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BAFI 1014 - Topic 1 Intro to Financial Planning and the Legal Framework of Financial Planning Environment Dr Daniel Richards & Associate Professor Abdullahi Ahmed Financial Planning - Chapters 1& 2 BAFI 1014 - Topic 1 Study Guide- Financial Planning - - - - - - - Refer to Course Guide & Timetable Read relevant chapters for each lecture Complete tutorial questions before tutorials Familiarise yourself with all course documents Participate in class in tutorials Lecturer contact - In person & email Encourage to conduct own research BAFI 1014 - Topic 1 INTRODUCTION Personal financial planning is a rapidly expanding industry. There have been increasing demands for services over the last decade particularly in the area of retirement planning. Financial Planning in Australia was traditionally the domain of accountants and legal practitioners In recent years financial planning has become a separate profession. The two professional accounting bodies, CPA Australia and the ICAA have introduced specialist financial planning designations for their members. BAFI 1014 - Topic 1 Role of Financial Planner & Financial Planning Process SOA Life goals tracking Cashflow Management Retirement Income Streams Banking Tax planning Our Clients Social Security Planning Superannuation Strategy Debt Advice Wealth Accumulation Estate Planning Risk Management Investment Strategy BAFI 1014 - Topic 1 Importance of Financial Planning Financial planners help clients to: - Make informed decisions about their money - Develop a sound financial plan - Use their money to best advantage - Select financial products to suit their needs - Understand risk BAFI 1014 - Topic 1 1. AUSTRALIA has $1.5 trillion ($US1.555 trillion) superannuation fund pool. 2. Australia's rise to fourth position follows a compound annual growth rate of more than 18 per cent over the past decade in US dollar terms. 3. Strongest bias to investing in shares (54% of asset, 52% by US, 45% by British pension funds, 27% in Netherlands (6th largest pension fund market). BAFI 1014 - Topic 1 Why the Increased Focus? Deregulation of the Australian financial system New investment opportunities Increased legislative complexity Ageing population Reduction in capital guaranteed investments Government trends toward financial self-reliance and individualism Increased promotion of risk sharing portfolio investments Increase in number of individuals owning shares Global market influence on personal wealth creation strategies BAFI 1014 - Topic 1 6 Process -Financial Advising Process Review, revise and maintain the personal finance plan 6. 5. 4. 3. 2. 1. Implement the agreed-upon plan Prepare written report Identify financial problems, ie set priorities, decide on trade-offs and opportunity costs Identify the client's goals Gather qualitative and quantitative data BAFI 1014 - Topic 1 6 Steps for Financial Planning Gather client data Establish goals and objectives Analyse and evaluate the client's financial status Develop and present financial planning recommendations and / or alternatives Implement the financial planning recommendations Periodically monitor and review the plan BAFI 1014 - Topic 1 Preparing Personal Financial Statements Gather client data Importance of client fact finder Importance of establishing the relationship Goal setting Goals will change over time and through different stages of life: Goals need to be specific and include a set time frame relating to both personal and financial nature - short term (1- 2 years) - medium term (2 - 5 years) - long term (5 or more years) BAFI 1014 - Topic 1 The importance of lifestyle planning Includes consideration of the chosen or desired lifestyle A financial plan is unlikely to be successful in the long term if lifestyle considerations are ignored Life cycle theory - needs and wants will change during a persons life cycle unmarried working individual working married couple with no children couple with children and mortgage couple with no dependent children retired couple BAFI 1014 - Topic 1 Risk profiling Financial planners have an obligation to assess client's tolerance to risk in developing appropriate strategies and plans Risk is concerned with establishing a person's attitude to a loss in the value of their investments Usually based on questions established in client fact finder The two extremes are the conservative investor and the aggressive investor Financial planners must 'know their client' - Investment risk/security of capital - Income requirements - Liquidity requirements Why is personal financial planning important? continued Theoretical Income and expenditure over a lifetime BAFI 1014 - Topic 1 Purpose of Asset Allocation WHY? Need to understand risk profile of client High risk taker, Low or conservative risk taker Medium risk taker, Risk averse. Clients needs, Clients comfort level Construction of Portfolio Optimal Portfolio Compliance & Legal requirement Ongoing Relationship & business BAFI 1014 - Topic 1 How do we explain risk? 1. 2. 3. 4. 5. 6. Education Experience Booklets Plan appendices Discussion Risk Profile questionnaire What is the clients current understanding? BAFI 1014 - Topic 1 Understanding Risk Mismatch risk - Mismatching of a person's objectives, investments and time frame Inflation risk - Real value of investments may be eroded over time - Capital growth will help guard against the impact of inflation Interest rate risk: 2 aspects - Reinvestment risk When fixed assets mature, must reconsider current interest rates - Market volatility If fixed-rate investments are sold in an emergency situation, full value of investment will not be realised BAFI 1014 - Topic 1 Market risk - All markets have ups and downs - Some markets are more volatile than others Market timing risk - Very difficult to choose when to get into the market and when to get out Lack of diversification risk - Diversification reduces the overall risk of an investment portfolio - Investment portfolio should be diversified across a range of asset classes Currency risk - Applies if investments are valued on foreign currencies - Value of investment may rise or fall BAFI 1014 - Topic 1 Market/Stock Risk Source: Comsec BAFI 1014 - Topic 1 Liquidity risk - Always important to have access to cash for emergency purposes - Redeeming investments may be an expensive alternative Credit risk - Applies to investments such as term deposits, debentures, mortgages and bonds Legislative risk - Governments can make changes to current laws and regulations - Change in the rules may have either a favourable or unfavourable effect on investor's previous decision Gearing risk - If an investor borrows money to invest, loan must be repaid, even if the investment falls in value BAFI 1014 - Topic 1 Main Regulators 5 KEY BODIES APRA RBA ACCC ASIC ATO BAFI 1014 - Topic 1 REGULATORY FRAMEWORK Regulations and controls include: - Acts of parliament (Corporations Amendment (Financial Advice) Regulation 2015 - modified best interest duty for advice). - - - - Common law Statutory complaints resolution scheme Industry reform mechanisms Powers of ASIC BAFI 1014 - Topic 1 Financial Services Reform Act (FSRA) 2001 Objectives are to: - Promote confident and informed decision making by consumers of financial products and services - Reduce systematic risk and provide fair and effective clearing and settling facilities Various licensing regimes including Australian Financial Services Licence (AFSL) BAFI 1014 - Topic 1 Corporations Act 2001 Licensing regime in the financial products and financial services advice industry which defines the capacity in which a person can provide advice Authorised representatives: - Principals must hold an Australian financial services licence (AFSL) issued by ASIC - Principals must keep a register of their authorised representatives BAFI 1014 - Topic 1 Corporations Act 2001 Licensee's obligation to monitor and supervise representatives to ensure compliance Representatives must be adequately trained and competent Includes definitions of when a financial service is being provided Clear distinction is made between retail and wholesale clients BAFI 1014 - Topic 1 Financial Services Reform Act (FSRA) 2001 Provides single regulatory regime for: - - - - Financial services Financial products Financial markets Clearing and settling facilities Administered by ASIC BAFI 1014 - Topic 1 Disclosure requirements: Retail clients Point of sale disclosure Ongoing disclosure and periodic reporting Advertising requirements Obligation to provide confirmation of transactions BAFI 1014 - Topic 1 Disclosure documents Financial Services Guide - Contains all the contact details of the adviser and the company they represent, the types of products that the adviser can advise on, any details of remuneration, trailing commission, other benefits and third party relationships, details of the internal and external complaints resolution schemes an authorisation statement from the principals of the firm BAFI 1014 - Topic 1 Disclosure documents Financial Services Guide - Must be clearly labelled - Must be provided at the outset of dealings with a retail client, unless The client already has an FSG The product is a market-traded derivative BAFI 1014 - Topic 1 Disclosure documents Statement of Advice - Contains the advice, the basis on which it was given, information about the fees, commissions or association that might affect the advice, any warning if the advice is based on incomplete information details of one product replacing another BAFI 1014 - Topic 1 Disclosure documents Statement of Advice - Must be provided as soon as practicable and before any further financial service is carried out - i.e. must be given before a client commits to any strategy or signs up for any investment or risk management product Know your Client Rule - Corporation Act section 945 A. - Appropriate advice- Suitability Rule - Adequate research conducted - Know your product Rule FPA - Professional Rule of conduct Rules - 108-110. Source: www.fpa.asn.au BAFI 1014 - Topic 1 Writing a Statement of Advice (SOA) 1. Covering Letter 2. Cover Page 3. Executive Summary 4. Current Situation 5. Risk Profile Investment Portfolio 6. Strategy recommendations Social Security 7. Plan Review 8. Disclosures 9. Implementation 10. Authority to proceed 11. Projections 12. AppendicesGeneral Info Superannuation Income streams Asset Allocation Risk management Estate Planning BAFI 1014 - Topic 1 Disclosure documents Product Disclosure Statement - Prepared by the product issuer and is similar to a prospectus - Contains full details of the financial services product being offered the risks associated with the product fees and charges taxation implications any other information that may influence the client's decision BAFI 1014 - Topic 1 Disclosure documents Product Disclosure Statement - General rule: - Must be given to a client when an adviser recommends a product for investment or purchase - 3 tests must be applied to determine whether a retail client requires a PDS - Any financial services product using a PDS now includes a 14 day cooling off period BAFI 1014 - Topic 1 Code of Ethics (FPA) - Governing CFPs, - General Standards: 1. Integrity 2. Objectivity 3. Competency 4. Fairness 5. Diligence 6. Professionalism 7. Confidentiality 8. Compliance BAFI 1014 - Topic 1 Future Financial Advice (FOFA) Regime Purpose of FOFA: Implications for advisers/Clients/Industry - - - - - - Best Interest Duty (interest of clients) Opt in/ Opt Out Fee Disclosure Ban On Conflicted Remuneration Ban on Soft Dollar Benefits (extra bonus) Scale Advice (limited) Further Reading: http://futureofadvice.treasury.gov.au http://www.asic.gov.au/asic/ASIC. BAFI 1014 - Topic 1 FPAS' Rules of Professional Conduct - in the areas of: - Financial Plan Preparation. - Presentation & Explanation. - Implementation. - Minimum Education. - Competency, etc. BAFI 1014 - Topic 1 Analysing a client's financial position Having set financial goals, need to determine how they'll be achieved - (ie budgeting) - Balance sheet (assets and liabilities) - Cash budget (income and expenditure) - Income includes salary, wages, interest, profits, bonuses, fees charged, dividends, distributions, social security pensions or allowances, other earnings - Expenditure includes food, clothing, gas, electricity, rent, interest on loans, rates, entertainment, holidays, education, pay television, telephones, other expenses - Savings = income - expenditure BAFI 1014 - Topic 1 Financial Statements Example Personal Cash Flow Statement Collin and Carol Smith Income (2014) Collin (after PAYG tax) $100 000 Carol (after PAYG tax) 16 000 Rent 12 000 Dividends 2 000 Total $130 000 Expenses Food, clothing, utility $27 000 School fees, uniforms etc 30 000 Insurances 12 000 Repayments 32 000 Investments 14 000 Entertainment 15 000 Miscellaneous 8 000 Total 138 000 Surplus/deficit $ (8 000) BAFI 1014 - Topic 1 Projected Cash Flow Statement Collin and Carol Smith 2014 2015 2016 2017 2018 $130 000 $133 000 $137 500 $141 000 $145 Income 000 Expens 138 000 Net $(8 000) 142 000 $(9 000) 146 000 $(9 500) 138 000 $3 000 141 000 $4 000 BAFI 1014 - Topic 1 Personal Balance Sheet Collin and Carol Smith Assets House & contents $ 650 000 Cash 2 000 Vehicles (2) 70 000 Rental property 280 000 Share 48 000 Superannuation 400 000 Total $1 450 000 Liabilities Credit card $ 10 000 Home mortgage 180 000 Rental prop. mortgage 240 000 Car loans 30 000 Total $460 000 Net worth $990 000 BAFI 1014 - Topic 1 Using Financial Ratios As A Planning Tool Solvency Ratio = Net worth x 100 Total assets = $990 000 x 100 $1 450 000 = 68.28% This means that the Smiths' family assets would need to fall by 68.28% for their ownership of their assets to fall to zero. BAFI 1014 - Topic 1 Using Financial Ratios As A Planning Continued Liquidity Ratio = Liquid assets x 100 Current debt = $2000 x 100 $42 000 = 4.76% This shows the percentage of liquid assets to cover current. Multiply by 12 to show how many months of debt could be funded if income ceased and liquid assets were needed to meet current debt obligations. .0476*12= .5712 or half a month. BAFI 1014 - Topic 1 Using Financial Ratios As A Planning Continued Savings Ratio = Savings x 100 Net income = $6000 x 100 ($14,000 - $8,000) $130 000 = 4.62% Savings expressed as percentage of total income. It is likely that the savings ratio will be low for a young couple with small children and also for an elderly couple. BAFI 1014 - Topic 1 Using Financial Ratios As A Planning Continued Monthly Debt Service Ratio = Annual debt commitments/12 mths x 100 Annual net income/12 mths = $42 000/12 x 100 $130 000/12 = 32.31% This ratio can be used to indicate the effect of a particular course of action BAFI 1014 - Topic 1 Factors affecting financial planning Important to remember that many key players in the market place can affect the outcomes of a financial plan the economy - domestic and international - business cycles political system social environment Cannot establish a financial plan and investment strategy in isolation BAFI 1014 - Topic 1 A diagrammatic illustration of the business cycle Con tio trac an sio n Peak n Ex p % change in Real GDP Trough Time BAFI 1014 - Topic 1 Investment/Economic Clock TOP OF THE BOOM 12 Rising real estate values 11 Easier money 10 Rising overseas reserves 9 Rising commodity prices 1 Rising interest rates 2 Falling share prices 3 Falling commodity prices 4 Falling overseas reserves 8 Rising share prices 7 Falling interest rates 5 Tighter money 6 Falling real estate values BOTTOM OF THE RECESSION BAFI 1014 - Topic 1 Features Of The Economic Environment Four Stages in the Business Cycle 1. Boom or expansion - Employment and economic growth are high - Increase in inflation is cause for concern 2. Contraction - Economic growth starts to slow - Sales begin to fall - Unemployment starts to rise 3. Recession - High unemployment - Low (and possibly negative) economic growth 4. Recovery - Unemployment begins to fall - Economic growth starts to rise BAFI 1014 - Topic 1 History Of Financial Planning Industry From 1980 Historical Developments 1980-83 - 5% tax on superannuation payouts - Double dipping: pension plus lump sum 1983 - Rollover funds introduced 1985 - Capital gains tax (CGT) introduced 1986 - Fringe benefits tax (FBT) introduced 1987 - Double taxation ceased with the introduction of dividend imputation and franking credits 1990 - Simplifications to reasonable benefit limit (RBL) rules BAFI 1014 - Topic 1 History Of Financial Planning Industry From 1980 Continued 1993 - Superannuation guarantee introduced 1998 - Life expectancy policies introduced 2001 - 'Attribution rules' for pensioners commenced 2004 - Allocated pensions introduced - Reduction in calculation of assets under social security asset test for age pensions 2005 - Member choice of superannuation fund introduced BAFI 1014 - Topic 1 History Of Financial Planning Industry From 1980 Continued 2007 - Simple Superannuation law 2009 - The Ripoll Report (Financial Planning) 2010 - Henry Tax Review - Cooper Superannuation Review 2013 - Future of Financial Advice (FOFA) BAFI 1014 - Topic 1 History of Financial Planning Industry From 1980 Continued Economic Changes 1987 share market crash 1990 property trust freeze 1991 Pyramid Building Society closure 1992 Japan share market crash 1994 bond market crash 1997 Asian crisis 1998 Ralph Report (business tax law) BAFI 1014 - Topic 1 History of Financial Planning Industry From 1980 Continued April 2000 share market jitters 1 July 2000 Goods & Services Tax 2001 World Trade Center disaster 2001-02 corporate collapses 2002 falls in world market shares 2004 share markets rebound 2004-05 tsunami impact 2008 Global Financial Crisis (GFC) BAFI 1014 - Topic 1 Lessons for Investors and Financial Planners Be aware of: - - - - - - market cycles risks accompanying high returns benefits of diversification underlying portfolio of investment products scams need to review investments BAFI 1014 - Topic 1 Readings Further research Financial Planning Code of Ethics- www.fpa.asn.au Financial Ombudsman Service (FOS)- www.fos.org.au Regulatory Statements ( RG)- www.asic.gov.au RG 146 -Minimums Education Requirements RG 175- Financial Product advisers- Conduct & Disclosure BAFI 1014 - Topic 1 SUMMARY Personal financial planning is about setting in place some personal objectives and arranging financial means to satisfy those objectives Both financial planners and investors need to understand the risks involved and the economic and legislative environment Analyse risk - Topic 2 Analysing the risk and return of investments Financial Planning - Chapters 2 & 4 Jump to first page Analyze risk Topic 2 Learning Objectives Describe the importance of the time value of money Determine the present and future values of single and multiple cash flows, and explain the impact which compounding has on any investment alternative Understand the difference between nominal and effective interest rates Explain why risk measures are important Analyze risk- Topic 2 Learning Objectives Identify the types of risk commonly associated with investments Describe how the risk of a portfolio is determined Identify the risk characteristics of different asset classes Understand how diversification acts as riskreduction strategy Appreciate the diverse characteristics that might describe a client Financial Planning - Topic 2 Introduction Financial planning requires specialist knowledge across diverse areas. Technical skills are required in terms of investments: How they are affected by compounding. Their risk attributes. Their returns. Diversification as a risk-reduction strategy. Issues associated with gathering client information. Financial planners require strong working knowledge of fundamental mathematical concepts that relate to investment and retirement planning. These include a basic understanding of The nature of compound interest. The time value of money. Financial Planning - Topic 2 Time Value of Money Time value of money is a very important concept in financial planning. It is used as the basis of valuing all investments Concept that a dollar received today is worth more than a dollar received in the future. People prefer cash now rather than later because: Risk or uncertainty of future collection. Opportunity cost. Postponement of present consumption. Applying this concept allows financial planners to determine the financial needs and requirements of clients Financial Planning - Topic 2 Time Value of Money Source: - Australian Master Financial Planning Guide Financial Planning - Topic 2 Time Value of Money- Inflation Effect Effects of Inflation on Purchasing Power Source: - ABS Data Financial Planning - Topic 2 Time Value Terminology The number of time periods between the present value and the future value is represented by 'n'. The rate of interest for discounting or compounding is called 'i'. Present value is shortened to PV Future value is shortened to FV All time value questions involve four values: PV, FV, i and n. Given three of them, it is always possible to calculate the fourth. Financial Planning - Topic 2 Time Line - Compounding & Discounting 0 1 2 3 Future Value 4 Present Value FUTURE VALUE VS PRESENT VALUE Future value (FV) measures cash flows at the END of the project's life Present value (PV) measures cash flows at the BEGINNING of the project's life Financial Planning - Topic 2 Terminology Simple interest: - applies when interest is calculated only on the original principal or amount borrowed for the entire period of the loan Compound interest: - occurs when interest is calculated on the balance of the amount of the amount outstanding as income is reinvested Nominal interest rate: - is the annual interest rate when the compounding period may be more frequent than yearly Financial Planning - Topic 2 Simple interest -Calculating interest on a fixed deposit Cash is traded in the short term money market The interest is calculated on a simple interest basis, and paid to the nearest cent. I = PV x i x n where: I = Interest amount PV = Present value of cash deposit i = Interest rate per annum expressed as a decimal (e.g. 12% = 12/100 = 0.12) n = Number of days cash is on deposit 365 Financial Planning - Topic 2 Example 1 $10,000 deposited in the short term account with NAB at 2.00% for 90 days. What is the interest amount? I = PV x i x n = $10,000 x .045 x (90/365) = $110.96 Financial Planning - Topic 2 Future values Future value of a single sum is the amount that a sum will grow to on maturity Need to discount money that we will be receiving in the future when comparing with money we have now. FV = PV (1 + in) i.e. Future value = principal + interest PV = Present Value or price FV = Future Value or Maturity Value i = the interest rate n = number of days in period/365 or number of years full Financial Planning - Topic 2 Example 2 $100,000 is deposited in a term deposit account for 30 days. If the rate offered is 12.60% p.a., how much will be in the deposit account on maturity? FV = PV (1 + in) FV = 100,000 (1 + .126 x 30/365) FV = 101035.62 Financial Planning - Topic 2 Present value of a future amount Aim is to determine what an amount, that will be received in the future, is worth today. The factor that determines this is the applicable interest rate PV= FV (1 + in) Financial Planning - Topic 2 Example 3 You want to receive $4,560 in 4 years time. How much must you invest now at13% simple interest in order to receive the $4,560? PV= FV (1 + in) PV = 4560 1+ (.13 x 4) PV= 4560/ 1.52 = $3000 Financial Planning - Topic 2 Application in the money market Typical money market securities such as Short term notes and bonds, Bank bills, Treasury notes use simple interest calculations. The price of these are calculated as a discount to the face value. Eg. A bank bill which has 90 days to maturity has a face value of $100,000. What is the purchase price to achieve a yield of 2.25% simple interest? Present Value= Discounting PV = FV__ (1 + in) Financial Planning Topic 2 Application in the money market PV = FV__ (1 + in) PV= $100,000 (1 + 0.0225 x 90/365) PV= $100,000 1.00554794521 PV = $99448.26 Financial Planning - Topic 2 Compound Interest Used to calculate the amount of interest on the outstanding balance where the interest is reinvested onto the principal For each succeeding period that the interest rate is calculated, the principal figure has grown by the amount of interest earned in the previous period. Principle of compounding is a strong recommendation for establishing savings and investment programs early and sticking to them Financial Planning - Topic 2 Compound Interest continued Future Value Example $1000 invested at 8% for 4 years Interest in year 1 = 8% x $1000 Interest in year 2 = 8% x ($1000 + $80) $ 80.00 $ 86.40 Interest in year 3 = 8% x ($1000 + $ 80 + $86.40) $ 93.31 Interest in year 4 = 8% x ($1000 + $ 80 + $86.40 + $93.31) $100.78 Value at end of year 4 = $1360.49 Financial Planning - Topic 2 Compound Interest continued Future Value Formula FV = PV(1 + i)n where FV = future value of an amount invested today. PV = amount of present sum of money i = interest rate per period n = number of periods Using the formula for the example, we get FV = $1000(1 + 0.08)4 = $1360.49 Financial Planning - Topic 2 Compound Interest Example How much interest a $10,000 deposit earn over four years at an annually compound rate of 9.45% pa? Also how much interest has been earned over this period? Using the formulate: FV = PV(1 + i)n Interest earned = FV - PV FV= 10,000 (1+ .0945)4 = $14,350.36 Interest earned = 14350.36 - 10000= $4,350.36 Financial Planning - Topic 2 Present value compound interest of a single amount In interest rate markets, we use this formula to calculate the present value of the face value of a bond. PV= FV (1 + i)n Example : What would you pay for a cash flow of $50,000 to be received in three years if the three-year interest rate is now 7.82% p.a.(compounding)? PV = FV (1 + i)n PV = 50000 = 50000 (1+.0782)3 (1.25342393177) = $39890.73 Financial Planning - Topic 2 Nominal and Effective Interest Rates A nominal interest rate is the stated interest rate that a bank might quote. However, the value of the investment is affected by the frequency at which the interest rate is determined. The effective interest rate is the real rate after adjusting for frequency of compounding. Financial Planning - Topic 2 Nominal and Effective Interest Rates continued Since the time value of money formula assume annual compounding, to obtain the periodic interest rate (i) an adjustment must be made: The number of years (n) is multiplied by the number of compounding periods (m). The annual interest rate (j) is divided by the number of compounding periods (m). Periodic interest rate formula is i = j/m Financial Planning - Topic 2 Nominal and Effective Interest Rates continued Example Jason invests $1000 compounded quarterly at 9% p.a. over 4 years. Determine the FV. Solution Step 1: Multiply n x m i.e. new n = 4 x 4 = 16 Step 2: Divide j by m i.e. i = 0.09 / 4 = 0.0225 of 2.25% Step 3: Use normal formula i.e. FV = PV (1 + i)n FV = $1000 (1 + 0.0225)16 = $1427.62 Financial Planning - Topic 2 Nominal and Effective Interest Rate - Formulae For example a nominal interest rate is stated by the bank at say 6 %. What is the effective interest rate if paid semi annually? Effective Interest Rate : ie = (1 + i/m)m -1 = ( 1 + 0.06/2)2 - 1 = (1+ 0.03) 2 - 1 = 0.0609 = 6.09% where m = no. of compounding periods for annum Financial Planning - Topic 2 ANNUITIES An annuity is a stream equal periodic cash flows over a specified period Characteristics: has a fixed term to maturity is a regular stream of equal payments can be paid in arrears (general) or in advance Types of annuity Ordinary annuity : paid end of each period Annuity due : paid beginning of each period Deferred annuity : paid sometime in the future Perpetuity : payments continue forever Financial Planning - Topic 2 Annuities Continued Future value FV = C [(1 + i)n - 1] i Present value PV = C 1 1- 1 + i n i where: C = the per period cash flow n = the number of complete periods i = the per period interest rate Financial Planning - Topic 2 Example Calculate the future value of $1,000 invested each half year for 8 years at 10% pa, compounded semi-annually. Use formula Future value FV = C [(1 + i)n - 1] i FV= $1000 [ (1+.05)16 -1] .05 FV= $ 1000 [(2.18287458838) - 1] .05 FV= $23, 657.49 Financial Planning - Topic 2 Risk And Return: Definitions of risk the chance of loss of capital the chance of loss of purchasing power the variability of returns Financial Planning Topic 2 Risk and Return: Which stock has better return? Soup co. or Ice Cream co? Which stock has more risk? Year Soup 1 $9.00 2 $8.50 3 $14.00 4 $14.50 5 $15.00 6 $15.00 Ice Cream $1.50 $2.50 $2.75 $2.00 $2.75 $3.00 Return Return ice Soup cream -6% 65% 4% 3% 0% 67% 10% -27% 38% 9% Financial Planning Topic 2 Risk and Return: Expected return E(R) = mean of annual returns Soup co. E(R) = (-6% )+ 65% +4% 3%+ 0%= 13% 5 Ice cream co. E(R) = 67% + 10% +(-27%) + 38% + 9% = 19% 5 Note: Expected return can be more complicated with weighted expected return and include dividends Financial Planning Topic 2 Risk and Return: Standard Deviation of returns is a measure of the riskiness of an investment. Variance of returns Where X is the return in period i. n = number of periods. Stand deviation = Financial Planning Topic 2 Standard Deviation -Risk Soup co. = (-6 -13)2+ (65 - 13) 2 +(4-13) 2 + (3-13) 2+ (0-13) 2= 5 -1 4 = 8.42% = Standard Deviation = = 29.01% 33.67 Ice cream co. = (67-19)2 + (10-19) 2 +(-27-19) 2 + (38-19) 2 + (9-19) 2 = 51.17 5 -1 4 = 12.79 = Standard Deviation = = 35.77% Financial Planning - Topic 2 Standard Deviation -Risk Advisers View 1 SD - 66.7 % 2 SD - 95% where: E(R) is the expected return 1 is the standard deviation Financial Planning - Topic 2 Probability Distribution: Which stock is riskier? Why? 37 Financial Planning - Topic 2 How can diversification reduce risk? Risk refers to the variability of returns. Risk can be measured by using the standard deviation. For a portfolio, we must consider the risk and returns of the whole portfolio rather than just the individual components. The expected return for a portfolio is the weighted average returns of the individual shares. Financial Planning Topic 2 How can diversification reduce risk? Use a portfolio combinations of Soup and Ice cream! Year 100 %Soup 50/50% Ice Cream100% 1 2 67% 31% -6% 3 10% 37% 65% 4 -27% -12% 4% 5 38% 20% 3% 6 9% 5% 0% But also combinations of both. Financial Planning Topic 2 50/50% 100% Soup 90 % Ice Cream 10% Soup 100% Ice Cream Financial Planning - Topic 2 How can diversification reduce risk? Continued Portfolio risk is not simply a weighted average of the standard deviations of individual shares in portfolio. It is necessary to understand the concept of correlation between the shares. Financial Planning - Topic 2 Correlation Principle of correlation - to select the combination of assets within a portfolio that reduces the overall risk whilst maximising return Need to select those particular assets whose riskiness moves in different directions so that they cancel out each others' risk. The shape of the efficient frontier will depend on the correlation between the asset returns of the two assets. +1 positive correlation -1 negative correlation Financial Planning - Topic 2 How can diversification reduce risk? Continued The correlation coefficient shows the extent of correlation among shares. It has a numerical value of -1 to +1 which indicates the risk reduction between shares: Negative correlation (-1) Large risk reduction Positive correlation (+1) No risk reduction On average, the correlation coefficient for returns on two randomly selected shares would be in the range of +0.5 to +0.7. Icecream co. and Soup co. have a negative correlation = -0.24 Financial Planning - Topic 2 Adding Stocks to a Portfolio What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added? p would decrease because the added stocks would not be perfectly correlated, but the expected portfolio return would remain relatively constant. 44 Financial Planning - Topic 2 stock 35% Many stocks 20% 45 Financial Planning - Topic 2 Risk vs. Number of Stock in Portfolio p 35% Company Specific (Diversifiable) Risk Stand-Alone Risk, p 20% Market Risk 0 46 10 20 30 40 2,000 stocks Financial Planning - Topic 2 Diversification Across Asset Classes Financial Planning - Topic 2 The efficient frontier \"Sector Funds International Australian Equities Equities International Fixed Interest Return Property Mortgages Australian Fixed Interest Cash Risk Financial Planning - Topic 2 The Risk Return Relationship High International Shares Australian Shares THE PLACE TO BE Property Return Fixed Interest Low Cash Low High Risk Financial Planning - Topic 2 Application of the Diversification Decision Modern portfolio theory assumes there are only two asset types risky assets risk-free assets Financial planners need to help clients make decisions about investments in growth assets fixed-interest assets This will depend on a client's risk tolerance which can be assessed by risk profiling. Financial Planning - Topic 2 Application of the Diversification Decision continued Modern portfolio theory states the risk-return relationship by the formula: E (R pi ) Rf E(R p ) Rf p pi where: E(Rp) E(Rpi) p = pi = Rf = expected return on entire portfolio = expected return on the risky fund standard deviation of entire portfolio standard deviation of risky fund = risk-free interest rate Financial Planning Topic 2 Application of the Diversification Decision continued With modern portfolio theory, if you know risk a client appetite in terms of standard deviation of return, you can allocate them a correct portfolio to them. E.g. Risk free asset (treasury bonds) Rf = 6% Risky Asset (fund) E(Rpi)= 16% and pi = 12 % Desired risk is p = 9 %, E(Rp)= 6% + 16% - 6% (9%) = 13.5% 12% E(Rp)= [E(Rpi) - Rf]X + E(Rf) 13.5 = [16% - 6%]X + 6% = X = 75% 75% should be allocated to risky fund. Financial Planning - Topic 2 Stand-alone risk = Market risk + Diversifiable risk Market risk is that part of a security's standalone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a security's stand-alone risk that can be eliminated by diversification. 53 Financial Planning - Topic 2 Math formulae of Return and Risk R R n p i i i 1 R p 1 R1 2 R2 E R p 1 E ( R1 ) 2 E ( R2 ) S E R p E ( R p ) E 1 R1 E ( R1 ) 2 R 2 E ( R2 ) 2 p 2 2 2 12 12 2 2 212 E R1 E ( R1 ) R2 E ( R2 ) E R1 E ( R1 ) R2 E ( R2 ) Cov R1 , R 2 1,2 Cov R1 , R2 12 1 2 Var ( R1 )Var ( R2 ) 2 2 2 p 12 12 2 2 212 1,2 1 2 2 Financial Planning - Topic 2 Correlation of +1 2 p 2 12 (1 ) 2 2 2 1, 2 (1 ) 1 2 1, 2 1 2 p 2 12 (1 ) 2 2 2 (1 ) 1 2 ( 1 (1 ) 2 ) 1 (1 ) 2 2 Correlation of -1 p 2 2 12 (1 ) 2 2 2 (1 ) 1 2 p 1 (1 ) 2 2 Financial Planning - Topic 2 Data Collecting And Information Gathering Relevant issues include: Refer To ASIC's RG175 Concern regarding inflation Need for current income Liquidity requirements Desire for capital growth Concern about taxation issues Attitude toward security of the investment Financial Planning - Topic 2 Data Collecting And Information Continued Desire for ease of management Impact of decisions on estate planning needs Desire for flexibility of any investments Time frame over which any investments will be made Comfort with short-term volatility of returns Financial Planning - Topic 2 SUMMARY A financial planner needs to understand the time value of money. Simple financial mathematics enable financial planners to calculate the value of different investments in different time periods. Investment advice needs to be based on the specific needs of the client. BAFI 1014 Topic 3 Direct Investment Financial Planning - Chapters 4,5& 6 BAFI 1014 Role of Financial Planner & Financial Planning Process SOA Life goals tracking Cashflow Management Retirement Income Streams Banking Tax planning Our Clients Social Security Planning Superannuation Strategy Debt Advice Wealth Accumulation Estate Planning Risk Management Investment Strategy BAFI 1014 Investment objectives and strategies Investment objective: - represents the desired outcome in a specified time frame: people differ in their objectives people's objectives can be influenced by many factors (eg. culture, age, attitude to risk) - guiding principle when setting objectives: understand your client's needs so you provide investment services they will value and appreciate Investment strategy: - is the means used to achieve the investment objectives: investor allocates funds between asset classes; or purchases products where this decision is made for them BAFI 1014 Investment Objectives of Investors Access Income Capital Growth Combination of income and capital growth Speculative Tax Driven Investments Philosophical Investing eg/Ethical/Environmental Educational Reasons- Investment Clubs BAFI 1014 Asset classes The choice of asset classes consists of the following: - cash - interest bearing deposits (domestic and international) - shares (domestic and international) - property Selection into particular investments can be made directly or indirectly The selection of the appropriate asset class and mix of assets will depend on a number of factors relating to the client's circumstances BAFI 1014 Direct investment occurs when investors make their own decisions where funds are ultimately placed. Indirect investment involves investors placing their funds with fund managers. Direct investment is very popular in Australia. It is important to appreciate the nature and structure of the relevant markets BAFI 1014 Cash And Fixed-interest Securities Participants in the fixed-interest markets include: - - - - - - - depository financial institutions (DFIs) non-bank financial institutions (NBFIs) insurance companies funds managers private individuals ordinary businesses governments BAFI 1014 Overview of the financial system Federal Government The Reserve Bank The Financial System Sydney Futures Exchange APRA AFMA Businesses Households Intermediaries Banks Specialist banks Non-banks Australian Stock Exchange ACCC AUSTRAC Debt market Lenders & Savers Governments ASIC Intermediation Derivatives market Foreign exchange market Offshore End Users Intermediation Investors Borrowers Importers Exporters Equities market BAFI 1014 Participants in the Fixed-Interest Markets continued These participants may taken on various roles as: - lenders - borrowers - both lenders and borrowers BAFI 1014 The Nature of Markets-Fixed Interest Essential features - Interest rate set at start of loan period - Fixed face value (principal) All interest rates are based on cash rate which is the interest rate paid on money lent between commercial banks overnight. Margins added to compensate lenders for increased risk and increased time to maturity. The cash rate is managed by the RBA by manipulation of the money supply to inject or withdraw funds by buying or selling securities. Fixed-interest investments can vary from immediate access to up to 20 years. Two types of fixed-interest markets: - Money market (short term) - Capital market ( long term) BAFI 1014 The Nature of Markets and Products continued Commercial bills are usually of 90-180 days duration and have higher risk and higher returns. Corporate debentures are long-term securities that pay regular interest at fixed rates on face value. Unsecured notes are riskier and offer higher interest rates. Government and semi-government bonds enjoy very good security ratings. Trading of securities occurs in the primary market initially and later in the secondary market. There is an inverse relationship between the price of a bond and interest rates. The difference between selling price and the face value is the interest, hence bonds can be traded at a discount or at a premium . BAFI 1014 Deposit products and non cash payment services Commercial banks provide both at call deposit accounts and Term Deposit Accounts to all clients. Subject to PDS, at call deposit accounts allow you to access your funds at any given time. Term Deposit Accounts are deposits where if you leave your funds in the account for a fixed term you will earn a fixed rate of interest. The current brands include: Trust account Cheque account At Call investment account Term Deposit Account BAFI 1014 Non-Cash Payment Services Online banking (Internet banking & Mobile banking) Rapid Response telephone banking BPAY bill paying service Visa Debit card Personal cheques Regular payments, Direct debit Customer loyalty schemes BAFI 1014 Risks of fixed interest investments Economic risk ie Credit crisis & monetary policy Market sector risk- Bond Rating Political risk- Government changes Liquidity risk - Corp v's Government Credit risk - Issuer may default on payments - US Mortgage Backed securities - Default on sub prime mortgage securities - Govt Treasuries attractive at low returns - Interest and capital default - Trading versus holding to maturity S&P Ratings/ Fitch Ratings & Criticism - - AAA to D & Default risk - Credit risk - Measure of guarantee BAFI 1014 Normal yield curve & Market conditions Yield Terms Yield to Maturity Current Market or RBA influence Long bond rates> short term Inflations & I.R expectations Source: SMH Dec 2014 http://www.smh.com.au/business/markets/the-most-important-charts-to-watch-in-2015-20141218-12a37z.html BAFI 1014 Example A security with a face value of $1000 has 180 days to maturity and sells for $970. What is the discount at which the bond is sold and the yield on the investment? Solution Discount on face value = 30/1000 x 365/180 = 6.08% Yield on investment = 30/970 x 365/180 = 6.27% Note : Fixed-term investments appeal to more risk-averse people because: - There are guaranteed interest payments at a given level. - The level of capital remains fixed which means there is a low risk of loss. BAFI 1014 Types of fixed interest investments Debt Securities Treasury notes and bonds Indexed/adjustable rate bonds State/semi/local Government bonds Corporate bonds Bank and non-bank bills Promissory notes Convertible notes and hybrids Debentures Unsecured notes Fixed interest managed investments Term deposits Short Long Discount Long Term Risk - Investor- Liquidity Yield- Tender, Maturities BAFI 1014 Two common fixed interest investments for retail investors 1) Government Bonds - Exchange Traded Treasury Bonds (eTBs): - Exchanged Traded Index Bonds (eTBs)- adjusted for inflation http://australiangovernmentbonds.gov.au/ BAFI 1014 Two common fixed interest investments for retail investors Corporate Bonds - Exchange Traded Bonds (XTBs) - An exchange traded bond designed for small retail investors http://xtbs.com.au/ BAFI 1014 Property In Australia the rate of home ownership is one of the highest in the world. As an investment, property can offer: - A stable income stream - Capital growth in excess of inflation over the long term. Participants in the property market include: - Investors as owners - Residential tenants - Commercial tenants - Valuers, brokers and agents BAFI 1014 There are number of classes of property: residential, commercial, industrial and rural. Returns are dependent on - - - - Type of property Position of property Continuity of rental stream Cost of upkeep TAXATION OF PROPERTY Rental income is assessable income Legitimate expenses are deductible Investment in property has both - CGT implications, and - GST implications BAFI 1014 Property Prices in Melbourne (All sales) Also remember that investors will be leveraged! Source: http://www.dtpli.vic.gov.au/property-and-land-titles/propertyinformation/property-prices BAFI 1014 Considerations for Purchasing a Home Finance out of savings or by monthly payments out of wages Expected to continue to live in same area Life style and personal satisfaction BAFI 1014 Shares (Equities) Shares have historically offered higher returns than other asset classes, over the long term. They can offer regular income. They can provide strong capital growth. Australian shares can offer the added tax benefit of dividend imputation. Participants in the equities market include - Listed corporations - Investors - Brokers - Hedgers - Speculators - Arbitrageurs BAFI 1014 World Indices US Dow Jones 30 ,S & P 500,NASDAQ, Russell England FTSE 100 German Dax Index France CAC 40 Australian, All ordinaries China ,Shanghai Composite, Hang Seng Indonesia Jakarta Composite Malaysian KLSE Composite Japan Nikkei 225, Topix BAFI 1014 Nature of the Equities Market Bulk of trading occurs on stock exchanges, with the ASX having a monopoly in Australia. Listed companies are divided into industrial (80%) and resource sectors. Market price is determined by interaction of supply and demand. There are various classes of shares. Ordinary & Preference Shares offer an investment of with limited liability. BAFI 1014 Shares/Equity Characteristics - - - - - Represents an interest in / ownership of a firm. Can share in a company's successes and failures. No guarantee of return on capital. Payment by companies of dividends is optional. Normally ranks last in event of liquidation. BAFI 1014 Investing in Stocks /Shares Advantages - - - - - May provide income. May provide capital growth. May be tax effective. Generally liquid. Can provide diversification benefits. Disadvantages - Involves risk. - Income and cash flow are not assured. - Ranks behind all creditors in event of liquidation. BAFI 1014 The global industry classification standard (GICS) Economic sectors Industry groups Energy Energy Materials Materials Industrials Capital goods Commercial services and supplies Transportation Consumer discretionary Automobiles and components Consumer durables and apparel Hotels, restaurants and leisure Media Retailing Consumer staples Food and drug retailing Food, beverage and tobacco Household and personal products Healthcare Health care equipment and services Pharmaceutical and biotechnology Financials Banks Diversified financials Insurance Real estate (listed property trusts) Information technology Software and services Technology hardware and equipment Telecommunication services Telecommunication services Utilities Utilities BAFI 1014 Analysis of Share Prices PASSIVE ACTIVE Fundamental Technical Contrarian Value investing Top-down thematic (macro) Bottom-up (micro) Quant Growth investing Top-down thematic (macro) Bottom-up (micro) Share prices are determined by market forces which are subject to the influence of many risk factors. BAFI 1014 Types of risk- Equities Business risk - the risk that a company may not be well run resulting in poor outcomes for shareholders in terms of income and capital growth. Credit risk - the risk that a company may not be able to meet its financial commitments (e.g. OneTel, Enron). Reputation risk - where a major incident involving a company causes a loss of faith by the market, devaluing its shares. BAFI 1014 Types of risk- Equities Market risk - loss of confidence in the sector or overall market can have a drop in share value. Political risk - stability of the present or future Government policies can affect the capability of companies to perform. Liquidity risk - the shareholder may be unable to find a buyer at the desired price. BAFI 1014 Types of risk- Equities Inflation risk - increases in overheads, costs and margins could adversely affect company performance and shareholder outcomes. Income risk - there is no certainty of dividend payments. Information risk - a case of poor/lack of information can cause a wrong investment decision or is incorrectly interpreted. BAFI 1014 Methods of analysis include: Fundamental analysis uses objective measures to analyse a company's current financial position. It involves studying three main factors in an attempt to determining the best time to invest: - 1. Firm specific factors ,(i.e. its performance, level of debt, dividends, management, future direction, asset base and competitive advantage). - 2. Industry wide factors,- (quotas, tariffs ). - 3.Economy wide factors , (unemployment, inflation, movements in interest rates, exchange rates, ) Fundamental Analysis can be usually divided into 2 levels: - bottom up approach focuses on the firm level predominantly and then moves towards analysing the economy level - top-down approach looks predominantly at general economic trends before moving towards analysing the firm level BAFI 1014 Bottom up approach Analysis the company initially to determine whether the company is under or over performing compared to its intrinsic (fundamental) value. One of the traditional methods of analysing financial statements is to perform ratio analysis - need to recognise limitations of ratio analysis Significant amount of information is available in the market place BAFI 1014 Contrarian strategies or \"picking the dogs\" Contrarians believe that investors tend to overreact to recent news causing the price to vary from its fair value Fads may also cause investors to overreact Price variations will correct themselves By going against the trend, contrarians hope to profit when investors realise they have oversold out-of-favour companies Ratios to consider Low P/E ratios, high dividend yield , low ratio of price / net tangible assets BAFI 1014 Commonly used ratios Earnings per share (EPS) - provides an indication of company profitability - calculated as: Operating profit after tax No. of ordinary shares Price / Earnings ratio (P/E ratio) - shows how much the market is prepared to pay for shares in relation to reported profits - calculated as: Current market price EPS BAFI 1014 Commonly used ratios Continued Dividends per share (DPS) - provides an indication of company profitability and payout of dividends - calculated as: Dividends to ord. shareholders No. of ordinary shares Dividend yield ( DY) - relates the dividends paid to the current market price - provides an insight into the return on investment - calculated as: DPS Market price BAFI 1014 Value and growth investing Value investment characterised by: finding undervalued shares (low P/E ratio) finding overvalued shares waits for market to correctly price the shares Growth investment characterised by: select shares with high growth prospects (high P/E ratio) prefer to invest in smaller companies BAFI 1014 Technical analysis Attempts to predict future share prices by studying past behaviour of markets as a guide to their possible behaviour Analysts believe that investors are moved by market psychology - ie herd mentality enables some sort of predictability in movements Tools for this include the following: - charting historical prices and volume - trend and cycle studies - investor sentiment - behavioural studies - looking at technical indicators (moving averages,momentum oscillators BAFI 1014 Chart Analysis - BHP BAFI 1014 Technical indicators numerical indicators the purpose which is to signal to the trader buying and selling opportunities purpose is to smooth out fluctuations to determine underlying trends 5 day moving average Day Share price 5 day average 1 1.18 2 1.25 3 1.25 4 1.30 5 1.32 1.26 6 1.28 1.28 7 1.30 1.29 8 1.40 1.32 BAFI 1014 Investment Consideration Whatever be the choice of assets classes, there are a number of factors that investors must take into consideration. Client objectives whether it's financial or lifestyle is your prime focus BAFI 1014 Investment Consideration Continued 1. Liquidity - how easily the asset can be converted into cash to pay short term debts - the greater the liquidity, the lower the yield Investment liquidity Savings and cash management trust High Government bonds Medium Debentures Medium - low Listed stocks Medium Property Low BAFI 1014 Investment Consideration Continued 2. Investment horizon - the selection of investments must be tailored to the investor's time frames - generally investors with a longer time frame can usually accept greater risk / volatility as a trade-off for higher returns - investors with a short time frame will be concerned with protection of capital - what sort of asset allocation would be required for a 2 year time horizon as compared to a 7 year time horizon? BAFI 1014 Investment Consideration Continued 3. - - 4. - - 5. - Taxation each investment has its own taxation attributes and impact upon the investor's tax position need to ascertain how important tax is in constructing a portfolio Diversification achieving optimal return for the given level of risk diversification is insurance it reduces risk, BUT AT A COST Transaction costs entry, exit, broker fees, estate agents, solicitors, accountants BAFI 1014 Investment Consideration Continued 6. Timing - how important is it to time the market? consider efficient market hypothesis Strategies to eliminate timing problems - long term investing - dollar cost averaging BAFI 1014 Investment Consideration Continued 7. Return need to determine the reason for investing major role of financial planners task is to find right balance between income and growth. Will need to consider taxation also choice between investing in assets that yield regular income and those that have better potential for capital gain or combination of both income only income and growth growth only BAFI 1014 Investment Consideration Continued 8. Risk analysis What is risk analysis a framework for understanding risk, comparing the risks of different investments, and analysing the relationship between risk and return Principle of risk - reward trade-off generally, investors seek the best return from investments with the lowest level of risk Different investors have different risk profiles and it is important to know the level of risk the investor is willing to accept an investors tolerance to risk can be measured to an extent by risk tolerance Establish efficient frontier BAFI 1014 Understanding the clients Financial Concerns Part of Risk Profile Questionnaire Clients Issues Time Horizon Liquidity Tax Benefits Accessibility Stability/Capital security Diversification Investment Income Estate Planning Investment Risk Capital growth Insurance Retirement Goals BAFI 1014 Types of risk Awareness of types of risk can assist in trying to reduce its impact. Systematic (market) risk - portion of investment return variability that is caused by factors affecting the value of all comparable investments - cannot generally be reduced through diversification - factors affecting systematic risk result from: economic, political and sociological factors Unsystematic (specific) risk - represents that portion of risk unique to a firm, industry or property - factors affecting an investment are independent of factors affecting other investments - can be reduced through diversification BAFI 1014 Risk options Cautious/Risk Adverse - 100% income Conservative - 30% growth, 70% income Prudent/Balanced - 60% growth, 40% income Growth - 70% growth, 30% income Aggressive - 90% growth, 10% income BAFI 1014 Asset allocation by types of investors Asset class Conservative Cautious Prudent Assertive Aggressive Cash Fixed interest domestic Fixed interest - intern'l Property Shares - domestic Shares - intern'l 25 75 - 10 60 10 15 5 10 25 5 10 35 15 10 10 5 10 40 25 10 5 45 40 Time frame 1 yr. 3 yrs. 5 yrs. 7 yrs. 10 yrs. BAFI 1014 Asset allocation Is the process of determining the mix of investments in a portfolio among different asset classes having in mind the investment outlook and the risk / return objectives of the investor: objective is to find an allocation which is appropriate for the investor and aims to provide the most efficient portfolio. asset allocations range from conservative through to aggressive financial planner has to devise a strategy based on needs and objectives of client (know your client and products) empirical evidence indicates that consistent long-term performance is more attributable to process of correct asset allocation than exact investment selection BAFI 1014 Asset allocation From the latest details forwarded to you from the manager of a managed fund, you note the following details relating to the strategic and tactical asset allocation of funds. What does this information tell us about the markets and the approach adopted by the manager? Asset class Strategic asset allocation % - - - - - Cash Bonds Property Domestic equity International equity Tactical asset allocation % 5 30 10 35 20 Current allocation % 0 -10 25-35 5-20 20-45 15-25 4 26 5 40 25 BAFI 1014 Approaches to asset allocation Strategic - focuses on long term performance objectives to establish asset mix - portfolio will need to be amended from time to time to bring portfolio back to original mix Tactical - changes the asset mix based on predictions of how the investor expects the market to perform - asset switching occurs in an attempt to outperform the market BAFI 1014 Investment approaches Buy and hold Timing the market Dollar cost averaging BAFI 1014 Buy and Hold All Ordinaries 1996 - 2016 (20 Years) BAFI 1014 TIMING THE MARKET Time will smooth out volatility... Sept 2007 - 7 mths on $ 100,000 Sept 2007 - 6 yrs on $ 200,000 95,000 90,000 150,000 85,000 80,000 100,000 75,000 50,000 70,000 Sep-07 Nov-07 Jan-08 07 08 09 10 11 12 13 BAFI 1014 Dollar cost averaging Is a strategy of investing fixed amounts at regular intervals regardless of market trends Avoids the need to pick the highs and lows of the market Smooths out the average cost of an investment because the fixed amount of money buys more units of the investment when the price is low and less when the price is high Provides a saving discipline How does it Work Month Monthly Investment Cost per unit $ January February March April May June Total $200 $200 $200 $200 $200 $200 $1,200 Number of units purchased 1.00 0.90 0.90 1.05 1.05 1.00 i:SALE/ppt library/Dollar Cost Ave.ppt 200 222 222 190 190 200 1,224 61 BAFI 1014 The benefits of dollar cost averaging Value of a $ 1000 investment and $200 per month in the Advance Imputation Fund $94,993 $7,267 Value of $1,000 in the Advance Retail Imputation Fund Source: Colonial First State Retail Imputation Fund, excluding fees, tax and charges Data to 31st July 2004 Note: All Fund performance figures are stated after fees. Performance has been calculated based on exit price to exit price. Distributions paid have been treated as being reinvested in the period of entitlement. Performance does not take into account initial application fees. These figures represent past performance only. No guarantee of future returns is implied. Recent performance of asset classes Annual gross investment returns for 3- and 5-year periods to January 2016 (%) Property- Generally moves in line with GNP and inflation Shares- Performance can be seen in terms of the All Ordinaries Index Fixed-interest securities -The cash rate is central to interest rates Year (1 Jan) Cash Fixed Interest Listed property Australian shares Int. Share 3 years 2.46% 5.03% 13.68% 5.14% 20.90% 5 years 3.15% 6.46% 14.05% 5.32% 12.96% Source: Vanguard BAFI 1014 Time plus rate equals even more money Irene Saved $2,000 a year from age 30 for 10 years Total contributions $20,000 earning 7% pa. Steven Saved $2,000 a year from age 40 for 25 years Total contributions $50,000 earning 7% pa. Michael Saved $2,000 a year from age 30 for 10 years Total contributions $20,000 earning 9% pa. Value at age 65 ???? BAFI 1014 Time plus rate equals even more money Michael $285,000 Irene $160,000 Steven $135,000 AGE BAFI 1014 Common strategies for creating and preserving wealth Income Splitting- Take advantage of Tax Free Threshold. Dividend Imputation- Reduce tax individual liability Derivatives - Options, Futures, Warrants etc. Superannuation; Salary Packaging & Personal Risk Protection Income versus Capital- Client individual long-term needs Gearing; Leveraging, Capital Growth and Tax Benefits, and Diversification strategies reduce risk. Investors need to decide between 'growth' and 'value' investments. Issues that need to be considered are: price to earnings (P/E) ratio yield; buying with 'growth' in mind; buying with 'value' in mind & portfolio performance BAFI 1014 Topic 4 Managed FundsIndirect Investment Financial Planning - Chapter 7 Role of Financial Planner & Financial Planning Process BAFI 1014 SOA BAFI 1014 Global Perspective-Funds Management BAFI 1014 Australia's Funds Management Structure BAFI 1014 Introduction The managed fund industry is made up of: - superannuation funds - unit trusts - managed investment schemes - Friendly society and life insurance bonds - Allocated Pensions It is important to understand the role of managed funds in a balanced portfolio. BAFI 1014 Introduction Estimated at $2649.2 billion worth of funds under management at 30th December 2015 (ABS 5565.0). Unit trusts, pooled investments, managed investments, investment funds, cash funds. Indirect investments Retail, Mezzanine & Wholesale Diversification benefits Investment Professionals Distribution mainly through financial planners Legal Tax structures ie Unit Trusts Product Design & Asset Allocation BAFI 1014 Smorgasbord of Investment options Clients Objectives ie Income Growth Risk Profile and Asset Allocation Diversified Portfolios v's Sector Asset Classes Specialised Funds- Asian, Ethical Funds Legal and Tax Structure Specialised Fund Managers & Blending Diversification - Absolute Funds International investment allows superior investment performance in terms of risk and return, and pension funds are well placed to take advantage of the benefits BAFI 1014 Players of Managed Funds Investment Managers Portfolio Managers Investment Analyst Investment Strategist Economist Business Development Managers Financial Planners Large Institutions e.g Life Insurance Companies, Banks, Boutiques etc. Internet companies- Morningstar, DirectInvest BAFI 1014 The Basics of Managed Investment Funds in Australia A managed fund is a type of financial services organisation that receives money from its investors and then invests that money on their behalf in a diversified portfolio of various assets. It is unlisted, not on stock exchange. Involves pooling money with many other investors. Managed investment funds have been available to investors in Australia for a long time. BAFI 1014 Characteristics of Managed Funds A managed fund is characterised by the: - Type of asset the fund invests in - Management structure - Regulatory structure required for its operation Managed funds provide investors with a pooled investment structure with: - Decreased costs - Decreased risks - Increased returns BAFI 1014 Regulation of Managed Funds in Australia Three pillars of financial services regulation ASIC - Monitors managed fund industry - Ensures compliance with legislation - Regularly issues policy statements outlining changes and areas of concern APRA - Supervises banking and financing industry (Prudential regulation) RBA - Monetary policy, systemic stability and payment systems regulations Industry bodies impacting on managed investment markets are: -Financial Services Council (FSC) -ASX - SFE BAFI 1014 The Managed Investment Industry in Australia - - - - - - TRUST The trust deed The trust manager The trustee MANAGED INVESTMENT TRUST Constitution and compliance plan Prospectus Product disclosure statements (PDS) (Risk, Cost, Return) - A single Responsibility Entity (RE) (a public company holding an AFSL) - Unit holders (investors) BAFI 1014 The Operations of a Managed Investment Scheme Investor completes application form in prospectus and submits with cash. monies are collected into marketable parcel for investing in the listed assets. Certificate issued to investor and a statement of fees. Income earned on fund released to unit holders periodically. Change in value of the assets reflected in changes in the unit price. BAFI 1014 Using Managed Funds as an Investment Strategy Managed funds provide investors with a greater choice of assets than direct investing. Using managed funds helps investors build a diversified portfolio of investments. Broadening out of risk-return frontier Wider range of assets for Asset Liability Management purposes Shortfall risk more evenly balanced Take advantage of the benefits of international investment BAFI 1014 Benefits of Diversification Diversification across managers - Active or passive approach to investing - Index-linked portfolio ma