Portfolio Management Flashcards
1
Q
Define Tax-Efficiency
A
Minimizing the impact of taxes on returns
2
Q
Rank the “tax-friendliness” of various assets, investment vehicles, and account types
A
- Tax-Exempt yields are beneficial for they don’t produce taxes, may carry a lower yield, good to compare them with taxable equivalent yields to see the difference in return
- Other investment types can produce ordinary income, capital gains, or qualified dividends taxable events. They have different tax rates, but choosing when to sell the positions can provide more favorable taxable events
- Mutual funds may create taxable events, even if the taxpayer doesn’t sell it. They create capital gains, dividends, ordinary income, and sometimes have large turnover rates. Be aware of that
- Roth IRAs and Traditional IRAs are tax advantaged accounts that either let you pay taxes now so you don’t pay them later, or you don’t pay taxes now but will pay them later
- Taxable accounts you pay tax on any transactions that occur in the account; capital gains, ordinary income
3
Q
What is the impact of taxes on returns and future value?
A
Tax drag on investments creates a significant impact on compound return over a long period of time
4
Q
Apply a decision-making framework for choosing securities for tax harvesting
A
- Be cognizant of wash sale rules
- Consider the current volatility of the security/valuation. If the holding is at a low and it’s sold, it’s implied that it will be bought back at a lower basis, which makes it difficult to harvest losses in the future
- Are there net realized capital gains or ordinary income available that could be offset with the tax loss harvest?
- Consider the value of the harvested loss. Will it make an impact on the tax return of the client?
5
Q
What are the criteria for choosing bond and equity managers based on after-tax performance?
A
For bonds, compare and contrast the after-tax yield with the before-tax yield on taxable bonds and the tax-exempt equivalent yield vs. the tax-exempt equivalent yield to compare and contrast a taxable bond to a tax-exempt one
For equities, consider performance net of investment fees to see which provides more alpha over time
6
Q
Calculate post tax performance for bond and equity managers
A
- Taxable bonds: after-tax yield = before-tax yield*(1-tax rate)
- Taxable equivalent of a tax-exempt bond: taxable equivalent = tax-exempt yield/(1-tax rate)
- Equity that’s taxed at ordinary income rates: FV = PV[(1+r) * (1-td)]^n
- Also, FV (after tax) = PV{(1+ar)^n-td[gr((1+ar)^n-1)/ar+b]} if ar doesn’t = 0
FV (after tax) = PV(1-td*b) if ar = 0
ar = accumulation rate after tax on the currently taxable component of return. ar = gr+[(1-to)(1-g)r]
r = total before-tax rate of return
g = proportion of total before-tax return, r, attributable to tax-deferred capital gain
n = number of periods
to = tax rate on ordinary income component of investment return
td = tax rate on long-term capital gain (tax-deferred) component of investment return
b = built-in gain or tax-deferred return proportion of the investment, PV, or periodic payment, PMT, if any
7
Q
What are the common characteristics of alternative investments?
A
- High fees
- Large size of investments
- Low diversification of managers and investments within portfolio
- High use of leverage
- Restriction on redemptions
Other: - Illiquidity
- Narrow specialization
- Low correlation
- Low regulations and less transparency
- Limited historical risk and return data
- Legal and tax considerations
8
Q
What are real assets?
A
Real assets are physical assets that have an intrinsic worth due to their substance and properties. Real assets include precious metals, commodities, real estate, land, equipment, and natural resources
9
Q
What are structured products?
A
They range from financial products that are linked to individual securities, or a financial index. Common examples include Exchange Traded Notes and Collateralized Debt Obligations
10
Q
What are commodities?
A
Commodities are raw materials used to manufacture consumer products. They are inputs in the production of other goods and services, rather than finished goods sold to consumers
11
Q
How to integrate an appropriate mix of alternative assets in a portfolio?
A
- Reduce the correlation and add diversification to the portfolio by adding alternative investments
- Consider the mean return and average standard deviation as well as historical downside frequencies and worst return in a month for potential portfolio combinations
12
Q
Compare the benefits and risks of the different categories of alternative investments
A
Advantages, disadvantages, tax implications, and use case for:
* Hedge Funds
* Structured Products
* Real Estate
* REITs
* Asset-backed securities
* Oil & Gas
* Gold & Precious Metals
* Collectibles
* Private Placement and Venture Capital
13
Q
Describe advantages, disadvantages, tax implications and use case for hedge funds
A
- Hedge funds are professionally managed pools of capital that are largely unregulated and available to only sophisticated (accredited) investors
- Advantages - professional management, funds operated by highly experienced and accomplished professional investors. Flexibility, investment manager takes positions in many asset classes across disparate markets. High return potential, often, hedge funds make concentrated bets and the return potential is much higher. Low correlation with other asset classes
- Disadvantages - High fee structure, lack of liquidity, lack of regulation, opaque nature, risk, no current income, and difficult to value assets
- Tax - Flow through vehicles and they are subject to income taxes on the interest, dividends, or capital gains distributed from the fund. Generally more trading in the hedge fund, so larger tax bills can be generated. May produce Unrelated Business Taxable Income (UBTI) for tax-exempt investors and accounts. For US investors, investments in an offshore hedge fund may be treated as passive foreign investments and may be taxed as ordinary income
- Use cases - When investor is looking for long-term appreciation. When investor desires additional diversification of their investment portfolio into an asset class that is not highly correlated to the equity and bond markets. When an investor is looking for professional investment management expertise. When the investor has the financial means and is psychologically willing and able to take relatively high risks in return for possible large rewards. When the investor desires a completely passive role and does not wish to be actively involved in the operation of the investment
14
Q
Describe the advantages, disadvantages, tax implications, and use case for structured products
A
- Structured products are varying financial products that are linked to individual securities or a financial index. They fall into five basic categories: principal protected notes, enhanced income notes, performance participation notes, leveraged participation notes, derivative or combined instruments
- Advantages - Professional creation and management, alternative return and risk profiles, minimum investment size, and potentially low correlation with other investments
- Disadvantages - High cost, complexity, credit risk, and low marketability
- Tax - A moving target. The prospectus of the structured product should be reviewed to learn about the potential taxation of the investment
- Use case - When the investor desires a risk and return profile that is different than that available by investing in the traditional underlying assets. When the underlying asset is difficult to invest in directly, especially for small investors
15
Q
Describe the advantages, disadvantages, tax implications, and use case for real estate
A
- Real estate is land and the building improvements on land. Includes natural assets under the land. Typically in four categories: land, residential, commercial, industrial
- Advantages - Owners have tax related advantages through deductions, it’s tangible, it’s historically a good hedge against inflation, it’s unique, and enables an investor to maximize potential leverage
- Disadvantages - Almost always illiquid, a degree of management is necessary, the investment will require the commitment of investable funds for a long period of time, costs related to the purchase or sale can produce short-term gain, the real estate can’t be moved, if land has been improved with a building then it is difficult and expensive to modify or remove, it is difficult to assess the economic risks and projected return on real estate with exactness, and the tax benefits of real estate are subject to being challenged by the IRS
- Tax - May deduct expenditures that are ordinary and necessary in collection of income, cost of supplies and labor, real estate property taxes, interest on unpaid balance of the mortgage, and losses incurred on the sale of real estate. May deduct reasonable rental costs if tenant is leasing business property. The cost for real estate (except land) is fully depreciable. Sellers may report gain of real estate over more than one taxable year. One parcel of real estate can be exchanged for another without immediate recognition of taxable income. If there’s an involuntary conversion of real estate, the investor does not have to pay any tax upon the receipt of cash from insurance or condemnation award, so long as the cash is reinvested in qualified property of equal or greater value. Liquidity can be obtained without paying taxes through the mortgage on the property. And the cost of rehabilitating certain buildings may qualify for a special investment tax credit
- Use case - When there’s a desire to have an investment with tax shelter potential. When there is a need for a long-term hedge against inflation. When they require a relatively constant cash flow. When they are looking for long-term appreciation. When they prefer tangible investment. When they want to make maximum use of leverage
16
Q
Describe the advantages, disadvantages, tax implications, and use case for REITs
A
- REIT is a publicly traded closed-end investment company that invests in a managed, diversified portfolio of real estate or real estate mortgages and construction loans rather than in financial securities like stocks or bonds. Three types of REITs: equity, mortgage, hybrid
- Advantages - Limited liability, no corporate-level tax, pooling of resources, knowledgeable professionals, record-keeping, small denominations, ability to leverage investments, utility as collateral, liquidity, discounts from book value, high dividend payouts, automatic dividend reinvestment, diversification in a real estate portfolio, inflation hedge, and diversification beyond stocks and bonds
- Disadvantages - Loss of control, lower potential returns, management fees and administrative charges, no flow-through of tax benefits, discounts from book values, considerable risk, and poor inflation hedge
- Tax - Subject to federal income tax if they satisfy the IRC provisions. Distributions are treated as investment income. Shareholders pay taxes on distributions from the REIT’s earnings. Generally treated as ordinary income, but qualified dividend income is treated as capital gains. Gains or losses realized when investors sell shares is a capital gain or loss, basis is original cost of shares minus cash distributions received in excess of the REIT’s net income. REITs are exempt from the requirement that pass-through entities report to shareholders, as income, their shares of expenses of the fund
- Use case - When an investor has limited capital and cannot afford to purchase real estate properties or mortgages directly. When an investor wants the added safety that a broadly diversified portfolio of real estate investments or mortgages provides. When an investor does not have the skill or inclination to manage his own real estate investments. When an investor desires long-term hedge against inflation, equity REITs are indicated. When an investor desires an investment that produces potentially increasing cash flows and the possibility for long-term capital appreciation, equity REITs are indicated. When an investor desires current high income, mortgage REITs are indicated. When an investor desires an investment combining features of equity REITs and mortgage REITs, hybrid REITs are indicated
17
Q
Describe the advantages, disadvantages, tax implications, and use case for asset-backed securities
A
- ABS are debt-type securities that are secured by a pool of similar debt obligations or receivables. Best-known sources are Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC); Ginnie Maes, Fannie Maes, and Freddie Macs
- Advantages - Provides one of the highest rates of return available from a debt instrument. Usually promised a monthly payment of interest and principal, whether or not the issuer has actually collected the sums. Secondary market for MBS, meaning little to no difficulty in selling securities if the need arises. Early repayments of mortgage loans may be subject to prepayment penalties, which get added to the monthly income the investor receives
- Disadvantages - Price will tend to fall when market interest rates rise. Subject to inflation risk, that the purchasing power of the income will erode over time and the risk that the purchasing power of capital received at maturity will have diminished. High minimum investment is required. Risk that the underlying mortgages will be paid off more quickly than anticipated and the holder will received the stated interest for a shorter time period. Face greater reinvestment risk than regular bondholders because the periodic payments must be reinvested at lower rates and lowering future return. The liquidity for these instruments can dry up and result in high volatility of prices and difficulty unloading securities
- Tax - Report interest income as ordinary income in the year it’s received. Portion of the monthly payment that represents the return of principal is a nontaxable repayment of the original investment. Prepayment penalties, assumption fees, and late payment charges passed through to the investor are ordinary income in year received. Gains on the sale of issues typically are capital gains. Amounts withheld from the investor by the issuer of the certificate to pay servicing, custodian, and guarantee fees are expenses incurred for the production of income and as such are deductible as miscellaneous itemized deductions, only if it exceeds the 2% floor
- Use case - When the investor desires a relatively high rate of return. When the investor requires a high level of cash flow. When the investor seeks to diversify their portfolio beyond stocks and bonds
18
Q
Describe the advantages, disadvantages, tax implications, and use case for oil and gas
A
- Exploration for and production of oil and gas. Four basic types of investments: exploratory drilling, development, income, and diversified (combo of the three)
- Advantages - A number of tax advantages: Deduction for the depletion of the oil or gas reserves in the ground, intangible drilling costs (IDC), enhanced oil recovery credit in lieu of deductions for depreciable property and IDCs equal to 15% of investor’s qualified enhanced oil recovery costs, interest expenses on funds borrowed to finance investment are deductible, investor has potential to receive long-term capital gain treatment upon sale of interest, if investor purchased limited partnership unit, can divide up credits that are disproportionate to ownership interest. Investment required is relatively small when compares with the potential profit. Since typically done through a limited partnership, liability is limited to extent of capital contributions to the partnership, any contributions investors contractually agree to make in the future, and any partnership debts the investors agree to guarantee in order to leverage their tax benefits
- Disadvantages - Assumes an extremely high degree of risk if the investment is in exploratory drilling. Tax advantages of investments are offset by the at risk and passive loss rules. Possibility of AMT. Time line of the investment varies, often long-term. Value of an investor’s interest can quickly drop due to volatility of energy prices. Value of an investor’s interest can drop in the long-run due to conservation efforts, new technology, or alternative energy resources
- Tax - Deduction for intangible drilling costs, deduction for percentage depletion, potential credit for enhanced oil recovery costs. Tax benefits may be reduced by limitations on depletion deduction, the at risk and passive loss rules, and for certain producers and royalty holders, the impact of the AMT
- Use case - When the investor is in a high income tax bracket and in need of tax shelter. When an investor desires additional diversification of his or her investment portfolio into an asset class that is not highly correlated to the equity and bond markets. When the investor is psychologically willing and able to take relatively high risks in return for possible large rewards. When the investor desires a completely passive role and does not wish to be actively involved in the operation of the investment
19
Q
Describe the advantages, disadvantages, tax implications, and use case for gold and precious metals
A
- Gold, silver, and platinum
- Advantages - They provide a degree of psychological security matched by few other investments. Precious metals can be purchased in relatively small quantities in a variety of forms. Underlying demand for them as a commodity in addition to their speculative or investment value. If held over a long period of time, have proven to be a relatively safe and stable form of investment
- Disadvantages - Precious metals are highly speculative form of investment. Historically, prices of precious metals have been highly volatile and the investor is subject to a high risk of significant loss of capital in a short period of time. Have frequently been controlled by various governments. Direct investments in precious metals typically yield no current income. Investment in physical precious metals involve storage costs, directly or indirectly. Sales tax may be payable. There may be assessment costs involved in the purchase
- Tax - Taxable gain is realized and must be recognized to the extent an investor receives more upon disposition than they paid. No gain is reportable until the investment is disposed of in a taxable transaction. A loss from a precious metals transaction is allowable to the extent an investor paid more for the asset than he received from the sale. Gain or loss on a precious metals transaction is a capital gain or capital loss assuming the metal is held as an investment, rather than by a dealer for trading purposes. No gain or loss must be reported if one precious metal is exchanged solely for another. The exchange of a precious metal for property other than a similar type of precious metal will result in reportable gain/loss. Coins acquired in a taxable transaction must be valued for tax purposes at their FMV rather than face value
- Use case - When the investor anticipates instability in traditional capital markets. When the worldwide economic or political outlook is one of uncertainty and fear, precious metals tend to be viewed as more stable and secure investment. When the investor anticipates that the purchasing power of the dollar will be eroded by high rates of inflation. When the value of the investor’s dollars is declining because of international currency fluctuations. When the investor desires to further diversify a portfolio that contains stocks, bonds, and real estate
20
Q
Describe the advantages, disadvantages, tax implications, and use case for collectibles
A
- Any item that meets the criteria: rarity, popularity, and ready marketability
- Advantages - Potential for long-term capital growth, investors with specialized knowledge or information can realize above-average returns, they are fun, and they have proven to be a relatively stable form of investment with steady appreciation
- Disadvantages - Generally provide no current income, most are not expert enough in a particular area to judge the specific quality of the item they are purchasing, subject to wild swings in popularity, absence of organized market puts both buyer and seller at a disadvantage, the investor must take risk that an item will be damaged or stolen or destroyed, the value of a particular collectible may drop if a supply previously unknown is discovered, the potential for fraud and forgery is possible, the bid-ask spread is typically much larger, and the value of any collectible is determined by the Greater Fool Theory
- Tax - Any gain realized on the sale of an item will be subject to long-term capital gain on a collectible, taxed at a maximum rate of 28%. The individual can control of any gain or loss. Increase in value of collectibles occurs on a tax-deferred basis year after year
- Use case - When the investor has little or no need for immediate income and desires long-term capital appreciation. When the investor has particular knowledge and insight of factors affecting the value of a specific type of collectible. When an investor has unusual access to the sources of supply and demand for a particular type of collectible. When an investor wishes to combine the potential for capital appreciation with the psychological pleasure of owning a collectible. When an individual is looking for an investment with relative capital stability.
21
Q
Describe the advantages, disadvantages, tax implications, and use case for private placement and venture capital
A
- Private placement is when new securities are sold directly to a single buyer without going through the process of a public offering. Venture capital is a source of funding typically made available to startup firms and small businesses with strong growth potential
- Advantages - PP does not have to be registered with SEC. PP debt issues normally offer a higher yield than publicly offered debt. VC investment may offer opportunity to actively participate in running one or more business organizations (if they have background in areas like management, marketing, engineering, or finance)
- Disadvantages - Lack of investment liquidity, lack of current income, high degree of investment risk, lack of management control, uncertainty of investment timing, and size of required investment
- Tax - PP, stocks and bonds are sold to buyer. Same tax consequences of stocks and bonds. VC has tax consequences applicable to limited partners
- Use case - For investors who are willing to commit relatively large amounts of capital for a significant period of time. For those that generally have no need for current income from their investments. For those who are able to accept a relatively high degree of risk in their investment portfolio in anticipation of substantial capital gain potential. VC is for those that may be able to contribute some significant managerial or business expertise. For those that desire the relative secrecy and flexibility of negotiating the sale and purchase of securities privately. For those who are willing and able to lock-up funds for a relatively long period of time
22
Q
What is the broad application of ESG investing?
A
It can be seen as a way to mitigate risk in a portfolio, particularly with unprecedented future risks
It’s a long-term investment strategy
23
Q
Compare and contrast positive screen and negative screening in investment selection
A
- Negative screening: looking through different companies and taking them out if they have a bad score in regard to sustainable investing
- Positive screening: adding companies to the portfolio through defined criteria that aligns with sustainable investing
ESG tries to look at positive and negative drivers of return
24
Q
What is diversification?
A
Each asset class and each specific asset carries its own unique degree of risk. Investing capital across a broad range of investments helps provide exposure to different asset classes, return opportunity, and helps mitigate risk
25
Q
What is hedging?
A
A conservative strategy used to limit investment loss by effecting a transaction that offsets an existing position
26
Q
What is tactical asset allocation?
A
An allocation strategy that attempts to capitalize on changing market conditions. The overall asset allocation is frequently adjusted to take advantage of perceived opportunities in the current market
27
Q
What is market timing?
A
An investment strategy that involves making trades in anticipation of price fluctuations
28
Q
What is risk budgeting?
A
- The establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk
- The threshold of risk tolerance that a client has for the level of volatility around their portfolio benchmark
29
Q
What are options?
A
Options are a type of derivative and they provide the investor the right or the obligation to buy or sell a security or property sometime in the future
30
Q
Constructive Sale Rules
A
- Transactions attempting to neutralize future gain and/or loss in a current appreciated stock. Strategies that eliminate nearly all potentially gain or loss are considered this
- Enters one of the following transactions:
1. Short sale of the same or substantially identical property
2. Offsetting notional principal contract with respect to the same or substantially identical property
3. Futures or forward contract to deliver the same or substantially identical property
31
Q
What are the trade-offs of each risk management strategy?
A
- Diversification - Does well with minimizing risk, but doesn’t prevent or put a cap to losses
- Hedging - Could result in constructive sales, which results in a taxable event of the hedge
- Tactical asset allocation - Relies on high turnover in the portfolio, may create tax events and may result in losses if markets do not act in the way the rebalanced portfolio anticipated
- Market timing - Timing when to get in and out of the market is extremely difficult and often unreliable
- Risk budgeting - Acceptable asset allocation may not be most efficient when considering the client’s risk level and the type of goals they have
- Options - Can be tricky, if done improperly it could result in constructive sales
32
Q
What are the impacts of options hedging strategies in a portfolio?
A
- Creates ‘guardrails’ for how much an investor can gain, but also lose.
- Can generate income if initiating multiple contracts over an extended period of time
- Certain strategies limit downside risk, but have unlimited upside potential
33
Q
What are the trade-offs of implementing an options hedging strategy?
A
- Must be aware of constructive sale rules
- Must be aware of straddle rules
34
Q
What is the impact of non-options hedging strategies in a portfolio?
A
- Able to set price limits on when to buy/sell a security. Can help prevent losses/protect gains earned
- Short sales of close substitutes can hedge a long position
- These strategies rely on the investor to hold the long position they currently have. They work around it to try to protect gains/mitigate losses
35
Q
What are the trade-offs of implementing a non-options hedging strategy?
A
- Sometimes stop/limit order will execute but not at the desired price if markets fluctuate too much
- Sometimes short sales of close substitutes don’t act in the same manner as the long position. Could negatively impact the strategy
- Must be aware of constructive sale rules
- Typically subject to constructive sale, meaning that the individual is taxed at the time the hedged position is created even if the investor did not sell
36
Q
What is portfolio immunization?
A
A risk-mitigation strategy that matches asset and liability duration so portfolio values are protected against interest rate changes
37
Q
What is asset-liability matching?
A
Liability matching is an investment strategy that matches future asset sales and income streams against the timing of expected future expenses. It’s used in pension plans to hopefully limit liquidation risk by timing the dividends, interests and asset sales with the pension plan payments
