7% a year. The investors required rate of return is 12%.
According to the constant growth dividend discount model, what is
the value of this stock?
The annual dividend is 4 $0.40 = $1.60. Therefore, 1.60(1.07) (.12
.07) = $1.712/.05 = $34.24

28. XYZs earnings are estimated to be $3.60 per share next year. The
current P/E ratio is 12. What price would you estimate for XYZ next
year?
$3.60 12 = $43.20

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29. Use the growth-oriented intrinsic value model to calculate the price of
the following stock: XYZs forecasted earnings are $1.10 per share,
and the stock has grown at a rate of 7.5% in the past. The current Aaa
bond rate is 5.8%.
$1.10 {(37.5 + [8.8 7.5]) 5.8} = $1.10 {(37.5 + 66.00) 5.8} =
$1.10 17.84 = $19.63

Note that the percentages are used as whole numbers in this formula.

47 Explain how time value of money concepts apply to bond valuation.

30. Explain how time value of money concepts apply to bond valuation.
The value of a bond is the present value of the stream of interest
payments plus the present value of the maturity, or face, value. Bond
coupon payments, although of equal amounts, contribute less and less
to a bonds present value as it moves into the future; because the
required rate of interest (i) increases or decreases the denominator in
the bond valuation model, rising interest rates depress bond prices and
falling interest rates raise bond prices. Likewise, the present value of
the amount of the bond to be received at maturity (the maturity value,
face, value, or par value) is less the longer the time to maturity.

48 Identify factors affecting the market value of bonds.

31. Identify factors that can affect bond values.


size of cash flows, timing of cash flows, interest rate changes, changes
in inflation rates, credit risk, currency risk, and reinvestment risk

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49 Explain the terminology and concepts of fundamental analysis.

32. List several variables that fundamental analysis takes into account for
each of the following areas.

a. economic analysis
business cycle

Federal Reserve policies

new tax policies, unemployment


wage rates

inflation expectations

public confidence
economic trends

trade issues

savings rates

b. industry analysis
competition
technology
change
accounting conventions
cost structure
demand factors
business cycle
financial norms

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c. company analysis
earnings

dividends

cost of capital

cash flow
products

financials

R&D
strategy

competition

management
financial ratios

33. Explain the Fed model.


The Fed model is based on the relationship of the yield on 10-year
Treasury notes and the earnings yield of the S&P 500 index. The
earnings yield is the projected earnings for the stocks in the S&P 500
index divided by the value of the index. If the earnings yield is greater
(less) than the Treasury note yield, then stocks are undervalued
(overvalued). The fair value of the model can be calculated by dividing
the earnings of the index by the Treasury note yield.

34. List the stages of the business cycle and typical characteristics of each
stage.
a. expansion: high interest rates, high capacity utilization, increasing
wage demands, and inflation
b. recession: increased unemployment, falling interest rates, slowing
consumer demand and purchases of capital equipment, and
decreased lending

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c. recovery: longer hours worked, increased economic output,
reduction in unemployment, and increased consumer spending

35. Explain how the following government policies affect the economy.

a. fiscal policy
In times of recession, government fiscal policy aims to stimulate
the economy through tax reduction (so that consumers have more
money to spend on goods and services) and increased
government expenditures, which also tend to increase the level of
economic activity.

b. monetary policy
During periods of recession, the Federal Reserve generally
increases the money supply, loosens credit restrictions, and
attempts to drive down interest rates as these actions tend to
stimulate the economy. The reverse prevails during times of
expansion, when inflation is the Feds key concern.

36. Define and provide examples of each of the following types of ratios
used in financial statement analysis.

a. liquidity ratios
measure of a companys ability to meet its short-term financial
obligations
current ratio: current assets/current liabilities
quick ratio: (current assets inventory)/current liabilities

b. profitability ratios
measure the relative profitability of a company
return on equity: net earnings/net worth
return on common equity: (net earnings - preferred stock
dividends)/(equity - preferred stock)

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return on assets: net earnings/total assets

c. debt ratios
measure the extent to which the firm finances its assets by debt

debt to equity: total debt/net worth

debt to assets: total debt/total assets

d. activity ratios
measure the rate at which a company is turning its inventory or
accounts receivable into cash

inventory turnover: cost of goods sold/average inventory

average collection period: receivables/sales per day

receivables turnover: annual sales/accounts receivable

410 Describe a working definition of technical analysis.

37. What is meant by technical analysis?


Technical analysis attempts to predict future stock prices by analyzing
a range of market information related to supply and demand.

38. List several assumptions used in technical analysis.


a. Supply and demand determine stock market prices.

b. Shifts in supply and demand can be detected sooner or later in


charts.

c. Stock prices move in trends (less minor fluctuations) that are fairly
persistent over time.

d. Trend reversals are the result of important supply/demand shifts.

e. Price movement patterns repeat themselves over time.

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411 Describe the results of major studies regarding technical analysis
and the larger issue of market timing.

39. Describe several conclusions that can be drawn from major studies
regarding market timing.
a. Avoid high levels of trading based upon technical information or
market timing.

b. Use market timing only infrequently and in the broad sense


rebalancing portfolios from one asset class to another in response
to very long-term movement in the economy or the industry.

c. Educate clients to the fact that stocks are their best friend over the
long term.

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References
Bengen, William P. Determining Withdrawal Rates Using Historical
Data. Journal of Financial Planning, March 2004.

Bernstein, Peter. Forecasting and the Market. Financial Analysts Journal,


NovemberDecember 1991.

Brinson, Gary P., Brian D. Singer, and Gilbert L. Beebower.


Determinants of Portfolio Performance II: An Update. Financial Analysts
Journal, MayJune 1991.

Brinson, Gary P., Robert Hood, and Gilbert L. Beebower. Determinants


of Portfolio Performance. Financial Analysts Journal, JulyAugust 1986.

College for Financial Planning. Chartered Mutual Fund Counselor


Professional Education Program, Module 6. Denver: 2010.

Dolan, Karen. A Big Fund Cost You Dont See. Morningstar.com


website, March 23, 2010.

Ellis, Charles. Investment Policy: How to Win the Losers Game, 2nd edition.
Homewood, IL: Business One Irwin, 1993.

Gibson, Roger C. Asset Allocation: Balancing Financial Risk. Homewood, IL:


Business One Irwin, 1990.

Graham, Benjamin, David L. Dodd, and Sidney Cottle. Security Analysis:


Principles and Techniques, 6th edition. New York: McGraw-Hill, 1990.

Hensel, Chris, Don Ezna, and John Iekiw. The Importance of the Asset
Allocation Decision. Financial Analysts Journal, JulyAugust 1991.

Hirt, Geoffery A, Stanley B. Block, and Somnath Basu. Investment Planning


for Financial Planning Professionals. New York: McGraw-Hill, 2006.

References 163
1996, 20022011, College for Financial Planning, all rights reserved.
Ibbotson SBBI 2011 Classic Yearbook. Chicago: Morningstar, 2011.

Kester, George W. Market Timing with Small versus Large-Firm Stocks:


Potential Gains and Required Predictive Ability. Financial Analysts
Journal, September October 1990.

Lawrence, C. J. Weekly Market Comment. January 7, 1991.

Malkiel, Burton. A Random Walk Down Wall Street, 4th edition. New York:
W. W. Norton & Co., 1985.

Mayo, Herbert B. Investments: An Introduction, 8th edition. Fort Worth, TX:


The Dryden Press/HBJ, 2006.

Mamudi, Sam. Bond ETF Buyers Must Stay on Guard for Hidden Risks.
The Wall Street Journal, March 1, 2010, p. C7.

Reilly, Frank. Investment Analysis and Portfolio Management, 8th edition.


Fort Worth, TX: The Dryden Press, 2006.

Sharpe, William. Likely Gains from Market Timing. Financial Analysts


Journal, MarchApril 1975.

Strauts, Timothy. Bond ETF Pricing: Efficient or Erratic?


<http://news.morningstar.com/articlenet/article.aspx?id=367406>.
January 26, 2011.

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Glossary
Activity ratio. A measure of the rate at which a company turns its
inventory or accounts receivable into cash.

Asset allocation. The process of distributing portfolio investments among


various asset categories.

Asset allocation policy. A formal plan that determines both the


categories of investments suitable for the clients portfolio and the
percentage of funds that should be assigned to each.

Business cycle. A term used to define the stages of expansion, recession,


and recovery that the economy appears to pass through over time.

Core/satellite asset allocation. An asset allocation method in which a


portfolio is divided into two parts: (1) a core part consisting of 70% to
80% of the portfolio usually invested in broad-based mutual funds, and
(2) a satellite portion for the remainder of the portfolio consisting of
investments in areas such as real estate, microcap stocks, sector funds,
and commodities (the satellite is used to try to take advantage of
particular opportunities that add return, diversification, and/or reduce
risk to the portfolio).

Correlation coefficient. The extent to which the returns of one asset, or


class of assets, corresponds to the return of another asset or class of assets.
Two assets are said to be perfectly correlated if their prices move up
and down in perfect tandem. Two assets are said to be perfectly
negatively correlated if they move in opposite directions. Correlations
range between 1.0 and +1.0 where 1.0 is perfectly negatively correlated,
+1.0 is perfectly correlated, and 0.0 indicates no relationship.

Current yield. The annual dividend or interest from a security divided by


its market price.

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Debt ratio. A measure of the contribution of borrowed money to the
financing of a company and the return to investors. Perhaps the most
important of these financial ratios is the debt-to-equity ratio, or total
debt/net worth.

Diversification. . Diversification is the act of acquiring assets that have


different risk characteristics, react differently to a given economic
scenario, and whose returns increase or decrease at different times and to
different degrees.

Dividend discount model. A mathematical model based upon time value


of money concepts used to determine the value of a particular stock.
Here, the value of a stock is the present value of the stream of all future
dividends.

Duration. The average weighted time to receive a bonds payments. It


measures the price sensitivity of a bond to interest rate changes.

Efficient market hypothesis. An hypothesis which holds that current


market prices of securities reflect all the information available about
issuers and the future expectations of their investors. A necessary
consequence of this hypothesis is the belief that attempts to find
undervalued securities in an efficient market is a waste of time.

Exchange-traded funds (ETFs). ETFs are baskets of securities that follow


indexes, which may be widely followed or created by the sponsor of the
ETF and trade like stock throughout the day.

Exchange-traded notes (ETNs). Exchange-traded notes (ETNs) are


unsecured debt securitieswith maturities of 30 years not being
unusualtypically issued by large commercial banks or investment
banks. Like ETFs, they track an index or benchmark, trade like stock, and
can be shorted. As a result, from the investors perspective, ETNs look
and seem like ETFs. Unlike ETFs, however, ETNs do not hold a basket of
stocks, but rather represent promises by the issuers to match the returns
of an index or commodity, minus fees.

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Expected return of a portfolio. The sum of the expected returns of each
asset category in a portfolio, weighted by their relative percentages in the
portfolio.

Face value. The principal amount of a bond or other note at maturity.

Fair value pricing. An alternative pricing method for mutual fund


securities that more accurately reflects what the stock prices should be, as
opposed to the last price at which they were traded.

Fed model. A stock valuation model that is based on comparing the yield-
to-maturity of 10-year Treasury notes to the earnings yield on the S&P
500 stock index.

Fundamental analysis. An approach to security selection based upon an


in-depth look at the many variables that affect the intrinsic value of a
security. It is conducted within the larger context of industry and
economic analysis.

Growth-oriented intrinsic value model. A mathematical model that


relates the historic growth rate of a stocks earnings, its current earnings,
the prevailing interest rate on high-grade bonds, and two numeric
constants.

Liquidity ratio. A measure of a companys ability to meet its short-term


financial obligations.

Longevity risk. The risk for a retiree of outliving his or her financial
resources.

Market timing. An approach to investing that attempts to buy securities


at low points in their market values and then sell at high points in their
market values.

Maturity date. The date on which the face value of a bond or other
obligation is due to the holder.

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PEG ratio. This ratio divides the P/E of a stock by its estimated future
earnings growth rate. In general, a ratio of 1 is considered to be fair value,
over 1.0 is overvalued, and under 1.0 is undervalued.

Price/earnings ratio. An indicator of how much investors are willing to


pay for $1 of current earnings. For price forecasting purposes, a
forecasted earnings figure (per share) can be used to make an estimate of
future price.

Price/sales ratio. An indicator of what the market is willing to pay for $1


of a companys current sales. The price/sales ratio as a value estimator is
based upon the premise that profits and value are ultimately related to
sales.

Profitability ratio. A measure of the relative profitability of a company.


Two important profitability ratios are net earnings on net worth, also
called return on equity, and net earnings on total assets, also called return
on assets.

Real estate investment trust (REIT). An entity formed to invest in real


estate mortgages (mortgage REIT), outright ownership of property
(equity REIT), or a combination of the two (hybrid REIT).

Real estate limited partnership (RELP). A partnership formed to


purchase, manage, and eventually sell real property. Unlike the standard
partnership, the limited partnership has two classes of partners: general
partners and limited partners.

Recession. A phase of the business cycle marked by a contraction of


economic activity. The National Bureau of Economic Research declares
that the U.S. economy is in recession when it records two or more back-
to-back quarters of reduced Gross Domestic Product.

168 Asset Allocation & Selection


1996, 20022011, College for Financial Planning, all rights reserved.
Security selection. An investment approach that attempts to identify
bargainsthose securities whose current prices are less than their
estimated intrinsic values.

Standard deviation. A statistically derived measure that captures the past


variability of investment returns. Standard deviation considers the
variability (the distance) of all data points from the average of all the
points.

Strategic asset allocation. An investment approach that focuses on


creating efficient portfolios from different asset classes that provide an
optimal balance between expected risk and return over long investment
horizons.

Tactical asset allocation. An investment approach that attempts to


improve portfolio returns through periodic revision of the asset mix.

Taxable equivalent yield. The yield that a taxable investment must offer
to be equivalent to the lower yield of a tax-exempt investment.

Technical analysis. An approach to security selection based upon study


of trading volume and price patterns.

Yield-to-call. The yield earned on a bond from the time it is acquired


until its call date. This yield includes both interest income received and
the redemption or call price received for the bond.

Yield-to-maturity. The yield earned on a bond from the time it is


acquired until the time the bond matures. This yield includes both
interest income received and the par value, or face value, at maturity.

Glossary 169
1996, 20022011, College for Financial Planning, all rights reserved.
Appendix
Investment Characteristics Matrix

Inflation/Deflation Hedge
Variability of Cash Flows

Minimum Investment ($)

Personal Management
Time (Holding Period)

Marketability/Liquidity

Acquisition Costs (%)


Periodic Cash Flows

Capital Appreciation
Risk Level (Overall)

Leverage Available
Expected Yield (%)
Safety of Principal

Sources of Risk

Distributions
Investment

Taxation

Bank S H H L PP OI X L 0 3+ Sm Q L
Savings
Accounts

Certificate of V H, V L R, PP OI X L 0 3-12 d 100 Q L


Deposit

EE U.S. L H H L PP OI, TD 0 4+ d 25 L
Savings
Bonds

HH U.S. L H H L PP OI X L 0 6 d 500 SA L
Savings
Bonds

Money S H H L R OI X m 0 3-12 e 1,000 Mo L


Market
Mutual
Funds

Treasury V H V V R, I, OI, CG X L 0-1 5-12 d X 1,000 SA L


Bonds PP

Municipal V H V V R, C, I, TF, X L 1-3 4-9 d X 5,000 SA L


Bonds PP CG

Corporate V H V V C,E R, OI, CG X L 1-3 5-12 d X 1,000 SA L


Bonds I,
PP

Treasury S H H L R, I OI 0-1 5-10 e X 10,000 L


Bills

170 Asset Allocation & Selection


1996, 20022011, College for Financial Planning, all rights reserved.
Inflation/Deflation Hedge
Variability of Cash Flows

Minimum Investment ($)

Personal Management
Time (Holding Period)

Marketability/Liquidity

Acquisition Costs (%)


Periodic Cash Flows

Capital Appreciation
Risk Level (Overall)

Leverage Available
Expected Yield (%)
Safety of Principal

Sources of Risk

Distributions
Investment

Taxation
Bonds with Features:

Zero V H V V C, I, OI, CG 1-3 5-12 d V L


Coupon PP, E

Discount V H V V I, PP, OI, CG X L X 1-3 8-12 d V SA L


R, E

Convertible L H m m I, PP, OI, CG X L X 1-3 8-20 d, i 1,000 SA m


C, R,
B, M,
E

Preferred V H m L,m B, M, OI, CG X L X 1-5 5-15 X Sm Q m


Stock I, PP

Income V H m L,m B, I, M OI, CG X L,m X 1-5 5-15 i X Sm Q M


Common
Stock

Growth V H L/m m B, M OI, CG X m X 1-5 5-20 i X Sm Q m


Common
Stock

Aggressive V H L m,H F, B, CG X 1-5 LR X Sm H, m


Growth M
Common
Stock

Gold V H L m,H F, B, CG X 1-5 LR X Sm H, m


M

Collectibles L V L H M CG X +/- LR i Sm H

Appendix 171
1996, 20022011, College for Financial Planning, all rights reserved.
Inflation/Deflation Hedge
Variability of Cash Flows

Minimum Investment ($)

Personal Management
Time (Holding Period)

Marketability/Liquidity

Acquisition Costs (%)


Periodic Cash Flows

Capital Appreciation
Risk Level (Overall)

Leverage Available
Expected Yield (%)
Safety of Principal

Sources of Risk

Distributions
Investment

Real Estate: Taxation

REITs: V H m m B, M OI, CG X L,m X 2-3 4-12 i X Sm Q m


Equity

REITs: V H m m F, I, OI, CG X L,m 2-3 4-12 d Sm Q m


Mortgage PP, R

Limited L L L V F, B, OI, CG X H X 8+ LR i 5,000 Q L


Partnerships M

Income L L m V B, I, R, OI, CG X m X 10 LR i X V Mo H
Property M, F

GNMAs V H V m R, I, OI, CG X m 1-3 7-14 d X 25,000 Mo L


PP

Single L H L PP TD V 5+ d 5,000 L
Prem. Def.
Ann.

Variable Life L m m B, M, I TD X V 5-15 d, i V m

Universal L H L R TD V 5-12 V L
Life

Futures S V L H M CG X fee LR i X 2,000 H


Contracts

Options S V L H B, M OI, CG X 2-10 LR X Sm H

Symbols:
B = business H = high MF = mutual fund S = short
C = call i = inflation Mo = monthly SA = semiannually
CG = capital gains I = interest rate OI = ordinary income Sm = small
d = deflation L = long or low PP = purchasing power TD = tax deferred
e = equal LR = large range Q = quarterly TF = tax free
E = event M = market R = reinvestment V = varies
F = financial m = medium or X = yes, available
moderate
1996 College for Financial Planning, all rights reserved.

172 Asset Allocation & Selection


1996, 20022011, College for Financial Planning, all rights reserved.
Index
A master index covering all modules of this course can be found in the Self-Study
Examination book.

Asset allocation Dividend discount model (DDM),


94
practicing, 28
Duration, 63
time horizons, 20
calculation, 63
Bond price flucuation
practical applications, 64
change in interest rates, 62
Dynamic asset allocation, 36
coupon rate, 62
Economic analysis, 112
credit risk of the debt
instrument, 63 Exchange-traded funds (ETFs), 85

time to maturity, 62 Exchange-traded notes (ETNs), 90

Bond valuation, 102 Fundamental analysis, 110

Bonds and other debt instruments, the method, 110


45
top-down process, 111
Brinson study, 11
Growth-oriented intrinsic value
Cash equivalents, 71 model, 101

Common stocks, 39 Immunization, 65

Company analysis, 119 Industry analysis, 118

Core/satellite asset allocation, 37 Investment risks, 60

Correlation, 24 call risk, 61

Current yield, 57 currency (exchange rate) risk, 61

Diversification effect, 24 default risk, 60

Index 173
1996, 20022011, College for Financial Planning, all rights reserved.
interest rate risk, 62 Returns of major asset classes, 15

purchasing power (or inflation) Risks. SeeInvestmentrisks


risk, 61
Strategic asset allocation, 34
reinvestment (or reinvestment
Tactical asset allocation, 36
rate) risk, 61
Technical analysis, 122
Mortgage-backed securities, 66, 67
Yield, 57
Mutual funds, 77
Yield-to-call, 59
PEG ratio, 99
Yield-to-maturity, 58
Preferred stock, 42

Price/earnings (P/E) ratio, 96

Price/sales ratio, 100

Real estate, 73

investment performance and


risk, 76

real estate investment trust


(REIT), 75

real estate limited partnership


(RELP), 75

174 Asset Allocation & Selection


1996, 20022011, College for Financial Planning, all rights reserved.