Exchange Traded Funds Essay

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ETFs

The first step is setting up an investment account is to understand the client. Everything flows from this. The client profile is developed through an extensive interview process, wherein the advisor seeks to gain an understanding of the client's personal circumstances, current and envisioned financial situation, risk tolerance and investment knowledge (Anthony, 2011). With this information, the financial advisor can then build a profile based on the portfolio objectives and risk constraints. For this portfolio, the focus will be on exchange-traded funds. The objective of this exercise is to build the optimal portfolio for the client, taking into account the client's personal circumstances and the variety of funds that are available to build the portfolio.

Client Profile

The client is a male, late 20s, with a long-term girlfriend. They have no current plans for children. They are American, living and working in Miami, and therefore are eligible to purchase securities on American exchanges. The client recently graduated with an MBA in Finance, and has taken a job with an investment bank, the current role doing forex at the Miami office, where the specialty is Latin American currencies. The client has set aside this initial $100,000 for an investment fund. The client has another savings account of $200, 000, but this is earmarked as a down payment for the purchase of a house on a canal. The client has also started a tax-protected retirement fund. So the total investment funds are $100,000 at this point. The client expects that his earnings and those of his girlfriend will be sufficient to cover all living expenses, so the investment fund constitutes money that is not expected to be used any time soon. It is purely a saving account. The time horizon therefore is retirement, which the client expects will be 30-40 years hence.

Armed with a master's degree in Finance and a job in forex, the client is a sophisticated investor. While he has not studied derivatives or arcane instruments extensively, the client has the background knowledge to get up to speed on any investment product quickly. The client is fully aware of market risks, the relationship between risk and return, and other basic financial concepts. He is familiar with and subscribes to the efficient market hypothesis. The client has explicitly stated that with this fund he has a high risk tolerance, owing to his high level of financial knowledge and the fact that the account has a long time horizon.

Asset Allocation

The client has a long time horizon, high level of investment knowledge and high risk tolerance. The client also does not believe that he can beat the market, so is willing to accept funds. Further, because of the client's view, he prefers funds with low MERs, so exchange-traded funds are ideal, since he only pays the upfront transaction cost, and then the transaction cost again upon disposition. An MER is the expense ratio, the fee that is taken by the fund manager for the managing of the fund to cover operating costs. This is expressed as an annual percentage of the fund's value (Investopedia, 2013).

For a client with a long-term time horizon and little risk of needed the money in the short run, the basic assumption is that a riskier portfolio can be constructed. For this client, the stated acceptance of high risk confirms this. The portfolio can be 100% equity at this point, as Costa (2011) notes for the "dynamic" portfolio. Cash can be held during periods of uncertainty but at this point there is little cause for uncertainty in the markets. Within asset classes, there are a mix of risks, so that should be taken into consideration. Not all options are internally diversified. Something like, for example, ProShares Ultra Pro-Financials is a basket of financial companies, so would be affected more by changes in interest rates than would a basket that featured a broad-based index or another industry. The basket therefore should focus on 4-5 different asset classes. A total of 40% in moderate risk classes and then 60% in broad-based ETFs. This portfolio would have a high-risk construction, featuring a beta of at least 1.2 (maybe up to 1.4), thereby giving the client the expectation of returns above the market average. The downside is that these funds will sometimes have MERs, which would reduce the real return on the funds. If they are priced rationally already, then the rational investor might not want to have funds that have MERs, because they would not offer a positive risk-adjusted rate of return.

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The objective for the client at this point, however, is to earn a higher return over the long run, and to do this we need to invest a portion of the portfolio in higher-risk sectors. This move is expected to yield above-market returns in the long-run. The client can bear this risk because there is no need for the funds in the foreseeable future -- the time horizon is 30-40 years.

Exchange Traded Funds

An exchange-traded fund is a fund that "tracks an index like the Nasdaq 100 Index, the S&P 500 or the Dow Jones" (NASDAQ, 2013). Exchange traded funds have the objective of replicating the performance of their index. ETFs have several benefits. The first is that they provide diversification. With a total portfolio value of $100,000, it will be difficult to get diversification for the client buying stocks directly. The use of ETFs or mutual funds will be required to get a properly diversified portfolio. Another benefit is that the transaction costs are lower with ETFs, compared with building a portfolio. Only a few transactions are needed with ETFs compared with dozens when buying equities, and the diversification will probably be greater. ETFs are a good value method of building a portfolio (Costa, 2011).

Another benefit of exchange traded funds is that they are suited for passive management, because they are intended to mirror marketing performance. This fits in with the efficient market hypothesis, something my client expressed belief in. Further, the fund managers only need to make periodic changes to the funds, which results in lower management costs (MERs) when compared with actively-managed funds (Costa, 2011). ETFs are a low-cost method of investing for those who prefer the passive management style (NASDAQ, 2013). It should be also noted that ETFs are more tax-efficient than actively managed funds, because there are fewer capital gains accrued in a given year, due to the lower transaction volume (Iachini, 2012).

Flexibility is another advantage of exchange traded funds (ETFs). The fact that they are traded on exchanges enhances liquidity, and perhaps more importantly they can be traded during the day. The client therefore locks in the price at the point of the decision to sell. This contrasts with mutual funds, where prices are set at the end of the day. This can be financially damaging when the market is declining rapidly, because the client is unable to sell during the trading day, and therefore accrues all of the losses that occur after the sell decision has already been made (Hansen, 2006).

Choice of Funds

Morningstar outlines the different ETFs that are available. The first decision is with respect to the 50% that is going to be allocated to a broad-based ETF. The decision here is the choice of exchange. The NASDAQ 100 is weighted towards technology companies, Dow funds represent a sufficient degree of diversification while the S&P 500 provides the greatest degree of differentiation. These indexes have slightly different performance characteristics. With a 40-year time horizon, it is impossible to tell which of these is likely to increase the most, but of them the S&P 500 is the least volatile and the NASDAQ the most.. The NASDAQ's heavier-than-average exposure to tech gives it greater growth potential, but the client intends to use the remaining 60% of the portfolio to pursue growth. This 50% is the safety part of the portfolio, so an S&P 500 fund is going to be chosen. The recommended fund is the Guggenheim S&P 500 Equal Weight. Many S&P 500 funds are weighted towards a specific industry, but that is not the mandate of this part of the portfolio. This fund gives equal weight to the index, rather than the market weight. This means that each stock within the portfolio is given the same weight, subject to occasional rebalancing. Each stock is given 0.2% of the fund. The result is a slightly greater emphasis on smaller-cap stocks with growth potential, while retaining a fund that has mainly large caps. The long-run performance of this fund is superior to the S&P 500 (Morningstar, 2013). This fund is rated five stars by Morningstar and has an MER of 0.4% (Morningstar, 2013).

Another 10% will be allocated to the iShares Dow Jones, which gives exposure to the largest U.S. companies. This fund mirrors the performance of the Dow Jones Industrial Average, so it should be the most stable component of the portfolio. Its role is to provide stability to.....

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