Financial Planning and Wealth Management - Essay Example

? FINANCIAL PLANNING AND WEALTH MANAGEMENT Table of Contents Introduction and Background of the Case 3 Part Identification of Appropriate Investment Options 4 Part 2: Critical Evaluation and Justification of Alternative Investments 9 Conclusion and Recommendation 14 References 16 Introduction and Background of the Case A portfolio is group of securities such as bonds, stocks, commodities, and derivatives where an investor invests his or her money to mitigate the risk of holding a particular asset through diversification. Diversification of investment spreads the risk over many assets. The concept of simple portfolio diversification is that some securities may not perform as anticipated but other assets might exceed in performance making the actual return of the portfolio reasonably close to anticipated return. Investing the entire sum of money in a single stock exposes the investor to the risk of that asset. So, in case when the price of that security falls in the market due to any reason, the investor will suffer huge losses. This, risk of concentration of money in a single stock is mitigated through diversification. As per the preliminary interview conducted with a married couple named Kevin and Katia we came to know the following details: Katia aged 43, is a primary school teacher earning ?35,000 per annum and contributes 7.6% of her gross annual salary to the Teachers’ Pension Scheme. Kevin aged 45, is a construction site project manager earning ?80,000 per annum and contributes 6% of his gross annual salary to a defined contribution scheme. The couple has two children – Tilly and Jemima aged 7 and 9 years. The couple seeks advice for their retirement planning that is after 17 years when Katia is 60. The couple would like to achieve a combined retirement income of approximately ?45,000 in today’s terms. In addition to need to save for retirement, they anticipate some additional significant outflows to occur in the next 17 years which are as follows: The couple would like to fund the university fees for both children; Katia has indicated that she would like to purchase a holiday home in North Wales in 10 years time for which she has a provisional budget of ?100,000. The couple has little experience with investment products, though they have savings of ?30,000 (?20,000 in a bank deposit account and ?10,000 in a stocks and shares Individual Savings Account). Kevin has identified a range of investments that the couple might consider to help achieve their retirement planning objectives (including index-linked gilts, corporate bond funds, authorised investment funds and offshore equity funds) but is not sure about the option to choose. With an investment of ?10,000 annually a target of 7% is required to achieve their target objectives. Therefore, in this paper we would analyze and evaluate the various parameters to achieve the desired objectives and return. Part 1: Identification of Appropriate Investment Options Portfolio management is the fundamental work of investment management. It can be done by minimizing the risk through diversification. In order to manage an investment portfolio, three steps are considered by portfolio manager i.e. planning to execution to feedback. In the planning step, the objectives and policies of investment are formulated, strategic asset allocations are ascertained and capital market expectations are formed. In the execution step, a portfolio is constructed by portfolio manager. And, in the feedback step, the portfolio manager examines and assesses the portfolio compared with the plan (Villanova, No Date, p.5). The steps discussed here were in the short form. Taking in account the large form, the portfolio manager have to consider the following steps in order to manage his investment portfolio. The steps are as follows: Specification of investment objectives: In order to manage an investment portfolio, the usual objectives sought by investors are capital appreciation, current income and safety of principals. Choice of asset mix: Asset mix decision is the most important decision in the portfolio management. This is concerned with the proportions of bonds and stocks in the portfolio. The stock-bond mix mainly depends on the investment horizon and risk tolerance of the investor. Formulation of portfolio strategy: An active portfolio strategy attempt to earn better risk-adjusted returns by resorting to market timing, or security selection, or sector rotation, or some combination of these. A passive portfolio strategy involves maintaining a fixed level of risk exposure and holding a diversified portfolio. Selection of securities: For perfect portfolio management, in order to do stock selection, the investors usually go by technical analysis and fundamental analysis. Portfolio execution: The portfolio manager implements the portfolio plan by buying and selling particular securities in given amounts. Portfolio revision: Fluctuation in stock prices is a common factor. So, in order to manage the portfolio, the portfolio manager needs to do the portfolio rebalancing. It includes a shift from bonds to stocks or stocks to bonds. It may also call for security switches as well as sector rotation. Performance evaluation: The portfolio manager needs to evaluate the performance of a portfolio periodically. The key dimensions are risk and return and the main issue is whether the return of portfolio is proportionate with its risk exposure. These types of review provide positive feedback in order to improve the quality of portfolio management on a regular basis (Chandra, 2008, pp.13-14). Index-Linked Gilts – The government promises investors investing in its bonds an amount including an annual interest along with the principal amount at a predetermined future date. These gilts are being used as an alternative to U.K. pension funds as these gilts offer inflation protected cash flows. The securities have become expensive. They are generally related to the Consumer Price Index. The investor knows the real value of the bond since its purchase and the uncertain risk is eliminated. So it turns out to be a valuable investment for the investors. The risks involved in Index-linked gilts are that they are becoming expensive and the real yields are turning negative. These bonds now form a significant portion of the bond market in the United Kingdom. Index-Linked Gilts are less volatile than nominal bonds and help investors in maintaining their purchasing power. All sorts of indexing that is the linking the gilts to the Consumer Price Index is not based on market price, rather it is based on face value. There can be a loss in capital value if one buys the security at a price higher than its face value and hold it to maturity. The interest and principal payments will be attuned downward to reflect this, making nominal gilts a better investment in the event of deflation. The Debt Management Office issues linkers in auctions. The bidders need to be part of an approved group of investors to participate in these auctions. It can also be bought in the secondary market through brokers. The main risk that investors in the bond market face is inflation. With known forward stream of cash flows a bond investor purchases an asset. The investor will lose out if the purchasing power of those cash flows is battered over time. From the point of view of trustees and pension fund managers, one of the major priorities has always been hedging against the risk of inflation. The introduction of index linked bonds was not surprising given the demand from the UK’s pension fund industry. In 1981, index-linked gilts hit the market for the first time in UK. Offshore Equity - The main objective of the portfolio is to get adequate amount of long term growth in income for Katia and Kevin. In order to achieve this objective, substantial amount of the investment corpus should be invested into offshore equity class of assets and fewer portions should be invested in debt instruments. This is because, while the equity will ensure long term capital growth for the investor through proper diversification, debt portion of portfolio will ensure fixed and stable income for the investor. Proper diversification will help reduce the overall portfolio risk by spreading stock specific risk into combination of securities. Offshore equity assets are investment funds that are often traded as commodity in the stock markets. Longer time frame of investment will ensure elimination of short term volatility or fluctuations in the current prices. Authorized Investment Funds – The authorised investment funds in UK are authorised by FCA (Financial Conduct Authority) and hence are subjected to the rules and regulations under the act. These funds are generally regulated in the interest of investors and the two most popular regulatory structures with respect to UK are Open-ended Investment Companies and Unit Trusts. In the former case, the funds are structured on the basis of underlying company requirements and are generally managed by one fund manager (hence lower fund management expense). The later is a type of fund where fund assets also known as scheme property are held for investors by trustees that own the scheme property. The investors in this type of funds are direct beneficiaries and are also the owner of the fund unit. These schemes do not have any lock-in period and are hence very liquid assets and are often recommended by wealth managers. Corporate Bond Funds – These bonds are issued by corporations. The risk depends on the ability of the company to pay back the loan within the stipulated period or at maturity. These bonds carry a guarantee by the company issuing the bond. Companies issue corporate bonds in order to raise capital. They are a form of debt finance and are an alternative to equity financing from the stock market. Investing in a corporate bond fund which spreads the money from lots of investors across lots of corporate bonds is the safest way into corporate bonds for private investors. This diversifies the risk. One has to do a risk profiling and ascertain the investment objectives before investing into the bond portfolio. High yield bonds generally invest in riskier companies to get the desired high returns on the bond portfolio. Companies seeking moderate yield will only buy bonds of the most reliable blue-chip companies in order to reduce risk. When choosing a corporate bond fund it is necessary to find out whether the charges of the fund manager are taken from the income it generates or from the capital of the fund. Charges taken from the fund's capital will maintain quoted income levels but will reduce the capital, whilst charges taken from income will lessen the income returned to investors, but will allow the capital to grow. Part 2: Critical Evaluation and Justification of Alternative Investments A balanced portfolio is a combination of bonds and stock. For investors, investing in bonds and stocks plays important role in order to maintain balanced portfolio. They invest in stocks for investment growth and in bonds for income generation. Establishing a balanced portfolio by investors enables them to hedge against the ups and downs prevailing in the financial markets. By combining definite portion of equities in a bond portfolio, one can get a low risk profile and a better return. If the investors have more knowledge about the stock market and how it works and about what actually diversification is, they have more appetite for risk. There is a rule; if one is forty years old, then he should have 40% in bonds and 60% in equities, and if one is sixty years old, then he should have 60% in bonds and 40% in equities (Bennett, 1995, pp.68-72). On the basis of the information provided in the case regarding the income of Katia and Kevin as well as other relevant details discussed earlier, it is now possible to construct a portfolio that will fulfil their desired objectives: Total Investment ? 10,000.00 Investments Returns Weights Weighted Returns Investible amount Returns Returns after 17 years Index linked gilts 0.0178 0.28 0.0050 ? 2,785.87 ? 2,835.46 ? 45,098.06 Invesco Offshore UK equity income fund 0.0190 0.27 0.0051 ? 2,678.90 ? 2,729.80 ? 43,417.52 M&G UK Infl Lnkd Corp Bd GBP A Inc 0.1452 0.22 0.0323 ? 2,221.39 ? 2,543.94 ? 40,461.41 HSBC Specialist Investment Funds 0.1197 0.23 0.0277 ? 2,313.84 ? 2,590.80 ? 41,206.78 Total 1 0.0700 ? 10,000.00 ? 10,700.00 ? 170,183.77 Katia's Annual Income ? 35,000.00 Last Salary ? 2,916.67 WEALTH MANAGEMENT   Scenario: 1 Scenario: 2 Scenario: 3 n (years) 35 35 35 Monthly Savings       Avg return 5% 2% 2% Annuity rate 4% 7% 6%         Retirement Income Goal ? 45,000.00 ? 45,000.00 ? 45,000.00 Forecast Income ? 8,000.00 ? 8,000.00 ? 8,000.00 State pension ? 3,828.13 ? 3,828.13 ? 3,828.13 Income Gap ? 33,171.88 ? 33,171.88 ? 33,171.88 Present Value of Annuity ? 619,140.22 ? 429,498.57 ? 480,934.02 annuity Factor 18.66 12.95 14.50 PV (Savings) ? 143,255.08 ? 237,113.66 ? 265,509.67 Annuity Rate 5% 7% 6% 30 year Annuity factor 15.37 12.41 13.76 Yearly Savings ? 9,318.95 ? 19,108.14 ? 19,288.99 Monthly savings ? 776.58 ? 1,592.34 ? 1,607.42 Hence, on the basis of the above portfolio it is expected that if the investible funds are allocated in the proportion shown above then the weighted returns of Katia and Kevin would be approximately 7.00% and the projected retirement income would be ? 170,183.77. In order to estimate the expected returns from the investment after 17 years the time value of money concept was used. The discount rate was chosen higher than the minimum expected rate of return of the investors. The basic pension for Katia would be approximately ? 3,828 and the projected income at the time of retirement would be ? 143,255. The easiest way to save tax free is through Individual Saving Account. It enables to invest from cash to stock and shares to government bonds. Individual Saving Accounts are accessible from range of sources such as banks, supermarkets, building societies, investment firms, national savings, financial advisors, stockbrokers and insurers (Glasgow, 2011). To simplify the Individual Saving Account structure, the difference between mini and maxi Individual Saving Accounts has disappeared. Nowadays, there is only a difference between a Cash Individual Saving Account and a Shares and Stocks Individual Saving Account. This means that an Individual Saving Account can now include up to two different types of investment i.e. one is stocks and shares and the other is cash (Sutherland, 2003, p.280). Individual Saving Account investment growth does not usually incur a tax liability. It is flexible because it allows both regular fixed contributions and lump sum investments. In UK, Individual Saving Account is a tax efficient method of saving (Glasgow, 2011). Following latest changes in government legislation, the limit of future Individual Saving Account are tied to the Retail Prices Index. It is now possible for the people to transfer money which are held in a Cash Individual Saving Account to Stocks and Shares Individual Saving Account without affecting yearly allowance or the tax status of the investment. The index-linked gilts provide diversification in the client’s portfolio due to the correlation of inflation-linked bonds compared to the nominal bonds. Diversification is most useful in a portfolio at times of market stress and economic uncertainty. Often, we can find that the correlation is lowest at times of market stress and economic uncertainty. The potential for growth in case of index-linked gilts is huge. In spite of the good performance of inflation-linked UK government bonds last year and the slow pace of increase in the cost of living has not impacted the demand for index-linked gilts. The market for index-linked gilts is growing at a healthy rate. Interest is payable on all the gilts registered gross, without deduction of tax. The interest income received from the gilts must be declared on tax returns and is taxable. The Index-Linked Gilts represent better liquidity in the marketplace. The Index-Linked Gilt considered for the portfolio is UK Gilt Index-Linked Stk. carrying a coupon rate of 4.125% with maturity on 22nd July, 2030. The yield generated on the bond is 1.78%. It is a type of loan which includes gilts and bonds. It is used by companies and governments to raise money. UK government bonds are known as gilt-edged securities and the bonds which are issued by companies are known as corporate bonds. Bonds are useful for the investment fund’s managers in order to control income within the fund because it pay regular interest and are also repaid in full on the repayment date (Nestpensions, p.1). The regular returns from these securities will help the Katia and Kevin to accumulate savings and also purchase holiday home in North Wales in 10 year time period. The portfolio constructed for Katia and Kevin must be evaluated regularly by the wealth manager and based on the following key areas, the wealth manager has to periodically revise the weights assigned to different assets: Risk - Investments are subject to market risks and a rational investor always prefers to minimize risk over given investment return of maximize return over given risk. The risk profile of a portfolio is determined on the basis of risk appetite of investor. If the investor is risk prone then such investor would prefer investing larger portion of portfolio in risky assets such as common stocks or growth EFTs where as an investor with a lower risk appetite would prefer investing in safer assets to ensure protection of principal investment. The logic or procedure to determine the amount to be invested in risky assets is determined on the basis of time horizon, objectives, and diversification. Growth - The investor expects capital growth by investing in maximum 15 funds by using long term buy-hold strategy. In such case, greater weight age should be given to equities and debt portion may consist of tax exemption bonds that will limit tax liability of the investor. When the value of the original investment will increase over the years, then the objective of the portfolio such is long term capital appreciation. In the given case it is evident that Katia and Kevin have long term plans primarily in terms of their children’s education, purchase of assets, and plan retirement fund. These objectives will be achieved only when money is invested in close ended assets that have maturity period after which the investor experiences appreciation of invested capital. Taxation - Taxes are payable on capital gains which are arising from sale of securities. Generally, short-term capital gains are taxed at a higher rate than long-term capital gains. Therefore, higher tax on short term capital gains works as a constraint. Liquidity - Another important area to evaluate during money management is liquidity. All securities are not equally liquid at same degree which means that the liquidity of different asset classes will vary. For instance, gold is much less liquid than cash, when it comes to selling in a bear market. This is because commodities like gold are considered as safe havens and such asset classes have inverse relationship with market movements. In other words, when the market moves up the gold prices tend to come down and when the market moves down gold prices go down since people prefer to hold gold in bearish markets for safety of investment. The same relationship also holds true for Gold ETFs where significant portion of the portfolio is invested in gold. Hence, if the objective of the investor is long term investment such as securing children education with help of personal education fund, then this type of strategy of monitoring liquidity monitoring will be useful at the time redemption on or before maturity. Transaction Charges - Regularly buying and selling of securities for portfolio rebalancing may increase the transaction cost thereby minimizing the gains from portfolio rebalancing. Therefore, the transaction cost involved may act as a limitation towards timely revision of portfolio. Needless to say that higher transaction cost will lower the net returns of Katia and Kevin. Conclusion and Recommendation The wealth managers should actively monitor the fund performance in order to ensure that portfolio risk is within expected volatility range and if there are too many fluctuations in the portfolio then it needs to be analyzed and modified accordingly. References Bennett, R. A., 1995. Black Enterprise. Vol. 26. No. 3. New York: Earl G. Graves, Ltd. Chandra, P., 2008. Investment Analysis and Portfolio Management. 3rd edn. New Delhi: Tata McGraw Hill Education. Glasgow, F., 2011. Personal Finance and Investing All-in-One for Dummies, UK Edition. England: John Wiley & Sons. Nestpensions, No Date. Different Types of Investment. [Pdf]. Available at: http://nestpensions.org.uk/schemeweb/NestWeb/includes/public/docs/Different-types-of-investment,PDF.pdf. [Accessed 30 March 2013]. Sutherland, S. and Sutherland, P., 2003. The Fast Track to Financial Independence. England: Fast- Track Education Ltd. Villanova, No date. The Portfolio Management Process and the Investment Policy Statement. [Ppt]. Available at: www57.homepage.villanova.edu/shelly.../portfolio/.../chapter1st.pptx. [Accessed 30 March 2013]. Read More