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Unsystematic Investing Risks

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Understanding Company, Sector or Industry Risk

[By Julia O’Neal; MA, CPA]

fp-book1

Unsystematic risks are those associated with factors particular to the underlying company, sector or industry. 

Unsystematic risks are all risks that can be eliminated by diversification and are thus unrewarded.  

The Alpha Factor 

The residual nonmarket influences unique to each stock are measured by its alpha factor.

When one stock has a higher or lower rate of return than another stock with the same beta, this is said to be a result of its alpha factor.  If the physician-investor can pick enough stocks with positive alphas, the portfolio can be expected to perform better than its beta would have indicated for a given market movement. 

Diversification 

Unsystematic risk is reduced through diversification.  

As more stocks are added to a portfolio, the chance of obtaining a positive alpha, as well as the risk of getting a negative alpha, is diversified away. The volatility of the portfolio becomes much like the market itself.  

Assessment 

Therefore, a fully diversified portfolio – if there is such a thing – has a beta of 1.0 and an alpha of 0. Is your portfolio appropriately diversified; or is it di-worsified? 

Conclusion

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Inflation Risk and Investing

fp-book4Understanding Purchasing Power Risk

[By Julia O’Neal; MA, CPA]

Purchasing power risk refers to the effects of inflation and disinflation on the future purchasing power of the income and principal from an investment.

Seeking “Total Returns” 

The typical physician investor seeks an investment that at minimum returns the same number of dollars as originally invested.  In addition, he or she hopes to achieve current income flow and/or capital appreciation on the security due to favorable results at the underlying company.

This is called “total return.”

Although a physician or other investor may realize a positive nominal (actual) return, however, once the effects of inflation are factored into the return, there is a chance that the real return could be negative.

For example, if it takes 20 years for an investment to return 75%, during which time the price level has risen 100%, the investor is receiving a smaller amount of purchasing power than was originally invested.  

Assessment 

  • Over the very long term, common stocks have provided an effective hedge against inflation.
  • Over shorter periods of time, however, physician investors have been disappointed in stocks as a hedge against inflation, as the rate of inflation has often exceeded the gain in common stock prices.

And so, are you a long-term physician-investor; and how long-is long-term, anyway? 

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Conclusion

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Systematic Securities Risks

Understanding Stock Market Risk

By Julia O’Neal; MA, CPA  

Systematic risk, also known as market risk, is that part of a security’s risk that is common to all securities of the same general class (e.g., stock or bonds) and is caused by economic, sociological, and political factors.

Systematic risk cannot be eliminated by the physician-investor through diversification in an investment class. 

Beta Co-efficient Measurement 

The measure of systematic risk in stocks is the beta coefficient. The beta coefficient is the covariance of a stock in relation to the rest of the stock market. It reflects the magnitude of the co-movement of the stock’s returns with those of the market.

Stock Market Proxy 

The Standard & Poor’s 500 Stock Index is generally used as a proxy for the market and has a beta coefficient of 1. Any stock with a higher beta is more volatile than the market. 

For example, a stock with a beta of 1.3 is 30% more volatile than the market (up and down), and any stock with a lower beta can be expected to rise and fall more slowly than the market. 

Investing Strategies 

Conservative physician-investors whose main concern is the preservation of capital should focus on low-beta stock.  Other doctors, more willing to take greater risks in an attempt to earn higher potential rewards, should include high-beta stock in their portfolios. 

Three Types of Systematic Risk 

Common to all assets are the following three systematic risk factors: 

  • Inflation or purchasing power risk,
  • Interest rate risk, and
  • Movements in the market in which a security is traded. 

Conclusion 

Are you willing to accept systematic, or stock market risk, in your investment portfolio; why or why not? 

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Investing and Interest Rate Risks [IRR]

Understanding Inverse Relationships

By Julia O’Neal; MA, CPA  

 

Interest Rate Risk [IRR] refers to the tendency of all investments to rise as interest rates decline and fall as interest rates rise. This inverse relationship is common among all investments, although not to the same degree.  

Pure Interest Rate Movements 

A U.S. Treasury security best demonstrates the pure interest rate move. 

The risk is present with other investments as well, since the discount rate—the required rate of return used to place a value on an asset—in part consists of the return available from a default-free investment. 

History shows that when the average level of interest rates rises, absolute volatility also rises. 

Assessment 

When looking at interest rate risk and other investments, it becomes important for physician-investors to look at the other component of the discount rate or the required risk premium over and above the risk-free rate.  

For example, in the case of high-grade bonds or utility equities, the default rate dominates the total discount rate, making interest rate risk more influential.  

For other investments, such as junk bonds or growth equities, the risk premium required has a much greater influence, somewhat reducing pure interest rate risk. 

Conclusion 

Are you willing to accept interest rate risk in your investing portfolio; how much IRR and for how long? 

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Pervasive Investing Risks

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Understanding Pandemic Risks

[By Julia O’Neal; MA, CPA]

Pervasive risks are those perils associated with all investments, such as purchasing power risk.  

In other words, this is the risk that because of the influence of price inflation or deflation, the investment return achieved is worse or better than expected.  

Another pervasive and hard-to-control risk is political risk. Typical political risks include the prohibition against exchanging domestic currency for foreign currency, failure to meet debt service, expropriation of assets, differences in taxes, and restriction on expatriating funds. 

Conclusion

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Real Estate Investments

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Doctors Must Understand the Unique Risks

[By Julia O’Neal; MA, CPA]

Real Estate [RE] requires a separate discussion of unique risks relative to other financial asset classes. 

Macro Economic and Other Risks 

RE investments possess not only the macro-economic risks found in all financial assets, but other unique risks, as well.

For example, these risks include illiquidity, lack of a continuous auction trading market, and quoted prices that may or may not represent intrinsic value.  

Lack of Diversification 

Given the large size of many real estate projects, it may also be difficult to diversify adequately and reduce total portfolio risk.

And, because of the chance of segmented markets, the risk of imperfect information is also present.  

Assessment

Remember, real estate is not easily divisible and is nonhomogeneous; such risks cannot be fully negated through diversification. 

paint room

Conclusion

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Investing Sector Risks

Understanding Industry Risk

 By Julia O’Neal; MA, CPA

fp-book3

Often also called industry risk, sector risk is the risk of doing better or worse than expected as a result of investment in one sector of the economy instead of another.

Economic Classifications 

A typical economic classification includes capital goods, consumer durables, consumer nondurables, financial, energy, utility, basic materials, technology, retail, and service. There are many more; of course.

Conclusion 

Which sectors do you invest in, and do you appreciate the associated industry risks? 

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Investing Terms and Portfolio Design Definitions

A “Need-to-Know “ Glossary for all Medical Professionals

Staff Writers

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Absolute volatility: The true volatility of an investment. 

Accumulation phase: A phase in an investor’s life when he or she is trying to accumulate an estate; usually characterized by growth-oriented investments.

Alpha factor: Measures the residual non-market influences that contribute to a securities risk unique to each security. 

Arithmetic mean: The sum of a set of numbers divided by the number of numbers in the set. 

Capital appreciation: The growth of an investment’s principal. 

Capital asset pricing model (CAPM): A model that uses beta and market return to help investors evaluate risk return trade-offs in investment decisions. 

Capital Market Line: Represents a spectrum of two-asset portfolios, moving from a portfolio invested in 100% of the least risky asset to a portfolio invested in 100% of the most risky one. The Capital Market Line is plotted on a graph with % return plotted on the Y-axis and risk (standard deviation) plotted on the X-axis. 

Co-movement: The degree to which an asset moves with other assets. 

Consolidation phase: A phase in an investor’s life when he or she generally shifts assets to more conservative or stable investments with the hope of preventing any major losses to accumulated assets. The investor is still interested in the growth of the investments. 

Covariance: The volatility of investments in relation to other investments. 

Current income: Income received from investments. 

Discount rate: The annual rate of return that could be earned currently on a similar investment; used when finding present value or opportunity cost. 

Earnings momentum investing: A style of investing that looks for companies that are on growth trends similar to a growth style. Two nuances differentiate these two styles: (1) the earnings momentum style focuses mainly on the growth of the earnings of the company and (2) the earnings momentum style looks for an accelerating increase in the growth of earnings. 

Efficient frontier: A line that represents the highest return for each particular mix of assets in a portfolio. 

Geometric mean: The Nth root of the product of “n” numbers. 

Growth investing: A style of investing that tries to outperform the market by investing in companies that are experiencing growth patterns in earnings, cash flows, sales, capitalization, etc. 

Market timing: Trying to predict the gains and declines of the market and then buying at market lows and selling at market highs. 

Mean rate of return: The return that is between two extreme returns. 

Modern portfolio theory: An approach to portfolio management that uses statistical measures to develop a portfolio plan. 

Negatively correlated: Two securities that move in opposite directions.

Nominal return: The return that an investment produces.

Periodic re-balancing: The act of shifting capital from asset classes that performed well to those that did not, in order to maintain a set ratio between asset classes. 

Positively correlated: Two securities that move in the same direction.

Probability distribution: A statistical tool used to show the dispersion around an expected result. 

Real return: The actual return after factors such as inflation and taxes are taken into consideration. 

Realized gain or loss: Gain or loss experienced by an investor during a period.

Regression analysis: A statistical tool used to measure the relationship between two or more variables. 

Relative efficiency: The belief that the markets reflect current information in their prices. 

Risk-averse: Describes a physician investor who requires greater return in exchange for taking on greater risk.

Sector rotation investing: A style of investing in which the goal is to out-perform the market by investing more heavily in the sectors that are forecasted to perform better than the market in expected economic scenarios.

Spending phase: The phase in an investor’s life when he or she is living on accumulated assets; generally characterized by a portfolio invested mainly in income-oriented investments, although a portion of growth is usually maintained.

Standard deviation: A statistical method used to measure the dispersion around an asset’s average or expected return and the most common single indicator of an asset’s risk. 

Unrealized gain or loss: A gain or loss on paper that is not realized until the investment is sold. 

Value investing: A style of investing that searches for undervalued companies and buys their stock in hopes of sharing in the future gain when other analysts discover the company.

Yield curve: A graph that represents the relationship between a bond’s term to maturity and its yield at a given point in time.

Yield to maturity: The fully compounded rate of return earned by an investor over the life of a bond, including interest income and price appreciation. 

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More terms: www.HealthDictionarySeries.com 

Note: Feel free to send in your own related terms and definitions so that this section may be updated continually in modern Wiki-like fashion.

    

Credit Risk

Understanding Company Specific Risk

By Julia O’Neal; MA, CPA  

 

There are several kinds of investing risk, for example:

  • Credit or company specific risk refers to the firm’s business and financial risks.
  • Business risk is the risk inherent in the nature of the business.
  • Financial risks are those in addition to business risk that arise from financial leverage [credit or debt].  

Business Risk Example 

An example of high business risk would be a computer component manufacturer whose product demand is highly sensitive to macroeconomic activity and who has small profit margins.  

Assessment 

A company’s unique business risk would be increased by adding debt to an already unpredictable business. 

Conclusion 

Can you appreciate that credit risk is associated with a firm’s ability to meet financial obligations on the securities [bonds, notes and obligations, etc.] it issues?

More importantly, do you invest with this risk in mind? 

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About American Depository Receipts

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Physician Investing Basics

[By Julia O’Neal; MA, CPA]

caution

American Depository Receipts [ADRs] are shares of foreign stocks held by U.S. banks abroad that are sold on exchanges in the United States.

Often, foreign governments do not allow stocks to be sold to non-citizens, and ADRs allow U.S. investors to purchase foreign securities.  

ADRs usually exist on only the largest foreign publicly held companies, but their numbers are rapidly growing. They are traded in dollars, and dividends are paid in dollars. (Morningstar, Inc., in Chicago, publishes regular research reports on ADRs.) 

Assessment

Do you own ADRs, and why or why not? 

Conclusion

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Types of Common Stock

Physician Investing Basics

 [By Julia O’Neal; MA, CPA]

fp-book1There are several different types of common stock listed below, and more. 

Utilities: Utilities are companies in public-service businesses, such as electric utilities, natural gas delivery, or telephones, which pay high dividends and are often used by investors for income. 

Blue chips: These are high-quality, well-known, large-capitalization, dividend-paying companies with long track records of steady, secure earnings.  

Capitalization: Market price × Number of shares outstanding. Usually market cap of less than $500 million is considered “small capitalization,” but in recent years, companies between $500 million and $1 billion are also being considered “small caps.” 

Growth: Companies with earnings growth in excess of industry or market averages. Although these companies have strong earnings, they usually reinvest them into research or expansion rather than pay them out as dividends. 

Emerging growth: Smaller capitalization companies with even stronger earnings potential. Smaller companies are on the early part of the growth curve. While the start-up phase is the riskiest, the expansion phase follows, where growth is the fastest. Small companies may be in new businesses or new markets, and they often have the advantage of being able to react quickly to change. Some investors look especially for smaller companies that are “under-owned by institutions”—that have not been discovered by the big professional investors. 

Cyclical: Companies in businesses providing basic materials or products that are subject to the economic cycle; profits are based on increased consumer demand for high-cost items that can be deferred in tough economic times. Some examples are steel, autos, and building materials. These may be big, strong, mature companies that pay dividends, but they are not blue chips because the possibility exists that earnings may slump drastically and dividends may disappear during economic downturns. 

Defensive: Companies that continue to produce earnings in all economic cycles because they provide a necessary product or service (for example utilities, healthcare and food companies). 

Assessment 

Of course, stocks are further subdivided by industry type, from retailing (department stores and other direct sellers to consumers) to restaurants to technology to steel. The list is long, and sectors are often classified differently.

New areas, such as bio and nano-technology and networking software, are constantly being added. 

Conclusion 

And so, do you prefer common stocks, mutual funds, index funds or ETFs, and why?

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What is Common Stock?

Physician Investing Basics

By Julia O’Neal; MA, CPAfp-book1

Common stock is fractional company ownership and does not have to pay a specified dividend. It is assigned a par value only for bookkeeping purposes on the balance sheet. (Additional value of book equity is called paid-in capital or capital surplus.) 

Par Value not Market Value

Par value has no relation to market value. Some types of preferred stock do not carry voting privileges, but common stockholders must vote on certain corporate matters, such as the election of the board of directors.

Classes  

Moreover, there are some companies that offer two, three or more different classes of stocks under Common Stocks. They often call these as Class A, Class B and Class C, etc. Class A stock holders have literally more voting rights than Class B stock holders, and so forth.

Company stocks that have more than one class is not a common stock and most physicians and investors refrain from buying company stocks with more than one class; unless carefully evaluated.

Stockholders are invited to attend the annual meeting to vote, but may also vote by mail, in a proxy vote.  

Conclusion

And so, how much common stock do you own?

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What is Preferred Stock?

Physician Investing Basics

By Julia O’Neal; MA, CPA 

fp-book3

Preferred stock is designed to resemble bonds and usually has a par value of $100. Dividends are stated as a percentage of par—6% preferred would pay $6 annually. The stated dividend is the minimum that the company will pay out. If there are not enough earnings to pay the dividend, the company will pay out whatever is available for dividends. 

Preferred Stock Differences 

There are different types of preferred stock, which are based on the method of dividend payment. 

Cumulative preferred carries a provision that all prior dividends due on preferred stock must be paid before dividends can be paid on common stock.  

Participating preferred may earn dividends in excess of the stated percentage if they are available after dividends are paid on common.  

Convertible preferred is also issued at $100 par. The stock may be converted into (exchanged for) a designated number of common shares. The conversion ratio and conversion price are determined at the time the stock is issued. 

Conversion ratio = Par value / Conversion price

When the stock reaches its conversion price, the cumulative preferred stock is said to be “at parity” with the common stock.  

Cumulative preferred stock usually sells “at a premium to” (above) its par value because of the added value attached to the conversion feature. Most of the time, cumulative preferred stock is callable, which means the corporation has the right to “call” or buy back the preferred stock at a specified price, sometimes after a set date. 

Cumulative convertible preferred stock is popular. Investors appreciate the ability to combine the attributes of both stock and bond ownership in one vehicle and, because they are so popular, corporations can market these securities easily, often with a lower coupon than a straight bond would require. 

MORE: C v P

Assessment: Is preferred stock best for personal or corporate portfolios?

Conclusion: Your thoughts are appreciated.

***

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

Equity-Based Securities Terms and Definitions for Physicians

A “Need-to-Know” Glossary for all Medical Professionals

[By Staff Writers]HDS

ADRs (American Depository Receipts): Securities that allow trading of shares of foreign stocks on U.S. exchanges. ADRs are issued by U.S. banks in place of foreign shares that the banks hold in trust. 

Advance/decline ratio (A/D ratio): The number of stocks that have advanced divided by the number that has declined over a certain time period. Ratios plotted one after another show the direction of the market, and the steepness of the line shows the strength of that direction.

Alpha: The measure of the amount of a stock’s expected return that is not related to the stock’s sensitivity to market volatility.

Arbitrage: Profiting from differences in price by simultaneously buying and selling the same security on different exchanges or using different types of contracts on the same security (buying rights and selling the stock, for instance). 

Asset allocation: Apportioning investments among different categories of assets (cash, stocks, and bonds, for example, or different subcategories like cyclical stocks, small capitalization stocks, blue chips, and defensive stocks). An important financial planning tool used to control both risk and return.

Beta: The measure of a stock’s volatility relative to the market. A beta lower than 1 means the stock is less sensitive than the market as a whole; higher than 1 indicates the stock is more volatile than the market. 

Book value: Determined from a company’s balance sheet by adding all current and long-term assets and subtracting all liabilities, including outstanding bonds and preferred stock. This total net-asset figure is divided by the number of common shares outstanding to arrive at book value per share. 

Callable: Preferred stock or bonds that may be redeemed by the issuing corporation before their stated maturity at a pre-stated “call price” that is higher than the original issue price. 

Capitalization ratios: Analysis of the components of a company’s capital structure, including debt (bonds), stock, and surplus, which show the relative importance of the sources of financing. 

Common stock: Units of ownership of a public corporation that usually carry voting rights; common stock is sometimes called “capital stock” when the company has no preferred stock. Common stock is the last to be paid off at liquidation but generally has the most potential for appreciation. 

Convertible securities: Preferred stock or bonds that are exchangeable for a stated number of shares of common stock at a pre-set price (“conversion price”). The “conversion ratio” is determined by dividing the par value of the convertible security by the conversion price. The amount by which the conversion price exceeds the current market price is the “conversion premium.” 

Coverage ratios: The number of times income will meet the fixed charges of bond interest and preferred dividends.

Cyclical stock: Stocks that tend to rise or fall quickly, corresponding to the same movements in the economic cycle. Automobiles and housing, for instance, are more in demand when consumers can afford high-ticket durables. Lumber, steel, and paper are more in demand when manufacturing production is high.

Defensive stock: Stocks from companies that make necessities, such as food, drugs, and utilities that are in demand regardless of the economic cycle. These stocks tend to respond less negatively to down market cycles. 

Dilutive effect: The lowering of the book or market value of the shares of a company’s stock as a result of more shares outstanding. A company’s initial registration may include more shares than are initially issued when the company goes public for the first time. Later, an issue of more stock by a company (called a “primary offering,” distinguished from the “initial public offering”) dilutes the existing shares outstanding.  Also, earnings-per-share calculations are said to be “fully diluted” when all common stock equivalents (convertible securities, rights, and warrants) are included. “Fully diluted” numbers are used in analysis when there is a likelihood of conversion or exercise of rights and warrants.

Earnings per share (EPS): The amount of a company’s profit available to each share of common stock. EPS = Net income (after taxes and preferred dividends) divided by Number of outstanding shares.

Efficient market theory: Belief that all market prices and movements reflect all that can be known about an investment. If all the information available is already reflected in stock prices, research aimed at finding undervalued assets or special situations is useless. 

Emerging growth stocks: Shares of companies participating in new markets or niches with greater future expectations than those in established industries or services. Companies are usually smaller and do not yet have steady earnings streams or pay dividends. They may be more highly priced relative to the rest of the market.

Ex-dividend:  When dividends are declared by a company’s board of directors, they are payable on a certain date (“payable date”) to shareholders recorded on the company’s books as of a stated earlier date (“record date”). Purchasers of the stock on or after the record date are not entitled to receive the recently declared dividend, so the ex-dividend date is the number of days it takes to settle a trade before the record date (currently three business days). A stock’s price on its ex-dividend date appears in the newspaper with an X beside it. 

Form 10-K and Form 10-Q: Annual and quarterly reports, respectively, required by the Securities and Exchange Commission (SEC) of every issuer of a registered security, including all companies listed on the exchanges and those with 500 or more shareholders or more than $1 million in gross assets. Audited financial statements for the fiscal year must include revenues, sales, and pretax operating income, a 5-year history of sales by product line and a sources and uses of funds statement comparative to the prior year. The quarterly report is not required to be as extensive, nor must it be audited, but it should contain a comparison to the same quarter in the prior year. As a matter of public information, these reports are available to the general public and are required to be filed on a timely basis. 

Free cash flow: Cash flow after operating expenses; a good indicator of profit levels. 

Fundamental analysis: Equity research aimed at predicting future stock prices based on financial statements. FA considers past records of sales, earnings, markets, and management to attempt to determine future performance. Technical analysis relies on charting patterns of price and volume movements; it does not take financial fundamentals into account.

Growth stock: A stock that has a record of relatively fast earnings growth—usually 1½ to 2 times the average for the market as a whole. If the growth is expected to continue, the stock carries a higher price/earnings multiple (see price/earnings ratio) than the average for the market. 

Hedging: Offsetting investment risk by using a security that is expected to move in the opposite direction. Options and short selling are commonly used to hedge stock positions.

Index: Stock indexes measure changes in groups of stocks. They range from broad to narrow, measuring the overall “market” or small industry sectors. Some indexes are averages; others are weighted based on market capitalization. The most often quoted major stock indexes are the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500). 

Initial public offering (IPO): A corporation’s first offering of stock to the public (sometimes called “going public”). 

Insider: Technically, an officer or director of a company or anyone owning 10% of a company’s stock. The broader definition includes anyone with non-public information about a company.

Leverage: Financial leverage is the amount of long-term debt in a company’s capital structure relative to shareholders’ equity. Operating leverage measures the sensitivity of a company’s profits to sales levels. 

Limit order: An order to buy or sell a security at a set price or better. 

Liquidity ratios: Financial measurements of the ability of a company to meet short-term obligations quickly. Helps analysts determine a company’s credit quality.

Listed stock: Stock that trades on one of the registered securities exchanges. “Listed” usually implies listing on the two major exchanges—the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX). “Unlisted” company’s trade “over the counter,” usually through the National Association of Securities Dealers Automated Quotation System (NASDAQ). Listed stock symbols are three letters; unlisted symbols are four or more letters. 

Maintenance call: Sometimes called a “margin call”; a demand on a customer with a margin account to deposit cash or securities to cover account minimums required by regulatory agencies and the brokerage firm. Because these minimums are based on the current value of the securities in the account, maintenance calls can occur as a result of movements in the market price of securities.

Margin account: Brokerage account established to extend credit to the customer. Market capitalization: Current stock price multiplied by number of common shares outstanding. The higher the market capitalization is relative to book value, the more highly the investment community values the company’s future.

Market timing: Buy and sell strategy based on general outlook, such as economic factors or interest rates, or on technical analysis. 

Multiple: See price/earnings ratio. The “relative multiple” is the company’s P/E ratio relative to the multiple of the market, usually the S&P 500, but sometimes the price/earnings ratio of an index that more closely mirrors the company’s sector. 

Naked option: An uncovered option position. When the writer (seller) of a call option owns the underlying stock (said to be “long” the stock), the option position is a “covered call.” If the writer (seller) of a put option is short the stock, then the position is a “covered put.” Writing a covered call is the most conservative options strategy, but writing a covered put is the most dangerous because there is no limit to how high the stock can go and thus to how great the loss can be on the short sale.

Odd-lot theory: Supposition that small investors, who tend to buy in smaller units than the standard round lot of 100 shares, are always wrong. The idea is to buy when odd-lot investors are selling and sell when they are buying. The theory has not proved to be correct in modern times and is no longer very popular. 

Options: Contracts to buy (call option) or sell (put option) a security at a stated price within a stated time period. Puts and calls are “types” of options. All the same type options of the same security are said to be of the same “class.” Options of the same class may have different exercise prices (the stated buy or sell price, called the “strike price”) and different dates. All options of the same class with the same strike price and expiration date are called a “series.” The price of an option is called a “premium.” The price of a premium is made up of “intrinsic value” (the difference between the current price and the strike price) and “time value” (the difference between the premium and the intrinsic value). An option is said to be “covered” when the investor has another position that will meet the obligation of the option contract. When option rights are used they are “exercised”; unexercised options are said to “expire” after their set time period is up. A buyer of an option is called a “holder” and a seller is called a “writer.”

(NOTE: Companies often offer employees “incentive options” as part of their compensation. These operate more like rights or warrants and allow the employee to purchase stock in the company at a specified price for a certain number of years). 

Par value: For common stocks, the value on the books of the corporation. It has little to do with market value or even the original price of shares at first issuance. The difference between par and the price at first issuance is carried on the books of a corporation as “paid-in capital” or “capital surplus.” Par value for preferred stocks is also liquidating value and the value on which dividends (expressed as a percentage) are paid—generally $100 per share. 

Penny stocks: Stocks selling for under $1; usually highly speculative.

Pink sheets: Daily publication of wholesale prices of over-the-counter (OTC) stocks that are generally too small to be listed in newspapers. 

Preferred stock: A class of stock with a higher claim on the company’s earnings than common stock. Preferred stock usually is entitled to dividends and does not carry voting rights. Also, dividends on preferred stock must be paid before any dividend can be paid on common stock. “Cumulative” preferred stock accumulates dividends, and all past dividends owed must be paid before common stock can receive dividends. “Convertible” preferred stock is exchangeable for a set number of shares of common stock, and “participating” preferred stock allows shareholders to collect dividends above the set level, sharing in the profits allocated to common stock. 

Price/earnings ratio (P/E ratio): Often called a stock’s “multiple.” PE is the current price per share divided by earnings per share. Earnings can be “forward” (predicted) or “trailing” (actual last four quarters).

Quantitative analysis: Financial analysis, based on measurable mathematical actualities, that ignores considerations of quality of management. Advanced quantitative analysis has produced historical measures of stocks’ volatility relative to their own past history and the market’s. 

Quote: Current buy and sell prices of a security. The lowest price any seller will accept at a given time is “asked,” and the highest price any buyer has offered for a stock at a given time is the “bid.” The difference between bid and asked is the “spread.” 

Random-walk theory: A direct refutation of technical analysis, this theory posits that markets cannot be predicted because they move in a random manner like the walking pattern of a drunken person.

Retained earnings: That part of a company’s profits that is not paid out in dividends but used by the company to reinvest in the business. 

Rights: Granted to existing shareholders when a company issues more shares in a new issue. Usually the rights last for only a short time and the shares are offered at a lower price than they will be offered to the public. “Preemptive rights” are sometimes mandated by state laws to allow existing shareholders to maintain a proportionate share of ownership, thus preventing “dilution” of their existing shares.

Risk tolerance: The ability of an investor to tolerate the chance of loss on an investment. Risk measurement attempts to quantify these chances, which can result from inflation, interest rates, market fluctuations, political factors, foreign exchange, etc. 

Round lot: Standard unit of trading. For stocks, a round lot is usually 100 shares, although 10 shares may make a round lot for inactive or highly priced stocks. 

Secondary offering: A sale of a large block of securities already issued by a corporation and held by a third party. Because the block is so large, the sale is usually handled by “investment bankers” who may form a “syndicate” and peg the price of the shares close to current market value.

Sector: A group of stocks in one industry. 

Sell discipline: An investor’s criteria for selling a stock. A value investor, for instance, may sell when the price/earnings ratio of the security is a certain percentage higher than its historical level.

Shareholders’ equity: Total assets minus total liabilities of a company divided by the number of common shares outstanding. Theoretically, this is the value of the company to the shareholder at liquidation.

Short interest theory: When short interest positions in a stock are high (see short sale), although it is an indication that many investors feel the stock price will drop, the theory is that the phenomenon is bullish for the stock because the short sellers will all have to purchase the stock in the near future to cover their short positions. 

Short sale: An investor anticipates that the price of a stock will fall, so he sells securities borrowed from the brokerage firm. The securities must be delivered to the firm at a certain date (the “delivery date”), at which time the investor expects to be able to buy the shares at a lower price to “cover his position.” 

Small capitalization stocks: Publicly traded company with a market capitalization (see market capitalization) of $500 million or less.

Stock buyback: A corporation may repurchase shares outstanding on the open market and retire them as “treasury shares.” This anti-dilutive action increases earnings per share, which consequently raises the price of the outstanding shares. Companies often announce a “share repurchase plan” when insiders feel the company is undervalued; the action strengthens the company and helps preclude a takeover.

Stock dividend: Payment of a dividend in stock rather than cash, usually as a percentage of existing shares held. A dividend may be stock in the original company or that of a subsidiary. A stock dividend is a way for a corporation to maintain its cash position without being subject to the accumulated earnings tax, since it reduces retained earnings and increases capital stock on a company’s books. A stock dividend also carries a tax advantage for the shareholder, since a dividend would be subject to ordinary income tax but the tax on capital gains is not payable until the shares are sold. 

Stock split: The division of the outstanding shares of a company into a larger number of shares, while the overall equity in the company remains the same. Shareholders have more shares but the same proportionate interest in the company. Unlike a stock dividend, a stock split does not affect the books of the company. After a split, the shares will immediately fall to a proportionate market value (that is, in a 2-for-1 split, $30 shares will fall to $15 each). A split makes the stock cheaper and helps to broaden ownership in the company. A “reverse split” (1-for-10) allows a company with low share value to be noticed by institutional investors who may be restricted from considering low-priced stocks. 

Stop order: An order to buy or sell at the market price once a security has traded at a set price, called the “stop price.” A stop order to buy is placed above the market price and is used to protect a profit or limit a loss on a short sale. A stop order to sell is placed below the market price and is used to protect a profit or limit a loss on a stock that is already owned. Although stop orders are designed to be used to protect investors from market movements, there is no guarantee that the order, when it is executed, will be at the stop price. The buy or sell order could be triggered by a temporary market movement that was no longer in effect when it was executed. For this reason, stop orders are sometimes combined with limit orders (see limit orders). 

Style: Investment style is attributed to sophisticated institutional investors. Major styles include “value,” “growth,” and “contrarian” (going the opposite way of most investors at the time). “Bottom-up” and “top-down,” respectively, refer to picking stocks based exclusively on their individual characteristics or as a part of a broader economic view that predicts certain sectors will do better than others. 

Subscription price: The price at which a right or warrant is offered. 

Technical analysis: Research based on price and volume movement “patterns” in an attempt to predict stock movements based on supply and demand. When a stock shows a “breakout” above a “resistance level,” it is said to be “oversold”; this is considered a good time to buy. When a stock shows a “breakout” below a “support level,” it is said to be “overbought”; this is considered a good time to sell. An “accumulation area” is a place on a technical analyst’s chart where the stock does not drop below a certain price range, indicating that buying is occurring. A “distribution area” shows that the stock is weak—selling is occurring. Technical analysis usually focuses on short-term stock movements and does not consider the financial situation of a company. It may be applied to the overall market as well as to individual stocks. 

Tick: Move up or down in price as a security trades, which may also apply to the overall market when index movements are measured in ticks. Zero-minus and zero-plus ticks are ticks at the same price as the preceding trade when the last preceding trade took place at a lower or higher price, respectively.

Total return: Measure of performance that includes capital appreciation (or depreciation) and reinvestment of dividends. 

Turnaround: Positive reversal in the performance of a company. 

Undervalued: Company that has an asset or a business niche that is not recognized for its true worth or value by the rest of the investment community.

Value stock: Stock trading below its own historical value for market, economic, or other reasons. If the stock is a large capitalization stock in a viable industry that has a relatively stable history, it usually can be expected to revert back to its prior value.

Warrants: Certificates that allow the holder to buy a security at a set price, either within a certain time period or in perpetuity. Warrants are usually issued for common stock, at a higher price than current market price, in conjunction with bonds or preferred stock as an added inducement to buy. 

Note: Feel free to send in your own related terms and definitions so that this section may be updated continually in modern Wiki-like fashion.

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Debt-Based Securities Terms and Definitions for Physicians

A “Need-to-Know” Glossary for all Medical Professionals

Staff Writers

 

Accrued interest: Interest that has been earned but not received; when a physician purchases a bond from a bondholder, the physician owes the bondholder interest for the period of time the bondholder held the bond. Because interest is paid semi-annually, the period of time that has elapsed is the accrual period. 

Basis point: One one-hundredth of a percent; a measure for interest rates and bond yields. Bearer bond: A bond with coupons attached, evidencing ownership. 

Call feature: The provision in the indenture allowing the issuer to redeem the bond prior to its maturity date.

Convertible bond: A bond that promises that the holder can convert it into stock within a specified period of time at a specified price and specified ratio (a bond equals a given number of shares of stock). 

Coupon rate: The specified interest rate paid by a bond issuer.

Credit rating systems: The classification systems used to indicate the risk associated with a particular bond issue.

Debenture: A debt security that is not secured by a mortgage on a specific asset. It is backed only by the earnings of the issuer, known as full faith and credit.

Default: The failure to pay interest or principal on debt securities when those payments are due. 

Discount: The sale of a bond below its par value. 

Duration: The measure of volatility, expressed in years, taking into consideration all of the cash flows produced over the life of a bond. For example, if the duration of a bond is four years, then the price of the bond changes 4% for every 1% change in interest rates.

Indenture: A formal agreement between the issuer of a bond and the bondholders that specifies the maturity date, interest rate, and other terms.

Interest: The payment the issuer makes to the physician bondholder for the use of the bondholder’s money. 

Maturity: The time at which a debt issue becomes due and the principal must be repaid. 

Principal: The face value of the bond, also known as par value. 

Refunding: The act of issuing new debt and using the proceeds to retire existing debt.

Registered bond: A bond that has its ownership registered with the commercial bank that distributes interest payments and principal repayments. 

Sinking fund: A fund in which money to pay off the debt accumulates; bond issues that have a sinking fund are considered less risky than those without one.

Trustee: The entity, usually a commercial bank that is appointed to ensure that the terms of a bond’s indenture are met. 

Yield: The potential return offered to the bondholder. 

Yield curve: The relationship between yields and dates of maturities of debt securities as plotted on a graph. 

Yield to maturity: The yield earned on a bond from the time it is purchased until it is redeemed. 

Zero coupon bond: A bond that pays both principal and interest at maturity. 

  • Related info: www.HealthDictionarySeries.com 
  • Note: Feel free to send in your own related terms and definitions so that this section may be updated continually in modern Wiki-like fashion.  

ETFs and Tax Efficiency

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A Better Financial Product than Mutual Funds?

[By JD Steinhilber]

Exchange-traded funds are inherently more tax efficient than actively managed mutual funds, which have been rightly criticized for their tax-inefficiency. Tax-efficiency is a critical issue for financial advisors and physician-investors because delaying the taxation of appreciating assets normally enhances after-tax returns over time.

For example, it is estimated that between 1994 and 1999, investors in diversified U.S. stock mutual funds lost, on average, 15% of their annual gains to taxes. The tax inefficiency of mutual funds is the result of portfolio turnover at the fund level caused by two factors: the trading activity of the portfolio manager and the activity of other shareholders in the fund.       

The Mutual Fund Performance / Redemption Problem

Due to fund manager efforts to outperform benchmarks, actively managed mutual funds almost invariably experience more “manager-driven” portfolio turnover than ETFs, where trading is generally driven by change in the composition of the underlying indexes being replicated. Mutual fund portfolio turnover can also be caused by the actions of shareholders in the fund. 

In a mutual fund structure, redemption requests by shareholders can force the fund to sell securities to raise cash. These sales may give rise to gains that, by law, must be distributed and will be taxed to all shareholders in the fund.

Unique Architectural Structure

ETFs, in contrast, are structured in such a way that the actions of one shareholder do not result in tax consequences to another shareholder.  ETFs accomplish this through the innovative architecture in which ETF “units” (which are subdivided into individual ETF shares) are created and redeemed to accommodate the fluctuating demand for the shares of a particular ETF.

ETF units are created and redeemed by institutional investors though non-taxable, “in-kind” transactions, which means that only securities – not cash – change hands in the creation and redemption process. 

An example of this process would be an institution exchanging a portfolio of stocks constituting the S&P 500 index for an S&P 500 ETF “creation unit”. And, once created, the S&P 500 ETF can be subdivided into individual shares that are tradable by investors on the exchange.   

Assessment

As a result of the above – physicians may be insulated from a tax standpoint by the actions of other investors – because taxable transactions don’t take place at the fund level.  Instead, ETF shares are traded between retail investors in transactions on the exchanges, so the tax accounting becomes very similar to that associated with individual stocks.    

Have you used ETFs in your own portfolio, and what is your tax efficiency experience with them; truth or hype? 

Conclusion

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ETF Portfolio Diversification and Cost Reductions

A Multi-Dimensional Investment Product

By JD Steinhilber

 Certified Medical Planner  

Most physicians and their financial advisors and/or Certified Medical Planners™ [CMP™] believe that effective diversification is most readily achieved by combining poorly correlated asset classes within an investment portfolio.

And, when combined with low costs, a winning combination may be achieved for most any physician-investor’s wealth achievement and management goals.

Diversification Impact

One of the most basic examples of proper diversification is two poorly correlated assets like stocks and bonds. Over time, the returns of these two asset classes have a very low level of correlation. Over shorter time periods, the degree of correlation between stocks and bonds can vary widely.

From January 1999 to November 2002, for example, stocks and bonds had a negative, or inverse, correlation. Real Estate Investment Trusts [REITS] and international stocks are examples of other asset classes that tend to be poorly correlated with US stocks. And, volatility is expected to increase beyond 2008.

Because exchange-traded funds replicate the performance of entire asset classes, which themselves are diversified among numerous securities, it is possible to construct well-diversified, high-performing portfolios with only 5-10 ETFs. Accordingly, ETFs provide a highly efficient means of diversification.

Reduction of “Style Drift

Mutual funds also facilitate diversification, but actively managed mutual funds are susceptible to “style drift” and their portfolio holdings at any particular time are unknown. This presents a challenge to diversification efforts.

In contrast, ETFs offer asset class purity, meaning their holdings are totally transparent, disclosed daily and not subject to style drift. Actively managed mutual funds are also more expensive and less tax-efficient than ETFs.

Cost Impact

Exchange-traded funds have some of the lowest expense ratios of any registered investment product. In fact, ETFs have a cost advantage, on average, in excess of 100 basis points relative to actively managed mutual funds. This can have a significant impact on a portfolio’s performance over time.

For example, assume that investor A and investor B each invest $10,000 and earn the same gross annualized return over a 20 year time frame. After expenses, assume that investor A earns a net return of 10% and investor B earns a net return of 9%. After 20 years, investor A would have $67,275, while investor B would have $56,044, representing a difference of $11,231.

Trading Cautions

It is important to point out that physician-investors have to pay commissions when they buy or sell ETFs.As a result, the cost advantages of ETFs relative to mutual funds diminish the more actively an ETF portfolio is traded. ETFs are therefore not appropriate vehicles for active traders; they are more suitable for investors.

Of course, physicians and all investors tend to be more conscious of investment costs when portfolio returns are low or negative.Given that costs are among the few controllable variables in a portfolio’s returns, investors and advisors should always be evaluating portfolio costs relative to the benefits received.

Assessment: 

Exchange-traded funds may provide an opportunity to enhance net returns by reducing investment expenses and increasing returns through improved diversification.

Conclusion

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Exchange Traded Funds (ETFs)

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A New Type of Index Fund Hybrid

[By JD Steinhilber]

ME-PExchange-traded funds (ETFs) are perhaps the most exciting and innovative investment products to be developed by the securities industry in the past 20 years. ETFs, which are essentially index funds that trade on the major exchanges, can enable the physician-investor or financial-advisor to add value to client relationships, by addressing the key issues of diversification, tax efficiency and investment costs.

Definition 

More formally, ETFs are defined as securities that combine essential elements of individual stocks and index funds. Like stocks, ETFs are traded on the major U.S. stock exchanges and can be bought and sold through any brokerage account at any time during normal trading hours.

Also like index funds, ETFs are pools of securities that seek to replicate the performance of specific market indices, or benchmarks, in a low-cost, tax-efficient manner. ETFs give physician investors the opportunity to buy or sell an interest in an entire portfolio in a single transaction.

In short, ETFs provide the advantages of traditional index mutual funds, including low annual fees, diversification and tax-efficiency, with the liquidity and ease of execution of stocks. 

ETFs trade throughout the day and allow investors to buy and sell them at stated market prices, unlike traditional open-end mutual funds, which are only bought and sold at their net asset value (NAV) determined at the end of each day. ETFs can also be bought on margin and sold short. 

ETFs were developed by large institutions, such as: Barclays Global Investors, State Street Global Advisors and Vanguard.In 2003, approximately $90 billion was invested in U.S. exchange-traded funds; that figure has more than doubled by 2008. 

ETF Asset Classes

ETFs provide exposure to a wide range of asset classes defined by various equity and fixed income indexes. At launch, available ETFs fell into multiple major categories, including:

  • Small-, mid- and large-capitalization
  • Growth, value and core
  • International (broad-based and country- or region-specific)
  • U.S. industry sectors
  • Fixed income

Of course, there are many more tranches or slices today, and for almost any asset class type imaginable. The indexes upon which ETFs are based are from Dow Jones & Company, Inc., Frank Russell Company, Goldman, Sachs & Co., Lehman Brothers, Morgan Stanley Capital International (MSCI), Standard and Poor’s, Cohen & Steers Capital Management, Inc. and the NASDAQ Stock Market, Inc; etc; among many others asset class benchmarks.

Sponsors and Types

The two principal initial sponsors of sector ETFs were State Street Global Advisors and Barclays Global Investors. State Street’s sector ETFs are termed Sector SPDRs (Standard & Poor’s Depositary Receipt), because they are based on the S&P 500. 

The nine original Sector SPDRs collectively encompassed all 500 companies of the S&P 500. Barclays’ iShares sector funds differ from the Sector SPDRs in that they are based on the Dow Jones classification system, which segments the U.S. economy and stock market into 10 sectors encompassing 1,625 companies.

There were iShares ETFs for each of these 10 sectors as well as certain industries, such as biotechnology which are components of broader and/or narrower sectors.  Today, they are almost TNTC.

Assessment 

Continuous information about sector and industry ETFs is available at www.ishares.com.  Information about Sector SPDR ETFs is available at www.spdrindex.com.

Conclusion

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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Product Details  Product Details

Investment Policy Statement Construction

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Developing a Sample IPS Document Template

 [By Clifton McIntire; CIMA, CFP®]

[By Lisa McIntire; CIMA, CFP®]fp-book

Here is an abbreviated sample Investment Policy Statement [IPS] template for a healthcare entity, clinic, private physician or hospital endowment account; posted by “Ask-a-Consultant” subscriber request. 

Introduction

An IPS typically contains the following sections, at a minimum. It may be a 5-15 page document for a single physician investor, or a 50-100 page tome for a hospital endowment fund.

Statement of Purpose

The purpose of this section is to guide and direct physician managers in the investment of hospital endowment funds. You want details about goals and objectives, as well as the performance measurement techniques that will be employed in evaluating the service rendered by the physician managers. 

Realizing that your overall objective is best accomplished by employing a variety of management styles, you will adjust your asset tolerances and permissible volatility to incorporate specific doctor-manager styles. 

Statement of Responsibilities

To achieve overall goals and objectives, you want to identify the parties associated with your accounts and the functions, responsibilities, and activities of each with respect to the management of fund assets. 

Physician managers or financial consultants [FC] are responsible for the daily investment management of Plan assets, including specific security selection and timing of purchases and sales. 

The custodian is responsible for safekeeping the securities, collections and disbursements and periodic accounting statements. The prompt credit of all dividends and interest to our accounts on payment date is required.  The custodian shall provide monthly account statements and reconcile account statements with manager summary account statements. 

The physician executive or financial consultant [FC] is also responsible for assisting us in developing the investment policy statement and for monitoring the overall performance of the Plan. 

Investment Goals and Objectives

The asset value of the funds, exclusive of contributions or withdrawals, should grow in the long-run and earn through a combination of investment income and capital appreciation a rate-of-return in excess of a specified market index for each investment style, while occurring less risk than such index. 

It is recognized that short-term fluctuations in the capital markets may result in a loss of capital on occasion, commonly expressed as negative rates of return. The amount of volatility and specific frequency of negative returns shall be detailed for each investment style. We will provide specific numeric targets by which we will measure whether or not objectives have been met.  

The investment policy of the Plan is based on the assumption that the volatility of the portfolio will be similar to that of the market.  A specific index or combination of indexes will be assigned to each manager based on the class of securities and style of selection to be employed. The physician consultant or FC will determine an overall index for volatility and asset allocation within the Plan as a whole.

It will be the duty of the physician or FC to monitor this section closely and advise us of necessary changes to comply with our overall policy. We expect that the accounts in total will meet or exceed the rate of return of a balanced market index comprised of the S&P 500 stock index, Lehman Brothers Government/Corporate Bond Index and U.S. treasury bills in similar proportion to our asset allocation policy. 

Recognizing that short-term market fluctuations may cause variations in the account performance, we expect the combined accounts to achieve the following objectives over a three-year moving time frame:   

  1. The account’s total expected return will exceed the increase in the Consumer Price Index by 7.0 percentage points annually.  Actual returns should exceed the expected returns about half the time.  Expected returns should exceed actual returns about half the time (i.e. if the CPI increases from 5.0 percent to 7.0 percent, then expected return should exceed 9 percent).
  2. The total annual return of the account is expected to exceed the average CPI for the year by an absolute of 3.0 percentage points (i.e. if the average CPI is 5.0 percent, then the expected annual return should exceed 8.0 percent).
  3. The average total expected return will exceed 10 percent annually. 

Suggested Performance Comparison Indexes

Style Index
Small Cap Growth Russell 2000 Growth
Medium Cap Value Russell Medium Cap Value
Small Cap Value Russell 2000 Value
Growth Russell 1000 Growth
Value Russell 1000 Value
Tax-Free Bonds Lehman Brothers Municipal
Taxable Bonds Lehman Brother Govt/Corp
Blended Account S&P 500/ Lehman Brothers Govt/Corp

Proxy Voting Policy

The physician manager or FC shall have the sole and exclusive right to vote any and all policies solicited in connection with securities held by us.

Trading and Execution Guidelines

Trading shall be done through a brokerage firm.  However, this request should in no way at any time affect the performance of accounts.

Instruction to execute transactions through a brokerage firm assumes that their service is equal to, and the rates are competitive with, other nationally recognized investment firms.

Additionally, it is understood that block transactions or participation in certain initial public offerings might not be available through a primary broker. In this case the manager should execute those trades through the broker offering the product and service necessary to best serve our account. 

Social Responsibility

No assets shall be invested in securities of any organization that does not meet the standard for socially and morally responsible investments we establish and communicated separately in writing to our physician investment manager. 

It is the responsibility of the physician or FC to maintain a list of such prohibited investments with us and to inform the respective managers of this list. 

Asset Mix Guidelines 

It shall be the policy of the foundation to have the assets invested in accordance with the maximum and minimum range for each asset category stated below.

This section applies to our overall account as monitored by the physician consultant.  Separate asset category guidelines will be provided for multiple physician managers, according to specified style and standard deviation tolerances.  

ASSET MINIMUM TARGET MAXIMUM REP
CLASS
WEIGHT
WEIGHT WEIGHT INDEX
         
Equities 50 60 70 S&P 500/FRC 2000 Index
Fixed Income 25 40 55 LB Muni/LBGC Inter
Cash & Equiv 0 0 30 90 Day Treasury

Portfolio Limitations

The following are general requirements of the account as a whole.  These specific limitations would be adjusted for a different medical manager or FC whose performance expectation would make it necessary for us to expand on our definitions. 

Equities: 

Equity securities shall mean common stock or equivalents (American Depository Receipts plus issues convertible into common stocks). 

Preferred stocks with the exception of convertible preferred share are considered part of the fixed income section. 

The equity portfolio shall be well diversified to avoid undo exposure to any single economic sector, industry group, or individual security. No more than 5 percent of the equity portfolio based on the market value shall be invested in securities of any one issue or corporation at the time of purchase. No more than 10 percent of the equity portfolio based on the market value shall be invested in any one industry at the time of purchase.

Capitalization/stocks must be of those corporations with a market capitalization exceeding $250,000,000. Common and convertible preferred stocks should be of good quality and listed on either the New York Stock Exchange [NYSE], American Stock Exchange [AMX] or in the NASDAQ System with requirements that such stocks have adequate market liquidity relative to the size of the investment. 

Fixed Income Investments: 

Types of securities of funds not invested in cash equivalents (securities maturing in one year or less) shall be invested entirely in marketable debt securities issued either by the United States Government or agency of the United States Government, domestic corporations, including industrial and utilities and domestic bank and other United States financial institutions.  

Quality: only fixed income securities that are rated BBB or better by Standard and Poor’s or Baa by Moody’s shall be purchased.  

Maturity: the maturity of individual fixed income securities purchased in the portfolio shall not exceed thirty years.

No more than 30 percent of the fixed income portion of the portfolio may be placed in these lower rated issues.  The average quality rating of the fixed income section shall be grade A; or better. 

Restricted Investments:  

Categories of securities that are not eligible without prior specific written approval of the physician investor, healthcare entity, clinic or hospital foundation include:     

  • Short Sales
  • Margin purchases or other use of lending or borrowed money
  • Private placements
  • Commodities
  • Foreign Securities
  • Unregistered or Restricted Stock
  • Options
  • Futures

Administration

The custodian will be responsible for settling trades executed by the physician manager in our accounts. From time to time, we will request disbursements from the accounts. Checks covering these requests must be mailed to us on the date of the request providing telephone notification is received before 2:00 pm; EST. 

Performance Review and Evaluation

 Performance results for the physician manager or FC will be measured on a quarterly basis. Total fund performance will be measured against a balanced index posed of commonly accepted benchmarks weighted to match the long-term asset allocation policy of the Plan.

Additionally the investment performances specific for individual portfolios will be measured against commonly accepted benchmarks applicable to that particular investment style and strategy.

The physician investor or FC will be responsible for complying with this section of our policy statement.  The managers or FCs shall report performance results in compliance with the standards established by AIMR (Association for Investment Management and Research); now the CFA Institute.  Reports shall be generated on a quarterly basis and delivered to us with a copy to us within four weeks of the end of the quarter. 

Communications 

Copies of all transactions will be maintained on a daily basis and will conform to our Investment Policy Statement. Monthly statements for each of the accounts will detail each transaction and summarize the account identifying unrealized and realized gains and losses. 

A formal meeting will be prepared quarterly by the consultant and delivered to us within six weeks from the end of the quarter.  The report will review past performance and evaluate the current investment outlook and discuss investment strategy of the physician manager.  These reports will compare the performance of the manager with the respective market benchmarks measuring return and volatility and compare the managers with their respective peer groups. 

Conclusion 

Of course, an IPS can include or exclude almost whatever you – or your institution’s governing board – may wish.

Finally, any professional financial manager or FC will be required to forward to you the SEC Form ADV Parts 1 and 2 annually, or at any interim point the ADV is substantially revised.

Remember to use a fiduciary financial consultant and/or physician-focused and/or appropriately degreed and/or licensed CPA, CFA, RIA or CMP™.  Investment results should never be guaranteed!

QUESTION: Does your hospital institution, medical practice, clinic or healthcare business entity have an ISP; more importantly – do you?  Please comment.  

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

DICTIONARIES: http://www.springerpub.com/Search/marcinko
PHYSICIANS: www.MedicalBusinessAdvisors.com
PRACTICES: www.BusinessofMedicalPractice.com
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CLINICS: http://www.crcpress.com/product/isbn/9781439879900
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FINANCE: Financial Planning for Physicians and Advisors
INSURANCE: Risk Management and Insurance Strategies for Physicians and Advisors

Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners(TM)

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“BY DOCTORS – FOR DOCTORS – PEER REVIEWED – FIDUCIARY FOCUSED”

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ADV: Essential Form for Physician-Investors

ADV: Parts I and II Defined

Staff Writers 

An ADV is a form that is kept on file with the Securities & Exchange Commission [SEC]. It contains critical financial information about a Registered Investment Advisor (RIA), and/or an RIA representative.  

A Two-Part Form:  

Part 1: Discloses specific information about an RIA that is important to regulators (name, number of employees, form of the organization, nature of the business, etc.). 

Part 2:  This part acts as a disclosure document for clients of the business entity and includes information such as services provided and fees levied, whether the investment advisor acts as a broker-dealer and transacts securities, and so on. It is also known as the Uniform Application for Investment Advisor Registration.

To request a copy of Form ADV you can usually contact the SEC branch closest to you. Even better yet; be sure to request it before you invest with any “advisor” or firm.

And so, have you ever invested without reviewing this form; and how did it work out for you? Were you even familiar with this important form before reading this post?

 

 

401-k and 403-b Retirement Plans

The Time to Change Allocations

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By Clifton McIntire; CIMA, CFP®

By Lisa McIntire; CIMA, CFP®fp-book1 

401k and 403b plans offer great opportunity to change asset allocations.   

For example, Karen Markland, a Certified Registered Nurse Anesthetist at Carolina’s Medical Center, found it was relatively easy to shift from bonds to stocks some years ago. No taxes or commissions were involved. A simple phone call moved her allocation from 40 percent bonds, 50 percent stocks and 10 percent international to 20 percent bonds, 70 percent stocks and 10 percent international after a recent stock market decline. 

One point of caution when using 401k or 403-b plans for asset allocation is required. Quite often the trustees of 401k plans will decide on a single group of mutual funds for the participants. Not all funds in the group are worthy of your money.

Jean Surber, a Certified Registered Nurse Anesthetist at Presbyterian Hospital, did not have a good international option and so had to limit her allocation in that 401k plan to stocks, bonds and cash. She used her Individual Retirement Account (IRA) at a brokerage firm for international investing.

Employed healthcare professionals should “max out” on their 401k/403b plans. You should put all that you are allowed into your 401k/403b plan, unless the selection of managers is so bad that even with the tremendous tax break and “dollar cost averaging” of monthly contributions, the envisioned end results would be small.  

For example, the simple compounding of $10,000 at age 30 investing $416 per month and experiencing a 10 percent annual rate of return would provide $1,905,788 at age 65. 

Wake-Up Call 

The Federal Government annually mails a detailed explanation of social security benefits to its workers.  This is an attempt to remind people that social security fulfills only part of their retirement income needs. To many, this will be a wake up call. The status of 401k or 403b plans is normally sent to participants’ quarterly. This is an excellent time to do some asset allocation and review manager performance.  Since most 401ks and 403bs use mutual funds and/or ETFs, and offer daily valuations by telephone, you don’t have to wait for the quarterly report, which is often received 60 days after the end of the quarter. When changes are made in the allocation of existing positions, the percentage allocation of future contributions should be made as well. 

For example, when Karen Markland repositioned her 401k portfolio, she also changed her future contribution percentages. 

Information Sources 

Morningstar, a Chicago based company that analyzes and computes statistics on most of the mutual funds produces a monthly report that you can review at the library, or online at home.Most banks and brokerage firms subscribe to this service. They can send you an up to date single page analysis of each of your funds; or an internet syndication feed. This is good material, well researched, but it is historical data.“Past performance is no assurance of future results.” 

The Morningstar system rates funds from 1 star (worst) to 5 stars (best).  This is sometimes referred to as the Sesame Street method of selecting mutual funds.  If you can count to 5, you can pick the best fund. Using this report alone is like driving on an Interstate highway at 80 miles per hour using only the rear view mirror (that can be fatal). 

Why; it’s because fund portfolio managers’ change. Good managers are hired away by their competitors; bad managers are fired. Managers themselves are not always consistent in maintaining their style or in their performance. Morningstar and the Internet is a good place to start because you can review a lot of information at a single setting. You can see historical returns, sector weightings, manager tenure, investment style, costs (except trading commission expense) and statistics concerning risk. However, Morningstar’s independence has been questioned of late. Nevertheless, it is from these and many similar sources that you may learn of the performance you can reasonably expect. 

Few physician managers, but many financial advisors are well versed in a variety of mutual funds. Representatives of the funds call on them frequently.  Many brokerage firms perform independent due diligence research. Mutual funds are a large part of the Financial Services Industry and you can expect the availability of extensive information. 

Stay the Course 

Most 401k and 403b plans should be invested for growth of capital. You are generally talking about long-term investment objectives.You should be very reluctant to withdraw funds from this tax-sheltered environment.  Unfortunately far too often, the participant becomes discouraged, (usually in a down market cycle) and moves the money out of stocks and into a money market fund at the wrong time. 

It is not unusual to see doctor participants assume a very defensive posture a year or so before retirement. This is shortsighted. The investments are meant to provide income and growth of capital for many years, not just until retirement. Upon retirement the funds will be rolled out directly into an IRA and invested with almost the same asset allocation. 

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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FINANCE: Financial Planning for Physicians and Advisors
INSURANCE: Risk Management and Insurance Strategies for Physicians and Advisors

 

 

Product Details  Product Details

A Different Breed of Healthcare Advisor

The New Financial Planners and Investment Advisors

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The healthcare industrial complex represents a large and diverse industry, and the livelihood of other synergistic financial professionals and consultants who advise doctors depend on it.  These include financial planners and investment advisors who themselves wish to avoid the collateral damage and negative ripple effects of healthcare reform. 

Introduction 

As a financial planner, investment advisor or general securities registered representative, you understand that the financial service sector is going to become the next great growth opportunity of the 21st Century.  Even H & R Block and the Charles Schwab Corporation are trying to build medical professional interest in their respective firms and compete with your independent practice. They are fervently wooing away one group or another to interface with their embryonic management, accounting or advisory programs. As are the banks; like SunTrust.

The Pondering 

Meanwhile, more than 260,000 of the nation’s brokers are moving into the investment advisory and financial planning business because securities sales and transactions are being commoditized by the internet’s World Wide Web.

A survey conducted a few years back clearly demonstrated the dominance of fiduciary consultants and registered investment advisors (RIAs) over stockbrokers, among clients 35-49 years old. With the average Merrill Lynch private client well over 60, it’s easy to ponder the future vulnerability of this business model.  When asked to determine the added value of key industry players, baby boomers in a recent Dalbar study ranked fiduciaries first, followed by financial planners, stockbrokers, CPAs, mutual fund companies, insurance agents, and commercial bankers, respectively.  

Even however, if you are a financial planner or CFP® – and despite the proliferation of investment advisors – evidence suggests that your individual impact is still narrow within the healthcare industrial complex and with individual physicians.

The Realization 

Among the challenges you face to broaden your influence is to offer your physician clients new value-added services, perhaps by establishing your expertise in the medical niche and capitalize on being different. You must not be just another of the more than 250,000 or so individuals who claim to be financial planners, with a collective universe of an additional 700,000 or so who purport to be financial advisors, in some fashion or another. 

The Niche

You must begin to develop the strategic competitive advantage of medical niche practice management knowledge to synergize with your existing financial service and product line. Integrated practice management and true physician-focused financial planning will also become much more competitive among physicians because of the above fusion. 

Now, no one is suggesting therefore that you abandon your core financial advisory business for medical management. It is merely a fact that healthcare has drastically changed during the past decade, and the knowledge that you used yesterday is no longer enough for the future.  

And, medical practice management is the natural outgrowth of traditional financial planning for doctors which is synergistically central to the implementation of a contemporary medical office business plan.

Finally, you realize that the most successful physician focused financial planners therefore, will be those who incorporate practice management services into their truly informed niche practices. 

The Epiphany 

A light then goes off in your head, epiphany! 

Enter the Certified Medical Planner™ professional designation program. 

For more information: www.CertifiedMedicalPlanner.com

When to Change Money Managers?

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The Money Managers

By Clifton N. McIntire, Jr.; CIMA, CFP®

By Lisa Ellen McIntire; CIMA, CFP®

Sometimes even the best made plans just don’t work out. Despite extensive time and energy spent on due diligence before hiring an investment manager, it becomes evident that the doctor must change managers. 

Here are a few thoughts when considering a change:

 § You should have initially hired the manager with a long-term relationship in mind. Realizing that styles go in and out of favor, we were not simply buying last quarter’s best numbers. 

§ Market statistics often mask “real” performance of money managers, both good and bad. The S&P 500’s 1998 performance can be attributed to a few very large companies. 

§ Generally, a full market cycle would be required to assess money manager performance. 

Having said that, what could happen that would warrant changing managers? 

· Style Drift: You have a growth manager and when growth stocks turn down, you begin to see the purchase of “value” stocks.

· Not Sticking to Previously Established Disciplines: If the process is to sell if the price declines 20 percent down from the original buy range and now they are holding because, “This time, it is different.” 

· Personnel Changes: New analysts are hired with a different philosophy. Recent transactions seem 180 degrees off course.

·  Principals Leave: Like professional sports figures, good money managers are in demand and sometimes change firms. The replacement may be a 27-year-old MBA with little experience. 

· The Firm is Sold: This may be good new if it broadens ownership and helps retain good people. Look for long-term incentive driven “staying” bonus plans.

· Loss of Major Accounts:  Reduced revenues may force cut backs in personnel and services. Attention may shift from portfolio management to marketing.

Finally, sometimes the relationaship is just not working. Misjudgments in asset allocation and poor stock selection over a reasonable period of time can be reason enough for a doctor to change managers.

***

231_1

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Assessment

Do you use a money manager or self direct your own portfolio? Have you ever needed to change you money manger? 

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

***

Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

***

Guide to Risk-Adjusted Market Performance

What isn’t Measured – Isn’t Improved

By Jeffrey S. Coons; PhD, CFA

By Christopher J. Cummings; CFA, CFP™ 

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Market performance measurement, like physician quality improvement reports, is an important feedback loop to monitor progress towards the goals of the medical professional’s investment program. 

Performance comparisons to market indices and/or peer groups are a useful part of this feedback loop, as long as they are considered in the context of the market environment and with the limitations of market index and manager database construction. 

Introduction

Inherent to performance comparisons is the reality that portfolios taking greater risk will tend to out-perform less risky investments during bullish phases of a market cycle, but are also more likely to under-perform during the bearish phase.  The reason for focusing on performance comparisons over a full market cycle is that the phases biasing results in favor of higher risk approaches can be balanced with less favorable environments for aggressive approaches to lessen/eliminate those biases. 

Can we eliminate the biases of the market environment by adjusting performance for the risk assumed by the portfolio?  While several interesting calculations have been developed to measure risk-adjusted performance, the unfortunate answer is that the biases of the market environment still tend to have an impact even after adjusting returns for various measures of risk. 

However, medical professionals and their advisors will have many different risk-adjusted return statistics presented to them, so understanding the Sharpe ratio, Treynor ratio, Jensen’s measure or alpha, Morningstar star ratings, etc. and their limitations should help to improve the decisions made from the performance measurement feedback loop. 

[a] The Treynor Ratio

The Treynor ratio, named after MPT researcher Jack Treynor, identifies returns above or below the securities market line. It measures the excess return achieved over the risk free return per unit of systematic risk as identified by beta to the market portfolio.  In practice, the Treynor ratio is often calculated using the T-Bill return for the risk-free return and the S&P 500 for the market portfolio. 

[b] The Sharpe Ratio

The Sharpe ratio, named after CAPM pioneer William F. Sharpe, was originally formulated by substituting the standard deviation of portfolio returns (i.e., systematic plus unsystematic risk) in the place of beta of the Treynor ratio.  A fully diversified portfolio with no unsystematic risk will have a Sharpe ratio equal to its Treynor ratio, while a less diversified portfolio may have significantly different Sharpe and Treynor ratios. 

[c] Jensen Alpha Measure

The Jensen measure, named after CAPM research Michael C. Jensen, takes advantage of the Capital Asset Pricing Model to identify a statistically significant excess return or alpha of a diverse portfolio.   

However, if a portfolio has been able to consistently add value above the excess return expected as a result of its beta, then the alpha (ap) should be positive and (hopefully) statistically significant.

Thus, alpha from a regression of the portfolio’s returns versus the market portfolio (i.e., typically the S&P 500 in practice) is a measure of risk-adjusted performance.  

Now, how do you measure the success or failure of your portfolio?

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Money Management and Portfolio Performance

Money Management and Portfolio Performance

By Jeffrey S. Coons; PhD, CFA

By Christopher J. Cummings; CFA, CFP™ 

Evaluating portfolio performance is a vital and often contentious topic in monitoring progress towards a physician’s investment goals.   

Introduction 

A typical portfolio’s objective may be to preserve the purchasing power of its assets by achieving returns above inflation – or to have total returns adequate to satisfy an annual spending need without eroding original capital, etc.  Whatever the absolute goal for the doctor; performance numbers need to be evaluated based on an understanding of the market environment over the period being measured.

One way to put a portfolio’s a time-weighted return in the context of the overall market environment is to compare the performance to relevant alternative investment vehicles.   This can be done through comparisons to either market indices, which are board baskets of investable securities, or peer groups, which are collections of returns from managers or funds investing in a similar universe of securities with similar objectives as the portfolio.

By evaluating the performance of alternatives that were available over the period, the physician investor and/or his/her advisor are able to gain insight to the general investment environment over the time period.

The Indices 

Market indices are frequently used to gain perspective on the market environment and to evaluate how well the portfolio performed relative to that environment. 

Market indices are typically segmented into different asset classes.

Common stock market indices include the following:

· Dow Jones Industrial Average – a price-weighted index of 30 large U.S. corporations.

· Standard & Poor’s (S&P) 500 Index – a capitalization-weighted index of 500 large U.S. corporations.

· Value Line Index – an equally-weighted index of 1700 large U.S. corporations.

· Russell 2000 – a capitalization-weighted index of smaller capitalization U.S. companies.

· Wilshire 5000 – a cap weighted index of the 5000 largest U.S. corporations.

· Morgan Stanley Europe Australia, Far East (EAFE) Index – a capitalization-weighted index of the stocks traded in developed economies. 

Common bond market indices include the following:

· Lehman Brothers Government Credit Index – an index of investment grade domestic bonds excluding mortgages.

· Lehman Brothers Aggregate Index – the LBGCI plus investment grade mortgages.

· Solomon Brothers Bond Index – similar in construction to the LBAI.

· Merrill Lynch High Yield Index – an index of below investment grade bonds.

· JP Morgan Global Government Bond – an index of domestic and foreign government-issued fixed income securities.

Assessment

The selection of an appropriate market index depends on the goals of the portfolio and the universe of securities from which the portfolio was selected. 

Just as a portfolio with a short-time horizon and a primary goal of capital preservation should not be expected to perform in line with the S&P 500, a portfolio with a long-term horizon and a primary goal of capital growth should not be evaluated versus Treasury Bills.

Conclusion 

While the Dow Jones Industrial Average and S&P 500 are often quoted in the newspapers, there are clearly broader market indices available to describe the overall performance of the U.S. stock market.

Likewise, indices like the S&P 500 and Wilshire 5000 are capitalization-weighted, so their returns are generally dominated by the largest 50 of their 500 – 5000 stocks.

Fortunately, capitalization-bias does not typically affect long-term performance comparisons, but there may be periods of time in which large cap stocks out-or under-perform mid-to-small cap stocks, thus creating a bias when cap-weighted indices are used versus what is usually non-cap weighted strategies of managers or mutual funds.

Finally, the fixed income indices tend to have a bias towards intermediate-term securities versus longer-term bonds.  Therefore, a physician investor with a long-term time horizon, and therefore potentially a higher allocation to long bonds, should keep this bias in mind when evaluating performance.

How do you evaluate your portfolio?

Do you evaluate it on a risk-adjusted basis?

Understanding Active Asset Allocation

The Two Types of Active Allocation

[By Jeffrey S. Coons; PhD, CFA]

[By Christopher J. Cummings; CFA, CFP™]

ACASometimes, physician investors feel that the markets either overreact or under react to a given piece of news – related to a specific security – and are generally willing to commit their time and resources to find mispriced securities.  

For example, a young physician with a long time horizon may feel that the financial markets are too focused on the near-term following a decline in a pharmaceutical company’s stock from a disappointing FDA report.  Or, the recent banking industry debacle is a good sector wide example of abrupt depression. 

And so, if active asset allocation makes sense based upon the limitations of passive asset allocation in managing risk over even long periods of time, how do physician investors – and their advisors – make active asset allocation decisions?   

The Approaches 

There are two distinct active asset allocation approaches used to build an investment portfolio.   They are the top-down method and the bottom-up method, and they differ based on how important economic and industry variables are to the decision-making process relative to individual security variables.  

Top-Down Approach

Advocates of the top-down approach generally begin their investment process by formulating an outlook for the domestic economy, and in certain circumstances the outlook is constructed for the global economy.  This may be a direct result of a quantitative model using various market and economic data as input to reach a conclusion regarding the best asset mix on a tactical basis, or it may be a more subjective process resulting from a qualitative assessment of the market and economic outlook.

In developing an economic overview for qualitative top-down asset allocation decisions, the medical professional and/or his advisors typically consider factors such as monetary policy, fiscal policy, trade relations, and inflation. Clearly, macroeconomic factors such as those listed above are likely to have a significant impact on the performance of a wide range of investment alternatives.

After a thorough analysis of the overall economy has been completed, top-down investors will either buy broad baskets of stocks representing an asset class or perform an analysis of industries that they believe will benefit from the economic overview that has been developed. 

Factors that may influence the attractiveness of particular industries include regulatory environment, supply and demand of resources, taxes, and import/export quotas. 

The top-down approach generally views the best company in a weak industry as being unlikely to provide satisfactory returns.  

The final step in the top-down process involves analyzing individual companies in industries that are expected to benefit from the forecasted economic environment.  

Stock_Market

Bottom-Up Approach

In contrast, investors employing a bottom-up approach will focus their attention on identifying securities that are priced below the investor’s estimate of their value.

Physicians and investors using the bottom-up approach to asset allocation and portfolio construction will only purchase securities deemed attractive according to their basic pricing and security selection criteria, thus adjusting the overall mix of investments by the limit of securities considered attractive at current valuations.

A truly bottom-up approach will consider economic and industry factors as clearly secondary in identifying investment opportunities. Investors using this approach will focus solely on company analysis.   However, they must recognize that investment decisions cannot be made in a vacuum.  Macroeconomic factors, as well as industry characteristics and traits are likely to be key elements in identifying attractive investment opportunities even on a security-by-security basis.

The key to bottom-up asset allocation and portfolio management is to realize that the decision variables driving the basic mix of assets in the portfolio are more related to the availability of attractive individual investments than to a general top-down market or economic overview.

Are you an active or passive investor?

If an active investor; what type are you?

Conclusion

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Book of Month

The Arbitrage Pricing Theory [APT]

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A Multi-Faceted Representation of Systematic Risk

  • By Jeffrey S. Coons; PhD, CFA
  • By Christopher J. Cummings; CFA, CFP™

fp-book2Introduction 

Did you know that the economist Stephen Ross PhD developed a more generalized Modern Portfolio Theory [MPT] model called Arbitrage Pricing Theory (APT)? 

Definition

APT is based upon somewhat less restrictive assumptions than the Capital Asset Pricing Model [CAP-M] and results in the conclusion that there are multiple factors representing systematic risk.  The APT incorporates the fact that different securities react in varying degrees to unexpected changes in systematic factors other than just beta to the market portfolio.

The risk-free return plus the expected return for exposure to each source of systematic risk times the beta coefficient to that risk is what determines the expected rate of return for a given security.

Physician-Investors

An important point for physicians to keep in mind is that the APT focuses on unexpected changes for its systematic risk factors. The financial markets are viewed as a discounting mechanism, with prices established for various securities reflecting investors’ expectations about the future, so any excess return for an expected change will be arbitraged away (i.e., the price of that risk will be bid down to zero). 

For example, market prices already reflect physician and other investors’ expectations about GNP growth, so prices of assets should only react to the extent that GNP growth either exceeds or falls short of expectations (i.e., an unexpected change in GNP growth).

A Rhetorical Interrogative?

And so – we can ask – why do lay investors, medical professionals and their advisors go wrong in making passive asset allocation decisions using MPT?   The problem has less to do with the limitations of CAPM or APT as theories and more to do with how these theories are applied in the real world.

The basic premise behind the various MPT models is that both return and risk measures are the expectations assessed by the investor.   Too often, however, decisions are made based on what investors see in their rear view mirror rather than what lies on the road ahead of them.

Theoretical?

In other words, while modern portfolio theory is geared towards assessing expected future returns and risk, investors and financial professionals all too often simply rely on historical data rather than develop a forecast of expected future returns and risks.

While it is clearly difficult for physicians and all investors to accurately forecast future returns or betas, whether they are for the market as a whole or an individual security, there is no reason to believe that simply using historical data will be any more accurate.  

MPT Shortcomings

One major shortcoming of modern portfolio theory as it is commonly applied today is the fact that historical relationships between different securities are unstable.  And, it would seem that a physician or other healthcare provider should not rely on historical averages to establish a passive asset allocation.  

Of course, the use of unstable historical returns in modern portfolio theories clearly violates the rule-of-thumb related to the dangers of projecting forward historical averages; MPT is nonetheless an important concept for medical professionals to understand as a result of its frequent use by investment professionals. 

Critical Elements of Investing

Furthermore, MPT has helped focus investors on two extremely critical elements of investing that are central to successful investment strategies: 

  1. First, MPT offers the first framework for investors to build a diversified portfolio.   
  2. Second, the important conclusion that can be drawn from MPT is that diversification does in fact help reduce portfolio risk.

Assessment

MPT approaches are generally consistent with the first investment rule of thumb, “understand and diversify risk to the extent possible.”  

Additionally, the risk/return tradeoff (i.e., higher returns are generally consistent with higher risk) central to MPT based strategies has helped investors recognize that if it looks too good to be true, it probably is. 

Conclusion

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CAPM – Another Portfolio Pricing Model to Consider

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The Capital Asset Pricing Model

By Jeffrey S. Coons; PhD, CFA

By Christopher J. Cummings; CFA, CFP™

While Dr. Harry Markowitz is credited with developing the framework for constructing investment portfolios based on the risk-return tradeoff, William Sharpe, John Lintner, and Jan Mossin are credited with developing the Capital Asset Pricing Model (CAPM). 

Introduction

CAPM is an economic model based upon the idea that there is a single portfolio representing all investments (i.e., the market portfolio) at the point of the optimal portfolio on the CML and a single source of systematic risk, beta, to that market portfolio.   The resulting conclusion is that there should be a “fair” return physician investors should expect to receive given the level of risk (beta) they are willing to assume. 

Thus, the excess return, or return above the risk-free rate, that may be expected from an asset is equal to the risk-free return plus the excess return of the market portfolio times the sensitivity of the asset’s excess return to the market portfolio excess return.

Beta then, is a measure of the sensitivity of an asset’s returns to the market as a whole.  A particular security’s beta depends on the volatility of the individual security’s returns relative to the volatility of the market’s returns, as well as the correlation between the security’s returns and the markets returns. 

Thus, while a stock may have significantly greater volatility than the market, if that stock’s returns are not highly correlated with the returns of the overall market (i.e., the stock’s returns are independent of the overall market’s returns) then the stock’s beta would be relatively low.

A beta in excess of 1.0 implies that the security is more exposed to systematic risk than the overall market portfolio, and likewise, a beta of less 1.0 means that the security has less exposure to systematic risk than the overall market.

The CAPM uses beta to determine the Security Market Line or SML.  The SML determines the required or expected rate of return given the security’s exposure to systematic risk, the risk-free rate, and the expected return for the market as a whole. The SML is similar in concept to the Capital Market Line, although there is a key difference. 

Both concepts capture the relationship between risk and expected returns.

However, the measure of risk used in determining the CML is standard deviation, whereas the measure of risk used in determining the SML is beta.  

Conclusion 

The CML estimates the potential return for a diversified portfolio relative to an aggregate measure of risk (i.e., standard deviation), while the SML estimates the return of a single security relative to its exposure to systematic risk. 

Now, if this is the essence of the Capital Asset Pricing Model, what are the arguments against CAPM?

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Understanding Modern Portfolio Theory

Portfolio Management 

By Jeffrey S. Coons; PhD, CFA

By Christopher J. Cummings; CFA, CFP™

Modern Portfolio Theory (MPT) is the basic economic model that establishes a linear relationship between the return and risk of an investment.  The tools of MPT are used as the basis for the passive asset mix, which involves setting a static mix of various types of investments or asset classes and rebalancing to that allocation target on a periodic basis.  

Introduction

According to MPT, when building a diversified investment portfolio, the goal should be to obtain the highest expected return for a given level of risk.  A key assumption underlying modern portfolio theory is that higher risk generally translates to higher expected returns.

From the perspective of MPT, risk is defined simply as the variability of an investment’s returns.  While MPT is based upon the idea that expected volatility of returns is used, risk is measured by standard deviation of historical returns in practice. 

Standard deviation is a measure of the dispersion of a security’s returns, X1,…,Xn, around its mean (or average) return.   

Often, standard deviation is calculated using monthly or quarterly data points, but is represented as an annualized number to correspond with annualized returns of various investments.  

Now, let us assume Stock A has a mean return of 10.0 percent and a standard deviation of 7.5 percent. 

Then, approximately 68 percent of Stock A’s returns are within one standard deviation of the mean return, and 95 percent of Stock A’s returns are within 2 standard deviations.

In other words, 68 percent of Stock A’s returns should be between 2.5 percent and 17.5 percent, and 95 percent of the returns for Stock A should be between negative 5.0 percent and 25.0 percent. 

However, a key assumption underlying this logic is that the returns for Stock A are normally distributed (i.e., including that the distribution curve of Stock A’s returns is symmetrical around the mean).

Unfortunately, in reality security returns may not be symmetrically distributed and both the mean return and standard deviation of returns may shift dramatically over time. 

Sources of Risk 

There are many different sources of risk, but the two forms of risk hypothesized by Harry Markowitz Ph.D., father of MPT, were systematic risk and unsystematic risk.

Systematic risk is sometimes referred to as non-diversifiable risk, since it affects the returns on all investments.  

In alternate theories like the Capital Asset Pricing Model [CAPM], systematic risk is defined as sensitivity to the overall market. While Arbitrage Pricing Theory has several common macroeconomic and market factors that are considered sources of systematic risk.   

Investors are generally unable to diversify systematic risk, since they cannot reduce their portfolio’s exposure to systematic risk by increasing the number of securities in their portfolio. 

In contrast, physicians diversifying an investment portfolio can reduce unsystematic risk, or the risk specific to a particular investment.  Sources of unsystematic risk include a stock’s company-specific risk and industry risk. 

For example, in addition to the risk of a falling stock market, physician investors in Merck also are exposed to risks unique to the pharmaceutical industry (e.g., healthcare reform), as well as the risks specific to Merck’s business practices (e.g., success of research and development efforts, patent time frames, etc). 

Assessment

A physician investor can reduce unsystematic risk by building a portfolio of securities from numerous industries, countries, and even asset classes.  

Thus, portfolio risk in MPT refers to the both systematic (non-diversifiable) and non-systematic (diversifiable) risk, but a basic conclusion of MPT is that no investor would be rational to take on non-systematic risk since this risk can be diversified away.

Conclusion 

MPT is the philosophy that higher returns correspond to higher risk, and that doctor investors typically desire to earn the highest return per a given level of risk.

The tradeoff between expected return and volatility of returns to make investment decisions is known as the mean-variance framework and is central concept in many of today’s passive asset allocation portfolio management principles. 

Now, is MPT as viable today – as when it was originally proposed?

Conclusion

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The Market Technicians

Technical Analysis – Defined

[By Julia O’Neal; MA, CPA with Staff writers]

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Technical market analysis focuses on the historical price and volume changes that occur as a stock trades, and it attempts to predict the stock’s future behavior based on prior patterns.

Technical analysis is not concerned with the financials of a company; it assumes that fundamental factors are already reflected in the market behavior of a stock and that the history of that behavior gives a strong clue to the future. The focus on price and volume in technical analysis could also be considered a study of supply and demand. 

Technical analysis applies technical market theories to stock market data on stock prices, indexes, and trading. Technicians identify market trends and try to predict future movements.  

Theoretically, technical and fundamental analysis exist in opposition to each other, but in reality, most fundamental analysts sneak a look at the charts from time to time and technical analysts pay attention to some fundamentals. 

Both schools of thought are based on the possibility of predicting the future using the past. Market psychology, which does not always follow rhyme or reason, can prove both types of analysis wrong.

Technical analysis involves discovering patterns that repeat themselves. Patterns can exist for an individual stock or for an index, and stocks can be compared to their respective indexes. 

Stocks (and indexes) are said to trade in a range. When prices go above this range, they often encounter selling pressure. This is called an area of resistance, and stocks are characterized as “overbought.” 

Conversely, a decline below a level of support will instigate buying, because the stock seems cheap or “oversold.” 

When a breakout occurs above a resistance level – or below a support level – technical analysts predict the stock will stay on the new course.  

Methods for taking advantage of anticipated upward trends include buying stop orders or call options at a level slightly above the resistance level.  To profit from downward trends, physician investors would enter a sell-stop order, sell short, or purchase put options at a price slightly below the support level.  

  • Accumulation areas occur when medical buyers are accumulating stock and the support level is moving up.  
  • Distribution areas occur when physician selling is occurring and the stock is considered weak.  
  • A sideways movement (the stock continues to be bought and sold at the same price for some time) is called an area of consolidation. 

Technical analysis

Other technical patterns:

A head and shoulders pattern may be either above (“head and shoulders top”) or below (“head and shoulders bottom”) a constant trend line. This theory assumes that after a top there will be a reverse; after a bottom, there will be a move back to a top.  

Rising bottoms and ascending tops/falling bottoms and descending tops.  A rising trend in the low prices of a security shows higher and higher support levels. Combined with ascending tops, this would be a bullish indicator. The reverse would be bearish. 

Double top and double bottom show resistance and support levels.  A double bottom shows the stock could break below support levels and reach new lows; a stock with a double top pattern might be expected to move on to a new high.

Assessment

What kind of physician investor are you; fundamental or technical?

Conclusion

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Equity Price Influencers

How Economic and Business Cycles Influence Equity Prices 

Julia O’Neal; MA, CPA with Staff Writers

 

The equity markets react to the business cycle as it moves through standard phases.

For example, coming out of a recession, when gross domestic product (GDP) is increasing, cyclicals do best, since consumers are fulfilling “pent-up demand” for big ticket items that could be deferred during tough economic times.  Conversely, as the economy turns down – so do cyclicals – often slightly ahead of the overall economy.

As inflation heats up in a rising economy, companies can raise prices and profit at first as expenses stay constant.  But ultimately inflation raises interest rates and capital becomes more expensive, so companies have to spend more to borrow capital to finance growth. Gentle interest rate increases do not always make the stock market fall, but it will rise more slowly.  

However, high interest rates and high inflation ultimately are negatives for the stock market. 

A bull market in stocks generally consists of three consecutive phases:

Monetary: Interest rates are falling, either naturally as inflation eases or with the help of a central bank, like the Federal Reserve, which can artificially lower short-term interest rates.

• Earnings-Driven: Companies have been able to borrow capital cheaply and have spent the down-market time practicing efficiencies, so now they are geared up for growth. Consumers are buying, so earnings are beginning to flow through to the “bottom line.” 

Speculative blowout: The markets are responding to the good earnings reports—sometimes beyond what is justified. P/E ratios begin to get very high relative to a normal market, and markets are “overbought.” Wary physicians and canny medical investors may want to sell stocks to take profits. 

According to Goldman Sachs Research, the stock market may peak while the overall economy is still in a growth phase. Since 1952, the S&P 500 peak has led the overall economy’s peak by about seven months. During down markets, high-dividend-paying stocks and stocks of companies that sell necessary goods or services, like utilities and food companies tend to hold their value. These are called defensive stocks.  

Conclusion

Fundamental analysis takes into consideration economic factors such as consumers’ ability to buy a company’s goods or services or the company’s borrowing needs at current rates.

How has the recent economic and medical business cycle affected your investments?

Interest Rates and the Money Commodity

Medial Office Equipment Interest Rate Costs

David Edward Marcinko

Dr. David E. Marcinko; MBA, CMP™

[Publisher in Chief]

Physicians, administrators and healthcare entrepreneurs are aware of the compounding effect of interest. However, since interest is deductible as a medical office business expense, many seem to forget about it despite the fact that it must be continually paid until the asset is either purchased or otherwise disposed. 

So, what are the various types of interest rates important to the medical practitioner and commodity – money?

[1] Simple Interest

Simple interest is merely the pro rata interest on a loan or deposit and represents the most basic interest rate type.

For example, for every $100 Dr. Bill borrows at 12 percent annual interest, he pays twelve dollars per year. The interest is calculated by multiplying the principal or original amount, by the interest rate in decimal form (100 x .12). 

[2] Add-On Interest

Add on interest immediately attaches the annual interest amount, to the principal amount, at the beginning of the payment period. Payments are then made according to the number of years required.

The following formula is useful: 

Add-on-Interest minus Payment  = Total Interest on Balance/Number of Payments

For example, if Dr. William Needy borrows $10,000 at 8 percent add-on interest, he will repay $10,000 plus $ 800 ($10,000 x 8%) or $10,800, divided by twelve months, for a total of $900 per month, since $ 900/month x 12 months equals $10,800.  

[3] Discounted Interest

When using the discounted interest method, the interest amount is deducted from the principal right up front. Notice that this is the opposite of add-on-interest that is applied up front.

For example, if Dr. Bill borrows the same $ 10,000 at a discounted interest rate of 8 percent, he will only receive a $9,200 loan, since $10,000 – $800 is $9,200.

Obviously, the discount method is the most expense way to borrow money.  

[4] Annual Percentage Rate

 Most financial institutions advertise an annual percentage rates (APR) for loans, deposits and investments.  The APR is the periodic interest rate multiplied by the number of periods a year. If the APR is 12 percent, and interest is compounded monthly, you receive (or pay) 1 percent of your balance each month, and the balance shifts with each compounding. 

For example, if Dr. Bill deposits $ 100 dollars at 12 percent APR compounded monthly, he receives $ 1 interest the first month (1% of $100), $1.10 the second month (1% of $101), and so forth. If compounding is daily, the interest accumulates at the rate of 1/365 of the APR each day.  

Unless interest is compounded annually, the APR will be lower than the effective annual interest rate, discussed below. 

[5] Effective Interest Rate

It is important to differentiate between the effective interest rate and the APR, which is often the most prominent figure in advertisements for medical business equipment, consumer goods and financial services (loans, annuities, IRAs, CDs, investment analysis, college funding or retirement planning).  Although the APR is the periodic interest rate multiplied by the number of periods per year, the effective annual interest rate is the periodic rate, compounded. 

In our case, if the APR is 12 percent, compounded monthly, the monthly interest rate is 1 percent and the effective annual rate is the monthly rate compounded for 12 periods.

Therefore, if your calculation is for a single year, you can treat the effective rate as simple interest. If you deposit (or borrow) $1,000 at 12 percent APR, the effective rate is 12.68 percent, and interest for the first year is about $126.80 (12.68% of $1,000).

For longer periods, you can use the effective interest rate as the periodic interest rate, compounded annually. 

[a] “Rule of 72” (Double your Money)

The number of periods required to double a lump sum of money can be quickly estimated by using what is known as the “Rule of 72”. To get the number of periods, usually years, just divide 72 by the periodic interest rate, expressed as a whole number (not a decimal).

For example, if the annual interest rate is 10 percent, it will take about 7.2 years (72/10) to double any lump cache of money. Conversely, you can also calculate the interest rate required to double your money in a given period by dividing 72 by the term.

Thus, to double your money in ten years, you need to earn about 7.2 percent annual interest (72/10) = 7.2%).  

[b] “Rule of 78”

According to this method, interest is front end loaded like a home mortgage, or office condominium, to discourage prepayment of a loan and consequently preserve the lender’s profit. In other words, it is a method of calculating installment loan interest rebates. 

The number 78 comes from an approved method of accelerated tax depreciation, known as the “Sum of the Years Digits” (SOYD) method (i.e., 12 + 11 + 10 + 9 . . . = 78). This fact is important because, throughout the period of a loan, even though the payments are all the same, the portions that are interest and principal are very different.

Using this method for a one year loan shows that, in the first payment, 15.38 percent of the interest due is paid off, and by the sixth month, 73.08 percent of the interest is paid off.  This means, that if a physician makes a one year equipment loan with a total interest charge of $ 100 and pays the loan off in full with the sixth payments, he or she will not get an interest rebate of $ 50, but only $ 26.92, since $ 73.08 of the interest has already been prepaid. 

Most ethical lenders use simple interest rates for loan rebates, and the Rule of 78 is unfair according to many authorities.  

[c] “Rule of 116”

A derivative of the Rule of 72 is the Rule of 116.  This determines the number of years it takes for a principal amount to be tripled and is calculated by dividing the annual interest rate into 116.

The Rules of 72 and 78 are very handy for figuring the amount of interest payments made or growth of funds invested. They can also be used in reverse to calculate at what rate of interest money must be invested to double or triple in a certain number of years.     

[6] Medical Equipment Payback Cost Analysis

The payback period, expressed in years, is the length of time that it takes for the medical equipment investment to recoup its initial cost out of the cash receipts it generates. The basic premise is that the quicker the cost of an investment can be recovered, the better the investment is. It is most often used when considering equipment whose useful life is short and unpredictable.

When the same cash flow occurs every year, the formula is as follows: 

Investment Required / Net Annual Cash Inflow = Payback Period 

Thus, in today’s tightening medical reimbursement atmosphere, practice cost control and expense reduction is the easiest method to increase medical office profitability.  Keeping the cost of the commodity money in the form of interest rate charges, as low as possible, will assist in this endeavor 

Assessment

And so, how have these rules affected your medical office borrowing costs; if at all? Does these principles apply to the medical student loan crisis, today? 

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Diversification and Portfolio Management

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What is Financial Asset Allocation?

By Jeffrey S. Coons; Ph.D, CFA

By Christopher J. Cummings; CFA, CFP™ 

Once the risk management goals and objectives for a physician’s financial portfolio have been identified and prioritized, the next step is to build a mix of investments that will best balance those conflicting goals.   

Asset allocation is defined as the portfolio’s mix between different types of investments, such as stocks, bonds, and cash.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet the medical professional’s objectives.

Establishing the appropriate asset allocation for a physician investor’s portfolio is widely considered the most important factor in determining whether or not he/she meets his/her investment objectives.  In fact, academic studies have determined that more than 90 percent of a portfolio’s return can be attributed to the asset allocation decision.  

So, how do physician investors and their advisors typically make asset allocation decisions? 

One method is best characterized as a passive approach, in which a set mix of stocks, bonds and cash is maintained based on their historical risk/return tradeoff.  The alternative is an active approach, in which the mix among various asset classes is established based upon the current and expected future market and economic environment. 

In addition to pursuing a passive investment strategy, such as indexing, medical professionals supporting the notion that market prices accurately reflect all available information generally are not concerned with the timing of their investment decision.  

The most frequently used strategy to avoid a market timing decision when establishing an initial allocation to stocks is referred to as dollar cost averaging. Dollar cost averaging entails investing the same amount of money at regular intervals.

For example, an investor who wishes to dollar cost average may decide to invest 1/24 of the allocation on the first of each month for two years rather than investing the full amount immediately or trying to time buys when stocks are trading at a low point.

Value-cost averaging does the same thing with the same number of shares, rather than dollar amount, for its regular intervals.

Now, what is your personal favorite strategy?

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What is a Market-Neutral Fund?

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Market Neutral Funds Demystified

[A Special Report]

[By Dimitri Sogoloff; MD, MBA]

Introduction

It’s hard to believe that just 20 years ago, physician investors had only two primary asset classes from which to choose: U.S. equities and U.S. bonds.

Today, the marketplace offers a daunting array of investment choices. Rapid market globalization, technology advancements and investor sophistication have spawned a host of new asset classes, from the mundane to the mysterious.

Even neophyte medical investors can now buy and sell international equities, emerging market debt, mortgage securities, commodities, derivatives, indexes and currencies, offering infinitely more opportunities to make, or lose, money.

Amidst this ongoing proliferation, a unique asset class has emerged, one that is complex, non-traditional and not easily understood like stocks or bonds. It does, however, offer one invaluable advantage; its returns are virtually uncorrelated with any other asset class. When this asset class is introduced into a traditional investment portfolio, a wonderful thing occurs; the risk-return profile of the overall portfolio improves dramatically.

This asset class is known as a Market-Neutral strategy. The reason few medical professionals have heard of market neutral strategies is that most of them are offered by private investment partnerships otherwise known as hedge funds.

To the uninitiated, “hedge fund” means risky, volatile or speculative. With a market-neutral strategy however, just the opposite is true. Funds utilizing market-neutral strategies typically emphasize the disciplined use of investment and risk control processes. As a result, they have consistently generated returns that display both low volatility and a low correlation with traditional equity or fixed income markets. 

Definition of Market-Neutral

All market-neutral funds share a common objective: to achieve positive returns regardless of market direction. Of course, they are not without risk; these funds can and do lose money. But a key to their performance is that it is independent of the behavior of the markets at large, and this feature can add tremendous value to the rest of a portfolio.

A typical market-neutral strategy focuses on the spread relationship between related securities, which is what makes them virtually independent of underlying debt or equity markets. When two related securities are mispriced in relation to one another, the disparity will eventually disappear as the result of some external event. This event is called convergence and may take the form of a bond maturity, completion of a merger, option exercise, or simply a market recognizing the inefficiency and eliminating it through supply and demand.

Here’s how it might work

When two companies announce a merger, there is an intended future convergence, when the shares of both companies will converge and become one. At the time of the announcement, there is typically a trading spread between two shares. A shrewd trader, seeing the probability of the successful merger, will simultaneously buy the relatively cheaper share and sell short the relatively more expensive share, thus locking in the future gain.

Another example of convergence would be the relationship between a convertible bond and its underlying stock. At the time of convergence, such as bond maturity, the two securities will be at parity. However, the market forces of supply and demand make the bond underpriced relative to the underlying stock. This mispricing will disappear upon convergence, so simultaneously buying the convertible bond and selling short an equivalent amount of underlying stock, locks in the relative spread between the two.  

Yet another example would be two bonds of the same company – one junior and one senior. For various reasons, the senior bond may become cheaper relative to the junior bond and thus display a temporary inefficiency that would disappear once arbitrageurs bought the cheaper bond and sold the more expensive bond.

While these examples involve different types of securities, scenarios and market factors, they are all examples of a market-neutral strategy. Locking a spread between two related securities and waiting for the convergence to take place is a great way to make money without ever taking a view on the direction of the market.

How large are these spreads, you may ask? Typically, they are tiny. The markets are not quite fully efficient, but they are efficient enough to not allow large price discrepancies to occur.

In order to make a meaningful profit, a market-neutral fund manager needs sophisticated technology to help identify opportunities, the agility to rapidly seize those opportunities, and have adequate financing resources to conduct hundreds of transactions annually.  

Brief Description of Strategies

The universe of market-neutral strategies is vast, spanning virtually every asset class, country and market sector. The spectrum varies in risk from highly volatile to ultra conservative. Some market-neutral strategies are more volatile than risky low-cap equity strategies, while others offer better stability than U.S Treasuries.

One unifying factor across this vast ocean of seemingly disparate strategies is that they all attempt to take advantage of a relative mispricing between various securities, and all offer a high degree of “market neutrality,” that is, a low correlation with underlying markets.

[A] Convertible Arbitrage

Convertible arbitrage is the oldest market-neutral strategy. Designed to capitalize on the relative mispricing between a convertible security (e.g. convertible bond or preferred stock) and the underlying equity, convertible arbitrage was employed as early as the 1950s.

Since then, convertible arbitrage has evolved into a sophisticated, model-intensive strategy, designed to capture the difference between the income earned by a convertible security (which is held long) and the dividend of the underlying stock (which is sold short). The resulting net positive income of the hedged position is independent of any market fluctuations. The trick is to assemble a portfolio wherein the long and short positions, responding to equity fluctuations, interest rate shifts, credit spreads and other market events offset each other.  

A convertible arbitrage strategy involves taking long positions in convertible securities and hedging those positions by selling short the underlying common stock. A manager will, in an effort to capitalize on relative pricing inefficiencies, purchase long positions in convertible securities, generally convertible bonds, convertible preferred stock or warrants, and hedge a portion of the equity risk by selling short the underlying common stock. Timing may be linked to a specific event relative to the underlying company, or a belief that a relative mispricing exists between the corresponding securities.

Convertible securities and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk free interest rates, call provisions, supply and demand for specific issues and, in the case of convertible bonds, the issue-specific corporate/Treasury yield spread.

Thus, there is ample room for relative misvaluations. Because a large part of this strategy’s gain is generated by cash flow, it is a relatively low-risk strategy. 

[B] Fixed-Income Arbitrage

Fixed-income arbitrage managers seek to exploit pricing inefficiencies across global markets.

Examples of these anomalies would be arbitrage between similar bonds of the same company, pricing inefficiencies of asset-backed securities and yield curve arbitrage (price differentials between government bonds of different maturities). Because the prices of fixed-income instruments are based on interest rates, expected cash flows, credit spreads, and related factors, fixed-income arbitrageurs use sophisticated quantitative models to identify pricing discrepancies.

Similarly to convertible arbitrageurs, fixed-income arbitrageurs rely on investors less sophisticated than themselves to misprice a complex security.

[C] Equity Market-Neutral Arbitrage

This strategy attempts to offset equity risk by holding long and short equity positions. Ideally, these positions are related to each other, as in holding a basket of S&P500 stocks and selling S&P500 futures against the basket. If the manager, presumably through stock-picking skill, is able to assemble a basket cheaper than the index, a market-neutral gain will be realized.

A related strategy is identifying a closed-end mutual fund trading at a significant discount to its net asset value. Purchasing shares of the fund gains access to a portfolio of securities valued significantly higher. In order to capture this mispricing, one needs only to sell short every holding in the fund’s portfolio and then force (by means of a proxy fight, perhaps) conversion of the fund from a closed-end to an open-end (creating convergence).

Sounds easy, right?

In considering equity market-neutral, you must be careful to differentiate between true market-neutral strategies (where long and short positions are related) and the recently popular long/short equity strategies.

In a long/short strategy, the manager is essentially a stock-picker, hopefully purchasing stocks expected to go up, and selling short stocks expected to depreciate. While the dollar value of long and short positions may be equivalent, there is often little relationship between the two, and the risk of both bets going the wrong way is always present.

[D] Merger Arbitrage (a.k.a. Risk Arbitrage)

Merger arbitrage, while a subset of a larger strategy called event-driven arbitrage, represents a sufficient portion of the market-neutral universe to warrant separate discussion.

Merger arbitrage earned a bad reputation in the 1980s when Ivan Boesky and others like him came to regard insider trading as a valid investment strategy. That notwithstanding, merger arbitrage is a respected stratagey, and when executed properly, can be highly profitable. It bets on the outcomes of mergers, takeovers and other corporate events involving two stocks which may become one.

A textbook example was the acquisition of SDL Inc (SDLI), by JDS Uniphase Corp (JDSU). On July 10, 2000 JDSU announced its intent to acquire SDLI by offering to exchange 3.8 shares of its own shares for one share of SDLI.

At that time, the JDSU shares traded at $101 and SDLI at $320.5. It was apparent that there was almost 20 percent profit to be realized if the deal went through (3.8 JDSU shares at $101 are worth $383 while SDLI was worth just $320.5). This apparent mispricing reflected the market’s expectation about the deal’s outcome. Since the deal was subject to the approval of the U.S. Justice Department and shareholders, there was some doubt about its successful completion. Risk arbitrageurs who did their homework and properly estimated the probability of success bought shares of SDLI and simultaneously sold short shares of JDSU on a 3.8 to 1 ratio, thus locking in the future profit.

Convergence took place about eight months later, in February 2001, when the deal was finally approved and the two stocks began trading at exact parity, eliminating the mispricing and allowing arbitrageurs to realize a profit. 

Merger Arbitrage, also known as risk arbitrage, involves investing in securities of companies that are the subject of some form of extraordinary corporate transaction, including acquisition or merger proposals, exchange offers, cash tender offers and leveraged buy-outs. These transactions will generally involve the exchange of securities for cash, other securities or a combination of cash and other securities.

Typically, a manager purchases the stock of a company being acquired or merging with another company, and sells short the stock of the acquiring company. A manager engaged in merger arbitrage transactions will derive profit (or loss) by realizing the price differential between the price of the securities purchased and the value ultimately realized when the deal is consummated. The success of this strategy usually is dependent upon the proposed merger, tender offer or exchange offer being consummated.  

When a tender or exchange offer or a proposal for a merger is publicly announced, the offer price or the value of the securities of the acquiring company to be received is typically greater than the current market price of the securities of the target company.

Normally, the stock of an acquisition target appreciates while the acquiring company’s stock decreases in value. If a manager determines that it is probable that the transaction will be consummated, it may purchase shares of the target company and in most instances, sell short the stock of the acquiring company. Managers may employ the use of equity options as a low-risk alternative to the outright purchase or sale of common stock. Many managers will hedge against market risk by purchasing S&P put options or put option spreads. 

[E] Event-Driven Arbitrage

Funds often use event-driven arbitrage to augment their primary market-neutral strategy. Generally, any convergence which is produced by a future corporate event would fall into this category.

Accordingly, Event-Driven investment strategies or “corporate life cycle investing” involves investments in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, liquidations, reorganizations, bankruptcies, recapitalizations and share buybacks and other extraordinary corporate transactions.

Event-Driven strategies involve attempting to predict the outcome of a particular transaction as well as the optimal time at which to commit capital to it. The uncertainty about the outcome of these events creates investment opportunities for managers who can correctly anticipate their outcomes.

As such, Event-Driven trading embraces merger arbitrage, distressed securities and special situations investing. Event-Driven managers do not generally rely on market direction for results; however, major market declines, which would cause transactions to be repriced or break, may have a negative impact on the strategy. 

Event-driven strategies are research-intensive, requiring a manager to do extensive fundamental research to assess the probability of a certain corporate event, and in some cases, to take an active role in determining the event’s outcome. 

Risk and Reward Characteristics

To help understand market-neutral performance and risk, let’s take a look at the distribution of returns of individual strategies and compare it to that of traditional asset classes.

 Table 1:  Average Return / Volatility of Market Neutral Strategies And Selected Traditional Asset Classes 

 

Strategy Average Return Annualized Volatility
Convertible Arbitrage 11.95% 3.57%
Fixed Income Arbitrage 8.33% 4.90%
Equity Market-Neutral 11.62% 4.95%
Merger Arbitrage 13.29% 3.51%
Relative Value Arbitrage 15.69% 4.31%
   Traditional Asset Classes:    
S&P 500 12.62% 13.72%
MSCI World 8.57% 13.05%
High Grade U.S. Corp. Bonds 7.26% 3.73%
World Government Bonds 5.91% 5.96%

The most important observation about this chart is that the Market Neutral funds exhibits considerably lower risk than most traditional asset classes.

While market-neutral strategies vary greatly and involve all types of securities, the risk-adjusted returns are amazingly stable across all strategies. The annualized volatility – a standard measure of performance risk – varies between 3.5 and 5 percent, comparable to a conservative fixed-income strategy.     

Another interesting statistics is the correlation between Market Neutral strategies and traditional asset classes and traditional asset classes

Table 2: Correlation between Market Neutral Strategies and Traditional Asset Classes

 

Asset Class/Strategy S&P500 MSCI World GovBonds CorpBonds

The correlation of all market neutral strategies to traditional assets is quite low, or negative in some cases. This suggests that these strategies would indeed play a useful role in the ultimate goal of efficient portfolio diversification.

To test the “market neutrality” of these strategies, we asked, “How well, on average, did these strategies perform during bad, as well as good, market months?”

It turns out, in good times and bad, these strategies displayed consistent solid performance. From 12/31/91, in months when S&P 500 was down, the average down month was 3.03 percent. Market Neutral strategies performed as follows:

  

Strategy Average Monthly Return
Convertible Arbitrage + 0.65%
Fixed Income Arbitrage + 0.50%
Equity Market-Neutral + 1.19%
Merger Arbitrage + 0.88%
Relative Value Arbitrage + 0.81%

In months when S&P 500 was up, the average up month was +3.24 percent.  Market Neutral strategies performed as follows:

  

Strategy Average Monthly Return
Convertible Arbitrage +1.17%
Fixed Income Arbitrage +1.20%
Equity Market-Neutral +1.37%
Merger Arbitrage +0.60%
Relative Value Arbitrage +1.25%

Clearly, a compelling picture emerges. While these strategies, on average, underperform during good times, they show a positive average return during both good and bad markets.

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Inclusion of Market-Neutral in a Long-term Investment Portfolio

A critical concern for any medical investor considering a foray into a new asset class is how it will alter the long-term risk/reward profile of the overall portfolio. To better understand this, we constructed several hypothetical portfolios consisting of traditional asset classes:

·  US Treasuries (Salomon Treasury Index 10yrs+)

·  High Grade Corporate Bonds  (Salomon Investment Grade Index)

·  Speculative Grade Corporate Bonds  (High Yield Index)

·  US Blue chip equities  (Dow Jones Industrial Average)

·  US mid-cap equities  (S&P 400 Midcap Index)

·  US small-cap equities (S&P 600 Smallcap Index)

Portfolios varied in the level of risk from 100 percent U.S Treasuries (least risky) to 100 percent small-cap equities (most risky), and are ranked from 1 to 10, 1 representing the least risky portfolio.Each portfolio was analyzed on a Risk/Return basis using monthly return data since December 1991. The results are shown in Chart 1.Predictably, the least risky portfolio produced the smallest return, while the riskiest produced the highest return. This is perfectly understandable – you would expect to be compensated for taking a higher level of risk.

Chart 1: Risk/Return characteristics of traditional portfolios vs. Market Neutral strategies 

Clearly, the risk-return picture offered by Market Neutral strategies is much more compelling (lower risk, higher return) than that offered by portfolios of traditional assets. What happens if we introduce these market-neutral strategies into traditional portfolios? Let’s take 20 percent of the traditional investments in our portfolio and reinvest them in market-neutral strategies.

The change is dramatic: the new portfolios (denoted 1a through 10a) offer significantly less risk for the same return. The riskiest portfolio, for instance (number 10) offered 20 percent less risk for a similar return of a new portfolio containing market-neutral strategies (number 10a).   
 
Chart 2:  Result of inclusion of 20% of Market Neutral strategies in traditional portfolios 

This is quite a difference.  Everything else being equal, anyone would choose the new, “improved” portfolios over the traditional ones.

How to invest

The mutual fund world does not offer a great choice of market neutral strategies. 

Currently, there are only a handful of good mutual funds that label themselves market-neutral (AXA Rosenberg Market Netural fund and Calamos Market Neutral fund are two examples).

Mutual fund offerings are slim due to excessive regulations imposed by the SEC with respect to short selling and leverage, and consequently these funds lack flexibility in constructing truly hedged portfolios. The dearth of market-neutral offerings among mutual funds is offset by a vast array of choices in the hedge fund universe. Approximately 400 market-neutral funds, managing $60 billion, represent roughly 25% of all hedge funds.

Therefore, further focus will relate to the hedge fund universe, rather than the limited number of market-neutral mutual funds.

Direct investing in a market-neutral hedge fund is restricted to qualifying individuals who must meet high net worth and/or income requirements, and institutional investors, such as corporations, qualifying pension plans, endowments, foundations, banks, insurance companies, etc.

This does not mean that retail investors cannot get access to hedge fund exposure. Various private banking institutions offer funds of funds with exposure to hedge funds. Maaket-neutral funds are nontraditional investments. They are part of a larger subset of strategies known as alternative investments, and there is nothing traditional in the way doctors invest in them.

Hedge funds are private partnerships, which gives them maximum flexibility in constructing and managing portfolios, but also requires medical investors to do a little extra work.

[A] Lockup Periods

One of the main differences between mutual funds and hedge funds is liquidity. Market-neutral strategies have less liquidity than traditional portfolios. Quarterly redemption policies with 45- or 60-days notice are common. Many funds allow redemptions only once a year and some also have lock-up periods. In addition, few of these funds pay dividends or make distributions. These investments should be regarded strictly as long-term strategies.

[B] Managerial Risks

Success of a market-neutral strategy depends much less on the market direction than on the manager’s skill in identifying arbitrage opportunities and capitalizing on them.

Thus, there is significantly more risk with the manager than with the market. It’s vital for investors to understand a manager’s style and to monitor any deviations from it due to growth, personnel changes, bad decisions, or other factors.

[C] Fees

If you are accustomed to mutual fund fees, brace yourself; market-neutral investing does not come cheap.

Typical management fees range from 1 to 2 percent per year, plus a performance fee averaging 20 percent of net profits. Most managers have a “high watermark” provision; they cannot collect the performance fees until investors recoup any previous losses. Look for this provision in the funds’ prospectus and avoid any fund that lacks it. Even with higher fees, market-neutral investing is superior to most traditional mutual fund investing on a risk-adjusted return basis.

[D] Transparency

Mutual funds report their positions to the public regularly. This is not the case with market-neutral hedge funds. Full transparency could jeopardize accumulation of a specific position. It also generates front running: buying or selling securities before the fund is able to do so. While you should not expect to see individual portfolio positions, many hedge fund managers do provide a certain level of transparency by indicating their geographical or sector exposures, level of leverage and extent of hedging.

It does take a bit of education to understand these numbers, but the effort is definitely worthwhile. 

[E] Taxation

The issue of hedge fund taxation is quite complex and is often dependent on the fund and the personal situation of the investor. Advice from a competent accountant, specialized financial advisor, tax attorney with relevant experience is worthwhile. The bottom line is that investing in market-neutral funds is not a tax-planning exercise and it will not minimize your taxes.

On the other hand, it should not generate any more or fewer taxes than if you invested in more traditional funds.

From the medical investor’s perspective, the principal advantages of market-neutral investing are attractive risk-adjusted returns and enhanced diversification.

Ten years of data indicate that market-neutral portfolios have produced risk-adjusted returns superior to traditional investments. In addition, the correlation between the returns of market-neutral funds and traditional asset classes has been historically negligible.

Adding exposure of market-neutral return strategies to the asset mix within a consistent, long-term investment program offers a medical investor the opportunity to improve overall returns, as well as achieving some protection against negative market movements.

Now, after all of the above, has your impression of hedge funds in general or MN funds in particular, changed?

APPENDIX:  

Asset class weighting in traditional portfolios:
Portfolio US Treasuries US High Grade Corp Bonds US Low Grade Corp Bonds Large Cap Stocks Mid Cap Stocks Small Cap Stocks
1 50% 50%        
2   50% 50%      
3 10% 30% 50% 40%    
4   50%   50%    
5   10% 10% 50% 30%  
6     10% 50% 20% 20%
7     10% 30% 20% 40%
8       20% 20% 60%
9         20% 80%
10           100%

 

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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Of Bull and Bear Markets

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What is a Bull or Bear Market? 

[By Staff Writers]

A bull market is generally one of rising stock prices, while a bear market is the opposite. Metaphorically, a wild bull tends to throw prey up; while a bear claws prey down. There are usually two bulls for every one bear market over the long term.

More specifically, a bear market is defined as a drop of twenty percent or more in a market index from its high, and can vary in duration and severity.   In the bear market of Y-2001, for example, the PE ratio of Standards & Poor’s fell from a high of 36, to a low of about 22. The PE for the Dow DJIA fell to about 19, from its high of 28. Recall, that PE is a measure of share price value relative to earnings per share. Historically, it has been about 15-16, according to most analysts.

However, as a physician investing for the long-term, do not worry since the average bear market has lasted only about a year. Sans the 2001 implosion, the bear markets of the prior past fifty years are listed below, using the Dow Jones Industrial average as a benchmark:

  • Dec. 1961 to June, 1962: Days lasted: 195 Decline: 27% 

  • Feb. to Oct. 1966: Days lasted: 240 Decline: 25% 
  • Dec. 1968 to May, 1970: Days lasted: 539 Decline: 35% 
  • Jan. 1973 to Dec. 1984: Days lasted: 694 Decline: 45% 
  • Sept.1976 to Feb. 1978: Days lasted: 525 Decline: 27% 
  • April 1981 to Aug. 1982: Days lasted: 472 Decline: 24 
  • Aug. to Oct. 1987: Days lasted: 55 Decline: 36 
  • July-Oct. 1990: Days lasted: 86 Decline: 21%

Assessment

What about now?

Today, it’s possible that the United States is already slipping into recession; downturns are recognized only in retrospect, and the Dow is down 10.3 % this last quarter of 2007.

Ironically, The Economist noted recently, 95% of American economists polled in March 2001 said a recession was not likely, but it was already under way. So, go figure!

Still, the Fed’s Beige Book report showed a slowing economy in October 2007. The anecdotal snapshot of the economy said retail sales were relatively soft, and retailers are bracing for a weak holiday shopping season; while demand for residential real estate remained depressed.

So, what do you think? Are we heading for a bull, or bear market?

Bear + A Falling Stock Chart

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Link: http://feeds.feedburner.com/HealthcareFinancialsthePostForcxos

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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DICTIONARIES: http://www.springerpub.com/Search/marcinko
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BLOG: www.MedicalExecutivePost.com
FINANCE: Financial Planning for Physicians and Advisors
INSURANCE: Risk Management and Insurance Strategies for Physicians and Advisors

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