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CFP® Study Tip

In the May e-newsletter, we discussed investment suitability. The following case was included. The answers are provided below.

Case Study

Natalie inherited $1 million from her deceased uncle. Natalie is a 35-year-old teacher who is married to Roberto, a 36-year-old advertising executive. Both Natalie and Roberto earn $60,000 per year. Both have attractive company pension plans and have $300,000 in RRSPs combined. Natalie and Roberto have 3 children; 10 years, 7 years and 5 years of age.

Natalie has experience in investing in stocks and mutual funds, and while she can live with volatility, she does not want to “go off the deep end” with her investments. Her major goals for investing the inheritance are retiring at age 55 and 56 for her and Roberto, respectively, and saving for the children’s post-secondary education.

1. What is Natalie’s risk tolerance?

  1. low
  2. medium
  3. high
  4. low to medium           

Answer 1:  b. – medium

Rationale: The case states that Natalie can live with volatility but does not want to go off the deep-end with her investments.

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2. What is Natalie’s major investment objective?

  1. safety
  2. income
  3. growth
  4. speculation

Answer 2:  c. – growth

Rationale: Natalie’s major goals for investing are retirement and for the children’s education. Since she is investing for future needs, inflation is a concern and growth in her investments is required.

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3. You are an investment advisor and your firm offers the following mutual funds.

  1. balanced
  2. equity
  3. money market
  4. specialty

Rank these mutual funds, as to suitability for Natalie, from the most appropriate to the least appropriate

  1. I, II, III, IV
  2. III, I, II, IV
  3. I, II, IV, III
  4. II, I, III, IV

Answer 3:  d. – II, I, III, IV

Rationale: Since Natalie’s major investment objective is growth, she would want a mutual fund that offers growth. Since she has medium risk tolerance, the most appropriate fund would be the equity fund. The specialty fund is too risky. The second most appropriate fund would be the balanced fund which has growth as one of its objectives. The least appropriate funds would be the money market fund, which has no growth potential and the specialty fund which is too risky.

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4. Recommend an asset allocation for Natalie based on the age approach.

  1. 20% cash ; 30% fixed income ; 50% equity
  2. 5% cash ; 30% fixed income ; 65% equity
  3. 10% cash ; 40% fixed income ; 50% equity
  4. 15% cash ; 20% fixed income ; 65% equity

Answer 4:  b. – 5% cash ; 30% fixed income ; 65% equity

Rationale: According to the age approach the equity component should equal (100% - the client’s age) or 65 (100 – 35). The cash component should be 5%, and up to 10% for conservative investors. For Natalie, 5% cash is appropriate. The remainder of the funds would be invested in fixed income securities. This equals 30% fixed income for Natalie (100% - 70%).

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In this e-newsletter we will discuss portfolio management and asset allocation followed by a brief case study.

Passive versus Active Portfolio Management

  • A passive style of portfolio management attempts to match the return on a market index. For example, the investor can buy index mutual funds or broad-based sector Exchange Traded Funds (ETFs)

  • With an active strategy the portfolio manager attempts to outperform a benchmark. Here the investor is prepared to pay a management fee to obtain superior performance.

Active Asset Allocation Techniques

While different approaches can be taken to actively manage a portfolio, one approach is an integrated asset allocation approach. This consists of:

  • Strategic Asset Allocation: This represents a long term asset allocation. This is where the asset allocation of the portfolio is relatively fixed as to percentage weightings: e.g., 5% Cash, 45% Fixed Income; 50% Equity.

  • Dynamic Asset Allocation: This represents rebalancing the portfolio on a regular basis; e.g., annually or after major market movements.

  • Tactical Asset Allocation: Here the portfolio manager is allowed to tilt the portfolio away from the strategic asset allocation to take advantage of short term opportunities. For example, the portfolio manager might overweight the portfolio in equity securities to take advantage of an expected short term movement in stock prices.

Types of Investments

Once an asset allocation is determined, diversification within the asset classes is important. The following represents a breakdown of types of investments under each asset class.

  • Cash: Cash, CSBs and money market instruments including T-bills, Bank Accounts and Commercial Paper.  Cash investments also include money market mutual funds and long term debt instruments which will mature within one year.

  • Fixed Income: Term deposits, GICs, mortgages, mortgage backed securities, marketable bonds and preferred shares.  Fixed income investments, also include mutual funds and ETFs that invest in marketable bonds, mortgages and preferred shares.

  • Equity: Common shares, convertible bonds, convertible preferred shares and mutual funds and ETFs that invest in common shares.  Equity investments also include income trusts and derivative securities including rights, warrants, calls and puts.

Following is a portfolio for hypothetical client John Wright, as at June 1, 2011.   Please review his portfolio, then answer the following questions:

  Securities # Shares/ Units Cost Current Price Market Value
• Bonavista Oil and Gas Income Trust 300 $26 $30 —
• BlackRock S&P/TSX 60 i shares ETF units 400 42 40 —
• GrowthWorks LSVCC Fund – investing in BC companies only 500 14 12 —
• CIBC $25 Par 5% Preferred Shares, Series E 200 24.50 27 —
• Dynamic Canadian Corporate Bond Fund (Mutual Fund) 200 8 14 —

 

    Face Value Cost Current Price Market Value
• CSBs, Series 42, C bonds maturing Nov. 1, 2016
(current minimum interest rate 3%)		 $14,000 $100 $100 —
• GOC T-bills maturing in 60 days (yield 2.44%) 10,000 99.60 99.60 —
• Province of BC, 4.75% bonds maturing March 1, 2015 15,000 102.50 104 —
• GOC stripped coupons maturing in 10 years 2,500 67.30 67.30 —

 
Questions:

Question One: Determine the asset allocation for John’s account as at June 1, 2011 in respect to: cash investments, fixed income investments, and equity investments.

Question Two: If John liquidated his investments as at June 1, 2011, what would be the capital gain or capital loss on the portfolio?

Conclusion

We will discuss the answers to the case study in the next e-newsletter. Good luck in your study program with Advocis.

Sincerely,

Ron Foran, CFP, CFA, CLU, FCSI
President, Foran Financial Institute


Note: Advocis does not award the CFP® and Certified Financial Planner® designation. The right to use the marks CFP®, CERTIFIED FINANCIAL PLANNER® and CFP(logo) is granted under licence by FPSC to those persons who have met its educational standards, passed the FPSC's Certified Financial Planner Examination, satisfied a work experience requirement, and agreed to abide by FPSC Code of Ethics.