ETFs
The first step is setting up an investment account is to understand the client. Everything flows from this. The client profile is developed through an extensive interview process, wherein the advisor seeks to gain an understanding of the client's personal circumstances, current and envisioned financial situation, risk tolerance and investment knowledge (Anthony, 2011). With this information, the financial advisor can then build a profile based on the portfolio objectives and risk constraints. For this portfolio, the focus will be on exchange-traded funds. The objective of this exercise is to build the optimal portfolio for the client, taking into account the client's personal circumstances and the variety of funds that are available to build the portfolio.
Client Profile
The client is a male, late 20s, with a long-term girlfriend. They have no current plans for children. They are American, living and working in Miami, and therefore are eligible to purchase securities on American exchanges. The client recently graduated with an MBA in Finance, and has taken a job with an investment bank, the current role doing forex at the Miami office, where the specialty is Latin American currencies. The client has set aside this initial $100,000 for an investment fund. The client has another savings account of $200, 000, but this is earmarked as a down payment for the purchase of a house on a canal. The client has also started a tax-protected retirement fund. So the total investment funds are $100,000 at this point. The client expects that his earnings and those of his girlfriend will be sufficient to cover all living expenses, so the investment fund constitutes money that is not expected to be used any time soon. It is purely a saving account. The time horizon therefore is retirement, which the client expects will be 30-40 years hence.
Armed with a master's degree in Finance and a job in forex, the client is a sophisticated investor. While he has not studied derivatives or arcane instruments extensively, the client has the background knowledge to get up to speed on any investment product quickly. The client is fully aware of market risks, the relationship between risk and return, and other basic financial concepts. He is familiar with and subscribes to the efficient market hypothesis. The client has explicitly stated that with this fund he has a high risk tolerance, owing to his high level of financial knowledge and the fact that the account has a long time horizon.
Asset Allocation
The client has a long time horizon, high level of investment knowledge and high risk tolerance. The client also does not believe that he can beat the market, so is willing to accept funds. Further, because of the client's view, he prefers funds with low MERs, so exchange-traded funds are ideal, since he only pays the upfront transaction cost, and then the transaction cost again upon disposition. An MER is the expense ratio, the fee that is taken by the fund manager for the managing of the fund to cover operating costs. This is expressed as an annual percentage of the fund's value (Investopedia, 2013).
For a client with a long-term time horizon and little risk of needed the money in the short run, the basic assumption is that a riskier portfolio can be constructed. For this client, the stated acceptance of high risk confirms this. The portfolio can be 100% equity at this point, as Costa (2011) notes for the "dynamic" portfolio. Cash can be held during periods of uncertainty but at this point there is little cause for uncertainty in the markets. Within asset classes, there are a mix of risks, so that should be taken into consideration. Not all options are internally diversified. Something like, for example, ProShares Ultra Pro-Financials is a basket of financial companies, so would be affected more by changes in interest rates than would a basket that featured a broad-based index or another industry. The basket therefore should focus on 4-5 different asset classes. A total of 40% in moderate risk classes and then 60% in broad-based ETFs. This portfolio would have a high-risk construction, featuring a beta of at least 1.2 (maybe up to 1.4), thereby giving the client the expectation of returns above the market average. The downside is that these funds will sometimes have MERs, which would reduce the real return on the funds. If they are priced rationally already, then the rational investor might not want to have funds that have MERs, because they would not offer a positive risk-adjusted rate of return. The objective...
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