TERMS & DEFINITIONS: Alphabetical.
ACTIVE & PASSIVE INVESTING:
Active investing involves mutual fund portfolio managers who pick individual stocks with the expectation of generating a higher return than their benchmark or index. For example, a portfolio manager would purchase stocks for the fund that are expected to outperform the S&P 500 index performance. This portfolio manager might also choose to overweight stocks in the technology sector and underweight stocks in other sectors as compared to the S&P 500 index. In essence, the portfolio manager is actively selecting stocks expected to outperform the index. If the portfolio manager is successful in picking winners and avoiding losers, then the overall fund performance will exceed the S&P 500 index. If the portfolio manager is not successful in picking good stocks, then the fund performance will be less than the S&P 500 index. There are many indexes, and the Russell 2000 is an example of a “small cap” index. An active mutual fund portfolio manager with the Russell 2000 index would choose smaller stocks in an attempt to outperform the Russell 2000 index.
Meanwhile, a passive approach would simply seek to replicate all the stocks and their weights in the S&P 500 index without attempting to pick outperforming stocks. This passive approach is often referred to as “indexing”. Performance of passive index funds is very close to the representative index less modest expenses. The reality is that most actively managed funds underperform their benchmark indexes. There are two primary reasons for this underperformance. First, there are many active portfolio managers and analysts diligently seeking to pick outperforming stocks, so there are very few true undiscovered bargain stocks. Most stocks are followed closely by numerous highly competent analysts so that mispricing (either over-priced or under-priced) gets quickly traded (or arbitraged) away. The market is complex and it is priced to maintain a fine balance between upside opportunities and downside risks. This means that stocks are “efficiently” priced and there is no sure-fire way to consistently and systematically find enough good stocks and avoid bad stocks to generate outperformance for the fund. In fact, the Efficient Market Hypothesis in various forms is generally accepted as highly credible within the industry. The second reason for active underperformance is that these funds have much higher expenses that detract from investment performance. The expense structure is higher due to the higher employment cost for the analysts and portfolio managers. Passive funds need much less human involvement but rather rely heavily on computers.
As a result, passive index funds generally have superior performance to actively managed funds. This means that for the individual investor, low-cost passive index funds will likely outperform active funds and Cornerstone strongly believes that passive indexing is the way to get started. Cornerstone also believes that indexing should constitute the bulk of most high-net-worth portfolios. Active funds offer potential risk and return opportunities, however, and active assets can play an important role in larger portfolios or unique needs.
Asset Allocation involves the process of determining the asset classes and asset class weights for portfolio construction. For example, a simple Asset Allocation structure could involve:
42% in US large capitalization companies from an S&P 500 index fund,
18% from a foreign developed large capitalization companies from a foreign index fund, and
40% in a US aggregate bond index.
Asset Allocation can then get more complex by taking part of the US large capitalization index fund and putting some of the funds into mid capitalization company stock holdings and part into small capitalization company stock holdings. US stock holdings can be further parsed to include real estate, commodities and hedge funds. Foreign holdings can be divided into large company stocks, small company stocks and emerging market company stocks. The process can get even more complicated by determining the mix of growth and value stocks within the overall portfolio. Finally, the aggregate bond index can be divided into various bond categories including US Treasury securities, mortgage bonds, corporate bonds, high-yield bonds, foreign developed bonds and emerging market bonds. The bond part of the portfolio can also be structured with bond maturities ranging from ultra-short (maturing in under a year) to very long maturities (like 30 year US Treasury bonds).
Strategic and Tactical Asset Allocation: Asset Allocation also needs to be considered within the context of strategic and tactical. A Strategic Asset Allocation plan would determine fixed % weights for each asset class, and then rebalance back to these weights whenever market movements caused a significant diversion from the strategic fixed weights. For example, a very simple strategic asset allocation plan might include 60% in an S&P 500 index fund and 40% in an aggregate bond fund. If stocks performed more strongly than bonds over the course of time, then the portfolio weight might be 63% S&P 500 and 37% Fixed income. A strategic asset allocation fund would then need to rebalance back to the original 60/40 strategic weights.
Meanwhile, a Tactical Asset Allocation plan would seek to achieve a better Risk/Return outcome by changing the simple strategic 60/40 weights. For example, if a Tactical Asset Allocation plan believed that equities would outperform bonds than the 60/40 strategic weights might be tactically adjusted to 65% equities and 35%bonds. If stocks performed more strongly than bonds, than the tactical stock overweight would produce a greater return than the strategic 60/40 portfolio. In the case where stocks beat bonds, then the original 65% stock weight might appreciate to 68% of the portfolio as the stock market goes up. Rebalancing would then trim the stocks back to the original tactical 65% stock weight. Tactical asset allocators can also choose to underweight stocks if they expect stocks to underperform bonds. Obviously, tactical asset allocation produces a higher return than strategic asset allocation if you are tactically overweight the strongest performing asset classes. But it produces an inferior return if the tactical adjustments underperform the strategic weights.
Tactical asset allocation is generally differentiated from market timing based on the fact that the tactical adjustments are modest and they are intended to work over longer time periods. Classic market timing would make large, frequent asset class weights. A market timer might place a 30% weight in cash with the expectation that the market would collapse in the next few weeks. Other big moves might include large trades into gold or bio-tech stocks. Market timing is not recommended by Cornerstone.
Cornerstone Asset Allocation: Cornerstone’s Asset Allocation structure is included in the Cornerstone Model Portfolios. There is a “Focused” model for smaller portfolios and a “Base” model for larger High Net Worth portfolio. Cornerstone also maintains a “Comprehensive” model for the largest portfolios and this is available by special request. See: Cornerstone Model Portfolios
BROKERAGE ACCOUNTS AND DIRECT ACCOUNTS:
Brokerage firms like Schwab or Fidelity maintain brokerage accounts for individual investors that can hold a wide range of investment securities. For example, a Fidelity brokerage account could hold Fidelity mutual funds, Schwab Exchange Traded Funds, common stocks, individual bonds, REITs and many other securities. These securities can be purchased with a commission or even as a No-Load security.
Direct accounts are set up by a firm like T. Rowe Price that holds only TR Price funds. T. Rowe Price would also have brokerage accounts available.
BUY AND HOLD:
Buy and Hold is a common investment term that generally holds merit. Cornerstone defines Buy and Hold as an investment strategy that makes long-term investments and does not react to short-term events and it certainly does not react to daily headlines. If a Buy and Hold strategy is implemented with low-cost index funds, appropriate rebalancing, and with an asset allocation plan that appropriate for your investment objectives, then prospects for meeting your needs look good. It needs to be said, however, that Buy and Hold can be detrimental if there is no rebalancing, if there are high-cost investments, etc.
COSTS & EXPENSES-The Value Proposition:
Costs and expenses are a critical component of your overall investment return.
You can take a cost minimization approach and also dedicate very little of your own time, and end up with abysmal performance. This could be called cost minimization and investment return minimization.
You can also ignore the cost/expense factor and be eaten alive by costs/fees, high commissions, Variable Annuities, poorly performing hedge funds, so that you end up with abysmal performance.
Investment costs for funds are reported and investment performance is reported net of these fees in fund prospectuses. This information is also available in sources like Morningstar.
Trading costs are not reported, but investment performance is reported net of these trading costs.
For most people it is prudent to hire an adviser. Adviser compensation can be hourly, or a retainer. An annual fee of 1% of assets under management-AUM is common within the industry. Sometimes there is an AUM fee and a planning/tax fee. AUM fees typically decline with larger asset sizes and economies of scale.
Taxes in a taxable account. Your objective is the highest after tax return. A good adviser can deliver higher after-tax performance.
Derivatives are securities whose value is determined, or derived from, other assets or securities. Derivatives exist for both conservative risk management and for aggressive speculative strategies. Typical derivative applications are for:
Hedging where you might want to provide downside protection for a portfolio.
Increasing potential upside with a derivative that multiplies the return of an underlying asset (and also multiplies the downside if you are wrong.)
Common derivatives exist for: a) Options, b) Futures Contracts, c) Forward Contracts and d) Swaps. Options are the most common derivative category for individual investors.
Call Options: A Call Option is where you could Buy (Go Long) a derivative Call Option on the SPDR S&P 500 ETF-SPY. This Call Option is a contract that gives you the right but not the obligation to purchase the option on the SPY. You would buy a Call Option if you expected prices to move up in the future. In this case, you would buy a Call Option on the SPY by paying an option premium that gave you the right to buy the SPY over a specified time frame (like 6 months) at a specified Strike Price.
A hypothetical example would be buying a call option on XYZ for 6 months for a $1 premium and a $105 Strike Price when the underlying XYZ security was trading at $100. If the underlying security never reached $105 over the 6 month term, then you would have lost your $1 premium. However, if the underlying security moved up to $108, you could Exercise the option and purchase the security for $105 and sell it for $108. In this case you made a profit of $2. The profit is $108 sale price – $105 purchase price -$1 option premium.
Another way of looking at this is that you had significant leverage because you invested a $1 premium and you received a $2 profit. Your downside is a market that doesn’t move upward, and your portfolio’s return was reduced by your option premium. If the market declined to $98, your value is $97 because you spent $1 on the call option premium.
It is important to remember that there is another person on the other side of this Call Option. They are essentially Selling (or Shorting or Writing) a Call Option so that you can Buy it. They have a loss when the market goes up and you make the gain. However, they make their gain (the $1 premium that you sold them) when the market doesn’t go up to $105.
Put Options are another common derivative used by investors. You could Buy (Go Long) a Put Option on the XYZ security if you wanted to protect yourself from a large market decline. In this hypothetical case, you might Buy a Put for $1 when XYZ is trading at $100. This Put would allow you to Buy XYZ for $95 over the course of the 6-month term of the option. If XYZ declined to $90, you would be able to exercise your option for $95. This essentially puts a downside floor under your position for $94. ($95 minus the $1 Commission.) The purchase of the Put Option is a way to manage risk. The person selling the Put on the other side of the trade makes a $1 profit on the Commission if the XYZ security does not decline below $95. But, this Put seller takes a huge risk if the market drops sharply. For example, if XYZ fell to $80, then they would need to sell XYZ for $80 and buy it for $95. The loss would be -$14. ($95 purchase price-$80 sales price + $1 Commission.)
We would like to make a few generalized comments. First, the options market is played by highly experienced traders, and they often take money from people who don’t have the experience or expertise. Also, the options market is less than a zero-sum game because there are commissions on each side of the trade. Finally, it is important to remember that Buying (going Long) options is generally less risky than Selling (going Short or Writing) options. Selling/Writing options exposes an investor to huge losses if the market goes against you. There is no easy money to be made with options.
The Options market is not for inexperienced investors and Cornerstone does not recommend any derivative strategy unless there is significant experience and expertise.
Diversification is widely recognized as Job #1 for investing. You don’t put all your eggs in one basket. The market is very efficiently priced (See Active & Passive) and it is difficult to pick only big winners. Some stocks look like sure winners and yet they may disappoint and underperform. Some stocks look weak and are unloved until unexpected positive earnings or other developments cause the stock to strongly outperform. Despite all the surprises and volatility, the broad market trends upward and historically generated a long-term total return of roughly 10% per year. Consequently it is important to hit a good average. Meanwhile, if you only pick one stock or one sector, and you are wrong, then you greatly diminish your prospects for meeting your investment goals.
DOLLAR COST AVERAGING:
Dollar Cost Averaging-DCA involves making investments at a pre-determined time and dollar level rather than trying to time a lump sum investment. DCA is an excellent way to systematically get into the market at a reasonable price, and it takes a lot of emotion out of investing. DCA provides a good average investment cost that is often better than an emotion-driven lump sum investment. DCA is also an excellent way to implement your financial plan. A good way to implement DCA is simply by having a monthly transfer from your checking account to your investment account.
Equities are a broad asset class that typically includes common stock and preferred stock. Equities generally have higher returns and risk than Fixed Income. Equity investments can simply be purchased through a mutual fund or an Exchange Traded Fund that buys common stocks. These funds typically hold commons stocks of hundreds of companies. For example, if you purchased a large-capitalization fund, Apple-AAPL and 3M-MMM would likely be part of your holdings. You could also buy individual common stocks like Apple-AAPL or 3M-MMM and assemble your portfolio as a mix of the stocks that you purchased.
Fiduciary Standards are a key consideration if you choose an outside adviser. Fiduciary Standards require that an adviser act in the best interest of the clients. Stated simply, a fiduciary places your interests above their interests. Cornerstone is generally cautious about the brokerage business model because brokers are not fiduciaries and current laws and regulations hold brokers to a lower standard than RIAs. Whereas RIAs need to act as a fiduciary in the best interest of the client, brokers must only provide investments that are “suitable”. As a result, brokers and may use products with high commissions rather than an alternative with lower costs. RIAs with dual registrations may have the same potential conflict of interest because they can offer commission-based products. Historically, partnerships and Variable Annuities are other examples of investment products that have high commissions and lower investment returns. The Department of Labor has proposed rules that require brokers to have a fiduciary standard similar to RIAs for retirement accounts but courts have struck down this provision. At this time it is difficult to know what fiduciary standards may develop from the various regulatory agencies and the courts.
Bonds and Fixed Income are terms for a broad asset class that typically covers debt that pays interest income. This category typically has lower returns and risk than equities. Fixed income bonds include US Treasuries, government bonds, mortgage bonds, corporate bonds, corporate high-yield bonds, floating rate notes, municipal bonds, foreign bonds and emerging markets bonds. The Fixed income category is also comprised of various bond maturities and levels of credit quality. Bonds are typically purchased through mutual funds and Exchange Traded Funds. Portfolio managers for these funds will purchase a wide range of bonds that comprise their portfolio. You can also purchase individual bonds, but this not recommended for most portfolios due to bond pricing inefficiencies and size requirements for sufficient diversification. Cash is an important category within the overall Fixed Income weight.
Fundamental analysis incorporates ongoing monitoring of economic variables and corporate earnings reports. Consideration is given to consensus expectations and factors that appear to be priced in the market. Proprietary econometric forecasting is maintained to help understand and gauge future prospects. Forecasts are maintained not so much for predicting as maintaining perspective and avoiding over-reacting to short-term events. Cornerstone maintains disciplined data corroboration from multiple sources to ensure accuracy. See Also Technical Analysis
EXCHANGE TRADED FUNDS-ETFs:
ETFs generally are structured to replicate common indexes like the S&P 500 and thus they are similar to index mutual funds. The primary difference is that ETFs trade all day on a stock exchange rather than having a Net Asset Value for the mutual fund that is determined at the close of trading. Another difference is that ETFs usually trade based on a modest commission whereas mutual funds can trade based on either a commission (Load) or on a No-Load basis. Often there are a number of free trades before the commissions kick in. Finally, ETFs don’t generally produce taxable distributions and so they are usually more tax efficient than mutual funds. In most cases Cornerstone recommends the broad-based ETFs rather than mutual funds because ETFs are typically more tax efficient.
Investment Objectives are important for investors so that their portfolios can be better aligned with specific needs. For example, a millennial saving for retirement would have an Investment Objective for a portfolio with a long horizon that would allow for more risk and a higher expected return. The millennial might have a more conservative Investment Objective for saving for a down payment to purchase a house. A retired person would typically have a more conservative Investment Objective for retirement income. Since equities have higher expected return and risk, they are best for more aggressive portfolios. Bonds historically generated lower returns and had lower risk, and they were better for shorter time horizons and greater income needs. Since interest rates are still low by historic standards, the bond part of current portfolios should maintain shorter average maturities. Typical Investment Objectives are summarized below:
Aggressive Growth-90%+ Equities and Less than 10% Bonds.
Growth-80% Equities and 20% Bonds.
Growth With Income-60% Equities and 40% Bonds.
Income With Growth-40% Equities and 60% Bonds.
Income-0-20% Equities and 80-100% Bonds. (Including a sizable proportion of cash.)
So the millennial investor might hold a retirement portfolio that is Aggressive Growth and also a house down payment savings portfolio that is Income. Meanwhile the retired person might have an Investment Objective that is Income With Growth. These are broad generalizations, and unique circumstances dictate more fine tuning. For more information see: Investment Objectives
INVESTMENT STYLES-Growth, Core/Blend, & Value:
Investment styles for equity assets are frequently categorized as: a) Growth, b) Core/Blend or, c) Value. It is important to understand the Investment Style for the individual holdings in your portfolio, and also for the overall Investment Style of your portfolio. Some mutual funds and exchange traded funds have an Core/Blend objective that does not have style tilted heavily to either Growth or Value. Meanwhile, other funds have objectives that specifically target either the Growth or Value Investment Style. These Growth or Value funds can be important factors in a portfolio Risk/Return potential. Neither style is unequivocally better, but long-term studies show slightly stronger investment performance for the Value style. Nevertheless, the Russell 1000 Growth Index has significantly outperformed the Russell 1000 Value Index for the 10 years ending in 2015. But, the Russell 1000 Value index is outperforming the Growth counterpart in 2016. The important takeaway for most investors is that you want a portfolio that has a reasonable balance between the two styles. An investor certainly doesn’t want a huge overweight in either style. Some managers are Growth managers and some are Value managers. Morningstar.com is an excellent free website that can show the investment style for individual holdings and for an overall portfolio.
Growth equities are characterized as having revenue and earnings growth rates that exceed US GDP growth. Valuation metrics for the Growth style incorporate Price/Earnings Ratios (PEs) that are above the Value and Core/Blend styles. Growth stocks have traded at a valuation premium due to the expectation of higher rates of growth. Growth sectors include technology, bio-tech, consumer discretionary and staples.
Core/Blend sits between the Growth and Value Investment Styles and contains assets with valuation levels that are roughly at average levels. This style typically holds the more moderate part of the Growth style rather than the “hot, fast growers” which are quite expensive on a PE basis. The Core/Blend style also holds the more moderate part of the Value spectrum as opposed to the “deep” value assets that are extremely cheap. When constructing a portfolio, it is best to start with a heavier weight in Core/Blend and than hold lesser weights in Growth and Value.
The Value style represents equity assets with below-average valuation levels due to lower growth rates. Dividends are higher as they pay out more of their earnings as dividends and they re-invest a lower proportion in capital expenditures. Value stocks have traded at a discount due to lower expected growth rates, and due to a higher proportion the investment return coming from dividends. Value sectors typically include financials, pharmaceuticals, energy, telecommunication services and utilities.
Mutual funds represent the largest investment product category within the investment universe and they provide a solid basis for portfolio construction for the individual investor. Mutual fund portfolio managers essentially buy common stocks (and/or bonds) and aggregate them into a fund that is usually tied to indexes like the S&P 500 index or the Barclays Aggregate Bond Index. The mutual fund takes fund inflows and outflows each day, and then determines a Net Asset Value at the end of the day. All mutual fund investors would get this closing NAV price regardless of when they bought the fund during the day. Mutual funds are often managed based on an Active investment style that seeks to provide a superior risk/reward return compared to the benchmark. Index mutual funds are a smaller category that takes a passive approach to generate a return near the index return less small investment costs and expenses. Exchange Traded Funds have grown more rapidly in recent years but mutual funds still have a larger total dollar investment amount.
Passive Investing-See Active and Passive Investing.
The investment selection process often uses past performance as a primary reason for making a purchase. It is understandable that investors want to see how an investment asset has performed. Unfortunately, funds with strong recent performance get marketed and hyped by the industry. There is an inference that what has happened in the past will continue into the future. Nevertheless, past performance is a poor predictor of future performance, and this is particularly true of trendy “hot products”. This is called performance chasing, and the track record is poor. The worst example is the internet euphoria in the late 90s. More recently, hedge funds and alternative funds were hyped after the 2008/2009 market collapse. CFIA is not necessarily recommending buying poor performers, but rather purchasing securities based on our fundamental criteria.
Rebalancing is a tried and proven discipline that is sometimes described as the only free lunch in the investment business/landscape. Quite simply, you start with your strategic asset allocation structure as determined by your investment objective. For example, it might be as simple as a 60/40 mix of stocks and fixed income/bonds. As the market changes over time and different parts of the market expand or contract, the 60/40 mix might reprice to 65/35. A down equity market might produce a 55/45 mix. Rebalancing would then say sell the overweight and buy the underweight. This means that you are selling your winners in an up equity market. This can be difficult due to the euphoria of the gains. It also means that you are buying equities in a down market. This is even more difficult due to the discomfort felt from a down market and lower account balances. Nevertheless, it incorporates a Buy Low, Sell High discipline.
Although rebalancing is not rocket science, it is commonly underutilized by investors. Rebalancing requires disciplined monitoring portfolios during times of significant market moves, and then taking action to bring the portfolio asset allocation back into line with the overall investment objective. From a practical standpoint, rebalancing is available through the purchase of lifestyle funds or target date funds that do the rebalancing for you. Another way is through the use of Robo-Advisor products. For the Do-It-Yourself investor, rebalancing should be utilized when volatile markets take your portfolio weights away from your investment objective by 5% or more.
The best example of the need for rebalancing occurred during the Dot Com frenzy in the late 1990s. Internet stock euphoria captured the fancy of investors. The technology-heavy NASDAQ index went from 2,000 to 3,000 to 4,000 to 5,048 in a brief period. Then it went down to 4k to 3, to 2k to 1.1k for a decline of 78%. Many high-flyers did even worse. Many investors piled on (Momentum) during the late 90s and then bailed as the stocks crashed. The S&P 500 technology weight went from 16% to 33% and back to 16%.
An investor who rebalanced continued to lock in gains on the way up, and then bought cheap after they crashed.
HNW individuals often have a concentrated stock due to options, a privately owned business, or a concentration in commercial real estate. These assets need to be considered within the context of the overall rebalancing process.
Technical Analysis: Content to be added soon.